The devil is in the detail… Don’t get caught out by the traditional equity partnership model
David Beech, CEO of Knights 1759, the UK’s fastest-growing regional professional services business, discusses the controversial topic of how and why so many traditional law firms are concealing debts and risking the livelihood of optimistic lawyers.
It’s no secret that these are challenging times for some of the UK law sector as it tries to keep up with emerging digital trends and increasing demand from clients. But there is buoyancy in the market and opportunities for those businesses that are agile and brave enough to challenge the status quo - the traditional equity partnership model.
At Knights 1759, we’ve seen it all too often where partners have been duped into putting their assets against a failing business that is riddled with debt. We’ve even received calls from partners to discuss bankruptcy and that the possibility of moving house is no longer possible, due to the Limited Liability Partnership (LLP) they joined going into liquidation.
Why are traditional law firms riddled with debt and failing?
Last year it was reported that profits decreased at half of UK law firms[1] and the collective debt held by the top 100 firms reached £4.3bn – a 14% increase in 12 months[2].
This ultimately comes down to an archaic way of working and outdated business structure. An LLP is no longer an efficient and effective business model for law firms. Decision-making is painfully slow amongst partners, overheads are spiralling out of control with businesses employing an unnecessary number of support staff which leads to rising debts and a troubled cash flow.
How are traditional law firms able to conceal debts and convince new and existing partners to put in equity?
When tax returns are filed in January, it is unfortunately a time when even more partners get lured in to putting equity into a dying business and the devil really is in the detail.
As cash is running out the managing partner convinces existing partners, potential new partners and the banks financing LLPs, that the Work in Progress (WIP) stated within the accounts of the firm as ‘current assets’ is a real and tangible asset when a large proportion of it is irrecoverable.
The WIP figure actually provides a comfort blanket for existing partners and helps to convince prospective partners that equity partnership, the Holy Grail, is valuable and should be aspired to. However, the unfortunate reality for many LLP members is that it is a high risk career move that can easily end in financial disaster.
Those managing LLPs retain old, non-billable and non-collectable WIP on their balance sheets and pay tax upon it in preference to the unpalatable alternative, which is to admit that their business is distressed. If the truth comes out, there is a significant likelihood that the banks will demand that the partners “put more skin in the game” and will facilitate this by making Professional Practice Loans (PPLs) available.
Deceit and deception
Essentially, new partners that pay into the failing LLP are being deceived. Busy partners that are focused on generating new work and service delivery day-to-day are not privy to the conversations being had with the banks. A cash call could be sent out to partners on the basis of a desire to increase growth yet the actual reason is being concealed as the organisation finds itself in distress. Complete trust is put in the management board as the LLP’s overheads spiral out of control and cash flow failures are unknowingly putting their personal assets at risk.
The monies raised from the partners will be used to reduce the LLP’s debt to the bank. In the bank’s eyes, this then improves the firm’s position swapping its poor security - the LLP’s WIP and debt book – for the personal assets of the LLP’s partners, which are left wide open for attack. Partners who meet a cash call from a failing LLP are literally putting their family’s homes ‘on the line’, but few think about the risks.
Truth sacrificed
Usually those on the management board have the most to lose because of significant capital tied up in the LLP.
The truth is sacrificed in favour of the misguided view that a greater good will be served if the facts are suppressed and the cash call progresses. Of course, the bank will not disclose its concerns about the LLP. It is not in the bank’s interests to reveal the inconvenient truth behind the cash call; its willingness to lend more money by way of PPLs also conveniently reduces its exposure to a distressed LLP.
A whole paper could be written about why lawyers do things which they would never advise their clients to do. But having acted for hundreds of former partners of various failed LLPs, we believe that the misstatement of the WIP is the very tip of a highly unprincipled ice-berg.
The alternative solution
So, what is the alternative and is it really all doom and gloom for the legal sector? Thankfully not. There are opportunities in the sector for those organisations that are bold enough to change their business model.
Law firms should introduce a corporate structure which requires no capital contribution, allowing partners within the business to flourish and do what they do best.
Alternative Business Structure (ABS) licences have opened up the legal sector to an entirely new way of working. However, they are yet to make the instant impact many would have predicted in 2012.
Since being established, more than 700 ABS licences have been granted. Yet only around 25 of these law firms have truly embraced the opportunities it brings for business growth and very few have secured external investment and made significant changes to their business model.
The next move for a managing partner?
Judging by the signs of distress in the legal market and the approaching gloom in the economy, it’s likely that many more law firms will fail than ever before.
As a partner, if you are tempted to meet a cash call, do your due diligence or better still, avoid putting your personal assets at risk and move to a well-funded and properly managed corporate structure which does not require you to make any capital contribution at all.
Knights is a UK top 100 legal business. Find out more at www.knights1759.co.uk or join the conversation at @Knights1759
About Knights 1759:
Knights 1759 was founded in 1759. It operates from six regional offices in Derby, Chester, Cheltenham, Oxford, Newcastle-under-Lyme and Wilmslow.
Knights 1759 is a full service professional services business with a team of circa 500 staff.
In January 2013, Knights 1759 became the first UK commercial law firm to be granted an ABS licence and attract private equity investment and is now one of the fastest growing legal firms in the UK with a team of 500.
Knights 1759 provides specialist legal and professional support to businesses in all areas of corporate, commercial and real estate. As well as support with legal issues, Knights’ ABS status enables it to provide ‘non-law’ services such as town planning, corporate finance, management consultancy and specialist tax advice. Knights 1759 is also highly regarded for its specialist private client work in the areas of family finance, agricultural and rural affairs, landed estates, property sales and purchases and complex wills, probate, tax and trusts.
[1] Source: PwC Law Firms’ Survey
[2] Source: Edward Drummond
