Classic: Why BigLaw firms go down the money hole

‘Why BigLaw firms go down the money hole’ was first published by Ed Reeser in 2015. It is re-posted on Dialogue as a Classic because I have recently been made aware of two Australian law firms that are in difficulty, at least in part, for reasons related to Ed Reeser’s thesis, namely propping up profits per equity point is somehow viewed as a means of maintaining confidence in the firm.   

The logic behind the compression in law firm partner membership for the past five years was simple: after the financial performance trauma of 2008, the confidence of partners in the viability of many firms needed reinforcement. As partners generally look to their personal distributions as the measure of financial success and stability of their firms, maintaining and increasing those distributions is a management focus. With declining revenues and increasing costs, that task is difficult. Firms can quickly and easily descend into over distributing cash relative to actual earned income as operating margins narrow and profits pools decline. 

Unfortunately, the law firm failures of the last few years have graphically demonstrated to everyone that the average law firm typically borrows for four basic reasons, two of which can be, but are not always supportable, one of which is supportable if limited to the purpose of being a short term reserve, and one of which should never be supportable:

1) Capital spending for organic growth

Business is expanding for the lawyers currently in the firm, so the firm borrows to open a new officeo, or hire more people. The borrowing may be from a bank, or from the existing partners through a capital call or reduced distributions.

2) Capital spending for lateral growth

The law firm borrows in order to purchase an existing cash flow, or stream of income. Specifically lateral candidates who bring business. This type of hiring can be individual lawyers, small group acquisitions, or taking over entire firms through combinations.

3) Cash flow support for operations

Covering liquidity shortfalls for operations with short term borrowing. This must be distinguished from the payment of partner distributions when there is inadequate cash to do so, as that is accelerating the timing of receipt of cash from outstanding accounts receivable by drawing from the bank, then repaying the loan when clients later pay.

4) Financial engineering

Recharacterizing items of expense as capital investment to overstate earnings, then distributing cash to partners as ‘profits’. Any dressing up of the books with financial engineering is a red flag, which is why it is more likely to occur in firms where access to the books is denied to partners. There is never an excuse for it.

Author 

Edwin B. Reeser is a business lawyer in Pasadena specializing in structuring, negotiating and documenting complex real estate and business transactions for in­ternational and domestic corpo­rations and individuals. He has served on the executive commit­tees and as an office managing partner of firms ranging from 25 to over 800 lawyers in size. You can connect with Ed on LinkedIn and email him at Edwin.reeser@att.net.

‘Why BigLaw firms go down the money hole’ is reprinted with permission of Edwin B. Reeser and first appeared in the San Francisco Daily Journal February 5, 2015. Ed’s full article may be found here.