Bracing for Troubled Waters

Few doubt that the U.S. economy is either dangerously close to a recession or already in one. There is equally little doubt that other global economies are weakening as liquidity further tightens and new bank write-downs emerge. There is a common perception that law firms also suffer when the economy goes bad. While it is true that transactions-oriented practice groups fare worse during times of economic slowdown, law firms generally fare well, irrespective of economic conditions, when compared with other business sectors. Both managing partner and CFO will instinctively return to the basics of law firm economics. To a degree, reviewing the basic drivers of profitability is a helpful exercise ' but this provides part of the answer. Irrespective of whether your firm is on the winning or losing side of a looming recession, undoubtedly the firm's finance department will be involved heavily in anticipating solutions to 'shore up for troubled times ahead.'

Watching New Matters

How far are we already into this slowdown? One of the key indicators of the future is the number of new matters by work type that the law firm opens. From which clients do they come? Which clients have decreased the number of matters they provide? Are certain industries more affected than others? By providing basic data on new business, the firm's finance department can provide useful insights into the future revenue of the firm. The finance department also can use this information as ammunition for a recession program ' require each partner to speak to those clients that constitute 80% of that partner's revenue about future business ' and use the opportunity to evaluate where the firm can add even more value.

Redefine What Data Drive Decisions

Beyond new matters, the time is right again to seek much closer cooperation with marketing. Most firms base their planning on internal data, ignoring the host of external data available to them. It is here where practice group structures break down and industry group structures shine. For example, as ethanol producers come under pressure, they will increase their regulatory speed, and consolidation of independent producers will increase, thus resulting in higher potential in the medium-term for the firm that specializes in this area. The law firm's accounting department, without working together with marketing, will not be able to help its firm and its partners plan for this. Even when the departments do work together, strategic planning will not be possible unless the firm makes investments in systems that can canvass and make use of these cyclical dynamics to the best advantage of the firm.

Roll the Budget for Planning Flexibility

A solid information base to make decisions about the future is critical. Yet, in most law firms, accounting continues to be based on historic, not forward-looking information. Unfortunately, with an information base that is largely historic, it is very difficult to project out future revenue, especially with an inflexible, annual planning cycle. For this reason, this author's firm, Kerma Partners, has long advocated that law firms do away with an annual planning cycle: It hits the firm at the wrong time of year ' in the late fall, a busy season for most lawyers, certainly transactional ones. It is inflexible ' the conditions in December 2007 reflected none of the revenue assumptions that were made in October 2006. A rolling budget, adjusted quarterly, shortens the budgeting process and is more able to cope with changing economic, and therefore revenue, assumptions, especially as clients adjust their buying behavior quickly.

With a sensible information base, the more traditional factors of profitability can be reviewed in their proper light.

Watching Declines in Leverage

In the United States, partnerships tend to reward individual performance more than team or firm-wide performance. In particular, in firms that reward individual production, when there is economic trouble ahead, the percentage of partner hours invariably increases. We find this true particularly in departments that already are weak performers within the firm. While there is a legitimate argument that clients demand more partner time to help them navigate troubled waters, when one scratches beyond the surface, more often than not partners choose to delegate less to ensure that they will be 'safe' for their annual review. The CFO's role is critical here: The sooner signs of work-hogging are detected, the earlier the practice group leader or managing partner can intervene to lessen its effect. Reviewing leverage across practice areas, at an office level and at a team level, should become a weekly or bi-weekly exercise, depending on the timekeeping disciplines within the firm.

Increasing Utilization When The Work Goes Dry

There are at least three aspects that affect utilization: availability of work, partner and senior associate delegation skills (see above), and timekeeping disciplines. The decrease of work in some teams and departments is an excellent reason to review the timekeeping practices of these teams and departments ' and to use what one has learned from these teams to review the firm's overall practices and disciplines. Investing in one finance team member's time to review a sample of time entries by a struggling team will soon pay dividends. In a training session designed around noncompliant practices, temporarily unproductive teams can at least be shown how to record all time in a way that minimizes written-down, written-off, or uncollected time.

The focus on time entries should be on completeness and projection of value. First, all time spent working on firm matters, whether at the office or not, should be recorded. In particular, lunch hours, travel time, and e-mail time management are constant culprits of under-recorded time. Second, and more importantly, all time entries must convey that the client receives value for the time spent. Every task should enable the client to understand what work was performed, why it was performed, and why the performance of this work, at this time, and at this level of timekeeper, provided value to the engagement at this time. It is here where most law firms can significantly improve their timekeeping.

Pricing As a Means to Counteract Decreasing Market Share

To be successful, firms need to have a clear understanding of: 1) what markets they serve relative to their competition, 2) what is their value proposition, and 3) what are their competitive differentiators. An unclear definition in any area, or a lack of one, exposes a firm to too many competitive pressures. This lack of clarity slowly tears at the firm's fabric, forcing leadership to devote excessive time on internal issues, especially when the economy slows down. The firm's pricing paradigm, and therefore also its rate structure, directly relate to the above three understandings. Three issues must be addressed: The firm's rate structure, the firm's pricing management practices, and the firm's pricing paradigms.

Law firms are achieving ever-higher hourly rates. During the last boom in 2005-2006, hourly rates in the global financial centers have reached and exceeded the $1,000 per hour sound barrier. This is good news for law firms in the short-term, but bad news in the medium-term; during times of economic trouble, clients are much more sensitive to their lawyers' hourly rates and, facing cost pressures themselves, care little about the fact that the cost of the associate complement has skyrocketed during the last three years. CFOs should encourage their staff to take initiative at several levels. The firm's rate structure, especially among partners, must be rational and based on each lawyer's relative 'worth' to the market, instead of internal factors of seniority, equality of practice areas, or other invalid reasons. Second, finance staff should take the initiative and, working with their marketing counterparts, find ways to help partners convey to their clients their unique value compared with competitors, and provide clients with the tools to achieve the best rate among their clients.

Most firms have a difficult time implementing the above suggestions because the pricing function falls between two departments: finance and marketing. Neither is responsible for ensuring that the firm always achieves the best price (that's the partners' responsibility in most firms), and neither has all skills and information available to assist partners in sound pricing decisions. The only thing that pricing and the finance department have in common is numbers, and as a result accountants focus on what they know ' the effective rate, which is almost always based on internal considerations (budgeted profit). However, pricing is primarily a marketing function, but often marketing does not have either the skill or the external financial data available to assist partners in making sound pricing decisions. A forward-looking CFO will take an economic downturn as an opportunity to recommend and implement a sweeping reform in how pricing is managed at the firm. Pricing requires a central management function, as well as data, people, and systems to enable the firm to differentiate itself from its competitors ' and to enable the firm and its partners to be sufficiently confident to state what price the firm is willing to accept at what terms and what price the firm is not willing to accept.

Progressive law firms manage to redefine the relationship with their clients, especially when recession looms: It is at this time that clients are looking to cut costs, including their legal costs. This is a prime time for law firms to examine their key client relationships and, through discussions with their clients, gain a new understanding of the client's value drivers, and thus change the pricing paradigm with particular clients. In the face of $1,000 hourly rates and bad times, clients are more and more demanding that their law firms find ways to charge less and to share risks with them. While most work continues to get billed by the hour, the leading upper-mid market firms all have negotiated contracts in place with their key clients for certain types of work. For instance, a struggling M&A department should examine the last 10 transactions for its key clients and determine where it has provided superior value and where it has not. It can use this information to find common aspects of transactions that provide superior value and put in place a pricing arrangement that provides a potential upside to both client and firm if it completes successfully. Litigation can be equally creative, and probably more so: Litigation tends to have a predefined path around which price points can be structured.

There is a perception that work done on anything other than an hourly rate basis is, by definition, unprofitable. A different pricing paradigm also requires different pricing practices: For instance, an engagement now done on a fixed-fee basis will be unprofitable if its timekeepers continue to think they have an open clock to get the work done. Changing the pricing paradigm invariably leads to an examination of how the work is executed which, in turn, usually leads to efficiencies for the firm, and to the client: a potent combination when clients seek to cut costs.

Financial Hygiene and Working Capital

Conserve cash ' sensibly. A looming recession is an excellent excuse to review goals for inventory and collection age. This should be done at the partner and the client levels. CFOs can add tremendous value by providing the required ammunition to the partners to have conversations with their clients about payment terms, and to their managing partners to have conversations with their flock about paying attention to financial hygiene.

Controlling Margin: The Baby and the Bath Water

When the economy is growing, firms often invest in client-satisfaction programs, professional development, delegation, associate development, and learning because these are times when one can afford to do the right things. Upon the looming of an economic downturn, there is a tendency for the focus to return to the money. The unstated expectation of the CFO is to take charge of all performance management and impose the 'tried and true' cost accounting regime in an effort to protect the profit per equity partner number. While a close look at the firm's finances is certainly in order, there is a tendency to overemphasize short-term profitability among the other important areas of performance, at which the firm must continue to do well if it is to be profitable long-term. The CFO invariably will be asked to review the firm's costs to see whether there is room for reduction. Unless there is an immediate liquidity crisis, care must be taken to decrease costs in a way that is productive in the medium-term.

Productive activities include a review of the firm's leasing situation to determine whether its office locations are put to best use. For instance, the firm may ask itself whether its word processing department must occupy space in expensive downtown Manhattan or whether an administrative support center in a less expensive location will do. The firm also wants to evaluate which parts of its operations it should retain in-house and which parts its should contract out to specialists (I intentionally do not use the word 'outsourcing' here). The CFO should not stop at evaluating operations: Can certain parts of legal work be done at a less expensive location? Discovery, file review, and due diligence are prime activities that, with proper procedures in place, do not need to be done on Park Avenue by expensive personnel (who are under-challenged by the work) in expensive space. Reviewing vendor relationships to negotiate higher discounts for faster payment also is a productive activity.

Misdirected activities in a quest to cut margin can take several forms. For example, it is generally unproductive to cut on 21st century professional services. We continue to meet 'transactional' firms where personal digital assistants are reserved only for senior associates or partners ' and one-half of a finance person is employed to ensure that all personal phone calls get re-charged to the lawyer involved. In most firms, once professional personnel and rent is accounted for, the remaining overhead often does not account for more than 10% of the firm's profits. Any of the measures outlined above will do more to maintain profitability than most costs that can conceivably be cut out of a law firm's budget.

Misdirected activities also cut the firm's professional complement carelessly. Clearly those departments whose primary work has been to package mortgages into Collateralized Debt Obligations will wonder where future work will come from, making layoffs necessary. However, all downturns are temporary. During the tech bust, many firms laid off associates that only two or three years later they had to rehire at a significantly higher cost, plus the higher attrition rate and recruiting fees that come with it. Those firms that were known to lay off lawyers at the first sign of trouble had to pay dearly, and continue to pay, in the talent war that ensued. If there is a decrease in attorney complement, the cuts should be used to realign expectations as to performance, both at partner and at associate level. Especially during a recession, an overly busy partner does not have time to mind clients ' who need special care during difficult times.

The Role of the Business Plan

The firm's business plan should be the firm's working base. The CFO ' and the entire C-Suite ' should support the managing partner to evaluate whether the firm has strayed from the business plan, whether it needs revision in light of this new information. Does the strategic direction deserve a review because the recession will change the competitive environment? An economic downturn rarely calls for a complete realignment of the firm's long-term goals, but the decision to stick to the plan should be a conscious one, and not one made by default.

Fact: Balanced Performance Management, Based on Outside Information, Wins

In troubled times, CFOs will be tempted to manage their firms by the numbers ' internal numbers. Basic financial health and hygiene are important ' but they are a reflection of, and do not drive, the bigger picture. Those firms that review their direction and, in light of it, continue to manage by a balanced scorecard ' not just the numbers ' will continue to be successful. Instead of focusing exclusively on the current-year, profit-per-equity partners, they will not fail to make investments in services, professional development, and client relations. The most successful CFO will take a measured approach to managing firm profitability through a recession ' and will do so using a variety of numeric and non-numeric approaches, in harmony with their managing partners and the other C-Suite members.

Michael Roch is a partner with Kerma Partners. He advises law and other professional services firms on the economics of their practice and advises accounting firms on their competitive positioning. ' 2008 Kerma Partners

Few doubt that the U.S. economy is either dangerously close to a recession or already in one. There is equally little doubt that other global economies are weakening as liquidity further tightens and new bank write-downs emerge. There is a common perception that law firms also suffer when the economy goes bad. While it is true that transactions-oriented practice groups fare worse during times of economic slowdown, law firms generally fare well, irrespective of economic conditions, when compared with other business sectors. Both managing partner and CFO will instinctively return to the basics of law firm economics. To a degree, reviewing the basic drivers of profitability is a helpful exercise ' but this provides part of the answer. Irrespective of whether your firm is on the winning or losing side of a looming recession, undoubtedly the firm's finance department will be involved heavily in anticipating solutions to 'shore up for troubled times ahead.'

Watching New Matters

How far are we already into this slowdown? One of the key indicators of the future is the number of new matters by work type that the law firm opens. From which clients do they come? Which clients have decreased the number of matters they provide? Are certain industries more affected than others? By providing basic data on new business, the firm's finance department can provide useful insights into the future revenue of the firm. The finance department also can use this information as ammunition for a recession program ' require each partner to speak to those clients that constitute 80% of that partner's revenue about future business ' and use the opportunity to evaluate where the firm can add even more value.

Redefine What Data Drive Decisions

Beyond new matters, the time is right again to seek much closer cooperation with marketing. Most firms base their planning on internal data, ignoring the host of external data available to them. It is here where practice group structures break down and industry group structures shine. For example, as ethanol producers come under pressure, they will increase their regulatory speed, and consolidation of independent producers will increase, thus resulting in higher potential in the medium-term for the firm that specializes in this area. The law firm's accounting department, without working together with marketing, will not be able to help its firm and its partners plan for this. Even when the departments do work together, strategic planning will not be possible unless the firm makes investments in systems that can canvass and make use of these cyclical dynamics to the best advantage of the firm.

Roll the Budget for Planning Flexibility

A solid information base to make decisions about the future is critical. Yet, in most law firms, accounting continues to be based on historic, not forward-looking information. Unfortunately, with an information base that is largely historic, it is very difficult to project out future revenue, especially with an inflexible, annual planning cycle. For this reason, this author's firm, Kerma Partners, has long advocated that law firms do away with an annual planning cycle: It hits the firm at the wrong time of year ' in the late fall, a busy season for most lawyers, certainly transactional ones. It is inflexible ' the conditions in December 2007 reflected none of the revenue assumptions that were made in October 2006. A rolling budget, adjusted quarterly, shortens the budgeting process and is more able to cope with changing economic, and therefore revenue, assumptions, especially as clients adjust their buying behavior quickly.

With a sensible information base, the more traditional factors of profitability can be reviewed in their proper light.

Watching Declines in Leverage

In the United States, partnerships tend to reward individual performance more than team or firm-wide performance. In particular, in firms that reward individual production, when there is economic trouble ahead, the percentage of partner hours invariably increases. We find this true particularly in departments that already are weak performers within the firm. While there is a legitimate argument that clients demand more partner time to help them navigate troubled waters, when one scratches beyond the surface, more often than not partners choose to delegate less to ensure that they will be 'safe' for their annual review. The CFO's role is critical here: The sooner signs of work-hogging are detected, the earlier the practice group leader or managing partner can intervene to lessen its effect. Reviewing leverage across practice areas, at an office level and at a team level, should become a weekly or bi-weekly exercise, depending on the timekeeping disciplines within the firm.

Increasing Utilization When The Work Goes Dry

There are at least three aspects that affect utilization: availability of work, partner and senior associate delegation skills (see above), and timekeeping disciplines. The decrease of work in some teams and departments is an excellent reason to review the timekeeping practices of these teams and departments ' and to use what one has learned from these teams to review the firm's overall practices and disciplines. Investing in one finance team member's time to review a sample of time entries by a struggling team will soon pay dividends. In a training session designed around noncompliant practices, temporarily unproductive teams can at least be shown how to record all time in a way that minimizes written-down, written-off, or uncollected time.

The focus on time entries should be on completeness and projection of value. First, all time spent working on firm matters, whether at the office or not, should be recorded. In particular, lunch hours, travel time, and e-mail time management are constant culprits of under-recorded time. Second, and more importantly, all time entries must convey that the client receives value for the time spent. Every task should enable the client to understand what work was performed, why it was performed, and why the performance of this work, at this time, and at this level of timekeeper, provided value to the engagement at this time. It is here where most law firms can significantly improve their timekeeping.

Pricing As a Means to Counteract Decreasing Market Share

To be successful, firms need to have a clear understanding of: 1) what markets they serve relative to their competition, 2) what is their value proposition, and 3) what are their competitive differentiators. An unclear definition in any area, or a lack of one, exposes a firm to too many competitive pressures. This lack of clarity slowly tears at the firm's fabric, forcing leadership to devote excessive time on internal issues, especially when the economy slows down. The firm's pricing paradigm, and therefore also its rate structure, directly relate to the above three understandings. Three issues must be addressed: The firm's rate structure, the firm's pricing management practices, and the firm's pricing paradigms.

Law firms are achieving ever-higher hourly rates. During the last boom in 2005-2006, hourly rates in the global financial centers have reached and exceeded the $1,000 per hour sound barrier. This is good news for law firms in the short-term, but bad news in the medium-term; during times of economic trouble, clients are much more sensitive to their lawyers' hourly rates and, facing cost pressures themselves, care little about the fact that the cost of the associate complement has skyrocketed during the last three years. CFOs should encourage their staff to take initiative at several levels. The firm's rate structure, especially among partners, must be rational and based on each lawyer's relative 'worth' to the market, instead of internal factors of seniority, equality of practice areas, or other invalid reasons. Second, finance staff should take the initiative and, working with their marketing counterparts, find ways to help partners convey to their clients their unique value compared with competitors, and provide clients with the tools to achieve the best rate among their clients.

Most firms have a difficult time implementing the above suggestions because the pricing function falls between two departments: finance and marketing. Neither is responsible for ensuring that the firm always achieves the best price (that's the partners' responsibility in most firms), and neither has all skills and information available to assist partners in sound pricing decisions. The only thing that pricing and the finance department have in common is numbers, and as a result accountants focus on what they know ' the effective rate, which is almost always based on internal considerations (budgeted profit). However, pricing is primarily a marketing function, but often marketing does not have either the skill or the external financial data available to assist partners in making sound pricing decisions. A forward-looking CFO will take an economic downturn as an opportunity to recommend and implement a sweeping reform in how pricing is managed at the firm. Pricing requires a central management function, as well as data, people, and systems to enable the firm to differentiate itself from its competitors ' and to enable the firm and its partners to be sufficiently confident to state what price the firm is willing to accept at what terms and what price the firm is not willing to accept.

Progressive law firms manage to redefine the relationship with their clients, especially when recession looms: It is at this time that clients are looking to cut costs, including their legal costs. This is a prime time for law firms to examine their key client relationships and, through discussions with their clients, gain a new understanding of the client's value drivers, and thus change the pricing paradigm with particular clients. In the face of $1,000 hourly rates and bad times, clients are more and more demanding that their law firms find ways to charge less and to share risks with them. While most work continues to get billed by the hour, the leading upper-mid market firms all have negotiated contracts in place with their key clients for certain types of work. For instance, a struggling M&A department should examine the last 10 transactions for its key clients and determine where it has provided superior value and where it has not. It can use this information to find common aspects of transactions that provide superior value and put in place a pricing arrangement that provides a potential upside to both client and firm if it completes successfully. Litigation can be equally creative, and probably more so: Litigation tends to have a predefined path around which price points can be structured.

There is a perception that work done on anything other than an hourly rate basis is, by definition, unprofitable. A different pricing paradigm also requires different pricing practices: For instance, an engagement now done on a fixed-fee basis will be unprofitable if its timekeepers continue to think they have an open clock to get the work done. Changing the pricing paradigm invariably leads to an examination of how the work is executed which, in turn, usually leads to efficiencies for the firm, and to the client: a potent combination when clients seek to cut costs.

Financial Hygiene and Working Capital

Conserve cash ' sensibly. A looming recession is an excellent excuse to review goals for inventory and collection age. This should be done at the partner and the client levels. CFOs can add tremendous value by providing the required ammunition to the partners to have conversations with their clients about payment terms, and to their managing partners to have conversations with their flock about paying attention to financial hygiene.

Controlling Margin: The Baby and the Bath Water

When the economy is growing, firms often invest in client-satisfaction programs, professional development, delegation, associate development, and learning because these are times when one can afford to do the right things. Upon the looming of an economic downturn, there is a tendency for the focus to return to the money. The unstated expectation of the CFO is to take charge of all performance management and impose the 'tried and true' cost accounting regime in an effort to protect the profit per equity partner number. While a close look at the firm's finances is certainly in order, there is a tendency to overemphasize short-term profitability among the other important areas of performance, at which the firm must continue to do well if it is to be profitable long-term. The CFO invariably will be asked to review the firm's costs to see whether there is room for reduction. Unless there is an immediate liquidity crisis, care must be taken to decrease costs in a way that is productive in the medium-term.

Productive activities include a review of the firm's leasing situation to determine whether its office locations are put to best use. For instance, the firm may ask itself whether its word processing department must occupy space in expensive downtown Manhattan or whether an administrative support center in a less expensive location will do. The firm also wants to evaluate which parts of its operations it should retain in-house and which parts its should contract out to specialists (I intentionally do not use the word 'outsourcing' here). The CFO should not stop at evaluating operations: Can certain parts of legal work be done at a less expensive location? Discovery, file review, and due diligence are prime activities that, with proper procedures in place, do not need to be done on Park Avenue by expensive personnel (who are under-challenged by the work) in expensive space. Reviewing vendor relationships to negotiate higher discounts for faster payment also is a productive activity.

Misdirected activities in a quest to cut margin can take several forms. For example, it is generally unproductive to cut on 21st century professional services. We continue to meet 'transactional' firms where personal digital assistants are reserved only for senior associates or partners ' and one-half of a finance person is employed to ensure that all personal phone calls get re-charged to the lawyer involved. In most firms, once professional personnel and rent is accounted for, the remaining overhead often does not account for more than 10% of the firm's profits. Any of the measures outlined above will do more to maintain profitability than most costs that can conceivably be cut out of a law firm's budget.

Misdirected activities also cut the firm's professional complement carelessly. Clearly those departments whose primary work has been to package mortgages into Collateralized Debt Obligations will wonder where future work will come from, making layoffs necessary. However, all downturns are temporary. During the tech bust, many firms laid off associates that only two or three years later they had to rehire at a significantly higher cost, plus the higher attrition rate and recruiting fees that come with it. Those firms that were known to lay off lawyers at the first sign of trouble had to pay dearly, and continue to pay, in the talent war that ensued. If there is a decrease in attorney complement, the cuts should be used to realign expectations as to performance, both at partner and at associate level. Especially during a recession, an overly busy partner does not have time to mind clients ' who need special care during difficult times.

The Role of the Business Plan

The firm's business plan should be the firm's working base. The CFO ' and the entire C-Suite ' should support the managing partner to evaluate whether the firm has strayed from the business plan, whether it needs revision in light of this new information. Does the strategic direction deserve a review because the recession will change the competitive environment? An economic downturn rarely calls for a complete realignment of the firm's long-term goals, but the decision to stick to the plan should be a conscious one, and not one made by default.

Fact: Balanced Performance Management, Based on Outside Information, Wins

In troubled times, CFOs will be tempted to manage their firms by the numbers ' internal numbers. Basic financial health and hygiene are important ' but they are a reflection of, and do not drive, the bigger picture. Those firms that review their direction and, in light of it, continue to manage by a balanced scorecard ' not just the numbers ' will continue to be successful. Instead of focusing exclusively on the current-year, profit-per-equity partners, they will not fail to make investments in services, professional development, and client relations. The most successful CFO will take a measured approach to managing firm profitability through a recession ' and will do so using a variety of numeric and non-numeric approaches, in harmony with their managing partners and the other C-Suite members.

Michael Roch is a partner with Kerma Partners. He advises law and other professional services firms on the economics of their practice and advises accounting firms on their competitive positioning. ' 2008 Kerma Partners