There are certain things I wish someone had discussed with me about finances and running a practice before I started. I hope this article helps someone down the road—I certainly learned the hard way.
The most important advice I can give any lawyer is you are not a certified public accountant (CPA). Hire one. A great CPA can be an incredible tool in your practice. A CPA is not someone who just prepares your tax returns. A great CPA is a partner who can help you do your tax planning, bookkeeping, reporting, budgeting, and financial planning. More importantly, a good CPA will provide you with information and relieve you from math so that you can focus on strategic planning for your law firm.
What Are the Costs of Running a Law Firm?
Although we like to think of the practice of law as a service profession, for us to be successful practitioners and best serve our clients, we must think of the practice of law as a business. The costs of running a law firm change over the life cycle of the firm and can also vary with the practice area and size of the firm.
The biggest mistake you can make when running a law practice is not having a budget. What is a budget? A budget is an estimate of your projected expenses and income.
Should your budget be daily, weekly, monthly, yearly, or longer? A good budget is one that you can modify to look at statistics for your expected expenses on daily, weekly, monthly, three-year, five-year, and perhaps even ten-year projections. The budget is your measurable monetary dashboard showing whether you are achieving the goals of your business. You strategically focus your practice by comparing your budget to your actual expenses. It is not something you do once a year, like taxes. A budget is a tool to help you run your practice daily in a financially effective manner.
If you are just starting a practice, you will have difficulty budgeting, which means you need to do your research to develop your budget. Some of the basic start-up expenses include a phone, computer equipment, business cards, rent, supplies, office furniture, Internet, various insurance, parking, employee salaries and benefits, research services, software, and a car. The expenses will depend on your practice area. If you go to court, your expenses might be different than if you are a transactional attorney. The important thing is to try to come up with every expense you anticipate and build it out for at least three years on a monthly basis. One of the ways to learn about finances is to speak with practitioners who are experienced about the costs where you practice. Quite frankly, the best way to learn the expenses of a law firm is to work in one for several years. The operating expenses of a law firm are not something easy to understand unless you have seen a firm in action—including its financial ups and downs over time. One of the reasons that many firms wait several years before making an associate into a partner is to educate the lawyer on firm finances.
Once you have your expenses in place, you can now budget for the income. You will budget your income to cover your expenses (hopefully). Once you have the number that you need to generate for income each month, you need to figure out how you will generate the income number. Calculating your income is also complicated and depends on your practice areas, as how your income is generated can vary from a personal injury practice, to a litigation practice, to a transactional practice. It is not as simple as putting the same income amount in for each month of the year. Generating the income to meet your budget is a topic for another article.
If you have been practicing for a while, budgeting for the next year might be a little simpler. Many times, you can take the previous year’s income and expenses and make reasonable projections for income and expenses for the next year. Just realize as your law practice matures, so do your expenses and income. For example, you will need to budget for advertising expenses, digital backups, physical storage, etc. It’s also important to remember the nickel-and-dime expenses such as coffee for clients or gifts for employees. All these items make a difference in the success of your practice. Moreover, income projections change as you grow in your practice and clients leave and new clients are retained.
Having a budget is not enough. Once your budgets are in place, you need to use the budgets as a tool. It is important to regularly compare your budgets to your actual expenses and income. Doing so on a regular basis will prevent unexpected problems in cash flow and will guide your decision-making process. For example, if your bar dues increase, you can reduce CLE expenses to compensate for the reduction. Or if you lose a regularly income-producing client, you can focus your efforts on generating incomes in other areas.
What Bank Accounts Do You Need for Your Business?
Just like having a CPA, having an excellent banking relationship is critical to a law practice. The first step is to find a bank that is familiar with the intricacies of banking for law firms in your state. Many banks do not understand state restrictions on trust accounts and procedures. Interview banks to make sure you are receiving favorable interest rates on deposits and receive minimal or no charges or fees.
Also important is to reconcile your bank accounts monthly. In this electronic age it is easy to get complacent in managing bank accounts. However, a good business practice is to properly account for your monies regularly.
Operating accounts. An operating account is generally used to pay your business expenses and deposit income. This is a very important account for preparing tax returns, for budget planning, and for the basic operations of the business. It is also a good idea to have a separate operating account for bill payments and electronic payments. Having a separate account that has minimal funds for electronic transactions can prevent fraudulent transactions from hitting a large amount. When opening operating accounts, make sure you are aware of balances and the Federal Deposit Insurance Corporation (FDIC) insurance amounts.
Trust accounts. This is also an important account to keep track of your client funds. Some practices require more than one account depending on balances and the type of clients. You must understand your state bar rules regarding managing trust account funds. Some states require special procedures to set up such accounts and special accounting rules. It is critical that you read the trust accounting rules in the state where you are licensed and practicing. Failure to properly account for trust account monies is one of the most common reasons that attorneys are disbarred. A good practice is to never tie your debit card to a trust account. Also, make sure your trust account does not have electronic transfer capability. Losing money from a trust account can be devasting if the account is compromised. Protecting the trust account in every way you can is protecting your law license.
Payroll accounts. Generally, it is a good idea to use a separate account to pay employees. A payroll account is used for wages and payroll taxes. Often these types of expenses are electronically transferred to employees and also to taxing authorities. Keeping this account separate is important to prevent unauthorized withdrawals.
Escrow accounts. An escrow account or several of them may be needed in various practice areas such as real estate or business closings. Depending on the amounts in question, a separate account may be necessary for each transaction.
How Do I Finance My Business?
There are two basic ways to finance a law practice: equity and debt. When selecting funding, the advice of a CPA is critical to help you select the most advantageous financial position. Armed with a budget and a CPA, you will be in the best position to determine which method of financing is best for your firm.
Equity financing. Equity is financing the business with cash. In general, only law-licensed individuals can fund a practice and take an ownership equity interest. An equity interest is completely at risk and may or may not be paid back. Partnering up may be one way to finance a law practice, as is utilizing individual savings. If you invite other lawyers to join your business, you need to develop appropriate business entity documents to finance your business in your state. You may need a partnership or corporate entity. The funds deposited to the firm need to be properly accounted for.
Loans and credit cards. Loans and credit cards are types of debt financing. There are many types of loans that can finance your business, and once again research is key to determine the right option for your practice. If you are purchasing an office, you may need to obtain a secured real estate loan. You may need an unsecured loan to tide your business over for operating expenses. Many law firms look to small business loans to finance their practices.
Many law firms utilize credit cards to finance short-term expenses. Utilizing credit cards also requires research. Many bar associations, including the American Bar Association, have providers that you may use. It is important to review the interest rate and other perks such as cash back or points.
Factoring receivables. Factoring receivables is a process of essentially selling monies owed on cases rather than collecting the fees due. This allows your firm to receive a cash flow more quickly to grow your business. Factoring is essentially selling the amounts due and payable to a firm for a lesser amount to get paid faster. Various companies purchase receivables at various rates, and it is important to research the charges. It is also important that your fee agreements comply with your jurisdiction’s requirements regarding proper disclosure to clients that fees due and payable may be factored.
Litigation insurance. One of the new ways to finance and protect your firm is litigation insurance. Litigation insurance is generally used in contingency cases. If a case is lost, costs are generally covered by the insurance; if a case is won, the costs are reimbursed. It is important to make sure your state bar allows such financing of litigation costs.
Lease contracts. Although most lawyers do not think about leasing as a way to finance a practice, the reality is most lawyers and law firms use leases every day to run the business. The most common lease is a cell phone contract lease, which everyone is generally familiar with. However, leases are available for many of the tools needed for law practices, such as computers and automobiles. It is very important to incorporate such leases into your budget. It is also important to read your lease. You would be surprised how many lawyers running law firms fail to read the terms of the contract before signing.
Summing It All Up
This article only summarizes a few basic financial considerations of a law practice. Unlike other businesses, bar rules impact financial considerations in numerous respects, such as equity financing and trust accounts, which makes the financial aspects of the business challenging. The basic principles remain the same, but they are rarely followed on a daily basis by practitioners. Don’t just blindly run your firm’s finances or you will become one of the many law practices that fail. Running a law practices is more than just hoping the income from your next case covers your expenses; it requires careful and thoughtful long-term financial planning for success.