The Lost Measure: Cost of Capital - Stress Test Your Firm

Admin — Tue, 10 Mar 2009 19:13:00 GMT

When I started working with law firms in 1999, I used to have heated (and futile) debates about the importance of the time value of money in assessing firm (or practice, billing lawyer, etc.) performance. My argument was simple. Take the law firm business model to any venture capitalist and pitch them: “I have a great business for you. An illiquid minority position in a talent-based, service business with few tangible assets, subject to capital calls. What do you think?” The scenario provoked a lot of chuckles. When I then suggested that the minimum necessary return for that scenario was probably north of 50%, outrage ensued. Cash, after all, was cheap (multiple people suggested Libor as a cost of capital) and easy to get. Collections were predictable.

I think it’s time to revisit the argument. Of course, interest rates today are even lower. Capital, however, is scarce from both internal and external sources. Moreover, the risk component to working capital, the largest component of most firms’ capital base has dramatically changed. For years, Redwood has utilized a model of “discounting” outstanding A/R based on historic collection patterns versus different points of the aging curve. This has allowed firms to more quickly grasp and manage the devastating impact of aging receivables. I think the time has come for more aggressive modeling. At a time when corporate America is scraping cost savings from anywhere they can get it, in a buyer’s market for legal services with utilizations tanking and with rising unemployment (including among lawyers), I think the time has come for law firms to utilize the same sort of “stress tests” being run elsewhere. Can my firm survive 85% or even 80% collection realizations? What if these are combined with 30/60 day extensions? What is the impact on my working capital? Where is my point of “no mas”? In my example below, under a “Perfect Storm” scenario, the firm has tested a deterioration of realizations and an extension of cash collections and has seen a total decrease in available working capital of $20 million plus an incremental $4.5 million of capital costs.

I believe firms that incorporate cost of capital assumptions this way will be better prepared to deal with adversity, and I suspect all who do so will come to the same conclusion that I have. Namely, that the cost of capital for firms is much higher than most realize and that the firm would be very well served by aligning the reward/punishment components of its compensation schemes with much higher costs. These higher costs can provide a measure of protection firms need in today’s climate.

--Norm Mullock

Norm is the Redwood Product Champion for LexisNexis. Since 1999 Norm has helped firms of all sizes deploy solutions that reduce the effort needed to produce existing analyses and enhance firm performance.

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The Lost Measure: Cost of Capital - Stress Test Your Firm