How practice loans work, and what lenders check first

Two bills put more pressure on small law firms than any other. The first is partner capital, the money a new partner has to put into the firm on admission, or an existing partner has to find when the firm needs more. The second is the professional indemnity insurance premium, which for most firms in England and Wales falls due in one lump at renewal and has to be paid before cover starts. Both are predictable, both are unavoidable, and both arrive at moments when the firm’s cash is already spoken for.

Practice loans exist to spread those costs. What follows is an explanation of how they work and what a lender is weighing up before it agrees to fund a solicitor’s practice.

What is a practice loan?

A practice loan is a term loan made to a law firm, or in the case of partner capital to the individual partner, and repaid in instalments over an agreed period. The borrowing is unsecured in most cases, which means the lender relies on the firm’s income and the partners’ covenant rather than a charge over property. In my view, lenders who specialise in professional practices treat solicitors differently from general trading businesses, because the income is fee based and the regulatory framework is well understood.

The three common uses are partner capital, PII premium funding and tax funding. Partner capital loans are usually taken in the partner’s own name, with the firm’s agreement, and repaid out of drawings over several years. PII funding is a shorter facility, typically repaid over the policy year so the firm is not paying for last year’s cover while buying this year’s. Tax funding spreads the payments on account, which fall due on 31 January and 31 July, for partners who are taxed as self employed.

Why do lenders look hardest at PII?

Because professional indemnity insurance is a condition of practice. The SRA Indemnity Insurance Rules require every regulated firm to hold qualifying insurance from a participating insurer, on terms no less favourable than the SRA’s minimum terms and conditions. A firm that lets cover lapse without securing replacement insurance cannot continue to practise, subject only to the extended policy period described below.

Closure carries its own cost. Run-off cover lasts six years and is provided by the insurer on cover when the firm closes, which normally charges a premium for it. That is why closure is a funding event as well as a regulatory one. The firm’s obligation to have arrangements in place is in clause 5.3 of Annex 1 to the SRA Indemnity Insurance Rules, and successor practices are covered at clause 5.5.

For a lender this cuts two ways. On one hand, it makes PII funding a strong proposition. The premium is a cost the firm must pay, the policy is a condition of the firm’s income, and the amount is fixed by the renewal. On the other hand, the premium itself is a signal. A lender funding a PII premium will ask why it has risen, whether the firm has moved insurer, what the claims history looks like, and whether cover was obtained in the open market or through the extended policy period.

A firm that has been through either period, or whose premium has jumped sharply against a flat fee income, is telling the lender something, and the lender will ask about it.

Lenders will also usually want to see the policy schedule, or at least the renewal terms, before they release funds, and some will pay the insurer or broker directly rather than the firm. Firms should expect that and have the documents ready.

What do lenders check before funding partner capital?

Partner capital is personal borrowing in substance, so the checks run in two directions. The lender looks at the partner, and it looks at the firm the partner is buying into.

For the partner, the questions are the ordinary ones about income, existing commitments and credit history, with one addition. The lender wants to understand how the capital contribution is reflected in the partnership deed or the LLP agreement, and in particular what happens to it if the partner leaves. A deed that returns capital on retirement within a defined period gives the lender comfort. One that is silent, or that subordinates capital to other creditors indefinitely, does not.

For the firm, the lender reads the accounts. Fee income over three years, the trend in profit per equity partner, the level of drawings against profit, the age of the debtor book and the balance of unbilled work in progress all tell a story. A lender is looking for a firm whose partners draw less than they earn, whose clients pay within a reasonable period, and whose lock up is under control.

What does the borrower take on?

The risk does not sit only with the lender. Credit has a cost, and a firm or partner should compare the total amount repayable, not just the monthly figure, before signing. A partner capital loan taken in the partner’s own name remains a personal liability after the partner leaves the firm, and it has to be repaid whatever happens to the capital account. Where the deed delays the return of capital, or subordinates it to other creditors, a departing partner can be left repaying the loan for some time before the capital comes back. Partners should read the deed alongside the loan agreement before they commit.

What regulatory information will a lender ask for?

Specialist lenders know the SRA’s framework, and they use it. They will ask whether the firm’s most recent accountant’s report under the SRA Accounts Rules was qualified. Under rule 12 of those rules, a report must be obtained within six months of the end of the accounting period and is delivered to the SRA only if it is qualified. A firm is exempt altogether where all its client money came from the Legal Aid Agency, or where its average client account balance did not exceed £10,000 and the maximum did not exceed £250,000, so a lender asking whether the last report was qualified may be told the firm is exempt.

Lenders will want to know that the compliance officers are in post and that there is nothing outstanding with the regulator. They may ask about succession, because a firm with no successor and an ageing partnership carries a run-off cost that will one day need funding. A well run firm will have all of it to hand, and producing it quickly is itself a point in its favour.

How should the three facilities be structured?

The mistake small firms make most often is to treat all three needs as one problem and fund them with one facility. The PII premium is an annual cost and should be repaid within the year. Partner capital is a long term contribution and should be repaid over a period that reflects that. The January tax bill is a short term timing issue. Putting all three on a single long loan means the firm is still paying for cover that expired two years ago, and it reduces the capacity to borrow when the next renewal arrives.

What does good preparation look like?

Lenders fund firms that can explain themselves. A short summary of what the money is for, how it will be repaid and over what period, supported by the last three years of accounts, current management figures, the PII renewal terms and the partnership deed, answers most of the questions before they are asked. Where a firm has had a difficult year, a qualified accountant’s report or a claim, it is better to raise it in the covering note than to let the lender find it.

Arrangement fees vary by lender and by facility, and a firm should establish before it applies whether a fee is payable, when it falls due and whether it is contingent on funds being released. Brokers who specialise in professional practices arrange rather than lend, so a firm dealing with one should ask how many lenders it has access to, how it is remunerated, and whether it is paid by the firm, by the lender, or both. A bank the firm already uses may lend on comparable terms, and it costs nothing to ask both.