It’s Your Business: Invest Like an Owner
Ask anyone getting ready to start a business what is needed, and undoubtedly capital investment will spring to mind. Ask anyone who wants to expand their business, or simply remain competitive, what is needed and you’ll get the same answer. It is no different with law firms.
A true owner (or partner) mentality is comprised of two critical aspects: a tangible financial commitment that includes capital investment, as well as an emotional or cultural commitment. Both are necessary for law firms to operate as something more enduring than a collection of solo practitioners.
The very real operational and strategic needs for increased capital in law firms are growing. Firms have increasing needs to pursue strategic growth initiatives, to acquire talent, and make operational investments in business development, technology and the like.
An inability or unwillingness to invest appropriately can render a firm less competitive in the marketplace. We regularly see examples of this in our work with law firms:
Lateral talent acquisition
We recently worked with a firm that was losing clients because of its lack of depth in tax and ERISA work. The partners in the firm agreed on the need, but could not agree on the expenditure for acquiring such experience (headhunter fees, work-in-process ramp up time, etc.). As a result they were unable to move forward with a strategy to recruit sorely needed expertise.
Many firms face pressure from clients who increasingly balk at paying the cost of training for new lawyers. These firms face the choice of investing in lateral acquisitions or bearing the training costs to develop young lawyers at a faster and more aggressive pace.
Innovation is driving increased technology investment in law firms. In the last year we’ve seen a 250-lawyer firm give each of their lawyers an iPad (in addition to their computers), and another firm that gave each client an iPad configured to provide real time access to work product, documents and case status. These firms saw these investments as necessary to competitively serve clients and had sufficient capital to do so without resorting to debt. Not every firm may have the capital to do this kind of thing.
Firms continue to seek new markets and to expand in current locations. The office requirements for growth remain high, although innovative housing models like office sharing, hoteling or virtual offices are mitigating those historical costs in some cases.
Law firms have realized, now more than ever, that business development is a large investment that must be made continually. Professional expertise is required, as well as increased use of technology for client relationship management, and the like. A failure to invest here can prove operationally and/or strategically fatal.
The risks of undercapitalization are clear for law firms as with any growing business. Borrowing should not be the sole solution to finance growth and strategic needs as that can put a firm in peril. Profitable businesses can grow themselves into financial disaster if owner capital is insufficient.
What are the challenges equity partners face in financing their firms? According to our primary research conducted over the last decade, capital levels invested in firms have remained remarkably consistent as a percent of revenues and a percent of income, with some slight increases over time. However, on a per partner basis capital requirements have risen more aggressively.
Over the past fifteen years or so, partners significantly altered the structure and shape of their law firms. What was once a pyramid structure with many associates starting a career and a few surviving the tournament to partnership has been supplanted by a burgeoning group of senior associates and non-equity partners resulting in a midriff bulge.
The tournament rules changed and although fewer lawyers became owners, they were retained by the firm under other titles. The equity partnership did not want to dilute earnings, nor did they want to grant governing rights to lawyers who were not sufficiently capable of establishing significant books of business.
Law firms also looked within their existing equity ranks and began a program of stricter adherence to performance expectations measured primarily by a lawyer’s ability to get business to keep themselves and others busy. Demotion of poorly performing equity partners became more common in law firms. Such lawyers were moved into other relationships with their firms or in extreme situations, made redundant.
The consequences were rapid lawyer headcount growth coupled with substantially reduced equity partner growth. The growth in lawyers increased the need for capital to operate the business, while the constrained growth in equity ranks increased the per capita burden at an even higher rate.
Meanwhile, banks have, or should have, learned that law firms are businesses that can go under. This increases credit risk which in turn increases borrowing costs and elevates underwriting requirements. Coupled with tougher oversight of banks and their lending operations, the result is a competitive, more regulated lending market where banks are generally increasing expectations regarding partner invested capital. This can be seen in decreasing debt and available credit on a per partner basis according to Altman Weil research.
Banks therefore seek to lend against infrastructure investment with permanent financing (although not at 100%) and as a secondary provider of working capital with temporary financing to assist in funding operations and growth. The keys here are the banks’ expectations to be secondary providers with temporary financing.
It may be helpful to look at the two extremes of this capital v. debt argument – firms where no capital investment is required of partners and firms that operate completely without debt.
Why might a firm operate without any capital requirement?
There are several reasons. First, the firm’s owners may be quite comfortable with financial leverage – using others’ money rather than their own to finance the business. This is especially likely with the run of historically low interest rates of the past several years. Second, there is the “sweat equity” argument. Young partners claim to have paid their way by leaving “their profits” on the table for the partners during their latter associate years. And finally, many of these lawyers with a significant client following may believe that their clients constitute their “chips on the table,” which they can pick up and play elsewhere any time they like. In this scenario, loyalty is more vested in oneself than in the institution.
One potential downside, of course, is that a firm may find itself undercapitalized at a critical point and falter where another more well-funded firm could avert a sudden crisis or take advantage of an unanticipated opportunity. Even profitable businesses must limit or sometimes forgo growth because of limited capital. Another drawback of relying too much on bank loans is the reporting requirements to and oversight by banks when they are funding your business.
And what about those law firms that have no debt?
Most of these law firms have an available line of credit for emergencies, but they draw on it only occasionally and repay it promptly. Such firms operate on a fairly conservative fiscal philosophy. They reserve cash generated from operations to invest in infrastructure, require meaningful buy-in from new partners and ongoing partner capital additions (often by distributing most, but not all, of the earned income each year).
No debt law firms enjoy less bank monitoring of how they run their firms. They also are less likely to have personal guarantees, which are generally invoked when the bank is looking for assurance beyond the firm’s ability to pay. Having “skin in the game” gives comfort to the lenders. Reduced interest expense is yet another advantage to these firms.
The disadvantage, if it is one, is the increased cost of buying into these firms. And if these firms are not sufficiently profitable, capital calls will not be manageable relative to partner income.
It is clear that there is a growing need for investment in law firms. Capital is one source to draw on, as is debt. A businesslike, rational combination of the two is usually the best option.
A partner in a business, any business, invests not only sweat equity but real dollars as well if the organization is to grow and prosper. Undercapitalization in favor of current earnings is a foolish position to take and not likely sustainable over the long term. Partners who recognize this and want to operate as a true partnership will commit to investing in the firm.
Those lawyers who do not want to invest in their law firms but essentially practice as independent contractors do not have the partnership commitment that is increasingly necessary in a volatile marketplace. They may put their firm at a disadvantage in the short term or ultimately undermine its very existence – as we have seen all too vividly illustrated in recent months.
What should you do?
At a minimum we recommend that you try to project some of the investments your firm will need to make over the next five years. Consider if the firm will have depth, breadth or expertise gaps that you need to fill with laterals. Keep in mind the impact of the upcoming departure of Baby Boom partners – both in creating expertise gaps and in the significant capital drain they will represent as they depart the firm. Take a hard look at the firm’s technology plan and keep in mind that technological innovation is becoming integral to competitiveness while the lifespan of ‘new’ technology can be shockingly short.
Doing this kind of capital planning will focus the firm on important questions that will affect capital decisions and should help your firm avoid a capital crisis.
A version of this article originally appeared in the October 2012 issue of The American Lawyer under the title “Time to Dig Deep.” © 2012 ALM Media Properties LLC. Further duplication without permission is prohibited. All rights reserved.