Before determining whether debt is good or bad, we need to distinguish between two kinds of law firm debt: a line of credit and term debt.
“Neither a borrower nor a lender be.“
Shakespeare’s Polonius may have had his reasons for this black-and-white stance on debt, but it’s not blanket advice I would give a law firm.
In the management of a healthy, profitable law firm, debt can play a significant role — and not just as a safety net, but as a proactive part of a firm’s financial strategy.
But there’s good debt and bad debt.
Here’s how you tell the difference.
What Kinds of Law Firm Debt Are There?
Before determining whether debt is good or bad, we need to distinguish between two kinds of debt: a line of credit and term debt.
- A line of credit is a flexible, revolving loan that a business can tap into as needed — and repay as desired.
- Term debt provides a set amount of cash, with a repayment schedule, and an interest rate (fixed or floating, depending on the terms of the loan).
Why Would a Law Firm Use a Line of Credit?
A healthy firm needs to have between 10% to 30% of its annualized revenue as working capital — to make payroll and pay rent and other overhead expenses. Ideally, you get there by leaving cash in the business from previous profits.
But even the best-laid plans require a backup.
That’s when you might consider a line of credit. As a firm is building up working capital, there are still ongoing expenses. There are also times when the bank balance drops dangerously low, for example, because a major client is delayed in paying for a month or two, a case is taking longer to settle than anticipated, or there are higher-than-expected case costs.
A line of credit can help make up for a short-term dip in cash. However, what you don’t want to do is use it to mask problems with firm management. If clients are regularly late in paying, it might be time to tighten up your billing practices and review your client list. If your spending is always over budget in a certain area, it might be time to review expenses.
Use a line of credit to get through a rough patch (or two), not to paint a rosier financial picture than really exists.
Why Would a Law Firm Use Term Debt?
In addition to ongoing expenses, law firms often confront major financial decisions, such as an office expansion or a technological overhaul.
But, even if you have all the cash available to make such an investment, you need to be fair to your entire partner group: A healthy partner group has people of all ages, so if you use current cash for a large expenditure and write the whole thing off at once, you compress income and cash flow to the detriment of the older partners who are close to retirement.
That’s where term debt is a perfect option.
Essentially, if you match up the depreciation expense with the cash flow on the principal payments (that is, the term of the loan matches with the depreciation of the asset), there’s no large write-off. Term debt makes large investments more fair to the whole partner group: By spreading out the repayments over time, the younger partners benefit from the depreciation and the partners closer to retirement don’t get their income as compressed.
The Golden Rule: When to Avoid Law Firm Debt
There is one rule I tell my clients never, ever to break. One trap I never want to see a firm fall into.
That’s the “distribute every nickel of cash” trap.
I see it all the time. Come December, firms distribute every penny in cash, and then they start the new year with nothing set aside for operating expenses in Q1.
That creates a vicious cycle, whereby it gets harder to pay off the debt, so the debt increases.
Every dollar that gets collected is no longer profit available for distribution; a chunk of it belongs to the bank, which means playing financial catch-up until the bank balance is back where it belongs.
Yes, it’s important not to keep too much money in a firm, to protect against liabilities. But there’s a reason that 10% to 30% working capital cushion is one of the core financial metrics for law firms. It’s like having enough gas in the tank to get you to your destination, even if you have to take a detour (or many). Then, once you hit that target, you can distribute everything above that amount — without worrying about needing debt for the wrong reasons.
Read More On Financing Your Firm
- “How to Create a Great Loan Package”
- “How Much Capital in Your Law Firm?”
- “Building a Law Firm That Pays You First”
- “Would You Pass a Trust Account Audit?“
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