The business of law – Securing a steady source of working capital
11 Feb 2019
It is a misnomer to term any business a simple one, but the business of being a law firm can often be far more arduous than those of other industries. Phil Knight, the founder of Nike, famously said: “Business is like a war without bullets”. However, the business of law is even more taxing because the industry has an underfunded war chest.
Selling time monopolises time
A law firm’s success relies on its immediate ability to generate fees from paying clients and having a source of readily available working capital to fund day-to-day expenses.
Billable time is the “stock-in-trade” sold by a firm to yield income but, while easy to produce, it has no value if it is not manufactured or consumed. This pressure results in all available hands prioritising their billable hours, often overlooking fundamental business pursuits such as the development of firm strategy, marketing, client acquisition and ultimately having an adequate war chest in place.
Lawyers are often insufficiently trained in these non-billable – albeit still profitable – areas of the business. Even when in possession of a supporting commerce degree, an attorney can struggle to apply the principles without regular experience in the trenches. A university-acquired LLB degree does not qualify one to run a law firm or be a lawyer, and that’s a good thing: practice and apprenticeship are essential to learning one’s craft – just as it is for all other businesses.
Equity funding prohibited
Further hindering the growth of legal businesses – whether these are in their infancy or well established – is the law prohibiting direct third-party equity funding from investors. If such funding could be acquired, it would give firms more room to allocate funds to, inter alia, the appointing of a CEO and/or financial director to pay attention to finance efficiencies, company growth, branding and marketing, new practice areas, alternate business models or establishing a wider footprint.
It must be noted that several large firms have, in the past, bypassed the equity funding restriction by spinning out their advisory services to an investible sister company that carries both firms’ expenses. This model has seen mixed success. For most firms, this model is not an option, rendering the following irrefutable truth: regardless of the quality of service provided to its clients, funding for a law firm must rely on the firm’s own ability to generate cash in the very short term, and reduce its debtors’ days.
The reader should not be misled into thinking that law firms are fundamentally not able to create sizable and lucrative businesses via their own cash resources. Many firms of varying sizes have been successful despite their lack of access to capital investment. The point is that a greater number would have benefited exponentially from access to capital at both their outset and in scaling their businesses at a later stage.
How many firms in today’s technological age, for example, are able to set aside resources to develop a bespoke online legal services platform or small-business contacts suite that can generate annuity income? The legal industry lags behind in most areas of advancement when compared to its contemporaries in banking, insurance, and accounting.
Perhaps this risk-averse mindset has been instilled in the legal profession because it has always lacked access to the capital required to grow, take risk, challenge convention, and arbitrage change.
A law firm’s unbalanced sheet
Debt funding is the only remaining option available to firms to buttress their income and immediately pursue non-billable business endeavours that are nonetheless profitable.
Somewhat ironically, the legal industry is deemed less creditworthy than other industries by traditional financial institutions. When law firms do approach a financial institution for credit, they are often surprised at the lukewarm reception they receive.
A balance sheet is a snapshot of a company’s financial position and what it both owes and owns. The world of commerce relies on this document as the fundamental indicator to access capital and finance. However, when applied to law firms, it represents a poor set of metrics that do not adequately reflect a firm’s true financial position or appreciate its intrinsic value, growth potential, pipeline of business, or quality of clients.
The traditional finance institutions – incorrectly – place little value on these attributes, frequently offering law firms insufficient overdraft facilities which, in turn, provide little opportunity to take any next steps in their businesses.
As time is neither leverageable nor able to be counted as inventory, there is no physical stock that can be offered as security to raise finance. It is also the nature of legal partnerships to use any available capital for distributions to partners instead of acquiring leverageable assets that can be used in the long term.
A partnership of individuals
The law firm partnership model creates a conflict between using any available capital for distributions to partners, and its allocation to working capital. This conflict also discourages long-term planning in not considering the acquisition of leverageable assets that can be utilised by the partnership in the future.
Behavioural economics shows that a partner’s self-interest will, in all likelihood, prevail above all other considerations and result in the question: “If the firm acquires an asset today, instead of making a distribution to partners, will I be around as a partner tomorrow to gain any benefit from this asset?”
Unfortunately, this question creates a persuasive case against the long-term acquisition of any asset by partners who are incentivised only by focusing on their own self-interests.
Self-interest would, however, be subordinated if adequate funds could be raised from equity investors or corporate finance as such funds would not be considered for distributions and instead allocated for a beneficial long-term purpose in terms of a business plan that would be required to raise such capital.
The consequence is that the business transactions which can define a firm – such as partner succession, acquisitions, department expansion or taking on a new fee-earning partner – become Sisyphean due to a lack of finances to facilitate the process.
Law firms need the right financial partners
There is no shortage of talented lawyers that could build venerable law firms and pioneer new business if they had the financial means to do so. As any successful (and unsuccessful) entrepreneur will tell you, however, is that funding is far more important than talent.
Firms need to find financial partners that will provide strategic and productive debt funding, with an emphasis on examining the appropriate factors that define those firms. The finance institutions should, for example, take into account that a firm’s income is cyclical and, often, lower in the months following the four court recess periods and closing of government offices such as the Master’s Office and Deeds Office. Products that holiday the payment of interest and/or capital during these months should therefore be readily available to law firms.
Without this kind of innovation, the strict business indicators used by traditional financial institutions to evaluate an individual firm’s creditworthiness will continue to stymie the legal industry overall, even though the industry has some of the most intelligent, responsible, and driven minds in the country.
The business of law, like justice itself, can’t be defined by numbers to determine its veracity and potential.
Whether you are a law firm whose business is solely based on a billable-hour model, or a specialist contingency firm, having the right finance partner will not only augment the firm’s core offering to provide legal services but will also ensure that it can achieve its goals, maximise cash-flow efficiency, pursue secondary business endeavours and take advantage of new ventures and opportunities.
See also: Litigation game theory(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.)