Financial stability is a cornerstone of a successful law firm. However, managing reserves and distributions effectively can be a challenging balance. Without a well-thought-out approach, law firms may face cash flow issues, be unable to reinvest in growth, or even risk financial instability during challenging times. This blog, inspired by insights from Tamara B. Pow – Founding Partner, Strategy Law, LLP , presented at the Law Firm Growth Conference, outlines effective strategies for establishing financial reserves and managing distributions. 

Best Practice #1: Establish a target reserve fund

Benefit: Helps prevent insufficient financial reserves

Many law firms underestimate the importance of a dedicated reserve fund, leaving them vulnerable to unexpected expenses or slow periods. Without sufficient reserves, firms may be forced to reduce investments in key areas like staffing or marketing or to turn to high-cost credit to maintain operations. Establishing a robust reserve fund tailored to your firm’s needs is essential to prevent these challenges.

Key strategies:

• Determine reserve goals: Identify a target reserve amount based on the firm’s size, cash flow variability, and operational costs. Experts typically recommend maintaining reserves that cover three to six months of operating expenses. Keep in mind your largest costs such as malpractice insurance, as well as the cost of a tail policy in the event of a dissolution. 
• Account for practice-specific needs: For firms with contingency-based practices, consider a larger reserve to offset irregular income periods. Conversely, firms with retainer-based income may need lower reserves.
• Incremental building: Start with small, consistent contributions to build the reserve fund gradually. Setting aside a percentage of monthly revenue is often more manageable than large lump-sum contributions.
• Adjust regularly: As the firm grows, revisit the appropriate amount of funds to maintain in the reserve.  

Best Practice #2: Build reserves gradually

Benefit: Prevents over-reliance on credit

Many young or smaller firms rely heavily on lines of credit to manage cash flow gaps, which can lead to increased debt over time. High-interest costs on borrowed funds can quickly accumulate, impacting profit margins and financial flexibility. Relying on credit can become a costly cycle, particularly if revenue projections don’t meet expectations.

Key strategies:

• • Prioritize reserve savings: Set a goal to gradually build a self-sustaining reserve fund. Even setting aside a modest percentage of monthly revenue can provide significant relief over time.
  • Establish a phased withdrawal from credit: Start by limiting credit use to essential situations only and aim to reduce reliance by building up your reserve.
  • Review and adjust quarterly: Assess the reserve fund quarterly to determine progress and adjust contribution levels if needed to reach financial goals faster.

• Reduce draws: Eliminate or reduce distributions to partners until the line of credit is repaid in full. 

Best Practice #3: Develop a distribution policy

Benefit: Avoids cash flow strain from unplanned partner distributions

Unplanned partner distributions can place immense strain on a firm’s cash flow, especially if unexpected expenses arise soon after. Without a structured approach, distributions may drain operating funds, leaving the firm vulnerable during lean periods and limiting the ability to reinvest in the business.

Key strategies:

• Align distributions with cash flow: Separate reported profits from cash flow, as not all reported profits are available as cash. Determine a distribution percentage based on actual available cash, keeping reserves in mind. 
• Set distribution periods: Schedule distributions at specific times (e.g., monthly, quarterly or biannually) to provide predictability and allow for cash flow assessments.
• Review financial forecasts regularly: Before approving distributions, review projections for the next six to twelve months to ensure cash flow stability.

Best Practice #4: Use an objective distribution formula

Benefit: Improves transparency in profit and expense allocation

Disputes over profit and expense allocations can create tension among partners and impact firm morale. Subjective or inconsistent allocation methods may lead partners to feel unfairly compensated, which can eventually result in dissatisfaction or even partner exits.

Key strategies:

• Establish a blended distribution formula: Use a combination of objective metrics (e.g., billable hours, revenue generation) with subjective contributions (e.g., firm-building activities) to create a balanced and fair formula.
• Implement clear guidelines: Document and communicate the distribution formula to all partners to ensure transparency and understanding.
• Adjust regularly for fairness: Periodically review and adjust the formula to account for shifts in roles, responsibilities, or firm goals, keeping it fair and equitable.

Best Practice #5: Adjust reserves and distributions

Benefit: Manage cash flow variability in contingency-based or seasonal practices

Firms that operate on contingency fees or experience seasonal revenue fluctuations face unique challenges in maintaining a steady cash flow. For instance, litigation firms relying on large settlements may experience high-income periods followed by months of low income or losses. Inconsistent income can quickly drain reserves and make it difficult to plan distributions.

Key strategies:

• Develop a contingency plan: Set aside a significant portion of large payouts directly into the reserve fund to create a buffer for slower periods.
• Adjust distribution based on cash flow: Consider a more conservative distribution policy for high-variability practices, prioritizing firm reserves over immediate payouts.
• Annual reserve review: Evaluate the firm’s reserves each year to determine whether adjustments are needed based on the firm’s current income patterns and forecasted cash flow.

Best Practice #6: Structure reserve contributions

Benefit: Plan optimally for partner withdrawals and buyouts

Partner exits, whether due to disagreements, retirement, disability, or a career change, can lead to substantial financial obligations for the firm. Without adequate planning, buyouts may have to be funded from operating cash or through debt, creating strain on the firm’s finances and potentially affecting its operations.

Key strategies:

• Incorporate buyout contributions into reserves: Designate a portion of the reserve fund specifically for buyout costs to avoid using operating funds.
• Include buy-sell provisions in the agreement: Detail how partner buyouts will be valued and paid out in the partnership agreement, creating clarity for all parties involved and giving the firm time to pay (with or without interest) to even out cash needs. 
• Conduct periodic financial assessments: Regularly review the firm’s reserve levels to ensure they align with projected buyout obligations, especially if there are anticipated partner exits.

Best Practice #7: Partner with financial experts

Benefit: Avoid financial oversight and mismanagement

Many law firms operate without dedicated financial expertise, which can lead to mismanagement of cash flow, reserves, and distributions. Without regular financial assessments, firms may make decisions based on incomplete information, leading to instability or missed growth opportunities.

Key strategies:

• • Engage financial experts: Consult financial advisors or accountants with experience in law firm finances to develop and implement sound financial reporting and strategies.
  • Schedule quarterly financial reviews: Conduct regular assessments to monitor reserve levels, track cash flow, and ensure that distributions align with actual performance.
  • Use financial data to adjust policies: Utilize up-to-date financial insights to make informed adjustments to reserve contributions and distribution policies, keeping the firm aligned with its financial goals.

• Optimize tax planning: Institute tax-advantaged retirement plans and other programs for partner tax planning. 

Summary

Proactive financial planning is essential for supporting the firm’s stability, fostering sustainable growth, and effectively managing unexpected financial demands. By establishing a solid reserve fund, minimizing dependence on credit, aligning distributions with cash flow, and planning for future obligations, law firms can strengthen their resilience, navigate challenges, and seize growth opportunities. 

This blog is written as of March 2025. Recommendations and legal requirements are changing rapidly, so please continue to review our legal updates or review postings on relevant government websites.

All blogs on this site are for educational purposes only, do not constitute legal advice or opinion, and should not be applied to your situation or any specific situation without consultation with counsel. Strategy Law, LLP does not provide any legal advice concerning any matter discussed in a blog except upon formal engagement, including, without limitation, execution of Strategy Law, LLP’s formal legal services agreement, and with respect to specific factual situations.  No blog constitutes a guarantee, warranty, or prediction regarding the result of any legal matter discussed in the blog or any representation.