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The need for capital is perhaps one of the most confusing and misunderstood issues among law firm partners. How much capital is needed is an even larger challenge to get agreement on. This article will help educate your lawyers as to the changing need for better capitalization, how to determine how much capital is needed and how to rationally (and safely) use debt in the capital structure.

We were vividly reminded of the relationship between the two with the demise of Silicon Valley powerhouse Brobeck, Phleger & Harrison, LLP. Such an event may bring home a nagging question about your firm’s finances. If you are looking for a quick guide to whether your firm has taken on too much debt, I will also provide some easy metrics that you can use as an early warning system.

How to begin

I am often asked what is the proper capital structure for a law firm. There are guidelines that this article will explore later on. But in designing a capital structure for any particular law firm one must first start with the purpose of the organization, the partners’ financial tolerance and the dynamic shifts in the marketplace over 30 years.

Most law firms operate on a modified cash basis of accounting. Partners generally have relatively modest buy-in obligations and are entitled to equally modest buy-outs. These partners do not view the firm as a vehicle to accumulate wealth or provide for retirement¹ , at least not in the value of the organization. There are good reasons for this that are best left to a separate article on law firm valuation. For now let’s accept the proposition that, for many, the business we call a law firm does not build wealth like many of the business corporations that lawyers serve. Speak with partners in these firms and you are confronted with a healthy dose of skepticism about the owners investing much of their own money in the form of capital.

There are some law firms whose owners view this issue differently and see the accumulation of an equity position as at least an important component of their personal balance sheet, if not also a component of retirement security. At these firms, one will gain a more receptive audience with respect to owner investment in the firm. Partners in these firms often rely less on borrowed money to capitalize the firm.

The role of debt tolerance

Partners, and collectively their respective law firms, have a range of attitudes about debt, personal risk, investment and the like. We all know the extremes. On one side, there is the individual who has no debt (no mortgage, no car loans, no education debt and pays credit cards in full each month), has a year of living expenses in cash reserves and invests heavily for retirement. On the other side is the individual who has borrowed heavily (home, second home, cars, education, credit cards), lives from paycheck to paycheck with little or no emergency cash — possibly there is a home equity line that can be tapped for an emergency, little is saved. We know such individuals, even partners with high incomes who span such a diverse financial picture.

The collective financial personalities of the partners are reflected in the partnership. On one side are the firms that carry no debt (including minimal accounts payable balances) — financing all fixed assets out of current cash flow, maintain three months of operating expenses in cash reserves at year-end, the partners take out 90% of their earnings each year (which are paid out before year-end) and have a line of credit so little used that their bank officer calls them up and implores them to draw down even if they pay it all back two weeks later just to show activity on the account. On the other side is the law firm with little cash, accounts payable is at least 90 days old, the line of credit is usually at its limit, even at year-end, debt is so high that the banks are constantly pressuring about covenants, last years’ profits are barely paid out by Labor Day of the following year, and to top it off they are so pressured to meet certain targets that last year’s books are left open, dare I say into February?

Most firms lie somewhere in between the two extremes, as do most individuals. The important point is that some individuals and some law firms have higher tolerance for debt than others. This “debt tolerance quotient” must be your starting point in designing a capital structure. Understand the risk tolerance of the organization, and accordingly of its partners.

Effect of changing growth strategies

Now consider how law firms have evolved over the last 30 years. Firm size and geographic coverage have exploded. Homegrown firms where lawyers joined out of law school and practiced an entire career with one firm have been replaced by firms with more lateral insertions than homegrown lawyers. Growth through organic means has been largely supplanted by growth through acquisition. Setting aside the cultural issues this raises, this growth strategy fundamentally alters the capital requirements of law firms. Acquisition growth tends to be a much larger undertaking, requiring even greater capital availability. One mitigating factor has been the shift from unfunded retirement programs to funded pension programs, either qualified or through insurance products. The latter has given rise to an opportunity to reduce capital requirements as post withdrawal income obligations are being funded currently.

What are they using all that capital for anyway?

Thirty years ago the then modern law firm needed modest capital to operate. Clients were serviced and billed for those services. The law firms were paid and in turn paid their bills and compensated their partners. In some respects that basic timetable continues today.

The business of law has become a much more expensive proposition. Everything from salaries and benefits to technology infrastructure to space and the need to market have increased. Still, if the basic premise remains, what are they using all that capital for anyway? Not an unreasonable question. Law firms need capital to cover the cash gap that all businesses have. They need capital for growth. Capital is also needed for the technology driven infrastructure of law practice today.

The cash gap in a law firm is the difference between when you pay your expenses and when clients pay you. For law firms, this number is about 105 days. Unbilled time usually turns over in 60 to 70 days. Accounts receivable turn over in 60 to 80 days. Accounts payable are generally around 30 days. With labor costs the single largest overhead item (usually paid bi-weekly or semi-monthly); the burden is aggravated because labor‘s cash gap is closer to 120 days. The resurgence of rampant associate wage increases in the late 1990s compounded the situation further.

What this means is that as you operate your business, you are likely to have paid for the services rendered before you have billed the client. This is part of the gap that generates the need for capital. If the business is growing, the cash gap is a more critical issue to understand and manage. It is possible to grow a business so rapidly, that you can literally grow it into bankruptcy. Why, because the growth requires ever increasing outlays of cash. Meanwhile the growth in cash receipts lag. If your capital is inadequate, you consume all of your cash and you are in trouble. There are law firms in America today who are in this precise position.

Think about what happens as you add an associate. Day one the associate begins work. Yours is an efficient law firm — the associate is put on billable work fairly quickly. So, by the end of the second week, when the individual receives their first paycheck, he/she is busy on client work. At the end of the month, the second paycheck comes; the associate is still busy. First of second month, benefits begin and the attendant premium costs are paid in advance (for some policies an additional month’s premium is paid as an advance deposit). Middle of second month, the partner returns the pre-bills to accounting and the third paycheck is issued to the new associate. End of second month, the bill is mailed to the client and the fourth paycheck is issued. By now you can see where this is heading. We are up to four paychecks by the time a bill has gone out (if you are lucky). And we have not mentioned about paying for the laptop computer or other direct marginal costs of the individual, let alone any incremental general overhead. Not to mention the 60 days or so till the client pays. Multiply that cost by inefficiencies along the way and then again by the number of associates you hire each year.

Consider technology costs. Computers that are obsolete after two to four years have replaced the typewriters that used to last 20 years. Worse yet, the typewriters were only purchased for the secretaries and today everyone has a computer (and many have laptops). Phone systems are more complex (and expensive). In fact, the entire communication infrastructure of a law firm has changed — phone, fax, voice mail, pagers, cell phones, e-mail, videoconference, Internet, integration of voice/data/video, PDAs. All of these marvels require technology infrastructure and highly skilled (read expensive) people to deploy and manage them. Add in copiers, printers, fax machines, scanners, video projectors, and inter-office communication. And all of that requires capital.

Clearly, whether its business growth, inflation of wages and overhead, technology advances or credit terms with suppliers and clients, there is a heightened need for capital. The primary sources for capital remain with the owners and their bankers. Landlords help, particularly when they absorb the initial cost of the build-out. This is not too dissimilar for those law firms that have purchased real estate to house their operations, since the partners of those firms must arrange for the financing of those investments through mortgage loans at banks, private placements or capital contributions. Leasing technology equipment has burgeoned as a means to create off-balance sheet financing to reduce the need for partners to finance these assets via capital contributions or debt. Today firms are equally likely to use leases, debt or cash purchases to acquire their technology, depending on the respective financing deals available when the technology was acquired.

The potential perils of debt

What does it really mean when you borrow money?

1. The organization can grow faster than it could if it was restricted to the capital supplied by the owners.
2. The cost of growth or fixed assets is spread across those who are likely to benefit from them.
3. You have to pay it back and depending on what you used it for, there may be some unpleasant tax consequences at that time.
4. The organization that provided the loan expects you to live within the bounds of the lending agreement.

And let us not forget leasing, it is debt, just off balance sheet. We are not talking about abusive off-balance sheet financing behavior recently made famous or infamous by a few large corporations. We are referring to standard financing techniques for space, technology, vehicles and other equipment. They do represent an obligation of the firm, and hence its partners.

Law firms, even recently, have dissolved over excessive debt burdens. It happened to Finley Kumble in the eighties and more recently to Brobeck. And once you begin to rely too heavily on debt financing it does not take long to find oneself in such a condition. Managing Partners talk about building “the platform,” adding people and offices like so many pins on a map. As that is accomplished so is the infrastructure of support and technology, space and build out, and marketing that require those people to remain for many years producing revenue to pay for the investments. It does not take much of a reversal in the number of people for the infrastructure investment to become an overwhelming burden on the remaining partners. Carried one step further, it does not take more than one or two significant client losses to initiate a cascade towards dissolution if one is not vigilant. There are numerous recent examples. Such is the fragile nature of professional service organizations.

Bankers and debt

One would think that all bankers would now be attuned to law firm fragility, having seen some of the public failures over the last few years. This is not necessarily the case. I have recently worked with two law firms in serious condition, both on the brink of possible dissolution, whose bankers seemed blithely unaware of the firm’s predicament. In fact, in one firm the bankers were pressing the firm to take on even more debt when the current debt was about to cause the firm’s demise. This is an indication that firms should not rely on its bankers’ underwriting to provide comfort in terms of capital structures. That analysis and decision is yours.

However, some bankers have become more astute at scrutinizing law firms as businesses. Questions regarding the nature and stability of the partnership structure, governance, management, and client base are now quite common. It is typical for a new relationship to involve an analysis of the firm’s five-year history of partner activity. How many were promoted from the associate ranks, lateral insertions, retirements, competitive withdrawals and the like. What do the organizational documents say about governance and management? Who are in these positions and for how long? What are the protocols for owners to buy-in and contribute capital? How much of current income is annually retained in the firm for future capital needs?

Questions regarding clients may likely include a list of the top 20 to 50 clients (in declining fee revenue) for each of the past five years and to indicate the client industry, nature of work, special fee arrangements, how they came to the firm and who maintains the relationships (yes, bankers understand about rainmaking). The patterns of growth or decline, client concentration, industry concentration are all part of the analysis.

Some banks extend their review to the associate ranks to gain a sense of what kinds of people decisions are being made. For longer-term loans or leases, this exploration may help uncover how the future of the firm will unfold.

Debt and taxes

Some law firms borrow and use the proceeds to compensate their partners. This practice may create a tax benefit to the partners in the year it is paid out, but this benefit reverses when the debt obligation is repaid to the bank. A brief explanation of the tax implications of such actions follows.

Partnerships. A partner computes taxable income on his or her share of partnership income and the pass-through items of deduction and credit. The partner receives a K-1 from the law firm summarizing this information. The partner does not receive a W-2, as employees do, because a partner is not an employee, but rather is self-employed. The cash distributions a partner receives from the law firm partnership may or may not correlate with the taxable income he or she must report to the Internal Revenue Service.

For example, if a partnership borrows $500,000 and distributes the funds to the partners, the transaction has no income tax effect for the partnership or the partners. The partners are often jointly and severally liable for repayment of the partnership debt. Interest paid for use of the money is a partnership expense, and hence tax deductible.

The good news: The partners receive the borrowed money free from income taxes. The bad news: When the partnership repays the bank, it uses fee receipts, which normally are used to fund current operations and partner draws. This reduces the monies available for partner distributions. The repayment of the loan is not a partnership expense. The partners report taxable income on the funds that were paid to the bank. For some partners, the prior year windfall has already been spent, and the tax bill represents a financial hardship.

Corporations. If a professional corporation borrows $500,000 and distributes the funds to the shareholders, the payments to the shareholders normally represent compensation that is deductible by the professional corporation and taxable income to the shareholder-employees. The shareholders pay the appropriate federal, state and local income taxes on the funds. The professional corporation pays interest on the full amount borrowed. Interest is deductible.

Some professional corporations use this technique to eliminate taxable income at year-end. Such actions become necessary because of differing loan amortization and fixed asset depreciation schedules or miscalculations in planning. However, such action should be minimal and rare. When used, the funds should be repaid in the first month or at least by the end of the first quarter of the following year to minimize interest costs. Until the depreciation/amortization imbalance corrects itself, the other problems reverse, or additional capital is raised; this use of debt will continue to be necessary.

If, however, the borrowed funds were simply an advance against future income, there will come the day of reckoning when the borrowed funds must be repaid, creating taxable income at the corporate level. The worst possible situation occurs at that time as the professional corporation pays federal, state and local income taxes on the taxable income. The shareholders not only have reduced their current income by repaying the debt, but also have given taxing authorities a significant portion of the original principal.

1 For the moment we exclude the remunerative aspects of compensation, benefits and qualified retirement programs, which in combination can provide for the accumulation of personal wealth and retirement security.