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 committment 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. The attached chart, Balance Sheet Metrics, provides some key metrics for all firms and for the 25% most profitable firms. There are some clear differences in how the most profitable firms manage their balance sheet.

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.