By David Bilinsky and Laura Calloway
In her book The Rich Nations and the Poor Nations, Barbara Ward wrote, "There is no human failure greater than to launch a profoundly important endeavour and then leave it half-done." Those are wise words of caution for lawyers thinking of launching a firm without adequate capitalization.
The title of this column is Profitability, and from our first installment onward, we have tried to give you information that will let you check under the hood of your law firm to measure its bottom-line financial performance. Before going forward with this type of analysis, though, we need to pause to say a few words about financial stability.
Profitability and financial stability are not necessarily synonymous. Think of a mighty oak tree, which can appear healthy and robust until it is toppled in a strong wind because its core has rotted away from the work of years of rain and insects. In a similar way, law firms can provide high profits per partner—for a while, at least—but have internal problems, which, if left unattended, will almost certainly result in the firm's eventual demise.
One of the attributes of a financially stable law firm is adequate capitalization. In this issue, we wish to talk a little about capital.
Most lawyers, if they give it any thought at all, think that the only capital needed to start a law firm is the stuff between their ears—the education they received in law school, the experience they've gained in working with clients and handling cases, the contacts they've established, and the relationships they've built with those people. These things are, of course, a lawyer's most valuable assets. And when combined with some legal pads, some pens, access to the county law library, persistence and 20 or 25 years' experience, they once guaranteed a successful practice. Unfortunately, that is no longer necessarily the case.
The type of capital just discussed is still necessary, but it doesn't show up on a law firm's financial statements and, in and of itself, it is insufficient. Instead, to start a law firm in today's financial climate, one also needs the type of capital that can be defined as the wherewithal to obtain the tangible things needed to set up a firm and allow it to stay in business and grow. This type of capital comes in several different flavors.
First, there is fixed capital. It is represented by the long-term assets of the firm, such as any building owned by the firm, the library's contents (back in the day when libraries were actually comprised of books), and the other durable "infrastructure" needed to carry on the practice over the long haul. Put another way, lawyers seeking to establish a new practice—especially those expecting to seek help from their banker from time to time—should expect to invest enough of their own money in the practice to at least equal the start-up costs.
Then there is working capital. This is the funding necessary to make up the gap between cash needed to operate the practice—such as paying utilities and salaries and funding the expenses of ongoing cases—and cash coming into the office in the form of retainers and billing payments.
Finally, there is current capital. This represents the accrued profits that firm members have, one hopes, refrained from drawing out of the business. Current capital is a sort of "yin" to the "yang" of working capital and, if utilized correctly, ebbs and flows with the firm's business needs. Why, you ask, not immediately draw out profits as soon as they are available? Because current capital (or working capital, as it is also known) represents an investment in the firm's future ability to grow and meet the demands of increasing business opportunities.
Now that we understand a little more about what capital is, let's look at the role of capital in a law firm and what capital accounts can reveal about the long-term stability of the firm.
An adequately capitalized firm doesn't have excessive debt. Some would say an adequately capitalized firm doesn't have any debt. It all depends on your approach to risk, return, leverage and vulnerability to downturns.
The risk-management model views capital as the financial resources available to absorb unanticipated losses. For example, assume that you keep a "float" of $10,000 in your general account. Your monthly expenses average $7,500. That leaves a monthly cushion of $2,500. However, if for some reason your faithful client misses a $5,000 fee payment this month, you will be left with a $2,500 shortfall in your operating capital.
Ordinarily, you can cover that with a drawdown on your line of credit. But if your line of credit is already at the max, you are left scrambling—which typically means suspending payments on your accounts payable and forgoing your draw. You can see how the smaller your cushion is, the greater your vulnerability to economic shocks is. Accordingly, firms that operate by maxing out their debt to its limits and drawing down on working capital to pay out partners' draws or bonuses run very close to the financial cliff.
An adequately capitalized firm has the technology tools it needs to do the work. It is not operating on 8-year-old computers using software that hasn't been updated since Bill Gates made his first $10 million.
An adequately capitalized firm can afford to hire additional employees when the workload justifies it. It does not increase the workload on good employees until they flee for greener pastures.
An adequately capitalized firm does not turn down the "big case" for which the lawyers have been waiting their whole careers, or refer the case to another firm, because it lacks the capital resources required to finance the disbursements necessary to see the case through to resolution.
An adequately capitalized firm does not have to borrow to pay out draws or profits or to meet a partner's personal liabilities such as income tax.
In particular, the adequately capitalized firm does not spend time worrying about how to meet this month's payables and salaries.
So how much capital is adequate? Traditionally, the question was answered by looking at a firm's capital ratio, which is defined as:
Capital Ratio = Capital
and was expected to be between 4 percent to 10 percent (depending on the definitions of capital and assets used).
However, this model is somewhat inadequate because it fails to take into account the quality of the assets (meaning the risk inherent in the different assets, particularly the WIP built into the files) and, hence, the differing amounts of capital required by the firm.
To use more common metrics, capital contributions (permanent capital) are expected to be between $30,000 to $60,000 per lawyer in the firm. When you look at capital from the perspective of contribution per equity partner, then the benchmark for medium to large firms is between $75,000 to $150,000. (Of course, there will always be firms that have higher or lower amounts, depending on their practice area, geographic location, type, quality and amount of assets in the firm, number of equity versus non-equity partners and associates and other variables.)
While law firms as a rule do not tend to leave undistributed capital in the firm, there is a good case to be made that firms' operating capital needs have increased in recent years, driven partly by the need for increased technology. Accordingly, firms should be examining their capital requirements relative to their increased need to invest in technology. It may be necessary to increase the equity partners' capital contributions as a result, just to remain current and to keep the firm infrastructure in good working order.
Still another measure is the ratio between permanent capital and revenues. Typically, this ratio should be between 5 to 10 percent. This could be misleading, however, because as revenues drop, the ratio will increase. Thus, rather than just looking at this metric as a "snapshot," it may be better to look at it from year to year to see how it changes over time.
Lastly would be the ratio between permanent capital and equity partner compensation. This should normally be between 12 to 30 percent. But if your partner compensation climbs, then the ratio will diminish—potentially signaling trouble ahead for your firm. So either you need to rein in compensation or redirect the funds that would normally be paid out to partners as additional capital contributions. Otherwise, you are depleting the long-term assets of the firm for short-term gains to the current partners … and possibly impairing the firm's income-producing ability.
Law firms are unlike other businesses in that they cannot approach venture capital firms and trade an interest in the partnership for a capital infusion. Capital, if needed, must come from the partners themselves (by direct contributions or by forgoing draws) or by increasing the firm's debt. We've already seen how increasing the firm's debt load increases the firm's vulnerability to economic shocks.
Accordingly, firms need to be mindful of their future operating capital needs before increasing draws or paying out bonuses. It would be a shame if a group of lawyers launched a firm handling profoundly important cases, only to see it founder because they left the capitalization of the firm half-done.