Managing Alternatives to Hourly Rate Billing

Keys to Pricing: Client Values

One key to pricing legal services effectively is to understand what the client values most in the engagement: Is it highly specialized expertise, is it labor (ie, is this an engagement many firms can handle and the client is looking for inexpensive labor), is it speed of production, is it the reputation and credibility of the firm, is it a contact or connection, or is it risk sharing? What the client wants and needs will generally frame how legal services for the engagement can be fairly priced.

Generally, if the firm is taking the engagement, it should try to price its work consistent with what the client wants and needs. Structuring a fee arrangement that does not match up to what the client values frequently spells trouble for the relationship as well as for the collectability of the account.

If the client is seeking highly specialized expertise or access to decision-makers or needs work performed on an accelerated basis, a premium of some kind ought to be considered. If the client is looking for labor hours on a series of matters, competitive forces are likely to produce an arrangement in which a firm will effectively discount its hours on the early matters and eventually achieve efficiencies that will result in a recovery of the “loss” on the early matters. If the client wants risk sharing, both the lawyer and the client have to be able to reasonably evaluate the risks. If there is risk sharing on the down side, there should be reward sharing on the upside.

Pricing Arrangements

Task-based budgeting: Frequently clients will require budgets by tasks and then will insist on billing against the budget. This approach requires real discipline on the part of the attorney to think through the functions that are likely to be required. Clients like this approach because they realize lawyers, in their zeal to get the work and not to appear too expensive, tend to seriously underestimate the costs of each task. Clients then can force law firms to discount as the case unfolds.

If you are driven to this method, you should try to bargain for relief among tasks so that if you underestimate the work in, say, filing a motion to dismiss, you might be able to make it up in the discovery phase of the case. In addition, you might build in some mechanism for adjustment of the estimates should unforeseen events occur. If your estimate states the assumptions on which they are based (eg, four depositions) and it turns out that the client, after consultation, wants eight depositions taken, you can escape the effects of your low-ball estimate for that phase.

Contingent fees: Contingent fees are obviously not new, but firms may be increasingly tempted to use contingent fee arrangements in more cases than in the past. In assessing risks, one might calculate that there is a 50% chance of liability, and if the liability hurdle is cleared, there is a 50% chance of getting a judgment for $500,000. As a matter of probability, there is a 1-in-4 chance of a judgment of $500,000; the probability of a lesser amount would be somewhat higher. If the case were taken on a one-third contingency arrangement and would cost about $150,000 in time to try, there is a very good chance that the firm will lose on the case.

In deciding whether to accept an engagement, many firms get invested in a case during the assessment process, slide over the risk of a no-liability finding, and concentrate on the damage side of the case. Frequently, contingent cases are dangerous and unwise arrangements unless liability is close to well established. Another factor to be considered is control of the settlement process. If the client (without consequence under the fee arrangement) can reject a settlement offer that the firm in its professional judgment believes should be taken, the risks the firm is taking when it accepts the engagement include the risk of the client being unreasonable or not following the firm's advice. This additional risk needs to be addressed as part of the engagement, either by adjusting the fees that can be earned by the firm if the client rejects a recommended settlement offer, or by permitting the firm to convert the arrangement to an hourly rate arrangement and to withdraw if hourly charges are not paid. The latter suggestion is fine theoretically but ignores two likely factors: the client may lack the funds to pay on an hourly rate basis, and the firm may not be able to walk away from the case at the point the settlement is rejected.

Modified hourly rate with a success fee: In many engagements the client is willing to pay on a reduced hourly rate basis, with a success fee based on results. Defining success is generally a problem in this type of engagement. This approach can get complicated if the modified hourly rate also involves a cap or ceiling on total charges for the matter.

In such circumstances the firm is taking two risks: one for the reduced hourly portion and, the other, that it will not be able to accomplish the work within the ceiling amount. If the firm exceeds the ceiling, on the basis of its standard hourly rates, it may ultimately get its hourly rates on the matter only if it earns the success fee.

In this scenario, the firm's underestimation of the total work effectively eliminates its upside of a success fee.

If it is not successful, the firm will not make its hourly rate on the engagement. Generally, arrangements where the firm makes its hourly rate if it is successful but where it makes far less than its hourly rate if it is not successful are not good arrangements for the firm.

Fixed fee: Many engagements, particularly in the transactional area, have been priced on a fixed-fee basis for many years. Bond transactions and lease work are examples of this type of pricing in many cases. Certain functions such as a simple will or an incorporation are also typically priced on a fixed-fee basis. The expansion of fixed-fee pricing into new areas is being encouraged by clients and by some firms. Fixed fees cause the firm to ask how efficiently it can handle the matter and still effectively represent the client's interest vs. how much can be reasonably done on the matter without the client reacting negatively. The opportunity for the law firm is to be able to deliver the client value at low levels of hourly time expenditure.

One way is to achieve efficiencies in work retrieval; another is to have value related to something other than time spent. Value in this context really means value to the client from the lawyer's particular contribution. If the client can negotiate a particular deal to license software, for example, the transaction may mean millions to the licensee.

The lawyer's contribution may be worth a small amount or a large amount depending on how critical the particular lawyer's contribution is to the success of the transaction. If any reasonably skilled transactional lawyer could satisfy the client's needs, then the value of the work priced on a fixed-fee basis is really a front-end prediction of the time. It may make sense for everyone simply to bill that matter on an hourly rate basis subject to some sort of good faith estimate.

If the lawyer has some unique contribution to make ' if, for example, the lawyer has key insights to the licensor's requirements or has credibility and access to the licensor such that it will be very valuable to have this particular lawyer involved ' the value contributed by the particular lawyer can fairly be priced far in excess of the predicted hourly time charges. In these circumstances, the firm may set a fixed fee or an hourly rate with a success fee upon the successful negotiation of the license agreement.

Other Issues

The approval process: A firm with a very loose practice management structure can successfully operate in a milieu of hourly rate billing. Non-hourly rate pricing changes the calculus of risk and should cause firms to examine whether somewhat tighter practice management methods are needed. Given the heightened risk of loss in non-hourly rate engagements, some approval process regarding the pricing decision seems warranted. The procedures for case intake should be clearly articulated and enforced. There is typically a substantial lag effect between sloppy intake and bad pricing decisions, and the losses traceable to those failings. Prudent law firm leadership will not wait until the losses are experienced to address the intake and pricing procedures being used by the firm.

Training: Pricing is an acquired skill best utilized in a setting in which the firm's experience with similar matters can be accessed. Effective pricing strategies must both fairly reward the firm and be acceptable to the client. It is easy to develop a strategy that will protect the firm; the tough part is convincing the client that the deal is fair. Firms would be well served to conduct workshops on pricing and to tie that process to training in marketing. Firms should also consider creating databases to track their history with certain kinds of cases. Such information is helpful for a firm in deciding whether to take a case, in deciding how to price the legal work, and in convincing a client that the firm's proposal is fair.

Work-retrieval programs: Law firm efficiencies can be increased significantly by being able to access the firm's prior work product. The time and effort required to develop a systems approach to this task are significant. Even if some sort of system is created, there is a continuing need to update and maintain the system.

Law firm management on this issue frequently amounts to an occasional exhortation which produces an intermittent sputter of activity. The firm needs to decide whether it wants an organized, systematic approach to work retrieval; if it does, consider using paralegals or dedicated staff to organize and maintain the system.

[Ed. Note: This month's article by William G. Ross, "The Ethics of Billing by the Hour for 'Recycled' Work" explains the ethical constraints on billing for "recycled" work.]

Malpractice risk: A change in pricing can affect the independence of counsel in the matter. Most obviously, if there is a success fee in connection with a securities offering, counsel's independence may be compromised; that, in turn, could materially impair counsel's due diligence in assessing the loss potential associated with the engagement.

In a different setting, giving opinions on particular matters may involve relatively few fee hours but expose the firm to significant liability if the opinion is wrong. Hourly rate billing in these situations does not provide any protection in terms of independence and compensates the firm only for its labor, not for its potential exposure. The nature and extent of malpractice risks should be reflected in the pricing decision and should generally not be increased by the form of pricing.

Joel A. Rose, a Certified Management Consultant, is President of Joel A. Rose & Associates, Inc. (phone 876-427-0050, http://www.joelarose.com/). Headquartered in Cherry Hill, NJ, the firm is national in scope. An MBA graduate of the University of Penn-sylvania's Wharton Graduate School of Business, Joel has 36 years of experience consulting with private law firms, corporate law departments and government agencies on management and organization, strategic and financial planning, compensation, mergers and acquisitions, and marketing.

Demands of clients and competition among law firms are causing fairly dramatic changes in the pricing of legal services, away from straight hourly billing.

Total fees under an hourly rate system are frequently not limited by efficiencies, but rather by client controls, the size and scope of the matter, the lawyer's desire to be reasonable or at least not to alienate the client, and competition among firms. It is easy for law firms to price legal services on the basis of hourly time charges. Such pricing requires only the ability to set a rate, to accumulate time entries, and to do the math. But it is not easy to price legal services on a basis other than straight hourly rates. Lawyers are generally not trained in the art of estimating legal fees for particular matters, and many engagements do not lend themselves to easy prediction as to total time.

Litigation of complex cases, for example, is fraught with so much uncertainty that it is really anyone's guess in most cases how much time will be required to get through trial. Organizational systems that make perfect sense if the law firm is handling straight hourly work may become dysfunctional when the firm suddenly begins pricing for legal services on a fixed-price or some other basis in which there is risk and reward sharing with the client.

Keys to Pricing: Client Values

One key to pricing legal services effectively is to understand what the client values most in the engagement: Is it highly specialized expertise, is it labor (ie, is this an engagement many firms can handle and the client is looking for inexpensive labor), is it speed of production, is it the reputation and credibility of the firm, is it a contact or connection, or is it risk sharing? What the client wants and needs will generally frame how legal services for the engagement can be fairly priced.

Generally, if the firm is taking the engagement, it should try to price its work consistent with what the client wants and needs. Structuring a fee arrangement that does not match up to what the client values frequently spells trouble for the relationship as well as for the collectability of the account.

If the client is seeking highly specialized expertise or access to decision-makers or needs work performed on an accelerated basis, a premium of some kind ought to be considered. If the client is looking for labor hours on a series of matters, competitive forces are likely to produce an arrangement in which a firm will effectively discount its hours on the early matters and eventually achieve efficiencies that will result in a recovery of the “loss” on the early matters. If the client wants risk sharing, both the lawyer and the client have to be able to reasonably evaluate the risks. If there is risk sharing on the down side, there should be reward sharing on the upside.

Pricing Arrangements

Task-based budgeting: Frequently clients will require budgets by tasks and then will insist on billing against the budget. This approach requires real discipline on the part of the attorney to think through the functions that are likely to be required. Clients like this approach because they realize lawyers, in their zeal to get the work and not to appear too expensive, tend to seriously underestimate the costs of each task. Clients then can force law firms to discount as the case unfolds.

If you are driven to this method, you should try to bargain for relief among tasks so that if you underestimate the work in, say, filing a motion to dismiss, you might be able to make it up in the discovery phase of the case. In addition, you might build in some mechanism for adjustment of the estimates should unforeseen events occur. If your estimate states the assumptions on which they are based (eg, four depositions) and it turns out that the client, after consultation, wants eight depositions taken, you can escape the effects of your low-ball estimate for that phase.

Contingent fees: Contingent fees are obviously not new, but firms may be increasingly tempted to use contingent fee arrangements in more cases than in the past. In assessing risks, one might calculate that there is a 50% chance of liability, and if the liability hurdle is cleared, there is a 50% chance of getting a judgment for $500,000. As a matter of probability, there is a 1-in-4 chance of a judgment of $500,000; the probability of a lesser amount would be somewhat higher. If the case were taken on a one-third contingency arrangement and would cost about $150,000 in time to try, there is a very good chance that the firm will lose on the case.

In deciding whether to accept an engagement, many firms get invested in a case during the assessment process, slide over the risk of a no-liability finding, and concentrate on the damage side of the case. Frequently, contingent cases are dangerous and unwise arrangements unless liability is close to well established. Another factor to be considered is control of the settlement process. If the client (without consequence under the fee arrangement) can reject a settlement offer that the firm in its professional judgment believes should be taken, the risks the firm is taking when it accepts the engagement include the risk of the client being unreasonable or not following the firm's advice. This additional risk needs to be addressed as part of the engagement, either by adjusting the fees that can be earned by the firm if the client rejects a recommended settlement offer, or by permitting the firm to convert the arrangement to an hourly rate arrangement and to withdraw if hourly charges are not paid. The latter suggestion is fine theoretically but ignores two likely factors: the client may lack the funds to pay on an hourly rate basis, and the firm may not be able to walk away from the case at the point the settlement is rejected.

Modified hourly rate with a success fee: In many engagements the client is willing to pay on a reduced hourly rate basis, with a success fee based on results. Defining success is generally a problem in this type of engagement. This approach can get complicated if the modified hourly rate also involves a cap or ceiling on total charges for the matter.

In such circumstances the firm is taking two risks: one for the reduced hourly portion and, the other, that it will not be able to accomplish the work within the ceiling amount. If the firm exceeds the ceiling, on the basis of its standard hourly rates, it may ultimately get its hourly rates on the matter only if it earns the success fee.

In this scenario, the firm's underestimation of the total work effectively eliminates its upside of a success fee.

If it is not successful, the firm will not make its hourly rate on the engagement. Generally, arrangements where the firm makes its hourly rate if it is successful but where it makes far less than its hourly rate if it is not successful are not good arrangements for the firm.

Fixed fee: Many engagements, particularly in the transactional area, have been priced on a fixed-fee basis for many years. Bond transactions and lease work are examples of this type of pricing in many cases. Certain functions such as a simple will or an incorporation are also typically priced on a fixed-fee basis. The expansion of fixed-fee pricing into new areas is being encouraged by clients and by some firms. Fixed fees cause the firm to ask how efficiently it can handle the matter and still effectively represent the client's interest vs. how much can be reasonably done on the matter without the client reacting negatively. The opportunity for the law firm is to be able to deliver the client value at low levels of hourly time expenditure.

One way is to achieve efficiencies in work retrieval; another is to have value related to something other than time spent. Value in this context really means value to the client from the lawyer's particular contribution. If the client can negotiate a particular deal to license software, for example, the transaction may mean millions to the licensee.

The lawyer's contribution may be worth a small amount or a large amount depending on how critical the particular lawyer's contribution is to the success of the transaction. If any reasonably skilled transactional lawyer could satisfy the client's needs, then the value of the work priced on a fixed-fee basis is really a front-end prediction of the time. It may make sense for everyone simply to bill that matter on an hourly rate basis subject to some sort of good faith estimate.

If the lawyer has some unique contribution to make ' if, for example, the lawyer has key insights to the licensor's requirements or has credibility and access to the licensor such that it will be very valuable to have this particular lawyer involved ' the value contributed by the particular lawyer can fairly be priced far in excess of the predicted hourly time charges. In these circumstances, the firm may set a fixed fee or an hourly rate with a success fee upon the successful negotiation of the license agreement.

Other Issues

The approval process: A firm with a very loose practice management structure can successfully operate in a milieu of hourly rate billing. Non-hourly rate pricing changes the calculus of risk and should cause firms to examine whether somewhat tighter practice management methods are needed. Given the heightened risk of loss in non-hourly rate engagements, some approval process regarding the pricing decision seems warranted. The procedures for case intake should be clearly articulated and enforced. There is typically a substantial lag effect between sloppy intake and bad pricing decisions, and the losses traceable to those failings. Prudent law firm leadership will not wait until the losses are experienced to address the intake and pricing procedures being used by the firm.

Training: Pricing is an acquired skill best utilized in a setting in which the firm's experience with similar matters can be accessed. Effective pricing strategies must both fairly reward the firm and be acceptable to the client. It is easy to develop a strategy that will protect the firm; the tough part is convincing the client that the deal is fair. Firms would be well served to conduct workshops on pricing and to tie that process to training in marketing. Firms should also consider creating databases to track their history with certain kinds of cases. Such information is helpful for a firm in deciding whether to take a case, in deciding how to price the legal work, and in convincing a client that the firm's proposal is fair.

Work-retrieval programs: Law firm efficiencies can be increased significantly by being able to access the firm's prior work product. The time and effort required to develop a systems approach to this task are significant. Even if some sort of system is created, there is a continuing need to update and maintain the system.

Law firm management on this issue frequently amounts to an occasional exhortation which produces an intermittent sputter of activity. The firm needs to decide whether it wants an organized, systematic approach to work retrieval; if it does, consider using paralegals or dedicated staff to organize and maintain the system.

[Ed. Note: This month's article by William G. Ross, "The Ethics of Billing by the Hour for 'Recycled' Work" explains the ethical constraints on billing for "recycled" work.]

Malpractice risk: A change in pricing can affect the independence of counsel in the matter. Most obviously, if there is a success fee in connection with a securities offering, counsel's independence may be compromised; that, in turn, could materially impair counsel's due diligence in assessing the loss potential associated with the engagement.

In a different setting, giving opinions on particular matters may involve relatively few fee hours but expose the firm to significant liability if the opinion is wrong. Hourly rate billing in these situations does not provide any protection in terms of independence and compensates the firm only for its labor, not for its potential exposure. The nature and extent of malpractice risks should be reflected in the pricing decision and should generally not be increased by the form of pricing.

Joel A. Rose, a Certified Management Consultant, is President of Joel A. Rose & Associates, Inc. (phone 876-427-0050, http://www.joelarose.com/). Headquartered in Cherry Hill, NJ, the firm is national in scope. An MBA graduate of the University of Penn-sylvania's Wharton Graduate School of Business, Joel has 36 years of experience consulting with private law firms, corporate law departments and government agencies on management and organization, strategic and financial planning, compensation, mergers and acquisitions, and marketing.