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:
Keeping the management of equity partners straight forward
Preventing debate with future equity partners as to what the capital requirement is
Driving improved cash management and performance because of the ability to distribute ‘super profits’ and cash surpluses at certain agreed points after each year end
Preventing capital accounts growing disproportionally high and then making it easier to pay out retired partners
Delivering ongoing control over return on capital invested to the equity partners and allowing the firm to properly budget for paying out retired partners; because there is the requirement to distribute excess amounts regularly.
Along with the benefits, there are certain issues to overcome when agreeing to move to a fixed capital amount. These include:
Justification of the capital requirement. Forecasts need to show the impact of any new partners and any that are planning to retire to check the overall cash/capital requirement. The forecasts will also show the general cashflow requirements driven by the working capital needs of the firm
Separating capital and current accounts. To be able to drive forward with improving behaviours and do this properly, it is best to have a separate capital account and current account (the latter being where any ‘super profits’ would sit and then be distributed). By ‘super profits’ we mean profits actually earned less those distributed or capable of being distributed – this would in effect be the balance on the current account, but it is also net of any tax payments that are going to be made on behalf of the individual
Managing the process of implementing fixed capital. Realistic timescales should be agreed for the collection of any capital shortfalls, along with repayment terms of any excess capital held. Often it is the board that sets capital and drawings levels and determines whether distributions can be made. It is better to have set dates on which capital surplus (the current account) would be distributed (cash and board approval permitting)
Updating the partnership agreement to reflect all of the points above
Here at Armstrong Watson, we have implemented effective capital funding and distribution systems for many law firms. Get in touch if you would like to find out more about this, or to discuss the benefits that it could bring.
