How banks assess the creditworthiness of law firms

When reviewing a new request for credit or performing a periodic review of a law firm that’s already a client, commercial banks typically consider more than just the firm’s financial statement. We look at everything: the type and reputation of the firm; its exposure to industry consolidation; changes in the economic cycle; and whether there’s been a change in the top 10 clients or top 10 billing attorneys.

We use these questions to identify the health of the law firm and measure its long-term stability.

The standard questions

Of course, there are the usual questions you’d expect:

• Does the firm distribute more than it makes in a given year and what are the funds being used for?
• Is there a portion of debt that doesn’t revolve and, if so, would it be prudent for the firm to reduce that amount over time or consider hedging interest rate risk associated with long-term borrowings?
• Does the firm need a letter of credit to back its lease payments?
• To what extent has the firm retained capital throughout the years?
• Do the partners or shareholders provide personal recourse under the firm’s loan(s)?
• What’s the legal form of organization? For example, is it a Partnership, PC, LLP or LLC?

Taking a detailed look

Then, there are further questions that’ll help the bank understand the long-term stability of the firm. Expect questions like:

• How much hiring is taking place?
• How many employees are leaving?
• What’s the firm’s strategic approach to managing expenses?
• Is revenue concentrated among a few clients?
• How are individual practice groups performing?
• Is there an adequate succession plan in place?
• Is the ownership of the firm equitably distributed based on partner billings?
• What’s the firm’s Capital Program for its partners (or shareholders) and is there a need for a Capital Loan Program?
• Is there a pension in place and is it adequately funded?
• Are there significant retirement payments owed to founding partners and, if so, is there a reserve in place?
• What’s the firm’s go-to-market approach as it relates to its proportion of equity partners, income partners, associates, and the like?

Understanding the strategy of the firm as well as potential obligations help to round out the picture.

Determining the health of the firm

There are a few factors that help banks identify the healthiest firms. Strong firms generally:

• Manage cash flow well
• Limit distributions to that year’s pre-distribution net income
• Tie partner and shareholder compensation to realization rates and actual collections
• Manage the client base to avoid continual and excessive billing disputes and extreme seasonality
• Have operating cash flow sufficient to cover annual needs and seek term debt to finance longer term
• Use lines of credit to bridge intra-year seasonal timing differences between cash distributions and cash collections and then reduce line borrowings to $0 for a sustained period during the year
• Have strong collection practices and realization rates for accounts receivable and work-in-process, generally 85% or higher
• Have consistency and moderate-to-low concentration in top clients year-over-year, unless the work of the firm is more “one time” in nature such as class action or plaintiff personal injury
• Have diverse sources of revenue across practice groups
• Are more likely to remain independent or acquire talent or another firm (versus being acquired)
• Use term debt tied to a specific event, such as tenant improvement expenditures for an office move, and amortize over a reasonable period of time
• Utilize fraud protection services on operating accounts and remote deposit or lockbox services to speed collection of receivables
• Optimize revenue and expenses through a healthy balance of equity and income partners and associates