The reality of today’s law firm  marketplace is that debt is a tool used to fund and manage:

• Fluctuations in collections;
• Purchase of fixed assets (furniture, equipment and leaseholder improvements);
• Growth and
• Partner compensation.

The challenge is to use the debt tool wisely.

To this end, we often hear some variation of two questions:

• How much debt is too much?
• Are there any guidelines related to law firm debt and borrowing?

Keeping in mind that no two law firms are exactly alike, and markets and circumstances present new conditions regularly, it must be underscored that, in the ideal scenario, a law firm operates with no debt. To the extent a debt-free approach is too conservative, less debt is better than more.

Law firm debt, not unlike in personal finances, is a stressor. The more debt relative to our income and/or net worth the greater the stress, and the more risky our future.

Yet, as we’ve noted, almost all firms choose to carry some level of debt. So, here are some guidelines to consider.

Guidelines For The Management Of Debt

Working Capital Line of Credit. Precious few law firms have the luxury of a consistent level of client collections. Most utilize a line of credit to help smooth things out. Smart management limits use of a credit line to a level that you can comfortably be out from under for several months of the year. A line of credit should always be paid down to zero by year-end.

Fixed Asset Financing. Using your bank to cover the cost on new fixed assets is routine, but should be managed. Ideally, a firm should carefully examine self-financing these additions; but if you are going to use external funds, limit fixed asset borrowings to less than 80% of net book value (cost less accumulated depreciation). This approach will consistently leave the firm in a position of equity in its assets.

Growth. Generally we would say it is imprudent to borrow to grow your law firm. The rate of lateral hiring success is dismal in the profession. So if you don’t have the resources on hand to self-finance growth, wait until you do. In the rare instance that you have to add capacity in order to meet a certain and defined client need, a short-term (9-12 months) loan to cover typical start-up costs might be considered.

Partner Compensation. A law firm should not borrow to pay partners. If the firm has significant fluctuations in cash flow that create uncertainty regarding the timing or amount of distributions to partners the firm should focus on some combination of increasing contributed capital or decreasing draws. Borrowing to pay partners is an early and clear sign of law firm trouble.

These guidelines are generally applicable to most law firms. You may have a unique situation. If you believe that is the case you would be well served to seek an outside perspective. It is easy to justify increased borrowing; but it is a slippery slope that has led to the demise of many firms.

We are seeing an 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 firms are taking a longer term view of their organization, choosing to set money aside to finance growth and short term needs in exchange for a more secure future.Not only do we see this trend as positive but a conservative borrowing practice is becoming a bigger and bigger issue to lawyers looking to move their practice.

How does your law firm manage its debt?