On the balance sheet of essentially every corporation of any size or degree of profitability appears the line, “Retained Earnings.”
I have never seen such a line on the balance sheet of any law firm.
Why not?
More importantly, what should the capital structure of a law firm look like? As incessant as is the attention paid to the income statement, I have yet to read or hear a thoughtful, informed, and knowledgeable discussion of law firm capitalization.
Is this simply because in many ways we are an immature or cottage industry (as a friend of mine characterizes it)? Is it because, as another friend who also happens to be managing partner of an AmLaw 25 says, “when we need more capital, we pass the hat among our friends”?
Can this possibly make sense?
A month or so ago I got an email from a non-law-firm-land analyst trying to understand our industry a bit better, and he asked what should have been a simple question: What is a typical law firm’s cost of capital? I was stumped.
Understand that it’s easy enough to specify a law firm’s assets and liabilities: To construct, that is, its balance sheet. But why does it look the way it does and is it optimal? Sure, I know all about working capital, lines of credit, term loans, the utterly predictable seasonal variations throughout the year as firms pay out partner comp at the start of the year and collect wildly at the end. I know about mandatory partner contributions, whether they’re flat or progressive, how they’re tied, or not, to total compensation, how they’re phased in when you make partner and repaid when you retire, whether or not the firm pays interest on them, and so forth.
That’s not what I’m asking.
I’m asking why law firms have the capital structures they do.
This requires addressing some basic questions:
- On the capital-demand side, what are the firm’s plans for the capital? Geographic expansion? IT infrastructure? Carrying lateral partners until they become cash-flow positive?
- On the capital-raising side, what is the firm trying to accomplish and what behaviors is it trying to encourage?
- Is the firm allergic to bank debt on general principles? What are those “principles?”
- Because the reason all major firms that have failed have finally been forced to turn out the lights is that banks have declared them in default and shut off the money?
- To what extent does the firm simply want partners to have “skin in the game?” Is a non-trivial level of mandatory capital contribution a useful way to advance that goal?
- Conversely, is it “fair” to ask partners, whose entire income stream depends on the firm’s prosperity, to also invest a portion of their net worth in the same firm? Isn’t this the antithesis of portfolio diversification?
- Should the firm pay any interest or other return on contributed capital? Zero? Below-market? Market? (And what’s “market?”)
- Finally, is all of this being done in a way that is at least cognizant of tax efficiency?
I do not ask these questions rhetorically or academically.
I find this an area of law firm financial management that has been by and large cloaked in darkness. Most firms’ capital requirement practices seem far more rooted in history and experience than logic and financial analysis.
Blood, toil, tears, and sweat are spent on determining annual compensation. Where is even a modicum of attention paid to capital contributions? This strikes me–and perhaps you–as perversely odd. The only rational explanation is that capital contributions, compared to annual income, are de minimis. While that’s probably true at most firms, should it be?
I can assure you that in the next few years as private equity investors begin to assess the attractiveness of our industry following the effectiveness of the Legal Services Act, they will expect you to know the answers to some of these questions. Or, at the very least, to understand they’re germane to any assessment of your firm as a business.
I invite you to sit down with your executive committee and your CFO and take a good hard “clean sheet of paper” look at your capital structure. Does it make any sense whatsoever?
