Financing Start-up Law FirmsPublished by Dennis Duitch, CPA, MBA, Advisor, Mediator
By Dennis Duitch & Marcia W. Wasserman
Los Angeles Daily Journal September 13, 1999
A decision has been made to leave a big firm with a handful of lawyers willing to take the entrepreneurial risk of starting a new Firm. Will clients follow? Will the best associates come on board? How soon can it happen? These are among the easy questions!!! While the first stressful step is typically whose name goes first on the letterhead and where the office will be located, the fundamental business element of “financing the business” often gets overlooked. Lawyers often assume that their favorite banker will be delighted to provide start-up financing, but soon find that this process is a lot more complicated than they would have imagined.
The start-up and operating costs to finance a new law firm are significant and, except to the extent that retainer clients are among the first served, it is typical to find minimal cash flow during the first several months of operation. Accordingly, partner/owners of new law firms are immediately burdened with equity capitalization requirements — either through cash contribution or deferral of draws.
It is imperative that such capital requirements be realistically projected, and similarly that the capital contribution potential of partner/owners be realistically determined. Necessarily, debt financing will be required for any shortfall between the requirements, the funding capacity, and the degree to which trade vendors will carry payables. Traditionally, the most cost effective financing for a law firm has been bank debt, either in the form of a term loan to provide initial working capital, or in the form of installment debt to acquire or lease office equipment and furnishings. More often then not, such financing requires the personal guarantee of partners/owners.
The reasons for which new law firms do not typically qualify for non-guaranteed financing include: absence of historical reliability in billings and collections, recognition that acquired assets are worth substantially less upon liquidation, and concern for the mobility of key attorneys (inferring diminished degree of continuity in cash flow).
Dennis Gilkerson, Vice President of the Citibank Private Bank, advises that banks have a difficult time lending money to start-ups. What Citibank looks closest at is theexperience level of the partners. They want to know who is joining the Firm, their capacity to repay debt, their experience, and what their personal financial picture looks like. The quality of the new Firm’s practice area is also an important factor. Citibank further looks to the partners to guarantee any monies borrowed from the bank.
Pauline Schiff, Senior Vice President of City National Bank, advises that when financing is requested for a start-up, their process includes queries such as: Why partners are leaving their former Firm? Will the clients go with them? Whether the departure is mutually agreeable to facilitate such transition? Do the partners have any liability to their old Firm? City National also inquires about the client base, the type of practice, the industries they represent, and the stability of their client base. Clearly by these standards, contingency Firms are the most difficult to finance.
Most banks require submission of partners’ personal financial statements and commitments of the degree to which personal savings will be invested as start-up capital, so the bank is not solely at risk. Initially, many banks will only make loans to individuals; then after a Firm has been established for three to six months and evidences some pattern of revenue and receivables, the ‘Personal’ loans can be converted to a Firm revolving line of credit. In order to start the process, banks typically require pro forma projections (prepared by the Firm’s independent accountant) which indicate the intended use of borrowed funds and when payback can occur, based on collection of receivables.
Most new Firms need to utilize bank-provided financing to support asset acquisition, working capital needs and/or anticipated growth and look for a banker who can meet such needs with the least level of intrusion. The best way to ensure avoidance of such intrusion is to think in reverse — understand, anticipate, and meet the banker’s needs before important factors become issues (often with urgent timetables).
Since lending institutions are focused on making money — with one eye toward competitive market rates for lending, and the other toward ensuring repayment of such loans — it becomes the law firm borrowers task to help its banker achieve the required level of confidence about the Firm’s ability to repay, addressing such concerns as: What sources of collateral protect the bank? What ‘secondary source’ or guarantees are available? What business and accounting controls will be implemented to protect continuity? Are such controls reliable? This is the environment of lending. The sooner a law firm can accommodate its banker’s “need to know”, the sooner funding may be obtainable and longer it may remain available.
A start-up law firm should be aware of, and be in a position to timely provide a lender with the following:
(1) A BUSINESS PLAN: A narrative description of where the Firm is headed and how it plans to get there. The plan needs to clarify things like what type of clients are to be served, what type of services are to be provided, how the Firm wants to be perceived by the outside world, what is the intended billing approach, Firm philosophy (billable hours, culture, partner compensation concept), marketing plan, management plan, etc.
(2) PROJECTED FINANCIAL PLAN: Based on the strategies presented in the Business Plan, the Firm should generally prepare an Operating Expense and Revenue Budget, Cash Flow Statement, Income Statement and Capital Budget, each in sufficient detail to evidence a carefully-thought-through program. In the first year of operations, there are also various “start-up” expenses that need to be included in the Expense and Capital Budgets. These typically include security deposits, prepaid insurance premiums, phone and utility deposits, acquisition of furniture, computers and equipment, printing letterhead and announcements, temporary help, movers, agency fees, state and local business taxes/permits, and accounting/consulting set up (accounting/billing/timekeeping system, etc.).
The Revenue Budget should forecast projected billings, factor in a collection realization rate and collection lag (number of months from production to collection) to arrive at projected cash inflow. The Capital Budget outlines capital expenditures for such items as furniture, equipment and library on a month-by-month basis. The Cash Flow Statement details sources and uses of cash on a monthly basis.
(3) REASONABLE LOAN COVENANTS: Among the protective devices a banker will require at inception of financing for a law firm are restrictions relating to matters as diverse as maintenance of percentage ratios of assets to debt or worth, limitations on asset acquisitions or dispositions, partner compensation levels, etc. It is imperative that covenants be set realistically at the inception of a lending agreement, and that, subsequent compliance is achieved. Moreover, any default in covenant provisions must be communicated, along with sufficient information to analyze the consequence of such default, well before a banker comes asking.
(4) CONSISTENT, TIMELY REPORTS: A banker’s “need to know” does not stop with issuance of a loan commitment or funding. Every law firm lending agreement calls for periodic reporting of ongoing financial data to support the original expectations – a failure of which can result in suspension of further credit or acceleration of loan terms. Internal financial reporting on a quarterly basis is generally acceptable after the Firm has been in operation for at least six months, provided the banker has confidence in the underlying accounting systems and procedures. Virtually all law firm lenders request annual “full disclosure” financial statements to be prepared by independent CPA’s.
HOW MUCH “START UP” CAPITAL IS NEEDED?
For law firms whose practice involves monthly billed clients, at least three to four months of capital is generally needed to fund operations. For Firm’s with a defense practice billing quarterly, enough capital to fund operations for at least six months is typically required. If the practice is a contingent plaintiffs’ practice, enough capital to fund operations for at least one year is recommended.
It is obviously wise to keep start-up costs as low as possible. Rather than expending precious capital to purchase furniture and equipment, leasing is often a prudent strategy; one step more conservative is acquiring used furniture and equipment at auctions and liquidations. Another strategy is to postpone having to purchase a library, telephone system, copier, fax or needing to hire a receptionist by subleasing space from another law firm or leasing space at an executive suite.
Finally, the single largest expense and most critical component in law firm profitability is its labor cost factor. Before hiring employees, ask: Who do we really need? What experience is really required? How many people do we absolutely need? Who will fit into our culture? Consider part-time or, temporary employees. Hire an office manager (if 5-10 lawyers) or an Administrator (11 or more lawyers) to help set up the Firm. If the partners are not ready to hire a manager, use an outside consultant to help get the Firm started or to handle ongoing non-law-practice matters (e.g.: outsourcing human resources management). In addition to minimizing cash outflow, this strategy generally optimizes inflow, since it protects billable hours of the attorneys, which otherwise get lost during the transition from the old Firm to the new one or in subsequent administrative tasks.