April 2003  Volume 29, Issue 3
April 2003 Issue
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COVER STORY
10 Sure Ways to Fail:
Common Financial Mistakes & How to Avoid Them
by David J. Bilinsky and Reid F. Trautz
Finding your receivables high? Having trouble setting costs? Monthly invoices going out late? It's easy to do, but neglecting the financial side of the business of law can be the first step down a slippery slope to financial ruin. Few small firms have the luxury of professional managers to keep the firm's finances on the straight, true course. But help is here! If you've been frustrated by money management, pore over this list of the 10 most common mistakes small firms make-and how to get safely past them.

1. Don't Develop a Cash Flow and Financial Plan. Initially, lawyers do contemplate the financial side of their law practices. But in some cases, they don't give it all the attention it deserves-especially as things start to slide downhill. Don't assume that things will "just work out." The road to success isn't merely paved with harder work if you haven't kept your eye on the business fundamentals.

Timing is everything. Rent, salaries, other bills-all have to be paid on time or you do more than risk losing credit. You risk losing your business. When you combine overdue bills with clients who refuse to pay, or you delay making payments on your accounts, you can be caught in a financial squeeze.

Sit down and do the math. For an annual (12-month) period, prepare a month-by-month detailed budget. Build in all expenses that you know will occur, or that you can anticipate, and when they must be paid. Calculate in unexpected expenses, because it is a Murphy's Law that costs will always be greater than you anticipate, particularly as the volume of work increases. Build in marketing time and expenses. Most of all, build in your draw, because if you don't look after yourself, no one else will.
Compare the total expenses to your anticipated revenue. If you don't have a historical basis to forecast income, make an educated estimate based on your marketing plan. Yes, it takes planning. Financial security is rarely an accident.

2. Rely on Total Billable Hours Rather than Realization Rates to Track Progress. The realization rate is the percentage of actual income paid to the firm from the billable hours of each timekeeper. For example, Partner X bills 200 hours per month at $200 per hour for a total amount billed of $40,000. Of that amount, 10 hours are written down (taken off the books) for various reasons, and clients pay a total of $30,000. Partner X's realization rate is 75 percent. In contrast, Partner Z bills 165 hours at $200 per month, but she has no write-downs, and her clients pay 95 percent of that for a total of $31,350. Although Partner X bills more hours, because of the low realization rate, Partner Z-with fewer hours billed-is generating more income for the firm.

Your computer-based time and billing program should be able to create this report for you. Examine the results and use it to help guide any discussion of compensation for partners and associates.

3. Use Accounting Software that Doesn't Have Financial Modeling and Reporting. It's a given that you need good data to make good decisions. There are many good general and legal accounting packages out there. But recognize that accounting packages exist for accountants. As lawyers and business owners, we need software that will give us insight into how we are doing as business owners. So look for packages that build in as many management and modeling reports as possible.

Look closely at the software you now use. Unfortunately, most of the legal accounting packages out there put the powerful financial analysis tools into the "Pro" versions, which are suitable for larger firms. Solos and smaller firms face a Hobson's choice: Acquire the basic level of the software and forego the higher-end financial tools, or pay thousands of dollars for a full version that you will never use.

Although moving to a different accounting package may be a troublesome undertaking, remaining with one that doesn't help you run your business will be more expensive and troublesome in the longer run.

4. Fail to Regularly Reconcile Trust Accounts. A client trust account often poses a lawyer's greatest risk for ethics trouble. Yet it seems that one of the tasks lawyers quickly delegate is that of properly maintaining client trust (IOLTA) accounts. It is certainly acceptable to have a bookkeeper administer this function, but the lawyer must remain active in the oversight of the account. The lawyer should reconcile the account each month or thoroughly review the reconciliation completed by the bookkeeper. Here are quick tips to help keep your account in good shape:

  • Keep separate ledgers. In addition to the account journal (or general ledger) that has the running balance of how much money is in the trust account, you must create a ledger for each client on whose behalf you hold money. Also, create a ledger to record any administrative costs used to cover bank charges. (Your computer bookkeeping program may automatically do this, but if you don't know for sure, confirm it immediately.)
  • Never pay a client with cash; always have a check as a record. Do not use an ATM card to withdraw money, and never use a deposit ticket to get "cash back." Even a wire transfer isn't a good idea.
  • Don't disburse a check until the deposited funds have cleared. Be diligent, but don't let a client rush you. (It isn't even a good idea to issue postdated disbursement checks.) When you write disbursement checks, take a moment to add them up and compare against the client's balance in the trust account. Make sure there are funds available to cover the checks.
  • Have a good audit trail. In addition to the account statement and any canceled checks, keep a monthly folder with the following: copies of all checks deposited to or written on the account and copies of all deposit slips (your own copies-don't rely on the bank); copies of all disbursement statements or agreements signed by your clients and fulfilled that month; and a copy of your account journal (or a screen print from your computer) showing the account transactions for that month.
  • Reconcile your client trust account monthly, regardless of how boring the task seems. Compare your monthly bank statement to the canceled checks; the canceled checks to the copies you made before they left your office; the checks to the account journal; and the account journal to the client ledgers. Everything should match.

Many jurisdictions require that records of IOLTA accounts be kept for a period of years in case questions arise later. Check your state's rules to make sure you are in compliance. Organizing your recordkeeping now will save headaches later. Also, if you keep your trust records on computer, be sure to save the information before you decide to upgrade and discard your computer.

5. Don't Track Your Time. The first step in determining whether you were profitable on a sale of a service is being able to determine the costs of services delivered. To do that, you need accurate costing mechanisms that can include both direct and allocated (or fixed) costs.

Direct costs are your time, plus any direct disbursements incurred for the file-court reporter fees, filing fees and the like. Allocated costs are the file's share of the office overhead-staff salaries, rent, insurance fees, electricity rates and so forth.
Because the biggest direct cost is the time that you put into the file, you cannot determine what it cost you to produce a file unless you can track the time you put into it-billable, nonbillable, written off and so forth. When it comes time to distribute funds among partners, not knowing the true costs of the files worked on can lead to gross inequities. Most firms simply look at the gross revenue generated at the conclusion of a file, but this can be misleading.

Look at two files, each of which generated $100,000 in revenue (after disbursements). File A took three years and involved 400 hours of legal time (at $250/hr = $100,000) plus hundreds of hours of staff time. File B took six months and 100 hours of legal time (at $250/hr = $25,000) and the same amount of staff time. Which file was more profitable? Not only was B more profitable, you could argue that File A resulted in a net loss to the firm, since the total of legal and staff costs exceeded revenues. Don't make the mistake of treating these files equally.

6. Think You Don't Need a Fee Agreement with Every Client. Don't you believe it! It's important to communicate in writing with every client during, or immediately after, the initial consultation to define your professional relationship. Clearly defining whether or not you are acting on behalf of the client will help avoid any misunderstandings about the timing, scope and cost of your legal representation. Misunderstandings about the lawyer-client relationship often lead to the souring of the relationship-and to costly collection and malpractice suits.

A well-written fee agreement encompasses more than your hourly, flat or contingent fee. It should define the parameters of the work to be completed and address your obligations to the client and the client's obligations to you. It should also address your rights (for example, to seek withdrawal) and your client's rights (for example, to terminate representation). Be clear in the language you choose. Avoid legalese. Remember, because you are the person drafting this document, it is possible that any error or ambiguity may be resolved against you if a fee dispute arises later. Also, be sure to consult your jurisdiction's ethics rules regarding fee agreements. (See the sidebar on page 22 for tips on writing fee agreements.)

7. Put Off Dealing with Underperforming Lawyers. Generally, lawyers practice together because they perceive a positive economic relationship and, usually, genuinely like the other people in the firm. But in a smaller firm, failing to face up to the fact that "ol' Joe" isn't having a very good year (or years) can have dire consequences.
Schedule monthly meetings for the purpose of examining everyone's performance against stated financial goals: billable hour targets (WIP), WIP billed (bills rendered), bills collected, accounts receivable balances (net increase or decrease), accounts written off or deemed uncollectible, disbursements incurred, disbursements billed, disbursements written off and status of outstanding files.

If done regularly and honestly, this won't be a confrontational meeting. When everyone in the firm is required to report monthly to all other partners, you instill a culture in the firm that is self-correcting. If someone fails to regularly meet their financial goals, you have a decision to make and a forum within which it can be made.

8. Always Assume More Risk than Needed When Agreeing to Represent Clients. Many lawyers balk at the thought of turning down new clients. But ask yourself the following questions:

  • Looking at my present workload, do I have adequate time to devote to this matter? Or am I taking this client solely because it has been a while since the last client called?
  • Do I have the legal abilities and experience to handle this matter with the required level of competence?
  • Do I have the financial resources to handle this matter?

If you answer no to any of these questions, consider associating with additional counsel, or refer the client to several other lawyers you believe can handle the matter.
You should also assess whether you can accept the financial risks associated with taking the matter, just as clients will assess whether they can (and will) pay your fee. Spend time at the beginning of the relationship to learn if the client is able and willing to pay a reasonable fee for the legal work the client wants done. It's up to you to take the initiative to discuss fees and costs openly, candidly and comprehensively, preferably at the first interview. Look for danger signs in the client's story and demeanor to gauge whether the client will honor the impending commitment to pay your fees.

9. Avoid Having a Written Office-Sharing or Partnership Agreement. The purpose of having a written agreement between all parties in the firm is that everyone then knows the terms of the arrangement between them: the expectations, the consequences and the means to implement those consequences. Failing to have such an agreement between lawyers is the equivalent of a shoemaker's children running around barefoot.

Office-sharing agreements cover issues between solos sharing the same office suite. Common issues include management of the suite, lease payments, confidentiality, signage and sharing of the costs and services of common employees.

Every partnership agreement should cover management issues, capital contributions, income-sharing and compensation issues, disability, adding new partners, voluntary partner withdrawal, partner expulsion and dissolution. Further, every partnership agreement should incorporate the requirement for adequate life and disability insurance to ensure that, should someone die or become disabled, there is proper compensation for the partnership share, and that the firm can pick up the pieces and carry on the business. Inadequate insurance can leave a deceased partner's family and the remaining partners financially stuck or, worse, in litigation.

It can be very difficult to negotiate a partnership agreement. Be prepared for some tense moments. However, negotiating an agreement in advance is far less tense than litigating the issues later.

10. Rely on the Lottery for Your Partnership Retirement Plan. Lastly, another major issue facing smaller firms is how to deal with the introduction of new partners while funding the buyout of existing but aging partners. Without a succession plan that compensates aging partners over time by establishing a retirement fund, the firm might be unable to attract new partners. The reason is that prospective partners who are on the upswing may very likely be unwilling to contribute their billings to fund the exit of a diminishing partner. Make this planning part of your partnership agreement to ensure the future of your firm.

Sidebar: Build a Better Fee Agreement


David J. Bilinsky ( daveb@lsbc.org) is the Practice Management Advisor and staff lawyer for the Law Society of British Columbia. A past co-chair of ABA TECHSHOW, he is chair of the Pacific Legal Technology Conference and author of the ABA's Amicus Attorney in One Hour for Lawyers.

Reid F. Trautz ( rftrautz@dcbar.org) is the Practice Management Advisor for a Washington, DC, bar association. He is a member of the ABA Standing Committee on Solo and Small Firm Practitioners and a contributing editor of the ABA's Flying Solo (3rd edition).