No firm is too big to fail

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Published on 12/15/08

The largest law firms, which not too long ago were in the headlines for record high starting associate salaries and profits per partner, now often gain notoriety for their layoffs of lawyers and staff — and, in rare but highly painful instances, their actual demise.

Heller Ehrman and Thelan Reid may be extreme examples of the recession's impact on Big Law. But, a strong case can be made that the demise of law firms is caused more by poor business judgment of lawyers than economic headwinds.

Expanding without a safety net, relying on only a few big clients while making capital expenditures based on the continuity of that revenue, and failing to address a declining realization rate are the real reasons for many law firm troubles.

How can law firms with hundreds of skilled and intelligent lawyers collapse in a matter of months, even weeks? The answers offer an important lesson in running a law firm.

Expansion is always expensive and must be planned. After every merger or office opening there will be a period when expenditures are greater than revenues. Most law firms are not "cash and carry," necessitating the extension of some credit in the form of increased accounts receivable. Though profitable, accounts receivable don't get collected fast enough to pay expenses without borrowing, and credit lines have limits. Good planning requires either a slower pace for growth or larger line of credit.

Partner defections must be expected in today's world. There is less loyalty to the firm today. Strong firm cultures bonding lawyers together are harder to find. "Free agency" is the rule of the day, and personal compensation is the top priority. Decisions to relocate a practice are made on the published RPP (revenue per partner) and PPP (profits per partner) statistics. As in baseball, free agency will strip many stars away from a law firm. Once the rumors of economic challenges and partner dissatisfaction are in the open, law firms and head hunters come knocking. A few partners leave, then the landslide begins.

When any one client represents more than 10 percent of business, the firm is at risk. This was the case with Heller Ehrman, when a number of large cases suddenly settled. Losses can also occur when a major client is acquired by another company, or when the client has financial difficulties and either can't afford legal services further or actually disappears. The client can also leave because of dissatisfaction with the legal services received. Whatever the reason, the result for the firm is the same — economic hardship. When expansion or capital decisions are made based on sustaining the revenue from these large clients, the law firm is at serious risk.

When the "tipping point" is reached, it's too late to arrange a merger. A marriage while one partner is sick is very unlikely. Whether because of rumors, intuition or due diligence, potential merger candidates will inevitably pass on a firm in trouble. Sometimes even bargain sales are not attractive. If the firm eventually survives, potential suitors might be remorseful that they didn't act; but acquiring a troubled firm is fraught with too many uncertainties and doubts.

Not long ago the phrase "too big to fail" seemed to hold logic in most business sectors. Today we realize that no investment bank, no automotive manufacturer and no law firm is too big to be immune from poor business decisions.

A tough economy might give the final push, but anyone who manages a large organization to its demise should remember Shakespeare's observation: "The fault is not in the stars, but in ourselves."

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