Flailing firms: How mid-market law firms can return from the brink of failure

Running any business is difficult,
let alone in the challenging climate affecting most areas of the UK legal profession. Increased competition, market consolidation and regulatory changes are making it harder for many law firms to stay ahead of the game and run financially-viable businesses. Compounding the problem is the fact that many law firm partners were never trained to manage and market
a business.

The legal profession continues to produce more qualified solicitors each year and the number of firms has remained largely the same. Interestingly, the dynamics of the market has changed, with national and regional players getting larger. Many practices desperately need a strategy to either merge, consolidate or close.

But, how many practices are actually mergeable? Increased work levels, such as from conveyancing and an influx of partner capital loans, have merely papered over
the cracks, giving many partners a false sense of security. Numerous law firms
are facing a range of financial challenges which threaten their business stability.

Causes of instability

The Solicitors Regulation Authority (SRA) recently conducted a financial stability programme, which included intensive engagement with firms that were struggling financially. They did this to understand the main reasons why law firms were failing and the risks this posed to meeting regulatory objectives. A report was produced on the key findings.

The SRA found that main reason for financial instability in law firms was overdrawing by partners who did not appreciate the difference between profit and cash in the bank. Other factors which have contributed to law firm failure include:

• high borrowing to fund payments due, often seeking funding from second and third-tier lenders with high interest payments, which ultimately makes the cash position worse in the long run;

• continuing to pay monthly drawings to partners based on previous years' profits, despite pressures on cashflow;

• firms being controlled by an 'inner circle' of senior management, with rank and fixed-share partners not aware of
  the difficulties;

• succession planning pressures and funding departing partners' return
  on equity;

• rogue behaviour from partners or staff, linked to poor supervision;

• financial information not being shared amongst all the partners;

• no reserves for VAT, partner tax and professional indemnity insurance;

• VAT receipts used as office account funds, with consequential second-tier borrowing to fund VAT payments; and

• a weak or non-assertive finance director, without forward cashflow planning.

A significant number of law firms within
the mid-tier are failing to make critical changes that could prevent their business from failing. Is it because they think that,
as a mid-sized firm, they are neither too small to be concerned with one particular area of law going dry and not too big that they face large rent/salary/utilities or tax payments? Is it because they think they can trade through their financial downturn? Is it because they don't know where to
turn to for support and advice? Is it because they fear the consequences
of seeking such advice? Or is it because they cannot face the reality that the business is struggling? Have they
put their reputations before their remuneration?

Strategy flaws

There is a difficult balance to strike between running a business and providing legal advice. Sometimes the focus moves away from cashflow and running the business effectively to winning clients, but without the working capital to support the increase in turnover.

Another temptation is to look to buy
in work, which is not always the right move. Some firms think they can increase turnover with bolt-on lateral hires who promise
strong client followings. However, clients do not like being 'sold'; research has also found that 32 per cent of lateral hires fail.¹

Larger law firms often acquire firms in key regional or practice areas, but few of these acquisitions are successful. One reason is that becoming a successor practice carries huge risk and some partners still believe they can charge
a multiple on profits to any potential suitor. Many firms think their practice
contains real value and, if approached by a potential buyer, the age-old question of goodwill comes into question.² In fact,
many firms that are potential buyers are shocked by the demands of some prospective partners. This false expectation is rarely achieved and a clause of 'caveat emptor' has crept into the lexicon of
many buyers.

Reviewing each department and judging its profitability is an essential ingredient for survival. The number of practices that continue to provide services to clients at
a loss is astounding. Many firms consider conveyancing as part of their future, but a large number of firms (particularly those working with conveyancing panels) are losing money
on every file they open. Conveyancing provides relatively quick turnaround of
cash, but if every file opened loses
money, what's the point?

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HOW TO PREVENT YOUR LAW FIRM FROM FAILING

DO

• Share financial information with all partners (including office account balances) so that everyone is focused on cashflow. Some of the best finance directors circulate a daily email with the office account balance amongst the partners.

• Ensure drawings are linked to cash collection targets and do not draw more than net profits.

• Reserve monies to fund partners’ tax from income received.

• Consider the merits of a capital reserve account.

• Review your premises commitments.

• Test profitability levels and discard unprofitable work.

• Focus on cashflow – cash is king!

• Plan ahead for the cash spike months, e.g. January (partner tax) and October (professional indemnity insurance and practising certificate renewals).

• Review and revise cashflow forecasts.

• Track statistics on PII risks.

• Regularly communicate with key stakeholders – no one likes unpleasant surprises!

• Revisit your business model and consider the benefit of holding a recognised body or recognised licensable body entity as a ‘spare’ to allow for speed and flexibility in business planning.

• Consider adopting an alternative business structure with non-lawyer ownership and/or external investment.

DON'T

• Bury your head in the sand and hope things will improve on their own.

• Rely on lateral hires to bring in cashflow – there is always a lapse of at least six months before work in progress is turned into cash for the business, and that is on the proviso that they bring the fees they say they are going to.

• Become resistant to change. Firms which do not change will face stiff competition from those adapting to the opportunities in the evolving legal marketplace.

• Jump into a merger or acquisition without completing full due diligence to make sure it is right for your business.

The future of the partnership model and of the limited liability partnership is questionable; there are still significant advantages in incorporating your practice. This would not just be for tax purposes
but also for succession planning.

Changing the firm's business model could well be a solution. The management buyout (MBO) approach is not new, but creates a new opportunity for partners to incorporate the practice and buy their own business. The key is to take action early enough - this is an option for stressed
but not distressed practices.

To ensure your business is sustainable in the long run, always plan ahead. No matter how unlikely a risk is, always expect the unexpected. Do you have a key fee earner? What would you do if that fee earner suddenly left? Do you have one
or two key clients? What would you do
if they went elsewhere or stopped giving you work?

Often, by the time a firm realises that it is in difficulty, it is too late. So what can managing partners do to 'future-proof' their firm? While there is no absolute certainty to keeping your business afloat, there are ways to prevent your business from failing (see box). Many firms think they are okay because they have successfully journeyed through the recession. But, if working capital has been stripped, the upturn in work will stretch working capital pressures even further. Overtrading is a significant risk post-recession. Partners may not realise the potential personal consequences they face if the firm fails.

In one firm recently, the rank-and-file partners were not aware of the true picture of their firm's finances. However, as they were being held out as partners, the firm's creditors were also seeking recovery from fixed share and salaried partners. Indemnities from equity partners had limited value by this stage. They still remained liable, however, for any debt incurred on behalf of the firm, as the partners were jointly and severely liable.

If a law firm starts to struggle and/or
is just left to unwind in a disorderly fashion, this is likely to end in an intervention. This has consequences not just for the firm and its people, but also for every other law firm in England and Wales. This is because, ultimately, the cost of one firm's intervention will be picked up by every other regulated entity by way of Compensation Fund payments at the professional indemnity insurance renewal stage. Intervention costs are substantial; if Cobbetts had been intervened, the anticipated intervention costs would have amounted to £6m. Challinors was costed out at £4m.

A common theme among law firms which have faced financial challenges over the past few years is that do not acknowledge (or, rather, do not want to acknowledge) that there is a problem in
the first place. Another common theme is that,
once they do acknowledge it, they keep it secret from other partners, staff and stakeholders. This could be because
they do not want to concern people at
this stage and believe that they can deal with it themselves.

Firms which are either in a state of denial or are being secretive about what
is happening do not get the benefit of joint discussion between the partners about possible solutions. They also mistakenly believe that, if they keep the news within the senior management team, word will not get out and staff will be none the wiser. This is a big mistake, as people are generally very good at sensing when something is not quite right - and that's when the rumour mill starts, making things sound worse than they are. When people fear the worst, they tend to look to leave, which has a massive impact on cash coming into the business. Funding departing partner equity adds to the
firm's financial pressures.

Many of the firms that have managed
to turn themselves around have sought advice and shared information appropriately. They have quickly put into action preventative steps such as shedding unprofitable work, reorganising and reviewing their strategy.

Upcoming firm failures

We can expect to see more law firm failures in the coming months. Among these will be:

• firms that cannot fund their professional indemnity insurance premiums;

• legal aid practices without contracts; and

• firms in the personal injury sector
  which are depending on pre-Jackson work that is no longer available.

There is no doubt that lender portals will reduce their risks by reducing the numbers of law firms on their panels. If law firms do not have software to reduce risk and mitigate mistakes, they will not be eligible for a place on lender panels. Meanwhile, the accountancy sector threatens 700 legal practices on the high street - probate is
just the beginning.

Dropping unprofitable lines of work and value pricing services is the way forward for independent law firms. It all comes down to the simple motto of 'living within your means' and, if you find yourself in difficulty, putting in place preventative measures to steer your business into success.
 

Viv Williams is CEO of 360 Legal Group (www.360legalgroup.co.uk). Samantha Palmer is partner and head of professional and financial risk at Ashfords
(www.ashfords.co.uk).

References

1. See Lateral Partner Hiring and Integration for Law Firms: Hiring for Success, Mark Brandon, Ark Group, August 2013

2. See 'Brand equity: How to calculate the value of your law firm's brand', Thayne Forbes, Managing Partner,
   Vol. 18 Issue 2, October 2015

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