Personal injury firm growth: Solving for a chicken and egg scenario
25 May 2020
Litigating personal injury matters on a contingency fee basis places a heavy cashflow burden on most firms in the short-term. For those practices that can sustain the protracted dips and gaps in liquidity, the long-game is financially worthwhile.
The challenge in growing a contingent litigation practice lies in an inherent imbalance in the cashflow cycles typified by the medico-legal industry. On the one hand, firms incur intensive upfront expenses required to litigate matters. On the other, the nature of the Road Accident Fund court process ensures that most attorneys’ fees will be locked up in matters for months and even years. The “cash gap” that falls between the start and conclusion of successful matters places many personal injury firms under financial strain. It can also constrain successful attempts at growing a practice through the processing of multiple matters simultaneously.
In a classic chicken and egg scenario, personal injury firms require sufficient cashflow to take on new cases, secure expert testimony, sustain firm overheads and market to prospective clients. However most of their fees are locked up in matters that will only materialise down the line. Firms cannot take on more cases as there are insufficient funds to do so, but more cases are needed to grow the bottom line. This begs the question of how does a managing partner grow a contingent practice when the cashflow required to do so is rarely available?
The solution to sustainable growth can lie in securing third-party capital, where the cost of interest on this funding is less than the incremental income you’ll make as a result of litigating multiple matters simultaneously.
In this article, we’ll provide the tools you need to help you make an informed decision when it comes to sourcing additional capital to grow your firm.
The Internal Rate of Return (IRR)
In the medico-legal field, there are various expenses and revenues generated at different stages in the litigation process, but their timing can materialise months or even years apart. Managing partners of law firms need a tool which can calculate a rate of return that factors in the above inflow and outflow over an extended period of time, and the return of taking on a new contingent matter.
A useful financial metric is known as the Internal Rate of Return (IRR) which calculates the return on investments on an annualised basis and takes into consideration timing of your firm’s cash outflows and inflows. This return is then compared to the cost of funding a new matter with third-party capital in order to help you to decide whether this makes financial sense for your business.
To calculate IRR we need to consider both the various cash inflows and outflows throughout the litigation process as well as their timing. Taurus Capital has created a free calculator for you to conduct this exercise for your firm, which is available for free download here.
Jerry Davids is Managing Partner of ABC Law, a medium-sized personal injury law practice. He is considering borrowing funds to enable his firm to take on a new case. He approaches a specialist lender for the full amount required to see the case through to completion. Based on his calculations, he expects the case to cost him R378 000 over the course of 24 months. He anticipates being paid and recouping some of this cost only in year 3. He wants to know if taking the cost on is worthwhile or if the interest charge will negate any incremental profits his firm would stand to make as a result of taking on this new case.
Calculating your firm’s Return on Investment for litigating new personal injury matter is only half of the equation. Once you know the IRR, this then needs to be compared relative to your cost of capital. It is also important to use the after-tax cost of capital in the calculation, as certain funding structures allow for tax benefits which effectively lower the net cost of funds.
The specialist lender offers Jerry an after-tax rate of 20% per annum with his total capital cost being R151 200, repayable in line with his firm’s cashflow cycle, as opposed to a fixed monthly repayment.
Jerry inserts the figures for an average personal injury litigation at his firm and inserts them into the Taurus Capital Contingent Litigation IRR Calculator as shown below:
|Marketing Cost||25 000||1||Fees||300 000||30|
|Hospital Records||1 000||1||Disbursement Refund||350 000||33|
|Police Records||1 000||1||Taxed Bill of Cost||50 000||33|
|RAF 1 Report||1 000||1|
|Advocate Fees||50 000||18|
|Expert Reports||50 000||18|
|Advocate Fees||50 000||24|
|Expert Reports||200 000||24|
|COST OF CAPITAL||20%||PER ANNUM|
|INTERNAL RATE OF RETURN||62.3%||PER ANNUM|
Interpreting the Results:
Jerry’s calculation shows an IRR of 62%. This means that for the total amount spent on litigating a new case, his return on investment will be 62% per annum, a healthy return. Because he didn’t have the upfront cashflow required to cover the anticipated costs, Jerry needed to borrow the full amount required to fund the case. With a cost of funding at 20% per annum and an IRR of 62%, Jerry is still well positioned to create significant value for his firm. He can easily pay off the interest charge associated with the debt required and still make a healthy net profit in the process.
Based on the above results, Jerry should absolutely proceed with financing his case as the benefits visibly outweigh the cost.
He explains the decision to his co-director with an analogy to the stock market: looking at new litigation cases as share in an investment portfolio, imagine you knew for certain that a certain stock’s price would increase 62% over the next year. It would be completely logical to borrow funds at 20% to invest in this opportunity. Even though you will pay away some of your gains to the funder at the end of the process, these were returns you would not otherwise have had due to lack of sufficient funds.
In this article we introduced a financial methodology for deciding whether or not to grow your contingent personal injury litigation practice given a known cost of capital.
The three steps required are as follows:
- Calculate the IRR for your specific law firm (calculator available here)
- Identify your after-tax cost of capital (ask your banker or specialist lender)
- Make a decision:
1. If IRR > Cost of Capital then proceed to invest in more cases
2. If IRR < Cost of Capital then do not proceed to invest in more cases.
Taurus Capital is a specialist funder to the legal fraternity and experts in the business of law. Taurus Capital offers a tailormade working capital facility for attorneys who are looking to sustain or grow their personal injury litigation practice.
- Law firm finance 101 – Tools to limit interest expense on third party funding
- Pre-existing conditions: How they can affect a personal injury claim
- The Quantum of Damages in Bodily and Fatal Injury Cases: Quick Guide