One of, if not the key responsibility of a law firm leader is ensuring that the viability of the firm is not threatened. No doubt, one of the primary threats to law firms today is excessive debt.
Clearly it is a rare business that functions without incorporating some form(s) of debt as part of an operations strategy.
Law firms are no exception. And managed appropriately, debt can serve as an effective means of realizing certain goals and objectives.
The key here is appropriate management.
On one hand, most firms finance the purchase of furniture, equipment and leasehold improvements. On the other, some firms go as far as to 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 revenue, the greater the risk to the institution. With higher debt levels a firm is under increased scrutiny, and — in practical terms — the control of the debt provider. By default, handing greater control to a lender limits options for the owners of the firm.
Law firm debt in conjunction with a fluctuating market for legal services has led to crisis for an alarming number of firms. Some end up being successful in restructuring in response to the crisis. Others, sadly, are faced with no option other than firm closure.
In short, debt is being reduced or eliminated as firms reassess operational principles. Given what can often be erratic timing of revenue, many firms are requiring greater capital contributions from their owners — or simply choosing to live within their means.
The WSJ article points to a 100% increase in the average level of capital contributions from equity partners over the last decade.
Key to successfully implementing a move toward 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 had maintained a required equity 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, all funded out of year-end distributions.
I think Warren Buffett’s quoted perspective is worth considering.
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
Has your firm considered decreasing risk by decreasing the use of debt? Is this a conversation your partners are willing to have?