Partner profits, client perceptions, and the Litigation Investment Model (Part 2 of 2)

This post was written by Jim Hassett and Matt Hassett.

Last week, we noted that there are good business reasons for law firms to be reluctant to embrace the Litigation Investment Model.  To see one reason why, consider the math for a hypothetical case handled by a three lawyer firm, with two associates and one partner.  Assume that the firm accepted the case on the Litigation Investment Model, and used the assumptions from the article that  partner profits are 38%, and that 30% of revenue should be invested in the outcome of the case.

Here are some rounded figures showing what compensation for this firm might have looked like on a standard “bill as you go” agreement:

 

Partner compensation  (“profits per partner”)	38%	$380,000 ($300,000 salary plus 26.67% tax and benefits)
Overhead including rent and salaries of associates and staff	62%	$620,000
Total	100%	$1,000,000

 

Here is what happens to the partner’s short term pay if 30% is withheld until the end of the matter:

 

Profit invested in the case, paid or not paid at the end of the matter, depending on its outcome	30%	$300,000
Short-term partner compensation	8%	$80,000 ($63,200 salary plus approximately 26.67% tax and benefits)
Overhead including rent and salaries of associates and staff	62%	$620,000
Total		$1,000,000

 

In other words, the partner’s short-term salary was reduced from $300,000 to $63,200.  There are not a lot of lawyers who could easily take this kind of reduction and still pay their mortgage.

The thought that in the long term their salary could go back up to $300,000 if the case settled, or could double if they won the case, would take some of the sting out of the salary reduction.  But they might still have trouble paying their bills in the short term.  And if they lost the case, they would never recover the difference.

Of course, this type of salary reduction would not be necessary in a firm with 100 or 1,000 lawyers, because one lawyer’s shortfall in income could be made up from the billings of other attorneys, just as they are in contingency cases.  In essence, however, these larger firms would be robbing Peter to pay Paul. 

The truth is, given thousands of simultaneous matters at a large firm, with different fee structures, time frames, payment schedules and realization rates, many firms have traditionally found it difficult to track the profitability of individual matters.  According to the 2012 Altman Weil Law Firms in Transition Survey, 17% of firms are “not sure” whether their AFAs are more or less profitable than hourly matters on the average.  So they certainly don’t know how individual matters are doing.

Under the Litigation Investment Model, many lawyers will make less money. 

Now some clients may think that is perfectly appropriate and even a good thing.  As Susan Hackett noted in a recent post in the ABA Journal:

Surveys… usually confirm that the average in-house counsel who hires outside firms makes only slightly north of what a bonused first- or second-year associate in a big law firm makes. There are a few hundred large law department top leaders who haul in comparable returns for their work – usually through non-salary comp – but nowhere near the number or percentage of highly compensated partners that we find in the ranks at big firms where entire equity partnerships pull in hundreds of thousands or over $1 million a year in profit per partner.

The average in-house lawyer is well aware that he shares with those high-profiting partners the same schooling, sophisticated law firm background, and top-flight experience on his resumé. He’s made his choice, but please remember that he will more likely identify with the ‘99 percent’ – and not the partnership – when he’s assessing who’s getting coal this Christmas.

Could lawyers protect their profitability by delivering the same quality for 30% fewer hours (at the same average rate)? 

They might well be able to do so in some cases, but the answer depends on the actual total price.  If the winning bid was calculated based on the fees charged several years ago, some lawyers could apply project management techniques and reduce the total hourly billings by that much, while still producing a similar result.  But if the 100% price was based on a fiercely competitive bid, or a reverse auction, firms may have trouble breaking even with 100% of the price, much less with 70% of it. 

In November 2009, the ABA Journal published a piece about our LegalBizDev Survey of Alternative Fees with the headline “Law Firm Price Wars Break Out as Some Try ‘Loss Leader’ Bids for Work.” Since then, price wars and loss leaders have become a standard way of doing business in some practice areas. 

At the end of the day, is the Litigation Investment Model a good way to compensate law firms?

According to Toby Brown, Director of Strategic Pricing and Analytics at Akin Gump, “Law firm profitability is so difficult to define that you could not really use it to calculate what you were willing to invest.”  More importantly, he continued, “This model assumes that risk sharing is the motivation behind alternative fees, and for many clients it is not.”  Toby’s claim is supported by the results of a recent survey of ALM Legal Intelligence.  When 141 law departments were asked to identify the benefits of AFAs, only 35% named risk sharing.  This came in fourth behind cost predictability/transparency (87%), cost savings (68%) and increased efficiency (44%).

Chris Ende, Senior Manager of Project Management and Pricing at Goodwin Procter, also noted that even if risk sharing is the goal, “it shouldn’t matter whether the fee structure is based on profit. Clients who want to align their interests with the law firms they engage should focus on what value the law firms provide – not just based on efficiency, but also on results. You can do a great job of pushing down legal fees, but if you end up having to pay out $10 million in damages, you lost.”

Despite these objections, some in-house lawyers may find the Litigation Investment Model very attractive.

The General Counsel who uses it could begin earning points with his management on day one by tying payment to success.  It certainly pleased the CEO quoted by Hartmann and Mordan in their article:  “I only get a bonus if I win in the marketplace.  The same rules should apply to your law firms.”   

Even if the law firm is ultimately paid exactly 100% what it would have gotten when it billed hourly, 30% is paid at the end, so the client has much better cash flow at the law firm’s expense. If the client pays more than 100%, it will usually because they saved more than that based on the outcome of the case.    

From the law firm’s point of view, the picture is less clear.  The downside is certainly significant, and each firm will have to decide what cases make business sense at what prices.  To do so, they will first need a much better understanding of their own costs, and the organizational discipline to avoid accepting cases that will benefit individual lawyers by keeping them working on billable matters, but reduce the average earnings of the rest.

From the profession’s point of view, is this a sustainable way of doing business?  Over the next few years, we may find out.

 

Comments

[Doug Woods]

"organizational discipline to avoid accepting cases that will benefit individual lawyers by keeping them working on billable matters, but reduce the average earnings of the rest."

This is the hardest part, along with avoiding cases that benefit lawyers' origination credits to the detriment of overall firm profitability.

doug.woods@ogletreedeakins.com