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The top five reasons firms lose money and go out of business

“Lawyers become lawyers because they want to help people and practice the art of law,” says Los Angeles financial consultant Gene Siciliano, CMC, CPA, author of Finance for Non-financial Managers (McGraw-Hill, New York).

And once in practice, lawyers focus exclusively on their technical expertise, not the essentials of running a business successfully. “They think they can get by without it,” As a result, they make business mistakes. And it’s those mistakes that cause firms to fold, Siciliano says, not mistakes in the practice of law.

Here Siciliano cites the five major business blunders that create the disasters.

Blunder #1: Borrowing for the wrong reasons

The first blunder is bad borrowing practices.

Unnecessary borrowing can bury a firm in debt it may not be able to cover. And many firms get in just that situation.

A line of credit is a buffer against temporary cash slides, Siciliano says. When the cash is low and the firm needs to make payroll, the money is there.

Borrowing against it is a good move when it’s done to improve the firm’s services or to act as a buffer against revenue fluctuations. “But when a firm borrows money because it thinks something good is going to happen in the future,” expect disaster.

As to when to borrow, consider it a good move when the money is needed for operations, for client service, or to maintain a professional image.

If the firm doesn’t have the money to pay staff salaries this month, borrow.

If the office is run down and has lost its professional appearance, borrow.

Or if the firm needs equipment such as a computer upgrade to provide better service to its clients and it will be useful for the next three years, it’s a good strategy. Borrow the money and stretch the payments over the business benefit period of the equipment.

But absent one of those circumstances, do without.

Siciliano points out that some of the worst reasons firms borrow are also some of the most common. One is borrowing to cover partner draws. Another is borrowing to cover the labor costs of new people who are being hired “in anticipation of a groundswell of new business.”

Neither of those expenses is necessary to maintain business. It’s borrowing from an unknown future—assuming something good will happen and the money will be there to pay back.

Also common is borrowing to make improvements to the office that are “beyond functionality.” A marble floor in the conference room goes beyond providing efficient service or maintaining a professional image. It’s extravagant and not needed for client service. There’s no need to go in the hole for it.

In short: “Don’t borrow in anticipation of events that may never happen. But do borrow to buffer the ups and downs of working capital.”

Blunder #2: Not planning for the long term

The second business disaster is lack of long-term planning.

Look ahead to the next three to five years to figure out where the firm wants to be and what challenges it will face. “Know what’s coming and decide ahead of time what the firm is going to do about it.”

One area to look at is the lease. If it’s going to expire in the next two or three years, decide now if the firm wants to renew it or look for another location.

That means the firm needs to predict whether it will grow or downsize and estimate what the space needs will be as a result and whether the current location can cover those predicted needs.

Another long-term item is anticipated revenues from the current partners. Find out if any partners are planning to retire, and if so, start transitioning that partner’s business to other attorneys so the move is seamless for the clients.

No firm can afford to rock along and wait for the retirement announcement to start deciding what to do, he says. Fail to plan for that, and those clients can get an unexpected announcement of the retirement and take their business elsewhere.

Anticipate the negative as well. If it looks like the firm is going to lose those clients when the partner leaves, there needs to be a plan for replacing them, perhaps by hiring a lateral.

Expansion is another area that requires long-term planning. If the firm expects to add a practice area later, it has to plan now for that move by evaluating areas that are likely to produce good business and deciding what people it has to hire to handle the business.

Clients too need long-term planning. If a major client engagement is coming to a conclusion, the firm needs to figure out now how it’s going to find new business to make up for that loss.

Blunder #3: Not maintaining a cash reserve

The third mistake: failure to maintain a cash reserve. A firm can die from that, Siciliano says.

Most often the cash reserves dry up when the attorneys follow the very common practice of paying out all the year-end profits to the partners, which, of course, leaves nothing in the coffers to start the next year on.

While the partners spend the money on vacations or whatever, the firm has no money set aside to cover salaries and other expenses, and in comes the line of credit.

“That’s suicide.”

If a firm is going to survive, it has to have cash on hand. “How much depends on the consistency of the business,” but as a general rule, there needs to be enough operating cash at all times to cover at least two months’ expenses.

Draw on it as needed and replenish what gets used.

Blunder #4: Providing year-end client discounts

The fourth blunder is “the classic year-end exercise of accepting large discounts” on client bills. And most firms do that to pay out the partner bonuses.

The only time a discount is in order is when a client is on shaky ground. When that happens, get whatever can be got while the getting is good. “That client may not be around next year.”

But it’s absurd to offer a discount to a client who is financially solid and satisfied with the service, Siciliano says. “The firm should want 100% collection.” And it should not settle for less.

Look at what the firm is doing. It’s being lax in its billing and collections, and it’s taking a hit because of it.

What’s more, it’s exercising bad client psychology. It doesn’t take long for the clients to learn that if they wait till year’s end to pay, they’ll get a prize—a discount.

The firm needs effective billing and collection procedures so it gets the money in on time, and that starts with collecting sufficient retainers, billing against the retainers, and always being prepared to stop the work if the client doesn’t replenish the retainer.

Blunder #5: A dead budget

Finally there`s the mistake of not having a simple annual budget—or having a budget but not following it.

A usable budget starts with 12 months across the top.

Then for each month estimate the revenue broken down into revenue from trust services, from transactions, from in-house counsel, from outside counsel, and so on. Then show the total revenue for each month.

After that list the monthly general expenses of salaries, partner draws, rent, telephone, travel, and so on.

Get the numbers from previous history, and then adjust them to reflect “what`s going to be different next year,” Siciliano says. “Go to every person who produces revenue” and find out what`s going to happen that will change those numbers.

Then talk with the department heads to find out where expenses are expected to change. Also ask the clerical staff “what do you need in order to do your job?” It may turn out the firm needs a new copy machine or new computer terminals.

Then for each month show best case, the middle of the road, and worst case. To do that, just graph the amount of revenues the firm expects to see month-by-month. Then for each month graph the worst that could happen and also the best. The mid-point is what’s reasonable to budget.

Look at the budget each month before spending the money, not afterwards. If the firm is budgeted to take a retreat in the Bahamas and the fees are holding up, the trip is affordable. But if the fees are not holding up, the only way to justify it is to cut expenses from somewhere else.

Related reading:

A Basic Guide to Succession Planning for Law Firms

Some not-so-difficult ways to increase revenue

Paying too much office rent? Try these 7 rent-cutters