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Law firms are primary consumers of office space in virtually every U.S. commercial market. Conversely, real estate obligations, while generally appearing only in the footnotes of financial statements, are the single largest fixed financial obligation of almost all U.S. law firms. As such, they are a contributing factor to many law firm dissolutions, and landlords are often the single largest creditors. In light of this, most firms would be well advised to spend some serious time before looking for new space considering a range of important strategic and high-level operational issues. These issues impact the type of space and lease the firm should undertake, and help gauge a firm’s long term capability to meet its obligations. Going through this effort will reduce the likelihood that the lease will ultimately become a problem. It seems fairly intuitive to suggest that a firm should have a well-articulated strategy before entering a new lease. But, while many firms will use the upcoming expiration of a lease as a catalyst to reconsider their strategy, a surprising number do not. A firm’s strategy should guide a range of real estate decisions, including location of the new space, the quality of the space, layout, and expansion and contraction options. To help illustrate this point, consider the case of a firm focused on relatively routine and lower-priced insured litigation defense work. In such a firm, overhead is a primary consideration in profitability. This leads to the obvious suggestion that such a firm ought to consider highly efficient, lower-cost space, with functionality being the primary consideration. Large partner offices, excessive common space, and high level furnishings and finishes should be traded for technological and work process efficiency. A location near court may be valuable, but top floor space in a high-rise is not. In too many such firms, however, the strategic direction is not well articulated. Rather than focusing on maximizing the value and effectiveness of the practice and building the firm accordingly, many firms of this type have a poorly considered strategy of “diversification.” They spend time and considerable money trying to develop corporate and commercial practices. This leads them to seek space more suited for “corporate” law firms. They pay more than they can afford, and dilute the effectiveness of practice. A few years later, partners are complaining because their overhead burden is too high. Conversely, a corporate-focused firm with clients who frequently visit the offices could more appropriately consider expensive build-outs and building choices, suitable to the market they expect to attract. This is not to say, however, that a firm should leverage its future on lavish offices in the hope of using “image” to upgrade its practice. A firm should have a very clear understanding of its own value position in the legal marketplace and target its office design to mirror that position. In addition, it is important to think through the opportunities associated with the firm’s core practices, and develop some sense of the probable (not “wished for”) growth the firm is likely to see, as well as the risks of shrinkage in key areas of the practice. This assessment will aid the firm in negotiating for space options to grow or contract. For example, a firm with a large practice defending asbestos claims might want to negotiate for give-back options in the event a legislated solution to asbestos litigation forces a downsizing. In addition, some leases contain a “must take” provision, which requires the firm to acquire additional space on a certain date. Before making a commitment, firms need to determine whether or not such growth is realistic. A final strategic consideration relates to the firm’s merger strategy. A firm seeking substantial growth through merger in particular locations should be very careful about the size and duration of the real estate commitments it makes in those places. In general, it is advisable to consolidate all lawyers in a given city within the same office space. This is far easier if the firm is not encumbered by longer-term legacy space costs. ECONOMIC CONSIDERATIONS Occupancy costs are a significant overhead item, and the largest component of fixed cost. They are not easily adjusted in the event of changes in the firm’s circumstances, so it is important that the firm evaluate carefully the affordability of its occupancy. Just as a family should consider how much house it can afford before looking at new homes, the firm should consider the long term affordability of leases, and understand how much it can afford before looking at space. In general, a firm’s total occupancy costs should be kept below 8 percent of the firm’s revenue. If a firm spends much more than that, occupancy will begin to have an eroding effect on the firm’s competitive ability to attract and retain lawyers. Firms should develop realistic economic models to consider future revenue and profitability growth, linked to their strategy, before entering into lease negotiations. Another consideration is economic risk. For larger, multi-office firms, opportunities exist to develop risk-reducing real estate strategies. Real estate markets generally run in cycles. The firm could put itself in difficult circumstances if all of its leases come due during a real estate boom. Entering into new leases across the system at the high point in a cycle could put the firm at risk if the market changes substantially. Lease security is another factor the firm should consider before looking for new offices. While partially governed by local market conditions, security levels are negotiable. In large part, the amount and kind of security guarantee a landlord requires is related to the risk that the firm represents as a tenant. Letters of credit have a cost, and also limit the firm’s borrowing flexibility. Personal guarantees, even if only for a portion of the overall lease costs, are a conditional liability of the firm’s partners and may have an impact on the firm’s ability to retain key people. Particularly in smaller firms, discussion in advance of the liability to be assumed is particularly important. Landlords frequently commission due diligence studies of firms they are considering bringing on as tenants, particularly where substantial tenant improvement allowances or upfront incentives are under consideration. Some issues for firms to consider before entering into a new lease include: • Should the firm continue to exist? Particularly for a smaller law firm, expiration of a lease is an appropriate time for the partners to consider whether they really all want to remain in the same firm. Do the partners still have the same visions and goals? Do the practices make sense in the same firm? Should they remain together? • What is the firm’s culture? What are the common values holding the firm together? Are they sufficient to get the firm through difficult times? • How is the firm managed and led? Is the governance structure properly established? Are the right people running the firm? Do the practices function well and do they work together to advance the firm’s strategic goals? • Is the compensation system working correctly, helping to build the practice and knit the partnership together? • Does the firm have excessive off-balance-sheet liabilities, such as retirement or malpractice obligations, that could threaten the firm? • How is the firm’s cash flow? Is the firm properly capitalized, or does it rely extensively on debt to finance operations? Does the billing and collection process operate effectively and consistently, or does the firm collect all of its revenue in December? What are the high points in the firm’s annual debt usage cycle? What would the landlord recover if the firm broke up at that point? • Is the firm overly dependent on one or a few individuals? One or a few clients? What would happen to the firm if one of these were to leave or die? Would it still be able to afford its lease obligations? All of these issues have a significant bearing on the firm’s future. They are also issues that landlords will consider when deciding whether or not to enter lease negotiations, and if so, on what basis. The answers to these questions will definitely affect the security a landlord is willing to accept. If these issues have not been addressed as a normal part of a firm’s strategic thinking, they should certainly be considered before entering into new real estate obligations. Ultimately, the firms that are the strongest (and least risky) have the greatest range of options and negotiating leverage when entering a new lease. Joseph B. Altonji is a consultant in the Chicago office of Hildebrandt International. His practice is concentrated on improving the strategic focus and business management of law firms and legal departments.

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