What SME law firms need to consider for funding in the new normal

Kate Arnott, partner at MHA, says law firms should adapt their scope and approach to funding post-pandemic as the ability of the partners to repay their personal borrowings is predicated on the business being able to generate sufficient wealth and also on there being a succession plan in place.

Funding has been a common theme that has arisen when speaking with clients over the last few months – in particular, there are questions around the changes to the funding environment following the pandemic. This has been driven by the new CBILS loans that many firms now have in place and the tightening of the banks’ views in relation to the professional services sector.

We’ve seen banks looking more closely at firms when making lending decisions. In particular, the personal borrowings of the partners in relation to their partnership capital is being considered as well as the borrowings of the firm itself. This wider view of funding clearly makes sense because the ability of the partners to repay their personal borrowings is predicated on the business being able to generate sufficient wealth and also on there being a succession plan in place that enables partners to withdraw their capital upon retirement.

It’s quite easy to benchmark your firm’s borrowings to others as the annual accounts show the number of partners (or members of an LLP) and the borrowings. Two useful metrics to consider are ‘borrowings per partner’ (for example, bank debt divided by the number of partners) and, next, the ratio of partners’ capital to bank debt. These metrics give a ‘corporate view’ but ignore personal borrowings.

As an example, consider a firm with £6m of fee income and eight partners. The firm has bank borrowings of £1.5m and partners’ capital of £1.2m. On the face of it, the structure seems sensible in that the business is not overly reliant on the bank and the capital per member being a not unreasonable £150k each. Roll this forward to the ‘new normal’ and the bank may step back and consider that the partners have also borrowed 100% of their capital by way of personal loans, and perhaps the firm has taken a £0.5m CBILS loan as a safety net. All of a sudden, the bank is looking at borrowings of £2.7m plus an additional CBILS facility, which is much less appealing from the point of view of a lender.

So what actions could be taken? The first point is to remember that the CBILS loans are a comfort blanket but were not intended as long-term debt. If this was taken as a safety-net then consider leaving the facility to one side for that purpose. On one hand, this is cheap borrowing, but on the other hand, once it is spent the firm could have an uncomfortable debt level – which will be difficult to reduce in the future. Remember, to free up cash to repay bank debt, it’s likely that partner drawings will need to reduce in the future. There’s also a generational issue in that it may not be desirable to partners of the future to inherit a highly geared balance sheet.

The firm could implement a policy whereby a proportion of profits are retained in the business and used to repay partners’ capital loans and thereby reduce gearing. Where profits are healthy this may be possible, but it will not always be manageable. Also bear in mind the opportunity cost of repaying a capital loan compared to partners investing in a personal pension. A saving of say 3.5% interest (which is tax deductible) compared to tax relief on a pension contribution plus the future rolled-up growth in the related investment shows a stark difference.

Alternatively, the firm may consider simply increasing partner capital by withholding profits – for example, a capital call funded from profits. This would be of particular interest where a firm is currently ‘undercapitalised’. There is no right or wrong answer for a healthy level of capital as this will hugely vary from firm to firm.

Finally, the best answer to a funding issue is the one that your accountant will remind you of every year.  That is to improve your working capital position – for example, bill earlier to reduce WIP, chase debtors and actively review the mix of fee income. It’s amazing how often firms do not link unpalatable level of bank borrowings with poor working capital management. The link is direct and is generally within the gift of the partners to influence.