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5 posts from April 2015

April 29, 2015

Six challenges in defining law firm profitability (Part 4 of 4)

Law firms’ problems measuring profitability cannot be attributed to lack of trying. A growing number of software programs are available to handle the calculations. The two long-time leaders in the field—Intellistat Analytics from Data Fusion and Redwood Analytics from Aderant—have been providing sophisticated tools to quantify law firm profitability for several decades. But to use these tools, one must make a series of assumptions, and that’s where the trouble starts.

At the 2014 LMA P3 conference, Jeff Suhr, vice president of products at Data Fusion, noted that his company had 91 clients actively using their tools, including 10 of the top 35 AmLaw firms (Jeff Suhr, “Best Practices in Leveraging Profitability Analysis to Better Price, Staff and Manage New Engagements,” presentation at the LMA P3 conference, Chicago, May 13, 2014).  Exactly how did these 91 clients calculate profitability? Ninety-one different ways. The fundamentals are the same, but there are important differences in the details, which can have significant implications for the way profitability is interpreted and used to motivate changes in behavior.

Suhr distinguished between the relatively straightforward science of calculating profitability and the art of determining the exact methods that best fit the needs of each firm. He also discussed the different challenges of “macro strategies” for analyzing profits for a firm, an office, or a practice group, vs. “micro strategies” for analyzing a book of business or a particular matter. These sometimes require different assumptions and different approaches.

For starters, you would think it would be easy to measure the revenue associated with a matter, but it’s not. John Iezzi’s Results-Oriented Financial Management: A Step-by-Step Guide to Law Firm Profitability (p. 132) noted that:

There are three different revenue numbers you can use. One is the accrual basis revenue number, which is hours worked multiplied by hourly rate. The second is the bills rendered number. And third is the cash receipts number.

The first two numbers reflect theoretical revenue. After client write-offs and write-downs, a significant amount of this may never be received. So a profitability system based on either accrual or bills rendered rewards lawyers for putting in more hours even if they produce no revenue. This is particularly troublesome with fixed fees and other AFAs, where lawyers with too little to do may pile on the hours “since it costs nothing and could help the client relationship.” Not to mention that in many firms attorneys get paid more if they bill more hours, whether the client ever writes a check for the hours or not.

In my LegalBizDev Survey of Alternative Fees (p. 118), one AmLaw 100 decision maker told us that:

It often happens that alternative fee matters, particularly large ones, end up being a dumping ground for individuals who may not be fully employed because you are reportable to the client for the result, not the cost. When lawyers work unnecessarily on a project your profitability looks bad, so in order to really determine the profitability, we need to deal with that issue.

As one chair in this research put it:

What you’re trying to do internally is change the mindset of the attorney who is used to billing hours. In the past, if you billed 2,000 hours, you were better than somebody who billed 1,200 hours. But with an AFA, you have to be more efficient and more concerned with delivering the value to the client in a way that makes this a productive relationship.

That’s why the best measures of profitability must ultimately be tied to cash received. But there’s no way of knowing that figure until a matter is completed and the bills are paid. In a large firm with tens of thousands of simultaneous matters, each on their own schedule, comparisons between matters must be based on a long list of assumptions about what will happen in the future, or postponed until the end of a case, which could take years to resolve. And this can lead to arguments and gamesmanship.

One senior executive at a firm that bases compensation partly on accrual-based profitability highlighted one such problem:

We use dashboard tools including Redwood Analytics and Intellistat to track key metrics and responsibilities for each attorney as a working, billing, and originating attorney. This information is directly used in each person’s annual review and compensation setting, along with qualitative and subjective elements. They have visibility to this key information every day, and it begets a whole different sense of responsibility and accountability.

Determining cost is even harder. In order to truly determine the cost of delivering services for a particular matter, one must answer two basic questions: what was the cost of the direct labor of performing the work, and what overhead indirect costs (such as rent, clerical staff, etc.) should be allocated to that particular matter?

The problems start with how to estimate the cost of each hour of a partner’s time. If a rainmaker partner was paid $1 million last year, how much of that was her direct cost for working on legal matters vs. origination fees, payment for time spent on management, profit distribution, and other factors? A number of different systems of “notional compensation” are used to split compensation between the amount allocated to billable activity and the amount allocated to everything else. The details of how to do this could easily go on for many pages, but in this context the most important fact is that every single system includes arguable assumptions. And if there is one thing that lawyers do well, it is argue, especially if a calculation affects the way their financial results are perceived. And if matter profitability is tied to compensation and perhaps even to job stability, the debates on how to calculate these figures will rapidly get louder and more passionate.

If you think that since associates are on salary, it would be easier to calculate their direct costs, you’d be right. But even there, important decisions must be made. For example, suppose two mid-level associates earn the same $300,000 salary, but Associate A billed 2,000 hours last year and Associate B billed 1,500 hours. To keep this example relatively simple, we will ignore the cost of their health insurance and other benefits and focus strictly on salary. Some firms say that the direct cost of Associate A is $150 per hour ($300,000 divided by the 2,000 hours she billed) while Associate B is more expensive at $200 per hour ($300,000 divided by her 1,500 billable hours).

Now suppose that relationship partners are rewarded for managing matters more profitably. Of course they will try to assign more work to the busy $150 per hour associate than to the $200 per hour associate who has more time available. In this case, the attempt to measure profitability to develop a more efficient system rewards behavior that is actually likely to reduce efficiency by overworking the busiest associates.

Discussions of other aspects of overhead can also get into heated debates about such details as:

  • If one practice group heavily uses the services of the marketing department and another doesn’t, should the first group pay more marketing expenses through higher overhead?
  • If one lawyer has office space in a high-cost city like New York, and another has an office in a lower-cost city like Cincinnati, do they have different overhead rates?
  • If one lawyer in New York has a 600-square-foot office and another has a 300-square-foot office, should that be reflected in different overhead rates?
  • If one lawyer’s assistant makes more than another’s, should that be reflected in their personal overhead?

The questions go on and on, and they raise the kind of awkward issues that sow resentments and dissension. As one partner interviewed for Michael Roster’s article noted:

Many of us have long believed that the non-attorney costs of the various practice groups are wildly different. At most firms, no one wants to hear that, probably because it might open Pandora’s Box.

Some experts believe that this box should be opened, and when it is it will reveal that different practice groups can afford to charge different rates. One expert we consulted, who preferred to remain anonymous, put it this way:

Cost accounting should be kept very simple lest the lawyers argue about it forever more. That said, it should not be the same for the higher cost of production groups that need a lot of work rooms, support services, etc. (such as litigation) versus the very low cost of production groups that can work in a cubicle and only occasionally might need a conference room (such as trusts and estates). GM charges a lot less for a Chevrolet than for a Cadillac, and yet the overall Chevrolet division may be far more profitable that the overall Cadillac division.

Others disagree and feel that analyses that compare relative costs will become divisive by focusing lawyers on their short-term individual interests rather than the long-term benefits of working together. The labor and employment group may come to question the wisdom of belonging to the same firm as the M&A group that needs more expensive space. Lawyers from the Cincinnati office may begin to ask whether it is really worth having a New York office with much higher overhead.

To explore the real-world solutions that law firms are using most often, Jonathan Groner  contributed to my research by interviewing two of the leading consultants in the field: Russ Haskin, director of consulting services at Aderant Redwood Analytics and Jeff Suhr, vice president of products at Data Fusion Technologies/Intellistat.

According to Haskin:

If a firm has hired a pricing director but does not look carefully at profitability in a sophisticated way, it is doomed to fail.

Haskin said that very few large firms do more than pay lip service to the concept of profit margin—and those that do are far ahead of the game. Among other things, they are ready to respond to AFA proposals in a way that will be profitable for them. A firm that looks at profitability in the “old” way by examining gross revenue rather than profit margin as seen at the client or engagement level is simply not equipped to respond intelligently to an AFA request.

Both consultants agreed that the key to success is to simplify assumptions, and one way to do that is to look at gross margin (revenue minus direct costs). Suhr argued that at the matter level, gross margin is a better measure than any that includes overhead because issues like office space can’t be controlled at the matter level.

Haskin suggested that to simplify the cost analysis, the firm should allocate a standard cost rate to each lawyer or group of lawyers, for all clients, like the senior partner we interviewed who said:

We have a model that takes into account cost not based upon actual draws or salary, but it takes into account junior associate, mid-level associate, senior associate, junior partner, partner, and senior partner typical costs.

At the end of the day, there is a reason why Data Fusion’s 91 clients use 91 somewhat different methods to measure profitability. Companies like Data Fusion and Aderant Redwood work with each client to come up with a consistent approach that has grass-roots support within each firm.

As John Iezzi summed it up in Results-Oriented Financial Management: A Step-by-Step Guide to Law Firm Profitability (p. 145):

The subject of profitability at [the matter] level is one that is very difficult to grasp for those not fully versed in cost-accounting concepts. Whatever methodology is used, it should be agreed to by a consensus of the partners so that the results are accepted once the methodology is applied.… Make certain that everyone buys into how the process is going to be done, and more importantly, why it is being done and what decisions will be made from the information once the analysis is completed.

Jeff Suhr made a similar point more succinctly:

The right way to measure profitability is one that is accepted in your firm. The art is to measure it in a way that keeps everybody happy.

And as one managing partner in this study summed it up:

You can argue all day about what the right profitability metrics are or what you’d include. We argue about it a lot.

Many participants, like this senior executive, think that the cure is worse than the disease and that firms should stick to more traditional measures:

We’ve used realization as a surrogate for profitability to this point. True profitability has been reserved for senior management analysis. We haven’t wanted lawyers arguing about indirect allocations and whether they only use 10% of a legal administrative assistant’s time versus 33%.

The profession may never find the perfect solution that some lawyers seem to want.  But it is absolutely clear that firms which want to survive and prosper in the current environment must find an answer that fits their culture and allows them to clearly distinguish between the matters that make money and the matters that lose it. 

This series is an excerpt from my book Client Value and Law Firm Profitability.  An edited and abridged version of this series appeared in the March 2015 issue of MP magazineThe MP article can bedownloaded from our web page

 

April 22, 2015

Six challenges in defining law firm profitability (Part 3 of 4)

Challenge #5 The problem with leverage

As Toby Brown and Vincent Cordo explain in the book Law Firm Pricing: Strategies, Roles, and Responsibilities (p. 18):

[Leverage can be defined] as the percentage of partner time worked per matter or per client.… The basic economic concept of leverage is that the more [non-equity] workers work, the more owners (partners) benefit. Workers generate the profits that pay partners. Therefore, the more work is pushed down to them, the better leverage you have and the more profit is generated.

Software programs that are designed to help lawyers bid in a way that maximizes profitability often do so by encouraging partners to push more work down to associates.

This concept is tied to the “old normal” pyramid model of profit, in which it was assumed that clients would have all their work performed on an hourly basis and would generally pay all their bills. But the legal world has changed to a “new normal” in which these assumptions are often incorrect.

For example, in a fixed price environment, efficiency is king and leverage can lead to higher costs and more unbilled time. Suppose a $1,000-per-hour senior partner can solve a problem in one hour, but a $300-per-hour associate will require 10 hours to come to the same solution. If the firm is paid the same fixed fee regardless of who does the work, it is obvious that solving the problem at the unleveraged partner “cost” of $1,000 is more profitable than at the leveraged associate cost of $3,000. (Of course, billable rates are a very approximate indicator of cost, but they are used here to keep this example simple.) 

Some critics have long questioned the value of leverage. In 1993, Bartlit Beck was founded on a totally different model, as Fred Bartlit explained in a 2012 ABA Journal piece:

Experienced lawyers can clearly do a task more efficiently than untrained rookies. So, why not choose a model based on low turnover, where only a very few high potential lawyers were well trained and mentored in order to dramatically increase experience levels? Our philosophy has turned the typical law firm structure upside down. Most large firms have few true partners and a large number of inexperienced associates. A typical ratio is 3.5 associates to each partner. Our experience metric is dramatically different: instead of the usual 3.5 associates/partner, we have 3.5 partners for each associate. This reversal of the typical large firm partner/associate ratio gives us a major competitive advantage in experience.

The result has been an award winning and highly profitable organization that Bartlit describes in the same article as:

The only firm in the world that does billion dollar litigation for Fortune 100 firms and is never compensated based on the hours expended.

One member of our Research Advisory Board summed up this view:

Leverage is a goofy concept sold by management and consultants. Ultimately, except maybe for some of the elite New York firms, high leverage will fail. There’s a reason Bartlit Beck operates with 3.5 partners per associate and Munger Tolles operates with slightly more partners than associates. Leverage and turnover have always been a disaster, except for the “golden era” (1980 to 2005) when clients weren’t paying attention, and thus it looked like a great business model for law firms to be inefficient, with high leverage and high turnover.

At this moment in time, the role of leverage in profitability depends on the client and the fee arrangement. For clients on a fixed fee basis or for hourly clients who refuse to pay portions of their bills due to inefficiency, greater leverage may decrease profit. If you have hourly clients who don’t question their bills and pay in full, greater leverage will still produce more profit. But it seems reasonable to ask how long this will continue.

Challenge #6 Problems applying cost accounting

The obvious way out of all this confusion is to move toward the approach used in almost every other business: applying cost accounting to measure profit. The basic formula looks deceptively simple:

Profit = Revenue – Cost

Cost accounting establishes rules for defining both revenue and costs, but it’s not as simple as non-CPAs might think.

Before we started working with law firms, my company spent almost 20 years developing training programs for financial services clients and for government agencies. Many of the government contracts we worked under were “cost plus,” in which an hour of a person’s time must be billed at its “true cost,”—as defined by many pages of government accounting rules—plus a negotiated fixed fee. (Note:  In our experience, the negotiated fixed fee on government contracts was typically between three and five percent of cost, which seems laughable by the standards of many law firms.) So you’d think that if anyone could identify the true cost of labor, it would be a government contractor.

But we gradually learned that government contractors have a number of options for calculating both the direct cost of what a person is paid per hour and allocating the indirect costs of benefits, rent, general and administrative overhead, and so on, to different groups within the company. So there was no single number for the “true cost” of a particular hour of labor, despite all the rules and regulations. The answer depended on a number of assumptions and interpretations.

Many law firms see cost accounting as the Holy Grail, with potential benefits to both themselves and their clients. As ACC Value Co-Chair Michael Roster summed it up in an article entitled “Facing Up to the Challenge: Law Firm Metrics”:

Once a firm or practice group shifts to a true profitability set of measurements, the firm finally has incentives to:

  • Keep reducing its cost of production—meaning moving matters to those with appropriate expertise while lowering leverage and hourly rates, where hourly rates are now used to monitor the cost of production, not how to maximize what can be billed
  • Measure and deliver better outcomes and be rewarded for that
  • Learn how to fix the cost of any given type of work
  • Along the way, improve profitability

However, in the widely quoted text Results-Oriented Financial Management: A Step-by-Step Guide to Law Firm Profitability, CPA John Iezzi explained that in working with law firms, he learned that this is much, much harder than it sounds:

My first article [on law firm profitability was]… written in 1975… after I had recently left public accounting, convinced that one could apply the same cost-accounting techniques to the service profession as one did to any other industry. [However], this was not the case, as I later determined once I began attempting to apply various cost-accounting practices to the legal profession.

The result for many firms is that, as one managing partner in my research admitted:

We struggle with a standard profitability model, and we don’t really have one right now.

Another managing partner pointed out the underlying problem:

There’s really more art than science as to what you count as revenue, and similarly what the cost allocations are going to be. Lawyers will debate all day long about those things. So it’s important to have uniform or reasonably well-accepted best practices for profitability analysis. I don’t think our practice is there yet.

As far as we can tell, neither is anyone else. When I talked to several members of our Advisory Board about this, Don Ware, chair of Foley Hoag’s Intellectual Property Department, said:

I’ve never heard of a law firm that has a good way to measure matter profitability. Many say they do, but when you push on the details it becomes clear that they really don’t.

In the final part of this series, we will describe what firms doing to get closer to this goal.

This series is an excerpt from my book Client Value and Law Firm Profitability .  An edited and abridged version of this series appeared in the March 2015 issue of MP magazineThe MP article can be downloaded from our web page.

 

April 15, 2015

Six challenges in defining law firm profitability (Part 2 of 4)

Challenge #4 The varieties of realization

A better approach to profitability starts with realization, as typified by this chair we interviewed:

We have made a big point to our attorneys that the focus is not revenue, it is profitable revenue. We try to get to realization. We start with the standard rates on a person’s time, and then we can determine, when bills are rendered and receipts are achieved, what percentage of the standard value we collect. It could have been a discount at the beginning. It could have been a write-off along the way. It could have been a billing or payment adjustment, whatever. But we look at the relationship between the standard value and the collection. If you spend $3 million worth of time to produce $5 million worth of revenue, that’s a hell of a lot better than spending $4.5 million worth of time to collect $5 million.

But realization is a lot more complicated than most lawyers think, because it comes in many flavors and goes by many names, each with their own strengths and weaknesses. The best summary of the underlying issues appears in an article by Jim Cotterman of Altman Weil, one of the leading consultants in this area, which explains seven key components that underlie various definitions of realization:

  1. Timekeeper discounting at the timesheet
  2. Write-downs of unbilled time
  3. Client adjustments resulting in write-offs ofreceivables
  4. Pricing variance
  5. Efficiency variance
  6. Turnover of unbilled time
  7. Turnover of accounts receivable

One result of the complexity is the fact that a number of different realization rates could be used to summarize a single situation, as shown in the table below. 

 Five Different Realization Rates for a Single Situation

The facts: A lawyer has a standard billing rate of $500 per hour and bids on 2,000 hours of work at a discounted rate of $400 per hour. She works 2,000 hours but before the bill goes out, she writes off 100 hours of inefficient time, so she only bills for 1,900 hours at $400 per hour. The client refuses to pay for 100 hours of this, so the firm is ultimately paid for 1,800 hours at $400 per hour.

Version number

Revenue paid to the firm

Realization formula

Realization calculation

Realization rate

1

$720,000

Revenue bid/ Revenue at standard rates

$800,000 (2,000 hours at $400) / $1,000,000 (2,000 hours at $500)

80%

2

$720,000

Revenue billed/ Revenue at standard rates

$760,000 (1,900 hours at $400) / $1,000,000 (2,000 hours at $500)

76%

3

$720,000

Revenue paid/ Revenue at standard rates

$720,000 (1,800 hours at $400 / $1,000,000 (2,000 hours at $500)

72%

4

$720,000

Revenue billed/ Revenue at bid rates

$760,000 (1,900 hours at $400) / $800,000 (2,000 hours at $400)

95%

5

$720,000

Revenue paid/ Revenue at bid rates

$720,000 (1,800 hours at $400) / $800,000 (2,000 hours at $400)

90%

Note that in all five cases, the firm is putting in the same amount of work (2,000 hours by a single lawyer) and bringing in exactly the same amount of revenue ($720,000). But the realization rate could be as low as 72% or as high as 95%, depending on which realization formula is used. And there are many other ways that some firms define realization, so there are far more than five options.

If all these formulas and examples seem confusing to you, you are not alone. Indeed, the two major conclusions of this brief overview are:

  1. Firms’ different definitions of realization can lead to considerable confusion when people try to compare results across firms
  2. The definition that a particular firm chooses may affect lawyers’ behavior in unintentional and unproductive ways

When it comes to confusion, it is important to note that this can affect law firm leaders’ views of their own and other firms. We recently heard one story about two firms that were considering a merger, in part because one firm was impressed by the other firm’s 90-plus percent realization rate. But when they later looked deeper into the figures, they found that the realization rate would have been much lower if both firms used the same formula.

Cotterman’s article also included a number of examples of ways these differences have important business implications for firms as a whole:

We had a law firm client that was thrilled with their near perfect overall realization. Upon examination we discovered that their high realization was due to unbelievably low billing rates resulting in lost revenue overall. At the other end of the spectrum, large accounting firms have been known to have realization figures in the low 80%s due to routinely large discounts off high standard rates. These are two examples, one unintended and the other planned, where realization is affected by pricing decisions.

When Cotterman reviewed an earlier draft of this chapter, he noted that it “shows how easily one can become confused in the conversation and the need to examine realization on its individual components—that is where the real work is.”

Another reviewer offered this anonymous example of the problems one can get into when using realization as a measure of profitability:

I had one huge litigation where realization was not great, probably 80%. But all the associates worked long hours on the case, including nights and weekends. Effectively they were working overtime, at no additional cost to the firm. Also, the client had a policy that you could not bill for travel time, and there was a lot of it. I felt, in fairness, that they should record all their travel time and I would just write it off as billing lawyer. Other partners would have told them not to write it down at all, so their realization would have looked better, although profitability would have been exactly the same.

This confusion is one of the reasons firms are moving away from realization as the sole measure of profitability. As one chair said:

A lot of times, there is confusion that profit is just realization.

For an extreme example, consider an associate who earns $400,000 and bills 2,000 hours in a year. Now imagine that for competitive reasons that have nothing to do with the associate himself, the work was bid and paid at an average of $175 per hour. This does not cover the associate’s cost under any definition. Revenue of $350,000 (based on 2,000 hours times $175) does not cover a $400,000 salary plus benefits, no matter how you calculate cost. However, under definition 4 or 5 in the table above, that associate’s realization rate would be 100%.

When it comes to influencing behavior, the differences between definitions are not just mathematical subtleties that only a CPA would care about. You get what you pay for, and the realization approach a firm chooses can shape lawyers’ behavior, since firms often measure lawyers’ success and award their compensation based on realization. The lawyer in our table above could be rewarded for high realization if it was calculated at 95% (Version 4) or penalized if it was considered 72% (Version 3), despite the fact that both versions have exactly the same impact on the bottom line from a business point of view.

In today’s rapidly changing environment, the problems can be especially challenging for firms that use standard rates as the base for computing realization. In that case, to improve your realization all you need to do is lower your standard rate, as this senior partner implied:

When you look at those realization rates and you compare them to the actual profit margins based on standard hourly rates of the underlying timekeepers, it’s all over the board. There is no consistent profit margin in those rates anymore and hasn’t been for years, because nobody’s gone back and sunsetted them and started them all over again. So what’s happened over time is, as rates have been adjusted, some up, some down, you’ve lost that connectivity. So realization really is no longer an effective measure of profitability.

If partners are rewarded for realization rates based on what is billed rather than what is collected, it will drive them to put in more hours, even when that produces no revenue for the firm, as this senior executive noted:

For evaluating partners we’ve always looked at realization and realized rates, among other things. And some of our internal experts are concerned that those are the wrong numbers to be looking at because they can drive the wrong behavior, especially in an age where they allow people to price low and it doesn’t matter what we charge for it. They’re very concerned that if the project isn’t done on time and on budget, lawyers can be rewarded for putting in more hours, even though we don’t make any money.

Or, as a senior executive at a different firm put it:

I think we've been much too focused on realization and that partners have a skewed view of what’s really profitable. They assume low realization means not profitable and high realization means profitable, and we’re just starting to get them to come around to the idea that that’s not always the case. I think we can go a lot farther down the road of getting partners to understand the impact of leverage on profitability.

The next post in this series will discuss the concept of leverage.

This series is an excerpt from my book Client Value and Law Firm Profitability.  An edited and abridged version of this series appeared in the March 2015 issue of MP magazineThe MP article can be downloaded from our web page 

 

April 08, 2015

Six challenges in defining law firm profitability (Part 1 of 4)

When I interviewed chairs, managing partners and other leaders of AmLaw 200 firms for my book Client Value and Law Firm Profitability, it quickly became clear that while most agreed that profits are being squeezed by changes in the legal marketplace, they disagreed sharply on the definition of the word profit.

Of all the topics I investigated in this research, the definition of law firm profitability was by far the most controversial and the most confusing, by a large margin.  This series of posts describes six different approaches law firms take to profitability, and the challenges associated with each.

Challenge #1 Relying on intuition

An outsider with no knowledge of how law firms operate would naturally assume that all large firms use basically the same accounting procedures and formulas to define profitability. But they would be wrong.

35 participants in the survey answered this question:  “If you compare profitability for two lawyers in your firm, is there a software program or formula used to calculate profitability, or is the comparison more intuitive?”  74% said by software or formula, and 26% said the comparison was more intuitive.  In other words, about one out of four of our respondents did not have any objective measure of profit, but they know it when they see it.

As one senior executive put it:

We don’t calculate profitability by formula. It’s really seat of the pants.

The managing partner at another firm put it this way:

Profitability is to some extent in the eye of the beholder. We’re still looking for good tools to evaluate what is profitable and what is not.

A senior executive at a third firm pointed to subjective views of certain types of matters:

Lawyers have a visceral association about what kinds of litigation matters or corporate/securities matters would be very profitable, such as an IPO in the corporate sphere or a major, multi-state litigation.

The managing partner at a fourth firm listed some of the factors involved in forming an intuitive impression:

We look at gross revenue. We look at how that compares to standard rates versus discount rates or AFAs. We look at collection problems. We look at staffing. Is it staffed all with partners, or are there staff-staggered billing rates? And then we come up with an impression. But we don’t analyze profitability through any software program or formula.

Can you think of another industry where one out of four firms analyzes profitability intuitively? Me neither.

A more positive person might see the glass as three-quarters full rather than one-quarter empty. But even that may be too optimistic. According to Research Advisory Board member Steven Manton, strategic pricing leader at Debevoise, “Three out of four is actually a higher number than I would have expected. I’ll bet many are not really using the profitability number, even if they have it.”

Challenge #2 Relying on revenue

In the quote above from the managing partner who listed several factors in evaluating profitability, the first factor he mentioned was gross revenue. As another managing partner pointed out:

Law firm partners for a long time equated successful practice with revenue.

The senior executive quoted above about the visceral reaction that IPOs are profitable went on to say that:

Huge matters are associated with larger revenues and I think attorneys associate larger revenues with larger profitability. We’ve just started to be able to look beneath the surface on large and small matters to determine how much of these revenues are winding up being profits. But I think that we are a long ways away from having that be in the consciousness of the average attorney at the firm. It’s just a few people who are looking at that and thinking about those things so far.

Similarly, one anonymous reviewer of an early draft of this report commented:

When I was on our firm’s executive committee, it was always frustrating to me that gross collections seemed to dazzle my colleagues, even when write-offs were significant. I often reminded them that the partner with the biggest collections could also be the biggest reason for a bad year if he used up too many resources. I think we’re better at recognizing that now, but the impact of write-offs on net profits is still given too little weight in compensation decisions.

However, some firms continue to look at revenue as the primary measure of success, like this chair:

We’ve chosen revenue per lawyer as the principal metric that we pursue. It’s important to give your partners something to aim at. Lawyers are competitive and they respond well to goals. So if you don’t set a target, then you’re unlikely to get a very disciplined set of behaviors.

One problem with this approach was articulated by a consultant we interviewed recently. He told us a story about a partner who brought in $80 million a year to one firm and was highly compensated for it. But his clients constantly asked for greater discounts and realization went down sharply. Meanwhile, the firm had to hire many more lawyers to do all this new work, which further increased costs and made the $80 million still less profitable to the firm.

People in other businesses also sometimes make the mistake of focusing on revenue alone. There’s an old joke about an entrepreneur who was looking for investors in a farm stand. He needed more capital to keep up with the demand for the watermelons he sold for $2. But he was buying them for $2.10 each, and losing $.10 on each and every one. When a potential investor asked how he would make a profit, the entrepreneur answered, “I’ll make it up on volume.”

The application of this fallacy to the legal profession was well-stated by the managing partner quoted at the start of this section, who went on to say:

I have a $10 million practice. But that could be a disaster for a firm, because it could cost them $11 million to get $10 million, but nobody ever talks about it that way. We need to get partners accommodated to the idea that we don’t really care what your revenue is, we care what your profit is.

Challenge #3 Focusing on profits per equity partner

When lawyers talk about profit, many think first and foremost about profits per equity partner, a figure publicized in the American Lawyer’s annual rankings of the top 200 firms. These figures are widely perceived as a sign of financial health and sometimes used to recruit laterals to higher profit firms.

There are many problems with these figures, not the least of which is that they are unaudited. A New Yorker article about the demise of Dewey LeBoeuf noted that the firm reported high profits per partner before it collapsed and explained that, “Members of the executive committee knew that [the profit figures they publicized] were not the numbers… that appeared in its audited financial statements. The submission was justified as a marketing effort.” 

Dewey was not the only firm to exaggerate. A 2011 ABA Journal article entitled “Are BigLaw Firms Inflating Partner Profits? Citigroup Unit Reportedly Finds Fudging” reported that, “More than half of the nation’s top 50 law firms could be overstating profits per partner to the American Lawyer magazine… An analysis by Citi Private Bank Law Firm Group reportedly found that 22 percent of the top 50 firms overstated profits per partner by more than 20 percent in 2010. Another 16 percent inflated partner profits by 10 to 20 percent, and 15 percent boosted partner profits by 5 percent to 10 percent.”

The widescale reliance on profits per equity partner is unfortunate and has led to many misunderstandings.

The dictionary definition of the term profit is, “Money that is made in a business… after all the costs and expenses are paid.” But, as I wrote in my book Legal Project Management, Pricing, and Alternative Fee Arrangements (p. 102):

Unfortunately, the term “partner profit” is not typically used this way in the legal profession. “Partner profit” usually refers to the amount of cash remaining to distribute to equity partners after all other expenses and non-partner salaries are paid. Partner salaries come out of the “partner profits” pool. In a large firm, if there were no partner profits, partners would be paid nothing for their work.

The American Lawyer figure might better be called “net revenue per equity partner,” because that’s what it is. The fact that the term profit is used continues to lead to much confusion among lawyers and their clients. For example, one managing partner in our study said:

As a partnership, everything we make above our cost is profit. I once had a lawyer who stood up and said, “How did we lose money this month?” I said, “We didn’t lose money, we just didn’t make as much money as we would have liked.” It’s very hard for a law firm to lose money, that is, be in a situation where you’re not paying your partners anything.

High profit per equity partner figures also lead to client resentment and some misguided negotiating. In my book, Legal Project Management, Pricing, and Alternative Fee Arrangements (p. 209), I described a billing approach to litigation proposed in an ACC Docket article in which the profits per equity partner would be withheld until the end of each case and treated as a “bonus depending on the total amount invested and the outcome of the litigation.” What the authors did not seem to realize is that they were proposing that the partners work essentially for free unless the client chose to award this “bonus.”

Even if the figure of profits per equity partner were not so misleading, it summarizes the total profits of the firm and does not allow management to answer one of the most important questions in a changing marketplace: Which matters, practices, partners, and offices make money and which don’t? In most businesses, companies analyze which product lines and groups are profitable, and they act on that information by fixing or discontinuing unprofitable products or people. The remaining three posts in this series will describe other approaches that law firms are using to answer that question.

This series is an excerpt from my book Client Value and Law Firm Profitability.  An edited and abridged version of this series appeared in the March 2015 issue of MP magazineThe MP article can bedownloaded from our web page.

 

April 01, 2015

Tip of the month: Improve the way you plan activities at the start of every matter

Clients are demanding greater efficiency these days, and efficiency should start before each matter begins.  Instead of jumping right in, set aside a little time for planning and ask such questions as:

  • What deadlines will best align the client’s needs with the firm’s interests?
  • How can this large matter be divided into smaller sub-tasks which a single individual on your team could be responsible for?
  • Which tasks are on the critical path? That is, which tasks must be completed before others can start?

The first Wednesday of every month is devoted to a short and simple tip to help lawyers increase efficiency, provide greater value to their clients and/or develop new business. More information about this tip appears in the third edition of my Legal Project Management Quick Reference Guide.