Many opportunities come with dollar signs attached. It could be the chance to hire a well-renowned lawyer with a skill you want to add to your lineup, or a boutique firm that has become available and would fit into your firm’s line of services. Or maybe you want to update your office to attract the best young graduates.
Problems have dollar signs too – such as clients paying late or disputing an invoice, which can interrupt the firm’s cash flow. Or it could be that upgrading to a new version of a critical software package requires a major upgrade of the computer network.
Would your firm have access to the money required, particularly if acting right now will help the firm seize the opportunity or avoid a major loss?
Building an effective capital strategy, so you have financing available when needed, begins with getting a good picture of your current financial reality. This starts with some of the metrics that your firm probably already tracks, such as average hourly rate, utilization, and billable hours per month. But many firms do not take the next step, which involves drilling down into their financial performance. One of the most important ratios to track is Return on Capital Employed (ROCE), which shows how well the firm is generating net profits from the amount of capital held by the firm. That capital mix would include partner loans, bank borrowings, capital contributions and undistributed earnings.
A recent benchmarking study by a midsize accounting firm in the UK found that there is significant variation in ROCE among law firms, with larger firms outperforming smaller firms. One possible reason, the report suggested, is that the larger firms are able to ask for larger buy-ins from partners joining the firm, partly because those lawyers are already well established in their careers.
Why do law firms face increasing demand for capital?
A recent study of law firms in Toronto found that mid-market firms face increasing demands for capital spending. This may be due to a need to continually upgrade the computer equipment and software needed to generate future earnings, or paying more for operating expenses such as online databases and rent.
As a result, all partners in a law firm need to keep an eye on their firm’s ROCE, even as they track billable hours for themselves and those who report to them. They also need to inform themselves about how capital works. Through good capital planning, the firm has the financial strength to seize opportunities and deal with problems before they have a chance to get serious – without undue strain on the firm’s ROCE.
Here are five principles for wise capital strategy by law firms.
1. Borrow wisely
Because your firm can usually borrow money at an interest rate that is lower than individual partners would pay, firm-held debt can be better than partner capital/loans. Investigate your options in this area, including whether your firm should pay its partners interest on partner capital – our experience working with law firms has found that some firms pay interest, and some don’t.
2. Build loyalty through financial commitment
Aside from providing capital for the firm, one of the biggest benefits of partner loans is that the partners feel more committed to the firm. They tend to think not just of their own interests, but those of the firm as a whole. This means that they are less likely to engage in risky behavior that might threaten the value of their investment. They also feel invested in the firm’s objectives and more willing to take on roles such as mentoring junior staff.
3. Be accessible to potential partners
If you’re trying to attract the best and brightest lawyers to become partners, don’t let financial barriers stand in their way. They may find the need for financing to be daunting. Many lawyers want to become partners in a well-renowned firm, but this often happens at a time when they have many other financial stresses – maybe starting a family or buying a home. If you can help them become a partner in your firm without adding to their financial burden, this can push your firm to the top of their list for consideration.
Provide backing for the finance required, possibly using the firm’s access to lower-cost capital than would be the case if the partner went shopping for a loan personally. Many financial institutions have a division that focuses on professional loans, working with law firms to facilitate partner acceptance.
4. Adapt to the times
The economy as a whole – and the financial fortunes of law firms – have their ups and downs. Prepare for this reality by adapting your capital strategy to economic realities. This can include reducing your firm’s financial risk during the “down” times, so that permanent capital (money invested in hard assets such as computer networks and office furniture) is funded by long-term sources, including partner loans. Working capital, which helps the firm cover payroll, rent and other operating costs when incoming cash flow is delayed, is funded by undistributed earnings and short-term bank borrowing.
5. Get the right professional support
In the same way your firm’s clients bring your firm in to provide legal expertise they do not have in-house, law firms need to seek professional counsel in areas outside their expertise. In many cases, capital strategy is one such area. External advisors can help your firm understand its current capital structure, and based on experience working with other firms, can help you set up a strategy that works. In this way, capital will be available when needed to seize upon an opportunity or to deal with a problem before it gets serious.