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Partners may have to get used to taking a lower share of profits as firms feel the funding squeeze
Firms are being squeezed on all sides. While there is pressure on fees and rising costs such as salaries, property and technology, firms are also facing funding challenges.
Borrowing costs are high, few partners wish to put new capital into the business and lockup is under pressure.
As a result, the traditional law firm model of paying out profits to partners in full, albeit often during the subsequent financial year, may simply not be feasible any more.
Many of the cash outflows for a firm follow regular and predictable patterns, but predicting the flow of work and when payment will be received is much more difficult. Moreover, it’s likely to get harder, given the state of the economy.
As a result, it is essential that firms have sufficient funding to deal with unpredictable and possibly volatile cash inflows.
Many firms have traditionally relied on bank funding to provide a core element of this finance, but with the economy still struggling banking facilities are frequently now more expensive, onerous or even unavailable altogether.
An alternative is for firms to request more cash from partners or simply to defer amounts paid out. Arguably, the latter already occurs as some firms do not have the money to pay profit shares from previous years and undrawn profit remains within the firm.
However, increasingly firms are taking the strategic decision at the start of the year to retain some of their profits. This results in a proportion of profits being unallocated and kept back, much in the same way that a company may not pay out all its profits as a dividend.
Arguably, given the rising tide of competition between law firms, not to mention pressure from specialist niche practices and new entrants to the sector, this situation will become increasingly common, if only to maintain position.
The challenge is often to get partners to agree to such a change. After all, why would partners vote to receive a smaller profit share?
The answer is down to the strength of the management and the ability to communicate the issues and options available to the firm.
Where firms have a pressing need, such as a rapidly approaching overdraft limit, law firm management can be decisive and receive the necessary support for change.
However, in the absence of an immediate threat to the survival of the firm management needs to be able to demonstrate with clarity the importance of making change for the long-term health of the organisation.
One point to bear in mind regarding retained profits is that HM Revenue & Customs taxes partners on the full profit as opposed to profits that are allocated, so care needs to be taken to ensure equity between partners is maintained.
In an environment of potentially lower profits, rising costs and higher taxation partners may understandably be reluctant to buy into a strategy of leaving within the firm that which they may have, for many years, considered to be their own money.
However, if the end to full distribution is essential in order to create a prosperous and long-term future for their firms, they may be left with little option.