The Case for Deferring Payments to Equity Partners Now
In explaining why law firm stress tests may not give the clarity firms need in projecting future health, Hugh Simons argues saving cash now gives you options later. And it will instill partner confidence.
March 26, 2020 at 06:56 AM
7 minute read
When you're heading into a business downturn, your first question usually is: how bad are things going to get? Having answered this, you then identify what levers you need to pull to ride out the slowdown without financial distress.
In the current environment, this is the wrong first question. Why? Because it is unanswerable; we haven't faced a situation like this before. We know the economic slump will depress demand and slow client payments, but don't know when it will kick in, how bad it will get, or how long it will last. So, what is the right first question? It's this: what levers can we pull to reinforce the firm's financial solvency? Having answered this, you then pull all of them.
The biggest available lever firms have is to defer payments to partners. Deferring IT upgrades and nixing recruiting expenses are insignificant in comparison. For Big Law, typical profit margin is around 50% (i.e., partner income as a percent of revenue); hence, each month of deferred partner comp covers a full month of expenses. The only thing that comes close in size is delaying the funding of pensions, but that's often not viable.
Why such an unprecedented step? Because, in these unprecedented times, it will give partners confidence. It sends the right message for this moment: management is alert to the situation and taking no chances with the financial viability of the firm (and hence, implicitly, with your capital balance). Bear in mind that, at most firms, more than 65% of partners have never experienced any kind of recession as a partner, let alone one like this. Partners won't express openly that they're anxious but looking for downsides is so innate that they can't do otherwise and that provokes anxiety.
Partner confidence is the bedrock of a firm's financial stability. It's actually hard for a law firm to run out of cash unless there is first an exodus of partners. Partners are more likely to leave if they think the firm's financial condition is weak and their capital balances are in jeopardy. A first wave of partner departures makes a second wave more likely and so on, as no one wants to be among the last to leave. It is easier to stave off a rolling exodus before it starts than to stop it once started.
One might ask whether delaying payments to partners risks causing more anxiety than it relieves. Not if done immediately and in the right way. Everyone appreciates that the course of the next few months is unknowable; hence, deferring now will be seen as a generalized abundance of caution rather than indication of a specific or imminent risk. How am I so confident about this? Because I was directly involved in deferring partner payments in the wake of the dotcom crash; we never regretted the move (indeed, it garnered us some plaudits when an archrival later had a capital call).
If, thanks to the timing of your financial year, you've not paid partners their most recent profit share, then it behooves you to withhold it. This has been facilitated by the government's extension of the federal tax filing and payment deadline to July 15th (first quarter estimated payments are due at the same time although, anomalously, the second quarter estimated payments are still due on June 15th). If you have paid out last year's profit shares, then your partners are cash-rich and can endure relatively easily a deferral of draws for three to four months.
It's worth being thoughtful about how to announce such deferrals to partners. A broadcast email is efficient but inconsistent with the underlying objective of bolstering partner confidence as it forgoes an opportunity for interaction and low-key provision of assurance. Alternatives would allow for more engagement and (seeming) participation in the decision. As an example: over the course of a day, firm leaders could host a series of analyst-style conference calls each with the same agenda (allowing partners globally to pick the time slot that suits them best). The call would begin with an overview of the proposal, turn to the CFO or finance partner for specifics on the robustness of the firm's finances currently, and then to the tax partner to explain the tax consequences of the proposal. It would conclude with opening the floor to questions and, importantly, feedback. You can expect that partners will support the move allowing you to announce through more traditional means the next morning that, in accordance with the consensus feedback received, you're proceeding with the deferral.
Defer to Avoid Capital Calls
Deferring now is preferable to risking a capital call later. Capital calls are tax inefficient (partners write checks with post-tax dollars). They're also emotionally fraught—writing a check to the firm feels very different from the firm delaying a check to you. Further, with a capital call, you've chosen a moment at which to do it, thus fomenting paranoia about some "new" insight that management has suddenly obtained. More broadly, deferring now is consistent with the truism that the best time to borrow money is when you don't need it.
But what if you've taken a survey of the relationship partners facing your major clients and, in sum, what they project is not worrisome? Well, having seen this movie before, they will over-predict the timing and volume of cash receipts. Why? Because they simply don't know how clients will behave and will tend to project recent history forward despite the fact that we're transitioning through a singularity.
But what if your accounting department has come up with a cash flow forecast that shows you've no liquidity concerns? Well, law firms are not great at projecting cash flows. Many firms struggle even to compile a balance sheet—it's not something that warrants much consideration in the normal course, and they're scary: law firms are thinly capitalized compared to normal businesses, and run most of the year with negative working capital. Further, cash flow forecasting is just not what law firm accounting systems were designed to do (and they struggle even with that which they were designed to do, i.e., record hours, compile bills, and track collections). They are not a robust platform for making critical decisions.
For how long should payments be deferred? The obvious milestone is July 15th, the new federal filing deadline for tax year 2019. This is a little shorter time frame than ideal—setting a date that's further out would improve the prospects for announcing later that you're bringing forward the payout of deferrals, always a popular move. On balance, mid-July, with appropriate wording about flexibility to possibly defer further in a mechanism yet to be determined, is probably the way to go.
As you mull on the above, remember this: disasters only happen when you run out of options; preserving cash preserves options.
Hugh A. Simons is formerly a senior partner and executive committee member at The Boston Consulting Group and chief operating officer and policy committee member at Ropes & Gray. Early retired, he now researches and writes about the business side of law firms and does some consulting for old friends. He welcomes reader reactions at [email protected].
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