What SME firms must do to survive challenging times
Many small and medium-sized (SMEs) law firms have struggled over the past two years and have been forced to restructure their practices because of the recession. The downtown in the property market, cashflow problems as a result of the Legal Services Commission’s payment system, a general slowdown in transactional activity and the increase in professional indemnity insurance costs have all have caused significant pressure on firms’ ability to meet their liabilities as they fall due.
Halliwells is a high-profile example of a firm whose substantial property obligations significantly increased operating costs at a time when turnover was declining. This placed insurmountable pressure on cashflow.
However, we have officially reached the end of the recession and, for the SME law firm, the worst should be over. But there are two reasons why this may not be the case – one economic and one legislative.
The insolvency time lag
Insolvency statistics show a decrease in the number of formal insolvencies since the peak in 2009, but the insolvency trade body R3 has warned of an ‘insolvency time lag’. Figures from previous recessions in the 1980s and 1990s show that the peak in both personal and corporate insolvencies occurred after the return to growth. In the 1990s, the peak in company liquidations was a year and a quarter after the return to growth, and for personal insolvencies it was a year and a half after.
The lag is due to the time it takes before creditors begin to lend at pre-recession levels or before employment and spending pick up. The worst may not be over and liquidity problems will need to be tackled head on, particularly if the credit conditions do not ease over the coming months.
The Legal Services Act 2007
So-called ‘Tesco law’ will provide for alternative business structures, and impending threats to the smaller firm have not gone unrecognised. More than 200 law firms have signed up to relaunch themselves under the QualitySolicitors brand to compete with the large corporate brands expected to enter the legal services market. Other practices have been applying technological streamlining to remain competitive, marketing a new innovative charging structure and offering fixed prices in certain areas of service.
In addition, the Jackson report has proposed significant reforms to cut litigation costs. The implementation of his recommendations would hit personal injury practitioners hard, but could also be applied to clinical negligence, judicial review and defamation claims.
The list of serious business, economic and structural challenges facing SME legal firms could not have come at a worst time financially.
Historically, banks have been very comfortable with professional services firms because they have been run by wealthy, well-educated people. But lawyers are not financial experts, and smaller firms with inadequate management and reporting systems will increasingly be seen as a high risk.
Firms should focus on the four standard rules for business, namely:
- Avoid focusing only on profit. It is not usually lack of profitability that causes businesses to fail – it is lack of cash. The reason why most businesses fail is that they simply cannot pay their bills; they become cashflow insolvent. Adequate management systems need to be in place so that principals can spot and then act on the warning signs before they become problems.
- A view should be taken on clients' likelihood to default, as such an event can be crippling. Consider Companies House searches, checking with a credit reference agency, and forms of credit insurance. Clear credit and work in progress (WIP) exposure limits should be set to limit potential losses. The major financial assets of a law firm are its debtors and WIP; firms must have effective systems in place.
- Remember, ‘turnover is vanity and profit is sanity’. New business must be profitable, without significant risks and unfavourable terms for payment. It can be very tempting to bend over backwards for a shiny new contract with a large corporate client, but they often want longer payment terms so it could be months before you get paid and the margins may be lower.
- Spread the risk. A firm should not rely on just a handful of major clients, where the failure of just one could wipe out your business. The same can be said of fee generators: consider the effect of the retirement or resignation of key rainmakers, and the over-dependence on a single market.
SME law firms must have effective financial management controls and an understanding of key performance indicators, such as: utilisation; the percentage of total capacity chargeable; average hourly rates; realisation of time not written-off; the gross margin of fees to fee-earner salary; leverage; the number of fee-earners to equity partners; and overheads – all other non-fee-earner costs as a percentage of fees. This is not so they can start a new career as an accountant, but to identify the warning signs of financial vulnerability and keep the wolf from the door.
A recent report by KPMG for the Solicitors Regulation Authority noted that the number of interventions into firms has risen in recent years. The report recommended that firms should have a duty to tell the SRA when they are at risk of becoming insolvent, but there should not be any capital adequacy requirements. The SRA is developing more detailed proposals for consultation in October 2010, which will include a higher level of disclosure at certain trigger points. The current and sensible policy is that if a firm is sound and honest, the SRA may hold off an intervention and allow the firm to continue trading, even if the firm has entered into a formal insolvency procedure.
The incidence of small firm failure is likely to increase. Principals of theses firm need to be acutely aware of the pressures and put early warning systems in place to give themselves the best chance of survival.
The SRA appears to favour a more proactive than reactive involvement to monitor the solvency of firms – this should be emulated by firms.
If the worst happens, what restructuring procedures are available to a law firm?
If a firm becomes unable to pay its liabilities as they fall due, a restructuring must be the primary goal.
A law firm may be structured in four main ways. The SRA Summary of Performance Measures and Statistics March 2010 shows the number of practices as: limited company (1,742); LLP (1,167); partnership (3,787); and sole practitioner (4,056).
The sole practitioner bears a significant personal risk since there is no distinction between the private individual and the practitioner; business failure would most likely lead to an individual voluntary arrangement (IVA) or bankruptcy (which will automatically suspend the solicitor’s practising certificate, unless authorised in advance). A bankruptcy order may also lead to SRA intervention, with the costs being recoverable from the firm’s assets. Restructuring options for sole practitioners will include merger with another sole practitioner or joining another practice.
Partnership is still the most popular structure for practices with more than one principal. When a partnership gets into financial difficulties it may propose a partnership voluntary arrangement (PVA) for the partnership debts. The partners’ personal positions may also demand interlocking IVAs. Partnerships can also seek the protection of a partnership administration order, or may be wound up as an unregistered company.
Although liability for debts is limited with an LLP, in small firms partners may have had to replace limited status with personal guarantees to their bank, landlords and so on. The LLP or limited company may propose a voluntary arrangement; enter administration or liquidation (voluntary or compulsory). In liquidation the liability of the members (past and present) to contribute to the assets of the LLP are determined by the LLP agreement. The clawback provisions of the Insolvency Act 1986 apply to any member of an LLP who withdrew property (includes drawings) from the LLP for his own benefit during the two years before the commencement of the winding up.
Given the potential financial implications on partners of a small firm, a restructuring or rescue would be the preferred route. This may include capital injections from partners, negotiation with key creditors, reducing overheads or a formal insolvency process. Any formal insolvency process can be grounds for an SRA intervention, however an IVA/PVA will not automatically suspend a solicitor’s practising certificate (but conditions may be imposed).
Carl Bowles is a director of corporate recovery and insolvency at accountancy firm CBW. He can be contacted on 020 7309 3800, or at carl.bowles@cbw.co.uk
