Capital Introductions Driven by tax efficiency fail to address ownership issues
Recent UK partnership taxes have apparently forced many firms to ask second tier partners to introduce some capital to the firm essentially in order to preserve self-employed status. The problem is that capital introductions that are entirely driven by tax tend to obscure the real debate over ownership of law firms. There are two sides of the ownership equation.
- The firm’s assessment of how much partner capital it needs to run smoothly and
- The more interesting question of how much capital a partner needs to have vested in the firm’s future
The first part of this is that firms need to analyse their funding needs and balance them between the various sources of those funds – mainly partners’ capital and bank borrowings. Firms have tended to keep their fixed capital requirement low to make partnership affordable, and seek the minimum that they need to fund the firm. In this connection, recent law firm surveys have found a correlation between the level of working capital needed by firms and the amount of fixed capital provided by partners. The RBS 2013 Financial Benchmarking Report, for example, reported that 100 days of lock-up can be financed by fixed partner capital equivalent to 28% of fees – a figure which is not far off the median fixed capital shown by that Report. The PwC 2013 Annual Law Firm Survey found that fixed Capital in the UK Top 100 varies from an average of £184,000 at the bottom end to around £380,000 at the top end; these sound like big sums but in most cases are modest compared to both to the income returns to those partner and in relation to any realistic capitalisation value of the firm.
Risk and Ownership
The second part of the equation – the ‘skin in the game’ argument – forms essentially a risk and ownership question for anybody wanting to become a law firm owner. Even where the firm is sufficiently funded, a very general view seems to be that partner/owners should have some ‘skin in the game’ – in other words to have incurred monetary risk by being invested in achieving the firm’s goals. The origin of the phrase is unknown, but it has been variously attributed to Warren Buffett and to William Shakespeare’s Merchant of Venice where the famous ‘pound of flesh’ was put at stake as collateral. One argument often adduced is that the development of any firm is attributable not just to the partners’ financial investment in the firm but by virtue of their effort, performance and contribution over the years – the so-called ‘sweat equity’ principle. There is no doubt that this is true but the build-up of ‘sweat equity’ never obviates the need to require a financial investment.
In any entrepreneurial organisation, the owners introduce capital, take on huge risk and commit energy to the building of their firm, and as a result are real owners of the successful enterprise. In contrast, it has never been very easy to see who in reality owns the traditional law firm which may have passed through several generations of partners each of which introduced (on admission) and withdrew (on retirement) fixed capital contributions without ever being rewarded for their part in the building or development of the firm. Risk and return are inextricably linked. Few law firm partners, however, have traditionally looked on their financial input to their firm as an investment which needs to be commercially assessed and verified for returns on capital. Partners will often assess the risk of equity partnership when invited to become a partner but will rarely revisit the risk and return equation on a regular basis in the same way as they would consider their own personal portfolio of investments. It is worth remembering that Business Angels will expect at least a 60% annual return on their investments and Venture Capitalists and Private Equity Houses as much as 35% to cover their equity risk.
Any discussion about real ownership could be idle in a sector where firms are not worth much on the open market but it does cause a bit of a dilemma for firms as they face a liberalised future in which a few law firms are able to trade for real money, even if the majority of traditional firms remain relatively speaking unmarketable. There is probably no right answer. One option of course is to revalue the firm as a going concern every time a partner comes or goes. This would give every partner a real incentive to see the firm develop but it is likely to make partnership unaffordable to many. The other option is to continue juggle the firm’s funding needs between partners’ fixed capital and external funders and by tight financial management to maintain the firm’s working capital at an efficiently low level. By correlation partners’ fixed capital can be kept to modest levels if aligned to those needs alone. This would satisfy entrance eligibility but may end up with many partners feeling like birds of passage instead of real owners.
This article first appeared in “Managing Partner” Volume 16 Issue 10 (July/August 2014) and is reproduced with their permission