Where Will the Cash Come From?

08/01/2011
Reprinted from Greater Los Angeles Leadership Exchange
August/September 2011

The financial health of any law firm ultimately depends on cash management. Too many firms operate like small businesses on a cash-in-hand basis, with insufficient reserves to weather a crisis. They typically draw down their capital every year based on tax advice to reduce cash before December 31. However, this leaves them little or no reserves to meet emergencies or contingencies or to make capital improvements and expand the firm. Such thinking is no longer feasible (if it ever was) in today’s tight credit markets. So this raises the question that often confronts financial administrators: what are the best strategies to raise cash? There are four traditional answers, and one that appears to be emerging.

Capital Call

The traditional method of capital infusion for firms is a capital call from their partners. 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, and in return may need to get a second mortgage, pledge other assets as additional collateral or even get guarantors. 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 do have credit lines on which the firm borrows and repays at will up to the limit, but usually at least once per year. Banks are much more reluctant than they were before the recession to give credit to any commercial customer. Moreover, credit line terms can fluctuate substantially, however the bank dictates. Banks often set formal credit line amounts, such as three times monthly expenses. 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. In short, a line of credit is not a strong alternative.

Bank Loan

A term loan, which can be for 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 might obtain 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 a law firm’s equipment, usually three to five years. To get any kind of loan, firms must demonstrate the strength of their financial controls and business model, and have a high credit score in hand.

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. That means firms should not be banks that carry their client’s expenses, and should not offer discounts on fees that have been agreed upon. Stipulating rates and terms of payment 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.

Investors

Model Rule 5.4 prohibits firms from selling equity shares to non-lawyers by stating that lawyers and non-lawyer shall not share fees, meaning that firms could have no investors other than the partners. However this has already changed in Australia and England, and is starting to change in the U.S. North Carolina considered a bill to allow 49% non-lawyer ownership in firms, while the District of Columbia permits non-lawyers to own 25% interest in a law firm. This raises potential client confidentiality and public disclosure concerns, but not enough perhaps to overcome the desire of large firms to grow as big as their corporate clients. This issue could cause the breakup of the mandatory (integrated) bar association into state licensing agencies for large firms (just as corporations are licensed now) and voluntary bar associations serving the economic interests of sole and small firm practitioners – another potential complication in the administrator’s life.

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