THE GATHERING STORM: WHAT A JITTERY ECONOMY
REALLY MEANS TO LAW FIRMS
By Robert Weinberg and Steve Martini
There are hidden dangers for law firms in the gathering downturn in the economy. Indeed, in any economic contraction, law firms are among the first business enterprises to run into financial trouble, and in the coming months, if the economy goes south, some may fail.
We have seen this before, and the grim irony is that many law firms did not learn their lesson the last time they had the chance. The early 1990s saw a wave of consolidation in the legal profession as firms large and small alike disappeared into the arms of their competitors in hopes that, by joining forces, they might find economies of scale. Even among the survivors, however, many failed to understand that no matter what their size, law firms need to turn a profit.
The solution, however, is simple: Law firms should take a lesson from their business clients and understand that there is a difference between cash and profit and that accrual bookkeeping, coupled with a disciplined effort to manage accounts receivable, is an important key to success.
Too many firms now equate cash with profit; they do their bookkeeping on a cash basis, and if they end the month with more money in the till than they paid out, they think the difference is profit. But the truth is often the reverse. How? Consider the firm that settles a case yielding a contingency fee of $120,000. If the firm's monthly overhead is $100,000, cash-basis accounting shows the firm $20,000 ahead for the month.
Accrual accounting, on the other hand, might show that the firm billed only $80,000 during the month as against that $100,000 in salaries and overhead and thus that, setting aside the $120,000, the firm actually lost $20,000.
This is a far more accurate picture of the firm's profitability, and the mystery is why more firms do not keep their books on an accrual basis. Instead, the partners meet to review their financial position, compare deposits and disbursements, and go on about their business so long as the one exceeds the other.
What they fail to grasp is that like businesses of all kinds, law firms need strong accrual-based accounting systems producing accurate reports that will give the firm's partners a realistic understanding of their financial position.
But accrual accounting is only the first step. Law firms need to know that their billable hours exceed their overhead, but they also need to turn their invoices into cash. This means taking another lesson from their business clients and managing their accounts receivable with a professionalized discipline.
To that end, law firms must:
- Make their policies regarding fees a part of every engagement letter, and
- Establish back-office followup procedures to ensure that every problem invoice is handled in an efficient, professional and above all timely manner.
The first of these requires only that the firm insert language into every engagement letter stating that it expects payment within, say, 20 business days of the date of an invoice. The firm's standard invoice should carry the same message - "Terms: Net 20 days."
This puts the client on notice regarding payment terms going into any engagement and hence enables the law firm to remind the client company, should it be late in making a payment, that it agreed to the practice before work commenced.
What happens when a client is late paying an invoice? In recent years some firms have made it standard practice that the lawyer handling a given case make a personal telephone call to the client. This is poor practice, since it puts the lawyer in adverse position relative to the client, and since in any case it is the rare lawyer who is comfortable, much less effective, at making such calls. Worse, the lawyer who makes such calls risks giving the client control over the firm's cash flow. How? The discomfort in the lawyer's voice can sound like begging, inviting the client to set the terms of payment and, worse, to wonder whether the lawyer is a strong advocate.
The better idea is to give the job to an accounts receivable clerk trained in making collection calls, following up with confirming letters to the client, and keeping proper records.
The collection call should go to the clerk's accounts-payable counterpart in the client's office following something like this scenario:
"Hello, this is Kim Smith calling from ABC Law Firm. Our invoice to your company went into the mail on January 15, and as you know, our policy is that all invoices are due and payable within 20 days.
"If you were not aware of this policy, it is stated in our engagement letter with your company and appears at the bottom of the invoice. Is there any reason we have not received payment on this invoice?"
Commonly, the response will be that the invoice is in process; only rarely will the client express unhappiness with the firm's services, and when this happens, the law firm should of course take the incentive to do something about it.
Whatever the response, the firm's accounts receivable clerk should ask for a specific date by which the firm may expect payment, make note of the response, and follow up with a letter or e-mail confirming the conversation, including the expected payment date and the client's reason for delaying payment, and reiterating the firm's payment policy.
Should no payment arrive by the agreed-upon date, the clerk should make a second call reminding the client of the earlier call and reiterating the law firm's payment policy and the client's commitment to make payment by the agreed-upon date.
This time, however, the clerk should add: "We are giving you the courtesy of an additional 48 hours. If we have not received payment by the end of business two days from now, we will have no choice but to terminate the relationship and seek collection of any fees overdue."
This should be followed by another e-mail or letter confirming the conversation, the deadline, etc. Should payment still not arrive, the firm should send a substitution of attorney form to the client or, in matters not involving litigation, a letter of termination.
There is, of course, the special client of many years' standing who never pays on time. Such clients may be important enough to make it counterproductive to insist on rapid payment. But the more often a firm accommodates a special client by departing from a disciplined, professionalized approach to its collections policies, the less control it has over its financial health. Hence every firm should handle exceptions case by case, taking care to give special consideration only to the truly special client.
These are hardball tactics, to be sure, and they will not fit the culture of every law firm, much less the needs of the solo practitioner. Whatever their tactics, however, lawyers ought not to be embarrassed to ask for payment for their services in accordance with the terms of their engagement letter - or fear that if they do insist on payment, they will lose the client. After all, it is the client who decides to do business with a particular lawyer, and the client who terminates an engagement must find legal help elsewhere, losing time and in all probability money in the process. It may not always be clear to the lawyer why a given client chooses to seek his or her help. But clients stick with their lawyers to get the matter at issue settled so that they can move on without further disruption. They know very well that it is unwise to change horses in midstream.
In any case, lawyers have other means of hedging trouble, in particular by collecting financial information on new clients. For individual clients, this should include Social Security numbers or federal tax identification numbers for clients who own businesses, bank account numbers, credit references, and contact information for prior counsel, if any. When the client is a corporation, it may be advisable to obtain personal information and even personal guarantees from the principals, since the law firm may have no recourse to corporate assets in the event of a bankruptcy.
Lawyers can avoid such problems entirely, of course, by securing retainers from new clients at the beginning of an engagement, to be replenished as the engagement continues. But few do, and when the time comes to seek payment, many are reluctant to pursue their clients for payment, sometimes because they fear embarrassing the client, sometimes because they think that as professionals, they ought to be above money. They also fear that aggressive collection procedures may lead the client to threaten to terminate the relationship and even allege malpractice in hopes that the lawyer will settle for a lesser fee.
The result is that, under pressure to keep billable hours at 2,000 or more annually, many lawyers work into the night and on weekends in hopes that they can make up for those hours that do not result in payment. But the lawyer who bills 2,000 hours a year and collects on all but 50 does far better than the lawyer who bills more and collects less - and is a far more valuable commodity to his or her firm, too.
Put another way, it is not the billable hour that is king. It is the invoice marked "paid." And it lies within the power of every lawyer to get the job done.
Los Angeles attorney Robert Weinberg specializes in debtor-creditor matters and consults with business and professional firms on AR management. He may be reached at (818) 705-3254 or at email@example.com. Steve Martini, CPA, a partner in the Los Angeles accounting firm Martini, Iosue & Akpovi, offers consulting and management advisory services to middle-market companies. He may be reached at (818) 789-1179 or at firstname.lastname@example.org.