Professional Services Accounting ARTICLE -
What Partners Need to Know About Firm Capitalization
Target Audience: Legal Professionals, Professional Service Firms, Accounting Consulting Firm Interest and Topics, Working Capital and Capitalization Structures Interest
Every business needs money to operate and law firms are no different. Law firms usually generate money using several methods: client billing; borrowing from banks; and requiring partners to make capital contributions.
Because partner contributions generally fund the firm’s working capital — or the money needed for the daily operation of the firm — this source is especially important to the firm’s success.
Working capital
Different firms have different capitalization structures. But at the very least, working capital needs to be able to cover cash flow requirements of the firm’s billing and collection cycle. It should also be enough to provide a cushion for unexpected expenses and partner draws during slow months or other periods of shortfalls.
Finally, this money should be sufficient to fund some of the firm’s growth and expansion plans, including the cost of adding new associates.
How the firm is capitalized and the amount of each partner’s contribution depends on several factors.
These include the size of the firm, the liquidity of cash flow (or how quickly clients pay their bills) and how frequently the firm uses its bank line of credit. While some firms may require capital contributions of $100,000 or more per partner, the average mid-size firm usually mandates $50,000 per partner.
Signs of undercapitalization
Undercapitalized firms can present serious problems, hindering both daily operations and long-term growth plans. Some of the warning signs of an undercapitalized firm include:
- Increased borrowing on short-term bank loans,
- Aging accounts receivable,
- Reduced partner distributions, and
- Less than two months of a working capital reserve.
If your firm begins to exhibit these signs of undercapitalization, you may need to re-evaluate and increase your partners’ capital contribution requirements. Even if you don’t spot any red flags, your firm should examine its working capital needs annually or when it undergoes significant changes such as increased hiring or a rise in client costs advanced.
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