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The 3-Step Process to Useful Revenue Projections

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We’ve written before about maintaining cash flow in a crisis and how projecting revenues is vital to the planning process. While this isn’t a concern limited to economic hard times, the uncertainty caused by the pandemic dramatically increases the importance of establishing and implementing a sound system for estimating future revenues.

Establishing a process for projecting revenues should consist of three major steps.

  1. Have the firm’s timekeepers estimate revenues on a monthly basis.

Lawyers and paralegals who bill by the hour or charge flat fees should project revenues for the next 30 and 60 days. For contingency fee cases and significant matters billed by the hour, projecting revenues requires detailed scenario analysis. Whether, for example, the case is settled before or at summary judgment or it goes to trial will have a huge impact on how much the firm gets paid and when. The firm should gather data on each of these possibilities. Revenues for contingency cases should be estimated for the quarter in which money would be received.

A lot of lawyers will push back on this task, claiming there are too many variables to even begin making predictions. To address this concern, lawyers should prepare low, medium, and high estimates for every case. A lawyer working on a contingency fee matter, for example, might estimate a medium payment of $100,000 that would be collected by the firm in one year. A high-end recovery might require the plaintiff surviving summary judgment, and that in turn could generate estimated revenues of $300,000 in eighteen months. Creating three scenarios—low, medium, and high – for significant matters is especially important now, when the degree of uncertainty is increasing.

  1. Have someone at the firm aggregate and analyze the information.

These projections won’t mean much until someone puts them together and figures out their implications. Too many law firms generate financial reports without using them to aid in sound decision-making. The key is to look for patterns systematically. For example, is there a quarter on the calendar when almost nothing is scheduled to come in? Is there a case with such a major gap between the worst-case and best-case scenarios that the difference is worth the combined revenues of several other matters? This will not only affect the firm’s cash flow but its workflow. In this example, the firm might want to dedicate a lot more time to ensuring that one case achieves the ideal result.

  1. Follow up.

This process isn’t very effective if management fails to follow up. Lawyers should be updating the estimates for their cases monthly. It’s a learned skill, and some attorneys will find that their initial estimates were wildly inaccurate. It’s common for lawyers to be overly optimistic about the high end of their revenue estimates and overly pessimistic about the low end for specific matters. But, as with many skills, the ability to project revenues accurately improves with practice and appropriate levels of feedback and coaching.

Although the potential advantages of implementing accurate revenue projections are manifest, law firm managing partners and administrators should expect many lawyers to avoid trying to project revenues for fear that they will be criticized if the actual results don’t measure up. It is therefore critical that firm leaders emphasize revenue projections as an important management and decision-making tool and not as an opportunity to take punitive actions against those lawyers who try to project revenues in good faith.

For firms interested in implementing this kind of process, know that financial projections and cash flow planning are areas we can help with. Please get in contact by phone or email.

The Dangers of Excessive Optimism

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People who see themselves as successful are especially susceptible to overconfidence. Business owners often fall into this category, knowing how optimism has served them well as entrepreneurs. But in uncertain times like these, it’s doubly important not to get carried away betting on best-case scenarios.

In practical terms, this means that owners should plan for scenarios that include losing a third or more of their revenues in the near term, even those that have been generated by historically reliable clients. Many companies are conscious of managing cash flow, but fewer are considering that they may need to depart substantially from their existing business models to make money.

An article posted on the financial industry blog Naked Capitalism connects the dots in a way that accounts for the increased risk of a substantial downturn in business. Notably, it quotes from a recent Wall Street Journal article which details how restaurants, retailers, hotels, and other companies from Medtronic to Vox Media are recalibrating their time horizons:

“Executives who were bracing for a monthslong disruption are now thinking in terms of years. Their job has changed from riding it out to reinventing. Roles once thought core are now an extravagance. Strategies set in the spring are obsolete.”

The extra degree of caution needed also applies to underlying expectations regarding the prognosis for and timing of a vaccine. Experts have expressed some confidence that a vaccine is forthcoming in 2021 and that some of the preliminary experimental results have been promising. It is easy, however, to fall victim to a confirmation bias and ignore stories like this recent article in the San Francisco Chronicle which cites researchers at UCSF with concerns that people are shedding antibodies to COVID-19 too quickly to make a virus practical (full text available via the Benicia Independent). A vast majority of people are rooting for an effective vaccine, which is why we need to be mindful of the possibility that reality won’t conform to our hopes.

None of this information is meant to engender a sense of hopelessness. The unfortunate reality is that, while many sophisticated corporations are taking steps to weigh the risks of undesirable scenarios, many law firms and other professional services firms are not. We wrote early on in the pandemic about the importance of humility. COVID-19 has lasted far longer than most of us predicted in March and April. That fact alone suggests that law firms in particular need to do a better job of examining options and strategies that even a short time ago may have seemed unnecessary.

Cash Flow in a Crisis

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In our last post, we advised firms against letting go of personnel as a first resort in this time of crisis. That was published before the Small Business Administration launched its Payroll Protection Program, which provides significant financial incentives to keep people on the payroll through the end of June. We continue to advise most law firms to hold on to their people unless they foresee a reduction in demand that would continue once social interactions return to normal.

There is every reason to think that car accidents will resume once traffic returns. In contrast, cruise ship occupancy may not go back to pre-pandemic levels even after the threat of COVID-19 has passed. Notably, the question of how quickly business financing will bounce back remains up in the air.

After 9/11, even the most credit-worthy of business customers struggled for months to obtain financing. As consultants to law firms and other professional services companies, we are working with our clients to help evaluate how each of their existing practice areas is likely to fare, and we are identifying additional practice areas to complement their existing offerings.

So what can professional services firms do to protect their cash flow?

At many small and mid-sized firms, the equity partners collect around fifty percent of total revenues. So, the first place to look in addressing cash flow concerns is non-essential partner compensation. This might strike some as a quaint notion, but having owners economize to keep their people on the payroll is a tried and proven solution in times like these.

Toward the same end, we don’t recommend skimping on expenses that are directly tied to bringing in revenues. Invoices need to be sent out and collections issues need to be handled. Don’t let important administrative functions fall by the wayside, but look at all other outgoing checks for places to pull back.

Firms should first consider the low-hanging fruit, taking such measures as cancelling subscriptions to non-essential services, postponing or renegotiating perks like club memberships, and looking for cheaper alternatives to elements like the company’s phone plan. Communication is vital here to maintaining relationships with your vendors. If you decide to delay a payment or cut out a particular expense, talk to your providers about it so they can plan too. You don’t want to unexpectedly stiff someone, especially in a time when their margins are probably just as tight.

If these measures prove not enough and your firm finds itself in need of an infusion of capital to make payroll, you’ll have to decide where it’s coming from. The sooner you start thinking about this possibility, the better. The fastest option with the least red tape is for partners to pony up the cash personally. Standard bank financing might be harder to acquire during an economic downturn, but you won’t need any institutional approval to charge to your own credit card.

You could tap into an existing line of credit if you’ve got it or consider a higher-interest-rate loan, knowing that you’ll be paying it back in a short period. In this circumstance, business debt is particularly justifiable. Explore the financing options and defer bills where possible to keep the business afloat until revenues improve.

We recommend that you make these decisions in consultation with people who are not as emotionally invested in your firm. These are difficult conversations, so it is helpful to get used to talking about them. We also urge you to increase the frequency at which you review the firm’s cash flow. While monthly or even quarterly is often enough, during a crisis, you should be generating and assessing profit and loss statements every week, even every day if it comes to that.

These are tough times for sure, but professional services firms have generally done very well once past crises have abated.  We expect the same to happen here. This too shall pass, and we are here to help you.

Keep More Cash in the Register

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For too many law firms the holiday season is accompanied by an unfortunate tradition. It’s not the bad egg nog or the awkward silence that follows an inappropriate comment made by a lawyer who had too much to drink.

This law firm holiday tradition is financial in nature. Specifically, it’s when the equity partners of the firm take out virtually all of the firm’s cash to pay themselves at the end of the year. This is a practice that I have repeatedly encountered when consulting for law firms. The firm essentially starts every year as if it’s a brand new entity because it lacks a meaningful cash reserve.

This is particularly pernicious because, for many law firms that bill by the hour, January and February are their worst months in terms of revenues. The attorneys at such firms tend to bill fewer hours in November and December, and this in turn causes revenues to decline in the following January and February. Likewise, firms tend to incur more expenses in January, such as those related to payments for annual dues and subscriptions. Thus, the firm’s partners deplete the firm’s cash just before they are particularly likely to need it.

Why do law firms reduce their cash reserves at year end?

For some it seems to be a habit that they follow unthinkingly. Too often, however, the need for cash comes from the financial needs of one or more of the equity partners.  They may feel the need to support a lifestyle choice or to meet their personal cash flow crunch. This can lead to a race to the bottom, where the partners who are least responsible and stable cause the firm to make unwise financial allocations.

If you or your law firm is in this position, the first step to building an appropriate cash reserve is to determine how much cash the firm needs to save and keep on its books.  This amount is connected to the firm’s sales cycle and fixed costs. If, as in the example mentioned above, you bill by the hour and typically collect 2-3 months later, it can make sense to build a reserve that is equal to 2-3 months of billings. This will give you the security that the firm will still be on a solid cash footing even if collections drop precipitously.

And you probably should set aside a larger cash reserve if your firm predominantly charges a contingency fee and your pipeline of cases may not bring in money for many months at a time. For example, I consulted with a firm that had no revenues between January and October and then collected more than seven figures from two cases in November and December. This was a record year for the firm, but the cash flow pressures and need to maintain cash reserves were manifest.

In terms of fixed costs, it can be useful to use your payroll expenses (and multiples thereof) as targets for your cash reserve.  Thus, if you currently have a nominal cash reserve, set an initial target of saving enough cash (or collecting enough capital contributions from partners) to exceed the expenses generated for one payroll period. Once you have reached that target consistently, increase your savings goal to two payroll periods, etc.

A line of credit can of course also play an important role in helping a firm meet its cash flow needs. But credit lines often include complicating provisions, such as requiring law firm borrowers to pay back the entire amount that was borrowed plus accumulated interest by the end of every year. Thus, well-run firms maintain cash reserves that can be used as the first line of defense should something happen to reduce revenues or stymie collections efforts.

For many firms, meeting the cash reserve targets outlined above will require a sea change in how they think about cash flow and manage their finances. At a minimum, however, make this the year that you stop depleting almost all of your firm’s cash just because holiday music is filling the air.