Cotterman on Compensation: Law Firm Finance

Cotterman on Compensation:
Law Firm Finance

Evolving Leverage

May 9th, 2016 by Jim Cotterman

Changes in leverage are positively correlated with partner profits (as are the other four profit levers – utilization, pricing, realization and margin). Increase leverage and partner profits increase, if all else remains the same. David Maister wrote about the profit model over 30 years ago (See Profitability: Beating the Downward Trend, The American Lawyer. July August 1984), including the interdependency of the profit levers. From that conceptual framework came the understanding that practices had optimal business models where the levers for profitability are managed appropriately to that business model. Too much, too little, the wrong kind of leverage all hurt profitability. Not new, but tends to get lost in the discussion.

For example, a compliance practice is leveraged differently from a high-end advisory practice. A traditional insurance defense practice is leveraged differently from a traditional corporate practice. The same is also true regarding the other profit levers. For example, the profit drivers for an insurance defense firm were traditionally their high leverage, utilization, and realization. While the profit drivers for a corporate practice were traditionally good leverage and utilization with above average pricing.

What is current and changing is the business model. Practices that enjoyed leverage from reviewing documents for due diligence or discovery are finding that piece of their business model under assault by specialty service providers and technology. Clients are less willing to pay for process and more willing to pay for judgement, experience and expertise. Technology has, and particularly looking forward at artificial intelligence, the potential (and I suspect the promise) of major change in how law firms serve their clients. The watchwords for leverage today should be flexibility and adaptability. Firm’s must respond to changing and differing client buying preferences while at the same time investigating, implementing and “leveraging” technology – all in an environment of rapid technological change. The future should be quite interesting.

Financial Transparency

May 24th, 2014 by Jim Cotterman

Law firms are somewhat unique in the amount of information that is publicly available regarding their finances. Most closely held businesses do not operate in such an open manner. Of course, the accuracy of that publicly available information is a separate matter to consider, particularly when obtained from unofficial sources. Here each firm must decide what is appropriate for public disclosure and how to best convey that information.

Yet, transparency in the governance and operation of a law firm is a good practice for the owners of the firm. They are a large group relative to their firm’s total employment and are all active and personally invested in the firm. But such disclosure is not sufficient to avoid financial distress. Two additional factors are also important.

First, lawyers are not schooled in accounting or financial analysis. If transparency is to have meaning, partners must be able to understand and interpret the financial information and metrics. Firms should Invest in training sessions to acquaint partners with the financial reports and operating information, how to interpret that information, banking covenants and the metrics the bankers rely on, and how to reconcile the tax return, year-end financial statements and internal financial reports.

Second, and possibly most important, is a culture where 1) firm leaders welcome questions from partners and others about the firm and 2) where integrity and honesty is embedded in the ethos of the firm. Transparency assists accountability, but it also establishes responsibility. The responsibility to ask and then act when action is required.

Realization

March 14th, 2014 by Jim Cotterman

The profit metric that tells how efficiently work done at standard rates is converted into cash. It does not tell you how fast this happens, just the amount of slippage that occurs from end to end. There are key intermediate steps that are measured such as billing realization (converting time value into bills) and collection realization (converting bills into cash) and a number of variances (see below) critical to isolating and confronting slippage.

But first a bit of history and why it is now getting so much attention. Realization has been dropping since the mid-1980s — a long, gradual and persistent deterioration. But until the recent recession, rates were going up much faster; yielding a collected rate increase well in excess of inflation. Strip away the historic ability to increase rates and the realization slippage is uncovered for all to see. To confront this problem, examine realization where the slippage occurs. There are four general areas where losses occur that must be understood and managed.

1. Timesheet discounts — those adjustments individuals make to the time they record when they believe something took longer than it should. This is one area that does not show in the financial system realization numbers because it is not captured. It prevents firms from identifying budgeting issues and training needs.

2. Pricing discounts — the difference between standard and actual rates. Both the frequency of use and level of discount have been increasing and accordingly realization suffers.

3. Efficiency adjustments — those adjustments to the value of time recorded at actual rates before billing. These are done by the billing partner. They may be targeted or prorated across the timekeepers on the matter in proportion to their recorded time value.

4. Value adjustments — those adjustments made by clients when they perceive that the bill does not reflect fair value for the agreed to budget for services, the services rendered, and/or the outcomes achieved.

Each of these areas require separate tactics to tackle the associated realization decline. Terms like pricing variances, efficiency variances, value variances should accompany any discussion around realization. The realization journey begins with client acceptance and continues on to matter engagement, work planning, staffing, project management, billing and collections. Thus, firms should examine their policies about client selection, engagement letters, pricing/retainers, staffing, practice management, billing adjustments, AR write-offs and collection efforts. Those policies should be administered through the practice leaders who should hold individual partners accountable.

Also consider how the firm strategically positions itself with respect to pricing. Does it set high standard rates with an expectation of using discounts to satisfy financial and/or procurement departments in client organizations. Just look at the medical and accounting professions where these models have been in place for many years. Historically the legal profession did not adopt this pricing model, thus it has strived for high realization and little, if any, discounting. Clients are now more aggressive at pursuing pricing discounts, without the law firms having a pricing model with sufficient margin to easily accommodate them.

Realization issues also tend to concentrate among individuals, practices, offices and clients that are struggling — underperforming. It is important to look for outliers across these segments. Firms should manage their way through these issues by identifying the problem and taking corrective action. In the current market where there remains an imbalance between supply and demand for legal services, that corrective action is more likely going to be to shed the problem. It is not fixable by changing status or compensation, which unfortunately, is what is attempted all too often.

So, if you are going to the Managing Partner or Executive Committee to talk about low realization; be prepared to talk about what kind(s) of variance(s) exist, where and who is the problem, and the targeted options to correct or shed it.

Working Capital Requirements Likely to Rise

April 17th, 2013 by Jim Cotterman

The Wall Street Journal had an interesting and sobering article today about companies stretching payments to suppliers. What caught my interest is the discipline and aggressiveness of these policies in a post-recession environment. Such tactics increase working capital requirements for suppliers. Working capital is the amount of money a business needs to pay its bills while it waits to be paid for its goods and services. While this article focused on the portion of working capital attributable to the gap between invoicing and payment, there is also an equally important portion attributable to the gap from produced/worked to invoice.

Combined, the work to invoice and invoice to payment cycles can represent three to eight months of cash flow for a law firm. The median length of time is four months. Some specialty firms can be much longer. Law firms have over the past several years increased capital requirements and reduced their dependence on debt for financing. This latest move by clients could add to capital needs even more.

The article also mentions how the companies are approaching this problem by bringing banks into the mix. Essentially the bank buys the suppliers invoices at a discount and collects from the manufacturer. While this may work well now, in measured amounts and with historically low interest rates; how it plays out when rates increase and the investment in these receivables grows is yet unknown.

What Should We Measure?

July 9th, 2010 by Jim Cotterman

You know the old sayings – “You get what you pay for,” and “You get what you measure.”

In the US legal profession, the two most established and accepted partner performance metrics are client following (origination) and personal productivity (personal fees collected). They have been clearly the number one and two compensable factors in legal profession surveys over the years. Scattergrams and statistical testing for the strength of the relationship between a particular performance measure and compensation have repeatedly demonstrated that these two factors explain a significant amount of the variation in partner pay. And it is an inescapable truth that professional service firms that sell their time, expertise and experience are most profitable when their timekeepers are fully utilized with well-paying work. Logically we can conclude that having a client following and working hard are necessary ingredients to a remuneratively successful law practice.

But is a measurement system sufficient? For a solo practitioner or pure space sharers it may be. There are no relative considerations to make. But in group practice, is not judgment in making such decisions equally or possibly even more important in a partner pay program? Is it important to understand the nature and extent of each partner’s efforts? How about the differing roles partners accept or should assume as their careers unfold? What value is there in taking strategically smart risks (even if each undertaking is not entirely successful)? These and other factors require judgment, possibly supported by measurement when reliable metrics can be developed, understood and placed in proper context. For example, who is more valuable — the partner with a $1,000,000 practice that puts 25% in the hands of owners or the partner with a $5,000,000 that puts 5% in the hands of owners? Measurement is a tool to be used carefully and thoughtfully.

Yet, even more tools are likely needed as law firms grapple with a changing market. AFAs (Alternative Fee Arrangements) and project management are two hot topics in the profession. Each represents important steps forward in pricing, risk allocation, value and client satisfaction. Successfully implementing these techniques is hard work. Embedding them systemically in the law firm’s processes, including pay programs, will require even more work.

It appears that AFAs designed to provide cost certainty to the client and place greater risk on the firm for efficiency and outcome are the most likely to attract client interest. However, doing so without addressing the service delivery model is a significant risk to firms accustomed to an hourly pricing methodology.

Project management techniques ferret out inefficiencies and strip out unnecessary costs. It appears that undertaking a robust project management effort can yield some impressive streamlining. Fewer people get the same job done in less time with less cost. That is great news unless you are charging by the hour in an environment characterized by work volume constraints and competition for cost conscious clients. In other words, the volumes may be lower (that $2 million practice may end up being $1.7 million) and it may not be possible to raise rates sufficiently to offset the lower volume.

Together, AFAs and project management complement each other if one can price differently and capture some higher measure of profitability while being more efficient and less costly to the client. Now here is the rub, how does the partner establish compensable value when the practice size is smaller and considerable non-billable effort has been expended streamlining the operation? Personal productivity and origination metrics may still be necessary, but are clearly no longer sufficient. So, a new set of measurements will be developed, refined, tested, institutionalized and ultimately automated. Yet, judgment will still be required to apply the new metrics fairly.

It is the responsibility of each firm to determine, based on its value system and strategy, what is appropriate. But it will require informed and thoughtful judgment to make it work.

Stress Test Your Balance Sheet

April 23rd, 2009 by Jim Cotterman

Stress tests have grown from testing for heart disease to identifying the adequacy of bank capital during periods of prolonged recession. In the current economic downturn, a number of law firms have asked us to perform a “law firm stress test.” Our version looks at the strength of a firm’s balance sheet to determine its ability to weather financial storms such as deteriorating work levels, aging receivables and constrained credit markets as well as a firm’s ability to fund growth and invest in its future. We examine not only the adequacy of capital but also liquidity.

Lessons from this recession certainly include a better understanding of how quickly credit markets, practices, work and cash flow can disappear. Once in such a cycle an economy will experience an inverted economic multiplier. Traditionally an economic multiplier is used to calculate how enhanced economic activity ripples through an economy such that the initial dollar spent provides far more in total economic benefit. When inverted we see the magnifying effect on the contraction. This is what we have been experiencing during much of this recession. Having sufficient liquidity and capital provides the buffer to weather such conditions or at least to give leadership time to reshape the organization so that it can survive.

Some law firms have asked us to review their capital programs – generally thinking about how much capital each partner should invest in the firm or how much debt they can afford to carry. While important, the total amount invested by owners or borrowed from banks is only part of the answer. The availability of cash must also be considered. All is affected by a range of variables including billing and collection cycles, overhead levels, draw policies, growth needs, allowances for capital repayment on retirements and the like.

Dealing with Recession

March 24th, 2009 by Jim Cotterman

Good compensation decisions are tough enough to make in good times. Making them in times of severe economic challenges is another matter entirely. Many firms are torn by competing interests of culture/values as opposed to a strict adherence to meritocracy. There appears to be far more willingness to be generous with an under-productive individual or group or office when the rest of the firm is doing very well. But, when the pattern reverses and it is a few who are doing well while many others struggle, something different emerges. This is the reality that we find law firms in as this severe recession unfolds.

Aggravating these problems is an overlay of continued dysfunctional (or at least unaccommodating) credit markets brought about by the banking crisis. Banks seek personal guarantees, stricter default provisions covering more metrics, quicker repayment terms, higher interest rates, and greater coverage (i.e. lower borrowing authority); if they are willing to lend at all. And this is at a time when partners are hard pressed to inject capital due to the depressed value of their own assets. Thus, cash to sustain and buffer the business until revenues return is limited. Firms with strong balance sheets are thankful for the additional time such resources provide. But that time is limited as even the strongest firms are only a few months from liquidation.

To manage the effects of the recession law firms have taken a multitude of steps to combat these forces including terminations, furloughs, reduced time commitments, pay reductions, and delayed/deferred start dates. Other overhead can also be examined, but to meaningfully affect law firm finances one must attack payroll costs and include partners in the equation.

Challenging Economy — What to Do…

February 13th, 2009 by Jim Cotterman

We are in a very bad economy with excessively tight credit markets. That plays out with variations around the country and around the globe which complicates the ability of global law firms to mitigate recessionary pressures. Regional and smaller market law firms are more likely to be tied to the specifics of their local economy. As the recession unfolded, it first hit financial centers. Law firms with structured finance and real estate practices led the way. Now that the recession is more pervasive, it is affecting businesses (and law firms) in every market. Corporations and individuals are curtailing spending — and each affects the other.

Businesses (including law firms) can really only control what they spend. Revenues are always the more difficult variable. Hence the rush to tighten budgets and preserve cash. The cost structure of a law firm is 78% labor, 8% facility and technology and 14% other. The facility and technology costs are largely tied to leases and contracts that will not be easily broken. The ‘other’ category has potential savings. But there are some practical realities. You can conserve some, maybe defer some, and eliminate a few. But realize that within this category are your basic operating costs, a good portion of which are not going away.

That leaves labor and its associated costs. Some firms are trying hour reductions as opposed to layoffs. A worthy approach to consider, but it will present some challenges. Others are reducing pay rates and asking individuals to pay more of their benefit costs. Possibly the easiest to implement, but also not without some potential adverse consequences. But those firms are trying to preserve jobs. Stemming job losses is critically important because it keeps cash flow for households and maintains access to benefits. However, the mainstay will most likely be layoffs which have their own associated costs in the short term such as severance. This is the most likely action when the demand (work from clients)/supply (timekeepers to deliver services) imbalance is significant. Once the imbalance is at a manageable level the options mentioned above become realistic alternatives. Let’s face it, law firms are labor-intensive. That is where the money goes and that is where the savings are. We should point out that all three of those options — hours reductions, pay rate cuts, and layoffs apply equally to partners.

On the revenue side, law firms need to stay close to their clients, appreciate their clients’ challenges, and assist them as much as possible. Not raising rates or raising rates much more modestly can help. Work with the clients to find more efficient and effective ways to provide the services — hopefully such that the firm and the client can make progress.

These times are a bit unprecedented and the prudent course is not to act precipitously; but rather deliberately. This is not a problem where you can identify, assess and treat. It moves and changes so law firms must be diligent and maintain as flexible a position as possible.

The No Debt Law Firm

February 6th, 2009 by Jim Cotterman

Some law firms have avoided the use of debt. Rarely is this an accident. Those firms have a particular operating philosophy that stresses partner investment and avoids financial leverage. Is this a good position?

1. No debt raises the capital requirements of the partners. The funding will come from partners either through increased capital levels or reduced distributions (the hidden capital contribution!) or a combination of the two. It also encourages a heightened owner mentality since those partners have significant amounts of their own money invested in the law firm.

2. No debt without adequate liquidity is marginally useful because there is still a need to rely on lines of credit as a first measure to supplement operating cash flow. All too often we see law firm balance sheets with a good liabilities and equity side of the balance sheet but no cash to operate the business on the asset side.

3. No debt with adequate liquidity yields significant flexibility to manage the variability of daily operating cash flows, undertake opportunities and weather predictable yet unplanned contingencies. This leaves lines of credit for the more extreme variations from operating plans.

4. No debt may mean slower growth, but maybe more strategically oriented growth. Since the partners are funding the growth, they are likely to take greater interest in the strategic importance of the initiative.

5. No debt means not worrying about reporting to the bank, loan covenants, interest and other financing costs. Although some firms may end up paying interest to its partners for their capital contributions; it is generally better received when the interest goes to owners rather than bankers.

6. No debt (particularly if it includes adequate liquidity) is a strong balance sheet that makes doing deals easier and bankers more accessible if you do need funds. Having no debt does not mean not having banking relationships, nor does it mean that you do not have significant lines of credit available and/or letters of credit to satisfy deposit requirements for leases.

7. At year-end 2007 a little less than one-in-four law firms had no debt. But only about 8% of those firms with more than 150 lawyers according to the Survey of Law Firm Economics. We suspect that year-end 2008 will not be as good a year for law firm balance sheets and it will be interesting to see if those percentages hold.

No debt is a conservative operating philosophy. It should and most likely will be matched with partners of a similar inclination. We have seen that the more profitable law firms of any size category also have stronger balance sheets — less debt, more capital and better liquidity.

Expense Review for 2009

November 26th, 2008 by Jim Cotterman

My last post talked about revenues. This time let’s look at expenses. People costs represented 77% of total in 2002 and now run closer to 79%. This includes all compensation costs (fully loaded) as well as partners. Nearly half the law firms recently surveyed indicated they have terminated associates and staff while a quarter have reduced their partnership ranks. And they may not be through as three-quarters are considering partner reductions and over half more associate and staff cuts. We are way beyond the critical mass necessary for it to be acceptable to reduce headcount. Now even law firms in good condition are taking a critical look both the number and quality of personnel. This is when organizations return to a lean and flat operating philosophy. The result is that personnel who do not directly deliver a necessary service are most likely to be made redundant.

Partner reductions are a bit more complex. If key partners abandon ship, it will likely accelerate the firm’s decline. And too many partners leaving for whatever reasons may trigger default provisions in debt and lease covenants. But a careful review with strategically focused reductions are going to be necessary at many firms. Reducing draws may also be required. Smaller draws eases working capital needs and the firm can always make spot distributions if economic conditions/performance warrant.

Personnel turnover is expensive and disruptive. An alternative to layoffs is to reduce cash compensation. Working for less pay while retaining benefits might very well be preferable for both employer and employee then not working at all. This is not a common approach in law firms, other than for partner draws and distributions. Hourly staff will probably not be asked to reduce pay. Exempt staff may, but it is still likely to be a minority of these folks.

However, law firms are universally giving this a very careful study for associates. While law firm leaders are carefully considering their year-end associate bonuses (no one is anxious to be out in front this year and only a few have gone public so far) and their own year-end partner distributions; it may be wise to take heed of the reaction to the Big Three auto executives riding to Washington on private jets and the bonus announcements at some endangered investment banks. Justified or not, one needs to pay attention to optics. Your clients are already seething over high outside counsel costs and struggling mightily with budget cuts of their own. Another round of big associate bonuses and year-end partner distributions will not help your cause, particularly with pricing in 2009.

There is a need for balance in this situation. No bonuses or adjustments might not yield the proper result any more than throwing money at everyone would. High performers should be recognized and earn more, but this should happen within the context of the firm’s culture. A true firm mentality where the individual rises and falls based on how well the organization does is different from an organization where it is all about the individual. I am not advocating for or against either style, only that your pay decisions be consistent with the operating philosophy.

Benefit costs are likely to rise again this year for employers and employees. The most significant cost is health care coverage and employers are shifting even more of those costs to employees. Most notable are the higher deductibles in PPO plans where half now require a deductible of $1,000 or more as reported by Mercer.

Occupancy is the next most prominent expense line item. These costs averaging around 7% of revenue in 2002 and in better more recent years closer to 6%, are long term fixed costs, likely with escalators built in. In a robust economy that is an advantage as growing revenues allow you to leverage the fixed investment. However, in a down economy those fixed costs consume an even greater share of diminishing revenues.

Marketing, technology and personnel training/development costs are prime areas for reduction in difficult times. Projects will be reduced in scope and/or scale, some will be deferred and others will be canceled outright. Certainly, there are savings to be had, but a more prudent action would be to prioritize and invest across all of these areas for the most critical needs in each.

Budgeting Revenue for a Challenging Year

November 25th, 2008 by Jim Cotterman

Next year’s budget should be well underway — maybe for the nth iteration as forecasts are updated with each new low in the Dow. Revenue forecasts will be particularly tricky this coming year. 63.5% of respondents in a recent survey indicated that they expect 2009 revenues to fall up to 10% from 2008 levels, with 2008 being a challenging revenue year for many firms as well.

Price increase is the single most significant factor to enhance revenue in most businesses. Over two decades law firms have been able to raise billing rates at about 1.7 times the change in CPI. This is down from a long-term price increase average of nearly twice the CPI. Not many businesses can claim a long-term pricing pattern of this magnitude. This year half of law firms surveyed are expecting only minimal and targeted increases in hourly rates. And 14% hope to increase rates consistent with inflation.

Productivity in terms of average billable hours decline in a recession and an industry-wide 5% decline in 2009 could be a prospect worth considering. Clearly some practices have contracted severely (securitized finance and real estate being prime examples), while others may hold up well (insolvency and regulatory come to mind). While a modest decline does not sound serious, it really is very serious. Those declines translate dollar for dollar into lower profits.

Pricing variances have increased from 2.5% to 4.7% over the past five years. Meanwhile efficiency variances have held their own at about 7.5%. We expect further pressure to discount rates and therefore higher pricing variances in 2009. We further expect that clients will scrub your bills in greater detail, particularly with respect to staffing decisions. The likely result will be increased downward pressure on realization. And this will be on top of the more modest rate increases so the revenue effect will be more significant than it has been in the past.

Although law firms have not yet experienced a dramatic increase in the aging of their accounts receivable; anecdotal comments from corporations (your clients) indicate that they are more carefully managing their cash position, including stretching their accounts payable. How quickly you turn over your receivables directly affects your working capital requirements. Law firms have been particularly averse to maintaining liquidity averaging about a half-week of free cash flow at year end. The top quartile firms in terms of profitability however, average 1.7 weeks of free cash flow at year end placing them in a far more advantageous position to navigate these challenging times.

Budgeting this year should test the resiliency of your capital and profit profile against slower collections, more modest rate increases, a potentially slipping realization rate and varying challenges with respect to productivity. Partners should be talking with key clients to understand their needs and expectations for the coming year — both in terms of the client’s business and industry environment and their legal needs.

This may be a good time to build up capital and liquidity. Hopefully the credit markets will soon begin to function in a more orderly and rational fashion. But until that time, law firms should be wary of the availability of credit, particularly on lines of credit that are far more vulnerable to being reduced or withdrawn on short notice. Two means to improve liquidity include retaining earnings to raise your year-end free cash flow to two weeks from the aforementioned half-week norm. The second approach might include additional debt to ensure its availability even if you only buy short-term treasury securities with the funds until they are needed. Be mindful that if you raise debt that it still conforms to good financial leverage practices.

A Discussion on Partner Capital

August 7th, 2008 by Jim Cotterman

A law firm recently inquired about its capital structure after its bank indicated that it considered the firm’s debt high and its capital low. A review of the year-end balance sheet indicated the following:

– Debt to Net PP&E: 60% – Good is 50% – 75%; 85% is acceptable

– Months Free Cash Flow: (0.10) – Poor should be at least positive 0.5, but 1.0 to 2.0 would be better

– WIP & AR to Debt: 2.7 – Low, should be 9.5 or higher

The debt as a percentage of net fixed assets (PP&E) is reasonable; however, the pipeline (WIP + AR) as a multiple of debt is low. At this particular firm this is primarily driven by disciplined billing and collection rather than a lack of work. In this credit environment however, bankers are likely to be more concerned about this relationship as it indicates how much cushion exists to cover their loan. Conclusion: Debt is okay at its current level and is properly leveraging fixed asset investments and spreading a significant portion of the costs of those assets to the individuals who benefit from their use.

However, we did concur with the bank that the partner’s invested capital was low for their needs. It is apparent if one looks at the Months of Free Cash Flow in the above table. The key driver in this analysis was undistributed income at year-end. Had the firm converted this to capital and retained the cash, its liquidity would have been acceptable (i.e. it would have internally generated a minimally acceptable permanent working capital base on which to operate the law firm). This is an area where the firm can improve over time — probably over the next three to five years — as it is not an urgent issue, but it should be attended to.

Likelihood of Making Partner Affected by Economy

May 29th, 2008 by Jim Cotterman

In an earlier post I talked about what to do if you find that prior promotion decisions have left the firm with some very hard choices in difficult times. This post discusses how firms are grappling with promotion decisions during those same economic downturns.

US firms have raised the bar for promotion and more frequently ask the hard question, “Is there really a need for more owners in this practice?” A recent Law.com article, London Law Firm Leaders Taking a Hard Line on Partner Promotions, demonstrates that UK firms are facing similar economic and promotion challenges. And many of them are making tiered ownership distinctions, which further complicates the task.

Generally, law firms are best situated if they promote to ownership only those who can maintain, refresh and expand the business opportunities of the firm. Without this one attribute, no firm can remain competitive or viable for very long.

Unfortunately, this is easier to preach than to practice. Getting a good answer to the question and a fair understanding of one’s ability to attract business is easy in some situations. But in large law firms where the relationships with clients are quite complex — often spread across time zones, client business divisions, and law firm practice groups, law firm leadership is handed a very difficult and subjective assignment. This is particularly so since the candidates are mostly younger partners who are just beginning to establish their market presence and some of the decision is a bet on the future.

The hard-liners will say, “Candidates make it when we can no longer afford to ignore them.” Often this means waiting until the candidate and a string of clients are about to leave. Strongly Darwinian, this model does little, in my view, to create a collaborative organization. More likely it will reinforce individualism as the dominant cultural element. It will however, substantially lower the likelihood of bad promotion decisions. On the other hand, it raises the possibility of two opposite problems. First, such firms are more likely to miss opportunities to collaboratively grow business. Second, one may wait too long and the solid candidate bolts.

Others will preach generosity in recognizing the efforts of others to grow the firm. This is key to firms that desire a strong institutional culture. Many law firms we work with, and in particular larger law firms, work hard at establishing and maintaining this perspective. Unfortunately, this approach does increase the likelihood that promotion decision, particularly in good times, will create challenges when the market turns and only the most skillful of the partners will be able to further the workflow of the firm. It is during these times that the firm’s culture is truly tested. Will it move towards the Darwinian model as a consequence of economic pressures? Or will it pull together with increased efforts to maintain work intake to ride out the downturn.

Difficult Decisions in Down Cycles

March 12th, 2008 by Jim Cotterman

It is interesting to observe how law firms cycle in tune to the economy. In robust years, law firms are apt to be more generous in both promotions and pay increases. The sentiments behind those actions are good, but the unintended consequences are usually not. This is the third economic down cycle that I have experienced as a consultant. In each, as law firms grapple with declining revenues, the call volume on how to deal with “over-paid” or “under-productive” partners escalates.

Why does this happen? Law firm owners must be able to create market presence, build trust-based relationships, be alert to business opportunities and bring in work for their firms. In good times it is easier to do this. When the marketplace contracts, those who are least skilled, least experienced and least well positioned to get business will be hurt the most. Add to that what might, upon reflection, have been an excessively generous promotion or pay increase.

Obviously, a firm would prefer not to have the problem. But that takes discipline during good times to appraise an individual’s ability to sustain performance in a variety of circumstances. Therefore, compensation committees must look beyond the numbers, engage in realistic appraisals of sustainable performance and potential, make compensation decisions and promotions much more carefully and to discuss their conclusions with each individual. Frank, candid and constructive dialog consistent with the firm’s values and strategy are the most effective means to manage expectations and to build credibility as a leader. These steps will not eliminate the problem, but will go a long way to reduce the severity of the issues later on.

However, if a law firm is in the midst of the problem there are hard decisions to make. Some firms will turn to “non-equity” ownership structures as an answer. This is not a good reason to create a tiered ownership structure, but if you already have one it had better have clearly articulated and enforced performance standards for admission and retention into each ownership tier. Secondly, you have maybe a two to three-year window of opportunity to improve contributions from those who are in a tier not warranted by the individual’s sustained performance or immediate potential. After that, leadership’s credibility is damaged.

But the problem is now – and the heavy hitters are getting restless. Now is not the time to fully reverse course and to overreact in the opposite direction. Leaders must move with deliberate speed to address the situation.

First, assess the situation with brutal honesty. How bad is the market change? How long is it likely to last? What shape will the recovery likely take? What might not come back at all? What resources does the firm have to ride out the cycle?

Second, take the pulse of the firm. To what extent are the heavy hitters willing to ride it out? How well informed are the partners regarding the firm’s fiscal health, market forces and their own ability to contribute? Get assessments and projections for each major practice.

Third, craft a plan consistent with your analysis of the current situation and likely future. Balance the response to the facts and circumstances. Look at a range of fiscal and operational opportunities, yet do not forgo all investment for the future. Develop a time-line for each corrective action. When to begin the corrective action, how long it will take to be fully implemented as well as the time-line for how it will affect the firm’s finances.

Fourth, communicate, communicate, communicate. Engage in constructive discussions regarding the most promising corrective actions. Keep people informed, invite feedback and dialog. Remain open, candid and upbeat in all of your interactions and communications.

Lastly, treat people with respect and compassion. This is important to each leader for how they are perceived by others, to each affected person for their legacy perception of their firm, and to everyone else as the clearest possible indication about how they could be treated in the future. How you treat people in difficult times defines the true values of your firm.

How Much Debt?

February 8th, 2008 by Jim Cotterman

We are often asked how much debt a law firm should carry. The precise answer varies based on the collective financial leverage tolerance of the partners and the capital needs of the firm. However, here are two simple rules for a fiscally prudent answer.

1. Total debt (including capitalized leases) should be no more than 100% of the net book value of the fixed assets; 90% is okay, but 80% or less is much better.

2. Lines of credit should have a zero balance at year-end and for most of the year. The credit line should not be used to pay partners or be used as the first source of working capital. It should be there to augment working capital, covering unusual economic conditions (i.e., negative economic performance beyond one standard deviation of norm). An available line of credit equal to the funds required to cover one month of payroll (including owners) is one rule of thumb.

Balance Sheet Metrics

December 13th, 2007 by Jim Cotterman

Tis the season for getting the fiscal house in order. Many firms push on getting bills out in November and then make an even greater push for getting paid in December. Balance sheets tend to be in their best condition by year-end — lines of credit are at $0; accounts payable are probably around 1 month; Unbilled time and accounts receivable each represent about 2.0 to 2.5 months of revenue.

The question I get most when talking about capitalization is how much and in what form? I have two precepts. Owners should contribute meaningfully at buy-in and provide the majority of capital needs to their firms. Clearly law firms should expect meaningful financial investment from each owner. Having a seat at the table is serious business. Taking cash out of your pocket and putting it into the law firm’s is also serious business. Making a financial commitment is one of the attributes of fully contributing owners.

Second, the firm should have significant liquidity. My test is probably much more severe than most. For most firms there should be sufficient cash at year end to pay out earnings, fund the retirement obligation and all payables plus two weeks of cash flow. As you might imagine, there is a fair amount of push back on these items. But a look at the profession suggests that law firms are closer than they believe to doing this.

Partners Contribute Hidden Capital

December 9th, 2007 by Jim Cotterman

Law firm partner compensation is comprised of pay, profit and reinvested capital. Few law firms distinguish between the three and it may be fair to say few partners even think of their compensation in this way. However, if the partners took this view they might pay better attention to how each of these elements affects what they take home. Here are the elements with a brief comment on each.

1. The fair exchange for one’s labor—partners are very much active workers in the business. They must be productive in fee generation both as an originator and as a timekeeper. And they must undertake a host of non-billable activities for a modern law firm to operate well (manage, train, supervise and marketing are among a few on that list). This is their true pay.

2. PLUS profits from the labors of others—all other timekeepers should be profitable (generally even non-equity partners). They are consistently and significantly profitable in the top firms. This is their true profit. For an interesting and related IRS view on this see my article on Unreasonable Compensation For PC Shareholders.

3. LESS investment for growth—new people, offices, practices and markets are often funded out of current cash flow. Since firms deduct these expenses currently, they are the hidden capital invested by owners to grow the business.

4. LESS investment for capitalized assets—items shown on the asset side of the balance sheet when there is no corresponding third-party obligation for funding those assets (debt or capitalized lease obligations).

5. LESS investment in working capital—higher salaries for associates being a prime example of a limited duration cash gap often funded by initially lower equity partner compensation.