Avoiding Extinction in A Turbulent Legal Market: The Other Side of Consolidation

Strategy and Focus

To thrive in a competitive market, businesses must be capable of carving out a unique, differentiable and sustainable market position. It is a rare business that achieves such a position by luck alone, though it helps. Instead, good leaders understand that, to remain competitive, the company needs a defined strategy. Why should law firms be any different?

Given the degree of flux in the legal profession, however, law firms need a strategy just to improve the odds of survival, much less remain competitive. In troubled firms, there is rarely a well-articulated and implemented strategy.

A firm's strategy must recognize the firm's current position within its markets, while focusing on the position the firm intends to occupy. Firms that try to provide a broad range of services to a broad market will find it increasingly difficult to compete for new clients and retain existing ones. Today's purchasers of legal services are generally sophisticated buyers who seek out not only value, but also expertise and depth. Firms attempting to be full-service experts, particularly those that are small or mid-sized, lack credibility with clients who seek significant depth and breadth. The strategic risk to these firms is not incompetence, but irrelevance.

It should be recognized, however, that a bad strategy, or one that is not well thought through, might be little better than no strategy at all. And, there is some risk that, intentionally or inadvertently, a firm may adopt a strategic focus that does not work. For example, a firm may adopt too narrow a focus for its own good ' certainly several recently dissolved firms had an industry or practice focus. They were not, in effect, trying to be “all things to all people.” But their strategies were insufficient to overcome other issues or market forces.

Leadership

Leadership is critical to achieving focus. Leaders must command respect, be trusted, and have vision. They must also have the energy and the inclination to drive the thinking within their firms ' sometimes at the risk of taking unpopular positions – to develop a strategic focus and keep the firm focused on its strategy. “Leaders” who follow the crowd, or whose idea of the solution to a problem is the last thing they are told, are doomed to failure.

Unfortunately, partners in troubled firms often choose as leader the partner least likely to make waves (or the least unqualified – a ringing endorsement). This may appear to work for a short period. After that, the leader (who may have tried to make change and been utterly ignored) becomes frustrated and the firm falls back into its state of inertia. A firm's unwillingness to let an individual or a small group take charge of the firm and make tough decisions is a sign that the firm's performance will suffer, particularly in the current economy.

In successful firms, leaders set an example for the firm to follow. These leaders put the firm's interests ahead of their own and ask their partners do the same. They are not greedy. Strong leadership engenders a sense of trust and respect among the partners, which is critical for success.

Operational Effectiveness

Even if the firm has a good strategy and strong leadership, it cannot hope for success unless it also does a good job of managing and executing the various functions necessary to keep the business on track. This must start with strong and proactive management (which is different from leadership.) Management must be focused, first and foremost, on assuring that the lawyers are constantly focused on doing the things necessary to implement the strategy and assure the firm's well being ' ie, insuring accountability. It is also important that management assure that the firm's structures and processes are well organized and effective. These include, most importantly:

• Practice management, including effective group organization and leadership;
• Compensation systems, assuring both the tools to help drive the firm's strategy and avoiding creating disincentives to good behavior;
• Training and development, to assure the firm's future ability to deliver quality legal services;
• Marketing; and
• Administrative leadership and management (including technology, finance and accounting, HR and the like).

A critical but sometimes neglected area of operational effectiveness is client service. All firms give lip service to client service, but relatively few actively manage it. And, while most firms provide adequate service, it is troubling when clients feel that the firm is not client service oriented.

No law firm can thrive without a strong institutional commitment to client service. A well-run firm maintains a regular, open, dialogue with clients to continually assess the law firm's performance. A critical management function must be to become intimately familiar with the needs and expectations of the firm's current clients, and those it wishes to have as future clients, and drive firm performance in line with those expectations.

Financial Hygiene

At the end of the day, very little makes up for a lack of profitability. Firms with poor economic performance risk losing key partners. Usually, these are firms that lack strategic direction, leadership, operational effectiveness and a service-oriented culture. A few lateral defections can transform an outwardly successful firm to a failing firm overnight. The larger the economic gap between firms, the higher the probability that partners will make lateral moves. To ensure that partners remain committed, the firm's leaders need to quickly identify financial weakness and take corrective action. Some of the warning signs that management needs to identify include:

Excessive financial leverage and a weak “Economic Balance Sheet.” Excessive borrowing is the most obvious aspect of a weak economic balance sheet (which may be defined as the entirety of the firm's assets and liabilities regardless of whether included in the standard, cash-basis balance sheet). Many firms still rely on bank debt to fund operating cash flow, plus substantial additional debt to fund infrastructure and growth. There also remain a large number of firms that philosophically do not believe in significant partner capital, which drives an increased need for debt financing. While some firms can sustain unusual debt loads during good times, they act as an accelerant in bad times. If the firm hits a rocky patch, high debt firms are more likely than others to experience a raft of partner defections, particularly when the partners are individually responsible for the debt.

Significant deferred compensation payments (typically for retired partners) and excessive lease commitments. Too many firms overextend themselves in good times, either assuming growth rates will continue, or that somehow they can continue to pay for unnecessarily lavish office designs.

Inventory Buildup. Law firms need to pay close attention to their billing and collections patterns, beginning with assuring that the firm is accepting the right clients in the first place, and culling those that do not fit the firm's target profiles and have difficulty paying the firm's bills. Any excessive or unexplained buildups in inventory levels should also draw management attention, and remedial action with the responsible partners.

Realization. All too often, billing partners strike deals with clients to provide the firm's services at some discount from the firm's standard rates. There are a host of reason why this happens ' including inadequate client intake procedures, a compensation system that awards any kind of origination, and actual or perceived rate pressures.

Unfortunately, many partners fail to realize that a small discount from standard rates translates to a major reduction in the firm's profit margin. With overall realization rates for well-run firms ranging between 92-94% of standard rates, there is little room for a partner to offer discounts. In their role, management needs to ensure that partners comply with appropriate policies regarding write-offs and discounts, including the levels of pre-recording discounts happening in their practices.

Productivity. Law firms have recently experienced softness in workloads in some practice areas, particularly in corporate transactional matters. Firms that fail to deal with under-productive lawyers (at all levels) will find it increasingly difficult to compete. It is easy to say that the firm's leaders should eliminate under-producers; actually doing so is much harder. Firms that are unable to make hard decisions with respect to these lawyers are less competitive than their well-run brethren.

It is also important to make sure the firm carefully analyzes its productivity. One issue that arises regularly in slow practices is a shift of hours from the associates to partners. If the firm sees a shift in the levels of effective leverage in a practice, it is generally a signal that the partners are hoarding the work to prevent appearing under-productive.

Conclusions

The legal profession is in a turbulent state, and while most firms are doing well economically, others are feeling significant stress. As importantly, many apparently healthy firms have conditions that, left unattended, will result in long-term decline and eventual collapse. However, for most, time remains on their side, and early intervention and commitment to change can place a firm back on a solid long-term footing.

To avoid finding your firm on the side of the road with other broken-down entities, evaluate and test your strategy, empower your leadership and management, and take a renewed interest in your clients and their needs. Ultimately, that will keep you on the road to long-term success.

The early days of 2003 have brought a stark reminder to the leaders of law firms. While strong law firms have experienced an exceptional level of prosperity and growth in a consolidating market, continued expansion and ever increasing profitability are not the only potential destinies for law firms today. As the high profile closures of long established firms such as Brobeck; Peterson & Ross; Hill & Barlow and others demonstrate anew, firms can fail. And with failure come career interruption, client uncertainty and financial distress for many.

Recent dissolutions reinforce the fact that law firms are fragile enterprises. If not carefully and constantly renewed and developed, they are in danger of falling apart, often rather quickly. In reality, in spite of appearances of rapid failure, the seeds of collapse are generally sown long in advance ' in most cases, even long before the firm begins to noticeably decline (eg, as seen in the form of firm shrinkage or lowered profitability). The lessons learned from dissolving firms offer leaders an opportunity to avoid seeing their firms consigned to the dustbins of history ' if properly focused and motivated, there is almost always time to intervene and change a firm's direction, before it is faced with a final crisis.

Of course, leaders must know where to focus their efforts. There is no simple list of things that drive a firm to failure, and in most situations the underlying problems are many and complexly interwoven. In general, the sources of failure come from three overriding areas, and usually from more than one simultaneously. These are:

• Weak or non-existent strategic focus;
• Poor operational effectiveness; and
• Lack of financial hygiene.

If management can act to strengthen these areas early on, they can often limit their problems and bring the firm back to a prosperous track.

Strategy and Focus

To thrive in a competitive market, businesses must be capable of carving out a unique, differentiable and sustainable market position. It is a rare business that achieves such a position by luck alone, though it helps. Instead, good leaders understand that, to remain competitive, the company needs a defined strategy. Why should law firms be any different?

Given the degree of flux in the legal profession, however, law firms need a strategy just to improve the odds of survival, much less remain competitive. In troubled firms, there is rarely a well-articulated and implemented strategy.

A firm's strategy must recognize the firm's current position within its markets, while focusing on the position the firm intends to occupy. Firms that try to provide a broad range of services to a broad market will find it increasingly difficult to compete for new clients and retain existing ones. Today's purchasers of legal services are generally sophisticated buyers who seek out not only value, but also expertise and depth. Firms attempting to be full-service experts, particularly those that are small or mid-sized, lack credibility with clients who seek significant depth and breadth. The strategic risk to these firms is not incompetence, but irrelevance.

It should be recognized, however, that a bad strategy, or one that is not well thought through, might be little better than no strategy at all. And, there is some risk that, intentionally or inadvertently, a firm may adopt a strategic focus that does not work. For example, a firm may adopt too narrow a focus for its own good ' certainly several recently dissolved firms had an industry or practice focus. They were not, in effect, trying to be “all things to all people.” But their strategies were insufficient to overcome other issues or market forces.

Leadership

Leadership is critical to achieving focus. Leaders must command respect, be trusted, and have vision. They must also have the energy and the inclination to drive the thinking within their firms ' sometimes at the risk of taking unpopular positions – to develop a strategic focus and keep the firm focused on its strategy. “Leaders” who follow the crowd, or whose idea of the solution to a problem is the last thing they are told, are doomed to failure.

Unfortunately, partners in troubled firms often choose as leader the partner least likely to make waves (or the least unqualified – a ringing endorsement). This may appear to work for a short period. After that, the leader (who may have tried to make change and been utterly ignored) becomes frustrated and the firm falls back into its state of inertia. A firm's unwillingness to let an individual or a small group take charge of the firm and make tough decisions is a sign that the firm's performance will suffer, particularly in the current economy.

In successful firms, leaders set an example for the firm to follow. These leaders put the firm's interests ahead of their own and ask their partners do the same. They are not greedy. Strong leadership engenders a sense of trust and respect among the partners, which is critical for success.

Operational Effectiveness

Even if the firm has a good strategy and strong leadership, it cannot hope for success unless it also does a good job of managing and executing the various functions necessary to keep the business on track. This must start with strong and proactive management (which is different from leadership.) Management must be focused, first and foremost, on assuring that the lawyers are constantly focused on doing the things necessary to implement the strategy and assure the firm's well being ' ie, insuring accountability. It is also important that management assure that the firm's structures and processes are well organized and effective. These include, most importantly:

• Practice management, including effective group organization and leadership;
• Compensation systems, assuring both the tools to help drive the firm's strategy and avoiding creating disincentives to good behavior;
• Training and development, to assure the firm's future ability to deliver quality legal services;
• Marketing; and
• Administrative leadership and management (including technology, finance and accounting, HR and the like).

A critical but sometimes neglected area of operational effectiveness is client service. All firms give lip service to client service, but relatively few actively manage it. And, while most firms provide adequate service, it is troubling when clients feel that the firm is not client service oriented.

No law firm can thrive without a strong institutional commitment to client service. A well-run firm maintains a regular, open, dialogue with clients to continually assess the law firm's performance. A critical management function must be to become intimately familiar with the needs and expectations of the firm's current clients, and those it wishes to have as future clients, and drive firm performance in line with those expectations.

Financial Hygiene

At the end of the day, very little makes up for a lack of profitability. Firms with poor economic performance risk losing key partners. Usually, these are firms that lack strategic direction, leadership, operational effectiveness and a service-oriented culture. A few lateral defections can transform an outwardly successful firm to a failing firm overnight. The larger the economic gap between firms, the higher the probability that partners will make lateral moves. To ensure that partners remain committed, the firm's leaders need to quickly identify financial weakness and take corrective action. Some of the warning signs that management needs to identify include:

Excessive financial leverage and a weak “Economic Balance Sheet.” Excessive borrowing is the most obvious aspect of a weak economic balance sheet (which may be defined as the entirety of the firm's assets and liabilities regardless of whether included in the standard, cash-basis balance sheet). Many firms still rely on bank debt to fund operating cash flow, plus substantial additional debt to fund infrastructure and growth. There also remain a large number of firms that philosophically do not believe in significant partner capital, which drives an increased need for debt financing. While some firms can sustain unusual debt loads during good times, they act as an accelerant in bad times. If the firm hits a rocky patch, high debt firms are more likely than others to experience a raft of partner defections, particularly when the partners are individually responsible for the debt.

Significant deferred compensation payments (typically for retired partners) and excessive lease commitments. Too many firms overextend themselves in good times, either assuming growth rates will continue, or that somehow they can continue to pay for unnecessarily lavish office designs.

Inventory Buildup. Law firms need to pay close attention to their billing and collections patterns, beginning with assuring that the firm is accepting the right clients in the first place, and culling those that do not fit the firm's target profiles and have difficulty paying the firm's bills. Any excessive or unexplained buildups in inventory levels should also draw management attention, and remedial action with the responsible partners.

Realization. All too often, billing partners strike deals with clients to provide the firm's services at some discount from the firm's standard rates. There are a host of reason why this happens ' including inadequate client intake procedures, a compensation system that awards any kind of origination, and actual or perceived rate pressures.

Unfortunately, many partners fail to realize that a small discount from standard rates translates to a major reduction in the firm's profit margin. With overall realization rates for well-run firms ranging between 92-94% of standard rates, there is little room for a partner to offer discounts. In their role, management needs to ensure that partners comply with appropriate policies regarding write-offs and discounts, including the levels of pre-recording discounts happening in their practices.

Productivity. Law firms have recently experienced softness in workloads in some practice areas, particularly in corporate transactional matters. Firms that fail to deal with under-productive lawyers (at all levels) will find it increasingly difficult to compete. It is easy to say that the firm's leaders should eliminate under-producers; actually doing so is much harder. Firms that are unable to make hard decisions with respect to these lawyers are less competitive than their well-run brethren.

It is also important to make sure the firm carefully analyzes its productivity. One issue that arises regularly in slow practices is a shift of hours from the associates to partners. If the firm sees a shift in the levels of effective leverage in a practice, it is generally a signal that the partners are hoarding the work to prevent appearing under-productive.

Conclusions

The legal profession is in a turbulent state, and while most firms are doing well economically, others are feeling significant stress. As importantly, many apparently healthy firms have conditions that, left unattended, will result in long-term decline and eventual collapse. However, for most, time remains on their side, and early intervention and commitment to change can place a firm back on a solid long-term footing.

To avoid finding your firm on the side of the road with other broken-down entities, evaluate and test your strategy, empower your leadership and management, and take a renewed interest in your clients and their needs. Ultimately, that will keep you on the road to long-term success.