Money is essential to keep a law firm running, and Ed Poll explains some tips for creating capital even during tough economic conditions.

Law firms are businesses, businesses need capital to operate, and capital is tough to come by during a credit crunch. That is the dilemma facing many law firms of all sizes today. Lawyers might need new capital for any reason: to finance growth, recover from a disaster, meet unexpected expenses or purchase new technology. When cash needs exceed cash generation ability through client receipts, new working capital is a must. Otherwise the firm will become like a dehydrated athlete who may be able to continue exertion even after body fluids are dangerously low – until there is a collapse or even death.

It would seem that law firms should be able to find a way to accumulate capital, with minimal tax consequences, in order to fund their needs in a down economy. But, lawyers generally don't think this way. A number of years ago, the accounting industry seemed poised to make big inroads into the legal sector – until Enron hit and major public accounting firms retreated into their shells. One reason accounting firms were confident they would succeed was because they could create a capital fund, while lawyers (with a shorter-term vision) seemed to draw down their capital every year based on tax advice to clear out the firm’s cash before December 31. Such thinking is no longer feasible (if it ever was) in today’s credit markets. So this raises the question: how can lawyers raise cash?

Capital Call

The traditional method of capital infusion for firms is a capital call from their partners. Media reports indicate that a number of top law firms are asking their partners to increase their capital accounts and/or are reducing the partner distributions, all in an effort to raise more cash for the law firm. At least one megafirm has “invited” income partners to make a capital contribution to the firm in exchange for an ownership stake. This is not as good a strategy as it used to be. Partners who are themselves financially thin may have to ask the bank for help in order to satisfy the capital call. To get the personal loan needed to fulfill the capital call, the lawyer may have to mortgage his or her home, pledge other assets as additional collateral or even get guarantors.

This is obviously an uncomfortable situation, but it is the price of law firm ownership. Being an owner means being the last person to receive financial benefit from the firm. Staff and associates come first. Vendors and suppliers come next ... and then owners. It means that you are personally responsible for the debts and liabilities of the firm. It means that you lay awake at night wondering how to improve the efficiency and growth and profitability of the law firm. Seen in this light, a partnership requirement to contribute more to the firm can be a call to action for partners to make the firm better at its use of capital.

Credit Line

Law firms may have credit lines, in which the firm borrows and repays at will up to the amount of the credit line. But, given the headlines about lawyer and staff layoffs, banks may be reluctant to give credit to any law firm customer. This is particularly true because credit line terms can fluctuate substantially, however the bank dictates. Banks often set formal credit line amounts, such as three times the monthly expenses excluding partner draws. The bank also usually prefers that the law firm borrower be out of debt for at least 30 to 90 days each year. The firm may be able to borrow and repay at will up to the amount of the credit line. However, the line of credit is reviewed regularly by the bank and extended, cut or terminated as circumstances warrant.

Too often firms are tempted to use credit lines for payrolls, partner draws and tax payments in anticipation of collecting on accounts receivable and then fail to collect enough to cover the borrowing sufficiently. The result can be a damaged credit rating, not to mention potential civil and potential criminal penalties. In today’s difficult credit market, when banks are even unwilling to lend overnight to other banks, lines of credit are in danger of tightening or even drying up entirely. The simple fact is that banks need to be assured that they are going to be repaid or they won't loan money. When even large law firms run into financial and economic difficulty in today’s market, banks are going to be much more cautious in extending credit to any law firm customer – especially one that views a line of credit as a blank check to use at will.

Bank Loan

Most typical is a term loan, which can be as long as seven to ten years for a large law firm, three to five for a smaller one. In a revolving line of credit, the firm obtains a designated sum which is converted to a term loan, repayable over a period of from two to five years. And there are specialized loan transactions such as an equipment term loan, in which the amount provided to purchase new equipment will normally be no longer than the depreciable life of the law firm’s equipment, usually three to five years.

It’s important to remember, especially in this era of tighter credit standards, that bankers view and understand any law firm as a business, with cash flow, receivables, revenue and profits. Lawyers should educate their bankers on how their business operates in order to build a relationship of trust. That means documenting clear plans for cash and receivables management, marketing and business growth. It means establishing your qualifications under the “Four Cs” test (character, capacity to repay, capital and collateral). And it means having a high credit score by any of the various systems used. All this should be established before the firm ever needs to seek a loan. Then, when “crunch” time comes, the foundation established will be one on which the firm and the banker can rely in a loan transaction.

Client Collections

It cannot be emphasized too strongly that the best way for law firms to raise capital is to promptly collect the billings due to them. In today’s economy, more than ever, firms should not be banks that carry their client’s expenses. Stipulating payment rates and terms in the engagement agreement is the best way to get paid. This is particularly true when the client accepts a budget and understands what to expect, which increases the chances of collecting the fee significantly. Shared expectations, effective communication and dependable follow-through by law firm and client all define the kind of good relationship that results in collecting a higher percentage of the firm’s billings.

If the client hasn’t paid the fee while the firm continues to work on and bill for their matter, the client essentially gets a no-cost loan. Do not do this with a vague hope of being paid as expenses pile up. The engagement letter should clearly state the consequences to the client for failure to honor the agreed-upon payment commitment. Keep track of when clients are behind on their payments, and be firm in requesting payment. In a worst case situation, the ABA’s Code of Professional Conduct, Rule 1.16, allows lawyers to withdraw if the client has not met an obligation to pay and the firm has given adequate warning that representation will end. That is extreme, but is preferable to continuing to do work for which there will be no payment.

Stock Market?

Some suggest that law firms may be in the same position that investment banks were nearly 40 years ago – facing a switch from partner ownership to public ownership as a way to raise equity capital. In fact, outside the U.S., the first steps are already being taken. In 2007, in response to changes in the law that allowed non-lawyers to invest in law firms, the largest class action law firm in Australia launched the first-ever law firm initial public offering (IPO) and raised nearly US$30 million in equity. In the U.K., the 2007 Legal Services Act that authorized new alternative business structures for solicitor firms has theoretically cleared the way for such firms to list on the London Stock Exchange or Alternative Investment Market (AIM).

The thought of a U.S. law firm taking a similar step may seem remote. Ethical rules (Model Rule 5.4) prohibit firms from selling equity shares in law firms to non-lawyers by stating that a lawyer shall not share legal fees with a non-lawyer. Also, stock sales might force lawyers to put shareholder interests above duty to clients, and create conflicts between the attorney-client privilege and Securities and Exchange Commission disclosure requirements. Nevertheless, some commentators suggest that the doors to public ownership that have opened in other countries will eventually open here. Before anyone thinks it can’t happen, recall the fate of some of the largest law firms, investment banks and corporations that in essence ran out of capital during the past year. The demise of these organizations was once as unthinkable as law firms being listed on the stock market might seem today.

Lawyers are creative and capable of finding alternative paths to address an economic reality, the need for capital and continued growth. For example, I was approached just yesterday by a lawyer seeking my help to buy a small law practice. After some inquiry, I learned that she was being funded by a foreign investor. Under current rules, the foreigner could not own a law practice. But, that didn’t stop either the investor or the local lawyer from creating a structure satisfactory to them that skirted to local rules of professional conduct. Form over substance, but legal. The new economy may produce a new environment for law firm change.

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Growing Your Law Practice in Tough Times
By Edward Poll

Following the worst economic crisis since the Great Depression, and facing a sea change in clients' demands and expectations, law firms must respond and adapt quickly and effectively. Law firms must choose the kind of law practice they will be; the marketing and business development tactics they will use; the overhead that is critical to their functioning; how to price, bill and collect for services; and how to manage the cash flow cycle. Success lies in identifying and capturing the right kinds of clients, providing the services those clients need in ways that add value, and ensuring prompt payment and the ability to grow profits. This book, based on the experiences of the author and his clients over 20 years of coaching and consulting, provides the keys to successfully thriving in the new era.

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Special New Release Price: $79
Regular Price: $120
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