It has now been a while since the massive shake-up in the credit markets. As spring has gone and summer approaches, the days are getting longer, so what legacy have those darker days left for the finances of legal practices?
There is no question that every single practice needs to be looking carefully at its financial management in order to produce sensible strategies which will be resilient and robust, not only for the 2008 financial but as far forward as possible. Jonathan Hoffman, a partner in the Professions Group at Vantis looks at the specific implications for legal practices.
We all know that credit has generally tightened and the cost of money has risen for the foreseeable future. Accordingly, every practice is going to be under its banker’s scrutiny. More than ever, it is essential to recognise that one is in partnership with lenders and in order to get the best out of that relationship, it is essential that they are kept fully informed with up-to-date and accurate financial information. The UK banking system is still sufficiently old-fashioned that, provided it has confidence in its clients, its support will be forthcoming. Surprises that reduce the confidence factor can be extremely damaging.
At the same time, it may be appropriate to review your firm’s capital structure and day-to-day working methodologies, so here are some thoughts.
Capital structure
There is no such thing as a “correct” capital structure, as every practice is different. The issue here is that there should be a structure which fits well both with the partners and the partnership bankers. Some of the financial principles from the Dark Ages are as good today as they were then. For example, in the old days of horizontal balance sheets, there was a matching of partners’ fixed capital against fixed assets, thus separating long-term capital from working capital requirements. In that way, work-in-progress, debtors and cash were matched against current liabilities. I must confess that I rather like that approach because it enables partners to think more clearly about how much capital they commit to longer term investments and how much money they need to run the day-to-day practice.
Overall, it shouldn’t be too difficult to work out a partnership policy which works for your individual practice. That is not to say that the policy should be set in tablets of stone, but having a policy is an excellent first step and there is no reason why that policy shouldn’t have flexibility. This is not something that should be changed too often but my view is that it should be reviewed annually alongside the annual budget.
An added advantage of having a capital structure policy is that banks like to buy into ratios. Each partnership will have its own philosophy with regard to borrowing/capital ratios. Accordingly, if you have agreed with your partners and bankers that overall lending should be matched pound for pound by capital and current accounts, then everybody knows exactly where they stand and there should be no difficulty in drawing out excess profits or facing the music if your ratios have fallen below the agreed parameters.
One other tip regarding bankers is to try and negotiate a base rate price rather than a LIBOR (London Interbank Offered Rate) deal. Although occasionally LIBOR can be lower than base, it has historically been higher and one month’s LIBOR is less costly than three months’ LIBOR. In today’s environment, there is relatively little business being written against base rate and when it is, then generally margins are higher to reflect the true cost of money to the lender. However, that does not rule out base rate transactions and it is well worthwhile discussing the options with your bankers.
Non-bank finance
Despite the credit crunch, there has never been more availability of non-bank finance.
Fixed asset finance is very freely available and money can be raised to finance almost any asset. True, the margins may have widened recently but the market hasn’t disappeared. In this regard, the internet has become a real phenomenon with knowledge sharing available to everyone. Alternative asset finance can take the pressure off bank borrowing and help with the capital/bank borrowing rates.
I have talked about a capital structure and I am particularly wedded to capital being of a long-term nature. Whilst the Englishman’s home may be his castle, it still may suit some equity partners to increase their home mortgages in order to introduce capital into the practice. Tax relief will be available on the interest and most mortgage lenders will be more than happy to provide finance for this purpose.
There is also an occasional market when lenders are prepared to advance monies against future tax-free lump sums to come out of personal pensions. This market does seem to come and go but opportunities are still available and occasionally with limited or no security.
Fee ledger factoring is something else that may be worth looking at and can work well for practices which work for high-quality clients who, because of the nature of the work undertaken, require an extended settlement period. There has been a traditional resistance to fee factoring because of confidentiality and the worry that the factoring company will upset clients but for many years, quality confidential fee factoring really does work. On the other hand, your practice may be grateful for the factoring company hassling your clients to pay in a way that partners would feel embarrassed to so do!
Something else that might be worth having a look at is the terms of your property lease. As a result of the recent property shake up, your landlord’s investment may have weakened, possibly causing him some problems with his own lenders. The question here is whether you could make some form of variation within your lease in order to improve your landlord’s investment value. If this comes to you free of charge, then you will be in a win:win situation. For example, let’s assume you have a break clause in your lease but you know full well that you will not be exercising the break. You might happily give up your break for some financial incentive. Have you got a streetwise property adviser? That is something that may be worth thinking about.
Client management
Oh no! This is the last thing you want to read about as your managing partner may have been beating you to death over this! Sorry, but your managing partner is right. This is all very tedious but it has to be done and the first thing to do is to review your terms of business and ensure that they are not ancient relics. More and more these days, clients negotiate fees and in many different ways. I regard this a great opportunity, because whilst the client may require either a fixed fee or certain terms relating to the fee you can trade off competitive quotations with terms of payment. How about regular standing order payments when your particular transaction is going full swing? Alternatively, fixed payment dates against billing is a fair trade-off. Of course, you have to bill regularly to ensure that this works. All I am really saying here is that if the client wants something in terms of fee security, then it is not unreasonable for you to ask for something back in terms of payment.
Another really useful report is the “matters are not moved” with which I am sure you are familiar. It is a question of your practice’s working methodology as to the timing of billings but I would certainly recommend that there should be a policy of billing once a matter has been stuck for a certain period of time. Most modern computer systems are capable of producing reports of such cases. Individually, per case, this might not amount to much, but overall, within terms of the practice, it is surprising how much work-in-progress is sleeping quietly on the ledger.
Internal cash management
If a partnership is to pull together on the financial side, it is essential to have good clear cash flow forecasts showing both the short and the medium term. Collection targets and reviews are essential and, in my opinion, should happen more frequently than monthly. Then you have to sort out the politics. It can be embarrassing for a partner to chase a certain client, because if there is a difficult discussion, the relationship could potentially be damaged. Sometimes, it is better to use an intermediary in credit control to tackle the client and put a little space between the relationship partner and the client. Of course, each case depends on its merits but it is important that there is an internal understanding about who should be chasing for payment. It is no good having the partner and credit control looking at the ball in the back of the net, each with a quizzical look that says “where were you?” So the message here is to understand and get the client politics sorted internally.
I must now address the most difficult situation which is that despite taking all of the actions above, you are at your overdraft limit and your work-in-progress and debtors are excessive. You have to pay the rent, VAT and staff wages but there is a shortfall to pay the partners’ drawings. Now what do you do? Does the smoothie partner ring the bank and say “Old Boy, we’ve got a bit of a cash problem…” which actually really means “we have an issue with our working capital management” or, on the other hand, do you take the truly necessary action. That action is to cut drawings. Ouch! And of course, the drawings which should be cut are those under-performing partners as opposed to those who have billed and collected their agreed budget.
It takes a bold person to be able to deal with a drawings’ cut but, like many things in life, the first lesson is the best lesson and the initial pain will hopefully be rewarded with future pleasure.
I am not totally draconian in my views and am fully supportive of celebrating success. Your practice has done a fantastic job on a major client and has billed very full fees including a terrific uplift for care and attention. The cheque has come in by return. An immediate distribution to equity partners is recognition is something to which I would fully subscribe.
It is all a matter of stick and carrot.
Conclusion
Whilst we may be in the most serious credit squeeze for many years with banks under pressure, there are still opportunities to get your house in order. In fact, blaming the banks for having to take certain actions is quite a comfortable excuse for bringing your clients up-to-date with terms of business.
If you can get your capital base and balance sheet financing on a sound and sensible footing, you will be in pole position to have a financially-healthy practice. Take the initiative and lead your clients, bankers and partners. Let the dog wag the tail and face the challenges. Be detached and make the right business decisions and your long-term financial health will be assured.
June 2008
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