A shifting legal landscape is testing the resilience of large and small firms alike as they face the challenges of a post-recession world. The dissolution of Canadian legal giant Heenan Blaikie is a dramatic example of how things can quickly go wrong when partners losing confidence pull out in droves, taking their capital investment with them. Across North America and into the United Kingdom, there is increasing concern over the flow of money as large and mid-sized law firms report sharp revenue decreases as a result of increased competition for a shrinking pool of high-end work.
Ed Waitzer observes the legal profession is indeed undergoing change. “The market for major law firms is shrinking, certainly in Canada,” he says. More firms are employing in-house lawyers, global firms are competing with national ones, and there is a repurposing of functions.
Law firms are reacting by being more strategic and moving beyond traditional work and approaches. Heenan Blaikie’s foray into Africa, anchored in its Paris office, is perhaps an example of the new order. The result of treading into new territory, however, could mean more challenges for the management of the firm as well as a less harmonious culture within it. It could also prove more risky. “It’s a different world,” says Waitzer, a professor at Osgoode Hall Law School and senior partner at Stikeman Elliott LLP, where he was once managing partner.
The bottom line is an increasing need to focus on the bottom line. That has become more important when the overall collected realization rate — the percentage collected of the standard value of the work billed — has dropped to 83.49 per cent, according to the Georgetown University Law Center and Thomson Reuters Peer Monitor in the 2014 Report on the State of the Legal Market. A reduced realization rate could have a major impact on the working capital available. No longer should getting work be the main focal point of the firm. Ensuring the bill is paid in full and in a timely manner can be critical to a firm’s survival.
Recognizing when your law firm is having cash flow problems may not always be easy, says David Bilinsky. But keeping a close eye on the firm’s budget and reports comparing actuals to projections is a good place to start. “The income statement does provide some insight into the sources and uses of cash, but the problem in Canada . . . it doesn’t provide a true insight into the actual cash in the firm,” he says. “Just looking at an income statement will give you a false reading on the actual cash being generated.”
A closer examination through a work-in-progress report shows whether lawyers are meeting projections. It also forecasts future cash flow difficulties if targets aren’t achieved. An expanding firm can run short of operating cash when it invests in contingency files. Another area of concern is when lawyers bank time, but don’t bill or are not producing.
Bilinsky, a practice management consultant and lawyer for the Law Society of British Columbia, finds the statement of changes in financial position could prove telling. It takes the activities of the firm and reports on the sources and uses of actual cash in the firm. It also shows how much cash is being used in financing, investing, and operating activities. “Over time you can see trends and if the firm is spending too much cash say on investing or operating activities,” he says.
When advising firms, Colin Cameron makes some key suggestions to ensure they stay on track, have adequate capital to cover costs, and maintain enough capital to continue on with business by preventing a “run on the bank” should partners lose faith in the firm, deciding to take their money and go elsewhere. His approach, when his Vancouver-based company Profits for Partners begins to consult with small- and mid-sized firms, often begins with an examination of the balance sheet. The focus is on reducing accounts receivable and work in progress.
Cameron cites a 2012 survey showing a firm invests more than four months of resources before receiving income on that work. That means the firm is pouring cash into the file, investing its overhead as well as lawyer and staff time, all affecting the cash flow, realizing no returns for an extended period of time. “We need to decrease that lock-up time,” Cameron advises. “If that lock-up time is increasing, then you’re experiencing a reduction in cash flow.”
The trick to avoiding problems, adds Cameron, is prevention. It can begin by ensuring the bill will, at the end of the day, be paid by doing a credit check on new clients, particularly those requiring extra time and attention. Net profit for most firms is in the area of 40 per cent. So if a client can’t pay the entire bill, the realization rate is reduced and so is profit. Some research will also help to weed out problematic clients or those shopping around for a deal. “So the key is to avoid those kinds of clients. The firms that are truly successful are those that look at the cash brought in and the resources used to get it,” says Cameron. “As you are approving new clients, you should also ask for a retainer (of a quarter to half the value of the work) up front. . . . If a client doesn’t want to do that, then that’s a red flag.” A client who won’t pay before work begins may not pay when the work is done, he adds.
Another way to prevent bleeding red ink on the ledger is by offering a fixed fee. Negotiating a fixed fee gives the client some certainty, which could be an incentive for them to pay half up front.
But it doesn’t end there — a credit limit should be assigned to the client and if the value of the work exceeds that limit, then a stop-work order should be issued until payment is made.
Heenan Blaikie’s operating capital took a major hit when partner after partner decided to leave, each taking their entire capital investment with them. This leads Cameron to suggest firms implement a capital payout policy. To avoid a run on capital contributions, necessary for the firm’s operations, the policy should stipulate how partners should be paid out when they leave. It could be graduated over a number of years or limited to a percentage of annual net income to avoid a cash flow squeeze, particularly if a large volume of partners leave at the same time.
But it’s not just the firms that should protect themselves. Partners should too. That, says Mitch Kowalski, means they should heed the advice they regularly dispense to clients. “What Heenan Blaikie has shown is how fragile these firms are,” says lawyer and author Kowalski. “To me, this is a huge wake-up call to understand the financials.”
He suggests partners push to get quarterly financial details that lay out the firm’s current status and show where it’s heading. They should look for a detailed review of all of the costs and all of the revenue. Their review should include the budgeting for the current year as well as financials for past years, which would allow them to identify any trends. In addition to the numbers, they should look at the strategic plan for the firm for the next five to 10 years.
He compares it to the advice lawyers give clients when purchasing a business: examine all aspects of the balance sheet. And he’s certain that’s something lawyers don’t themselves do. He points at “the lightning speed” with which so many partners jumped off the Heenan Blaikie ship to join other firms. “There’s no way they had time to do the due diligence on those firms. And yet, they would never advise their clients to do that. The bottom line for me is if I’m going to go into a partnership that would be the same as buying into a business. . . . If you suddenly wake up one day and say: ‘Wait a minute, what’s happened to my firm?’ well, then, it’s on you.”
He expects many of those lawyers will find themselves moving to yet another firm within the next year as they become more acquainted with their new environment and realize it wasn’t such a great match after all. He hopes some will strike out on their own with an entrepreneurial approach to create new firms with models to better match the changing legal landscape. Many clients are demanding a better bang for their buck and with a fresh start, new, smaller firms can lay out a course to provide that while still ensuring they are profitable.