Ferrara Smith & Humboldt (FSH) was in trouble. The fictional law firm had only one month's cash reserves and a maxed-out bank line of credit. FSH's business was slow and getting slower, and its accounts receivable were aging. Worse, not all of the firm's partners recognized that the firm was in peril. Several complained when this year's partner distributions were smaller than usual, and a few even threatened to leave the firm.
Unfortunately, FSH represents a classic case of serious undercapitalization. In isolation, sluggish growth, lost clients or slow collections may seem like signs of a temporary rough patch. However, if a firm with inadequate partner contributions, for example, experiences several negative financial events, it may not even realize it has hit the iceberg until it is too late. The best way to avoid sinking is to know what your firm needs, and to do everything to meet those needs.
Estimate the Amount
All law firms need two types of capital:
- Working capital to fund day-to-day operations and
- Long-term capital to buy large assets and make strategic investments.
This may sound straightforward, but determining capital needs and meeting them is anything but simple.
Type of practice, overhead costs and the amount of revenue you reinvest are some of the items that will factor into your capital needs calculation. Capital to cover at least 12 months of operating expenses is a good place to start. However, if your income is unpredictable (for example, you work on a contingency basis) or you pay out-of-pocket expenses on behalf of clients instead of using retainers, you may need more.
To get a rough estimate, add your one-year operating budget to the cost of any major asset purchases and strategic growth initiatives (such as hiring new staff or opening a new office) planned for the coming year. Then, adjust that number for unusual events, such as the need to pay out a senior partner who is retiring. Because this quick calculation is intended to provide you with only a ballpark figure, consider asking your financial advisor to prepare a more comprehensive and accurate assessment.
What should you do if your firm is short of its ideal capital reserves or does not have the cash to fund a specific growth initiative? There may be a simple fix, such as billing clients more frequently and improving collections. However, you may need to look to one of your firm's other major sources of funds, such as partner contributions or bank debt (usually working capital lines of credit secured by accounts receivable or term loans secured by assets being purchased).
Whether you can secure capital through bank borrowing generally depends on your firm's financial history, current debt load and relationship with the lender. However, for many firms, asking partners to pony up from their own pockets is the easier solution to a capital crunch. Partnership agreements usually require partners to pay in when they join the firm and contribute additional cash periodically, either in equal shares or based on the previous year's distribution.
If these contributions are not enough to provide your firm with a healthy capital cushion, you likely need to revisit your partnership agreement.
Maintain Ideal Levels
No law firm should wait to act until it is in the desperate position of the fictional FSH. Indeed, steering clear of icebergs should be an ongoing priority. So, calculate your capital needs and do whatever it takes to maintain those levels. If you find your firm slipping, ask your financial advisor about sources of new capital or other possible solutions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.