• Friday, July 19, 2024
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Understanding the financial dynamics in a law firm

Understanding the financial dynamics in a law firm

There are just two questions to ask to attain success in business: First, ‘What business am I in?’ Second, ‘How’s business?’ This quote from Peter F. Drucker is an elegantly simple encapsulation of how to run the rule over a business.

Yet, conventional wisdom reminds us that simplifying any business process is never a simple task but on the contrary a complex one. Indeed, in this post-pandemic new normal, where businesses face myriad risks that are unprecedented in yesteryears, the challenge to take stock of ongoing business issues has compounded.

Law firms are certainly not immune to such exposures. Lawyers, notably those who assume management responsibilities, are not only expected to provide sound and timely legal advice to their clients, but are also called upon to make incisive business decisions for their own practices on the go and often, “these decisions have to be made by yesterday”.

This invariably calls for managing directors and partners to possess a sound appreciation of the financial fundamentals of a law firm. Let us take a look at some of them.

Capital of a law firm
Not unlike any other business, capital is quintessential in the setting up and running of a law firm. There are, however, several distinct differences between the capital of a law firm versus that of other businesses such as the manufacturing or trading sectors.

Foremost, the ability to raise capital by a local law firm remains fairly restricted by statute as compared to other conventional industries or foreign firms from jurisdictions with more liberal capital regulations.

Since it does not have access to funds as readily as other companies, capital of law firms tends to be both costly and scarce. Invariably, this results in a law firm having a longer business gestation period – more time to reach certain financial stability – as well as a more gradual growth pattern, in relative terms.

The capital structure of a law firm is also fundamentally different from other companies. It is apt to point out a common misconception concerning the capital of a professional services setup such as a law firm. A law firm typically is not required to commit to high capital expenditure, as the nature of legal practice allows it to stay infrastructure-light. Hence, “since little money is put into the business, capital to start a law firm is insignificant”. This statement cannot be further from the truth since it does not consider a key component of capital – the contributory value of the founding lawyer(s) to the firm.

On this point, we need to recognise that there is equity value attributable to human capital of a law practice. To derive a “true worth” of human capital, we can determine the future economic benefits which the individual, or team, can generate for the firm. Where such future contributions cannot be determined (or agreed upon), the subject’s opportunity costs – how much he can produce in an alternate setting – can be used as a proxy.

Whilst conventional accounting does not permit a law firm to recognise such human capital in the balance sheet other than what can be readily convertible to income (work-in-progress), it pays to keep track of it for practical reasons. Whether the firm is looking to admit new equity partners, acquire a new legal team or plan the succession for a retiring incumbent, this information is pivotal when determining the fair value (of the event).

Read also: N70bn budget: Nigerian lawmakers seek luxury amid constituents misery

Capital Deployment
As a law firm navigates through the various phases in its growth cycle, it will deploy its capital accordingly to meet its needs at that point in time. We can classify this deployment pattern into the following five broad categories:

a. Preservation – an aspiring lawyer stretches his capital dollar when he sets up his law practice.

b. Sustenance – a small firm achieves steady income growth as its business achieves stability.

c. Allocation – a law firm begins to allocate its accumulated profits to branding activities as well as infrastructure (e.g. support resources, systems).

d. Pooling – partners in a large firm agree to pool resources to grow income, reduce costs and mitigate risks.

e. Redeployment/Fractional pooling – a global firm ventures beyond its defined jurisdictions to establish green-fields as a growth strategy.

From time to time, conversations which I have had with managing partners of small and boutique firms would lead to the question: “How can my firm gain financial stability?”

In the legal services sector, competition is both intense and intensifying. Firms not only face competition for work, but for talent as well. Small and mid-sized firms face the relentless “conveyor-belt” routine of painstakingly developing talent, only to lose them to larger institutions, most times, international firms. The smaller firms are losing (human) capital as a result of such attrition, and to a large extent, this is attributable to the disparity in the cost of capital.

Since law firms do not have access to funds as readily as other companies, they tend to have longer business gestation periods.

From the perspective of capital deployment, firms are susceptible to such exploits when they have yet to attain the means of Pooling – the ability to maximise (client/talent/monetary) resource efficiency through cross-sharing and leveraging, while driving down costs and risks through aggregation. Given their multi-disciplinary practices and cross-jurisdictional footprints, larger firms can employ pooling much more effectively than smaller firms, thereby giving them a clear competitive advantage over the latter. In short, pooling can be viewed as an important step towards achieving financial stability for a law firm.

Having said that, it is worth mentioning that pooling is not proprietary to only large firms. Structures such as the Group Law Practice allow pseudo-pooling, whereby likeminded practices can pool work, expertise, and overhead expenses, without the need to share revenue and profits.

Measuring practice performance
In financial management, we rely on key performance indicators (KPIs) to monitor the financial health of the business. Simply put, they are critical quantifiable indicators that are used to track performance against a set of desired business targets. So, what are some of the more commonly used KPIs for the law practice, and are there any potential blind spots?

One common mistake that business-owners make is to set ineffective KPIs. From time to time, directors/partners have indicated to me that the KPIs which they track are simply billings, net profits and bank balances. Undoubtedly, these “indicators” say a lot about the financial health of the firm, although we should appreciate that they are more business outcomes than indicators of progress against intended business goals. In other words they do not provide value-add inputs that prompt mid-stream course of action to steer us towards the targets – they themselves are the results to which we pair against such targets.

What then would be the effective KPIs which law firms can adopt to track their performance? We can break them down into three general areas: Fee Income, Operating Costs and Cashflow
Fee Income: In the earlier section on capital deployment, we recognised the element of time to be an integral part of a firm’s capital structure. Similarly, from a fee perspective, it is the most common proxy used to measure the value of services that the practice delivers to its intended clients.

For a time-based service model, we can generally dissect fee income into the following four components:

Productivity – The number of productive hours which the practice has recorded within a certain period (e.g. a month), for working on the client’s matters.

Recoverability – Proportion of the total productive hours that the practice can effectively bill and collect from the client.

Billing Rate – The aggregate dollar-value equivalent of each productive hour that is billed and collected.

Leverage – The size and shape of each practicing team.

Whilst productivity is the most tracked amongst this set of four – since it measures the “gross output” of the practice, recoverability must be viewed as an equally pivotal indicator, as it represents how much of the total hours can in fact be converted into true income. There is a wide array of slippages that can potentially erode this revenue-to-cash conversion process.

In short, a managing partner can get a fairly accurate depiction of the fee-generating capability of his practice by monitoring these four KPIs in unison. However, we need to be mindful that there are always costs – not least, time and effort – associated with the information gathering, hence each firm should always weigh the benefits (of the information) against such costs, before embarking on the tracking. Smaller practices can always consider adopting one or two from the onset, before progressively taking on the rest.

Operating Costs
When monitoring the operating expenditures of a business, it is helpful to break down the overall cost structure into broad expense classes. Practice leaders, who are constantly fighting the clock, do not manage costs by drilling into every expense detail. Instead they can focus on certain expenditure cycles and trends that matter.

By taking a step back, overall costs can be generally divided into direct and indirect costs. For a law firm, the former would comprise of fee earners’ compensations and other matter-related costs, e.g. outside counsel fees, which are incurred in the execution of legal work. Indirect costs pertain to fixed overheads which are incurred to sustain the firm’s operations.

When a partner truly appreciates how direct costs would impact on fee generation of his practice, he gains invaluable insights which will steer him in making decisions on talent management – such as hiring, career-pathing, retention, training and deployment. It goes without saying that these are critical to building a commercially successful legal practice.

By way of an illustration, a country managing partner wanted to understand why the profitability of his highly ranked M&A practice was eroding rapidly. The fees of its projects were in fact better than before, and the team costs had dropped due to recent attritions. An in-depth examination revealed that the allocation of resources was seriously impaired as a result of the attrition – more senior lawyers had to undertake low-value work such as due diligence while secondees from other practices took longer time to complete the tasks. These inefficient deployments combined to erode the higher fees which the firm can charge for the M&A deals.

As for indirect costs, they can be further dissected into sub-classes, depending on how we choose to manage costs. For instance, a firm may opt to segregate fixed overheads (office rental) from variable overheads (marketing); or even isolate productivity costs (legal-tech subscriptions) to measure against legal services fees. The COVID lockdowns provided the perfect catalyst for businesses to accelerate the adoption of cloud-based business IT solutions, as well as the impetus for the workforce to implement a hybrid work arrangement. Law firms of all sizes are like-minded in this aspect, as many are re-rationalising their overhead cost structure – to establish an infrastructure-light operating model.

Cash Flow
The adage “cash is king” is perennial. The recent pandemic served as a good case in point on how cash liquidity can be vexed by adverse business conditions. More companies are now prepared to maintain a larger cash reserve to meet operating needs if similar disruptions occur in the future. Law firms, where able to do so, are opting to keep at least six-months’ cash float, as compared to a three-months’ buffer before the pandemic.
In addition, there is a stronger emphasis to shorten the revenue-to-cash conversion cycle – essentially, to bill and collect more promptly. The relevant KPIs in this aspect, are WIP and AR turnovers. The former tracks how long it takes for a block of billable time to be billed to the client, with the latter denoting how long it takes to collect the bill.
Where a firm can afford the resources, it should prepare a cashflow forecast which is helpful for the management to cater for the upcoming cash outlays against expected receipts. Typically, a three-month rolling forecast suffices operational needs, although it is noteworthy to factor in larger commitments that may be looming over the horizon.

 

Originally published by The Law Society