Andrew Allen looks at the potential risks of some of the government schemes designed to support businesses through lockdown, and looks at other ways law firms can ensure their financial resilience during the pandemic and beyond
The various government schemes designed to support businesses during coronavirus mean it is now easier than ever for law firms to get finance into their business. But is this finance actually the right thing for your business? By taking it up, could you be delaying (and possibly worsening) the point where headcount reductions and financial restructuring plans are actually needed?
It is tempting with all the cash on offer to take the easy option and defer difficult decisions. We can all remember how this panned out in 2008/9. Second time round, let’s all make the harder decisions sooner, to preserve our businesses for our people and our clients.
While the facilities may seem like a lifeline at this point, they could in due course become a burden, which could in extreme cases even bring down the business in the future. The government’s objective of keeping people in employment today is relatively short term. Business owners in law firms need to have a longer-term view.
In this article, I look at each of the key sources of finance and explore some of the risks of each, and consider what firms should be doing now to preserve their medium-term financial resilience once COVID-19 is under control and we return to the “new normal”.
1. The Job Retention Scheme (furlough grants)
Law firms will of course realise that while these grants take on the majority of the cost of an employee, they do not cover the overheads of the firm, or indeed make any contribution to profits; so where fee-earners can gainfully be employed (undertaking recoverable time where cash will materialise in a reasonable timeframe), it still remains sensible for those people to be working in the business.
There are also a number of risks for firms to consider in respect of these grants, including the following.
Could the government claim the money back?
Clear messages have already been given that HM Revenue and Customs (HMRC) will have the right to review claims by employers for five years after the claims has been made. The history of most government grant schemes involves a period of attempted recoupments, and we should reasonably expect these with this scheme in due course. It seems unlikely that much sympathy or leeway will be given to law firms in the audit process.
The risk to firms, of course, is that if they manage to limp through COVID-19 only to face a material recoupment of the grant in the future. This may well hit them financially at a crucial time during recovery, and once again, put the business at financial risk.
My advice to firms in this area generally has been to ensure that they maintain a folder of information to explain their actions and the basis of their claim, with the broad objectives of ensuring that:
- there is a commercial justification for the grant being claimed, and there is no evidence of exploiting the scheme
- there is documentation to support the rationale for people being put on and brought off furlough over the period the scheme is in operation
- key extracts from board minutes and partnership decisions are included on the file to show due process is being followed.
How will this impact other decisions about capacity and roles?
Firms should not rely on the grants to the exclusion of making difficult but important decisions about team structure and roles.
Do not delay otherwise inevitable redundancies or other restructuring decisions necessary for teams to manage the expected level of work over the next few years. Looking back to the effects on law firms of the financial crisis in 2008/9, it is clear that those which emerged stronger were those which took headcount reductions and reinvestment decisions sooner rather than later.
Many firms have already identified that the new normal post-coronavirus could involve a radically different way of working. That means now is this time to start looking at roles in your business which may simply no longer exist in the future, and take active steps to remove those roles and associated costs from your business during 2020. Many firms are planning a considerable reduction in support and administration staff in firms, to reflect the new working approaches of fee-earners. The traditional view in recent years of around 0.8 support staff per fee-earner is likely to fall considerably over the next few years, in my view.
2. Deferral of VAT and income tax payments
The government has announced a short-term lifeline for businesses, in the form of deferral of VAT and income tax payments into 2021.
While this may sound obvious for many firms, this is a short-term loan which, in most cases, needs to be repaid from future profits and restricted (or at least delayed) drawings by partners.
Look forward in your financial forecasts to ensure that cashflow-wise, you can reasonably (with headroom) expect to be able to repay these loans to HMRC in due course. This means projections being prepared today need to run to at least 31 March 2021, and potentially 31 January 2022, to ensure that with various demands and activity scenarios, the firm is able to trade through the repayments.
You may even need to consider whether, during 2021, you will have sufficient debt capacity in your balance sheet to refinance the loans with a commercial provider if your short-term cash generation looks unlikely to support the repayment of this debt to HMRC.
Most firms seem to be taking the deferral of VAT until 31 March 2021. However, we are increasingly seeing firms deciding to make the July 2020 payment of income tax on behalf of partners; primarily because:
- at present, cash is strong in most firms (following a good year to 31 March or 30 April 2020), and in January 2021, the cash position is likely to be much worse, and there may be greater risks of firms not having the funds to make the payments
- bank support for allowing such payments is likely to be stronger in July 2020 than January 2021
- the income tax is a personal liability of partners, regardless of whether tax reserves are held in the partnership or not, and paying out for personal tax liabilities in January 2021, when cash is poorer, may present greater risks to members in an LLP from an insolvency viewpoint.
3. Coronavirus Business Interruptions Loan Scheme (CBILS)
The primary risks here are similar to the deferral of taxes, and to some extent, furlough grants.
These loans are relatively easy to secure at present and ironically, through government encouragement, lenders have recently relaxed their requirements for forward-looking financial projections, and are primarily basing their lending decisions on the historical performance and ‘prospects’ for firms.
While this may ease the access to funding, firms still fundamentally need to have a basis for the level of loans they are seeking, and a clear view on the future impact to the business – that is, the affordability of the loan in both profit and cash terms.
You therefore need to understand the debt capacity in your balance sheet. This amount cannot be precisely defined, because it partly comes down to lender appetite. However, many lenders would say they are comfortable with total debt on the balance sheet being up to the level of partner investment. What does this mean in reality? What is total debt and what is partner investment?
Example: How to understand your debt capacity
Professional indemnity insurance loan
Short-term fit-out loan
Last balance sheet
Members Current Accounts
Members Tax Reserves
In this scenario, banks may consider there is a range to total debt in the balance sheet which is ‘safe’. Banks may see this in a number of ways:
a) based only on members’ capital of £2.5mi; taking into account existing debt in the balance sheet of £2m, this leaves spare capacity of £0.5m.
b) based only on members’ capital and current accounts of £3.5m; taking into account existing debt in the balance sheet of £2m, this leaves spare capacity of £1.5m.
c) based on all members’ funds, in total of £5m; taking into account existing debt in the balance sheet of £2m, this leaves spare capacity of £3m.
In practice c) is unlikely, so a reasonable range to consider is between a) and b) – so an additional £0.5m to £1.5m. £1m might therefore be a ‘sensible’ and ‘available’ level of debt to this business.
Most commonly, we find that law firms have a conservative level of debt in their balance sheets, and typically will be borrowing in the region of 50p for every £1 of money they have in their capital and current accounts combined at any point.
In the above example, the result was 57p in the £1; if we increased the debt by a further £1m, this result would rise to 85p in the £1. This is still within our ‘rule of thumb’ of £1:£1, but clearly much greater exposure than is currently the case.
Note also that when banks assess borrowing capacity, they often take into account the degree of personal capital loans the partners have in place. While technically, these are risk against personal rather than partnership assets, they are still usually fundamentally services by the same income stream (the law firm). This can, in turn, sometimes restrict the degree of borrowing available to the partnership.
Taking the above example, this means that many firms seem to have significant borrowing capacity, and to some extent, should be comfortable in accommodating a certain level of additional funding to survive COVID-19.
However, firms still need to consider important issues such as the impact of the additional debt on medium-term cashflow, in terms of:
- ability to pay future profits out to partners
- attraction of the business to future partners (for succession purposes)
- ability to secure additional debt for key future business changes, such as IT investments
- sensitivity in cashflow and repayment terms of the loans to other economic changes over the next few years
- credit rating of the business and future trading capacity
- sustainability of cashflow to make debt repayments when they fall due
- impact on future capital requirements for incoming partners
- impact on banks’ ability to offer partner capital loans to future partners.
How can you build financial resilience?
1. Secure usual working capital debt
Think ahead and consider the usual areas in your law firm where you rely on external debt, such as fit-outs, professional indemnity insurance and tax payments, IT investments on so on.
- Will providers be willing or able to provide you with debt in the future?
- Will this be affected by the level of COVID-19 loans you take now?
- Should you build in extra finance requirements to your COVID-19 applications now, to take account of this future impaired ability to secure normal working capital debt?
2. Consider future opportunities
Firms which flourished post 2008/9 were those which were in a stronger financial position and able to take advantage of opportunities in the sector. Whether this was merger, acquisition or simply being ahead of their field in investing in IT and new fee-earners, a common attribute of those firms is that they started from a strong financial position.
Consider this now in terms of the mix and level of debt you take on. Should you take on more now to fund future investment, or should you keep debt levels as low as possible to make you more agile in the future?
3. Build capacity
At some point, recruitment will become an issue again. A mistake professional firms made in 2008/9 was a mass exit from recruiting trainees. Firms should carefully consider changes in this area to ensure they are not left short of key skills at a point when the market picks up. It may also be relevant for firms to consider what they are training people to do; for example would it be sensible to build in more future capacity to family and employment teams who logically look set to have a busy few years?
4. Plan carefully for potential lock-up changes
What might the impact be on lock-up over the next 12-24 months.
- When will different work areas restart?
- How long will it take to rebuild matter starts and work in progress?
- Will the settlement pattern for fees and disbursements by clients change?
When you look at medium-term cash needs, model a range of sensitivity outcomes in this area to ensure your balance sheets are able to withstand a range of possible outcomes as the sector ‘restarts’.
5. Think about potential changes in structure and real estate
Many discussions and reports in the sector are rightly focusing on the new normal and the practical impact this may have for working arrangements. Law firms also need to consider the financial impact of these changes and build them into their planning (and debt requirements). Aspects to look out for include:
- the costs of early exit from property arrangements
- the impact on depreciation periods for accounts purposes of leasehold fit-outs if looking at shorter-term exit from properties
- providing for redundancy costs at the earliest point.
6. Address the impact on partner capital funding
Consider the impact on the level of partner capital in the business. In my view, this should be undertaken in conjunction with any additional debt being taken on as a result of COVID-19.
7. Consider setting up a service companies to support risk management
While we all might like to think that we have managed the furlough scheme impeccably, there is a reasonable risk that employment lawyers may conclude otherwise in the future, and law firms, like any other business, may be more exposed in the future to claims.
Is now the time to revisit the option of a service company to move employment risks away from the main law firm in some form?