The entire concept of capitalization is surprisingly misunderstood by many, otherwise business savvy, law firm partners.  Transactional lawyers spend their time working with large sophisticated clients where cash flow is often not an issue.  Litigators are good at untangling complex balance sheets and contingent liabilities, but law firms are simple organizations built on the basic principal, “Cash in must exceed cash out.”  And the operative word here is cash.

Consultants frequently complain that law firms are dangerously under-capitalized.  If viewed from the perspective of lenders, however, law firms are fairly asset rich organizations.  Aside from relatively small amounts of debt that is typically offset by fixed assets, most firms have virtually no debt that overlaps fiscal years.  At the same time, they typically are sitting on four to six months of annual revenue tied up in work-in-progress and accounts receivable.  The real issue, therefore, is not capital, but working capital – cash required to meet payrolls, cover operating expenses and pay partner draws.

So, how much working capital is enough?  There are four issues involved in determining an appropriate level of working capital. The first is the historic calculation of your firm’s cash flow.  This is simply the amount of cash your firm consumes in excess of revenue received at any given time.  Most firms kick out all of their profits at year end or early in the new year.  As a result, they need working capital to fund their expenses until sufficient revenues are collected in the new year to cover the cash deficit.  Therefore, the maximum cash shortfall during the year represents the cash deficit for which working capital is required.  Here’s an easy way to calculate this.  Review the history of the firm’s short-term bank borrowing facility.  The maximum amount drawn on the line of credit at anytime during the year represents the additional working capital required.  If your firm doesn’t use a line of credit, you either have very thoughtful vendors, or plenty of working capital.

The second issue involved in determining working capital is the need for cash in the coming year.  Aside from operating expenses, there are a couple of big uses of cash, which vary from firm to firm.  The first is the amount of partner draws.  Some firms only kick out cash to partners from actual profits less a cash reserve equal to a couple of months’ expenses.  Whenever there is enough for a distribution, they make one.  Essentially the partners are providing working capital from their current earnings.  The other major cash hog is lateral growth.  Firms focusing on rapid growth by bringing in laterals will need cash to pay the lateral’s draws and fund their engagements while the firm waits for the work-in-progress and accounts receivable pipelines to fill.

A third working capital issue is the comparative of how much other firms seek from their partners.  Aside from curiosity, contributed capital can be a significant competitive issue when attempting to attract lateral candidates.  Recently we did a survey for our clients of large (over 100 lawyers) U.S. law firms on the amount of working capital they required.  Since the contributed capital in about two-thirds of survey participants varies by partners’ profit participation and in some firms includes non-equity partner contributed capital, we elected to measure Capitalization Survey Reportworking capital as a percentage of total partner compensation.  As shown in the following graph, 82% of the 96 firms responding had total working capital equal to less than a quarter of total partner compensation (including non-equity partners).  It’s interesting to note that almost a quarter of firms have working capital of less than 5% of partner comp and nearly half have less than 10%.  We also learned that contributed capital requirements tend to increase with the size of a law firm.

The final issue in determining political capital is politics involved.  Does a firm’s leadership have the will and the capability to convince their partners that a major increase in capital is required?  And, once the decision is made, can they find a method of collection that is acceptable?  Even though capital contributed to a business remains as an asset on a partner’s personal net worth statement, it’s tough to get people to part with cash.

Now back to how much working capital is enough.  Setting aside all the math and comparisons, and just going on what I’ve observed over the years, I think I have concluded a safe harbor amount for growing law firms.  You’re probably not going to like the answer: for most firms it is somewhere in vicinity of 30 percent to 40 percent of partner compensation.   For firms that have relatively low partner draws, aren’t planning significant growth and are pretty well disciplined on their billings and collections, the amount is probably less – maybe 25 percent.  But for firms on the other end of the scale, the amount is probably closer to 50 to 60 percent.

Just remember the old adage:  Nobody ever went out of business because they had too much working capital.