Alternative Fee Arrangements

Although in-house counsel have been talking about Alternative Fee Agreements (AFA) for years, there has been little traction. Even in some conferences, counsel say they would rather have hours billed to them than work under an AFA. Clients know business risks, but lawyers tend to be risk-averse. Is the old business model still around because lawyers don't want the to assume risk? Is it because in-house counsel have vested interest in their structure to audit billable hours? Is it because they want to be able to ask for a discount on the hourly rates to prove they are getting a deal? Switching to a responsibly run alternative fee agreement will not only reduce the risk to the real client, but will motivate lawyers to be more responsible and much more efficient. Both the clients and the lawyers serving them can win.

The legal profession's business model has reached the end times. The old “hours times rate equals value” is disappearing at an accelerating rate. The tipping point has been reached. If law firms and in-house counsel are paying attention to books like Implementing Value Billing by Ronald J. Baker and publications like “The New Normal,” published in “Legal Rebels,” which you can see from time to time in ABA e-mails, the trend is evident. In the last six months, I have seen seven articles with examples on AFA. Is this the tipping point? Yes! Now is the time for the lawyer to prepare for the coming of AFA and create the infrastructure to deal with the implications of managing matters. Before AFA becomes the normal, in-house counsel and outside counsel must begin to test their delivery of service processes, matter budgeting, and project management.

Law firms and in-house counsel stand on common ground. They have clients. All professional service firms are subject to the shift to AFA, even though many may be uncomfortable with it because hourly billing is what they have used for over 40 years. So this article is presented as if you are an outside counsel or an inside counsel. Read this in that context.

Introduction

A few years ago, we asked a gathering of in-house counsel the following: Are you serious about AFA, or did you just default to hourly billing because you were comfortable with the approach? Because most of them had come out of law firms, they chose hours. But if lawyers talked to the CEO (the risk-taker) about AFA, he or she would be ready to try something that would reduce company risk and costs. If changes are to occur, there need to be leaders or leadership groups that will be willing to sign onto a change. The changes are difficult to accept because the change leaders are arguing against a 40-year history of hourly billing. So, is this a generation issue? Where do firms start? Do they start with the 30- to 40-year-olds, or will the leaders have to attack the 50- and 60-year-olds for the change to convince the younger people? Or will the world come crashing in on unprepared professionals who are forced into AFA without the preparation, experimentation, innovation, or trial runs?

More importantly, many law firms and businesses will not be able to make the change because of their hourly billing culture, the lack of skill sets such as project management, and the support systems, e.g., central values of collaboration and the focus on preserving and using accumulated knowledge. As one author put it in “The New Normal” mentioned above, lawyers will have to become system designers to get the full effect of their professional knowledge to their clients. See the June 8, 2011, posting by Paul Lippe. (www.abajournal.com/legalrebels/thenewnormal/). I have noted that more and more CLE courses are being offered on legal project management. Some people are getting the message.

Taking a Risk

Leaders and innovators in the legal profession have been writing and giving speeches on the need to move away from the billable hour since 1985. But the economic tail wind driving big law firms kept most from making the switch toward AFA. Only the law firms not in the “biglaw” group took the innovative steps to move to AFA and a better competitive position. The only exceptions to “biglaw” were some of the British-based firms such as Linklaters and their Blue Flag system. In the last few years with the down economy, many businesses are now seeking to reduce their risk and improve the quality of their legal services through discussions of AFA. To paraphrase one innovative partner: “If the general counsel will not listen, I will go to the founder or CEO who has the guts to take a risk with us and try AFA.” He also stated that “it is a waste of resources for counsel to audit hours when AFA works so well in reducing risk to the client and motivating the provider (law firm or counsel) to use the most efficient means possible to solve the client's problem.”

Starting with the basics, hourly billing is a cost accounting model. Businesses have found that using cost accounting pricing does not at all reflect the relative value the customer sees in the service and the product. The billable hour business model is a “cost plus” model that does not reflect the true value of professional services. Later in this article, there will be a value model that has appeared in almost all of the books addressed to professional service firms on pricing. Jay Shepherd of Prefix gives a great example in his article on “The Shower.” A lawyer spent 3.5 hours on a brief and dutifully wrote down the time amounting to $1,750. She then found the argument would not work due to a recent change in the law. But in the shower the next morning she had a stroke of genius on what the argument should be so she wrote down the 0.20 time she spent thinking about it, or $100. Since the 3.5 hours was a waste, shouldn't she write that off and then only bill $100 for the touch of brilliance? Jay and I would agree ' No! Bill the value added.

Tools

We will start with the Quality-Service Grid below, first published by Richard Whitely in “The Customer Driven Company,” and modified for law firms. As usual for consultants, we divide the world into four parts based upon a left-hand side of perceived quality of service and the bottom of usefulness to the client.

In this model, there are no commodity services. Only the client can define what is a commodity versus what is crucial. Regardless of what counsel thinks, the client has other ideas of what quality service is. The lawyer may provide technical quality, but if it does not pass the usefulness test (pricing, predictability, turnaround time, or other criteria), it does not pass the client's test for quality service.

The next tool is the Cobb Value Curve, also below. This takes the perceived quality of service and translates into the perceived value curve from the client. Again, different clients have different value curves. For some, it is a “you bet your company” issue, and for others it is a commodity. Perceived values vary from client to client depending on the impact on their position or the position of their company. For example, a small business owner may feel that a litigation matter is very threatening to the company, whereas a big corporation may feel that the issue is a commodity.

What do the terms in the model mean? A “Nuclear Event” is one that will kill the person's job or the company. Do hours matter here? No! The client wants someone who will save his or her company. Price is not an option. The “Hired for Experience” means the client is hiring a particular lawyer who can solve the problem in the most efficient and cost-effective way. “Brand Names Services” are those services that a client will typically seek from a brand-name firm or individual inside counsel for standard matters. In many cases, if the law firm is being hired, a discount in legal fees will be required. Finally, the “Commodity Services” are those that the client perceives any lawyer can handle. The lawyer with the lowest fee will be hired.

Note that services below the mid-line become more price-sensitive. This is one model that has made Alternative Fee Arrangements plausible, and that is why it shows up in the books on pricing legal services. An example: A client comes to a lawyer for an opinion. The lawyer, working on the hourly model, presents a bill for $15,000 for her services. A month later, another client comes to the lawyer with the same set of facts; much of the lawyer's previous research can be used. The client gets the opinion in half the time and a bill for $7,500. The first client should only have to pay $7,500 or the second client should get a bill for $15,000 because that was what it was really worth. The second client received better service and a better document, so why shouldn't he pay $15,000?

Or try this one: A very sophisticated real-estate investor hires a law firm to document a $1 million interim loan agreement. Because he does dozens of these deals a year, he could do it in-house, but goes to his brand-name firm because the bank requires an objective third party to document the transaction. He pays a discounted billing rate. On the other hand, a developer with one big deal a year goes to the same firm for the service. That deal is in the “hired for experience area” for this person. Why? Because the small developer is buying a different bundle of services. He wants a consultant, a reputation with the bankers, and 24/7 access to the team that will make or break his deal and his business.

Two Approaches

So there are two approaches. The old one is the “service leads to cost (based on billable rates) that leads to the price that leads to the client bill.” In the new business model, based upon AFA, the client determines the value, which leads to price, which leads to the investment by the firm (costs) and the services that will be required. This requires a laser-beam focus on what will be done, by whom, and when and where the service will be provided. The greatest example is “Blue Flag,” by Linklaters (see https://blueflag.linklaters.com). Also see Ron Baker's book, Implementing Value Pricing, page 150. Wiley Professional Value Services, 2010.

There is another use for the Cobb Value Curve ' staffing. In every major matter there are needs for expertise from particular partners, senior associates, other professionals, and even low-cost affiliates or outsourced assets. When the tasks are determined in the new business model, the lawyer in charge of the matter must determine which of these assets will be used when and how they will be used.

Action Items

Based on experience in law firms and many other studies in business, there are five basic steps lawyers should take in creating a basic model for AFA. Lawyers must start now if they are to be ready when the tipping point to the new business model comes in like a tsunami.

Step 1: Meet and inspire. Get the teams together with clients. Ask the clients what the value added is for them and what they expect you to do to meet those needs. They may have requirements that affect their future job evaluation or the company. Let the clients inspire your team to think the innovative way. One question I ask is: “If your client asks you to provide a fixed fee for the work given their budget, how would you respond? The challenge: You must respond without telling them you are billing by the hour.”

Step 2: Training. How much training have your lawyers and staff had in project management and sophisticated matter management? Do they have training in managing projects or are they just following the lead of the old business model i.e., the more hours they work, the more value they add? This must change and now.

Step 3: Forced experimentation. Make people provide estimates of what the fee should be for a particular client (use an old matter). Start at the bottom: The commodity services provided and even the task are only part of commodity services. Experiment with those services to find out what they should cost the client. For example, some clients have segmented what a deposition should cost for a floor supervisor, up to a manager, up to the CFO, and up to a CEO with respect to the time for preparation, deposition, and a debrief.

Step 4: Start slow. A recent article in The Harvard Business Review titled “P&G's Four Types of Innovation,” June 2011 p. 68, showed the change process that applies to this issue. A real-life example started with a general counsel and a law firm. They started with a two-day workshop on the changes needed based on client demands. Then they went to small-scale pilot programs in individual units and client teams. They implemented the changes over a five-year period, first group-wide, and finally firm-wide.

Step 5: Debriefs. As a lawyer, you need to debrief from work with your team, clients and with inside counsel on the matter that should be moved over to AFA. If you want the best results, bring in key people (I am not talking 20, I am talking about three to five) to work with you on a debrief of the matter, looking for ways to revise the process to save money and make the process more efficient with the same excellent results for you or the client.

Step 6: Measurements. Look at the key performance indicators (KPIs) such as the realization on the standard billing rates. If the standard billing rate for an attorney is $200 and because of AFA his time comes in at $300 after collection, the realization rate is 150%. The 50% is all profit.

Hard Questions

The first question. How can I trust my lawyers to be efficient or be able to control the use of the hours in fogging, churning, or rate transfer using AFA? “Fogging” is when lawyers put time into a file that adds no value. “Churning” involves running more people through a file than are necessary, e.g., bringing five or more people to a deposition when only two will suffice. “Rate transfer” is when a lawyer bills at his or her rate when the time should have been put in by lower-rate people. What does AFA buy? The law firm that assumes the risk receives the rewards for better management.

There are two options open to in-house counsel in the old versus the new business model. Build an internal staff to audit the billable hours and increase the cost to in-house clients, or move the risk to outside lawyers and make them assume the risk of becoming effective and efficient.

The second question. But what if my lawyers say that you cannot predict what the other side will do and cannot predict a fee? The answer is to ask them to break down the matter into areas they can predict versus those activities they cannot predict. One of my clients is able to predict initial discovery costs and can predict what each type of deposition will cost based upon where it falls on the value curve.

The third question. What about changes in scope? You will find the answer in Ron Baker's book, mentioned above, in his appendix. Both the in-house lawyers and the outside lawyers can reach agreements on what would cause a scope change, and plan for scope expansion. If tried, it can work. But are many in-house lawyers afraid to try it? Why? They do not trust their outside counsel. The key word is “trust.” If the arrangement is set up in a transparent and mutually beneficial manner, trust will build over time.

Summary

The new business model of AFA is coming. Sooner or later every lawyer, whether in-house or outside, will have to deal with it. The sooner lawyers start experimenting with AFA, the better they will be able to respond to client needs. The experiments must start internally as if AFA were already in place. You will find that some mistakes will be made at first, but innovations will start to be put in place that will enable the lawyer to quote a fixed fee to clients. You will find solutions one at a time until you feel comfortable with actually predicting the fees. Please get started before it is too late.

[IMGCAP(1)]

[IMGCAP(2)]

William C. Cobb, a member of this newsletter's Board of Editors, is the managing partner of Cobb Consulting (WCCI, Inc.), based in Houston. He has been a consultant in strategic issues affecting law firms and in-house counsel since 1978. E-mail: [email protected]. Website: http://www.cobb-consulting.com/.

Although in-house counsel have been talking about Alternative Fee Agreements (AFA) for years, there has been little traction. Even in some conferences, counsel say they would rather have hours billed to them than work under an AFA. Clients know business risks, but lawyers tend to be risk-averse. Is the old business model still around because lawyers don't want the to assume risk? Is it because in-house counsel have vested interest in their structure to audit billable hours? Is it because they want to be able to ask for a discount on the hourly rates to prove they are getting a deal? Switching to a responsibly run alternative fee agreement will not only reduce the risk to the real client, but will motivate lawyers to be more responsible and much more efficient. Both the clients and the lawyers serving them can win.

The legal profession's business model has reached the end times. The old “hours times rate equals value” is disappearing at an accelerating rate. The tipping point has been reached. If law firms and in-house counsel are paying attention to books like Implementing Value Billing by Ronald J. Baker and publications like “The New Normal,” published in “Legal Rebels,” which you can see from time to time in ABA e-mails, the trend is evident. In the last six months, I have seen seven articles with examples on AFA. Is this the tipping point? Yes! Now is the time for the lawyer to prepare for the coming of AFA and create the infrastructure to deal with the implications of managing matters. Before AFA becomes the normal, in-house counsel and outside counsel must begin to test their delivery of service processes, matter budgeting, and project management.

Law firms and in-house counsel stand on common ground. They have clients. All professional service firms are subject to the shift to AFA, even though many may be uncomfortable with it because hourly billing is what they have used for over 40 years. So this article is presented as if you are an outside counsel or an inside counsel. Read this in that context.

Introduction

A few years ago, we asked a gathering of in-house counsel the following: Are you serious about AFA, or did you just default to hourly billing because you were comfortable with the approach? Because most of them had come out of law firms, they chose hours. But if lawyers talked to the CEO (the risk-taker) about AFA, he or she would be ready to try something that would reduce company risk and costs. If changes are to occur, there need to be leaders or leadership groups that will be willing to sign onto a change. The changes are difficult to accept because the change leaders are arguing against a 40-year history of hourly billing. So, is this a generation issue? Where do firms start? Do they start with the 30- to 40-year-olds, or will the leaders have to attack the 50- and 60-year-olds for the change to convince the younger people? Or will the world come crashing in on unprepared professionals who are forced into AFA without the preparation, experimentation, innovation, or trial runs?

More importantly, many law firms and businesses will not be able to make the change because of their hourly billing culture, the lack of skill sets such as project management, and the support systems, e.g., central values of collaboration and the focus on preserving and using accumulated knowledge. As one author put it in “The New Normal” mentioned above, lawyers will have to become system designers to get the full effect of their professional knowledge to their clients. See the June 8, 2011, posting by Paul Lippe. (www.abajournal.com/legalrebels/thenewnormal/). I have noted that more and more CLE courses are being offered on legal project management. Some people are getting the message.

Taking a Risk

Leaders and innovators in the legal profession have been writing and giving speeches on the need to move away from the billable hour since 1985. But the economic tail wind driving big law firms kept most from making the switch toward AFA. Only the law firms not in the “biglaw” group took the innovative steps to move to AFA and a better competitive position. The only exceptions to “biglaw” were some of the British-based firms such as Linklaters and their Blue Flag system. In the last few years with the down economy, many businesses are now seeking to reduce their risk and improve the quality of their legal services through discussions of AFA. To paraphrase one innovative partner: “If the general counsel will not listen, I will go to the founder or CEO who has the guts to take a risk with us and try AFA.” He also stated that “it is a waste of resources for counsel to audit hours when AFA works so well in reducing risk to the client and motivating the provider (law firm or counsel) to use the most efficient means possible to solve the client's problem.”

Starting with the basics, hourly billing is a cost accounting model. Businesses have found that using cost accounting pricing does not at all reflect the relative value the customer sees in the service and the product. The billable hour business model is a “cost plus” model that does not reflect the true value of professional services. Later in this article, there will be a value model that has appeared in almost all of the books addressed to professional service firms on pricing. Jay Shepherd of Prefix gives a great example in his article on “The Shower.” A lawyer spent 3.5 hours on a brief and dutifully wrote down the time amounting to $1,750. She then found the argument would not work due to a recent change in the law. But in the shower the next morning she had a stroke of genius on what the argument should be so she wrote down the 0.20 time she spent thinking about it, or $100. Since the 3.5 hours was a waste, shouldn't she write that off and then only bill $100 for the touch of brilliance? Jay and I would agree ' No! Bill the value added.

Tools

We will start with the Quality-Service Grid below, first published by Richard Whitely in “The Customer Driven Company,” and modified for law firms. As usual for consultants, we divide the world into four parts based upon a left-hand side of perceived quality of service and the bottom of usefulness to the client.

In this model, there are no commodity services. Only the client can define what is a commodity versus what is crucial. Regardless of what counsel thinks, the client has other ideas of what quality service is. The lawyer may provide technical quality, but if it does not pass the usefulness test (pricing, predictability, turnaround time, or other criteria), it does not pass the client's test for quality service.

The next tool is the Cobb Value Curve, also below. This takes the perceived quality of service and translates into the perceived value curve from the client. Again, different clients have different value curves. For some, it is a “you bet your company” issue, and for others it is a commodity. Perceived values vary from client to client depending on the impact on their position or the position of their company. For example, a small business owner may feel that a litigation matter is very threatening to the company, whereas a big corporation may feel that the issue is a commodity.

What do the terms in the model mean? A “Nuclear Event” is one that will kill the person's job or the company. Do hours matter here? No! The client wants someone who will save his or her company. Price is not an option. The “Hired for Experience” means the client is hiring a particular lawyer who can solve the problem in the most efficient and cost-effective way. “Brand Names Services” are those services that a client will typically seek from a brand-name firm or individual inside counsel for standard matters. In many cases, if the law firm is being hired, a discount in legal fees will be required. Finally, the “Commodity Services” are those that the client perceives any lawyer can handle. The lawyer with the lowest fee will be hired.

Note that services below the mid-line become more price-sensitive. This is one model that has made Alternative Fee Arrangements plausible, and that is why it shows up in the books on pricing legal services. An example: A client comes to a lawyer for an opinion. The lawyer, working on the hourly model, presents a bill for $15,000 for her services. A month later, another client comes to the lawyer with the same set of facts; much of the lawyer's previous research can be used. The client gets the opinion in half the time and a bill for $7,500. The first client should only have to pay $7,500 or the second client should get a bill for $15,000 because that was what it was really worth. The second client received better service and a better document, so why shouldn't he pay $15,000?

Or try this one: A very sophisticated real-estate investor hires a law firm to document a $1 million interim loan agreement. Because he does dozens of these deals a year, he could do it in-house, but goes to his brand-name firm because the bank requires an objective third party to document the transaction. He pays a discounted billing rate. On the other hand, a developer with one big deal a year goes to the same firm for the service. That deal is in the “hired for experience area” for this person. Why? Because the small developer is buying a different bundle of services. He wants a consultant, a reputation with the bankers, and 24/7 access to the team that will make or break his deal and his business.

Two Approaches

So there are two approaches. The old one is the “service leads to cost (based on billable rates) that leads to the price that leads to the client bill.” In the new business model, based upon AFA, the client determines the value, which leads to price, which leads to the investment by the firm (costs) and the services that will be required. This requires a laser-beam focus on what will be done, by whom, and when and where the service will be provided. The greatest example is “Blue Flag,” by Linklaters (see https://blueflag.linklaters.com). Also see Ron Baker's book, Implementing Value Pricing, page 150. Wiley Professional Value Services, 2010.

There is another use for the Cobb Value Curve ' staffing. In every major matter there are needs for expertise from particular partners, senior associates, other professionals, and even low-cost affiliates or outsourced assets. When the tasks are determined in the new business model, the lawyer in charge of the matter must determine which of these assets will be used when and how they will be used.

Action Items

Based on experience in law firms and many other studies in business, there are five basic steps lawyers should take in creating a basic model for AFA. Lawyers must start now if they are to be ready when the tipping point to the new business model comes in like a tsunami.

Step 1: Meet and inspire. Get the teams together with clients. Ask the clients what the value added is for them and what they expect you to do to meet those needs. They may have requirements that affect their future job evaluation or the company. Let the clients inspire your team to think the innovative way. One question I ask is: “If your client asks you to provide a fixed fee for the work given their budget, how would you respond? The challenge: You must respond without telling them you are billing by the hour.”

Step 2: Training. How much training have your lawyers and staff had in project management and sophisticated matter management? Do they have training in managing projects or are they just following the lead of the old business model i.e., the more hours they work, the more value they add? This must change and now.

Step 3: Forced experimentation. Make people provide estimates of what the fee should be for a particular client (use an old matter). Start at the bottom: The commodity services provided and even the task are only part of commodity services. Experiment with those services to find out what they should cost the client. For example, some clients have segmented what a deposition should cost for a floor supervisor, up to a manager, up to the CFO, and up to a CEO with respect to the time for preparation, deposition, and a debrief.

Step 4: Start slow. A recent article in The Harvard Business Review titled “P&G's Four Types of Innovation,” June 2011 p. 68, showed the change process that applies to this issue. A real-life example started with a general counsel and a law firm. They started with a two-day workshop on the changes needed based on client demands. Then they went to small-scale pilot programs in individual units and client teams. They implemented the changes over a five-year period, first group-wide, and finally firm-wide.

Step 5: Debriefs. As a lawyer, you need to debrief from work with your team, clients and with inside counsel on the matter that should be moved over to AFA. If you want the best results, bring in key people (I am not talking 20, I am talking about three to five) to work with you on a debrief of the matter, looking for ways to revise the process to save money and make the process more efficient with the same excellent results for you or the client.

Step 6: Measurements. Look at the key performance indicators (KPIs) such as the realization on the standard billing rates. If the standard billing rate for an attorney is $200 and because of AFA his time comes in at $300 after collection, the realization rate is 150%. The 50% is all profit.

Hard Questions

The first question. How can I trust my lawyers to be efficient or be able to control the use of the hours in fogging, churning, or rate transfer using AFA? “Fogging” is when lawyers put time into a file that adds no value. “Churning” involves running more people through a file than are necessary, e.g., bringing five or more people to a deposition when only two will suffice. “Rate transfer” is when a lawyer bills at his or her rate when the time should have been put in by lower-rate people. What does AFA buy? The law firm that assumes the risk receives the rewards for better management.

There are two options open to in-house counsel in the old versus the new business model. Build an internal staff to audit the billable hours and increase the cost to in-house clients, or move the risk to outside lawyers and make them assume the risk of becoming effective and efficient.

The second question. But what if my lawyers say that you cannot predict what the other side will do and cannot predict a fee? The answer is to ask them to break down the matter into areas they can predict versus those activities they cannot predict. One of my clients is able to predict initial discovery costs and can predict what each type of deposition will cost based upon where it falls on the value curve.

The third question. What about changes in scope? You will find the answer in Ron Baker's book, mentioned above, in his appendix. Both the in-house lawyers and the outside lawyers can reach agreements on what would cause a scope change, and plan for scope expansion. If tried, it can work. But are many in-house lawyers afraid to try it? Why? They do not trust their outside counsel. The key word is “trust.” If the arrangement is set up in a transparent and mutually beneficial manner, trust will build over time.

Summary

The new business model of AFA is coming. Sooner or later every lawyer, whether in-house or outside, will have to deal with it. The sooner lawyers start experimenting with AFA, the better they will be able to respond to client needs. The experiments must start internally as if AFA were already in place. You will find that some mistakes will be made at first, but innovations will start to be put in place that will enable the lawyer to quote a fixed fee to clients. You will find solutions one at a time until you feel comfortable with actually predicting the fees. Please get started before it is too late.

[IMGCAP(1)]

[IMGCAP(2)]

William C. Cobb, a member of this newsletter's Board of Editors, is the managing partner of Cobb Consulting (WCCI, Inc.), based in Houston. He has been a consultant in strategic issues affecting law firms and in-house counsel since 1978. E-mail: [email protected]. Website: http://www.cobb-consulting.com/.