Taking the bull by the horns

The income of legal firms has seen limited growth in recent years. This is primarily as a consequence of the following factors:

• the impact of the recession with a reduced number of corporate and property based transactions;
• reduction in income derived from client monies held due to interest rates being so low; and
• changes in the structure of legal aid and personal injury compensation schemes.

Mounting pressure

Despite the recent signs of recovery, many of these factors remain, with the continued impact of the recession, low interest rates and further legislative changes ahead.

Additionally, there is an increase in merger activity within the sector with firms feeling that they need to be part of a larger organisation.

As a consequence, small- to medium-sized legal practices have been under more financial strain than they have been for many years, with firms relying purely on transactional fees or legal aid under particular pressure.

In these circumstances, financial management becomes a key to the success of firms.

Many law firms run their finances effectively, but some are still too focused on work volume rather than profitability. There are a number of different business models for firms and many different ways they can handle their finances – some good and some poor.

Good behaviours include:

• All partners regularly receive full financial information including office account bank balances.

• Drawings are linked to cash collection targets and do not exceed net profits.

• Provision is made to fund partners’ tax from income received.

• A capital element is retained from profit, and a capital reserve account built up.

• Premises costs are contained.

• Profitability levels are tested and unprofitable work is dropped.

Poor behaviours include:

• Amounts of drawings exceeding net profit levels.
• High borrowing to net asset ratios.
• Increasing indebtedness by maintaining drawings levels.
• Firms controlled by an ‘inner circle’ of senior management.
• Key financial information not shared with ‘rank and file’ partners.
• Payments made to partners irrespective of cash in the bank and all net profits drawn, with no ‘reserve capital pot’.
• Short-term borrowings to fund partners’ tax bills and VAT receipts used as ‘cash received’, resulting in further borrowings to fund VAT due to HMRC.

The answer for successful firms is to demonstrate the good behaviours and eliminate the poor ones.

Successful firms must also have a plan to manage risks. Risk management should not
be viewed as a one-off assignment, but a constantly evolving process, led by a senior person, that perpetually informs the long-term strategy of the business. Successful firms will make risk management one of their top priorities.

A business plan will analyse where work will come from and how to get more of it.

It will look at referral structures and professional networks and examine who is referring work and why. Firms must ensure they are maximising cross-selling opportunities and make clients aware of other service lines they could benefit from.

Profitable balance

Another key area of the plan is cash-flow and profitability.

It has always been essential for any practice to strike a profitable balance between expenditure and fee income.

However, with competition from new legal services providers, it is even more important for traditional firms to deliver financial stability and commercial success.

The basis of any law firm’s financial management is the ratio of income to overheads, because profitability and healthy working capital are built on fees billed out.

Firms would be well advised to look carefully at their overhead structure to see where costs can be reduced. Some services can be sold as a ‘loss leader’ if you are confident that you can sell other profitable services to your client, but this has to be monitored extremely closely to ensure there is a strong enough business case for doing so.

In undertaking strategic planning for the practice, another issue to consider is whether the corporate structure is the most appropriate.

Many businesses have already recognised the key advantage of incorporation – limitation of liability. Partners and sole practitioners carry the financial risks in the practice. In extreme cases of business failure, a limited company or LLP structure will reduce the impact on the individual’s personal assets.

Where the practice has significant borrowings, the bank will still look at maintaining a high level
of security over debts. They may ask for personal guarantees from the partners/directors, so
that an individual may not be entirely free from debt security.

But the bank can also take a debenture from the company, which typically gives security over book debts and work in progress. This will reduce the potential liability of the partners/directors in the event of business failure.

Many partnerships will already have a high value of goodwill in them, and so the trading name of the practice may well be worth protecting by the creation of a company. This will help to stop any other businesses trading off the good name of your practice.

Partnerships and LLPs with a small number of partners and members may be concerned about the continuing existence of the business. Of course, a limited company can be run with only one director/shareholder, and so concerns over the future should be resolved. This will also benefit sole practitioner businesses.

Advance planning

The flexibility that a limited company gives is that you are able to plan in advance for a partner/director’s taxable income.

This is based on the tax-efficient remuneration plan, and is completely opposite to the issue that a sole practitioner, partnership or LLP has, whereby the year-end accounts must be completed, tax adjustments calculated and taxable profits allocated before an individual is able to do any
tax planning.

The spikes of 31 January and 31 July tax payments can also be flattened out of the ongoing cashflow of the practice by moving to a limited company. Corporation tax is payable nine months after the company year-end, but the previously high tax bills paid by the individuals should be reduced significantly.

Again, this puts the business on a much firmer financial footing, as it is normal practice for partner’s personal tax liabilities to be paid out of the office bank account.

Greater competition and major legislative changes mean law firms must ask some big questions – especially whether to consider a merger, or drive organic growth through more effective marketing activity.

In the new era of alternative business structures, we must also consider how a limited company is the ideal vehicle to allow for external investment in the practice. You may be able to generate investors willing to put capital into the practice for a return.

A corporate structure may be bolted onto another legal practice company or LLP in a merger or consolidation scenario.

In my experience, up and coming fee earners do not always ask to become partners in a practice as they tend to be more risk averse than was the case in earlier years. The limited liability status may calm some of their fears.

There may no longer be the need to ‘buy in’ to the partnership and so this will remove the issue that younger individuals may have with limited personal capital, with banks making it more difficult to loan on an equity buy in.

Limited companies can allow a staged buy in of shares, with the potential support given to new directors of capitalised bonuses, say, rather than having to raise funds privately to buy the shares.

Scaling up

Mergers can also be facilitated by a more corporate structure of the business. Three key drivers of mergers are: retirement and succession planning; the need to diversify; and the wider issue of risk management.

Mergers are an increasing option for firms and are worth a further look.
Retirement costs may make a merger much more sensible, especially at a time when increased competition erodes the value of many traditional practices. Even shutting up shop can come with significant costs, such as making staff redundant, handling dilapidation issues on your building, and taking out run-off insurance cover.
Grooming your firm for a merger is a marathon not a sprint. Traditional high street firms may be attracted to a merger to gain economies of scale and other cost benefits.
The key issue here is making your firm attractive to a potential suitor, which involves careful positioning and preparation. This is not a quick window-dressing exercise, but more akin to training for a marathon – in terms of timescale as well as commitment of resources.
Mergers are also driven by the wider issue of risk management, which involves a firm looking long and hard at how it can reduce risk. The process of doing this in itself often suggests the possibility of a merger because firms implement better management practices and make themselves more appealing to other firms.

SJ

Seamus Gates is a director at accountancy firm Broomfield & Alexander www.broomfield.co.uk. Contact Seamus.gates@broomfield.co.uk