The Fundamentals of Law Firm Economics
The Basics of Law Firm Economics can be summarized in a handful of simple concepts. While the details of how the "levers" in the equations below are manipulated has changed over the years, the basic economic principles are as constant today at they were when I was learning law firm economics back in the 1980s.
Profit = Revenue – Costs Profitability is what law firms do or should be focused on improving. However , you have to be able to have revenue to improve profitability. Revenue Per Lawyer = (Gross Revenue – Origination Credits) / Total Number of Lawyers We believe this is the single most important metric for law firm leaders and management to focus on. Having a monopoly on the amount of revenue your firm can generate is essential. Only through having enough clients can you even begin to start talking about profitability. Labor Cost Ratio = Total Annual Compensation Expense / Gross Revenue No other cost is nearly as important as this one. It is the single biggest expense that law firms have and there are drastic differences among firms. This difference can lead to either large or small profit margins depending on other expenses. Management Leverage = [1/221 Days] per lawyer x [Indirect Expense Ratio – 1.00] No other report illustrates the power and impact of pricing than this one. Every hour reduction or change in price impacts profit, directly.
Law Firm Revenue Structures
Most creditors’ rights attorneys have learned to survive years of declining legal fee rates by cutting expenses. At some point reducing expenses as a sole means of economic survival becomes ineffective. To survive past that point may require new revenue models that match the firm’s cost structure.
Like small businesses in most industries, many law firms managed to survive the Great Recession that began in 2008 by cutting costs. However, for many firms, especially those without sufficient work to keep all of their lawyers busy full-time, cutting costs as a sole means of achieving economic viability may no longer be a sufficient strategy.
As Peter Frenza observes in 5 Signs that Your Law Firms Needs a New Business Model, "small to midsize law firms that are reluctant to reexamine their revenue models and adapt to the new normal are at a greater risk of losing ground to larger firms."
The article goes on to describe three law firm economic structures:
Law firms have generally relied on the first two types of revenue models. Large firms typically use hourly billing. Small and midsize law firms used to be able to use contingency fees for plaintiffs’ cases and hourly billing for defense work. Unlike hourly billing, the plaintiff’s bar has not yet been able to convince corporate clients that pure contingency fee billing is necessary, despite the fact that most large contingency fee awards have been granted the class action context where class members did not participate in the fee setting process.
Both hourly billing and contingency fees are risky for law firms. Many business clients refuse to pay even reasonable hourly fees. If the cost of generating revenue is too high, then the firm will lose money. If too many hours are required to handle a matter, then the firm loses money because it is taking money out of its operations. In tort law, the same problem can occur, for example when the defendant files frivolous motions just to run up fees with the expectation that a motion for attorneys’ fees will make it impossible to recover your fees.
Most attorneys are aware of alternative fee arrangements with clients. Some of those arrangements have been typical for years, such as a flat fee or retainer. Some firms have hourly billing and offer to discount their bill by a percentage if less than a fixed number of hours are spent on the matter. Other arrangements include monthly retainers to handle a portion of the client’s legal matters. While these arrangements offer important advantages to many clients, they also carry risks to the law firm unless they are properly vetted.
Law firms may need to look at other revenue arrangements. In addition to a flat fee (which is really an extension of hourly billing), law firms may want to consider subscription services. They will still need to periodically review whether the subscriptions are profitable for them, but it provides a more stable and consistent cash flow.
For many attorneys and law firms, creating alternative sources of revenue may be the best way to support the firm, its staff, and its lawyers. It allows the firm to provide useful services to clients that the clients need. It may allow the firm to expand its practice into other areas that have synergy with the firm’s existing capabilities.
How Law Firms Manage Costs
A critical component of law firm economics is the management of costs. It’s one of the three main drivers of profitability, in addition to gross revenue and leverage, or the firm’s ratio of partners to associates. Cost management surfaces a whole host of issues – from how to allocate attorney time and manage support- to the optimum mix of labor and non-labor resources, as well as how to optimize the use of technology and physical facilities. Improving the firm’s financial performance is not just a matter of moving to the next system tomorrow, it is a process requiring constant re-evaluation of current resources. Cost management is about risk mitigation, "enabling firms to properly plan and then analyze what they have to do as opposed to what they can afford to do," according to Gary Sweeney, President of KPMG Legal Management Consulting Group and a co-author of On The Brink, a new book on law firm strategy.
Labor
Labor costs for legal services continue to be the single largest component of a firm’s total legal service cost, comprising nearly half of overall legal expenditures. The 2008 results from the International Capital Market Association’s annual General Counsel Survey indicate that corporate clients favor a total cost approach to determining the best value of legal services. A key driver of that approach is finding ways to reduce labor costs through legal process outsourcing. Breakdown billing data by scope of work, and practice area to identify outside services that would be best at 25% less than billing rates, says Mike Tachovsky, Director of Consulting at Hildebrandt International.
In an analysis of the data captured in the Survey, the International Capital Markets Association, which across Europe represents more than 400 member firms and institutions involved in the bond market, found that companies that control a greater proportion of their external spend benefit from cost savings.
Operations
While most law firms have long been reluctant to change the way they staff their operations, Malia Stoll, Executive Vice President of Hildebrandt International, says that for small and mid-size firms outsourcing will reduce cost; "functionally this can work." Other law firm consultants concur: "Outsourcing is here to stay. Firms that want to be nimble will use some outsourcing strategies," says Susan Hackett, Senior Vice President & General Counsel of the Association of Corporate Counsel (ACC) and a contributor to ACC’s Value Challenge, a coordinated effort to help organizations and companies improve the way they think about ‘"value" in law department management and law firm selection/retention. Outsourcing pieces of functions such as marketing, accounting, and library services to smaller, more nimble companies enables firms to manage their costs while improving the skill set of the firms’ professionals.
Technology
One of the biggest gains in productivity in law firms comes from technology. Use it to automate practices, reduce time on low-level tasks, and eliminate repetitive mistakes. "Greater use of technology in the administrative processes is key to cost management," says Sweeney. The challenge for many firms is their reluctance to invest in new systems and processes in a tight market. However, firms can no longer overlook the fact that their clients value technology as a factor in driving organizational change. One way to make this happen is by leveraging collaboration tools found in social media. "Social media democratizes information. Everybody knows where to find the most current information and share it quickly," says Jim Hassett, Principal of LegalBizDev, LLC, a legal consulting, publishing and training company. "Social media can be applied by any firm to create their brand." Further, services such as electronic filing, automated document retrieval and storage, news aggregation, and search engine optimization are technologies that enable law firms to become more efficient and less costly for their clientele. Precedent Systems Inc. has recently launched an online networking service, called ‘Legalscape,’ to link lawyers cutting across borders that they might not have known of otherwise, and to facilitate the sharing of legal precedents.
The Impact of Technology on Law Firm Economics
The economics of law firms have evolved with the way in which technology has advanced. Complex financial models and a plethora of investments into innovation by firms looking to stay ahead of the competition, have provided a competitive edge. One example of this is Dentons who have made considerable investments into automation and AI which has reduced the cost of production while elevating their service levels.
LawConnect, for example, serves many purposes but predominantly operates as a free secure way to speak with clients via mobile or online. LawConnect was developed for collaboration, along with other tools being used to reduce the number of mundane steps in a workflow process. This has helped firms with improving their PEP, raising new capital and acquiring and integrating new non-firm talent.
Data analytics also plays a large role in how law firms, global leaders, in particular, will gain intelligence about their markets and align resource accordingly. Making decisions on pricing and the potential for new revenue streams have all been underpinned by information, benchmarking and forecasting. The Internet of Things is further driving growth through connecting various information systems that allow for cross-pollination about clients and prospective clients with easy access to vital data that provides actionable insight.
In a nutshell, artificial intelligence and Bots have become sophisticated enough to take on tasks that would typically be performed by associates and support staff. As a result this is likely to lead to firm mergers, expansion into other sectors and an entry into new markets.
Market Trends Influencing Law Firm Economics
The legal marketplace continues to be an evolving and challenging one for firms of all sizes. Recent estimates indicate that there are now approximately 1.2 million lawyers in the United States – double the number from 1990. While the number of lawyers continues to increase, the U.S. population has only increased 20% during this same time period – meaning that the ratio of lawyers to U.S. citizens continues to climb, with 1 lawyer for every 240 U.S. citizens. At the same time, competition amongst law firms has never been tougher. Mergers and consolidations in the legal marketplace over the past 10 years have produced a continuing stream of never before seen clients, all looking for "better" deals, whether they relate to pricing or other arrangements. Fewer firms also means many leading lawyers within a firm are focused on their own results , rather than the overall success of the firm. And finally, given the slower economy, clients are less likely to pay the higher rates they have in the past.
All of this means that law firms have to better analyze their economic reality than ever before. It is important for a firm to have a sense of where it stands as to most major market indicators. This information can then be compared against the current rate structure to see where the firm is performing well and where it may need change. This analysis also serves as a good first step for a firm when it begins to look at its compensation system. Compensation based on performance, for example, may do no good if the firm is not measuring the right things.
Law Firm Financial Performance Metrics
Client success is paramount to the success of a law firm. Client success in turn is defined by several financial performance metrics, including profit margins, realization, and utilization. Gauge your performance over time, not against other firms, to fully understand your true financial metrics.
Revenue
While revenue is the traditional measure of law firm economics, in today’s market, not all revenue is created equal. Billable hours and fixed fee arrangements are two different manners of driving revenue, but they are ultimately based on different principles. Billable hours focus on employee time while fixed fees focus on efficiency of that time as controlled by the firm.
Nevertheless, client success as measured by revenue is still the most common measure of "success" or "profitability" (hereafter "performance"). This focus on revenue without regard for expenses is not sustainable or logical in a market with increased competition and margin erosion. Moreover, understanding that how you charge clients will impact your revenue can help you make business decisions that will increase your margin. For example, if you charge by the hour, how many of your clients are late payers? Or, what percentage would pay an additional 10% for greater certainty on total fees?
Profit Margin
Profit margin is the effective end goal of every business unit and the law firm is no different. Profit margin requires you to look at the total client experience and how you charge for those experiences and the cost of delivering those experiences.
But unlike most companies, law firms largely ignore this discussion in favor of larger billable hour totals. In fact, most law firms treat all practice areas as equal when it comes to their revenue goals, performance measures, and overall importance to the firm’s economic engine. This is not only short-sighted, but in most cases does not maximize the potential economic engine of the firm. Rather, looking at all firm practices through the lens of profitability will change how you manage partners and their practice areas. While knowing your firm’s overall profit margin is important, identifying which practice areas are most profitable allows you to more accurately determine the value of each partner’s practice within the firm.
Realization
Realization directly impacts your profit margin by showing you how much billable time was collected. In order to maximize revenue and profit margin, you must take into account various forms of collection.
For example, invoicing large clients is different than invoicing numerous small clients. Cash flow differs from accrual billing. Different clients pay at different times and with different risk levels. Knowing when to collect payment for good work is critical to all law firms.
Utilization
Utilization is a measure of the firm’s efficiency defined as the ratio between direct labor costs and the total number of hours available to be charged to clients. If your law firm runs a 40% utilization rate for its attorneys, that means that approximately 60% of the attorney’s time is not being billed out to a client.
Law firms should operate at a 65%- to 85% utilization rate, or 1,600 to 2,080 hours per billing attorney per year. A lower utilization rate indicates inefficiency. However, an efficient firm with a low utilization rate may still be profitable because of high hourly rates or because of limited overhead.
Utilization drives profit for firms in today’s highly competitive market. Whether the firm is measuring direct utilization or indirect utilization, both are critical for law firms to monitor closely. Direct utilization refers to the amount of time each lawyer spends on billable activities. It generally excludes time spent on marketing and selling, client development activities, professional development, and administrative duties. Typically, only time spent on chargeable hours is included when measuring the direct utilization rate.
Indirect utilization refers to the time each lawyer spends on non-billable work, such as training, self-development, marketing, and administrative tasks. Indirect utilization can be thought of as "what is also my staff doing at my expense." Indirect utilization figures into the firm’s overall indirect overhead and can help the firm create better pricing models.
Total Cost of Work
The use of pricing models that correlate with the delivery of a legal service has changed the market. The impact of pricing on profit must be considered when looking at Total Cost of Work.
The Future of Law Firm Economics
Moving forward, managing all of the issues which affect law firm economics is going to be a continuing challenge across a wide spectrum of issues which are currently evolving because of changing client expectations, regulatory changes and economic cycles. At the same time, law firm leaders need to balance these challenges with the ability to grow the firm and its profits to reward shareholders and associates and to ensure the continuity of the firm. The balance will continue to shift between cost demands and the ability to pay of clients and the need to provide a return to shareholders to meet their needs. A number of factors continue to drive firms to explore changes to their financial models and client billing arrangements which allow them to shift risk to clients and generate the same or similar returns . Some changes will come from outside the firm, as sanctions and commitments by regulators force change in the core legal services market, while other changes will be self-imposed by large firms who need to continue to match or outperform their competition in size and profitability. These pressures will continue to generate a change in how law firm leaders think about and manage the economics of their firms, which will be vital to help them continue to attract and retain strong talent, whether or not they seek to be the largest or most prestigious firm in their markets (which, increasingly, many firms do not want, need or can afford to be).