An Economic and Demographic Case for Alternative Fee Arrangements

While much has been said about providing certainty to clients on legal bills and sharing risk to create a mutuality of interests, the bottom line is the absolute mandate from clients to reduce legal spending. It is driven by economic necessity and “C” suite mandate. Ignore this fundamental precept at your own risk. It is the top priority, according to a recent Association of Corporate Counsel (“ACC”) study.

To set the stage, let's quickly review how law firm partners make money. The practice of law is a revenue-per-timekeeper dominated activity, which is the net yield of three factors: chargeable hours, hourly rate (time value), and realization (the percentage of time value collected). Further profitability comes from controlling margin and utilizing leverage. No law firm has been able to escape this very basic economic fact, unless it has expanded beyond professional service into some sort of ancillary business.

Figure 1, below, shows how those metrics have changed over the years, using data from the archives of the Survey of Law Firm Economics (an ALM Legal Intelligence Survey). The period 1985 (the earliest we have good data on all of the metrics) to 2008 includes periods of economic expansion and contraction.

[IMGCAP(1)]

These are profession data points. Big law firms have different values for each metric, but have experienced similar changes over time. We can see that rates are up and realization is down, but not nearly so much as to significantly mitigate the power of rising rates. Partners are working many more chargeable hours (and many more marketing hours on top) while associates have slightly elevated hours.

Lawyer leverage is up, driven mostly over the last 10 years by an explosion in non-equity partner positions. And with the turmoil in the marketplace over the last 18 months, the law firm pyramid is reshaping itself into a diamond, with its above-center bulge filled out with very senior associates and non-equity partners (all high-priced in both rate and compensation). Paralegal leverage is up slightly, and may be destined for even higher levels as first- and second-year associate billable hours drop. Staffing ratios have decreased as technology takes a basic foothold in the profession (much more could and should be done with technology ' but that is best left for another article and another day).

And finally, margin has decreased as the cost of people (including benefits), space and technology (including communications and collaboration tools in law firms that now routinely span the globe) have risen. Figure 2, below, puts these metrics into an indexed ranking and shows where inflation falls relative to pricing/realization. Indexing simply reduces each metric to a ratio of the most current year (2008) to the base year (1985). It permits easy comparisons of different metrics and how each changes over time.

[IMGCAP(2)]

So now it is apparent that revenue per timekeeper (the most influential factor in profitability) has improved primarily with pricing (even net of realization decreases) well in excess of inflation, assisted by a solid boost in hours billed at the partner level.

And this brings us to the economic case for AFAs. Eighty percent of respondents in a recent study by the ACC indicated that reducing outside counsel legal spending is their top concern, the first time in three years that this is the case. Some may argue that such a reduction can be accomplished by bringing more work in-house and forgoing some work altogether. However, it seems doubtful that significant and sustainable gains will be made in this way. Instead, it is more likely that clients will make a concerted effort to get more work from outside counsel at a given price (efficiency gains) and/or gain absolute price reductions.

Also in the ACC study, in-house counsel “predict” (some might say have just signaled their position) that outside counsel billing rates will not increase for 2010 ' the first time in the nine years this study has been conducted. If the ACC “prediction” proves true, what will the next decade look like? If law firms forgo even one year of pricing increases, that increase is likely gone for good, as is the compound effect of that increase going forward.

Billing rate increases are generated from additional experience and value as well as inflation. The curve in Figure 3, below, illustrates the profession's experience/value curve in pricing.

[IMGCAP(3)]

As this graph demonstrates, there is a modest, gently upward-sloping value curve until very late in a lawyer's career. At that point, many in the profession are backing away from the practice of law for a variety of reasons. However, this generally upward curve's effect on revenues is mitigated by the profile of chargeable hours based on years of experience. The graph in Figure 4, below, demonstrates that the highest number of chargeable hours typically comes in the sixth to seventh year. From then, hours recorded follow a downward trend. Certainly, partner hours today are higher than they were two decades ago, but there still remains a decline in partner hours as they age. This does not play well in a profession that is aging ' and presents a demographic argument to abandon hourly billing.

[IMGCAP(4)]

Revenue continues to grow over a career because of rate increases, as is seen in Figure 5, below. And that reflects only the experience/value portion of the rate increases.

[IMGCAP(5)]

But what if rates don't go up, only go up a little, or even decline? Remember what the GCs indicated about reducing (not restraining the growth of) payments for outside counsel. The easiest way to do that is to mandate discounts ' rate reductions in a more palatable form. What might a new rate curve look like? It may very well show absolute reductions across the board and more severe reductions as experience decreases. We already are aware of clients pushing back on the use of first and second year lawyers because of cost versus value.

We do not see a good end game as long as law firm revenues are premised on hourly rates and hourly billing. Clearly, lawyers need to improve efficiency in delivering services to clients. But the benefit of those efficiencies under the current structure are likely to inure mainly, if not entirely, to the client.

Fixed or Results-Based Fees

The answer is to change to fee structures that allow the provider to retain those additional efficiencies. This is the heart of AFAs ' discerning a means to charge for services that is not time based so that efficiencies in delivering those services can be captured by the service provider. Clients will still bargain hard to achieve their top priority of reduced spending, and law firms will need to re-engineer how they do the work, but if done right, the benefits can accrue to those firms.

Therefore, AFAs must alter the focus from rate and hours to something else. That something else can be an agreed upon fixed fee or results. Either way, you will move the conversation away from the time to do the work to the client's perception of the value of the work.

Fixed fees generally work best on matters where the process and outcomes are generally well known in advance, are subject to minimal variation from matter-to-matter, and where there are a significant quantity of matters to handle.

Result pricing is evident in contingency or percentage fees ' the lawyer's compensation is directly tied to the result obtained for the client.

Each approach has different risk and return characteristics. And each has an infinite number of permutations, limited only by creativity. For example, many years ago, a law firm partner had an epiphany when looking to capture a larger share of a key client's work. This partner understood the client's business model and what levers applied to a successful venture. The client was a developer, and the partner offered a fixed price per square foot to cover legal work from project inception to completion. It was a hit because the key lever for this client was costs per square foot. The pricing worked for both sides. The client had certainty with respect to legal costs in a way that aligned with how ventures were assembled. The partner had a thick portfolio of projects, mostly large, that would keep the team busy and generate ample fees.

Some law firms are investing time to examine their legal services delivery model to identify and reduce inefficiencies and waste. Using project management techniques, the same sort of principles used in other business functions and in other industries, law firms can reduce variation in the delivery of standard legal services, and learn to better forecast the costs and time needed for the many non-standard legal services.

The Language Of Business

Of course, many lawyers believe that their particular practice consists entirely of non-routine elements that are impossible to predict and which contain too many variables, making reasonable prediction impossible. These lawyers are often surprised to learn that the art of practicing law contains no more uncertainties or variables than other complex business processes, such as designing and constructing a building over multiple years with multiple suppliers, vendors and materials. A consistent approach to project management techniques provides a greater level of certainty over many variables, and provides a framework to deal with the unknown. Furthermore, lawyers who embrace project-management techniques are learning to speak the language of business. This will assist them in serving as more capable advisors to business clients.

Take the initiative to alter the discussion from time to value. Do it now ' because the aging lawyer population is on a downward hours path and faces a severely limited pricing environment.

We have known for some time that the law profession is aging. Until now, the effect that such aging could have on law firm revenues has been entirely masked by law firms raising hourly billing rates well in excess of general inflationary pressures, rising costs of operations and the increased experience of its practitioners. Now we are in an environment where competitive and market forces will almost certainly alter the ability to raise hourly billing rates consistent with historic patterns. The time has come to embrace alternatives to hourly pricing.

Alternative Fee Arrangements (“AFAs”) include pricing schemes that are not based on the billable hour. This excludes discounted and blended rate programs here, even though they are techniques frequently used by the profession.

Client Mandate

While much has been said about providing certainty to clients on legal bills and sharing risk to create a mutuality of interests, the bottom line is the absolute mandate from clients to reduce legal spending. It is driven by economic necessity and “C” suite mandate. Ignore this fundamental precept at your own risk. It is the top priority, according to a recent Association of Corporate Counsel (“ACC”) study.

To set the stage, let's quickly review how law firm partners make money. The practice of law is a revenue-per-timekeeper dominated activity, which is the net yield of three factors: chargeable hours, hourly rate (time value), and realization (the percentage of time value collected). Further profitability comes from controlling margin and utilizing leverage. No law firm has been able to escape this very basic economic fact, unless it has expanded beyond professional service into some sort of ancillary business.

Figure 1, below, shows how those metrics have changed over the years, using data from the archives of the Survey of Law Firm Economics (an ALM Legal Intelligence Survey). The period 1985 (the earliest we have good data on all of the metrics) to 2008 includes periods of economic expansion and contraction.

[IMGCAP(1)]

These are profession data points. Big law firms have different values for each metric, but have experienced similar changes over time. We can see that rates are up and realization is down, but not nearly so much as to significantly mitigate the power of rising rates. Partners are working many more chargeable hours (and many more marketing hours on top) while associates have slightly elevated hours.

Lawyer leverage is up, driven mostly over the last 10 years by an explosion in non-equity partner positions. And with the turmoil in the marketplace over the last 18 months, the law firm pyramid is reshaping itself into a diamond, with its above-center bulge filled out with very senior associates and non-equity partners (all high-priced in both rate and compensation). Paralegal leverage is up slightly, and may be destined for even higher levels as first- and second-year associate billable hours drop. Staffing ratios have decreased as technology takes a basic foothold in the profession (much more could and should be done with technology ' but that is best left for another article and another day).

And finally, margin has decreased as the cost of people (including benefits), space and technology (including communications and collaboration tools in law firms that now routinely span the globe) have risen. Figure 2, below, puts these metrics into an indexed ranking and shows where inflation falls relative to pricing/realization. Indexing simply reduces each metric to a ratio of the most current year (2008) to the base year (1985). It permits easy comparisons of different metrics and how each changes over time.

[IMGCAP(2)]

So now it is apparent that revenue per timekeeper (the most influential factor in profitability) has improved primarily with pricing (even net of realization decreases) well in excess of inflation, assisted by a solid boost in hours billed at the partner level.

And this brings us to the economic case for AFAs. Eighty percent of respondents in a recent study by the ACC indicated that reducing outside counsel legal spending is their top concern, the first time in three years that this is the case. Some may argue that such a reduction can be accomplished by bringing more work in-house and forgoing some work altogether. However, it seems doubtful that significant and sustainable gains will be made in this way. Instead, it is more likely that clients will make a concerted effort to get more work from outside counsel at a given price (efficiency gains) and/or gain absolute price reductions.

Also in the ACC study, in-house counsel “predict” (some might say have just signaled their position) that outside counsel billing rates will not increase for 2010 ' the first time in the nine years this study has been conducted. If the ACC “prediction” proves true, what will the next decade look like? If law firms forgo even one year of pricing increases, that increase is likely gone for good, as is the compound effect of that increase going forward.

Billing rate increases are generated from additional experience and value as well as inflation. The curve in Figure 3, below, illustrates the profession's experience/value curve in pricing.

[IMGCAP(3)]

As this graph demonstrates, there is a modest, gently upward-sloping value curve until very late in a lawyer's career. At that point, many in the profession are backing away from the practice of law for a variety of reasons. However, this generally upward curve's effect on revenues is mitigated by the profile of chargeable hours based on years of experience. The graph in Figure 4, below, demonstrates that the highest number of chargeable hours typically comes in the sixth to seventh year. From then, hours recorded follow a downward trend. Certainly, partner hours today are higher than they were two decades ago, but there still remains a decline in partner hours as they age. This does not play well in a profession that is aging ' and presents a demographic argument to abandon hourly billing.

[IMGCAP(4)]

Revenue continues to grow over a career because of rate increases, as is seen in Figure 5, below. And that reflects only the experience/value portion of the rate increases.

[IMGCAP(5)]

But what if rates don't go up, only go up a little, or even decline? Remember what the GCs indicated about reducing (not restraining the growth of) payments for outside counsel. The easiest way to do that is to mandate discounts ' rate reductions in a more palatable form. What might a new rate curve look like? It may very well show absolute reductions across the board and more severe reductions as experience decreases. We already are aware of clients pushing back on the use of first and second year lawyers because of cost versus value.

We do not see a good end game as long as law firm revenues are premised on hourly rates and hourly billing. Clearly, lawyers need to improve efficiency in delivering services to clients. But the benefit of those efficiencies under the current structure are likely to inure mainly, if not entirely, to the client.

Fixed or Results-Based Fees

The answer is to change to fee structures that allow the provider to retain those additional efficiencies. This is the heart of AFAs ' discerning a means to charge for services that is not time based so that efficiencies in delivering those services can be captured by the service provider. Clients will still bargain hard to achieve their top priority of reduced spending, and law firms will need to re-engineer how they do the work, but if done right, the benefits can accrue to those firms.

Therefore, AFAs must alter the focus from rate and hours to something else. That something else can be an agreed upon fixed fee or results. Either way, you will move the conversation away from the time to do the work to the client's perception of the value of the work.

Fixed fees generally work best on matters where the process and outcomes are generally well known in advance, are subject to minimal variation from matter-to-matter, and where there are a significant quantity of matters to handle.

Result pricing is evident in contingency or percentage fees ' the lawyer's compensation is directly tied to the result obtained for the client.

Each approach has different risk and return characteristics. And each has an infinite number of permutations, limited only by creativity. For example, many years ago, a law firm partner had an epiphany when looking to capture a larger share of a key client's work. This partner understood the client's business model and what levers applied to a successful venture. The client was a developer, and the partner offered a fixed price per square foot to cover legal work from project inception to completion. It was a hit because the key lever for this client was costs per square foot. The pricing worked for both sides. The client had certainty with respect to legal costs in a way that aligned with how ventures were assembled. The partner had a thick portfolio of projects, mostly large, that would keep the team busy and generate ample fees.

Some law firms are investing time to examine their legal services delivery model to identify and reduce inefficiencies and waste. Using project management techniques, the same sort of principles used in other business functions and in other industries, law firms can reduce variation in the delivery of standard legal services, and learn to better forecast the costs and time needed for the many non-standard legal services.

The Language Of Business

Of course, many lawyers believe that their particular practice consists entirely of non-routine elements that are impossible to predict and which contain too many variables, making reasonable prediction impossible. These lawyers are often surprised to learn that the art of practicing law contains no more uncertainties or variables than other complex business processes, such as designing and constructing a building over multiple years with multiple suppliers, vendors and materials. A consistent approach to project management techniques provides a greater level of certainty over many variables, and provides a framework to deal with the unknown. Furthermore, lawyers who embrace project-management techniques are learning to speak the language of business. This will assist them in serving as more capable advisors to business clients.

Take the initiative to alter the discussion from time to value. Do it now ' because the aging lawyer population is on a downward hours path and faces a severely limited pricing environment.