Law Firms Need to Consider Alternative Finance Streams to Plug Funding Gap

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A recent survey by MHA, the national association of independent accountancy firms we are a member of, revealed that total external funding per equity partner in small and mid-sized practices decreased significantly in 2017, ranging from £42,000 in the smallest firms to £228,000 in the largest, compared with £156,000 to £506,000 last year. While reducing external finance may seem to be a positive move, it is more likely to have been driven in part by bankers putting pressure on firms to reduce overall lending. Kate Arnott, Head of Professional Services at MHA MacIntyre Hudson, explains for Lawyer Monthly.

Of the firms surveyed, bank borrowings fell significantly in all firms except sole practitioners, who tend to fully guarantee borrowing in their own names. Bank borrowings per equity partner ranged from £19,000 to £112,000 (in the largest practices) in 2017, compared to £21,000 to £228,000 the year before.

This comes as many regional and high street practices up and down the country saw a reduction in fee income in 2017, painting a different picture to the growth enjoyed by many of the larger national and inner-city firms. These practices have had to look for additional finance streams outside of their traditional banking facilities, partly to replace the fall in bank funding and partly to plug the gap equity partners are unable or unwilling to contribute to. Purchases of new assets tend to come with a finance option, and more short-term finance companies are being utilised to fund the payment of large one-off expenses, such as professional indemnity insurance. This greater funding need over the year has seen the average percentage of external funding to equity partner funding increase across all sizes of firms.

Increasing Reliance on Equity Partners

The lower level of external finance available to small and mid-sized firms has been mopped up by partners drawing less from the practice. In all sized firms, except sole practitioners, the amount of equity partner capital plus undrawn profits has risen over the last year. The range of own finance invested, per equity partner, varies from £64,000 in two to four partner practices, up to £336,000 in firms with over 25 partners.

Although total funding per equity partner has decreased across all firms we surveyed, the actual capital invested has varied depending on the size of the firm. Both the largest firms (with over 25 partners) and the five to ten partner firms saw increased levels of fixed capital being invested by their equity partners.

Many firms also saw reduction in fee income in 2017, which has meant equity capital as a percentage of fee income has risen drastically to concerning levels, and the downturn in income and profitability has left firms with an average of fixed equity capital at 27% of fee income, compared to just 11% last year.

While there’s no ideal level of capital to suit all firms, long term strategy, profitability, capital commitments and lock up can all affect the optimum capital level. This drastic increase of equity funding as a percentage of fee income shows a continued fall in return on capital for law firms across the board.

Long Term Debt

Traditionally, law firms have raised funding from partner capital injections, bank loans and finance leases. Increasingly there is a move towards more of a corporate outlook, especially in larger regional firms, and a move away from short term loan financing and bank overdrafts to an acceptance that longer-term borrowings are becoming par for the course.

The financial stability of law firms is increasingly in the spotlight, and the need to maintain a competitive edge requires investment in both technology and people. Professional practices will not escape the digital revolution and firms will need to future proof their operations sooner rather than later. As a result, firms are looking to more structured debt as a way of funding their businesses.

The current environment for law firms is challenging. Balancing external funding and capital effectively has never been more important. It’s vital to plan and monitor cash flow and funding requirements accurately, both in the short term, with a rolling quarterly cash flow, to an annual projection of cash needs. Every firm needs a strategic plan for at least the next five years to factor in issues such as partner retirements, increased staff costs and IT security risks.

Every firm will have various forms and levels of funding based on its own overall strategy and performance. On its own, the strategy will not point to the financial health or otherwise of the business, but significant funding investments should be monitored closely to ensure the original strategic objectives, such as fuelling growth or expansion are being met.

Further advice

We have developed a comprehensive guide: ‘The Roadmap to your Financial Future’, for professional practices, covering everything from partnership agreements and the financial responsibilities of becoming a partner, through to tax efficient financial management, succession planning and plans for retirement; it is essential reading for both new and established partners.

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