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 then one-in-four law firms had no debt. But only about 8% of those firms with more then 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.