October 23, 2007
Cash is the Life Blood of a Law Firm
Partners want all available income distributed every year. But doing so leads to trouble.
One of the toughest jobs managing partners have is the task of convincing partners to leave something on the table every year. Businesses need capital to sustain operations and for growth. James Cotterman lays out the argument for you in his article Firm Capitalization, appearing in the October issue of the online magazine Law Practice Today.
Cotterman even gives you a short quiz to determine if your firm is headed for trouble.
Law firm leaders in midrange law firms often underestimate the impact of cash on their actions. Few really understand the cash gap created by billing and collection practices. In some firms, that gap approaches half a year. The cash gap related to legal staff additions is even greater due to the learning curve and the required filling of the pipeline of billable work. It is quite literally possible to grow yourself out of cash.
Operating cash requirement arise from:
Client Cost Advanced: Client advances can range from about $20,000 per attorney to $100,000 depending on the type of practice
Fixed Assets: The main categories of fixed assets include technology, communications and facilities improvements. The average net investment for midrange firms is around $40,000 per attorney.
Growth: Speaking to a group of administrators in May 2007, Cotterman explained that one of the principle causes for the outflow of funds relates to what Cotterman calls the "pipeline". Even if the additions to the team are immediately fully productive (and they never are), the pipeline has to be filled before income (cash) starts flowing. The typical law firm takes 60 to 70 days to bill for work performed and another 60 to 70 days to collect billed amounts. And as already noted, we aren’t just talking fees. Client expense advances, especially in certain practice areas, can be material. There are only three places for that money to come from—cash reserves, borrowed funds, or the partners. The fact is law firms don’t have unrequired cash reserves. Remove funds intended for partner distributions, and law firms usually have cash reserves of less than two weeks running time. That leaves borrowed funds, which, if available, have to be guaranteed by the partners, or the partners' pocketbooks.
Retirement: Retirements over the next 10 years are going to put new or at least heavier strains on cash than previously experienced. Unprepared firms may find the load too burdensome to continue. In discussing unfunded retirement programs, Cotterman puts it this way: “The benefits paid in an unfunded retirement program are a tax on current income. That tax must be accepted as fair and bearable; otherwise, the current partners shall declare the tax null and void. Unsecured promises to pay benefits will not survive the demise of the firm. Such demise can happen by design—partners vote to dissolve, or by default—key partners depart with their clients, leaving a weakened unsustainable firm behind. Generally a tax less than 5 percent of owner compensation is okay; under 3 percent even better. Over 7 percent is dangerous and over 10 percent probably unsustainable.” Even if the law firm is free of unfunded obligations, capital accounts of retiring partners will become due and, unless funded by new partner contributions, must come out of the law firm's general funds, reducing cash for operations and distribution to remaining partners.
Unknown: Partners often fail to clearly realize that capital protects their future income stream. If the firm goes under, that income stream is interrupted. Granted that as a legal professional, the former partner of a failed firm can go elsewhere and practice law, but personal wealth and income is going to take a nose dive for some time. Law firms with only “two weeks running time” are operating on a razor’s edge. Most investors would find such a risk unacceptable. Leaving something on the table every year is a prudent investment to protect the income and wealth of law firm partners.
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Filed under Cash Flow Issues by Tom Collins
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