Archive for the ‘Capital’ Category

North Carolina will consider ownership of law and accounting PCs

March 16th, 2011 by Jim Cotterman

Today’s PinHawk Law Technology Daily Digest had an intersting item regarding recently proposed legislation in North Carolina.  A bill, Allow Nonattorney Ownership of PC Law Firms, would provide for minority ownership (up to 49%) of law firms and accounting firms by any individual.  The bill further requires that the respective licensees “own and control voting stock that represents at least fifty‑one percent (51%) of the votes entitled to be cast in the election of directors of the professional corporation.”  The section applicable to law firms also sets out a priority of interests in the case of conflicts between the interests of owners, clients and the court:  The stock certificates or other written evidence of ownership of any nonlicensee shall bear the following language, in at least 12-point type:  ‘No nonlicensee shareholder shall interfere with the exercise of professional judgment by licensed attorneys in their representation of clients. If there is an inconsistency or conflict between the duties to the court, to clients, and to shareholders, then that conflict or inconsistency shall be resolved as follows:

1.  The duty to the Court shall prevail over all other duties. 

2.  The duty to the client shall prevail over the duty to shareholders.’

This will be an interesting bill to follow.

Credit Markets

August 20th, 2009 by Jim Cotterman

While not as bad as the 4th quarter of 2008 and the 1st quarter of 2009, credit markets continue to be less friendly.  Credit limits are often lower as banks modify their ratios.  Loan covenants are more onerous and banks are more strictly enforcing them.  Those friendly waivers are harder and more expensive to obtain.

The latest trend appears to be line of credit facilities are commonly being written with variable rates tied to some benchmark rate plus a rate floor (”at no time will the rate be less than…….).

Economic Outlook

May 18th, 2009 by Jim Cotterman

Quarterly the AICPA and the University of North Carolina’s Kenan-Flagler Business School conduct the Business and Industry Economic Outlook Survey. Participants in the first quarter 2009 survey included 1,183 AICPA members employed as financial executives in industry.  The overall take on the report is a general sense of pessimism for the economy and a lengthened time-frame for recovery to begin.  Complete details of the study are available at the site.

This study is helpful to law firms in two ways.  The conditions affecting businesses are the same as those affecting law firms.  So it is helpful to see what other sectors of the market are experiencing.  In addition, this study provides insight into your clients’ situations — a likely precursor to the types and amount of future legal needs.  The comments on credit terms and covenants were particularly noteworthy.

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.

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 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.

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.

The Discussion On Partner Capital continues in an upcoming issue of Accounting and Financial Planning for Law Firms (an ALM Law Journal Newsletter).

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 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.

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.