One of the most troubling issues in law firm finance is the persistent desire of firms to draw more out of the firm than the level of profit that is being created in a year. In an ever more competitive world, it is very risky to weaken the firm’s finances by over-drawing profits.

This is not an isolated or even occasional problem; the evidence is that it is widespread and repeated. One of the findings of the Law Management Section’s most recent financial benchmarking survey was that in 2012, partners’ total drawings (including income tax) exceeded profits for 44% of participating firms. In 2013 the comparable proportion reduced to 39% – which could at least be described as a modest improvement were it not for the even more telling statistic that in 21% of practices total drawings exceeded profits for both 2012 and 2013.

To paraphrase Lady Bracknell, “to overdraw profits in one year may be considered a misfortune, but to overdraw in both years looks like carelessness.” Or maybe it is indicative of something deeper?

A Cultural Shift?

As Peter Drucker has been quoted as saying, “Culture eats Strategy for Breakfast”. The numbers emerging from the LMS survey suggest that there is something deeply embedded in the psyche of law firms that encourages them to engage in this risky behaviour. Lawyers are normally extremely risk averse, so there must be something driving them to put their business at risk in this instance.

In the 1990s American author Michael E Gerber became known for his books on entrepreneurialism in the E-Myth series, and particularly for his phrase that entrepreneurs should “work ON their business, not IN their business”. An equally important but less memorable hypothesis of Gerber’s was that “there is only one reason to create a business – and that is to be able to sell it”. He accompanies this by saying that “if your business depends on you for delivery, you don’t own a business, you have a self-employed job”.

The essence of Gerber’s theory is that the mindset of an entrepreneur needs to be focused on growth rather than extraction, and that the reward to the owner will come from a combination of rising income and capital appreciation realised on the sale of the business. Unfortunately, this rarely seems to hold true for partnerships in general, and for law firms in particular. In the absence of the potential for capital growth, the equally important potential for growing profits in the future takes second place to maximising extraction today. In the words of one of our clients – “we’re actually quite happy with our current level of profitability, we would just like to be able to draw it now”.

Our questionnaire on meeting the partners in new clients includes “Is this a Firm or a Chambers?” For this purpose a firm is a coherent entity headed largely in the same direction, whereas a Chambers is a collection of sole practitioners sharing overheads. In many ‘firms’ the answer unfortunately is that it is actually in large part a Chambers, with the focus on “me” and “my clients” rather than on “our firm” and “our clients”.

Measurement Matters

Another saying attributed to Peter Drucker is that “what gets measured gets better”. The principal measure of success in the corporate world is the share price or stock market valuation. This measure incorporates objective historical factors including profitability but, very importantly, also includes subjective and forward-looking factors about the growth potential of the business which are reflected in the Price-Earnings (P/E) ratio. In law firms the comparable measure of success is Profit per Equity Partner, which is an entirely historical measure of the capacity to extract, with no future orientation at all. Is it any wonder when all of the league tables encourage extraction that this, rather than growth, has become the measure by which lawyers define success?

Inevitably, the focus of attention in looking at the firm’s performance, both in monthly management accounts and in the annual accounts, is on the bottom line of the profit and loss account – namely Profit before Tax.

It would only take a small step in the presentation of these accounts to put the focus in a healthier place. Placing 3 lines after Profit before Tax can change the emphasis – these lines need to show the tax payable, the drawings extracted and therefore the Retained Profit. If these were given similar emphasis to the profit before tax, and there was an absolute insistence that retained profit must be positive, the emphasis would move and the damage would be reduced.

It is certainly not illogical for partners to want to maximise their earnings and the drawings in the short term. However, it is both illogical and dangerous for partners to overdraw their profits if they have any ambition to see their firm survive and grow in the increasingly competitive legal market – particularly when new entrants to the market will have both a different ethos and, in many cases, deeper pockets.

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