The Capital Funding Strategy and Succession by Sponsor Francis Clark

 

The Capital Funding Strategy and Succession

  

Francis Clark LLP

  

Succession can present numerous challenges in a legal practice but in this article we look at how the capital funding structure can play a vital role in managing the succession strategy and the related financial aspects.

How can principal succession affect the firm’s finances?

Principal succession within in a law firm can affect the business finances in several areas. However, from a financial viewpoint one of the main factors will be at the point where a principal, for example, decides it is time to retire. This principal may have a significant level of financial capital investment in their practice which, on departure, will need to be released back to them.

As capital is repaid to the outgoing principal that may place a strain on the law firm’s working capital (funds needed to operate day-to-day and financing of capital assets, i.e. business properties). Those funds may need to be replaced in part or in full.

Where those funds cannot easily be replaced it can present a real challenge to a practice in managing its finances.

Capital structure

The capital funding structure of a law firm could warrant its own full article. However, in the context of this feature we will only consider how the capital funding strategy could present a barrier to an incoming and exiting principal for succession purposes.

All businesses require some form of capital funding to provide financial resources to allow it to operate. This capital requirement can change on a daily basis.

If we look at a law firm structure in a partnership or LLP model, typically partners or members will have individual capital accounts combined with current accounts, tax reserves etc which contribute to the overall capital funding requirement.

Some firms have prescriptive models of how capital account levels are set, where others have no formal policy. Having a prescriptive model does, however, provide clarity not only for principal requirements but also in assisting in the overall management of the firm’s finances.

So how does capital structure affect succession?

Example 1

In simple terms, let’s say we have a law firm partnership owned equally by three partners A, B and C.

The partnership owns an office property at a cost of £500k from which it operates and has additional net assets with a value of £100k (Items such as fee and disbursements debtors, work in progress less amounts owed to suppliers etc).

As part of its capital funding strategy it does not take on any third party borrowing and capital is fully funded from the partners own resources.

So the capital funding demand is £600k (or split equitability, £200k per partner) as held in their capital accounts.

Partner A decides they want to retire and is to be repaid their capital value of £200k. Partner D as the successor is invited to join the partnership on a like for like basis to Partner A.

On a like for like basis, partner D needs to find £200k of capital to introduce into the business which is a significant demand.

Example 2

If we take the above example and the firm capital funding policy is to fund say 40% of the requirement from bank borrowing and 60% from the principals own resources. The capital funding demand on the principals becomes £360k (£600k of net assets less 40% borrowing) or £120k per partner.

When partner A leaves and partner D joins on a like for like basis, partner D now only needs to finance £120k opposed to the £200k in the example above.

Example 3

If we take this example one step further and say the partnership rents the office premises rather than owning them, subject to borrowing capabilities the capital requirement by the principals in the partnership will reduce to £60k (£100k net assets less 40% borrowing) or £20k per partner.

When partner A leaves and partner D joins on a like for like basis, partner D now only needs to finance £20k compared to £200k and £120k in the above examples.

Clearly, having a lower capital funding requirement reduces the potential financial barrier to the incoming partner, but also in terms of making it more manageable for the partnership to repay the partner exiting, particularly if there is not an immediate successor.

The capital funding position is not always as simple as the examples above, and there are also various other factors in deciding on how the practice is financially structured.

However, the above demonstrates the systems and decisions involved within the capital funding structure and the implications it has on a firm’s finances and succession.

The PKF Francis Clark professional practices team has all the specialist knowledge and experience needed to deal with the specific requirements and challenges of your firm. To this we also add the special ingredients of real sector expertise and empathy with our clients. If you would like to speak to us about any specific issues please get in touch.

 

This publication is produced by Francis Clark LLP for information only and is not intended to constitute professional advice. Specific professional advice should be obtained before acting on any of the information contained herein. Whilst Francis Clark LLP is confident of the accuracy of the information in this publication (as at the date of its production), no duty of care is assumed to any direct or indirect recipient of this publication and no liability is accepted for any omission or inaccuracy.

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