Equity Versus Debt Capitalization-Does it Really Matter? (Part 2)

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Both the debt and “no debt” business models can wind up on the same trash heap of failure. If the enterprise does not generate sufficient distributable cash on a sustained basis to carry the enterprise, then all that a heavy capital program has done is underwrite the inefficiencies for a longer period of time until the quotient of rate of return on assets invested that is tolerable has been reached or exceeded. Note that at such a tipping point, the partners who have been the beneficiaries of the over distribution policy have strong incentives to leave the firm and start over, not just those that have underwritten it and were theretofore unaware! Strong operating margins generated by sustainable income flows and cash balances are what make winners, not per se whether they use debt or equity to deliver it. Since law firms are not operations that require huge amounts of capital to operate, there are limited needs for debt or equity. A stable and quality receivables base and some cash reserves, with consistent and reasonably level receipts from month to month, or quarter to quarter, delivering distributable cash is what is required. Accounting tricks, governance tricks with respect to return of capital, management policies that take or defer income from other classes, or stealthily reallocate it internally within the equity ranks, are draughts of financial absinthe.

There can be “borrowing” in the “no debt” model — the partners just lend it to themselves.

(Reprinted with permission of The Daily Journal Corp. (2012).)

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Published In: Professional Practice Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Edwin Reeser, Edwin B. Reeser, A Professional Law Corporation | Attorney Advertising

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