Back on August 20th, I posed the question to you, "How do partners fund their capital contributions to the firm?" The votes are now in:
So the "winner," by a reasonable margin, is "a portion of my compensation is retained by the firm until I reach the necessary level." If you combine that with "a portion of my compensation is retained indefinitely," essentially one firm in two uses compensation-retention for capital funding. Another 42% of firms require partners to cough up the capital themselves, either by arranging a loan on their own or through a program created by the firm. Finally, somewhat surprisingly, 9% of firms simply do not require partners to contribute capital.
But whatever the policy, every firm has one.
This raises the interesting question: Which method provides the lowest overall cost of capital for the firm? I would analyze that as follows:
- Firms that require no partner capital contributions probably have the highest cost of capital; they're on their own to raise the funds in the open market, through banks, credit lines, and presumably lease or other asset financing.
- At first blush, it appears that firms requiring partners to borrow the funds to ante up have the lowest cost of capital—zero. And indeed that's the case from the firm's sole perspective. But partners, as owners of the firm, are required in this scenario to go into debt themselves (or to contribute funds they have on hand which they could otherwise invest, which imputes an opportunity cost to the capital contribution, if not an out-of-pocket cash cost). Hold that thought while we consider the last case:
- Firms that withhold compensation to fund the capital contribution. Again, it appears from the firm's perspective that the cost of capital is zero, since they're simply retaining funds they'd otherwise hand over to the partners. But in fact, isn't this essentially technique #2 in substance?
Here's what I mean: Firms can pay partners more and have the partners bear the expense of funding the requisite capital, or firms can pay partners less to begin with. Economically, isn't the substance of what happens in either case pretty much the same? In either case, there's no place the expense of raising capital can come from other than the firm's partners. Firms that give partner incomes a haircut are probably doing something that ends up from the partner's perspective being little different than if the partner were paid more and simultaneously saddled with a liability they needed to fund individually.
The only question becomes which entity—the individual partners or the firm as a whole —is likely to obtain more favorable terms and pricing in the credit markets. Dollars to doughnuts, it's going to be the firm, which represents a diversified "portfolio" of risk (the sum of the partners' practices) as opposed to the earnings potential of a single individual. So the 49% of firms that retain earnings may be marginally better off than the 42% that make the partners ante up.
Comments from the back of the room?
September 3, 2006 5:38 PM
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