There’s no lack of jokesabout lawyers. But lend-ing to law firms is no

laughing matter, as the primaryassets of these credits leave theoffice every night. If we bear inmind the fundamental principlesof underwriting credit, this sectorof the service economy offersstrong opportunities for long-last-ing and profitable relationships.So let’s review the key elementsof successful lending as theyapply to law firms.

Firm Business StrategyLaw firms are for-profit enti-

ties; thus, their business strategyshould state how they intend tomeet profit objectives. Typically,law firms discuss their strategiesthrough use of marketing materi-als that discuss their practiceareas, geographical locations, andservices offered. Often lacking areclearly defined goals, value propo-sitions, and business developmentplans for meeting profit objec-tives.

Strategic issues that law firmsneed to consider include firmcomposition, the partner-to-associ-ate ratio, the level of equity part-ners to non-equity partners, meth-ods of earnings distribution, suc-cession planning for future leader-ship, and retirement of seniorpartners.

In lieu of a written document,a discussion with a few of thefirm’s senior equity partners canshed light on the consistency ofthe firm’s strategy.

Financial StrategyA law firm’s financial strategy

should be consistent with its busi-ness strategy. The retention ofcapital required for growth typi-

44 The RMA Journal March 2005

SPECIALIZED LENDING

Five key elements underlie successful loans: business strate-

gy; financial strategy; purpose of the credit facility; issues

affecting repayment sources; and structural elements to pro-

tect secondary exit strategy. This article reviews those elements as

they apply to law firms.

© 2005 by RMA. Ed Cooper is a senior vice president in Cole Taylor Bank’s Middle-Market Lending division. He has20 years of commercial lending experience. Cole Taylor Bank is headquartered in Chicago, Illinois.

Lendingto

Law Firmsby Edward L. Cooper III

Q: What’s the problem with lawyer jokes?

A: Lawyers don’t think they’re funny, and no one elsethinks they’re jokes.

cally competes with the desire tomake partner distributions. Themethodology for determiningyear-end payouts should be basedon a cash accounting basis. Thefunding of long-term liabilities,such as lease commitments andretirement obligations, must beconsidered in a financial strategy.Capital needs for technologyupgrades—hardware and soft-ware—should be identified andclearly planned.

PurposeMost law firm credit requests

fall into three categories: 1) work-ing capital; 2) support of officeleases; and 3) equipment, technol-ogy, and leasehold improvementpurchases.

Working capital is a primaryseasonal need for law firms.Unless a retainer is received inadvance, the firm will have to payout-of-pocket for operatingexpenses (associate salaries andutilities) related to client mattersprior to billing and collecting.Certain types of clients—forexample, insurance defensefirms—have periodic billingcycles in which fees are paid quar-terly. This need is typically sea-sonal, as the collection of accountsreceivable by bonus payout dateprovides cash sufficient to retireany working capital debt.

Letters of credit may berequired to support the firm’slease obligations. These amountstypically represent one year’slease payments. As the firm estab-lishes a payment history with itslandlord, the level of support canbe reduced and often eliminated.As is typical in all credits, letter ofcredit amounts should be reserved

against the collateral position.Equipment, technology, and

leasehold improvement representintermediate lending opportuni-ties. As is typical of these assetclasses, a lender must be comfort-able with the firm’s intermediatecash flow. Repayment from thisform of collateral is limited atbest.

Issues Affecting RepaymentThe number-one repayment

source for just about all credits iscash flow from earnings. Thisexpectation should also ring truefor law firms. However, earningsoften are reduced by year-end dis-tributions. These distributions aremade to minimize the firm’s taxobligation. It is important toacknowledge that the tax obliga-tion is not eliminated, justdeferred. At a future date thisobligation may need to be satis-fied, a situation that may slowlycreate a permanent level of debtcapital that must be addressed.

The following are featuresthat may affect the primary repay-ment source:

• Concentrations. The loss ofa meaningful client or thereduction of a specific type ofservice (IPO and bankruptcyservices), due to cyclicaldownturn, can have devastat-ing effects on cash flow.

• Stability of key employees.It is important to understandwho the firm’s top billingpartners are and how they arecompensated. Gone are thedays when high-billing associ-ates waited their turn to sharein the profits.

• Flexibility of overhead.Should revenues decline, willthe firm be able to reduceoverhead? Is it willing andable to reduce staff levels? Isoverhead (lease payments,retirement payouts, term debtpayments) flexible? Are theremeaningful capital additionsrequired for technologyimprovements?

• Shift in strategy. Significantcommitment to a geographicexpansion, the addition ofnew practice areas, new officespace, and additional associ-ates all add to cash flowrequirements.

Protecting the Secondary ExitAs mentioned at the outset,

highly specialized service firmsare unique in that their assetsleave the office every night. Asthe assets go, so does the abilityto generate cash flow from earn-ings. Depending on the size anddiversity of the firm, some or allof the following structural ele-ments may assist in preserving asecondary exit.

• A borrowing base for workingcapital facilities, including areview of the accounts receiv-able aging and realization rate(similar to dilution, theamount collected as a per-centage of the amount billed).

• Collateral, primarily theaccounts receivable.

• Cash flow control throughmaintaining the depositoryrelationship.

• A limit placed on the lengthof the facility.

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• An annual cleanup require-ment.

• Guarantees from the partners.

• Regular reporting require-ments, including accrual andcash basis financialstatements.

• Covenants concerning aminimum level of part-ners and a minimumlevel of accrual-basedequity.

• The ability to limitpartner distributions ifcovenants are not met.

ConclusionA clear understanding

of the purpose and repay-ment of the credit facility,

combined with consistent affir-mation of the firm’s strategy,should prevent lenders frombeing surprised by law firm cred-its. Because cash flow is the dom-inant repayment source, the abili-ty of the firm to meet its strategic

goals and continue as a goingconcern is of prime importance.❒

Contact Ed Cooper by e-mail atECooper@ColeTaylor.com.

The RMA Journal March 200546

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