Peter Thorpe explores the funding routes available to partners of professional firms.
Partners in professional firms have traditionally used two methods to finance their firms: injecting funds as capital and leaving in the firm undrawn tax reserves and profits from previous years.
Obstacles to partner financing
Historically, capital account balances have remained broadly fixed with additional funding requirements being satisfied by the cashflow thrown off from increasing profits. However, with declining profitability and clients paying later the result has been depleted current account balances. This has led to pressure on cashflow and the need to consider alternative or additional sources of financing from third parties.
Following the financial crisis, lenders have become more risk averse, or more realistic, depending on your viewpoint (see next article), when it comes to lending to professional practices. Those banks that are agreeing to lend are offering reduced facilities at higher rates, often requiring security and/or personal guarantees from partners. In some cases, stringent financial covenants are also being put in place and, if breached, could result in facilities being withdrawn immediately.
Where funding is required for fixed asset purchases the firm may want to consider some form of finance lease arrangement to help procure the necessary equipment.
Increasing partners' capital
Most of the main banks offer professional practice loan facilities to partners. Partners can borrow a sum of money on a personal basis, which is then injected into the firm as capital. The partner generally repays the loan to the bank periodically from assigned profits, thereby maintaining the partner's capital interest. If the loan and subsequent capital injection is structured correctly, the interest payments will qualify for tax relief.
There is no requirement for capital to be injected in profit-sharing ratios. In fact, in some firms it is based on a fixed amount depending on the 'grade' of the partner. However, if the basis for injecting capital is to differentiate from the profit-sharing arrangements, the firm may wish to consider paying notional interest on capital balances as a first draw on profits to provide greater equity between the partners.
As an alternative, partners may be allowed to build up their capital by restricting the level of drawings. Clearly, this will provide the firm with capital over a period of time, and its projections will need to be reviewed to determine whether this is acceptable.
Looking ahead
With any funding requirement, it is essential that the firm prepares cashflow projections to demonstrate how much funding is needed over a certain period of time and how volatile this requirement is. This should be the case whether the firm is looking to the partners, the bank or, after the implementation of the Legal Services Act, a third-party equity provider.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.