When a law firm agrees with a client on an alternative fee arrangement, both sides usually see it as a win-win for the long term. That’s why they reached the agreement.
But what about the short term? Are fixed and contingent fees a good way for law firms to produce greater short-term profits while clients simultaneously pay less?
Of course, the answer varies from case to case. But when law firms talk publicly about the topic, they often focus on the win-wins. For example, when Howrey represented Chinese cell phone battery maker BYD, an article on alternative fees noted that:
[Partner Henry] Bunsow said Howrey was confident that it could get a favorable outcome defending BYD and felt comfortable agreeing to a hybrid contingency. The terms were that Howrey would charge a discount on its estimate for the trial and receive a bonus if either they prevailed in court or reached a low-cost settlement.
The decision paid off. In 2005, the case settled before going to trial for "less than the value of one day's production" at BYD's battery plant, Bunsow said. That earned the trial team a celebratory trip to China and a cool million-dollar bonus, which bumped the firm's revenue from the case 50 percent higher than it would've been with plain old billable hours, he said.
Similarly, when the New York Times wrote about alternative fees a few months ago, they quoted Carl A. Leonard, a former chairman of Morrison & Foerster and now a senior consultant at Hildebrandt about its profit potential:
In one case... Morrison & Foerster negotiated a fixed fee for defending a company in court, covering work up to the point of a motion for summary judgment.
On top of the fee, if the case settled for less than what the company feared having to pay if it lost in court, the law firm got a percentage of the amount saved. The arrangement made sense when the goal was to resolve the dispute quickly...
Lawyers on the case negotiated a settlement for much less than the client’s worst-case number, Mr. Leonard said. "The effective hourly rate was something like 150 percent of our hourly rates," he added. "We made money, the client was happy."
When asked about the profitability of non-hourly work, only 15% of firms reported that non-hourly projects were more profitable than those billed at an hourly rate.
At the other extreme, 24% of the 208 respondents said alternative fees were less profitable. When the results were broken down by firm size, large firms did even worse. Six of the firms who responded to the survey had more than 1000 lawyers, and three of them (50%) said alternative fees were less profitable than hourly work.
As discouraging as those figures are, I suspect they seriously underestimate the problem. Asking business people about profits is a bit like asking gamblers about their trips to Vegas. Due to selective memory and selective reporting, you are likely to hear much more about wins than losses.
In explaining the survey’s results, Altman Weil’s Tom Clay noted: “Most [law firms] still haven’t figured out how to structure and staff projects so they are more profitable – which they can be, if done right.”
While this is certainly true, in my 24 years of experience running fixed price and hourly projects in my own business, I have found that consistently profiting from fixed fee work is an enormous challenge, and a struggle that never ends.
Lawyers have been rewarded for their entire careers for putting in extra hours to analyze every risk from every possible angle. Most lawyers will have a hard time delivering the quality they are comfortable with when they must work within hourly limits. And large firm managers will have an even greater challenge when they try to juggle staff on dozens or hundreds of projects with constantly shifting deadlines. Traditionally, firms expect lawyers to be consistently productive 1600 or 1800 or 2000 hours per year. If firms shift a significant portion of their work to a fixed price basis, many will find those goals unreachable.
At the same time, it is also getting harder to protect profits as competition increases, prices go down and margins get squeezed. As noted in last week’s post, in the current economy buyers are the ones with the power. And they often use that power to cut costs. For example:
By working with outside counsel on alternative-fee arrangements, Cisco has managed to reduce its legal fees as a percentage of the company's revenue by more than 20% during the past five years, according to Mark Chandler, Cisco's general counsel.
Similarly, Pfizer has reported:
“substantial double-digit reductions in spending" even though matter counts had more than doubled from 2005 to 2006, and then jumped by close to a third from 2006 to 2007. How did Pfizer keep spending down? "Flat fees, volume discounts, and value-based assigning..."
When both inside and outside counsel talk about alternative fee arrangements, I predict they will continue to accentuate the positive, and focus on win-wins. People will speak most freely about the matters that make them feel good and look good, whether in terms of higher profits compared to hourly rates, or in terms of other benefits. But in my experience as a business owner, when one side wins a revenue concession, the other side loses money, at least for the short term.
In competitive markets, business people expect to invest in new business and to take risks. Pharmaceutical companies invest billions in drugs that never make it to market. But most law firms have done very well for themselves while minimizing risk. In 2007, the average profit per partner at AmLaw 100 firms was $1.3 million. Change will come hard. As Richard Susskind notes in his book The End of Lawyers (p. 280), “It is not easy to convince a group of millionaires... that their business model is wrong.”
But a few leading law firms have started to prepare for a new and more challenging future. Last week, the subscribers section of the National Law Journal web page included an article entitled Kirkland expands use of special fee structures which said:
During the past three years, the firm says it has given away more than $100 million worth of billable hours, but it hopes to make the revenue back through follow-up work from those clients.
Naturally, Kirkland did not want to reveal all the details of its strategy to competitors, so the article left readers with many questions. How much of the $100 million “give away” was based on fixed and contingent fees and how much from the types of blended rate discounts that all large firms are forced to offer every day? How many of those dollars represented new out of pocket costs, and how many came from associates and partners simply working more hours for the same base salary? But whatever the answers are to questions like these, the fact remains that a $1.6 billion firm is making a massive bet that the future will be tougher, and that they need to invest more in client relationships.
It’s too early to report formal findings from the survey we just started of the AmLaw 100’s use of alternative fees. But I can say I’ve been surprised by what I’ve heard so far. In the first two weeks of the survey, I’ve spoken to five Am Law 100 firms – two chairmen and three senior partners. All five predict that alternative fees will increase in the next few years.
When I asked for an estimate of the percentage of revenue that would be entirely or partly fixed (e.g., capped fees) five years from now, four participants were willing to go on record. The lowest prediction was 10-15%, and two of the participants tied for highest by predicting 50%. Let me repeat that: leaders of two of the largest firms in the US believe that five years from now, half of their revenue will come from non-hourly work! If they are anywhere near right, there’s a huge number of lawyers out there who have a whole lot to learn about bidding and managing alternative fee projects.
We live in a world that is changing rapidly. Large law firms like Kirkland are investing heavily in new tactics, and legal clients like Pfizer are paying less while doubling the work. In this environment, I believe that alternative fee arrangements should not be seen primarily as a win-win way to increase profits. But they are an absolutely essential tactic to generate cash flow and to survive in an ever more competitive world.
For a summary of this series and more, see the second edition of the free LegalBizDev Guide to Alternative Fees, in the Alternative Fees section of our web page. The third edition will be released in July.