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February 11, 2009

Alternative Fees (Part 5): Discounting

It is unfortunate that that a single term – alternative fees – has been widely used to refer to three very different types of billing:  hourly rate discounts, fixed fees, and hybrids which combine hourly billing with a fixed fee element.  While fixed fees represent a truly alternative model which can change the very way business is conducted, discounts are an alternative only in a very limited sense. 

Some law firms argue that they don’t need to discount because they are so efficient at assigning key parts of the each matter to less expensive junior lawyers.  However, clients do not always agree. One general counsel I spoke to from a Fortune 500 company (who preferred to remain anonymous) put it this way:  “Most of the firms we deal with claim to have junior associates or even paralegals do a lot of the preliminary work with the senior partners performing only a review function. From what I've seen, however, the junior associates and paralegals put in an extraordinary amount of time on a particular issue which adds up to quite a lot of money even though their hourly rate is not high.  I've also noticed that many times preliminary work has to be rewritten by more senior attorneys because the juniors just don't have the experience to identify the major issues.  At the end of the day, I haven’t seen much savings.”

In a booming economy in which specialized legal expertise is a limited resource, law firms have all the power, and there is little if any need to offer discounts.  According to Hildebrandt International’s Special Client Advisory: Fall 2008, the years 2001 to 2007 were a “six year period of unprecedented revenue and profit growth.”

Law firms have gotten accustomed to raising rates from this position of power.  But this year the economy is shifting the balance of power to clients.  As a result, every lawyer would be prudent to ask:  do I need to offer lower prices to protect critical client relationships?

If clients love your service as much as you think they do, maybe you can skip the rest of this post, and get back to billing hours.  Then again, there’s a good chance you’re wrong.  In a 2008 survey of general counsel, Inside Counsel magazine asked lawyers to grade their overall performance with clients as A, B, C, D, or F.  42% of the lawyers thought they were earning an A.  But when they asked clients the same question, in fact only 17% earned As.  In other words, most lawyers overrated their performance. 

When the economy heads down and power shifts to the buyer, it may be necessary to discount rates to hold on to clients. 

If you offer a discount too soon, you will simply give away money that you could have kept.  Then again, if you wait too long and a competitor offers a deep discount first, you may lose the client before you have a chance to make an offer.

So, like everything else in business, it all comes down to an educated guess. 

I think that there’s never been a better time for discounting and if in doubt, you should offer a discount. 

(In case you’re wondering, I’m putting my money where my mouth is, and offering  discounts to my own clients in 2009.  If I guess wrong and give some discounts that were not absolutely necessary in the short term, I still may be better off in the long term due to strengthened relationships.)

But also keep in mind the advice of Ian Shrank, a partner at Allen & Overy, to proceed slowly:  “If you offer a discount, it will always be accepted.  If in doubt, open a discussion with the client about its happiness with your billing arrangement (and probably all other aspects of the lawyer/client relationship) and see where the conversation takes you." 

In a volume discount, a law firm agrees to lower its hourly rates in return for getting a certain volume of work.  There are a number of ways to structure such an agreement.  For example, a firm could offer a 10% discount in return for a guarantee of 10,000 hours of work in the next year or for handling all of the client’s employment cases.  Or the discount could be tied to the actual number of hours as they are billed:  1% on the first 1000 hours, 5% on the next 5,000, and 10% on the next 10,000.

From a marketing perspective this is an excellent approach.  No matter how they are structured, volume discounts represents a true win-win:  the client pays less, and the law firm gets more security.

Another approach is a blended rate, in which a single middle rate is charged for both senior and junior lawyers.  This is far more complex, and may not be a discount at all.  Who wins and who loses will depend on the actual numbers in a particular situation. 

For example, consider a case that is expected to require 100 hours of senior time at $500 per hour ($50,000) and 100 hours of junior time at $300 per hour ($30,000), for a total of $80,000.  A firm could offer a blended rate of $350 per hour, which reduces the predicted cost of the matter to $70,000 ($350 times 200 hours).

But now suppose that once the matter is underway, the firm discovers that almost all the work could actually be performed by more junior lawyers.  If the senior lawyers only need to spend 20 hours supervising the matter (which would have cost $10,000 at the original rate of $500 times 20 hours), and junior lawyers put in the other 180 hours (which would have cost $54,000 at $300 times 180 hours), the client who pays the blended rate will actually pay more ($70,000) at the blended rate than they would have at the non-discounted rate ($64,000).

Now you could argue that it’s still a win-win, because if the firm had not offered blended rates, senior lawyers would have delivered 100 hours out of the 200.  The client won by paying $70,000 instead of $80,000, and the firm won by charging $70,000 instead of $64,000.

From a marketing perspective, that is a terrible argument.  In essence, it implies that senior people never should have been doing the work in the first place and the client must agree to be overcharged a little in order to avoid being overcharged a lot.

Blended rates invite gamesmanship, as individual lawyers may be tempted to manipulate predictions to maximize profit.  And they encourage the use of more junior level lawyers, even when it may not be to the client’s benefit.  For example, one review of alternative fees describes the experience of the general counsel at Marriott International who was unhappy with his blended rate experience because:

“The law firm only assigned to the matter those lawyers whose regular hourly rate was at or below the blended rate, and more senior lawyers were unwilling to engage in significant supervision.”

So if your primary goal is to offer a client a better deal that will strengthen the relationship, blended rates should be used judiciously, only in cases where the client will get an unambiguous benefit.  One way to guarantee that would be to use what could be called a transparent blended rate:  bill the client for actual hours spent at whichever amount was lower - the blended rate, or the standard rates of the lawyers who actually worked on the matter.

Next week’s post will provide guidance for a more radical approach that is a true alternative to the billable hour:  fixed fees.

For a preview of the major conclusions from this series, see the LegalBizDev Guide to Alternative Fees, in the free resources section of our web page.

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