Legal Business Development

What Would Andy Rooney Say About Law Firm Finances?

By Steve Barrett, Principal, LegalBizDev


Several years ago, an AmLaw 100 COO told me that his kids' Boy Scout troop had a more sophisticated financial management than his firm.  I remembered that…

We all were saddened by the recent passing of CBS TV’s 60 Minutes curmudgeon Andy Rooney.  But his death leads one to question some basics in our professional lives, as Rooney often did.  With the serious challenges facing the legal industry since the 2008 downturn, the expressed need for far more predictability and transparency of costs by major law firm clients, and the dip in law firm revenues, staffing and profitability, some thoughts arise.

The other night I was re-reading the Hildebrandt Baker Robbins/Citi Private Bank 2011 Client Advisory, a report that I’ve found gets to the heart of what’s going on amongst major law firms.  Several numbers leapt off its pages:

1. From 2001-2007 “demand for legal services was growing at…4.5% or so per year and…(firms passed along) annual rate increases in the 6-8% range.” (p. 5)


2. Secondly, while the 2010 HBR/Citi report noted a softening in law firms’ 2009 realization rates, this latest report notes that (chart 9, p. 13) by the end of the 3rd quarter of 2010, they had softened even further – even after more than 18 months of law firm headcount reductions and cost containment.  Indeed, billing realization averaged 89% and collection realization 87%, among the respondents.

What conclusions can we draw from these numbers?  In the first case, when times were good law firms’ rates increased much faster than the rate of demand growth.  So while the pie was growing, law firms’ appetites grew even faster (or their financial management wasn’t so hot).  Wonder how table manners would respond to a shrinking pie?

In the second case, combining the two realization rates, we see that law firms didn’t bill some 11% of their incurred hours (the 89%), and then also didn’t collect 13% of what they billed (the 87%).  Taken together, these two figures yield a combined realization rate of approximately 77% (0.89 X 0.87=0.7743).  Thus, in a rough sense, everyone’s been giving away an unintended 23% discount.

If major clients walked into a firm and demanded a 23% off-the-top, first dollar discount, brows would furrow.  But what if ALL clients demanded that discount?  Likewise, if a sophisticated Fortune 500 company’s management saw a recurrent 23% hit to their gross margins, whether from inventory shrinkage, loss, or inefficiency how long would it take for them to find the source and correct it?

In the past there's been little serious cost accounting – of the sort most big product-driven enterprises do – in the legal business, and there’s been little pressure for granular examination of cost structures.  Just add everything up at the end of the year, subtract expenses, set associate and staff bonuses, divvy up the remainder and give it to partners.  (A decade or so ago, I read that when the three major accounting software vendors - Aderant, Elite and Juris - were polled, they reported that only a tiny percentage of their law firm customers had either installed or used cost accounting software modules.)   

Almost all law firms practice cash accounting, and most of their indirect costs of servicing clients (copying, telephone calls, travel, lodging, etc.) have traditionally been reimbursed by clients, lessening the need for comprehensive cost accounting.  There are many firms who still mark up reimbursements (e.g. charge $2 per page for faxes when they cost pennies, 15 cents per page of copying, when Kinko's or Staples can do it for much less, add handling charges to telephone costs, etc.).  So there’s been little pressure to seriously examine costs of service.

Hourly rates have often been set based on the “rule of three”:  multiply salary by three so that 1/3 covers salary, 1/3 overhead (direct + indirect) and 1/3 partner profit distributions.  About the most significant adjustment made for cost variability is to set attorney hourly rates for expensive markets (e.g. New York, Los Angeles, DC, San Francisco) well higher than less expensive markets (like Atlanta, Denver, Omaha, Seattle and countless smaller markets).  This is because their payroll and occupancy costs are so much higher.  And each year rates were re-set like clockwork after budgeting time, by incrementing them upwards to cover next year’s projected costs.

BUT…law firms do spend a maniacal amount of time tracking and measuring HOURS.  Hours are – after all – not only the firms’ products, but also their inventory and Work-in-Process (WIP).  They’re the key component of most firms’ associate and partner compensation.  What gets measured, gets managed, right?  As Paul Lippe recently pointed out in a piece titled “Managing What You Measure” on LegalOnRamp: wrong!  He correctly says that what SHOULD get measured is “Value.”  But it’s stunning that perhaps the most-measured “value” in law firms is time.  Partners are compensated through Byzantine hours-based formulae, associates are bonused and advanced based on hours, firm performance is reported in units of time (“3rd quarter hours are up/down”).  In tenths of hours, no less!

But we’re losing 23% of the revenue from all this time by not billing it, or not collecting that which has been billed.  (This ignores hours worked but never recorded, but that’s another post.) 

Let’s have a closer look: 

Traditionally, most firms have struggled to police their WIP, since they haven’t been able – despite all sorts of initiatives – to get timekeepers to post their time promptly.  Remember, time equals overhead, inventory AND product.  An hour worked on the first day of this month often won’t appear on a pre-bill until after the end of month, get billed in mid-next-month, and collected 45-60 or 90 days later.  So WIP/inventory typically goes unpaid for from three to five months.  But the “suppliers” (timekeepers), landlords, equipment lessors, Lexis and WestLaw are all paid in “real time.”  So law firms start out well behind on the cash flow curve.

And who hasn’t heard the story of the associate given a task that should take five hours and he does it in 65?  Or the partner who submits $5,000-$10,000 in time from last March spent on a deal (and file) that closed before Labor Day?  So…when it comes time to up the efficiency of law firms, using Legal Project Management (LPM) and process improvement, one of the key constituents on the path to making gains stubbornly resists management.  Even in law firms where filing, document management and library systems have been bar-coded for years.

LPM encourages more-frequent matter status updates. If we cannot get all the costs entered at least every week, how are we ever going to get our arms around this problem?  Efficiency gains are becoming mandatory, and clients expect them.  Project management can substantially reduce that 23% going out the window.  It minimizes surprises.  It mandates time allotments for tasks assigned to others. It demands real-time querying of case status.  It prefers daily time entry, but could settle for weekly.  In any event, it cannot tolerate March time appearing in late August…or hours filed in the wastebasket.

One positive thing about many alternative fee arrangements is that they provide a real opportunity to improve cash flow.  Some are based on an annual or monthly retainer, paid in installments.  Some propose a stated number that can be pre-billed, then adjusted after the matter’s conclusion.  Where pre-agreed figures are settled on, it becomes simple to seek half down, half on conclusion, or a third, third and third…just like an orthodontist or your kitchen remodeler.  AFAs can also greatly reduce the staff needed for processing all those hourly invoices, reimbursements, etc.

Of course, today’s competitive environment is changing everything.  Firms are improving their financial systems, their internal procedures, their matter management, progress tracking and billing processes.  The ones that move quickest are most likely to thrive in this “new normal.”


Before Steve Barrett became a principal at LegalBizDev, he spent nearly two decades heading marketing at four AmLaw 200 firms and consulting to many more.  After reviewing drafts of the pricing series that started recently in this blog, he sent a long e-mail ruminating on his personal views of law firm finances.  That e-mail evolved into this week’s guest post by Steve.

The future of legal services: More project management and better collaboration

When the Ark Group asked Patrick McKenna, Dan DiPietro, Bruce MacEwen, Paul Lippe, Pat Lamb, Leigh Dance, Silvia Hodges, Larry Bodine and other leading experts to describe The Future of Legal Services in their new book of the same name, all agreed that this is a time of significant change. 

(Full disclosure:  I wrote the chapter on legal project management.  I will also be participating in Ark’s January 31 webinar to discuss this book including “What does it mean to you—and what are you going to do about it?”)

As Dan DiPietro, Chairman of Citi Private Bank, put it (p. 89): 

“The industry will not return to the golden era of double-digit profit growth any time soon…  But… the silver lining from the financial cloud is that partners of law firms – known to take perverse pride in maintaining the status quo – are more open to change than at any other time in all the years we have been studying the industry.” 

And what does DiPietro think that lawyers should change (p. 90)? 

“To stay ahead of the curve, law firms should consider seizing the initiative by asking how they could deliver legal services in a more efficient, cost-effective manner… Firms now need to turn their attention to project management and strategies to manage their costs.”

As Bruce MacEwen of Adam Smith Esq. noted in his article (p. 6), this approach is not a radical departure from traditional practice, but rather a logical result of changes in the profession:

 “Whether or not you know it, every time you run a matter for your firm, you are engaging in project management.  You can do it in an ad hoc haphazard manner, trying to put out fires as they arise.  Or you can use time-tested, proven tools to manage costs intelligently, to coordinate and organize people and tasks, and to head off surprises before they happen.”

Or, as Pat Lamb of Valorem summed it up (p. 74): 

“There is an enormous role for legal project management (LPM)…  LPM allows lawyers to plan, because frequently time to completion is important.  LPM allows lawyers to budget, because it is now rare that a client is indifferent to cost… [And] LPM allows firms to best utilize their resources; having some lawyers do nothing while others are overworked reveals a problem easily solved…  Every project is managed; some are just better managed than others.”

Of course, the book also describes many other important trends, including the expansion of global firms, changes in the Asian legal market, evolving relationships with in-house counsel, outsourcing, and a trend toward sharing firm leadership by appointing co-managing partners.

Of all the other trends, I was most interested in the increase in collaboration between clients and their law firms.  As Paul Lippe of Legal OnRamp put it (p. 30):

“the practice of law has shifted from an individual effort to one emphasizing teamwork and collaboration…  When firms had a monopoly on expertise, delivery of service was a one-way street.  But now most work involves collaboration and coordination between firms and clients.”

Of course, teamwork is the philosophy that lies behind the fastest growing segment of our business:  Client/firm collaboration workshops.  But that’s a story for another day.

Legal pricing (Part 3 of 8): Price competition, discounts, and loss leaders

“Law Firm Price Wars Break Out as Some Try ‘Loss Leader’ Bids for Work” said a November 2009 headline in the ABA Journal. The article was based on a post from this blog quoting AmLaw 100 senior partners who said things like:

“I have become aware of a large number of bids by competitors which I don’t think are sustainable…”

“Some firms are bidding alternative projects at very low costs. These are loss leaders which cannot survive in the long term.”

“Many firms are willing to discount their fees in order to keep people busy... It’s a jungle out there.”

In the two years since this piece appeared, in many markets legal price wars have evolved from front page news to a way of life.

As Peter Zeughauser noted recently in The American Lawyer (October 2011, p. 64): “The Achilles heel of many firms is that they use discounting to achieve high levels of client satisfaction … without focusing their partners on improving profit margins.”

This problem is familiar in other businesses. The widely quoted text The Strategy and Tactics of Pricing (p.4) notes that:

Customer satisfaction can usually be bought by a combination of over delivering on value and under pricing products… The purpose of strategic pricing is to price more profitably by capturing more value, not necessarily by making more sales.

Discounting can have a bigger much bigger effect on profitability than you might think. If you want to work through the math, see the table below to review the effects of a 10% discount for Beth, the fictional labor and employment lawyer we introduced in Part 2 of this series. Or you can skip the table and take our word for it: in this case, a 10% discount reduced profits by 80%.

	No discount	10% discount
Salary	$250,000	No change
Number of hours worked	2500	No change
Salary per hour	$100	No change
Direct labor ($100 salary per hour x 2000 realized hours)	$200,000	No change
Indirect labor overhead ($100 salary per hour x 500 unrealized hours for administration, marketing and unpaid bills)	$ 50,000	No change
Other overhead expenses (malpractice insurance, health insurance, fringe benefits, taxes, rent, phone etc.)	$100,000	No change
Total expenses	$350,000	No change
Actual hourly rate	$200	$180
Total revenue (Realized hours x hourly rate)	$400,000	$360,000
Profit (loss) for end of year bonus or correction	$ 50,000	$10,000

When law firms calculate their partner compensation for 2011, many will see all too clearly how last year’s discounting reduced their income much more than they expected.

Lawyers often justify discounts as loss leaders, under the theory that low prices will start a new relationship and later lead to more profitable work. But will it? Once clients become accustomed to low rates, it will be very difficult to get them to pay more.

As Ron Baker notes in Pricing on Purpose (page 146):

…purchasing agents have been rewarded for demanding low prices by getting discounts, concessions and other price decreases, thereby creating little Pavlov’s dogs. If you subsidize something, you get more of it, including low-price buying behavior.

If you do decide to use loss leaders to build new work, it might be wise to make sure the first job is a large one. A few years ago, Ron Paquette published an article (in the September 2007 issue of Strategies: The Journal of Legal Marketing) describing research conducted by Redwood Analytics to evaluate the widely held idea that small jobs often grow into big clients:

It’s called the acorn theory – from a tiny seed of work in one legal area can grow a mature oak of a client, which provides work across many practices. Nice theory. But how often does it happen in practice? We thought this theory was largely a myth… We’ve observed that regardless of the firm involved, most large clients appeared to have retained the firm for significant matters from the start of the relationship.

So Paquette and his colleagues looked at the top five percent of clients at one AmLaw 100 firm, and went back 23 years to see whether these clients had started large or small. More than 90% had started large (that is, already in the top 20% of the firm’s clients in their very first engagement). When Paquette analyzed similar data from an AmLaw 200 firm, they again found that today’s large clients had been large right from the start (in this case 84% of the clients). They concluded that:

Firms should be highly selective with regard to small clients. It is commonly held that small clients are on average less profitable than large clients. If your firm’s growth strategy depends at all on growing small clients into larger and more profitable clients, think hard about the likelihood that this will happen.

So what should law firms do? There are no easy answers in today’s challenging environment. But when this series resumes in a few weeks, we will continue to explore what lawyers can learn from pricing experts in other professions.

This post was written by Jim Hassett and Matt Hassett.

Legal project management tip of the month: Focus on communication

As Squire Sanders litigator Stacy Ballin put it, “I used to think that project management was limited to cost, schedule, scope and quality.  But [in the Certified Legal Project Manager® program] I developed a new appreciation for all that falls under the umbrella of the human business management side:  internal and external communications, motivation, keeping morale high, influencing, negotiating, facilitating, mentoring, coaching, and more.  You cannot control cost, schedule, scope, and quality unless you have effective communication with your client and with your team.”

The first Wednesday of every month is devoted to a very short and simple tip like this to help lawyers increase efficiency, provide greater value to their clients and/or develop new business.