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February 18, 2009

Alternative fees (Part 6): How to set a fixed fee

Lawyers often ask me how to structure fixed fee contracts to eliminate risk.  The short answer is:  you can’t.  As Nobel physicist Niels Bohr once said:  “It is very hard to predict, especially the future.”  And by their very nature, fixed fee arrangements involve predicting the future.  With fixed fees, you must accept the reality that sometimes you will win and sometimes you will lose. 

There are two basic approaches to setting fixed fees:  cost-plus pricing and value pricing. 

In cost-plus pricing, you “simply” estimate what you think it would cost to perform the work on an hourly basis, and then add a safety margin to cover unexpected developments and profit.  The size of the safety margin will depend primarily on your market.  The stronger the competition, the smaller your safety margin will be, because you will need to assume more risk to offer a competitive price.

The problem is that legal matters are often not simple at all, and many lawyers have little experience trying to estimate costs.  As Frederick Krebs, president of the Association of Corporate Counsel put it in a New York Times article entitled “Billable hours giving ground at law firms,”  “Many lawyers may not be good enough businessmen to pick the right price.”

Similarly, Fred Bartlit, founder of Bartlit Beck, wrote on Legal OnRamp:

“Almost NO ONE knows what tasks should cost done right. I usually ask meetings of General Counsel and other inside lawyers ‘what should it cost to prepare for and take the deposition of an economic expert in a 100 million antitrust case’, I get answers ranging from ‘$30,000 to $500,000 in the same room.’  So, to me, we have a dramatically atypical situation facing us: a huge market that is not competitive, that does not foster innovation in business processes, and has NO useful metrics for comparing efficiencies of different competitors or calculating roughly what various aspects of litigation SHOULD cost.”

(My thanks to Pat Lamb for calling my attention to these comments in his blog)

Clearly, the more you know about a situation in advance, and the more control you have over the way it will develop, the easier it will be to determine a reasonable fixed fee.

Ian Shrank, a partner at Allen & Overy, says that the best way to start is to:

“Make assumptions about as many objective factors as you can think of, such as the number of months to complete the matter, travel needs, number of meetings, number of drafts of documents, number of depositions.  Also include some softer considerations if they are feasible, such as how hard the other side negotiates.”  And if both sides agree that the fixed price is contingent on certain assumptions, be sure “to alert the client right away when an assumption is being violated, noting this may result in an adjustment to the fixed fee.  This is the single most important rule about fees - no surprises!  Always keep the client informed about the progress of the fee.”

In complex cases, it is wise to estimate scope for two different scenarios:  the best case and the worst case.  If those predictions are too far apart, try again by breaking the matter down into smaller stages, or specifying factors you could control that would affect cost. 

But avoid the trap of spending too much time on this step.  There is no right answer, so just come up with a reasonable cost estimate, and move on. 

The alternative to this cost-plus pricing model is called value pricing, which, according to Wikipedia, “sets selling prices on the perceived value to the customer, rather than on the actual cost of the product, the market price, competitors prices, or the historical price.”

And how do you do that?   Value pricing guru Ron Baker, founder of the VeraSage Institute, offers many examples in his books and his blog.  But he also believes that lawyers often overthink this step.  In a blog post entitled “How to value price: Just do it”, Baker advised lawyers to: “Stop analyzing, stop looking for a checklist, a formula, or detailed instructions like this was a piece of IKEA furniture—there aren’t any... Just do it.”

In another post, Baker makes the case for getting away from the cost plus model:

“If you want to become a better pricer, you have to trash timesheets. You have to do other things as well (project management, key predictive indicators, after action reviews, leadership, etc.), but there’s no doubt in my mind, if you are serious about creating and capturing value, the timesheet must be buried.

I used to not believe this. I used to say, ‘Keep your timesheets, but use them as they were originally intended, as a cost accounting tool only, but price on value.’ I no longer say this, because empirical evidence has changed my mind.

The best pricers across all Professional Knowledge Firm sectors—from accounting and law, to advertising and IT firms—all have one thing in common. None of them maintains timesheets.

I used to believe this is because they became so good at pricing, timesheets became superfluous. But I now believe that they became good at pricing precisely because they got rid of the timesheet, which forced them out of the ‘we sell hours’ mentality and made them obsessed with value.”

Ron Baker has worked closely with many value pricing leaders for years.  I, on the other hand, have not.  So I am not in a position to argue with his observations. 

But I can say that my own observations of running a consulting firm for more than 23 years, have led me to be more comfortable with the cost plus model, at least as a starting point. 

As for trashing timesheets, I’ve done that myself at times, but only when my company was small.  And even when I was the only employee, if I signed a contract for a complex or unpredictable job at a fixed price, I tracked my time so I could analyze profit or loss at the end.

In my experience, the more employees I had working for me, the more important timesheets became in tracking productivity and profitability. 

People feel very strongly about the relative merits of cost-plus and value pricing,and each has its fans.  It seems that both systems work for some people, some of the time.  In my own work, I use a hybrid approach, which starts from cost-plus estimates, and uses value pricing to determine the size of the safety factor.

Once you master the basics, how can you improve your pricing?  Practice, practice, practice. 

In his description of “Creating The Law Firm of the Future,” Ralph Palumbo, founder of the Summit Law Group, says:

“To be truly innovative, you have to learn to make your mistakes faster... every Summit lawyer has authority to propose any pricing system that the lawyer believes will match the Firm’s incentives to the customer’s goals. If an innovative pricing arrangement works well in one matter, we use it again. If a pricing arrangement doesn’t work, we change it to one that does and don’t repeat our mistake.”

But where to begin?  A few weeks ago Toby Brown, who works in Knowledge Management at Fulbright & Jaworski, wrote a post at “3 geeks and a law blog” noting, "Where this all comes to a head for me is deciding where to start. I have good idea of the various processes and systems involved, but I am struggling with the question of where to best attack this problem.”

Next week’s post will address this question with a step by step guide for succeeding with 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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Comments

As much as most lawyers would love to stop keeping timesheets, they're essential in any litigation where you may be asking a court to award fees. In some instances (Equal Access to Justice Act), reimbursement by the hour is set by regulation, but in almost all cases courts will insist on detailed time records to support a fee request. Even if there's no chance of getting an award of fees for the case generally, there is still the possibility of recovering your fees as part of certain sanctions of opposing counsel--and again, the court will look for hours spent.

Exactly, I agree with you there Ms Frye.

Jason

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