Bumps in the road

We have all had time to reflect on the 2024 autumn budget, and it is clear that law firms must navigate a landscape marked by significant economic challenges. The past year has seen interest rates reach a peak, heightened client cost sensitivity and the announcement that employer national insurance (NI) contributions will increase from April, all of which will put pressure on profitability.

In 2025, firms must continue to keep a close eye on regulatory changes, particularly those affecting client money management, cybersecurity, funding and compliance requirements. Additionally, adjusting to changes in the demand for legal services and finding ways to control costs will be essential for maintaining financial stability and promoting growth.

Financial benchmarking in 2024

Despite the economic challenges faced in 2024, the legal sector has demonstrated real resilience and financial strength. Each year, we summarise the results of our law firm clients in our annual benchmarking review, which covers firms of all sizes throughout the UK. We have now completed a mid-year benchmarking review based on data we have for the year to date, and we have seen the following key trends emerge:

Fee income

Fee income per equity partner has increased substantially (13%) since 2022/23, with the average fee income per equity partner now at £1.6m. This rise is, for the second year running, most notable in law firms with one to seven partners, with the average fee income per partner now £1,240,000, compared to £1,047,000 in the previous year. Conversely, the average fee income per equity partner in large firms has fallen 12%, from £843,000 in 2022/23 to £744,000 in 2023/24. Average fee income per fee earner, however, increased by 9%, and is now at £159,000.

The increase in fee income for smaller firms is, in most cases, due to them reviewing their charge-out rates in 2023/24. In comparison to larger firms, smaller firms have been impacted greatly by economic pressures (such as wages and energy costs) in recent years, but had previously been more reluctant to increase charge-out rates to compensate for such rises in overheads. However, in 2023/24, we found that many smaller firms had chosen to increase charge-out rates more substantively.

Net profit

Net profit per equity partner is currently £290,000, seeing a significant increase of £86,000 from 2022/23. We have found that, overall, increases in net profit for firms are due to three main factors:

1. The hike in interest rates contributed hugely to an increase in net profits, with firms seeing exponential growth in this potentially temporary income stream.
2. Firms are getting better at reviewing their overheads and are trying wherever possible to streamline them.
3. Many firms are now in a position where they can pick and choose the work they take on, allowing them to concentrate on more profitable work and shifting their split of work types.

Key takeaways

In summary, the benchmarking results for 2023/24 are highly encouraging, with both smaller and larger firms showing strong performance, particularly with fee income. Smaller firms have experienced notable rises in both fee income and net profit and are performing in some areas on a par with larger firms. These smaller firms have been impacted more by wider economic pressures in recent years such as rising staff and professional indemnity costs, so it is encouraging to see that they are managing to control these factors and produce a strong performance.

What should be on your radar in 2025?

It is crucial for law firms to stay ahead of the curve this year by understanding the key financial and regulatory changes that may shape the year ahead.

Client accounts and interest receivable

The increase in interest rates has had a substantial impact on client money accounts for law firms. This can be a tempting metric for firms to consider when evaluating their financial health, but client money interest is short-term and should not be used as a key metric. Here’s why:

Volatility of interest rates

Interest earned on client money can fluctuate significantly over short periods. While it has, in many cases, provided a short-term financial boost to many firms, relying on such an unstable source of income can lead to inaccurate financial planning and forecasting. In discussing this issue with firms, it is clear many are intending to reserve this additional revenue for capital expenditure and similar projects, rather than fall into the trap of embedding this additional income into increased partner / director distributions.

Regulatory constraints

Regulations governing client money accounts can impose strict rules on how interest earned should be handled. As part of the Solicitors Regulation Authority’s ongoing review of consumer protection arrangements in the legal sector, it has launched a consultation on potential changes to how and when law firms handle client money, and how this money is protected.

Among the key issues explored in the consultation are the following considerations:

• Are there alternative solutions to safeguard client money, and will it still be necessary for firms to hold client money as widely as is currently the case (if at all)?
• Do the rules around interest earned on client accounts and how long monies can be held need to change so they better serve client expectations?
• Are changes needed in terms of the controls, checks and balances firms are obliged to have in place to protect money held in client accounts? This includes obligations regarding accountants’ reports and certain rules regarding control and oversight over client money.
• Are changes needed as to how contributions toward the compensation fund are determined? Longer term, the consultation also asks questions such as whether contributions should be varied based on considerations including firm size, areas of law or other risk factors.

As part of this exercise, focus groups, roundtables, events and direct conversations have been held with more than 200 professionals and members of the public. The consultation will run until 21 February 2025.

Cybersecurity

When it comes to cybersecurity, it’s not a matter of ‘if’ your business will experience a cyber-attack, but ‘when’. Cybersecurity threats present substantial risks to professional services. Law firms in particular handle sensitive client information, ranging from personal to financial data, which makes them prime targets for cyber-attacks. The growing prevalence of cybercrime, data breaches and sophisticated phishing attacks underscores the importance for law firms to implement robust cybersecurity measures to safeguard client data, remain compliant and protect their reputation.

Phishing and social engineering attacks

Phishing remains one of the most common methods for cyber criminals to gain access to sensitive information. By impersonating trusted parties or creating deceptive emails that appear legitimate, attackers can trick employees into revealing login credentials or clicking on malicious links. In the legal sector, where confidentiality is paramount, a successful phishing attack could expose sensitive client communications, case files and other personal information.

Ransomware

Ransomware attacks involve encrypting a person’s data and demanding payment in exchange for its release. Given the critical nature of client files, this could result in operational disruption, financial loss and long-lasting reputational damage for a law firm.

Data breaches

Law firms manage vast amounts of confidential information, making them attractive targets for hackers. A breach can occur through various vectors, including weak passwords, unsecured networks and vulnerabilities in outdated software. A data breach can lead to regulatory fines, lawsuits and a loss of trust among clients. Furthermore, legal professionals are obligated to comply with strict regulations, such as the General Data Protection Regulation, under the Data Protection Act 2018.

Third-party risk

Firms often work with external vendors and service providers – such as IT contractors, cloud storage providers and e-discovery firms – that may have access to their systems or data. If any of these third parties have inadequate cybersecurity measures in place, they could inadvertently introduce vulnerabilities to the firm’s network.

Mitigation strategies

To safeguard against these cyber risks, businesses must adopt a multi-layered security strategy that focuses on prevention, detection and response. Below are several key measures that legal professionals can take to mitigate cybersecurity threats.

• Employee cybersecurity training. This is not just the responsibility of IT departments; it is a firm-wide issue.
• Multi-factor authentication is one of the simplest and most effective ways to protect user accounts from unauthorised access.
• Regular software updates and patch management. This involves keeping software and systems up to date – a critical component of good cybersecurity.
• Data encryption ensures that even if sensitive information is intercepted or accessed by unauthorised parties, it remains unreadable.
• Backup and disaster recovery plans can ensure that critical information is quick to restore. Law firms should implement regular backups, store backups in separate and secure locations (preferably offsite or in the cloud) and regularly test disaster recovery protocols to minimise downtime in the event of an attack.
• Incident response and crisis management plan. An effective response strategy should outline the steps to take in the event of a breach, including how to contain the incident, assess the impact and notify affected parties.

Cybersecurity is a critical concern for law firms, and with the increasing sophistication of cyber-attacks, proactive measures are necessary to protect both clients and the firm’s reputation. By implementing a layered security strategy – comprising employee education, technology solutions and third-party risk management – legal practices can reduce the likelihood of a successful cyber-attack and mitigate the damage caused by any potential breaches. The cost of prevention is always far less than the cost of recovery, making cybersecurity not just a technical necessity, but also a strategic priority for law firms in the digital age.

As legal professionals continue to embrace technology to enhance their services, they must also be vigilant in safeguarding the sensitive data they manage. In doing so, they can foster trust with clients and ensure the continued success and resilience of their practice against ever-evolving cyber threats.

Audit reform

The government has confirmed that monetary size thresholds for micro, small and medium-sized enterprises will increase by approximately 50%. At the time of writing, the legislation was due to come before parliament and is expected to come into force on 6 April 2025.

For companies that move down a size because of the threshold increases – an estimated 132,000 businesses – this may mean their reporting requirements are reduced and they no longer require a compulsory audit. While this will reduce costs and remove a regulatory burden for many, the benefits an audit provides will also be lost. Having an audit is not just a box-ticking process and can add value in many ways, such as:

• Financial accuracy and reliability: Audits ensure that financial statements are accurate and reliable, which is crucial for making informed business decisions and maintaining stakeholder confidence.
• Enhanced credibility: Audited financial statements are more credible to stakeholders, including investors, lenders and customers, which can improve your business’s reputation and trustworthiness.
• Regulatory compliance: Regular audits help ensure that your business complies with UK laws and regulations, reducing the risk of legal issues and penalties.
• Improved internal controls: Audits can identify weaknesses in internal controls and suggest improvements, helping to prevent fraud and errors within the organisation.
• Operational efficiency: By highlighting inefficiencies and areas for improvement, audits can help streamline operations and reduce costs, leading to better overall performance.
• Risk management: Audits help identify potential risks and provide recommendations to mitigate them, contributing to better risk management practices.

The Financial Reporting Standard 102 will also bring in new obligations to bring leases onto the balance sheet, so the capitalisation of property leases, especially longer-term leases, may add significant sums to gross assets and be enough to breach even the new £7.5m threshold. It only needs two of the three measures to be breached to trigger the audit requirement.

Navigating funding challenges

Some law firms are facing significant funding challenges, driven by recent economic changes and regulatory reforms. The autumn budget introduced several measures that have impacted the financial landscape for law firms, including accelerated tax liabilities due to the basis period reform and an increase in employer NI contributions.

Basis period reform and accelerated tax liabilities

The basis period reform will affect any partnership or limited liability partnership that does not have a 31 March or 5 April year end and has shifted the way some firms are taxed, aligning the taxation of profits with the tax year rather than the firm’s accounting year. This change has accelerated tax liabilities, requiring firms to pay taxes on profits sooner than anticipated. The transitional period has created a cashflow crunch for many firms, as they need to manage these accelerated payments while maintaining their operational expenses. There is a concession to spread the additional tax on transitional profits over a five-year period.

Increase in employer NI contributions

In addition to the basis period reform, the increase in employer NI contributions has added to the financial burden. Employers’ rates will rise to 15% from 6 April 2025, while the starting threshold will drop from £9,100 to £5,000, increasing the cost of employment and putting further pressure on law firm budgets. This change necessitates careful financial planning to ensure that firms can meet their obligations without compromising their financial stability.

Importance of detailed forecasting

Given these challenges, it is crucial for law firms to prepare detailed financial forecasts. Accurate forecasting will help firms anticipate cashflow needs, plan for tax payments and manage increased employment costs. By understanding their financial position and projecting future needs, firms can make informed decisions and avoid potential financial pitfalls.

Support and solutions

While these challenges are significant, there are solutions to help law firms navigate this complex financial landscape. For example, Armstrong Watson arranges funding and provides debt reviews to assist firms in managing their financial obligations. Additionally, our expertise in forecasting can provide valuable insights and support, helping firms to plan effectively and maintain financial health, while our new Cyber Security Solutions service can help firms safeguard their data, while ensuring compliance with industry standards.

It’s clear that law firms will need to stay sharp and flexible to tackle the economic and regulatory challenges ahead. Keeping an eye on costs, staying up to date with regulatory changes and adapting to what clients need will be key to staying financially stable. The road ahead might be tough, but with some smart planning, staying on top of finances and a focus on efficiency, law firms can navigate these times successfully.