Asked and Answered

By John W. Olmstead, MBA, Ph.D, CMC

Q. Our firm was started 20 years ago by four partners. We now have the original four partners as well as six associate attorneys. Originally, each of the four partners contributed $25,000 to their capital accounts. We are considering extending partnership to a couple of the associates. We have talked with other law firms and some require buy-ins (capital contributions) and others do not. What are your thoughts?

A. My first question is whether you are planning on creating a non-equity partnership tier. If so, then the associates would initially be brought into that tier first.

Typically a buy-in or capital contribution is not required for non-equity partners nor do I recommend such. Typically non-equity partners are salaried and may participate in some form of an incentive bonus system tied to individual, team, or firm financial performance. They are also not required to assume any responsibility for any of the firm's financial liabilities or debts.

If you intend on bringing in the associates as equity partners that is another matter. I believe that all new partners should be expected to contribute capital and have some "skin in the game." Whenever a firm admits a new partner, the firm should require the new partner to contribute capital. Increasingly, a partner's capital requirement should bear a relationship to the partner's share of profits. You may want to allow new partners a reasonable period of time to fund their capital accounts - say five years or help them arrange favorable terms at your bank to finance their capital accounts.

Some firms have a buy-in tied to either the cash-based book value of the firm or the accrual-based book value (includes accounts receivable and work in process). This is not the typical practice although I do run into it. Usually capital accounts are tied to working capital needed to operate the firm and the percentage of ownership/income that each partner will have.

There are only three ways to increase a firm's working capital to cover cash flow requirements and fund growth:

1. Have partners put more money in
2. Have partners take less money out
3. Borrow

Many firms use bank credit lines instead of capital contributions to pay routine firm expenses and partner draws during periods when cash flow is tight. It has been my experience that firms that follow this practice have ongoing financial challenges and problems.

The reality is that many firms are under-capitalized - don't become one of them!

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John W. Olmstead, MBA, Ph.D, CMC,(www.olmsteadassoc.com) is a past chair and member of the ISBA Standing Committee on Law Office Management and Economics. For more information on law office management please direct questions to the ISBA listserver, which John and other committee members review, or view archived copies of The Bottom Line Newsletters. Contact John at jolmstead@olmsteadassoc.com.