Recent commentary on trends among law firms has highlighted the increasing popularity of requiring greater capital contributions from owners. As Law.com‘s Nell Gluckman notes, instead of capital requirements in the 20-25% range as was common for years, law firms more frequently are jacking up the owner capital requirements into the 30-35% level. In some cases, the capital amount expected by leadership is even greater.
Increasing owners’ capital obligations is partly in response to the negative experiences from the Great Recession as well as encouragement from bank lenders.
From a firm standpoint, the decision to make owners contribute more capital is fiscally sound. Unwilling to take only half-measures, Richard Acello writes that many firms have not only increased the capital required, but also have slowed down capital repayment with a combination of extending repayment term and by breaking up repayment into installments. These steps not only help the firm with its cash flow, but they can also cause some owners to think twice about leaving.
For law firm owners, however, increasing their capital contribution may not be so welcome. True, when thinking solely about the firm, an owner should be comforted to know that more capital should make his or her firm stronger. Yet when that same owner focuses on self-interest, the popularity of this new capital model can’t be so comforting for a number of obvious reasons detailed by Edwin Reeser.
If your firm is thinking about increasing its capital by requiring owners to contribute more, be ready to address the following concerns from owners:
The Investment is at the End of the Food Chain. As simple matter of priority, capital is subordinate to virtually all other law firm obligations. That may be okay as long as the firm is in business, but if Armageddon comes the priority of all other claims means repayment will come, if ever, only after a long time.
The Investment is “Covenant Light.” Generally, once the capital is invested in the firm nothing triggers its repayment other than a departure or liquidation. A firm’s poor financial performance, unwise decisions, “run on the bank” departures don’t activate an owner’s right to be repaid like they may for a third-party working capital lender. Unless an owner leaves thus triggering a repayment obligation, the capital will simply sit there even if management is running the firm into the ground.
When Things Go Bad, Recovery Prospects Depend on Others Who Don’t Care About the Owners. Because an owner’s investment is subordinate to virtually every other interest, it is the holders of priority claims that will dictate the steps taken to satisfy obligations. Those priority claimants will care little about the owner’s interest (other than to make sure it doesn’t get paid ahead of them). Worse yet, while all of the priority holders usually can sell their interests to obtain a market-based recovery, the equity holder is often legally or ethically restricted from selling the equity interest even if theoretically a market exists.
Borrowing to Buy Equity Can Be Scary. As equity requirements ramp up, the idea of financing a capital contribution gradually out of year-end bonuses and distributions becomes less practical. Body dragging your owner to the firm’s friendly bank so the equity owner can borrow the funds needed to make the contribution is easy for the firm, easy for the bank and heck, even easy for the firm owner. But when that owner departs for greener pastures or sees the firm fail, the demand for payment of the capital loan will come long before any capital, if any, is recovered. Taking on senior debt to acquire equity can be scary for your owner.
The Returns May Really Stink. Law firm equity has an unreliable return profile. Typically no interest is paid or accrued nor is there a stated maturity date. If the firm has some great years, the ownership interest may, in fact, deliver pretty decent returns. But unless good years are consistently delivered so that distributions over an owner’s “budgeted compensation” are regularly paid, the returns on the owner’s capital investment can be underwhelming. And it is not as if his or her equity is a passive interest. The owner is still expected to work hard during the year to justify the “budgeted compensation.”
When law firm leadership takes steps to increase capital, it seeks to strengthen the firm as an institution. From an owner’s standpoint, however, the capital call may be unwanted. If your firm is thinking about raising its capital, will leadership be able to address these owner concerns?