The Great Recession's Lesson: Get Down to Business

Reprinted from:
Published 6/10

The operation of a law firm must be understood as a business-and in any business environment, financial health ultimately depends on cash management.

The Great Recession that began in 2008, and has yet to conclusively end, definitively showed law firms that, like any other sector of the economy, they cannot ignore the fundamental rules of business. These rules are nowhere stated in the statute books, but they are unquestionably part of a lawyer’s responsibility. Understanding the economics of law practice is a necessary part of the fundamental principles by which lawyers must offer their professional services because law firms are governed by the same formula that defines all business success: P = R - E, meaning profit equals revenue collected less expenses.

Although this concept is one that too many lawyers still resist, the operation of the firm must be understood as a business that depends on billings, collections, revenue and profits. Running a law firm in a businesslike way improves professionalism because it encourages approaching client service more efficiently—creating and adhering to a budget, stating clear payment and collection terms, providing sufficient details on clients’ invoices and so on. All law firms must provide value to their clients. And they must be profitable in order to open their doors the following day. The firm that runs its business so poorly that it must close its doors ultimately has failed to meet its fiduciary duty to clients.

Before the economic crisis hit, unfortunately, too many large and even midsize firms had gone their own merry ways for years, happily assuming that high associate salaries and partner draws, rising rates and leveraged mergers with other firms was a pattern that would continue indefinitely. But the Great Recession has forced law firms to sit up and pay attention to the consequences. Here are important lessons all firms should learn from the situation.

Manage Cash

Law firms are businesses and businesses need cash to operate, but, of course, cash is tough to come by during a combined recession and credit crunch. A law firm’s financial health, in any business environment, ultimately depends on cash management. Too many firms ignored this truth at their peril, operating on a cash-in-hand basis with insufficient reserves to weather a reduction in business. Cash flow problems invariably are the last symptom of a downward spiral that started long before, with inattention to business principles.

Cash flow fundamentally is the product of revenue. Every firm should know in exact detail the work done for its largest clients, how profitable that work is for the firm, and what opportunities exist to get more work. The loss of a large client with significant work is such a major risk that firms would do well to observe the axiom that no single client should exceed 10 percent of total revenue. Contributing to Heller Ehrman’s 2008 failure was the fact that the firm’s practice focused mainly on litigation and, when several major matters settled, the firm lost a quarter of its business with no replacement work in the revenue pipeline.

Firms should also make no long-term capital or other expenditures at the behest of larger clients without some type of assurance that their business will continue until at least the amortization for the new expenditure is completed. Otherwise, a long-term strategy based exclusively on fewer, larger clients will almost always lead to disaster.

All firms should create and consistently monitor a cash flow plan to spot cash problems and adjust the firm’s activities so that the cash flow can remain positive. Any dip toward zero or negative territory in any month is cause for serious consideration and evaluation. Failure to make necessary adjustments in revenues and expenses means failure to have a positive net free cash flow—and the firm will be in financial trouble.

Emphasize Receivables

It cannot be stressed too strongly that the best way for law firms to maintain cash flow is to promptly collect the billings due to them. Firm after firm has had to deal with the financial crisis even as literally millions of dollars in receivables sat on their books. In today’s economy, more than ever, firms should not be banks that carry their client’s expenses. Stipulating billing rates and payment terms in the engagement agreement is the best way to get paid. Engagement terms should clearly state the consequences to the client for failure to honor the agreed-on payment commitment. This is particularly true when the client accepts a budget and understands what to expect, which significantly increases the chances of collecting the fee.

Firms should no longer dismiss the importance or even the practicality of preparing a budget for a matter. Budgets define successful business planning and any business (whether it sells widgets or legal services) can and should operate according to a budget. Client involvement in the cost equation is here to stay and firms should involve clients in the budgeting process, get formal approval of the completed budget and communicate constantly about how expenses are tracking.

No firm should proceed on a vague hope of being paid as expenses pile up. Once bills have been sent out, firms must closely track clients’ payments and vigorously pursue collection on those that are behind. Forgetting or ignoring the receivables of "old" clients results in the failure to collect outstanding bills and dramatically lowers cash flow. The more lenient a firm’s terms to clients, the more cash it will need while awaiting payment. Conversely, tough credit terms (such as charging interest on unpaid balances) are likely counterproductive—clients who won’t pay their bill won’t pay the interest, either. Never give in to the temptation to extend credit in the hope that the client will offer more work. In a worst-case situation, end the engagement. ABA Model Rule of Professional Conduct 1.16 allows lawyers to withdraw if the client has not met an obligation to pay and the lawyer has given adequate warning that representation will end.

Reduce Overhead

All law firms have a finite limit to discretionary spending. Non-discretionary spending (payment of loans, utility bills and taxes) is mandatory. Anything else can be considered discretionary spending—overhead is the common term. Money spent for space and staffing may be hard to cut, but there are ways to do it. Money spent for technology and marketing offer additional and likely easier reductions, though not necessarily wise ones. Where to “cut” expenditures is always a painful discussion and care must be taken to consider the firm’s strategic plan and the economy’s impact on the firm. Every firm is different, but smart firms pursue overhead reduction throughout the business cycle rather than waiting until income slows.

This has held particularly true for large firms that grew through mergers. Combining law firms to make them bigger actually makes them better only when the parties have thought through what they want to accomplish and what synergies exist between them. Consider the former 600-lawyer Thelen Reid, which dissolved in 2008. When the firm announced its first layoffs, it stated that the layoffs were the result of not only a downturn in business, but of redundancies following the firm’s 2006 merger with a New York-based firm. Why did the firm wait two years to address such redundancies? Would it have advised corporate clients to do the same?

However, indiscriminate staff reductions are not always the right strategy, either. Too often, when driven by perceived or real economic pressures, firms have made hasty and harmful decisions by cutting attorneys too far too fast rather than transferring them to other still performing practice areas. These lawyers are trained in the culture of the firm, presumably capable, and often recruited at great expense and should be able to learn new technical skills. Certainly lawyers who do not generate the profit to cover their cost are candidates for layoff, but cutting without a measured assessment of what and where to cut eliminates muscle and not just fat. We will likely see the effect when the economy fully recovers and firms must scramble to catch up with client demand in a post-layoff environment.

Learn the Rules

Because they begin practice behind the curve compared to other service providers, lawyers definitely need better business sense. Most lawyers still enter law school with an undergraduate degree in the liberal arts. Law school curricula have little business focus, and many professors view the law as a profession in which any business training is trade-oriented and therefore inappropriate for law schools. The problem is too often perpetuated throughout a lawyer’s lifetime by a lack of professional training in management and client service issues. Lawyers learn the rules in these areas from the school of hard knocks and the recession has provided the equivalent of a graduate school course. With every crisis there comes opportunity, and firms that have learned the lessons of the Great Recession will find the most opportunities in the post-recession world.

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