As an accountancy practice specialising in the legal sector we are finding there are a growing number of law firms approaching us that are looking to include a fixed capital amount in their shareholder or partnership agreements. This change to the agreements can be brought about for a number of reasons including levelling up each partners contribution, looking to bring in new partners and not knowing what level of contribution is appropriate and, not least, because of the funding uncertainties brought about by the ongoing pandemic.
Capital is required by a firm to be able to fund its working capital requirements (lock up) and thereby allowing it to function on a day to day basis. This funding either needs to come from the partners themselves or from borrowings. The culture of a firm is paramount when addressing how to fund a professional practice, and particularly the owners desire to self-fund or their willingness to borrow.
A capital injection is usually required on admission to equity sharing status, and subsequently remains in the firm until retirement, when it is repaid over an agreed time period. It follows that with the admission of a new equity partner, total fixed capital will increase and with a retirement, total fixed capital reduces. To a great extent, the total capital required is a function of the number of equity partners and the firm’s cashflow requirements, although the number of equity partners should ultimately be driven by matters such as contribution, retention, incentivisation and profits per partner etc.
Those firms that do not have fixed capital have their financial requirements met by a combination of capital injections, undrawn profits and/or external funding. Undrawn profits fluctuate as new profits are earned and old profits are drawn. Often, as these practices grow and they recognise the need for more cash, some of that cash is funded by not paying out to members all the profits to which they are entitled. In this way, such firms have accepted that an amount of profit will never be available for withdrawal, unless the firm reduces its working capital requirements (reducing lock up) or the firm is prepared to increase borrowings, and those borrowings are available for distribution. In such circumstances the partners are taxed on all of the profits even if they do not receive all of the cash. More importantly, from a business management perspective, if the partners feel there is no set distribution policy to allow them to receive the benefit of the profits then they may not strive as much to generate the profits or reduce lock up to permit the distributions.
Benefits to having a fixed capital amount in place therefore begin to emerge and the importance of the relationship between undrawn profits and cash collection becomes much clearer.
Some of the benefits for opting for having a fixed capital amount include:
Along with the benefits, there are certain issues to overcome when agreeing to move to a fixed capital amount. These include: