The role legal finance can play in firm year-end collections

It’s an annual rite of passage: As summer ends and the days grow shorter, lawyers begin a monthslong struggle to collect outstanding fees before the clock strikes 12 on New Year’s Eve.

Before examining how to solve this problem, let’s address why it exists. What’s driving the pressure to collect? Why do law firm partners stoop to their annual transformation from trusted advisers to glorified bill collectors? In simple terms, law firms face external and internal pressures that create a perfect storm at year-end.

External Factors Delay Cash Flow to Law Firms

In matters where law firms charge by the hour, time to money is slower than in many other industries. Although firms can pressure clients to pay, they have limited leverage; a valuable client can react negatively to a firm’s heavy-handed approach and take its business elsewhere. In contingent-fee matters, where firms earn fees only when underlying cases are resolved successfully, payment requires success and can take months or years, even after a positive resolution. For example, firms frequently settle cases and stand to receive substantial fee awards but must wait for the settlement to win court approval. Given the slow pace of certain administrative proceedings, as well as the risk of objectors further delaying approval in the class action context, this often takes longer than firms hope or expect.

Internal Business Structures Create Urgency Around Revenue Recognition

Because most law firms utilize cash-basis accounting, they can recognize revenue only based on dollars actually collected. In other words, earned fees that are not collected do not contribute to a firm’s performance within a given accounting period, meaning those results often fail to reflect the true extent of the firm’s success. That poses obvious disadvantages. Internally, end-of-year partner distributions lag behind the firm’s level of activity, practice groups miss goals for revenue contribution or profits per partner, and morale suffers. Externally, revenue-based rankings sink, and headlines focus on disappointing annual results rather than significant victories won for clients.

The consequences of year-end revenue urgency can damage client relationships and impair firm economics. Although partners hate the year-end ritual, they are incentivized to repeat it in order to boost their own performance numbers and thereby their share of the firm’s profits. But clients often react poorly to the sudden push for collections, causing partners to squander their hard-won standing as trusted counselors.

Regardless of the number or intensity of haranguing phone calls and emails from the billing partner, clients retain greater leverage and a better negotiating position. As a result, firms frequently bargain away profit by offering steep discounts in exchange for an agreement to pay as soon as possible. Similarly, contingent-fee firms can seek to monetize outstanding fees in ways that seem expedient but ultimately harm profitability.

Payment collection delays have caused law firms to seek new options, one of which is litigation finance. In this context, litigation finance—which enables firms to accelerate and monetize fee receivables—can offer alternative avenues to firms as they approach the end of a fiscal year or partnership distribution dates.

An Alternative to the Year-End Collection Cycle

Acceleration

Third-party finance providers can purchase a portion of a firm’s outstanding hourly or contingent-fee receivables—allowing firms to recognize the revenue they receive immediately, regardless of when clients pay outstanding bills.

For a relatively low cost of capital, fee acceleration reduces the need to offer larger discounts to clients in exchange for payment, or to undermine valuable client relationships with an unseemly push for collection. It also applies in contingent-fee matters where the legal issues have been resolved but payment of the judgment or settlement—and thus the fee—is delayed for some reason, such as a court approval process or deferred payment under the terms of a settlement agreement.

Monetization

Third-party finance providers can purchase some or all of a firm’s contingent receivables when the possibility of a significant fee exists, but additional legal proceedings make the timing (or even the ultimate receipt) of the fee uncertain. Under this arrangement, for example, a firm can immediately monetize part of its fees from a win at trial to diminish the risk of a negative appellate outcome.

These solutions do not create debt for law firms, and financing is typically nonrecourse—that is, if a client ultimately does not pay or a fee never materializes, the law firm has no obligation to repay the finance company. At the same time, the law firm’s standard collection processes remain in place, and the transaction does not require the financing company to contact clients.

Financing Receivables in Action

What do these solutions look like in action? Beyond the purchase of hourly fee receivables from law firms, one blind example entailed the purchase of an eight-figure receivable in a contingent-fee matter from an Am Law 25 firm. The receivable was bought at a single-digit discount to its face value and funding of the transaction was finalized within 10 days of the initial conversations between the law firm and the financier. The firm had resolved the case successfully and wanted to avoid waiting for administrative approval of the underlying settlement agreement, which took almost another year.

Litigation finance providers routinely accelerate the contingent fees of law firms that serve as counsel in class actions, so that the firms can reduce the delay of court approval of the total settlement package. Additionally, finance providers can facilitate litigation settlements by converting a defendant’s promise to make payments over several years into a single lump sum for the plaintiff.

Interestingly, these techniques have been commonplace in other sectors for decades. Industries from construction to healthcare to manufacturing use accounts receivable financing, or “factoring,” as a matter of course to solve cash flow issues caused by slow-paying customers. This approach provides a debt-free solution to unlock the cash tied up in unpaid invoices. More broadly, companies of all kinds use corporate finance tools every day—such as by collateralizing their real estate, equipment or inventory to access capital to reinvest in the business. In many ways, litigation finance is simply the extension of these time-tested solutions to the legal industry.

So why has it taken so long for law firms to catch up? The answer lies in both supply and demand. On the demand side, the “new normal” of the post-recession legal services market has created ever more pressures on law firms, and ever more need for creative financing solutions. That need surpasses many firms’ capacity to bear sustained risk, and their traditional banking partners are unable and unwilling to provide ready and cost-effective financing on a nonrecourse basis. On the supply side, as part of the development of the legal finance market, a handful of specialist finance companies wholly dedicated to legal risk have emerged to fill this demand.

Tips for Firms

As year-end approaches, firms that seek to finance their receivables should look for pricing that accurately reflects the risk the financier is taking on. For example, the cost to accelerate unpaid hourly fees with little or no collection risk will be lower than to monetize contingent fees in matters that are still subject to appellate or other legal risk. Firms should seek finance partners with capital solutions that span this risk spectrum. Additionally, firms should consider how financing could affect the competing interests between retiring partners, who may be more willing to take a haircut on receivables to collect them quickly, and their newer counterparts, who may be more willing to wait for matters to resolve. Look for finance partners that can accelerate receivables at a price that satisfies everyone’s needs. In general, pricing terms will be offered by the financier after assessing a firm’s case materials and billing records to assess post-settlement collateral and/or fee receivables and to analyze estimated repayment time and payor credit risk. Be cautious of engaging any financier willing to provide pricing information without first performing this basic diligence.

If the parties enter into a transaction, the financier will grant the law firm immediate access to the agreed-upon amount of funds—offering an alternative to the year-end collection cycle and a way to pay partners, boost reported revenue and offset short-term financial uncertainty.

This article was first published on Law360 and is available here.