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    September 26th, 2008

    ♫ You load sixteen tons, what do ya get?
    Another day older and deeper in debt..♫

    Words and music by Merle Travis, recorded by Tennessee Ernie Ford.

    One of San Francisco’s premier grand old law firms voted to dissolve today, according to The San Francisco Chronicle. Heller Ehrman ranked 2nd on the American Lawyer’s  A-List of firms, “a measure based on a variety of factors such as profitability, pro bono representation, associate satisfaction and diversity ratings” according to the Chronicle.  Founded in 1890, the firm had quite a history.  It “led legal projects ranging from the financing of the Golden Gate Bridge to the overturn of the state’s ban on same-sex marriages”.

    It survived wars, earthquakes, the Depression and social changes but was unable to survive the effects of a 3% drop in revenue in 2007. The firm is reported to have had an “unusual” financial structure that may have contributed to its downfall.  It was a partnership of professional corporations. It is reported that in order to avoid double taxation, it distributed all of its earnings at years end.  This left it financing its current operations by way of a line of credit, at least until cash flows caught up to the debt (known as being ‘out of the bank’ according to Heller Ehrman partner Stephen Ferruolo).

    This raises several issues for law firms, particularly as we enter a period of financial instability and recession.  Law firms are classically under capitalized but this particular financial structure resulted in the firm using debt to finance, at times, the firm’s operating capital.  Structuring your business for tax advantages is fine so long as it doesn’t result in any distortions of the fundamental business foundations of a firm. In this case it appears that the desire to minimize tax overruled prudent financial management and capitalization principles (namely the debt/equity ratio).

    A highly-leveraged firm is vulnerable to shocks.  In Heller Ehrman’s case the triggering event appears to have been the loss of some large litigation cases that led to a 3% decline in revenues for 2007.  As a result, key partners left the firm  (the article doesn’t say so but reading between the lines, these departing partners must have been major revenue generating partners who saw their bonuses and/or draws reduced as a consequence).  Once these key partners left, an inevitable chain reaction was started which resulted in a diminishing number of equity partners carrying a large debt load. Eventually the firm collapsed under the weight of its debt without the infusion of new equity and new equity partners.

    After trying to find a merger partner and failing, the remaining partners  must have found the last days to have been crushing – working like crazy only to find they are a day older and still deeply in debt to the bank.  The dissolution must have been the only alternative left…

    Hat tip to Pete Roberts for drawing this to my attention!

     

     

     

    This entry was posted on Friday, September 26th, 2008 at 10:44 pm and is filed under Budgeting, Firm Governance, Issues facing Law Firms, Law Firm Strategy, Leadership and Strategic Planning, Trends. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

    2 Responses to “The 3% Dissolution…”
    1. John Ryan Says:

      It seems hard to believe that a business facing only a drop of 3% in sales would be enough to trigger a collaspe. Are margins that thin in the operation of law firms? I also noticed that their accounts recievable had climbed to over $110 million. So as you have said before David, have a good retainer agreement and get the money up front.

    2. admin Says:

      John:

      I wouldn’t say that margins in law firms are that thin. Rather, the way they ran their office, the 3% drop was taken directly against partner income – I don’t think they had any pad to cushion them against a turn in their economic fortunes. So combine declining revenues with an increase in accounts receivable (as you noted) and a large debt to be paid to the bank – and you have the recipe for disaster. The partners who are keeping the partnership afloat are the first to leave, since they have the most to lose. This only compounds the problem since the major cash flow producers have left and the firm then goes into a death spiral.

      The lesson in all this is to reduce debt down to a manageable level relative to partner equity and to increase the storehouse of ‘cash’ which then works as a shock absorber when you hit a rough spot.

      Cheers,

      Dave

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