I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing. – Warren Buffett
It is typical of all businesses, including law firms, to utilize some form(s) of debt as part of an operations strategy. Many firms finance the purchase of furniture, equipment and leasehold improvements. Some utilize debt to finance payments to the owners when collections are slow or business is down.
It is not breaking news that the greater the debt relative to their revenue, the greater the risk. With higher debt levels a firm is under increased scrutiny, and — in practical terms — the control of their bank. By default, handing greater control to a lender limits options for the owners of the firm.
Within the legal profession there is a healthy and increasing trend to decrease relative debt levels. This Law 360 article (subscription required, but also posted here on LeClairRyan’s website) discusses some of the rationale behind the trend. Simply put, many law firms are taking a longer term view of the organization, choosing to set money aside to finance growth and short term needs in exchange for a more secure future.
Key to successfully implementing a move towards a decreased reliance on external financing is getting the firm’s partners on the same page. The more disparate the aspirations of a partnership, the more difficult it is to obtain the requisite buy-in to a debt reduction plan. Some partners are conservative and willing to trade a degree of short term cash flow for longer term stability; others are predominately interested in maximizing immediate personal cash flow.
One approach that can help firms navigate a resistance to debt reduction is a phased-in reduction. This approach, through which a firm achieves a targeted level of debt reduction over time, is made even more painless if the funding of the debt reduction can be taken from year-end distributions.
One firm we worked with maintained a required partner contributed capital balance equal to approximately 8% of the partner’s income. In order to decrease outside debt, partners agreed to increase their contributed capital to 22% of their budgeted income. The increase was funded in increments of 2% per year for 7 consecutive years, and came out of the year-end distribution.
Is your firm decreasing risk by decreasing the use of debt?