Don’t get caught out by the traditional equity partnership model

A guest post by David Beech, CEO of regional alternative business structure Knights 1759

Beech: Many firms are stuck in an archaic way of working

It’s no secret that these are challenging times for some of the UK law sector as it tries to keep up with emerging digital trends and increasing demand from clients.

But there is buoyancy in the market and opportunities for those businesses that are agile and brave enough to challenge the status quo – the traditional equity partnership model.

At Knights 1759, we’ve seen it all too often where partners have been duped into putting their assets against a failing business that is riddled with debt. We’ve even received calls from partners to discuss bankruptcy and that the possibility of moving house is no longer possible, due to the LLP they joined going into liquidation.

Why are traditional law firms riddled with debt and failing?

Last year, PwC reported that profits decreased at half of top UK law firms, while Edward Drummond found that the collective debt held by the top 100 firms reached £4.3bn – a 14% increase in 12 months.

This ultimately comes down to an archaic way of working and outdated business structure. An LLP is no longer an efficient and effective business model for law firms.

Decision-making is painfully slow amongst partners, overheads are spiralling out of control with businesses employing an unnecessary number of support staff which leads to rising debts and a troubled cash flow.

How are traditional law firms able to conceal debts and convince new and existing partners to put in equity?

When tax returns are filed in January, it is unfortunately a time when even more partners get lured in to putting equity into a dying business and the devil really is in the detail.

As cash is running out, the managing partner convinces existing partners, potential new partners and the banks financing LLPs that the work in progress (WIP) stated within the accounts of the firm as ‘current assets’ is a real and tangible asset – when a large proportion of it is irrecoverable.

The WIP figure actually provides a comfort blanket for existing partners and helps to convince prospective partners that equity partnership, the Holy Grail, is valuable and should be aspired to. However, the unfortunate reality for many LLP members is that it is a high-risk career move that can easily end in financial disaster.

Those managing LLPs retain old, non-billable and non-collectable WIP on their balance sheets and pay tax upon it in preference to the unpalatable alternative, which is to admit that their business is distressed.

If the truth comes out, there is a significant likelihood that the banks will demand that the partners put more ‘skin in the game’ and will facilitate this by making professional practice loans available.

Truth sacrificed

Usually those on the management board have the most to lose because of significant capital tied up in the LLP.

The truth is sacrificed in favour of the misguided view that a greater good will be served if the facts are suppressed. Of course, it is not in the bank’s interests to reveal the inconvenient truth behind the cash call; its willingness to lend more money also conveniently reduces its exposure to a distressed LLP.

The alternative solution

So, what is the alternative and is it really all doom and gloom for the legal sector? Thankfully not. There are opportunities in the sector for those organisations that are bold enough to change their business model.

Law firms should introduce a corporate structure which requires no capital contribution, allowing partners within the business to flourish and do what they do best.

Alternative business structure (ABS) licences have opened up the legal sector to an entirely new way of working. However, they are yet to make the instant impact many would have predicted in 2012.

Since being established, more than 1,000 ABS licences have been granted. Yet only around 25 of these law firms have truly embraced the opportunities it brings for business growth and very few have secured external investment and made significant changes to their business model.

The next move for a managing partner?

Judging by the signs of distress in the legal market and the approaching gloom in the economy, it’s likely that many more law firms will fail than ever before. 

As a partner, if you are tempted to meet a cash call, do your due diligence or better still, avoid putting your personal assets at risk and move to a well-funded and properly managed corporate structure which does not require you to make any capital contribution at all.  

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