How to finance your legal practice
09 Jun 2019
A lawyer’s journey to a sustainable practice is arduous. Not every firm makes it, and much time and effort is required to grow to the next level. Whether it’s expanding into new offices, hiring additional staff, or funding new legal cases there will be a required upfront investment of time and money before seeing any returns.
As the adage goes, it takes money to make money.
The challenge is that monthly cash flow is uncertain and subject to significant fluctuations. As a result, hard-earned fees are continuously ploughed back into the firm.
Wouldn’t it be great if you could keep more of the fruits of your labour and use outside funds as the seeds for growth?
There are several possibilities to finance a practice. Each has a unique set of characteristics that will impact whether they are the right fit for the firm and its partners.
DIRECTOR / PARTNER FUNDING
The quickest way to inject funds into your law firm is from the personal savings of a director or partner. While it may be tempting to quickly draw funds from your home loan or sell your share portfolio to capitalise your practice, this can present several drawbacks, including:-
AVAILABILITY OF FUNDS
The first challenge is having unencumbered and available funds to meet the growing requirements of your firm. And, if funds are available, one will still need to consider the risk/reward as well as the opportunity cost of having rather invested capital elsewhere, such as paying off debt or saving for retirement.
As if law was not stressful enough, self-funding can compound the pressure. An expected self-interest is created in a funding partner who prioritises to make every Rand count. Patience can become impaired and its harder to take intelligent risks. Short-term and long-term priorities and misaligned self-interests can create discord among partners which prejudice vital intangibles such as trust within the firm.
One attorney recently joked that ‘prior to considering bringing on a financial partner he slept like a baby… every two hours he would wake up crying’.
There is another issue which shouldn’t be overlooked, and that is the tax shield provided by borrowing funds in an incorporated entity rather than in your personal capacity. Interest payments made from a firm’s account are tax-deductible resulting in a considerably lower net interest payment.
For example, an attorney borrowing R1 000 000 at an interest rate of 15% per annum in her personal capacity would pay after tax monies of R12 500 in interest each month. However, had the funds been borrowed through her firm, the net interest after tax would be only R9 000, reduced by almost a third (assuming an effective company tax rate of 28%). This tax deductibility is not available where borrowings are in your personal capacity.
FRIENDS AND FAMILY
Another option many consider is asking friends or relatives to lend the money required to grow the practice. The advantage of this approach is that funds can often be secured quickly, at preferential rates, and with flexible repayment terms.
But before you take money from your loved ones, you must think carefully about the commercial and non-commercial consequences because more than just money is at risk. The loan will leverage both the business case and the relationship between you and the lender. As Benjamin Franklin said: “Lend money to an enemy and thou will gain him; to a friend and thou will lose him”.
BANKS AND TRADITIONAL LENDERS
Traditionally, the first option for many lawyers has been to approach a bank for financing. For some this may be a good option as rates can be low and it is better than paying out of your own pocket.
However, the reality many lawyers quickly realise is that South African banks typically have a low tolerance for risk posed by the balance sheet produced by a law firm. Banks will look to satisfy two primary criteria before agreeing to disburse funds, asset security and consistent cash flows.
The first thing banks require is tangible assets as security for the loan. This may include cash-on-hand, property, equipment and the accumulated assets of the individual equity partners.
While asset backed lending works well for industrial businesses with large capital bases, it’s more problematic for businesses in the professional services which trade in the knowledge economy. For example, traditional lenders would usually not recognise value in many of the law firms’ most valuable assets such as its client base, contingent / differed fees, book debts, mandate and fee agreements, invoices, court orders and taxed bills of cost.
CONSISTENT CASH FLOWS
Secondly, banks look to lend to businesses with consistent cash flow patterns. They view the typical up-and-down cycle of a legal firm income with a jaundiced eye. As a result many law firms, including large and established practices, may only qualify for a small amount of the required funds.
Specialist lenders such as Taurus Capital are well positioned to fill this gap for the legal fraternity. They don’t take a blanket approach to funding but work with you to understand your unique needs and then tailor an appropriate financial solution.
They have first-hand understanding of the inherent challenges and opportunities facing the modern law firm. This allows them to recognise the intrinsic value hidden within typically unrecognised future income streams.
Because they are entrenched in the legal industry, they can work closely with each firm to craft a bespoke funding solution that best matches its unique business. This may include larger loan sizes, flexible repayment terms, variable interest rates, fast turnaround times and one-on-one business and financial support.
As one example, where a firm litigates matters on contingency-fee basis, a traditional bank cannot identify the value of the deferred or contingent fee expected at settlement. Furthermore, a traditional term loan can place you in a difficult position if cases fail to settle or if fees are delayed. A specialist lender would look to have a better understanding of the realities on the ground and can tailor the repayment terms to match the unique nature of your expected fee income.
Law firms that are looking to grow will require funding, and there are several options available. It is worthwhile weighing the costs and benefits of each to decide which is most appropriate. Specialist lenders are able to work with you to craft a custom-made solution for your unique needs.
The provision of funding to law firms is widely practiced internationally and Taurus Capital is proud to be the South African pioneer of this global best-practice.
If you would like more information on how we can help please contact us directly at [email protected]
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Disclaimer: This article is for educational purposes only and should not be construed as financial or tax advice. Consult an accountant or registered tax practitioner for advice specific to your financial situation.(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)