Succession Planning—How Does Your Capital Look?

Most firms have been dealing with partner retirements and client succession for many years. Planning for these events can be time-consuming and full of potential land mines. Done correctly, the firm is stronger, and the clients happier, for the proactive and careful approach to understanding the complexity both personally and professionally for the firm, retiring partners and clients.

In succession planning, be careful not to overlook the impact these retirements and/or departures have on the firm’s cash flow, capital requirements and loan covenants. Careful forward planning is necessary for the firm to understand how the retirement of these individuals and subsequent return of capital will affect the firm going forward, especially for firms with many older lawyers with similar retirement plans.

A Look Forward

Most firms generate a comprehensive annual budget and cash flow projections, which will help keep the firm on track for monitoring and preparing for revenue and expense expectations. Taking the time to create a long term capital plan in addition to annual financial planning will allow the firm to look at how retirements, new partner additions, and critical projects such as office moves, expansions, and technology investments will affect the firm’s operating cash needs.

Depending upon your capital pay-in and pay-out policies, retirements can place a burden on required capital, potentially at inopportune times.  Michael Ouellet, senior vice president for Citizens Bank’s Professionals Banking team, advises firms to review capital before looking for financing for a big project or expansion. “Banks need to see that the firm’s partners have a vested interest in the financial stability and strength of their organizations” says Mr. Ouellet. “Firms that gradually raise capital from their partners can make themselves far more attractive to a lending intuition, allowing favorable terms including better interest rates and reduced or no personal guarantees.” He also notes that planning for a gradual increase in capital contributions allows for the partners to adequately plan their own cash flow needs, and, if necessary, find resources to fund their capital obligations to their firm.

Other important factors are considered in lending decisions, but most loans will have specific covenants that require adequate capital contributions and retention. It is important when preparing for large needs of investment capital to look at the firm’s pending retirements and plans for adding new partners. Your capital plan must take these covenants into careful consideration, so that at no time will the firm fail these tests and force an unexpected capital call.

Every partnership agreement is different and firms often stagger the repayment and contributions of capital over many years. For those firms, it is even more important to project net contributions over a five-to-10-year period to work towards balancing between what is paid out and what will come in.

What Are Appropriate Levels?

This is often asked, and the best answer is “it depends.” Unlike many metrics, no one size fits all. Some firms use a graded capital pay-in structure, where newer partners are asked to contribute less in the first few years, with this amount gradually increasing over time.  Others have a set “cost of entry” which a partner must contribute. Before evaluating both the total capital needed and the amount each partner should contribute, take time to ask initial questions about your business.

  1. How often does the firm rely on financing to take care of operating expenses?
  2. How volatile have revenues and expenses been from year to year?
  3. Are there client or industry concentrations that could affect a loss of significant revenue?
  4. What are the strategic plans for the firm, in terms of expansion and investment in new markets, practice areas, staffing, and technology or office space?
  5. What are current long-term debt obligations such as deferred compensation and retirement benefits (such as defined benefit plans)?
  6. What are the ages of your partners and what are your mandatory retirement provisions?

With these questions answered, the firm’s partners can evaluate if and when the current capital structure must be revised.

Besides having the answers to the above questions, creating a capital plan necessitates several assumptions. Partners must be open to communicating what their long-term plans are for retirement, without the concern that such information could affect their compensation in the short run. The planning should also look at the associate ranks, and determine realistic timeframes to bring in new partners. Is there a gap in experience, or do partnership offers need to be accelerated? If so, how will new partners effect the distribution of income? These can be potential roadblocks if you are requesting your partners to both increase capital pay-ins while reducing their share in the profits.

Unless specifically detailed in a partnership agreement, the plan must assume how and when capital will be returned or paid in. Some firms may need to require a large initial pay-in for new partners, and if so, will the firm arrange for a third party to help the new partner arrange for their share.

After testing these assumptions, it may then be necessary to re-visit the partnership agreement or strategic plan to better match the firm’s capital needs.

Consistent Reviews

Like any plan, strategic or otherwise, the results will need monitoring, as reality vs. assumptions can present the need for adjustments. These capital plans should be a normal part of the annual budget and cash flow development. This way adjustments can be made in a timely manner that keep the partners aware of circumstances that can change the requirements for the firm. A good capital plan puts the firm in an enviable position to act on new opportunities to help the firm grow and compete in this ever-changing environment. An appropriate structured capital plan can be attractive to potential lateral hires or practice groups, and as noted before, should allow the firm to obtain competitive financing terms and rates. A strong capitalized firm also is better prepared  to weather the storm of economic downturns such as the legal industry saw less than 10 years ago. Many businesses that relied on “cheap credit” found themselves asking the partners for cash inflows at the very time that profits and portfolios were reducing. Planning in the good years protects in the challenging ones.

About the Author

Stephanie Hood is a principal at Traballo LLC, a consulting firm focused on offering professional service organizations practical operational and strategic solutions.

Send this to a friend