Chris Marston, Head of Professional Practices at Lloyds TSB Commercial, gives an insight into the banker’s mindset, and suggests some strategies for solicitors in their negotiations with the bank.
Things aren’t what they used to be
And I’d argue this is a good thing. The relationship between solicitors and their bankers may have been different in the past, but was it better? I’m convinced it wasn’t, and that a more professional, focused and productive relationship during the boom years might have brought benefits which could have provided a degree of insulation for firms against the harsh economic climate they face today.
A business meeting between banker and solicitor several years ago might have taken place perhaps annually, typically involving lunch and some small talk – maybe a round of golf. The banker would be rather nervous about asking for financial information because he remembered all too well the response last time he had the temerity to seek out the latest set of annual accounts. Such an impertinent request was a clear signal that the bank did not trust the firm or its management. It was an insult to the professional integrity of the firm. At best, a compromise of sorts would be reached where limited – and dated – information would be provided ‘to keep Head Office off my back’ from the banker’s viewpoint.
Many bankers, no matter how experienced and talented in supporting businesses of all types, were ill-equipped to ask the right questions in a sector where businesses didn’t seem to behave as other SMEs and which expressed itself using a baffling lexicon of jargon that was utterly meaningless in any other sector. I remember clearly my own very first meeting with a solicitor customer. I asked how business was going, and was told that ‘costs are going through the roof’. The blood drained from my face. How was I to know that solicitors refer to their income as ‘costs’?
At the same time, although bankers may not have realised it, many solicitors at these meetings with the bank were thoroughly uncomfortable about the prospect of facing questions about the firm’s financial position. They feared they would not know the answers and perhaps might not understand the questions. A range of tactics would be deployed to move the conversation towards more familiar territory.
In my experience solicitors tend to be secretive – it’s a natural extension of client confidentiality, I suppose. Questions that probed a little too deeply or which solicitors felt incapable of answering would be rebuffed. With varying degrees of subtlety, bankers might be reminded of how often the managers of other local banks were calling upon the firm, and how the other banks didn’t ask lots of difficult and unnecessary questions.
Some solicitors didn’t mind saying how much they didn’t know, making a virtue of it! One particular partner in a mid-sized firm once pointed out to me a large pile of brown A4 envelopes on the floor in the corner of his office. He informed me that these were the monthly management accounts which had been sent to him by the practice manager over the past three years, and which he had never opened. He was rather proud of his detachment from the rather tacky subject of money. That said, he had an excellent knowledge of his drawings, which he saw as inviolate and quite unconnected to the profitability of the firm.
I recall these times with some nostalgia and amusement, but can’t help seeing these as wasted years when bankers and their solicitor customers could have worked together to build business models that might have been better placed to remain robust and viable in more challenging times. An unhelpful cocktail of deference, disinterest, a strong economy and client account interest (remember that?) meant that a raft of fundamental issues were never addressed.
The new realities
The ABS era is now with us, and although as I write the SRA is not yet ready to issue licences, this is just a short term Parliamentary time glitch, and will be fixed pretty soon. New entrants to the market will bring management and financial skills of a different order and their financial disciplines will be robust and uniform – there will be no scope in those businesses for anyone to opt out.
There are only a limited number of sources of cash to finance a law firm. External equity is now an option, but this is expensive, dilutes ownership and requires a high level of disclosure, financial discipline and corporate thinking. There’s no interest to be paid, but external capital wants to see profits, growth and a profitable exit through sale or flotation. Taking external equity can enable rapid growth but will tend to turn business owners into employees. That won’t suit everybody.
At the other extreme, partner/member capital allows the owners to retain absolute independence, requires no disclosure and costs nothing, except for the opportunity cost, i.e. what other uses that cash could have been put to.
Most firms operate with a mix of partner capital and borrowed money – not always in ideal proportion- and consequently a good relationship with the bank is critical.
What are the factors affecting a lending decision?
Just as the law can seem mysterious to non-practitioners, the way bankers arrive at lending decisions may appear arcane. So here’s a summary of the fundamentals of credit assessment. It’s worth emphasising that the overwhelming majority of business lending decisions are made at local level, but the principles remain the same if a central credit function is involved.
Customer standing and background
We consider how long the firm has been established; how well we know it and how well placed it is to face the future in terms of staff and premises. We look at succession planning, the business mix and competitive issues. We look at the track record and experience of the firm’s management team and assess its ability to be effective in changing economic conditions. We consider whether management is prepared to take external advice from accountants or other advisors, and whether previous lending arrangements have been honoured.
Purpose and Amount
We assess the business case for the borrowing, what contribution the firm is making and whether the borrowing structure is appropriate. We want to see a matching of maturities; for example a loan for IT equipment with a lifespan of five years should not have a repayment period of seven years. We consider how the proposition fits with our credit policy, and take into account any regulatory issues such as those presented by the Consumer Credit Act or the Enterprise Finance Guarantee Scheme.
Financial Performance
We’ll need to see certified or audited accounts, and regular management information (see table) to understand the trading fortunes of the firm and the nature of lock-up. Many firms provide us with profit & loss accounts, but very few offer balance sheets except at the year-end.
The main components in an information pack from a solicitor
Profit & Loss: With comparison to budget, and comments on material variances.
Balance Sheet: To help the bank to understand movements of fixed and working capital as well as the drawings position.
Working Capital Analysis, to include:
• WIP
• Debtors
• Disbursements
• Creditors.
Each of these should be analysed by age and also by fee earner/department/branch office as appropriate for the type and size of firm. Creditors are all too often ignored – there could be pressure here, or conversely solicitors, keen to be seen as honourable, could be paying too quickly.
Cashflow forecasts, budgets and new instructions data complete the picture.
Repayment Capability
It’s important for a business to demonstrate it can repay; that its forecasts are robust and stand up to sensitivity testing. Don’t sensitise the forecasts before sending. We look at previous forecasts provided by the firm and assess how accurate those proved to be. I’ve heard solicitors say that it is impossible to prepare a cashflow forecast for a law firm. I disagree, and I know plenty of specialist accountants who can provide practical help to lawyers who don’t have the expertise or the time to do it. Whatever your forecast says, don’t forget to show that you have a Plan B!
Security & Risk Protection
We want to know if the firm can offer security. It won’t persuade us to lend unwisely, but it may secure a better borrowing rate. The interest rate should match the risk.
We want to be sure the firm understands and has addressed the risks it faces. In respect of operational risks we’ll look for accreditations such as Lexcel and ISO 9002. We’ll ask about PII cover and how the insurer judges the risks in the business. There are other risks too, such as a rise in interest rate, or the death or disability of a key person. We need to know that there is an effective insurance regime and a disaster recovery plan.
Many of our customers seem surprised at these questions, but if repayment depends upon the continued uninterrupted profitable trading of the business, then protection against these risks is critical.
Terms & Conditions
Once we have agreed to lend, the discussion turns to interest rates, fees and where appropriate, performance covenants. Post-lending monitoring processes will be agreed and any pre-conditions explained.
Manage your bank manager
As in all human relationships there are some behaviours that will usually lead to a productive and supportive partnership. Here are my tips: –
1. We don’t like surprises. Tell us the good news and the bad.
2. We don’t lend blind – we need high quality information and regular dialogue. Provide management information on time so it doesn’t have to be chased. It’s reasonable for you to expect your bank manager to acknowledge and comment upon the information you provide.
3. We don’t want an entrepreneurial stake. It’s your business, and for a lender, repayment is as good as it gets.
4. Show commitment and leadership. What’s your stake? How are you demonstrating your commitment in financial, behavioural and leadership terms? How ready are you to champion new ideas and disciplines? How does your team view you?
5. Have a plan, know it and articulate it (and have another in case the first one doesn’t work).
Chris Marston
Head of Professional Practices, Lloyds TSB Commercial
www.lloydstsb.com/solicitors
