by Michael Roster (first published 2013)
Introduction
Recent surveys show that 80% of U.S. law firms and 80% of clients are now using value-based (what some call alternative fee) arrangements. That is, work is handled other than solely on a billable hour basis at least some of the time, and of those using these alternative arrangements, increasing numbers say that 20% to 30% of their work is on this basis with many now between 50% and 90%.
That is a huge change from just five years ago when virtually no one was talking in terms of value-based relationships.
But something very important is missing from this otherwise beneficial development in the legal profession: What is the purpose for using value-based fees? What is the purpose for using project management, Lean and Six Sigma and similar tools? What specifically are the parties trying to accomplish?
To put it another way, you can’t get there if you don’t know where you’re going – if you don’t have a destination. And much of what is taking place consists of a lot of positive motion, but without a destination.
Based on discussions with general counsel and law firm leaders alike, as well as my own experiences in both roles, delivering value boils down to achieving three basic targets:
· Reducing the client’s total legal costs by a significant amount measured from either a recent base year or a relevant industry benchmark. As discussed below, many of us have found 25% to be a very achievable target, but no matter what percent you use, it needs to produce significant savings and it needs to force a rethinking of conventional wisdom.
· Providing near-complete predictability in cost and process.
· Significantly improving outcomes such as number of labor disputes, average cost of settlements or the like.
In-house and outside counsel should be committed to providing at least one of the above targets to their clients. Failing to deliver at least one is essentially saying, we lawyers have no control over what we do. We just do what we do and the client will pay for it.
That is hardly a definition of value.
Those of us who have undertaken a re-engineering of legal services have found that all three targets are interrelated and quite achievable.
And companies should be willing to reward law firms, and even their own in-house lawyers, who deliver these results. This is how successful companies operate: continually reduce cost, improve quality and reward those who meet and exceed defined objectives.
The Numbers Speak for Themselves
If general counsel, CFO’s, CEO’s, directors and others feel that legal costs have been out of control, the following numbers should help confirm their worst fears:
· Cost of services to U.S. companies increased 20% in the past 10 years, except the cost of legal services increased 75% during the same period. [based on increases in the consumer price index and published billing rates of NLJ 250 law firms; source: Bill Henderson, Law Firm Working Group, article in California Lawyer referencing Corporate Executive Board interviews, and panel presentations by Hildebrandt and Citibank advisors]
· Legal expenditures constituted .4% of U.S. GDP in 1978; they more than quadrupled to 1.8% of U.S. GDP by 2003 (and that’s of an expanding pie!). [source: Bill Henderson chart; footnote 30 in Bill Henderson’s article in 70 Maryland Law Review 101 (20--) citing Marc Galanter, Planet of the APs: Reflections on the Scale of Law]
When attending meetings of general counsel and other senior officers, one often hears them asking what kinds of improvement in the quality of legal services or outcomes would justify these kinds of cost increases.
As we have recently witnessed in many other sectors of the economy, this kind of explosive growth in cost is symptomatic of a bubble, and when bubbles inevitably burst, there is considerable disruption. What is especially remarkable is we have witnessed the escalation in legal costs even as the number of highly capable lawyers and firms in the U.S. and worldwide has increased substantially during the same time periods.
One general counsel, who himself has also been a partner at a major law firm and a CEO, made an interesting observation at an event in Ohio several years ago attended by both in-house and outside counsel. Twenty to 30 years ago, he noted, there were maybe 10 or 20 firms in the U.S. you went to if you had a significant corporate or litigation matter. Today, there are 100 or even 300 firms that are highly capable of handling these matters. So all that’s happening is that companies are moving down the cost curve, and in the process getting equal if not better work for a lesser price. With respect to the law firms, this general counsel noted that as a given firm loses clients to a lesser-cost but equal if not higher-value firm, the first firm will market itself to new prospects that are currently using more costly competitors.
In medicine, we’ve seen a similar process take place. Whereas complex surgeries once were done mostly if not exclusively at premier teaching hospitals, those hospitals produced far more outstanding practitioners than they themselves could retain, so extremely competent doctors are now at competing hospitals with lower overhead, outstanding physical facilities and often superior support systems that are highly focused on patient service. The outcomes at these competing hospitals, even for highly complex procedures, are now often equal to or even better than at the so-called premier hospitals, but at less cost
In summary, there has been a huge escalation in legal costs during the past ten to 25 years that now must be addressed. The blame, if there is to be blame, falls not only on the law firms but also on the companies that went along with the cost increases and didn’t at least expect improvements in outcomes and service, let alone push back on price. Which no doubt is why the focus on value has resonated as widely as it has.
Diametrically Opposed Purposes of Hours: Cost of Production versus Profitability
I think it’s time to face a fundamental problem that has existed in the legal profession for the past 30 or so years, ever since we moved away from fixed prices, retainers and the other approaches that had long been used and instead went to fees for services based solely on hours.
Hours are performing two diametrically opposed functions. On the one hand, they are a unit of production. In that capacity, we can budget how many hours might be needed for various tasks or matters and then see if there aren’t ways to improve efficiency. But that means, as we do in manufacturing and everywhere else, looking at ways to reduce the hours needed for a given task and likewise to reduce the cost of those hours (that is, the actual internal cost of an hour of production).
And yet firms simultaneously have made hours the basis of profitability, which means benefiting from an increase in the number of hours needed for a task or matter and benefiting from regular increases in the hourly rates.
You can’t have the same unit (hours) functioning simultaneously for these two opposing purposes.
Hours Undermine Value-Based (Alternative Fee) Relationships
So it’s also no wonder most firms (and even clients) are still grappling with value-based relationships (what some call "alternative fees") because their first instinct is to look at hours as a means of comparison, and that is setting everyone up for failure. In addition to the contradictory goals of using hours for productivity costs versus profitability, if you are measuring success by a continual comparison with hours, the only way the new alternative fee/value-based approaches will be to everyone’s satisfaction is if the work is delivered at exactly the same price as it would have been under the traditional hours arrangement. If the work comes in at less than the cost of production via hours (which it should, assuming the firm is now focused properly on expertise, effectiveness and efficiency), then clients will feel they have made a bad deal, particularly if they insist on still seeing hours. And if the work comes in higher if it had they been billed with traditional hours, at least some in firm management will say, “see, this isn’t working” -- even though the work is usually quite profitable under the alternative arrangement, but the firm is measuring the wrong things.
This is why the three targets of the ACC Value Challenge are so important: (1) reduce the client’s cost from a historical benchmark, (2) provide near certainty in cost and/or (3) significantly improve outcomes. If both the firm and the client focus on these targets, they are no longer looking backwards at the cost of production (that is, hours). Rather, they are looking forward at what outcomes are desired and being rewarded for achieving the targets.
Need a New Model for Profitability
Which brings us to the need for a more effective and internally more accurate way for firms to measure profitability. The model used, moreover, should be totally neutral as to whether a given matter (or portfolio, or whatever) is billed via traditional hours or via alternative arrangements.
By creating a profitability model that is completely neutral as to how a matter is priced and billed, the firms will create a system that can accommodate whatever type of billing a client wants, and the firm’s lawyers will no longer be schizophrenic about handling billable matters one way and alternative fee/value-based matters another way. And the firm will now be able to focus on reducing the cost of production (that is, less hours and lower rates that are based on actual cost per hour) without in the process working against profitability.
Which means it’s also time to blow up the formula.
The Formula
The formula is often attributed to an early 1990’s article in The American Lawyer by David H. Maister, the very knowledgeable and highly skilled consultant and writer. David subsequently published a slightly modified version, as follows:
PROFITS PROFITS FEES HOURS PEOPLE
--------------- = ------------- x ----------- x ----------- x ----------------
PARTNERS FEES HOURS PEOPLE PARTNERS
= MARGIN x RATE x UTILIZATION x LEVERAGE
David H. Maister, Managing the Professional Service Firm, 1993, page 32.
I would urge all readers (both law firm attorneys and the in-house lawyers who pay the bills) to spend a few minutes reading the formula several times and each time consider how it impacts the way law firms manage themselves and, for clients, what it then means as to how our work is handled.
And then consider the following, which is advice regarding this formula that appears on the web from one of the many hundreds of consultants to law firm managers and is typical of the advice that has been dispensed for the past two decades or more:
“These factors, expressed as ratios, are interdependent, meaning one of them cannot be changed without affecting the others. For example, if you doubled your billing rate, profitability would also double, by definition. . . . Leverage is the ratio of non-equity fee earners to equity partners. The most profitable firms in a 2007 LexisNexis survey had the highest billable hour leverage. The goal is to increase leverage once partners reach or exceed the target billable hour threshold. Since there are only so many hours an individual can work, if you want to increase profitability it is imperative that work be passed to another fee earner once that threshold is reached. Delegation is one lawyer behavior that should be rewarded by compensation committees.”
Just as I asked you to read the formula several times over, do the same with this advice. And then consider the significant inefficiencies that are being reinforced by this conventional wisdom.
For those interested, the original formula read as follows:
Net income per partner = L (1+leverage) x HR (blended hourly rate) x U (utilization) x RE (realization) x M (margin)
Here are some quick observations about the individual elements in the formula. Obviously much more could be said about both the merits and the weaknesses (to both the firm and the clients) where a law firm’s structure, operations and billings are based upon maximizing these elements:
Net income (profits) per partner, especially when calculated as an average that is spread across the entire firm, has little if any real meaning. It masks the real profitability (and losses) of each person and group. David’s book in fact suggests looking at individuals and groups, not necessarily a firm-wide average.
M (margin) is a ratio of costs compared to revenue. Under the formula, to the extent overhead is reduced and/or fees are increased, margin is improved. So that means this number looks better to management not only where revenue is increased (that helps the fraction) but also if the firm has lawyers retyping drafts versus hiring more (but less costly) assistants to handle documents and investing in other systems so that attorneys primarily spend their time on actual legal work, and do so far more efficiently.
HR (hourly rate/blended hourly rate) puts constant pressures on increasing rates, even if that might mean a loss of business for individual attorneys and groups. It also masks the real efficiency, value and profitability of a $1000 attorney and a $200 attorney when each is assigned to their individual highest and best use.
U (utilization) means the number of hours billed. It puts an emphasis on billing hours versus what should be the goal for both sides, which is achieving the same and even better results with fewer hours.
L (leverage) is equity partners versus all other timekeepers, with many larger firms aiming for 3-to-1 and even 4-to-1 leverage (never mind that some of the most profitable firms in real terms ignore the formula and operate with more partners than associates). One effect of this element is that profitability somehow looks like it increases if the firm de-equitizes existing partners, extends time to partnership and keeps increasing the associate ranks with little intention of making most of them partners, notwithstanding all the costs of hiring and training this cadre of professionals.
RE (realization) is what percent from a posted hourly rate is actually collected and is reduced by (and from firm management’s perspective, made worse by) discounts, write-offs and the like. A practice group that is properly priced and focused on results rather than hours should actually achieve much higher realization rates than with hours (should actually be well above 100%).
Selling Expertise and Skill, Not Hours
The fundamental mistake in all of this has been the absolutely wrong notion of the past two or more decades that the only thing a law firm has to sell is hours. Nonsense. What firms have to sell is expertise and skill. Hours are a unit of production, and as with manufacturing, it should be everyone’s goal to reduce that cost of production while improving quality and outcomes (and yes, profitability). By irrevocably linking a law firm’s profitability to increasing the cost of production (read both the formula and the advice again if you still need to understand this dynamic), the formula has turned everyone in the wrong direction. Profitability, under the formula, puts a premium on inefficiency and degrades (indeed, creates disincentive for applying) expertise
Which then leads to a churning of work, incentives to maximize hours, incentives to increase hourly rates, pressures not to write down a bill even for clear inefficiencies, stretching out time to partnership, de-equitizing or even eliminating so-called servicing partners, etc.
Firms should be asking instead: how can we best deliver expertise and be paid appropriately for it? Part of the breakthrough will be to no longer use hours as both a means to measure profits (which, as already said, results in pressures to raise rates and bill more hours) and at the same time a means to measure productivity (which should result in pressures to lower the per unit cost of production and to try to deliver the same if not better product with less of those production units). For clients, it means asking: how can I incentivize my law firms to deliver expertise and improved results, reduce their cost to me for doing so, and actually maintain and even improve their profitability by achieving these goals.
Where We Should be Heading
Once a firm (or practice group, or whatever) goes to a true profitability set of measurements (including one that includes client satisfaction and outcomes), the firm finally has incentives to keep reducing its cost of production (meaning moving matters to those with appropriate expertise while lowering leverage and hourly rates, where hourly rates are now used as a measure for the cost of production, not how to maximize what can be billed), measure and deliver better outcomes (and being rewarded for that), learn how to fix the cost of any given type of portfolio, matter or stage of matter (which may actually be worth a premium to some clients), improve client satisfaction, and along the way, improve profitability.
I’m not going to try to develop a grand unified theory here, although I believe that several exist. Rather, I offer the following as a possible starting point:
1. Compute the cost of a given practice group (or office, or attorney, or whatever unit you pick; practice group has lots of benefits as the starting point). This is mostly salary and benefits.
2. Add the indirect costs (space, support staff and services, etc.). In the past, many firms have used a formula that the indirect cost is 1.5 times salary for partners, 1 times salary for associates, and .5 times salary for paralegals. However, firms should also ask whether use of these percentages might be giving some seriously wrong results about profitability (by matter, practice group and even individual attorneys); whether some groups (such as litigation) draw much more heavily upon space and support services than other groups (such as estate planning and probably most so-called servicing partners); and whether a rough but somewhat more granular estimate of the indirect costs wouldn’t provide more accurate (and sometimes surprisingly revealing) information.
3. Compute the revenue (meaning actual collections) for the practice group (or office, or attorney or whatever). This means actual dollars received, not what is billed, not what is in the pipeline to be billed, and not bills that haven’t yet been paid. Only what has been paid should count.
4. Deduct the all-in cost of the group you are considering (practice group, office, attorney, or whatever) from revenue attributed to that group.
5. Consider ways of handling crossover issues (for example, lawyers in the tax group contributed substantial expertise to a new form of bond offering being primarily handled in the corporate finance group).
6. The net result is the profitability you might then attribute to the practice group, office, attorney or whatever.
7. Deduct some percent from that overall profitability for redistribution firm-wide as a way to encourage good institutional behavior (many believe that 5% to 10% are reasonable ranges) and develop some methodology for distributing this pool for desired institutional contributions (hiring, training, etc.).
Determining Attorney Compensation
Once a firm starts managing itself based on true profitability, it also needs to address the related question, how to compensate the partners and associates and in some organizational arrangements, the entire workforce (remember, efficiency and true breakthroughs don’t necessarily all come from the lawyers). What is critical here is that the compensation system needs to be aligned with the institutional goals of the firm, the three targets and true profitability
Again, I’m not going to try to resolve the compensation problem here, nor am I going to try to present a grand unified theory (although again, I think there are several). No matter what, the appropriate compensation methodology should no longer care if a given attorney, matter, practice group or whatever is billing by the hour or by some alternative.
One of the benefits of this proposed system is that it helps the firm make the transition (and for an indeterminate time, coexist) with a billable hours system and an alternative fee/value-based system. Some of the many secondary benefits of this proposed compensation methodology are that so-called books of business now have to stand on their own, there is no longer an incentive to stretch out the time to partnership and de-equitize partners who actually are highly profitable but don’t rely on leverage, there is a premium on improving the skills of associates as fast as possible, there is a premium on having stability in the attorney workforce, and there even should be a premium for institutional priorities, not solely individual or other more provincial priorities.
Something to consider along the way: a guaranteed base income for partners, and possibly for senior associates, with everything else linked to this variable compensation arrangement. By using this approach, while at the same time building in strong incentives that clients are clients of the firm and not of individual partners and that everyone’s interests are firm-wide, a lot of other social and economic factors should fall into line as well.
And profitability will likewise be enhanced, even as the client’s costs are stable and even reduced and outcomes substantially improved.
The Targets Are Achievable
The three targets listed at the outset of this paper are achievable. I know this from my own experience, and others who have reengineered legal services – whether in-house, at law firms or most often with both sides working together as partners – continually achieve the same results: a 25% reduction in legal costs, near-certain predictability and significant improvements in outcomes.
My own experience as general counsel at Stanford between 1993 and 2000 is that, within a year of restructuring legal services, we achieved a 25% reduction in legal costs and, five years later, found that we had about half the litigation we had had the prior decade.
Companies like Ford, DuPont, Tyco, Levis, Pfizer, Target, [Royal Dutch Shell, Chase, Bank of America] and others are reportedly achieving similar results, working with firms such as Eversheds, Seyfarth Shaw, the DuPont network of firms and others. And there are some very significant projects underway or in the advanced planning stages which, once they become public, are likely to report similar results.
To make the breakthroughs, one has to re-think everything:
· How in-house counsel interact with outside counsel.
· How to harness expertise, not hours.
· How to determine price for services and, for firms, how to determine compensation.
· Which issues require legal intervention and which issues are better resolved using other skills.
· How to empower lawyers (whether at firms, in-house or both) to make rational decisions and not spend huge and unnecessary legal resources for CYA purposes.
· What it means to be properly calibrated (the client wants a Chevy and the firm delivers a Rolls Royce), and how to give the firm comfort that it won’t be sued for malpractice for making appropriate cost-benefit decisions.
Getting Started
I appreciate many lawyers will say that legal costs are unpredictable and there’s no way to commit to improved outcomes by nature of what lawyers do. They will argue that the plaintiffs are unpredictable, courts and government agencies are unpredictable, the client’s decision-making is unpredictable, the other side in a negotiation is unpredictable, and on and on.
I used to think that, too. And so did all of my colleagues who eventually restructured their companies’ legal operations. We general counsel come to a tipping point, however (see discussion of “Moments of Truth” below), through various pathways: our CEO demands change, our competitors are demonstrating better numbers, we have to make better use of shrinking budgets, one or more of our law firms seem out of control, or whatever. But once we start examining what we have been doing, we find that our legal costs year after year are surprisingly predictable. Individual cases in litigation (such as wrongful termination lawsuits, or whatever) might have slightly different legal costs and slightly different settlements or verdicts matter-by-matter, but collectively they keep coming at the same average number. Same for just about every other function we handle in the general counsel’s office. And once we see the patterns, we also see ways to significantly reduce cost even as we improve outcomes.
Law firms are coming to the same realization, as Seyfarth Shaw, Eversheds and others now demonstrate on their web sites and in their marketing materials.
Each industry also has a fairly reliable benchmark that measures total legal costs as a percent of revenue or some similar number. In private universities and medical centers, for example, I found that legal costs on average are approximately .58% of revenue, and when I called my colleagues at other major universities, they replied they weren’t aware of such a benchmark but upon reflection confirmed their all-in legal costs were pretty much at that number.
When determining the relevant numbers – and this process can apply to the entire legal budget (inside and outside combined) or to specific portfolios (for example, HR, environmental, etc.), geographic regions, etc. – a general counsel should pick a recent year, discount any truly aberrant once-every-ten-years extraordinary matters and then develop a plan to provide legal services for 25% less. An alternative, especially for general counsel who have already made major improvements, is to see if they are 25% below their relevant industry benchmark, and if not, consider what additional steps they can take to get there:
· Stop sending two lawyers to the same meeting (including the unnecessary doubling up of inside with outside counsel); rather, manage matters so that the most appropriate person attends the meeting and efficiently communicates with others.
· Stop micromanaging. That alone will free up considerable in-house resources.
· Watch for repetitive actions and figure out ways to streamline or even eliminate them.
· Identify areas that are continually generating problems (the 80-20 rule) and then develop approaches so that the problems no longer occur or, if they do, are identified and resolved early on.
· Put a premium on delivering expertise and not hours.
Again, all of this is absolutely do-able.
Incrementalism Doesn’t Work
Most general counsel and law firm leaders typically look for incremental changes including discounts (which in reality are like getting 5% off a full coach airfare or the price posted on the back of a hotel door), blended rates (an inflationary average) or the like. These approaches do not deliver meaningful or long-lasting improvements, as the bubble numbers at the beginning of this article demonstrate.
It’s only when you set a major goal for change that you are forced to re-think the entire process. And that’s when you make the truly significant and long-lasting breakthroughs.
There’s A Premium for Predictability
Some very thoughtful general counsel say that their primary focus is on predictability. For example, I recently heard a general counsel for a major, worldwide company explain that she’s not worried about cost since she has moved her work to firms that are properly priced and she has taken other steps to assure the company’s costs are at or below various targets. What she is most focused on is predictability, and she and her internal clients are often willing to pay a premium for that predictability.
It is far better, she explained, to be able to tell a division head what the legal costs are going to be for a given matter (wrongful termination lawsuit, negotiating and handling a long-term contract for purchase of materials used in manufacturing, etc.). With a fixed price, her division head can finally include a number for legal costs in the budget, and that certainty has value in itself.
This general counsel reports that 95% of her company’s legal work is on a fixed price. The remaining 5% is largely M&A, where it isn’t predictable from year to year whether the company will be buying other entities or selling portions of its own operations. But even here, the general counsel has several law firms on standby for M&A work, and once a transaction emerges, the firms and the client can quickly agree upon a fixed price for doing the transaction based on metrics they have learned are highly predictive of the cost (the magnitude of the due diligence, the purchase price and similar factors).
Transitions Aren’t Easy
Other industries have been through similar upheavals. Just think about what has happened or is happening in airlines, automobile manufacturing, media and elsewhere.
The interesting pattern that emerges in every one of these industry transformations is that those companies that once were industry leaders (Eastern Airlines, Pan Am, TWA, Pontiac, Oldsmobile, Yahoo, BlackBerry, Kodak, major newspapers and magazines, etc.) suddenly find they aren’t keeping up with new competitors. And when they finally realize the threat (some would say, the tipping point) and try to make the necessary changes, they often don’t just lose market share, they oftentimes fail.
There are some common reasons for these failures, all of which should be key warnings to law firm leaders and general counsel alike:
· Existing methodologies – The legacy airlines had a fixed way of pricing tickets, scheduling and maintaining equipment, boarding passengers, providing in-flight services, etc. Any suggestions for change were strongly resisted, even as new entrants to the airline industry were making radical changes. Law firms and in-house counsel have similar biases about how they do things and typically insist there’s no way on earth they are going to change their methodologies. That attitude will eventually have those lawyers and firms looking a lot like the companies listed above that have significantly lost market share or no longer exist.
· Legacy support systems – The legacy U.S. automobile companies all had long-established ways new car designs were conceived and executed, and similar inflexibility existed in their engineering, marketing and finance departments. And interestingly, each of these internal departments functioned in near total autonomy and without a unified focus on: what will our target customers pay for a first-rate product, how much profit do we need, and with what’s left over how do we create, manufacture and sell a car that will dominate the market? The Japanese companies figured all of that out including with a unified process, and now our U.S. car companies (hopefully) have, too. In law firms, production (that is, the real legal practice) is often removed from the financial, marketing and other parts of the firm. More important, the entire law firm management reporting system is based on billable hours in the pipeline, realization rates and a few related metrics. These legacy systems may not be the best ones for managing a modern law firm and for achieving the highest and most sustainable profitability, but the legacy systems aren’t able to handle alternative approaches, other than converting everything to a billable hour equivalent. The result is that the legacy systems often work against more profitable ways to do business. And those who try to run a firm partly on billable hours and partly on targeted profitability and outcomes find life becomes truly schizophrenic if not impossible. (See discussion of Measuring Profitability at the outset of this paper.)
· Income expectations – In legacy airlines, pilots, cabin crews, ground crews and others had contracts that provided for fairly high incomes, especially with seniority. Non-legacy airlines began with a clean slate. In law firms, the income expectations aren’t by contract but rather what partners and associates have become accustomed to, even if those expectations arose in a bubble industry operating in a bubble economy. Most of these lawyers have yet to accept the harsh reality that for shareholders and senior managers at companies, incomes shift dramatically from year to year (base, bonus, value of options, etc.) and that what goes up one year can decline dramatically the next. Very few law firm partners seem to be ready to accept this kind of volatility in income while still demanding all the other attributes of shareholder owners.
· Culture – This factor is the toughest of all. There are very noticeable differences in how GM operates versus Mercedes Benz versus Hyundai. Changing a culture at any of those companies is difficult. With law firms and individual lawyers, change borders on the impossible. We lawyers thrive on precedent; we excelled in law school and passed the bar exam by being great at issue-spotting; we can tell you everything that might possibly go wrong with any proposed action. It’s thus very difficult to totally blow up long-held approaches even in the face of evidence that the new approaches are going to be far better for our customers/clients, will produce better outcomes and will actually be more profitable for us. Our predisposition is to argue about it and then just say no.
So it is no wonder we’ve witnessed the failure of a number of long-established and highly respected law firms (Brobeck, Coudert Brothers, Dewey, Heller, Howrey, Thelen, Wolf Block, etc.) and with many more failures likely to come. Because just as happened in other industries, even when leadership sees where the company (or here, law firm) should reposition itself, the task of getting from here to there may trigger elements that result in the firm not being able to hold itself together.
Equilibrium versus Moment of Truth
There are some consultants, columnists and others who question from time to time whether the shift away from billable hours is making all that much progress. Anyone watching what is taking place both at the law firms and at clients, however, knows that there in fact is a steady movement toward value-based relationships. The error of most of those who say there has been little if any progress is that they are looking at averages. Of course the shift from billable hours when measured “on average” is slow. That’s the nature of any change, at least until a tipping point is reached.
But more to the point, there’s the distinction between what I call “equilibrium” versus “the moment of truth.” If you’re the chair of a law firm or the general counsel of a company, there is no reason for you to blow up something that currently is in equilibrium – that is, that is working reasonably satisfactorily – especially when the alternatives may be untested (for you, at least) and what will be involved in the transition will likely be difficult and disruptive. Both the law firm chair and the GC face immense pressures each day just to keep things running. To make wholesale change takes time, resources and a compelling reason to do so.
But in most instances a moment of truth will inevitably arrive. For the firm it often will be when a key client wants something quite different or the client says it will take its work elsewhere (or as many firms are finding, a key client accepts an offer from a competing law firm that the client couldn’t refuse, and only tells the original firm when it calls to say it is pulling its work).
For the GC, it’s a realization of how much inefficiency is involved, both internally and with the firms. Or worse, it’s when the GC is told by the CEO that every other unit in the company has held its costs steady or even reduced them, particularly as a percent of revenue, whereas legal costs keep going up. Either the GC will achieve the same targets as all the other support groups, says the CEO, or someone else will be brought in to do it.
Every year I get five to ten calls from GC’s and deputy GC’s who have had these moments of truth, and in every conversation, the callers then say that they looked at their numbers and at their current methodologies, and why in the world hadn’t they seen these shortcomings and solutions sooner?
Leverage and Turnover
I tell general counsel and other in-house lawyers if you’ve got two otherwise comparable firms – in rates, expertise or whatever – all you need to do is look at their leverage and their turnover and you will immediately know which firm offers you the greatest value.
Let’s start with leverage. Many firms drank the Kool Aid in the past 20 years and believed they would have highest profits by operating with 3-1/2 or 4 associates or more per partner. Never mind that Munger Tolles operates with a one-to-one ratio (actually, slightly more partners than associates) and Bartlit Beck has long operated with 6 partners per associate.
Once a highly leveraged firm has a large cadre of untrained lawyers, its business and training model requires figuring out ways to assign as many of these lawyers as possible to a given litigation matter, corporate transaction or whatever. And that leads to the sort of bills that drive clients crazy, in substance as well as cost.
Turnover is another important metric. Most of the major firms have operated in recent years where 85% of their first year associates are gone by the sixth year. That’s an incredible turnover, especially when one realizes the average cost per recruit has been $250,000 to $400,000 per new lawyer. That’s the cost of on-campus interviews, bringing large numbers of candidates to the firms’ various offices for further interviews, making offers for the summer, running the summer program, determining which third year law students should receive permanent offers, recruiting those who get the offers, and then paying those who accept the offers while they take the bar exam. And remember, at least until the meltdown, most major firms were hiring something like 200 first year associates a year at these costs, and yet 85% were gone by the sixth year.
The costs for training these new associates are on top of the recruiting costs, and as long as leverage and a markup of hours was working for the firms, there was little if any economic incentive for firms to bring the new associates up the learning curve quickly. Quite the contrary, which unfortunately then led to general counsel prohibiting junior lawyers from working on our matters even though, if properly mentored and trained, these junior lawyers are actually capable of doing extremely good, front-line work.
At the ACC Value Challenge web site, there’s an Excel-based model available to law departments, law firms, practice groups, individual lawyers and anyone else interested. The model allows you to input existing numbers of lawyers at specific associate and partner levels, their incomes, billing rates, recruitment costs, turnover rates and similar variables and then to instantly see the impact on profitability when any one or more of these variables is modified.
We tried an early test shortly after the model was built: Bring the size of the entering class of new associates to what it was ten years ago, return the turnover rate to what it was ten years ago and similarly allow the partner admissions numbers to return to what they were ten years ago. Guess what? Firm profitability typically rose 30% or more.
This is all relevant to clients because we’re the ones paying for embedded inefficiencies. And until recently, we didn’t push back.
Average Profits Per Partner
Which brings us to average profits per partner, a measure law firm leaders use to compare one another but in fact is an extremely unreliable and highly destructive concept, for both the firm and its clients.
Why in the world should average profits per partner matter to anyone? Worse, if that’s what firm management is managing to, it results in managing a fraction: stretch out the time to partnership, reject more qualified lawyers to be partner, and de-equitize existing partners.
This would be as if we ran our two hospitals at Stanford by primarily looking at average profits per doctor. That would be ridiculous. The dermatologists might have one benchmark and the surgeons something entirely different. And once the profitability of a practice group was understood, we could then also look at the efficiencies, outcomes and other contributions of each doctor within the practice group to determine individual salaries and bonuses.
Several years ago, a group of general counsel was assembled at a breakfast prior to a panel we were going to do. All of us were from well-known companies – companies most law firms would feature at the top of their representative client lists. We got into a discussion about “servicing partners,” a term most of us had not heard until recently. These were partners, we were told, who actually did extremely good work BUT they often practiced with little if any leverage (that is, associates per partner) and at annual incomes that might be “only” $600,000 or so whereas firm management was aiming for average profits per partner well above $1 million.
The name of a partner at a major law firm came up in the discussion, and incredibly, virtually every one of us at the table used this particular partner and considered him one of the best lawyers we worked with. He had extraordinary expertise in his field of law. When you called him, he was highly accessible and gave highly reliable answers on the spot or else said he wanted to check a couple of items and would call back later that day, and he always did so. What were his prospects at his firm, someone asked, and since several of us knew the firm well, we honestly answered his prospects might be in doubt. He was holding the firm’s “average profits per partner” down; the two or three associates working with him were extremely well trained and were similarly wonderful to work with but would never make partner because that would be outside the firm’s concepts of leverage; and it was quite possible the partner himself would be de-equitized or even asked to leave.
Even though the partner was quite profitable in his own right (remember, his annual partner draw was about half that of the firm’s average) and he was helping bind trophy clients to the firm, he was pulling down the firm’s “average profits per partner” number and thus was not particularly appreciated by firm management.
Ironically, once firms move back to fixed pricing and other value-based relationships, these types of servicing partners (as well as their associates) become some of the most profitable elements of a firm.
The point is, law firms need to find better ways to evaluate their efficiencies and profitability, including ways that align the firms’ internal targets with ways that help bind clients to the firm. Partners should not care about “average” profits per partner but rather their own profitability and that of their practice groups, and whether their specific compensation is reasonably commensurate with what they produce. And we clients need to understand that a firm that manages itself to average profits per partner is probably making a host of decisions – both big and small – that work against what our companies need for highly effective, value-based services.
The Regional Firms Are Winning
In the past four years, I’ve given nearly 100 talks to law firms, in-house law departments and similar groups. What I’ve noticed in my travels, and as most general counsel around the country already know, is that the regional firms are winning.
Major companies had started moving large portions of their legal work from New York and California firms to these so-called regional firms prior to the economic meltdown, and not just for regional work but nationwide and even worldwide work. These firms have these qualities in common: they operate in lower cost-of-living cities and regions, have high expertise, never sought high leverage, operate with low turnover, often work on-site with their local corporate clients (and thus are better calibrated as to what corporate clients actually want) and have maintained a strong core culture. With the meltdown, the shift of work to these firms has accelerated, often fairly dramatically.
One of the problems the nationwide law firms have encountered is that once they have substantial offices in New York and/or California, or if they started there and largely still operate from there, they lose their pricing advantage. It’s a common and rather predictable dynamic and one that has previously occurred in retail banking and other U.S. industries. A firm might start, say, in Denver where it might be one of the premier firms in the region. But for various reasons, the firm eventually is absorbed by a nationwide firm. Even though the Denver office has superb talent, is based in a lower cost-of-living area and thus can bill at lower rates and pay lower compensation, once its attorneys start working on nationwide matters (a) a “nationwide” rate starts to be used, and (b) the Denver lawyers, now working shoulder to shoulder with their New York and California counterparts, start expecting New York and California incomes.
The successful regional firms have avoided the higher cost cities or, even if they have offices there, continue to operate largely from other regions and thereby have retained a significant cost advantage, even for highly valued nationwide and worldwide clients and even for premium work.
Different Value-Based Approaches
Much has been written elsewhere about various alternative fee approaches, so let me simply add some brief comments about how these approaches can help facilitate reduced client cost, high predictability and significantly improved outcomes while actually maintaining and even enhancing firm profitability:
· Fixed prices by matter or stage – Once in-house and law firm attorneys find the patterns for various types of matters, they likewise find ways to quote a fixed price. And once they do so, they start finding ways to lower the cost of production for specific tasks while still improving quality. And in those situations where there is concern about how a matter will evolve over an extended period of time, an easy approach is to fix the price for the current stage in the matter, budget future stages based on the best information available, and then lock up the price for future stages when reaching those stages. And by engaging in this type of budgeting and managing, both the firms and the clients quickly develop reliable data that can be used in the future.
· Contingency arrangements – The plaintiffs’ bar somehow does very nicely with contingency pricing. Once corporate law firms learn how to measure risk and likely outcomes, they should do equally well. Their task will be to manage how much of the firm’s work can safely be handled on a contingency arrangement and assure they have appropriate methods to manage risk and cash flow.
· Portfolios – This is the approach we used at Stanford and many others are starting to use as well. For example, a client might give a firm all of its HR, environmental, real estate or similar work. Even better is if the portfolio includes both litigation and counseling since there then is an incentive for the firm to use its substantive expertise to start reducing exposures and improve efficiencies in a given area. This approach is probably the most risk-free of all value-based arrangements for both firms and clients since the lawyers handing a given portfolio can start making rational decisions about the use of resources: when should specific matters move at a fast pace and when is it better to slow things down? how many depositions really are needed, or how much due diligence is appropriate? who can best handle a given task at a given time?
· Consultation retainers – The concept here is that clients can call a firm and ask basic questions in one or more substantive areas without the meter running, subject to some pre-defined limits. Among other things, these arrangements encourage internal clients to resolve issues early on, they flag areas where in-house or outside counsel may need to intervene and they rapidly expand the sophistication of internal clients, thus allowing those internal clients to be more efficient users of legal services.
Smaller Law Departments Can Do It, Too
General counsel at smaller legal departments often complain they don’t have the purchasing power to implement alternative fees, that law firms aren’t interested in their companies’ work and/or that they don’t have the expertise to manage the necessary changes. One should remember, half of the ACC membership comes from law departments of five or few lawyers. That doesn’t necessarily mean the specific client is small or doesn’t have significant legal work.
If anything, smaller law departments have the advantage of being able to make decisions quickly and to implement them without unnecessary hurdles. Among other things, smaller law departments can:
· Suggest to one or more firms they will combine much if not most of their legal work in return for one of the targets (reduction in cost, predictability, outcomes) or possibly all three targets.
· Create strong, ongoing alliances with selected firms.
· Tell the firms the company will welcome having associates and junior and mid-level partners assigned to the company’s matters, with the added benefit that those lawyers will develop a long-term, personal commitment to the client.
· Shop for new law firms if existing firms aren’t interested in achieving the targets.
· Use other techniques that make the firms highly value the relationship (have the outside attorneys spend time at a factory, meet senior management as part of an annual all-attorney retreat, etc.).
It Takes a Partnership
Most of us who have made the kinds of changes discussed here have learned that the real breakthroughs also require a true partnership among the in-house lawyers, the law firm lawyers and other service providers.
With a true partnership (some call it an alliance), a lot of waste is eliminated while actually increasing the quality of services and outcomes. And although it seems counter-intuitive to the law firms, if they do it right they find that their profitability is maintained and even enhanced
Among other things, with a true partnership there is no longer double teaming (that is, two, three or many more lawyers attending the same meeting or endlessly reviewing drafts without adding anything of value). It means a continual focus on who has the right expertise and skills for a given task. It even means attorneys from otherwise competing law firms working cooperatively with one another for a given client.
At Stanford, the in-house and law firm attorneys were all listed alphabetically in the telephone directory that was given to clients and as a single unit. They attended the weekly staff meetings and annual retreat as a single unit. And they continually worked together as a single unit.
Here’s an example of how this partnership delivered value: Participating firms had whole portfolios (all of our labor work, real estate work, etc.). We were doing a major transaction involving our two hospitals and one of our partner firms had most of the Medical Center portfolio but a particular area of expertise for the merger document was part of the portfolio at another firm. So a partner at the first firm called a partner at the second firm, explained the paragraph she needed in the merger document, and even as they were talking, the second partner emailed to the person doing the draft the exact text that was needed.
“I can see why your system is working,” the first partner later told me. “In the traditional model, I would have sent a memo to our tax department, explaining how Stanford is organized, what the transaction is about, what the issues are regarding certain assets to be transferred, etc. That would have taken several hours to draft the memo, and then the tax lawyers would have spent time reading the memo and asking questions, and probably a week or so later. And then they’d do some research and send back a memo (after doing a number of internal drafts) and hopefully include some proposed language. The cost of that might be $10,000 to $20,000. Here, I had the exact right answer in five minutes since all of us working on Stanford matters know all about the client, and even know about the pending matters.”
Similar interactions need to take place among the in-house and outside lawyers: who can best cover a meeting, who can best review a given set of documents, what’s the highest and best use of each person’s time? To achieve this level of partnership among the participants takes some effort up-front, but it’s an investment well worth it.
The Bill as a Critical Channel of Communication
Value also comes from other ways to manage the relationship between firms and clients. The bill is an area that screams out for reform. It is, after all, possibly the single most important item of contact between the firm and client since the bill often is the only place where there is a summary of what is taking place, plus it arrives with monthly regularity.
And yet the bill is designed exclusively for the convenience of the firm – that is, it is structured so that time can be inputted as fast as possible, in any order, with a monthly printout to be mailed to the client. The entries are stacked one after another and come across as if written in a James Joyce stream of consciousness style. Visually, the bill portrays a process that looks totally random and out of control. And then it often quotes an unexpectedly high dollar amount that seems to confirm all of the foregoing.
And incredibly, no one running modern law firms seems to care. So even for firms and clients that continue with hourly billing, at least they should develop processes that make the bill something that helps in the management of matters and hopefully communicates value.
In fixed price and other value-based relationships, there no longer is need for the monthly bill. Rather, hours (assuming they are still kept) become a way for the client and the firm to jointly audit where resources might be going and to consider if that is the highest and best use of those resources. But hours spent are no longer the determinant of value.
The Product is the Practice Group
When talking with general counsel and other in-house counsel, I urge that they stop saying “I hire the lawyer, not the firm.”
Of course the lawyer or lawyers working on a given matter are important. But so is the firm. As already noted, leverage and turnover at a firm can be highly predictive of value. Firms that treat clients as institutional clients of the firm will perform in one way, versus firms where the culture is “you eat what you kill” (meaning, originating attorneys take a significant share of profits, often to the detriment of the people doing much of the work).
When in-house counsel say we hire the lawyer not the firm, we also empower law firm partners to sell our companies’ work as part of their book of business. And absent unique circumstances, when a partner moves from one firm to another, he or she is typically making the move to increase personal income, but often at our company’s long-term expense.
At most companies, succession planning for every division has high priority, including the law department. We general counsel are continually asked, if we are hit by the proverbial truck, who can take over and are we mentoring those possible successors properly? We should be demanding a similar process with our law firm providers: if a key partner is hit by the proverbial truck, who in the relevant practice group can take over, in which case, we want to see more of those candidates.
Which leads to the key point: at the end of the day, clients are shopping for and ultimately selecting and using practice groups. I might send much of my company’s labor work to one firm because I like that practice group, but I might not even consider that firm for tax because the firm’s tax group doesn’t have what I need. The closest analogy is: no one shops for Proctor & Gamble. We shop for P&G’s individual products: Tide, Gillette, Crest, Pampers, etc.
As firms look at marketing and branding, the greatest value they can project therefore turns on practice groups. Likewise, as firms look at profitability and efficiencies, the analysis that is most workable is likely to be by practice group as well, at least as a starting point. And once managers understand this fundamental dynamic, they also have the ability to start developing profitable ways to implement value-based relationships, including how to manage matters, quote fixed prices, determine compensation and partnership promotions and the like. A practice group likewise can now better understand its profitability models and, with that knowledge, develop methods to deliver equal or higher profits even as client costs are reduced and outcomes are improved.
“What if” versus “So What”
I once was in a meeting where two very prominent lawyers briefed the board of directors of a publicly traded company on a difficult and very important matter. At the end of the briefing, one of the directors said what was on the minds of all of us, although in a way that was somewhat startling to both his follow directors as well as the two visiting lawyers:
“I know it makes you lawyers feel good to do all of your hand-wringing,” the director said, “and you’ve been covering your rear ends along the way, which I understand. But now why don’t you tell us what you think we should do.”
When I mentor junior lawyers, I try to contrast the “what if” factors with the “so what” factors. Yes, one of the jobs for us lawyers is to continually ask ourselves, what if this or that should happen? That’s a module that should be running full time in our heads. All too often, however, we simply dump all of the “what if’s” on the client and assume we’ve done our job, and that it’s the client’s task to then make what we cleverly label as the “business decision.”
But that ignores an equally important module: “so what?” As counsel, this second module should also be running full time in our heads, thereby guiding us as to whether a given risk is really significant, how likely it is to arise, and does it even fall within the sphere where we need to spend time on it with the client?
One of the benefits of fixed pricing, portfolios and other value-based arrangements is that the “what if” versus “so what” factors automatically become part of the interactions between the firm and the client, and with great success for both sides.
It’s About Managing Resources, NOT Transferring Risk
I’ve had some law firm managers and third parties argue that fixed pricing and other AFA’s are simply a way to pass risk onto the law firms, and that isn’t fair since the firms can’t control what the other side (plaintiffs, courts, government agencies, etc.) will do let alone how efficient or inefficient the client might be.
Those of us who have used some form of fixed pricing or other AFA’s know that shifting risk is not the purpose and virtually never takes place, especially in a properly established alliance. The real benefit of fixed prices and other AFA’s is that the arrangement forces both the law firm and in-house lawyers to properly manage what they are doing.
If lawyers can simply “do whatever it takes” on a matter with little or no regard to whether something is worth doing in the first place, or might be done with higher efficiencies, then of course you can be happy with the billable hour. But if you want a firm to manage a finite resource, then some form of fixed pricing has inescapable benefits, and again to both sides.
And no, the client isn’t going to stick it to the firm if something wholly unexpected and truly extraordinary wipes out the budget and the assumptions on which the budget is based. Such unexpected changes are fully understood by the CEO and the rest of senior management, and no one on either side typically wants to hold to the original agreement. No companies I’m aware of that have successfully implemented value-based relationships have encountered difficulties when the truly extraordinary event arises.
Shadow Hours Are Guaranteed to be Lose-Lose
Many firms and even clients who have shifted to alternative fee/value-based relationships nevertheless measure everything they are doing by use of shadow hours – that is, the firm attorneys keep track of time the old fashioned way and then the firm and often the client compare the fixed or other price arrangement with what it would have cost with traditional hours.
If you think about it, if you are measuring success via shadow hours, the only way the new alternative fee approach will work to everyone’s satisfaction is if the work is delivered at exactly the same price as it would have been under the traditional hours arrangement. Because if the work comes in at less than the cost of production via hours (which it should, assuming the firm is now focused properly on expertise, effectiveness and efficiency) then clients will feel they have been screwed. And if the work comes in higher if it had they been billed with traditional hours (which often will be the case during the transition year), at least some in firm management will say, “see, this isn’t working.”
This is why the three targets are so important. With the three targets (25% reduction from historical cost, near certainty in cost and/or significantly improved outcomes), both the firm and the client are no longer looking backwards at cost of production. Rather, they are looking forward at what outcomes are desired (see Appendix A for a superb discussion of this dynamic in another industry).
Once the firm and the client have settled on at least one of the targets if not all three, there should be no reason whatsoever to care about how the alternative arrangement compares with the traditional billable hour arrangement. The focus is on the three targets, and in fact, it is in everyone’s interests that the firm actually be as profitable or even more profitable under the value-based relationship as compared to the traditional hourly relationship. If the client’s costs are significantly reduced from its historical cost, it is getting the benefits of fixed (or incentive, contingency and similar) pricing and/or the outcomes are measurably and significantly improved, the firm’s cost of production (it’s “hours”) are no longer relevant.
A law firm administrative participant at a recent conference on alternative fee/value-based relationships came previously from an engineering firm that provided consulting services for the automobile manufacturers. When the group got into a discussion about what to do when clients want to see shadow hours, he said he had been through a similar transformation in the auto industry, and his engineering firm simply refused to give an hours report to the auto companies for whom they were working. “We’re meeting and even exceeding your expectations for what we are producing; we are no longer pricing our work to you by hours; so no, we’re not going to show you our hours, even if we still keep them for internal purposes.” It was a scary approach, he reported, and one of the Big Three threatened initially to pull its work. But the auto company stayed with the firm and within a year, no one was asking for hours.
RFP’s
Requests for proposals can be helpful when a whole portfolio or other large segment of work is to be assigned to a winning firm for an ongoing period of time. RFP’s make little if any sense, to either side, for matters one at a time.
Most law firm leaders tell me the all-in cost (that is, the allocated cost for the marketing department combined with specific costs for a specific RFP) now comes to $30,000 to $50,000 for each RFP response. And firm managers often complain that the matter typically goes to a predetermined firm anyway, and that even though most RFP’s request a discussion of possible AFA’s, in the end the in-house counsel just request a discount.
Both in-house and law firm attorneys owe it to our corporate clients to bring greater efficiencies to the RFP process. Most of us on the client side wince when we get huge notebooks as part of the RFP response, and yet the firms are concerned that absent this heap of material, we won’t think the firm took the request seriously. The push back especially comes from individual partners who think more is better, notwithstanding all the advice the marketing department and senior management have to the contrary.
So maybe we could informally agree that RFP responses, absent a specific client instruction for more detailed information, should be limited to five to ten pages total, possibly with this outline:
§ In a single page state, all things considered, the total price for this project/matter (as a specific number, as a range, by stage and/or by describing in no more than a single paragraph the variables you believe will affect the determination of that price).
§ In a single page list all costs, if any, that will be passed on to the company (for example, telephone, travel, photocopying, electronic research, etc.) and the likely total for these items (as a specific number or as a range).
§ In no more than __ pages, describe the practice group(s)’ expertise for this matter/project.
§ In no more than __ pages, describe the attorneys and, if applicable, other professionals who will work on this matter/project.
§ State the firm’s (or if you prefer, relevant practice groups’):
o leverage (that is, the ratio of associates to partners)
o retention (that is, the percent of first year associates who started six years ago and who are still at the firm or in the practice group)
Make a Difficult Promise
Jeff Bezos, the founder and CEO of Amazon, was once asked how Amazon has continually moved into new businesses yet ultimately becomes a market leader with strong profitability. Bezos’ response was: “Make a difficult promise . . . and then keep it.”
The way to manage your way through the necessary changes in legal operations is to similarly start by making a difficult promise:
· Reduce the client’s total legal costs by 25%
· Provide near-certain predictability
· Significantly improve outcomes
Having made the promise, start rethinking everything you do. You’ll soon realize, as Bezos does, that not only will you keep the promise, but along the way you will force yourself to build a new but highly profitable business model, will become a market leader and will create a strong and long-lasting relationship between the service provider and the customer – here, the firm and the client.
(c) 2020 Michael Roster - All rights reserved.