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Use of Debt Financing by Law Firms

July 25, 2015 By Andrew Abramowitz 1 Comment

The Wall Street Journal recently focused on the decreasing reliance on bank debt by large law firms to finance their operations, with capital contributions by partners being used in its place.  The rationale cited by those quoted in the piece relates to the perceived risk of debt, i.e., the desire for the partners to “sleep at night.”  I would submit, however, that risk is created by the business decisions made by the firms, and not the means by which they finance their operations.

Use of Debt Financing by Law FirmsNo matter how conservatively it is run, any law firm has to use some form of financing to operate.  Revenues are inherently lumpy; the amount of work done and the speed with which clients pay for it can’t always be predicted.  At the same time, the law firm has expenses that need to be paid promptly and regularly – office rent, attorney and staff salaries, etc.  Financing is required to meet these obligations in the short term.  However, law firms run into trouble when revenues and expenses don’t match up over the long term.  It doesn’t matter whether the financing is in the form of debt or equity; if the revenue/expense mismatch persists for too long, the financing dries up.  If it’s bank debt, the bank can insist on compliance with covenants and drive the firm into bankruptcy.  If it’s capital from the partners, the partners can refuse to comply with a capital call for new money and jump ship.

The (seemingly) simple way to avoid this scenario is for the firm to avoid making long-term payment commitments.  That way, the firm can adjust its spending based on its actual earnings, rather than spending based on a possibly wrong guess about earnings in the future.  However, there are countervailing business reasons why a firm would want to make long-term commitments.  For example, law firms (at least large ones) need to rent office space, and lease terms are typically far longer than, say, an apartment lease.  If a firm entered into a series of one-year leases and had to move frequently, the attorneys and clients would be unhappy.  Additionally, firms are under pressure to make long-term guaranteed pay commitments to some of their attorneys, to assure the world that the firm is solid and won’t be crippled by defections.  Ironically, many lenders to law firms like to see these “golden handcuff” contracts, since they see it as protecting their investment, though the long-term guaranteed nature of it raises the risk to the firm if there is a work slowdown.  A well-managed firm will make investments in its future business, while attempting to keep risks under control.

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  3. Optimal Law Firm Size

Filed Under: Legal Practice Advice

Comments

  1. Charles Copeland says

    August 20, 2015 at 12:38 pm

    Andrew
    All your articles are well written. I especially liked your prospective on the pay ratio disclosure rule.
    We architects and engineers have similar challenges as law firms in terms of billings and financing. It is possible to avoid loans altogether as we have done since we opened our doors 45 years ago by being prudent about revenues and finances.
    Charlie

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