Alternative Fee Arrangements

With clients seeking savings and a greater degree of predictability in their outside legal spend, alternative fee arrangements are becoming more common. Fulbright's 6th Annual Litigation Trends Survey of senior corporate counsel reveals that more than a third of the respondents increased their use of alternative fee arrangements because of the economic downturn. See Fulbright's 6th Annual Litigation Trends Survey Report, Fulbright & Jaworski L.L.P. (2009) at 3. Yet law firms are concerned that changing their fee models will negatively impact profitability. How can a law firm choose a fee arrangement that is beneficial for the client and calculated to be profitable for the firm? Once that fee is set, how can the law firm best manage the engagement to ensure sustained profitability? How can it measure profitability in this new environment?

Aligning the Law Firm's Perspective to the Client's

Perhaps the most important preliminary step in effectively implementing alternative fee arrangements is to understand the client's business goals and align the law firm's cost structure to provide services within the price expectations of the client. Clients are seeking lower legal fees and costs, and they also want those fees and costs to be predictable. For some clients, predictability may be as important as the actual amount.

Clients also want value from their outside counsel. They want broader thinking: consideration of not only the “best” handling of the matter, but also of what will “do the job”; a game plan; clarity of objectives; and anticipation and management of difficulties. Clients want proactive risk management in areas with ongoing claims ' a program that is designed to reduce risk and a fee structure that offers rewards when the risks actually decrease.

Finally, clients want fee structures that encourage efficiency, knowledge, and assessment of cost drivers and their value to the client, as well as management of internal and external resources to keep costs down. See also the Association of Corporate Counsel's Value Challenge for a discussion of corporate clients' quest for value in legal representation. ” ' [T]he ACC Value Challenge is based on the concept that firms can greatly improve the value of what they do, reduce their costs to corporate clients and still maintain strong profitability,” www.acc.com/valuechallenge/, quoting Michael Roster, Chairman, ACC Value Challenge Steering Committee.

Related to this is clients' expectations that outside counsel will share some of the financial risk associated with legal fees. Risk sharing encourages outside counsel to estimate the fixed components of the fee structure more accurately and to manage the staffing and other aspects of the engagement more efficiently.

Law firms can successfully meet client needs, implementing alternative fee arrangements while maintaining or improving profitability, by shifting their goals to match those of their clients. In-house law departments are moving toward using law firms in a more-focused, strategic manner, and this change often involves decreasing the number of law firms used to fully leverage buying power. Law firms that want to ensure “a place at the table” will:

• Provide the appropriate quality advice at the suitable cost, based on what the specific matter warrants;
• Achieve a balance between quality and efficiency;
• Leverage data from time and billing systems;
• Identify creative solutions (not just options);
• Increase financial certainty and billing efficiency;
• Partner with law departments to develop budgets and fee approaches, with a demonstrated willingness to share in the financial risk;
• Communicate frequently and openly (early, often, and decisively ' there should be no surprises); and
• Reduce administrative and operating costs through strategic sourcing.

Choosing the Fee Arrangement

There are a variety of pricing structures a law firm can offer that may support its clients' goals better than traditional hourly billing. Alternative fee arrangements include anything that is not purely “time and materials” based. Examples include estimates, fixed fees, capped fees, success fees, cost-plus pricing, retainers, volume discounts, and/or standard hourly and special hourly rates. Choosing the best fee arrangement should be based on an assessment of the specific client and its needs, analysis of the matter type, and a data-based evaluation of the financial factors involved.

Which clients are good candidates for alternative fee arrangements? A variety of issues can be taken into consideration. Some of these client characteristics are outlined in Table 1.

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The choice of fee arrangement is a financial decision and risk assessment for the law firm. Major financial drivers that affect the law firm's cost to do the work include the nature of the practice, the type of work or matter, the location of the work, and the client's requirements. Through modeling or other means, the law firm can balance these drivers against an evaluation of the total utilization of partners, associates, and staff on the client's engagement to assess potential fee arrangements (and incidentally, identify opportunities for improved efficiencies). Historical data gleaned from the law firm's billing records are very useful for this analysis.

Pros and cons from the law firm and client perspectives of several of the most common alternative fee arrangements are listed in Table 2.

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Managing Profitability

The growing trend toward alternative fee structures has necessitated a rethinking of how law firms manage work in order to achieve or maintain their profit margins. Establishing and managing an efficient staffing structure can have the greatest impact on profitability of alternative fee arrangements. An approach that allocates resources based on the value of the work not only optimizes a law firm's use of its own resources, but also corresponds with law departments' focus on balancing cost and value. Thus, higher-value work, such as “bet the company” cases, calls for staffing at a higher level of expertise. Because of its value, the client will pay a correspondingly higher fee for this work. Staffing of routine work that is not high risk can be leveraged such that most of the work is done by lower-level timekeepers, with a correspondingly lower fee structure. Some repetitive tasks can even be outsourced to third-party providers.

Examples of some general staffing and rate structures commensurate with the nature of the work are illustrated in Table 3. By managing staffing to support the appropriate model for the work, a law firm can control its costs and manage profitability. Law firms that strategically partner with their clients in this way often see an eventual increase in revenues from those clients.

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Measuring Profitability

How can a law firm meaningfully measure its profitability in this changing environment? Timekeeping still plays an important role, regardless of fee arrangement, but cannot be the sole measure of profitability. A few profitability measures that transcend a variety of fee arrangements include the following:

• Utilization Rate: The attorney and staff hours “worked” as a percentage of hours available to work;
• Average Bill Rate: The amount billed in a period divided by hours charged or worked;
• Leverage: The ratio of fee-earning staff to partners;
• Profit Multiple: Fees earned divided by fee earner salaries (including partner notional salaries); and
• Overhead Rate: Overhead costs as a percentage of fees earned.

The key is establishing baselines for these metrics and routinely measuring and learning from the results, allowing a law firm to assess the profitability of specific matters and fee arrangements and of the firm as a whole. The law firm can use the resulting information to manage staffing and costs to maintain or enhance profitability. The information can also improve the law firm's ability to develop future fee arrangements that will both meet client needs and maintain law firm profits.

Conclusion

Forward-looking law firms are responding in innovative ways to their clients' clearly stated need for cost control and value. They are beginning to look at structured project management as a strategic tool for helping to manage their cases and profitability. Those firms that also intelligently develop their fee structures based on available data, and manage the work according to defined staffing models and measure their performance, can confidently expect long-term profitability.

Bret Baccus, a member of this newsletter's Board of Editors, is a director in Huron Consulting Group's Legal Consulting practice. His team, which includes contributor Fraya Lynn Hirschberg, provides services that add value to corporate legal departments and law firms by helping to reduce legal spend, enhance client service delivery, and increase operational effectiveness. Baccus can be contacted at [email protected].

With clients seeking savings and a greater degree of predictability in their outside legal spend, alternative fee arrangements are becoming more common. Fulbright's 6th Annual Litigation Trends Survey of senior corporate counsel reveals that more than a third of the respondents increased their use of alternative fee arrangements because of the economic downturn. See Fulbright's 6th Annual Litigation Trends Survey Report, Fulbright & Jaworski L.L.P. (2009) at 3. Yet law firms are concerned that changing their fee models will negatively impact profitability. How can a law firm choose a fee arrangement that is beneficial for the client and calculated to be profitable for the firm? Once that fee is set, how can the law firm best manage the engagement to ensure sustained profitability? How can it measure profitability in this new environment?

Aligning the Law Firm's Perspective to the Client's

Perhaps the most important preliminary step in effectively implementing alternative fee arrangements is to understand the client's business goals and align the law firm's cost structure to provide services within the price expectations of the client. Clients are seeking lower legal fees and costs, and they also want those fees and costs to be predictable. For some clients, predictability may be as important as the actual amount.

Clients also want value from their outside counsel. They want broader thinking: consideration of not only the “best” handling of the matter, but also of what will “do the job”; a game plan; clarity of objectives; and anticipation and management of difficulties. Clients want proactive risk management in areas with ongoing claims ' a program that is designed to reduce risk and a fee structure that offers rewards when the risks actually decrease.

Finally, clients want fee structures that encourage efficiency, knowledge, and assessment of cost drivers and their value to the client, as well as management of internal and external resources to keep costs down. See also the Association of Corporate Counsel's Value Challenge for a discussion of corporate clients' quest for value in legal representation. ” ' [T]he ACC Value Challenge is based on the concept that firms can greatly improve the value of what they do, reduce their costs to corporate clients and still maintain strong profitability,” www.acc.com/valuechallenge/, quoting Michael Roster, Chairman, ACC Value Challenge Steering Committee.

Related to this is clients' expectations that outside counsel will share some of the financial risk associated with legal fees. Risk sharing encourages outside counsel to estimate the fixed components of the fee structure more accurately and to manage the staffing and other aspects of the engagement more efficiently.

Law firms can successfully meet client needs, implementing alternative fee arrangements while maintaining or improving profitability, by shifting their goals to match those of their clients. In-house law departments are moving toward using law firms in a more-focused, strategic manner, and this change often involves decreasing the number of law firms used to fully leverage buying power. Law firms that want to ensure “a place at the table” will:

• Provide the appropriate quality advice at the suitable cost, based on what the specific matter warrants;
• Achieve a balance between quality and efficiency;
• Leverage data from time and billing systems;
• Identify creative solutions (not just options);
• Increase financial certainty and billing efficiency;
• Partner with law departments to develop budgets and fee approaches, with a demonstrated willingness to share in the financial risk;
• Communicate frequently and openly (early, often, and decisively ' there should be no surprises); and
• Reduce administrative and operating costs through strategic sourcing.

Choosing the Fee Arrangement

There are a variety of pricing structures a law firm can offer that may support its clients' goals better than traditional hourly billing. Alternative fee arrangements include anything that is not purely “time and materials” based. Examples include estimates, fixed fees, capped fees, success fees, cost-plus pricing, retainers, volume discounts, and/or standard hourly and special hourly rates. Choosing the best fee arrangement should be based on an assessment of the specific client and its needs, analysis of the matter type, and a data-based evaluation of the financial factors involved.

Which clients are good candidates for alternative fee arrangements? A variety of issues can be taken into consideration. Some of these client characteristics are outlined in Table 1.

[IMGCAP(1)]

The choice of fee arrangement is a financial decision and risk assessment for the law firm. Major financial drivers that affect the law firm's cost to do the work include the nature of the practice, the type of work or matter, the location of the work, and the client's requirements. Through modeling or other means, the law firm can balance these drivers against an evaluation of the total utilization of partners, associates, and staff on the client's engagement to assess potential fee arrangements (and incidentally, identify opportunities for improved efficiencies). Historical data gleaned from the law firm's billing records are very useful for this analysis.

Pros and cons from the law firm and client perspectives of several of the most common alternative fee arrangements are listed in Table 2.

[IMGCAP(2)]

Managing Profitability

The growing trend toward alternative fee structures has necessitated a rethinking of how law firms manage work in order to achieve or maintain their profit margins. Establishing and managing an efficient staffing structure can have the greatest impact on profitability of alternative fee arrangements. An approach that allocates resources based on the value of the work not only optimizes a law firm's use of its own resources, but also corresponds with law departments' focus on balancing cost and value. Thus, higher-value work, such as “bet the company” cases, calls for staffing at a higher level of expertise. Because of its value, the client will pay a correspondingly higher fee for this work. Staffing of routine work that is not high risk can be leveraged such that most of the work is done by lower-level timekeepers, with a correspondingly lower fee structure. Some repetitive tasks can even be outsourced to third-party providers.

Examples of some general staffing and rate structures commensurate with the nature of the work are illustrated in Table 3. By managing staffing to support the appropriate model for the work, a law firm can control its costs and manage profitability. Law firms that strategically partner with their clients in this way often see an eventual increase in revenues from those clients.

[IMGCAP(3)]

Measuring Profitability

How can a law firm meaningfully measure its profitability in this changing environment? Timekeeping still plays an important role, regardless of fee arrangement, but cannot be the sole measure of profitability. A few profitability measures that transcend a variety of fee arrangements include the following:

• Utilization Rate: The attorney and staff hours “worked” as a percentage of hours available to work;
• Average Bill Rate: The amount billed in a period divided by hours charged or worked;
• Leverage: The ratio of fee-earning staff to partners;
• Profit Multiple: Fees earned divided by fee earner salaries (including partner notional salaries); and
• Overhead Rate: Overhead costs as a percentage of fees earned.

The key is establishing baselines for these metrics and routinely measuring and learning from the results, allowing a law firm to assess the profitability of specific matters and fee arrangements and of the firm as a whole. The law firm can use the resulting information to manage staffing and costs to maintain or enhance profitability. The information can also improve the law firm's ability to develop future fee arrangements that will both meet client needs and maintain law firm profits.

Conclusion

Forward-looking law firms are responding in innovative ways to their clients' clearly stated need for cost control and value. They are beginning to look at structured project management as a strategic tool for helping to manage their cases and profitability. Those firms that also intelligently develop their fee structures based on available data, and manage the work according to defined staffing models and measure their performance, can confidently expect long-term profitability.

Bret Baccus, a member of this newsletter's Board of Editors, is a director in Huron Consulting Group's Legal Consulting practice. His team, which includes contributor Fraya Lynn Hirschberg, provides services that add value to corporate legal departments and law firms by helping to reduce legal spend, enhance client service delivery, and increase operational effectiveness. Baccus can be contacted at [email protected].