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February 13, 2013

How profitable are alternative fee arrangements? (Part 1 of 2)

The ABA Commission on Billable Hours Report predicted that the non-hourly approach would be a financial boon to law firms: “Alternatives that encourage efficiency and improve processes… increase profits” (p. ix).

Some consultants love to spread this good news message, and when law firms and law departments talk publicly about the topic, they too often focus on the upbeat side. For example, in an article entitled “Alternative Fees for Litigation: Improved Control and Higher Value,” James D. Shomper and Gardner G. Courson argue that “if properly structured, an alternative fee arrangement should result in a win-win scenario for client and law firm.”

To cite just one more example, a New York Times article about alternative fees quoted Carl A. Leonard, a former chairman of Morrison & Foerster, about AFA 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."

I think such examples are the exception to the rule and believe it can be very hard to turn fixed prices into win-wins, especially in a highly competitive market. My view has been shaped by my personal experience running fixed price and hourly projects in my own business. For more than 25 years, I have found that consistently profiting from fixed fee work is an enormous challenge, and a struggle that never ends.

In the hundreds of fixed fee projects we’ve performed, the vast majority were a zero-sum game. In the short run, when the project was over, one party did better than they would have on an hourly basis, and the other party did worse. Usually the client had power over the deal terms, and we were the one that did worse.

Fixed price projects begin with planning a budget upfront and then managing the work to keep within that budget as the project proceeds. When my company was billing by the hour, I found it relatively easy to maximize billing and profitability. If an employee had nothing to do on one project, I could usually find something for them to do on another, and keep them billing.

But during periods with a significant amount of fixed price work, it became extremely difficult to juggle dozens of projects with ever-changing deadlines in such a way that everyone remained billable and projects stayed within budget. And during mixed periods, when some of our projects were fixed price and some were billed hourly, it was an absolute nightmare. Employees quickly understood the never-spoken message that while they needed to be efficient on fixed price projects, inefficiency was winked at or even encouraged in hourly projects. For some employees, this inconsistent message created a conflict that threatened to make their heads explode.

Lawyers have been rewarded for their entire careers for putting in extra hours to analyze every risk from every possible angle. Many will have a hard time learning to deliver the quality they are comfortable with when they must work within strict funding limits. And law 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, most firms expect lawyers to bill 1,800 hours per year or more. If firms shift a significant portion of their work to a fixed price basis, many will find that goal unreachable.

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. But in my experience as a business owner, in fixed price deals one side usually wins a revenue concession and the other side does less well.

When I wrote about this a few years ago in my blog, Jordan Furlong, now a consultant at Edge International, made this incisive comment:

It may come down to how we define “winning.” I think a win-win alternative-billing scenario right now might look like this: the client wins because it reduces its outside legal spend, or at least improves its legal cost certainty, and the law firm wins because it gets to keep the client for one more day. That’s not the kind of victory lawyers are accustomed to settling for, but I think they ought to get used to it.

Next week, in Part 2, we will review the data on who is making more with AFAs, and who is making less.

This post was adapted from my new book Legal project management, pricing and alternative fee arrangements.

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