Partners must take the profits hit

The quickest way to cut costs at hard-pressed firms is for partners to take less out of the business

Giles Murphy

Managing a firm when fee income is at best fluctuating and at worst volatile is challenging, to say the least. Overheads remain painfully consistent (with a tendency to rise) but income is unfortunately much less predictable. In this situation law firms of any size can quickly come under strain, highlighting the fragility of the model.

Consider this: at the end of the month you invoice your client, say, £100. The next month you have to pay rent, salaries and other costs of £70, which leaves £30. Roughly £15 of this is put to one side to pay a future tax bill, leaving £15 for you as the partner.

You’ve got your own costs and plans for that money so you agree with the firm to take your money out straight away as a drawing. Your ability to take the money out has been restricted recently as clients have been slow to pay up, but the moment the money comes in you receive your drawing. This is the way most partnerships have operated for many years.

Now suppose you have a bad month and income falls by 10 per cent. You only bill £90, but still have costs of £70 so only £20 is left over. £10 is put aside for tax, but you would like to keep your drawings at £15, so you ‘borrow’ £5 off the tax amount you have set aside because, of course, once income picks up you will repay it.

Suppose this carries on for another three months. Your tax liability at this stage is £55, but you have borrowed from your tax reserve £20, almost half your tax liability.

Now multiply the £100 in the first line above by anything between 100,000 and 1,000,000 and you get an insight into why, when the tax payment deadline of 31 January approaches, a significant number of professional practice partnerships suddenly begin seeking emergency funding to pay tax – tax on work that was done up to 21 months ago and yet the money set aside is no longer there.

So what is the answer? Bluntly, if your income is falling you need to reduce your cash outflow. That means cutting costs, which can take time and, in the case of property costs, may not be possible in the short term.

But what can be cut quickly is the amount of money paid to partners. This is undoubtedly problematic for the partners involved but arguably less painful than what we have recently seen a top 100 law firm go through.

We wondered just how common it is for law firms to hold back profits and the answer came back ‘very’. In a survey of 119 law firms carried out by Smith & Williamson, a quarter of respondents said they would be retaining more funds in the business and a further quarter had this policy under review.

With potentially half the participating firms holding on to finance, this confirms how the partnership model is changing.

But at the end of the day it is important to remember the basics. As the old adage goes, ‘Cut your coat according to your cloth’. Never a truer word spoken.