Posted by George Bull, head of professional practices at Legal Futures Associate Baker Tilly
There is an increasingly strong belief that of the 200 or so mid-tier law firms, only 50 or so may survive in the short to medium term.
The work of our own recovery specialists has helped us understand the warning signs of firms which – if they do not mend their ways – may well be one of the 150 or so predicted failures in the top 200. To put it another way, if you wish to be in the successful 50, you need to avoid these pitfalls:
Allowing too much working capital lock-up
Work in progress not billed and debtors not collected in a timely fashion leads to increased working capital requirements. These requirements can be significantly reduced by active invoice management and regular credit control procedures.
Loss of key work-winners without suitable replacements
In a very competitive market, client attrition leads to loss of turnover. For firms with a traditional high fixed cost base of property, people and insurance, reductions in turnover inevitably result in profit erosion.
Ability to adapt and change cost base
If revenue continues to be under downward pressure, difficult decisions such as reducing staffing levels must be taken early. Prompt decisions help ensure that working capital is available to meet the often substantial costs of staff reduction programmes.
Ability to adapt and change service offerings
A thorough review of the profitability and cash requirements of each service line should be undertaken. Management should understand the commercial rationale for persevering with loss-making departments. This rationale should be reviewed and challenged on a regular basis.
Ability to adapt and change
Firms need the ability to innovate in the way services are delivered, moving from traditional models to more efficient process or project-driven, IT-enabled models.
Ability to adapt and respond to opportunities
The ability to identify growth markets and utilise existing skills and people to service these opportunities as they develop, or ability to attract key new partners to develop new markets, is vital to long-term sustainable growth;
Ineffective management team
A lack of defined leadership hampers the firm’s ability to create a defined strategic plan, to implement strategic plans and to develop growth and profitability.
Lack of management information
A lack of regular, usable financial information, often evidenced by inappropriate WIP and debtor provisioning, can lead to poor financial decisions being taken.
Difference between profits and cash
The lack of regular, usable financial information and the consequent failure to understand and highlight the difference between profit and cash can be very dangerous. Management teams driven by profit may not acknowledge future cash requirements and so may fail through unforeseen cash needs;
Weak financial management
If the chief financial officer does not have the status or presence to command respect among equity partners, their sound financial advice and planning may be ignored in favour of alternative strategies which cannot be funded.
Responding to the short-term attractiveness of rent-free periods and rentalised fit-out costs of new property transactions without the detailed analysis of the profit and cash effects on the firm in subsequent years can lead to significant cash difficulties;
Allowing partners to continue to take drawings in excess of the profits earned or the cash available in the partnership will quickly lead to financial difficulties.
Limited levels of communication from the management team to all partners about strategy and financial results will lead to disinterested and demotivated partners not all pulling in the same direction. This may lead to counter-intuitive actions being undertaken by partners or partners becoming disillusioned and leaving unnecessarily.
All profits drawn as remuneration
Leaving little or no reserves within the partnership means the firm has no ability to ride out the consequences of unexpected rainy days.
Merge in haste, repent at leisure
A poor choice of merger partners can turn a successful small firm into a large firm struggling for working capital and unable to pay the necessary restructuring costs leading to a downward spiral of performance;
Merger not adequately controlled
Without strong leadership and control of the merger process, a perfect strategic merger can lead to painful periods of firefighting to keep the larger firm afloat and lead to the loss of key work winners.
Poor post-merger integration
Firms often over-estimate the synergies achievable, and underestimate the time it will take, the complexity and ultimately the cost of integration.
Poor communication with and management of outside stakeholders
Failure to manage key stakeholders such as the firm’s bankers and the Solicitors Regulation Authority can lead to key decisions being enforced by parties outside of the firm. This obviously may not be in the best interests of the firm. Maintaining strong relationships with outside stakeholders and presenting unified workable plans gives firms a greater chance to control their own destiny;
High levels of debt
When interest rates eventually rise, firms with high levels of debt will see increased interest and finance charges. This erodes profits and limits cash available to be drawn as remuneration.
These risks can all be mitigated by strong leadership and communication from those charged with running the firm. Their leadership should be driven by considered strategic plans which are derived from accurate and timely management information and from a well-informed and insightful view of the current and future legal market.
As with all plans, they should be regularly revised and updated as dynamic conditions change.
So what happens next?
It is not just about ensuring that you are fit to survive but that you have a competitive edge. The mid-tier suffers from over-supply and pricing pressures with most firms having no clear differentiators. If you are determined to be one of the winners, then with the financial strength of survival comes the opportunity to build your own business through acquisitions of those firms who will not survive.
A firm that is financially fit with a clear strategy and real differentiators will not just survive but be one of the winners.