Michael J. Swanson – CEO Of Advocate Capital Inc. Shares The Benefits Of Financing Case Expenses For Contingent-Fee Attorneys on Business Innovators Radio

By Neil Howe

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MS: So it’s a very, very challenging business model, if you will. They face many challenges. From a capitalization standpoint, first of all, generally speaking, a law firm cannot sell stock in its business. So if my business partner and I wanted to grow Advocate even faster, and we wanted to raise growth capital, we could go out, and sell stock, and bring other investors into the business. This would allow us to take that capital and then ramp the business up further. And those investors would share with us in the profits and losses on a pro-rata basis. Well, only a lawyer can own a law firm. So law firms are not able to go out and sell equity or receive growth capital from outside investors, so that’s one way that they’re constrained from a capitalization standpoint.

MS: Secondly, most banks really don’t understand the contingent-fee contract to be a true accounts receivable. So in a service business, let’s say you’re a plumber, you do some work, you send an invoice to your customer, and they pay you. Well that plumber, if they had a lot of invoices, could take those to a bank and say, “These are my accounts receivable. I’ve done the work. I’ve billed my clients for them, and I expect to collect these dollars over the next 30 to 60 days.” A bank would recognize that as a true gap, rated receivable, and might be willing to allow that plumber to have a business line of credit based upon the receivables. Well, if you think about a contingent-fee lawyer, when they go to the bank and say, “I’d like a loan based upon my receivables,” the banker says, “Okay. Let’s see your receivables.” And they’re expecting to see invoices.

MS: Well, what they show them is, “Well, I have these contracts. And these contracts with my clients will enable me to get paid eventually when we win the case. Of course, if we lose the case, we don’t get paid at all.” Well, the banker says, “Wow. We don’t know how to put a value on that.” In a worst-case scenario, if something goes wrong, they don’t know how to liquidate that. And they will typically say, “Let’s just put a lien on your house.” So access to bank capital for contingent-fee law firms is constrained in this business, in this country, because banks don’t recognize the contingent-fee contract to be a valid receivable.

MS: So these are some of the challenges that plaintiff lawyers face. They also face a big, uphill battle when it comes to public relations, right? So you’ve seen some cheesy commercials on TV, probably late at night. There are some lawyers that make really bad commercials. And unfortunately, that casts a bad shadow over all plaintiff lawyers. But there are about 90,000 plaintiff lawyers in the country, and a very small percentage ever make it to TV. So there’s a reputational issue that they face, just in life and in hiring people to come work with them. There’s this idea that they’re all ambulance chasers. So what we’ve done at Advocate is, first, understand, in a very deep way, what they do; we appreciate what they do. And then we’ve designed a very specialized, kind of niche product to help them with a particular aspect of capitalization. So we’re not a one-size-fits-all. We are targeting the case expenses that a law firm has to spend to prosecute a case.

MS: So if they’re going to prosecute a case to the trial level, there are going to be expenses along the way. So they’ll have to ask for medical records. That costs money. They may have to hire expert witnesses. They may have to write a check for $10,000 just to get an expert to review the file. There will be deposition expenses, travel expenses, trial exhibits. And generally speaking, a rule of thumb is that if a case is going to be worth a total of $100,000, it’s going to cost a law firm about $10,000 to prosecute that case. So I mentioned before, there are all the issues with overhead and not getting paid. It’s even worse than that because they have to come out of pocket for the hard case expenses required to prosecute a case.

MS: Now, the law doesn’t say they have to pay for those expenses. It’s just been kind of the standard operating procedure, because who else is going to pay for them, right? The plaintiff can’t afford, typically, to front those. And so the tradition has been that the law firm advances those. So not only are they out their overhead and these kinds of expenses, they’re having to come out of pocket for tens of thousands of dollars on many of these cases. A typical client of ours has about 200 cases in various stages of development; some they’re signing up just this week, some are resolving this week, and all stages in between.

MS: The net effect is that they build up this large dollar amount, invested, if you will, in their ongoing case expenses, because as one case settles, they have to use those funds to pay for case expenses for a new case. And over time, that money can really add up. In fact, it can easily be hundreds of thousands of dollars. It is, for most of our clients. And for many clients, it’s millions of dollars; millions of dollars that they’ve had to pay into their cases, that they don’t get paid interest on that money. The only cash available for use for anything at a law firm is after-tax cash. So this is after-tax cash that the owners have essentially loaned to their business, interest free, with no coupon, and really, no hope of repayment until some day, maybe when they wind their practice down.

MS: So we’ve really focused on those case-expense dollars. And interestingly, so they have to pay all this money, the IRS says that case expenses advanced by a plaintiff lawyer are not expenses, right? Because they come back to the law firm about 95% of the time, the IRS has ruled that the moneys they’ve put into their practice for case expenses are really a loan they’ve made or a lot of miniature loans they make to their clients. So they can’t even report these expenses on their income statement to reduce their taxable income. They have to book them as an asset on their balance sheet, as a loan. So it’s kind of a double-edged sword.

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Neil Howe

Neil Howe is a 3-time #1 Best Selling Author, Online Media Strategist and business radio talk show host. He covers the most Innovative Business Leaders in Small and Local Business helping them share their stories with the world.