The lawyers’ and CEO’s news feeds in North America have recently blown up due to Weil, Gotshal and Manges LLP’s billion dollar law firm dissolving seemingly overnight leaving hundreds looking for new work. It seems only yesterday that this happened with Minden Gross and Heenan Blaikie in Canada. When this happens and the speed with which this seems to happen always leaves those reading about it scratching their heads – how is it possible that this could happen to such large firms? Is the legal industry secure? Is it AI, poor culture or something nefarious causing this? If you are an employee or partner at a law firm or a law firm owner, how can you mitigate these risks?
There are plenty of articles that speculate, or in certain cases, privately report on the goings on at each of these firms when it happens and certainly every circumstance is individual. Notwithstanding individual differences, there are large issues with the economics of a law firm as a business that, if properly understood by everyone involved, may shed some light on this issue. Given that most people simply don’t understand how law firms operate and make money, that might be a good place to start. As concise as possible, I will discuss three large concepts that may provide a clue on the speed with which law firms fail: poor diversification of revenue generation, mismanagement of cash flow, and failed mergers as a quick solution. These issues ultimately trump any other factors at top of mind like AI, poor culture, or some sort of conspiracy.
All businesses need revenue to survive but this is especially true with law firms. The reason for this is in part regulatory – law firms are not permitted to raise money from nonlawyer equity investors. This is unlike tech startups who can operate and even go public for years without being “revenue producing” because the operations survive on outside funding. Law firms, however, immediately require debt or sales to pay their bills. There are also regulatory rules against certain types of marketing and thousands of competitors in the market. The question then is: how do law firms get sales? For many firms, the answer is poaching lawyers who have “books of business”. Many firms starting out (and they continue doing this as they scale) approach other law firms and offer their “rainmakers” (more salesy type lawyers) large salaries and “partnership” units in exchange for joining their firm. The departing lawyer leaves their previous firm bringing their clients with them. Some of these clients have been with them for decades and might be senior executives at large companies, banks, and publicly traded institutions with ongoing recurring work. While some of these institutions require bids every few years, for the most part, once there is a relationship with a lawyer for a long time, these clients stick with that lawyer regardless of where the lawyer works. So, unless this type of client is properly transitioned across a firm, the largest revenue producing clients are stuck with a single lawyer and his or her team – not any law firm itself. When this lawyer leaves again, so do these clients, and there is very little the firm can do given a client’s right to choose their representation. To put this into perspective, if a law firm is doing 10M in revenue every year but one lawyer bills 1M of that and is responsible for 3M of referrals from certain clients, the moment that lawyer leaves, the firm’s revenues have been cut in half. Also, there is no corresponding reduction in expenses – for example, the rent stays the same. This leads to the next issue: cash flow.
My father (a 50 year business consultant and operator and public board member) always repeats the same adage – that what kills businesses isn’t profitability; it is cash flow. How a business makes its money and where it is spent weekly, monthly or quarterly is (strangely) ignored in large businesses or left to the wrong people. A company might be profitable and make revenues in the millions or billions, but this has very little to do with how much cash is in the business. For example, a law firm might make a 1 million dollars in a given month, and this could be reported properly in financial statements, but this million might only be held in accounts receivables – in other words, a client has been billed but the bill has not been collected. The accounts receivable is permitted to be booked on a company’s financial statements to show profit, but if not actually collected, there is no cash in the bank to spend on expenses. On the other hand, expenses typically are either prepaid (ie subscriptions) or preauthorized monthly (payroll, or rent). This explains how a firm can have over a billion dollars in revenue but can go out of business overnight. If a revenue producing lawyer leaves, and the expenses remain high, the firm might be profitable looking at it from a year perspective, but in a few months, it will have no choice but to dissolve its practice.
The final issue is the bandaid solution – failed mergers. Many times, rather than continue to find new ways to produce revenue, cut expenses and transition a departing rainmaker, law firms will attempt to find another law firm to merge with. Sometimes this is successful and the firm is saved. But it is a home run attempt – mergers require months of diligence and during that time, controlled messaging within the firm, staff, and clients. Leading partners are usually involved in the process to give buyers comfort during due diligence but this creates the opposite effect for those same partners. Many acquisitions do not close for a variety of reasons in the best of times. The moment merger discussions fail and the leading management or partners involved can see that, they will now leave of their own accord, fast-tracking the demolition of the firm. The merger is an all or nothing proposition which makes it the riskiest resolution at the worst time for a business as dependent on people as a law firm.
What does this mean for an employee of a law firm or law firm owner? As an employee or even a partner, it is crucial to understand the economics of the firm as soon as possible. While there might be a nice office in the city, consider how much rent that would be. Find out who the top clients at the firm are – if there is a lot of institutional work, chances are that is the top client – who is the lawyer most associated with that client? These are crucial questions to understand the firm’s longevity. Law firm owners should always understand their cash flow administration and needs on a weekly, monthly and yearly basis. This understanding can be delegated to a proper CFO but this CFO needs to be checked on weekly. And sales, the crucial part of a law firm, should never be delegated to a partner who can walk out the door tomorrow. Be proficient at sales, transition client relationships and find other ways to decelop business. Don’t merge/sell your way out of a problem. While this might not make your business invincible (no business is) it might provide you with crucial insight for the future.
This article was first published on Law360 at the following link: