A Rational Basis for Setting Hourly Rates

Gaining Acceptance of Rates

Beyond rationality, we find there are three keys to getting a firm's clients and its own lawyers to accept a rate structure. First, a lot of lawyers' egos are tied up in their billing rates. It is amazing that, while partners want to keep their rates low to please their clients, they also want those rates to be among the highest within the firm in order to appear favorably in internal comparisons. However, even though rates are a source of competitiveness among partners in some firms, the setting of rates cannot be a de facto partner evaluation system, or be used to send messages or to solve performance or firm citizenship problems.

Second, the system for setting rates must be transparent to all partners in the firm. The first step in getting clients to accept the firm's rate structure is to make sure that the lawyers themselves understand and accept how rates are established. This requires an open rate pricing structure ' a major policy departure for many firms.

Third, firm management and partners must understand that pricing and rate setting is not merely an internal, accounting-heavy exercise; pricing is key to establish the value proposition of the firm and its lawyers to the market place. Having a common understanding among the partners of the firm's value proposition and being able to communicate the firm's value proposition to the client is critical. Therefore, clients must understand the bases on which rates are determined and participate in the evaluation of the sophistication of their work. For many bil-ling attorneys, bil-ling rates are only addressed when there is a rate in-crease or the client is dissatisfied. Clients understand that there are a variety of sophistication levels, yet most are charged a single rate for a specific attorney regardless of the matter. If firm managers want to obtain a high rate for sophisticated work done by their best lawyers, they have to be willing to accept lower rates for more basic work.

The Kerma Partners Methodology

Kerma Partners has developed a rational rate-setting methodology that also satisfies all three of these criteria. Our Price Point Mapping' process has been two years in development. We are grateful to the law firms that beta tested our process and provided helpful feedback.

Using Price Point Mapping', a law firm constructs rate schedules that are internally consistent yet sufficiently flexible to accommodate the pricing needs of specific matters and clients. Construction of rate schedules involves five steps.

Step 1 ' Data Collection

The process begins by extracting information from the firm's time and billing system. In setting rates, law firms' management tends to look at last year's rate and how much of a percentage increase is required to achieve next year's budget. In addition, we recommend that firms look at each timekeeper's historic hourly rates for the past three years, together with realization information and the rates charged to the 10 clients for which the timekeeper did the most work during the past year. Both the scheduled or contracted rate and the rate that was actually billed should be reviewed. Many firms find it easier to create a single worksheet page for each timekeeper in Excel. These can later be combined into master spreadsheets by office and practice area.

Step 2 ' Experience and Reputation Rating

At their highest value, the benefits that lawyers bring to a client are experience and reputation. Skill is valuable but is normally associated with more routine work or lower level attorneys. One way of measuring experience and reputation is to ask all practice group leaders and office managing partners to evaluate all timekeepers in their group or office on a 10-point scale. The scale can represent any standards the firm chooses. The one we use goes the full range from '1 ' Capable of performing routine paraprofessional work of an advanced clerical nature with normal supervision' to '10 ' One of just a handful of lawyers in the market capable of providing specific legal services at the highest level.'

This exercise is purposely divorced from the number of years of practice to provide a measurement of actual reputation and experience; i.e., a young lawyer could conceivably have greater experience and a higher reputation in the marketplace than a more senior lawyer. While this rating could be performed through a questionnaire, we have found that conducting in-person interviews increases the consistency among raters, avoids a 'halo effect' and also elicits qualitative information about the marketplace in which that particular practice group or office operates.

Step 3 ' Sophistication and Complexity of Matters

While many firms do not adjust billing rates very often at the matter level, the sophistication of matters on which a lawyer typically works is a significant determination factor for his or her billing rate. A way to measure this factor is by generating a list of matters handled on which an attorney devoted at least 20 hours (Elite, CMS, and most major time and billing systems are capable of generating such a list). The practice group leaders are asked to evaluate the complexity of major matters on which members of their group worked. Using a scoring matrix, each matter is rated based on its complexity, the level in the client's organization at which the matter is supervised, the skills required of lawyers working on the matter, the price sensitivity of the client on work of this type, and any public scrutiny and profile the matter has generated. Again, we like a basic 10-point scale.

Step 4 ' Benchmarking

Using available survey data, the market rates in specific cities and areas of practice are analyzed to create midpoints of acceptable pricing for attorneys at various levels. Commercial surveys are available from various sources. We prefer the Benchmarking program offered by Redwood Analytics because its information is compiled quarterly instead of annually and because its information is extracted directly from firm time-and-billing records rather than being subjected to the error or exaggeration associated with surveys. [Editor's note: The authors confirm that Kerma has no financial interest in Redwood Analytics.]

Step 5 ' Rate Setting

Using the assembled data, we establish rate patterns within each practice group and office. By graphically mapping the comparative lawyer experience and matter complexity against the medians for each marketplace, a schedule of rate ranges is established for each timekeeper based on the type of matter and client. The rate schedule is designed to fit into the firm's existing rate structure, or a new rate structure can be designed to accommodate unique circumstances in the firm's practice.

A sample Price Point Map' for partners in a specific location is shown in the table below. Separate maps are created for equity and non-equity partners, and for each office if the legal markets differ significantly. The Price Point Map is typically designed to establish a mid-point billing rate for lawyers with average experience and expertise, who usually work on average complexity matters. The specific difference among point levels depends on the objectives and standards of the firm, but there usually will be a larger spread of rates for partners with a higher skill and experience level working on more complex matters, while the rates of lawyers with a lower skill and experience level working on less complex matters will be closer together.

For associates, the complexity of a matter becomes less important than the lawyer's capability, and there is a much more direct tie to years of practice. The firm may choose to create a full Price Point Map similar to that for partners, or it may use a simplified rate scale based on years of practice (with provisions for modifying rates in unique circumstances).

Conclusion

The described steps result in a consistent rate structure that gives attorneys a rational and explainable standard for pricing that communicates the firm's value proposition to its clients in an acceptable way. It also provides law firm managers with a methodology for establishing rate structures as part of the annual budget process that is defensible to the firm's partners.

[IMGCAP(1)]

Ed Wesemann, MPA, is a member of Kerma Partners, a global consultancy that advises professional service firms on strategic and competitive issues. The author of four books on legal management issues, Wesemann limits his consulting practice to law firm strategic, governance and growth issues. He may be contacted at [email protected] or 912-598-2040. Michael Roch, JD, CPA, MActg, is the lead author of Financial Management for Law Firms and is also a member of Kerma Partners. He advises firms on finance and capitalization issues, competitive positioning, mergers, and alliances. Based in Frankfurt and Denver, he can be reached at [email protected] or 720-937-6101. '2007 by Kerma Partners.

For the past 20 years, law firms have annually increased their hourly rates on the basis of various ad hoc criteria ' what the market will bear, matching the competition, cost-plus, maintaining profit margins ' that neither firm members nor clients find satisfactory. Alternative pricing methods (fixed fees, percentage of the deal, etc.) have long been advocated as a solution to hourly billing discontents, but in practice, for a large majority of firms they remain limited in application. Firms whose clients expect fees to be charged on an hourly rate basis therefore require a rational means of constructing an hourly rate schedule that is transparent and acceptable to clients as well as defensible within the firm.

Rate-Setting Factors

In the United States, the Model Code of Professional Responsibility (Rule 1.5) provides some assistance in establishing a basis for setting hourly billing rates. In setting a fee, lawyers are allowed to consider any of eight factors, including:

• The time and labor required, the novelty and difficulty of the issues involved, and the skill required to perform the legal service properly;
• The fee customarily charged in the locality for similar legal services; and
• The experience, reputation, and ability of the lawyer or lawyers performing the services.

Therefore, we can develop hourly billing rates that vary by the sophistication of the matter, by the reputation and capability of the specific lawyers involved, and by standards of the marketplace. The mechanics to develop such a system are relatively simple. Three sources of input are required: an empirical basis on which to make assumptions about the level of rates in the marketplace; a means of evaluating the capabilities and reputations of the firm's lawyers; and a system for measuring the comparative sophistication of client matters.

Gaining Acceptance of Rates

Beyond rationality, we find there are three keys to getting a firm's clients and its own lawyers to accept a rate structure. First, a lot of lawyers' egos are tied up in their billing rates. It is amazing that, while partners want to keep their rates low to please their clients, they also want those rates to be among the highest within the firm in order to appear favorably in internal comparisons. However, even though rates are a source of competitiveness among partners in some firms, the setting of rates cannot be a de facto partner evaluation system, or be used to send messages or to solve performance or firm citizenship problems.

Second, the system for setting rates must be transparent to all partners in the firm. The first step in getting clients to accept the firm's rate structure is to make sure that the lawyers themselves understand and accept how rates are established. This requires an open rate pricing structure ' a major policy departure for many firms.

Third, firm management and partners must understand that pricing and rate setting is not merely an internal, accounting-heavy exercise; pricing is key to establish the value proposition of the firm and its lawyers to the market place. Having a common understanding among the partners of the firm's value proposition and being able to communicate the firm's value proposition to the client is critical. Therefore, clients must understand the bases on which rates are determined and participate in the evaluation of the sophistication of their work. For many bil-ling attorneys, bil-ling rates are only addressed when there is a rate in-crease or the client is dissatisfied. Clients understand that there are a variety of sophistication levels, yet most are charged a single rate for a specific attorney regardless of the matter. If firm managers want to obtain a high rate for sophisticated work done by their best lawyers, they have to be willing to accept lower rates for more basic work.

The Kerma Partners Methodology

Kerma Partners has developed a rational rate-setting methodology that also satisfies all three of these criteria. Our Price Point Mapping' process has been two years in development. We are grateful to the law firms that beta tested our process and provided helpful feedback.

Using Price Point Mapping', a law firm constructs rate schedules that are internally consistent yet sufficiently flexible to accommodate the pricing needs of specific matters and clients. Construction of rate schedules involves five steps.

Step 1 ' Data Collection

The process begins by extracting information from the firm's time and billing system. In setting rates, law firms' management tends to look at last year's rate and how much of a percentage increase is required to achieve next year's budget. In addition, we recommend that firms look at each timekeeper's historic hourly rates for the past three years, together with realization information and the rates charged to the 10 clients for which the timekeeper did the most work during the past year. Both the scheduled or contracted rate and the rate that was actually billed should be reviewed. Many firms find it easier to create a single worksheet page for each timekeeper in Excel. These can later be combined into master spreadsheets by office and practice area.

Step 2 ' Experience and Reputation Rating

At their highest value, the benefits that lawyers bring to a client are experience and reputation. Skill is valuable but is normally associated with more routine work or lower level attorneys. One way of measuring experience and reputation is to ask all practice group leaders and office managing partners to evaluate all timekeepers in their group or office on a 10-point scale. The scale can represent any standards the firm chooses. The one we use goes the full range from '1 ' Capable of performing routine paraprofessional work of an advanced clerical nature with normal supervision' to '10 ' One of just a handful of lawyers in the market capable of providing specific legal services at the highest level.'

This exercise is purposely divorced from the number of years of practice to provide a measurement of actual reputation and experience; i.e., a young lawyer could conceivably have greater experience and a higher reputation in the marketplace than a more senior lawyer. While this rating could be performed through a questionnaire, we have found that conducting in-person interviews increases the consistency among raters, avoids a 'halo effect' and also elicits qualitative information about the marketplace in which that particular practice group or office operates.

Step 3 ' Sophistication and Complexity of Matters

While many firms do not adjust billing rates very often at the matter level, the sophistication of matters on which a lawyer typically works is a significant determination factor for his or her billing rate. A way to measure this factor is by generating a list of matters handled on which an attorney devoted at least 20 hours (Elite, CMS, and most major time and billing systems are capable of generating such a list). The practice group leaders are asked to evaluate the complexity of major matters on which members of their group worked. Using a scoring matrix, each matter is rated based on its complexity, the level in the client's organization at which the matter is supervised, the skills required of lawyers working on the matter, the price sensitivity of the client on work of this type, and any public scrutiny and profile the matter has generated. Again, we like a basic 10-point scale.

Step 4 ' Benchmarking

Using available survey data, the market rates in specific cities and areas of practice are analyzed to create midpoints of acceptable pricing for attorneys at various levels. Commercial surveys are available from various sources. We prefer the Benchmarking program offered by Redwood Analytics because its information is compiled quarterly instead of annually and because its information is extracted directly from firm time-and-billing records rather than being subjected to the error or exaggeration associated with surveys. [Editor's note: The authors confirm that Kerma has no financial interest in Redwood Analytics.]

Step 5 ' Rate Setting

Using the assembled data, we establish rate patterns within each practice group and office. By graphically mapping the comparative lawyer experience and matter complexity against the medians for each marketplace, a schedule of rate ranges is established for each timekeeper based on the type of matter and client. The rate schedule is designed to fit into the firm's existing rate structure, or a new rate structure can be designed to accommodate unique circumstances in the firm's practice.

A sample Price Point Map' for partners in a specific location is shown in the table below. Separate maps are created for equity and non-equity partners, and for each office if the legal markets differ significantly. The Price Point Map is typically designed to establish a mid-point billing rate for lawyers with average experience and expertise, who usually work on average complexity matters. The specific difference among point levels depends on the objectives and standards of the firm, but there usually will be a larger spread of rates for partners with a higher skill and experience level working on more complex matters, while the rates of lawyers with a lower skill and experience level working on less complex matters will be closer together.

For associates, the complexity of a matter becomes less important than the lawyer's capability, and there is a much more direct tie to years of practice. The firm may choose to create a full Price Point Map similar to that for partners, or it may use a simplified rate scale based on years of practice (with provisions for modifying rates in unique circumstances).

Conclusion

The described steps result in a consistent rate structure that gives attorneys a rational and explainable standard for pricing that communicates the firm's value proposition to its clients in an acceptable way. It also provides law firm managers with a methodology for establishing rate structures as part of the annual budget process that is defensible to the firm's partners.

[IMGCAP(1)]

Ed Wesemann, MPA, is a member of Kerma Partners, a global consultancy that advises professional service firms on strategic and competitive issues. The author of four books on legal management issues, Wesemann limits his consulting practice to law firm strategic, governance and growth issues. He may be contacted at [email protected] or 912-598-2040. Michael Roch, JD, CPA, MActg, is the lead author of Financial Management for Law Firms and is also a member of Kerma Partners. He advises firms on finance and capitalization issues, competitive positioning, mergers, and alliances. Based in Frankfurt and Denver, he can be reached at [email protected] or 720-937-6101. '2007 by Kerma Partners.