Manage your banker: How to get a bank loan for your law firm

23 Feb 2012Feature

Chris Marston

Things aren’t what they used to be – and I’d argue this is a good thing. The relationship between law firms and their bankers may have been different in the past, but was it better? I’m convinced that it wasn’t and that a more professional, focused and productive relationship during the boom years might have brought benefits which could have provided a degree of insulation for firms against the harsh economic climate ?they face today.

A business meeting between a banker and law firm several years ago might have taken place annually, typically involving lunch and some small talk – maybe a round of golf. The banker would be rather nervous about asking for financial information because he remembered ?all too well the response last time he ?had the temerity to seek out the latest ?set of annual accounts.

Such an impertinent request was a clear signal that the bank did not trust the firm or its management. It was an insult to the professional integrity of the firm. At best, a compromise of sorts would be reached where limited – and dated – information would be provided to “keep head office off my back”, from the ?banker’s perspective.

Many bankers were ill-equipped to ask the right questions in a sector where firms didn’t seem to behave as other SMEs and which expressed themselves using a baffling lexicon of jargon that was utterly meaningless in any other sector.

I remember clearly my own first meeting with a solicitor customer. I asked how business was going and was told ?that “costs are going through the roof”. ?The blood drained from my face. How was I to know that solicitors refer to their income as ‘costs’?

At the same time, although bankers may not have realised it, many solicitors at these meetings with the bank were thoroughly uncomfortable about the prospect of facing questions about the firm’s financial position. They feared they would not know the answers and perhaps might not understand the questions. ?A range of tactics would be deployed to move the conversation towards more familiar territory.

Solicitors tend to be secretive – it’s a natural extension of client confidentiality, I suppose. Questions that probed a little too deeply or which solicitors felt incapable of answering would be rebuffed. With varying degrees of subtlety, bankers would even be reminded of how often the managers of other local banks were calling upon the firm and how the other banks didn’t ask lots of difficult and unnecessary questions.

Some solicitors didn’t mind saying how much they didn’t know, making a virtue of it. One particular partner in a mid-sized firm once pointed to a large pile of brown A4 envelopes on the floor in the corner of his office. He said that these were the monthly management accounts which had been sent to him by the practice manager over the past three years and which he had never opened. He was rather proud of his detachment from the rather tacky subject of money. That said, he had an excellent knowledge of his drawings, which he saw as inviolate and quite unconnected to the profitability of the firm.

I recall these times with some ?nostalgia and amusement, but can’t help seeing them as wasted years when bankers and law firms could have worked together to build business models that might have been better placed to remain robust and viable in more challenging times. An unhelpful cocktail of deference, disinterest, a strong economy and client account interest (remember that?) meant that a raft of fundamental issues were never addressed.

The new realities

The alternative business structures era is now upon those of us in the UK. New entrants to the market will bring management and financial skills of a different order and their financial disciplines will be robust and uniform – there will be no scope in those businesses for anyone to opt out.

There are only a limited number of sources of cash to finance a law firm. External equity is now an option, but this is expensive, dilutes ownership and requires a high level of disclosure, financial discipline and corporate thinking.

There’s no interest to be paid, but investors want to see profits, growth ?and a profitable exit through sale or flotation. Taking external equity can enable rapid growth, but it will tend to turn business owners into employees. ?That won’t suit everybody.

At the other extreme, partner/member capital allows firm owners to retain absolute independence, requires no disclosure and costs nothing, except for the opportunity cost, i.e. what other uses that cash could have been put to.

Most firms operate with a mix of partner capital and borrowed money – not always in ideal proportion – and consequently a good relationship with the bank is critical.

Factors affecting lending

Just as the law can seem mysterious to non-practitioners, the way bankers arrive at lending decisions may appear arcane. So, below is a summary of the fundamentals of credit assessment.

It’s worth emphasising that the overwhelming majority of business lending decisions are made at the local level, but the principles remain the same if a central credit function is involved.

1. Customer standing and background

We consider how long the firm has been established, how well we know it and how well placed it is to face the future in terms of staff and premises. We look at succession planning, the business mix and competitive issues.

We look at the track record and experience of the firm’s management team and assess its ability to be effective in changing economic conditions. We consider whether management is prepared to take external advice from accountants or other advisers, and whether previous lending arrangements have been honoured.

2. Purpose and amount

We assess the business case for the borrowing, what contribution the firm is making and whether the borrowing structure is appropriate.

We want to see a matching of maturities. For example, a loan for IT equipment with a lifespan of five years should not have a repayment period of seven years.

We consider how the proposition fits with our credit policy, and take into account any regulatory issues such as those presented by the Consumer Credit Act or the Enterprise Finance Guarantee Scheme.

3. Financial performance

We will need to see certified or audited accounts, along with regular management information (see box: Main components of a law firm information pack), to understand the trading fortunes of the firm and the nature of lockup. Many firms provide profit and loss accounts, but very few offer balance sheets, except at the year end.

Cashflow forecasts, budgets and new instructions data complete the picture.

4. Repayment capability

It’s important for a business to demonstrate it can repay loans; that its forecasts are robust and stand up to sensitivity testing. Don’t sensitise the forecasts before sending. We look at previous forecasts provided by the firm and assess how accurate those proved to be.

Solicitors often say that it is impossible to prepare cashflow forecasts for their firms. However, there are plenty of specialist accountants who can provide practical help for lawyers who don’t have the expertise or time to do it.

Whatever your forecast says, don’t forget to show that you have a Plan B.

5. Security and risk protection

We want to know if the firm can offer security. It won’t persuade us to lend unwisely, but it may secure a better borrowing rate. The interest rate should match the risk.

We want to be sure the firm understands and has addressed the risks it faces. In respect of operational risks, we’ll look for accreditations such as Lexcel and ISO 9002.

We’ll ask about professional indemnity cover and how the insurer judges the risks in the business.
There are other risks too, such as a rise in interest rates, or the death or disability of a key person. We will need to know that there is an effective insurance regime and a disaster recovery plan.

If repayment depends upon the continued uninterrupted profitable trading of the business, then protection against these risks is critical.

Terms and conditions

Once bankers have agreed to lend, the discussion turns to interest rates, fees and, where appropriate, performance covenants. Post-lending monitoring processes will be agreed and any preconditions explained.

Managing expectations

We don’t like surprises. Tell us the good news and the bad.
We don’t lend blind – we need high-quality information and regular dialogue. Provide management information on time so that it doesn’t have to be chased. It’s reasonable for you to expect your bank manager to acknowledge and comment upon the information you provide.
We don’t want an entrepreneurial stake. It’s your business and, for a lender, repayment is as good as it gets.
Show commitment and leadership. What’s your stake? How are you demonstrating your commitment in financial, behavioural and leadership terms? How ready are you to champion new ideas and disciplines? How does your team view you?
Have a plan, know it and articulate it (and have another in case the first one doesn’t work)

Main components of a law firm information pack

Profit and loss: with comparison to budget and comments on material variances.

Balance sheet: to help the bank to understand movements of fixed and working capital, as well as the drawings position.

Working capital analysis, including:

work in progress;
debtors;
disbursements; and
creditors.

Each of these should be analysed by age and also by fee earner/department/branch office, as appropriate for the firm’s type and size.

Creditors are all too often ignored; there could be pressure here. Or, conversely, solicitors – keen to be seen as honourable – could be paying too quickly.

Chris Marston is the head of professional practices at Lloyds TSB Commercial (www.lloydstsbbusiness.com)