Capital introductions driven by tax efficiency fail to address ownership issues

Recent UK partnership taxes have apparently forced many law firms to ask second-tier partners to introduce some capital to the firm, essentially in order to preserve their self-employed status. The problem is that capital introductions that are entirely driven by tax tend to obscure the real debate over ownership of law firms.

There are two sides to the ownership equation:

• the firm’s assessment of how much partner capital it needs to run smoothly; and

• how much capital a partner needs
  to have vested in the firm’s future.

Funding requirements

The first part of the equation is that firms need to analyse their funding needs and balance them between the various sources of those funds – mainly partners’ capital and bank borrowings. Firms have tended to keep their fixed capital requirements low to make partnership affordable and seek the minimum that they need to fund the firm.

Recent law firm surveys have found a correlation between the level of working capital needed by firms and the amount of fixed capital provided by partners. The RBS 2013 Financial Benchmarking Report – Law Firms, for example, found that 100 days of lock-up can be financed by fixed partner capital equivalent to 28 per cent of fees, which is not far off the median fixed capital. The PwC Law Firms’ Survey 2013 reported that fixed capital in the UK top 100 varies from an average of £184,000 at the bottom end to around £380,000 at the top end.

These sound like big sums but, in most cases, are modest compared to both the income returns to those partners and in relation to any realistic capitalisation value of the firm.

Risk and ownership

The second part of the equation forms essentially a risk and ownership question for anybody wanting to become a law firm owner. Even where the firm is sufficiently funded, a very general view seems to be that partners/owners should have some ‘skin in the game’ – in other words, have incurred monetary risk by being vested
in achieving the firm’s goals.

One argument often adduced is that
the development of any firm is attributable not just to the partners’ financial investment in it but by virtue of their effort, performance and contribution over the years – the so-called ‘sweat equity’ principle. There is no doubt that this is true, but the build up of ‘sweat equity’ never obviates the need to require a financial investment.

In any entrepreneurial organisation,
the owners introduce capital, take on huge risk and commit energy to the building of their firm and, as a result, are real owners
of its success. By contrast, it has never been very easy to see who in reality owns the traditional law firm, which may have passed through several generations of partners, each of which introduced (on admission) and withdrew (on retirement) fixed capital contributions, without ever being rewarded for their part in building
or developing the firm.

Risk and return are inextricably linked. Few law firm partners, however, have traditionally looked on their financial input to their firm as an investment that needs to be commercially assessed and verified for returns on capital. People will often assess the risk of equity partnership when invited to become a partner, but will rarely revisit the risk and return equation on a regular basis in the same way as they would consider their own personal portfolio of investments.

It is worth remembering that ‘business angels’ will expect at least a 60 per cent annual return on their investments, while venture capitalists and private equity houses will earn as much as 35 per cent to cover their equity risk.

Valuing firms

Any discussion about real ownership could be idle in a sector in which firms are not worth much on the open market. But, it does cause a bit of a dilemma for firms as they face a liberalised future in which some of their peers are able to trade for real money, even if the majority of traditional firms remain ‘unmarketable’.

There is probably no right answer.
One option of course is to revalue the firm as a going concern every time a partner joins or leaves. This would give every partner a real incentive to see the firm develop, but is likely to make partnership unaffordable to many.

The other option is to continue to juggle the firm’s funding needs between partners’ fixed capital and external funders, and by tight financial management to maintain the firm’s working capital at an efficiently low level. By correlation, partners’ fixed capital can be kept to modest levels if aligned to those needs alone. This would satisfy entrance eligibility, but may result in many partners feeling like birds of passage instead of real owners.

Nick Jarrett-Kerr advises law firms worldwide on strategy, governance
and leadership development
(www.jarrett-kerr.com)