Recent disturbances in The Force of law firm economics (see Dickstein Shapiro’s demise) have brought some comments and observations directed to law firm capital. Some reflect multiple misunderstandings of what law firm capital is and how it works. So we are going to present the topic as though we were talking to a new prospective lateral partner, or an associate aspiring to be a partner, or somebody wondering how such smart people as lawyers can take juggernaut cash engines like law firms and drive them into the wall of insolvency and failure on such a massive scale.

Q. What is partner capital?
A. Partner capital is a deposit of cash with the firm by the partners.

Q. How is the amount of the deposit of cash determined?
A. It is usually determined as a percentage of a partner’s forecast compensation.

Q. What is a typical percentage used by firms?
A. The percentage varies from between 20 to 60 percent in large law firms, and averages around 35 percent.

Q. When is partner capital deposited with the firm by a partner?
A. It is usually deposited in full upon becoming a partner, and then adjusted at the beginning of each subsequent year.

Q. Is it deposited into a separate, segregated bank account?
A. No. Partner capital is deposited into the operating account of the firm.

Q. Why?
A. Because it is necessary to have working capital to pay expenses, buy equipment, improve office space and such.

Q. But the balance sheet financial statement of the firm shows all partner capital as equity in the firm. If those millions of dollars are not in a segregated account, where are they?
A. Most of it has been spent on operating expenses such as salaries, rent, supplies, utilities and services.

Q. Was that capital lost?
A. No, it was used to pay the costs of performing legal services, which creates accounts receivable.

Q. So when the accounts receivable are collected, that is cash and that is a return of equity?
A. No, that is partly income, which is taxable to the partners, and partly re-spent as operating costs to generate more accounts receivable.

Q. How do I ever get my equity out of accounts receivable?
A. When you withdraw from partner status in the firm, or when the firm liquidates and there is a surplus of cash after paying all creditors.

Q. So to evaluate the value of my ownership share in the firm, I should subtract all liabilities of the firm from the accounts receivable?
A. Probably not. Most firms require partners to waive any ownership interest in any assets of the firm. You only have a claim to a return of your capital deposit.

Q. So if I make the deposit and have no ownership interest in the assets or appreciation in value of the firm, and receive no rate of return on the deposit, what is that called?
A. It is called equity on the balance sheet. But functionally you are a subordinated lender with a non-interest-bearing claim.

Q. Subordinated to who?
A. Subordinated to everybody: The bank that lends millions of dollars in working capital to the firm will have a secured first-priority position, then all the vendors and landlords. You will come last.

Q. But the partners have tens of millions of dollars in equity used as working capital. Why would there be loans from a bank for working capital as well?
A. Because the partners didn’t want to self-finance the creation of all of the accounts receivable themselves or they would have had to forego substantial amounts of income distributions. Bank loans enable them to take greater distributions of cash currently.

Q. Will those partners who took those distributions have to pay them back?
A. Not if they retire before being obliged to do so.

Q. But those loans were in existence before I became a partner. I never received any of that money. Isn’t that taking money from the future and paying it out now?
A. That is correct.

Q. Will I have to bear the financial burden of the repayment of those loans?
A. Not if you follow the example of your predecessors and can sustain the firm long enough to retire/withdraw and receive the repayment of your deposit. Thereafter it is somebody else’s problem.

Q. Will I get my capital deposit back if the firm does not sustain itself while I am a partner?
A. Probably not in its entirety, and possibly none at all.

Q. Why is that?
A. Because the costs associated with winding down a firm are often significantly in excess of the liabilities shown on the balance sheet. There are costs for unwinding long term leases of equipment and real property, costs of administration, and reserves for professional practice errors. And dissolving firms tend to suffer from a significant reduction in the realization rate on accounts receivable, which is what your capital deposit went to help create.

Q. The partners will all bear that burden by their fair share, right?
A. Possibly. But a firm could structure a liquidation and dissolution to drain the capital accounts to a zero balance and distribute the surplus, so as to burden all withdrawn and retired partners disproportionately and reward those still current partners.

Q. What happens to a retired partner’s share allocation of profits when they retire?
A. It is redistributed in the partnership profits pool.

Q. That retired partner’s share goes to the other partners?
A. Yes.

Q. If the profits of the firm stay the same, even though the retired partner has left, what happens?
A. The other partners will be making more income, and they will be required to put up more capital, in this case 35 percent of their increased income.

Q. If the profits of the firm go down by the amount of the retired partner’s share of profit, what happens?
A. No additional capital is contributed.

Q. When a retired partner leaves a firm, what happens to the accounts receivable and work in progress on the books of the firm?
A. It belongs to the firm. And it is available for distribution to all partners.

Q. How much money is that typically?
A. About three to four months of draws to the retired partner, which is often the same or more as the retired partner’s capital deposit.

Q. So the firm will receive a boost in profits available to the rest of the partners that is equal to or greater than the capital owed to the retiring partner?
A. Yes.

Q. If the business of the retired partner stays with the firm, then the profits from that work stay behind as well, don’t they?
A. Yes.

Q. And even if none of the business of the retired partner stays at the firm, the profits from the tail of his work should cover his or her capital return, shouldn’t it?
A. Yes.

Q. Does a firm return all of the capital on partner’s withdrawal or retirement?
A. No. Typically it is returned over a term of years in installment payments without interest.

Q. Why does a firm do this?
A. Because they can. It is an interest-free borrowing of capital for cash flow support, for working capital. It increases stated income and enables higher distributions to current partners.

Q. So a firm could actually be imploding with rapid partner departures and still reporting reasonably high profits, and distributing cash to partners based on those reported profits?
A. Yes, for a limited time. Eventually there is a day of reckoning.

Q. Can a firm increase its capital infusion to pay for returns of capital to retiring/withdrawing partners without increasing the percentage of compensation for the partners who remain behind?
A. Yes.

Q. How?
A. Like this:

Q. Isn’t that just a way of having younger and newer partners pay for the older retiring partner returns of capital, which is already an obligation of the existing partners, when it really isn’t necessary?
A. Yes.

Q. Why would younger/lower levels of partners want to do that?
A. Because they may lose their jobs if they don’t.

Q. So if a firm has a lot of equity capital, it is more likely to be a financially sustainable entity, is it not?
A. No. The financial interest of the equity partner is based on the loss or diminished income and risk of capital loss if they stay, versus the loss of capital and higher income if they leave. The “tipping point” for this decision is unique to each individual partner.

Q. But if the firm is making profit it cannot fail, can it?
A. No, law firms making lots of profit fail. The problem is when they are not making enough profit. At that juncture they either hold back on partner distributions and risk them departing (and the firm fails), or they distribute more cash than they have profit, which ultimately leads to a liquidity crisis (and the firm fails).

Q. So, because the firm holds a retired or withdrawn partner’s capital account for several years, though that former partner in most cases has covered 100 percent of the return of capital within a matter of weeks after leaving, that partner risks losing all or most of the return if the firm fails or liquidates itself in a plan that prefers current partners?
A. Yes.

Q. Does this get worse?
A. Yes. If you borrowed the money to make the capital contribution and there is a balance when you leave the firm, you will not only be liable for the unpaid balance, but that balance may be accelerated in full when you leave the firm. And you still have to come up with capital if you are moving to a new firm.

Q. Is that it?
A. No. If your firm goes bankrupt, in addition to losing your capital, you will probably have to give back a portion of your distributions received as income or returns of capital for the prior 18 months to two years as clawbacks to the bankruptcy estate.

Q. Why did you become a lawyer?
A. I was risk-averse.

Edwin B. Reeser is a business lawyer in Pasadena, California. He has served on the executive committees and as an office managing partner of firms ranging from 25 to more than 800 lawyers in size. He is co-author of the ABA Journal article “Metrics can tell the tale of a firm’s fate.”

Editor’s note: The New Normal is an ongoing discussion between Paul Lippe, the CEO of Legal OnRamp, Patrick Lamb, founding member of Valorem Law Group and their guests. New Normal contributors spend a lot of time thinking, writing and speaking about the changes occurring in the delivery of legal services. You’re invited to join their discussion.