Back on August 20th, I posed
the question to you, "How do partners fund their
capital contributions to the firm?" The votes are now in:
So the "winner," by a reasonable margin, is "a portion of my
compensation is retained by the firm until I reach the necessary level." If
you combine that with "a portion of my compensation is retained indefinitely,"
essentially one firm in two uses compensation-retention for capital funding. Another
42% of firms require partners to cough up the capital themselves, either by
arranging a loan on their own or through a program created by the firm. Finally,
somewhat surprisingly, 9% of firms simply do not require partners to contribute
capital.
But whatever the policy, every firm has one.
This raises the interesting question: Which method provides
the lowest overall cost of capital for the firm? I would analyze
that as follows:
- Firms that require no partner capital contributions probably have the highest
cost of capital; they’re on their own to raise the funds in the open market,
through banks, credit lines, and presumably lease or other asset financing. - At first blush, it appears that firms requiring partners to borrow the
funds to ante up have the lowest cost of capital—zero. And indeed
that’s the case from the firm’s sole perspective. But partners,
as owners of the firm, are required in this scenario to go into debt themselves
(or to contribute funds they have on hand which they could otherwise invest,
which imputes an opportunity cost to the capital contribution, if not an
out-of-pocket cash cost). Hold that thought while we consider
the last case: - Firms that withhold compensation to fund the capital contribution. Again,
it appears from the firm’s perspective that the cost of capital is zero,
since they’re simply retaining funds they’d otherwise hand over to the partners. But
in fact, isn’t this essentially technique #2 in substance?
Here’s what I mean: Firms can pay partners more and have the partners
bear the expense of funding the requisite capital, or firms can pay partners
less to begin with. Economically, isn’t the substance of what happens
in either case pretty much the same? In either case, there’s no place
the expense of raising capital can come from other than the firm’s partners. Firms
that give partner incomes a haircut are probably doing something that ends
up from the partner’s perspective being little different than if the partner
were paid more and simultaneously saddled with a liability they needed to fund
individually.
The only question becomes which entity—the individual partners or the
firm as a whole —is likely to obtain more favorable terms and pricing
in the credit markets. Dollars to doughnuts, it’s going to be
the firm, which represents a diversified "portfolio" of risk (the sum of the
partners’ practices) as opposed to the earnings potential of a single individual. So
the 49% of firms that retain earnings may be marginally better off than the
42% that make the partners ante up.
Comments from the back of the room?
