Starting a new firm inevitably demands investment – not just in premises, systems and other costs, but to ensure you can cover your own personal financial needs until fees start rolling in. You need to be clear on how much you need, and happy with the level of risk you are taking on. You also need to put in place financial management systems that meet compliance requirements and help you stay in control of the firm’s finances, as Darren Cable of Lloyds Bank and Chris O'Day of The Cashroom explain. (18 July 2023)
If this is your first time running a business, you will quickly learn the importance of cashflow. Putting it simply, you have to keep an extremely tight lid on your costs until you have a steady flow of fees coming in. You want the excitement and satisfaction of running your own business, without the stress of worrying about your money running out when the bills need to be paid.
It’s easy to underestimate the full costs you may need to cover when you start a new firm. These typically include:
- premises and equipment, including any upfront payments or deposits on leases
- advisers’ fees
- professional indemnity insurance (PII)
- regulatory fees (eg SRA) and practising licences (eg The Law Society)
- your and any partners’ income requirements, to cover personal financial needs
- salaries for any employees
Against this, income when you first start the firm may well be minimal or even zero, particularly when you take into account delays between billing and actually receiving payment. Avoid the temptation to make unrealistic income forecasts.
For many start-ups, the net effect is an initial funding requirement which further increases over the early months. Fee income gradually builds up until your cash flow reaches break even. You will need to have – or raise – enough financing to cover your peak funding requirement, plus a further cushion of contingency funding.
A full projection of both costs and income is an essential part of your business plan. You should take a conservative approach, allowing for unforeseen cost overruns and revenue disappointments. Not only does this help protect you against unpleasant surprises, but it will help present a more convincing case to any funders you are approaching.
A good accountant – particularly one with experience in law firm start-ups – can help put together and sanity check your financial projections. Your accountant can advise you on the different financing options that may be available to you, and you should familiarise yourself with the key issues around bank finance and dealing with lenders.
One particular issue you should consider is the degree of financial risk you are prepared to take. Depending on how your firm is structured (eg as a traditional partnership or a limited company) and what types of financing you want, you may be asked to give personal security or a guarantee for borrowings. In the worst case, this could mean that the failure of the firm would leave you personally liable for debts.
If you start small, working solo from home and servicing clients who are happy to pay part of the fees upfront, you may be able to operate with relatively little or no need for external finance. Then, with a healthy bank balance, you can invest time and money into making your firm more efficient and more attractive to potential clients.
Professional indemnity insurance
PI insurance is provided on a 'claims-basis', providing protection against a claim when it is notified, not when the work was undertaken. So rates are discounted for new firms as there is no previous work to insure.
But startups are inherently risky. Most insurers prefer to insure firms with a successful trading history. Just as you will need to show a convincing business case to potential funders such as a bank, you will need to persuade an insurer that you are worth backing.
As well as excellent legal skills (eg post qualification experience of at least five years) you must demonstrate your team’s experience of running a law firm and managing risk – and your understanding of the Solicitors Accounting Rules in particular.
The whole process of preparing an application and finding an insurer may take several months, even with the help of a suitable insurance broker.
The market is constantly evolving and changing. For example, insurers and regulators are currently grappling with defining and then pricing ‘adequate and appropriate’ insurance cover for freelance solicitors. In particular, anyone proposing to work part-time or to run a practice as a sideline business may struggle to find cover.
Rates for PII cover for established law firms typically range between 2% and 5% of fee income, depending on the type of law practised and other risk factors. Rates also reflect the changing levels of competition between insurers each year. Insurance companies have a minimum premium below which they will not offer insurance, a minimum that varies between insurers.
"We receive applications from start-up firms throughout the year and proactively consider them. Given the lack of trading record, we look for principals who are invested in – and committed to – making the business a success. The thoroughness of the business plan and financial forecasts is key."
James Kerr, head of professional indemnity, Travelers
The cash flow priority
For a new law firm, with limited financial resources, cash flow is crucial. If your firm runs out of cash, you are out of business – and quite possibly facing personal financial difficulties as well. From the outset, you need to be realistic about the fee income you can expect and how soon you can expect payments to be made.
Across the legal sector, lock-up – the time it takes from doing the work to collecting payment – averages around four months. While this varies for different firms and areas of legal practice, that’s typically an extra funding requirement equal to four months’ turnover. Your firm may be unable to take on new clients – even highly profitable ones – if your cash flow is at risk of being overstretched.
The implications for a start-up are stark. You need to:
- include a realistic assessment of lock-up in your financial forecasts
- set up systems that help minimise lock-up and take personal responsibility for reducing payment delays
- if necessary, restrict the amount or type of work the firm is prepared to take on until you are in a stronger financial position
This attention to cash flow needs to continue throughout the life of the firm. You’ll want to have easy access to your current cash position and continually updated cash flow forecasts. Keeping a close eye on how actual income and costs differ from your budgets will give you early warning of any problem areas where you need to take action.
Realistic income forecasts
It’s easy to be over-optimistic about the level of fee income you can expect, particularly in the first few months of a new firm.
Be realistic about how long your marketing and sales efforts will take to bear fruit, depending on the types of client you are after and how you approach them. For example:
- Online advertising may allow you to quickly reach potential clients (at a cost). But building your online presence more generally – for example, through useful content and social media – is a much slower process.
- Raising your profile through networking necessarily relies on networking opportunities. It may take several meetings to develop a meaningful relationship.
- Corporate clients can be particularly slow. For example, if you need to tender or qualify before even being considered for future business.
Many new firms hope to short-cut this process to some extent with existing, loyal clients that the founder and any other employees bring with them from their previous firms. Again, be realistic. It’s easy for a client to say they are interested in working with your new venture and to sound supportive. But it may be a different story when the previous firm puts pressure on these clients to remain, especially if the services you offer aren’t exactly what the clients were expecting.
Looking further ahead, you need to be realistic about the number of billable hours you will be able to sustain, even if there is plenty of client demand. Your role is likely to involve spending significantly more time on management than previously. In a small start-up with few support staff and systems, you might be lucky to spend as much as half your working hours on billable work.
"Setting up a new firm is an exciting time, and it is easy to overlook some of the essentials. Careful planning and forecasting can make a huge difference to the success of your new firm."
Sharon Carr, legal sector manager, Armstrong Watson
Managing your finances
Making sure you have the right financial systems and people isn’t just a matter of compliance. It’s also about putting you in control of the firm’s finances, helping you to understand where the best opportunities are and what issues you need to address.
As a principal or manager, you want to be able to delegate or outsource day-to-day financial management as much as possible. For most start-ups, that largely means outsourcing – giving you flexible access to expertise without building up disproportionately high financial management costs. Key providers typically include:
- your accountant to help with initial set-up, registration for taxes, annual filings and so on, and as a general source of advice on finances and financial management
- a legal cashiering provider to take care of the nitty-gritty of keeping accounting records and handling payments
- bank accounts and perhaps third-party managed accounts (TPMAs) to handle the firm’s balances and client monies
This does not mean that you can wash your hands of financial management. You still need to take an active, personal role – making sure that systems are working and compliant, and using financial information to guide your decisions. Key areas where you should be involved include:
- deciding what in-house accounting systems and capabilities you need as part of your practice management system
- choosing external providers, negotiating terms and working out the processes for sharing data with them
- reviewing key monthly management information
- making sure budgets are regularly updated and that funds are being put aside to cover future tax payments
- ensuring that you (and any other lawyers in the firm) work with clients to minimise lock-up
Financial and risk management are naturally linked – not least because law firms hold both sensitive data and substantial funds, and are a frequent target of fraud attempts. Risk management is essential, not just for regulatory compliance but to protect the firm and its clients.
The SRA’s risk outlook offers useful background reading on the key risks facing law firms. The SRA’s guidance on AML risk assessment also provides an illustration of how to approach risk assessment and some useful tools.
Key issues to address include:
- maintaining a risk register, identifying potential risks and how you will monitor and manage them
- paying particular attention to compliance requirements and high-risk areas, such as client onboarding, payments and cyber security.
- ensuring that you have robust systems and processes
- carefully vetting external providers
- providing appropriate training and creating a culture where problems are openly discussed and addressed
- undertaking a risk review at least annually
The ability to demonstrate strong risk management can substantially reduce professional indemnity insurance costs. Our PII and avoiding claims topic includes answers to 98 common questions about PII along with detailed guidance on how to avoid negligence claims.
Finance and insurance top ten
- Assess all your initial start-up costs.
- Be realistic about whether existing clients will stay with you and how long it will take to win new clients.
- Focus on cash flow, taking into account the level of lock-up you should expect.
- Think about your own attitude and how much personal financial risk you are willing to accept.
- Take advice from an accountant with legal sector expertise.
- Outsource appropriate financial management activities.
- Keep financial control with regular review of key management information.
- Invest in setting up financial management systems and processes.
- Make sure you understand the key risks you need to manage.
- Create an open culture where shortcomings are acknowledged and addressed.
Why do law firms choose Lloyds Bank?
It’s because Lloyds is the only bank with a Lexel-qualified team of legal sector specialists who understand law firms and their specific funding needs.