Law firm finance 101 – Sensible vs. senseless debt
06 Apr 2020
Many of us were raised on the maxim that “no debt is good debt.” However, you may be surprised to find out that, if used wisely, debt can be wealth generative rather than destructive. In fact, many of the world’s top performing companies use debt funding as a strategic tool to access investment opportunities that would otherwise be unattainable.
Good debt vs Bad debt
The most basic definition of a loan is an amount that is borrowed today to be repaid in the future with interest. Debt is a mechanism for exchanging one’s future income for an immediate cash windfall. This is the opposite of saving; whereby instant gratification is delayed in order to secure a more prosperous future.
For this reason, if is often not advisable to purchase consumer goods such as clothing, furniture and electronic goods on credit. Instead of acknowledging one’s financial reality, that the cost of an item may be beyond one’s means, credit is used to kick the problem down the road.
There are however circumstances where debt may be advantageous. This is where funds are used to purchase an appreciating asset, grow a business, or invest in an opportunity that will result in increased future income. More specifically, debt is advisable where the rate of return on an opportunity is greater than the cost of funds to access that opportunity.
For example, an investor identifies a property investment which costs R10 million and will generate rental income of R1.5m per annum after operational expenses. The investor does not have sufficient capital to purchase the property outright. A bank loan is secured for the full amount, repayable at R1.3m per annum for 20 years. The investor is thereby able to earn a net return of R200,000 per annum with none of his own capital at risk.
While this example may be simplistic, is does dispel the myth that all debt is bad and illustrates how an appropriately structured loan facility can provide access to earn outsized investment returns.
Law Firm Funding
Opportunities for smart debt funding are plentiful in the legal sector. Examples of valid uses for this debt might include:
- Hiring of additional staff
- Expanding into new territories
- Buying office space instead of renting
- Expanding services offerings
- Litigating new matters
In all these cases, a well-structured debt facility can allow a firm’s partners to grow the practice exponentially.
The need for smart debt solutions in law firms is even more pronounced in a South African context. The Legal Practice Act’s limitations on law firm shareholder definitions significantly restricts these firms in their ability to raise third-party equity funding. This makes strategic debt a fundamental pillar in the financial structuring of all legal practices.
Case Study: Contingent Litigation
Alpha Beta Attorneys Inc specialises in litigating personal injury claims against the Road Accident Fund. Since many of its clients are financially vulnerable and cannot afford the legal fees, the firm litigates matters on a contingency basis. This places enormous financial pressure on the firm, which must pay for medico-legal disbursements upfront – months or years before these fees will be recovered from the claimant’s supposed payout.
The firm would like to grow and take on more contingent cases, but this is currently not possible due to cashflow constraints. A specialist finance provider has offered to provide funding at 25% per annum.
Consider a typical claim for Alpha Beta Attorneys:
- Average claim size: R800,000
- Expert reports: R300,000 (recoverable on success of the claim)
- Contingency fee on success of the claim: R200,000
- Taxed bill of costs: R100,000
- Average duration from expert reports to finalization of claim: 24 months
Put in purely financial terms, a R300,000 expense today will earn R600,000 income in 24 months. This is equivalent to 50% rate of return per annum. In this context, it makes sense to fund the case at a borrowing cost of 25% to make 50%.
Debt funding can make a lot of financial sense if you are using those funds to generate future income that exceed the cost of borrowing. If your law firm is looking for strategic advice on structured debt financing, consider utilizing the services of a specialist lender who can help you identify the potential risks as well as rewards.
Disclaimer: This article is for educational purposes only and should not be misconstrued as financial or tax advice. Consult an accountant or registered tax practitioner for advice specific to your financial situation.
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