Law Firm 3.0: Compensation, Billable Hour Limiting Firms' Success

Editor's note: This is the second installment of a series examining the shift in law firm business models and the issues law firms must address to remain competitive in a new age of providing legal services. A wealth of information, little market growth, and increased competition have created an environment where many firms need to consider changing, but significant obstacles, particularly compensation structures and reliance on the billable hour, remain in the way.

In order to make the necessary changes to stay competitive, consultants say, law firms need a clear strategy, strong leadership, buy-in from the partners and strategic discipline in order to succeed. Strategic discipline in a partnership, however, where culture and partnership equality have historic roots, can often be difficult to maintain. But in some cases, it has separated the winners from the losers.

“The highest performing firms have a very low tolerance for chronically underperforming people, practices and offices. They shed them,” says Kent Zimmermann of the Zeughauser Group. “Many law firms that are not high performing don't have the stomach to make those decisions.”

But decisions on compensation, fee structures, staffing and profitability goals are in some cases glaringly in need of attention across the country's largest law firms. Those firms were shielded from facing many of these issues by the ease with which they could increase billing rates, says David Gaulin, co-chair of PricewaterhouseCoopers' law firm services practice.

“I don't think that the primary determinant for quality in the past, which has been size, is going to be as much of a factor going forward,” according to Timothy Corcoran of Corcoran Consulting Group. He was referring to size of revenue, profits, head count and hours billed.

“It is so tied up in everything related to Big Law and yet it is a red herring,” Corcoran said. “Most businesses would not equate size with success.”

Compensation and Profitability

Perhaps the most obvious theme that stood out from any consultant who spoke on these issues was the need to address compensation models. After all, people do what they are financially incentivized to do.

“How do [firms] motivate people and get them to perform the work and do all of that and keep them happy?” LawVision Group consultant Marcie Borgal Shunk asked. “That is the piece that is most challenging.”

A large firm can have a greater level of variety in compensation structure, she said.

Many point out that, with fewer partners and more challenges to growth, profitability becomes more important than revenue growth and that eventually runs headfirst into compensation.

However, Aric Press, the former longtime editor of this newsletter's sibling publication The American Lawyer and now a consultant with Bernero & Press, pointed out that many firms have already altered their compensation models and have gone away from lockstep systems. But there is more that can be done on this front, some consultants said.

As Gaulin says, “You can't feed your family on maximizing revenue.” Firms have to maximize profitability of their practices. And when firms approach compensation with that mindset, more stratification occurs in regard to compensation across the partnership.

“Firms used to spread the peanut butter pretty evenly across the board,” Gaulin says. “It needs to be much more defined so that you are driving ' and rewarding behaviors that are most beneficial to the overall organization.”

Corcoran said he knows of partners who could double their books of business, but choose not to do so because their firm compensates them for billing hours. The fastest growing segment of Corcoran's practice is compensation redesign, he says. For several years, he has worked with firms on project management and alternative fees, but “sooner or later you run into a brick wall.”

“And it's simply that, when you put a lawyer in a position of choosing between his economic self-interest and what is good for the firm on a long-term basis, [he] will oftentimes choose what benefits [him],” Corcoran continues. He says he doesn't blame the partners for that.

“In any business, if you have a compensation plan that is in conflict with your strategy, the compensation plan becomes your strategy,” Corcoran comments.

He says firms can reward hunters and farmers ' rainmakers and service partners. But right now, many firms have compensation strategies that are in conflict with the cross-selling initiatives most firms espouse, particularly the focus on origination without accounting for sharing the credit or without a willingness to move credit to a new partner who has taken over the bulk of the work. Corcoran says having different formulas to compensate different behaviors is where firms should go.

“That will very likely result in income disparity and that is not, in and of itself, bad,” Corcoran advises.

Silvia Hodges, executive director of the Buying Legal Council, says the corporate world often pays salespeople more than executives who are technically above them in the organizational chart. If a firm values rainmaking, it can pay on that basis. It remains to be seen, however, whether that will be done through rainmakers or sales teams, she says. What firms should not pay top dollar for, consultants advise, is a book of business that isn't profitable.

“Too many people are overpaying for books of business and this really causes rifts,” Altman Weil consultant Tom Clay says.

A $3 million book of business with a thin profit margin is not as valuable as someone with a $1 million book of business and a 25% profit margin, he says. Clay refuted the counter-argument that the $3 million book is keeping more people busy. He said firms shouldn't be in the business of keeping people busy, but of being profitable. Firms also have to address who is being kept busy.

The data on how much business baby boomers control is “compelling and scary,” Clay said. “We've got to figure out how to pay them to let it go,” he said.

Kim Desmarais, a client consultant with Thomson Reuters' Peer Monitor, agrees that the age of the leadership at many law firms is part of the problem.

“They're a few years from retirement,” Desmarais said. “They don't want to lose their pensions.”

Downshift on Staffing Up

The law firm business model is maturing, with some help from the recession, but is really just facing the same business questions that other industries have already had to answer, Corcoran says.

When demand was high, law firms would have a staff that looked like a grocery store with 37 checkout lines open at 2 a.m. even though there were only four shoppers in the store. The idea was that firms would be ready for anything, Corcoran explains. Law firms can't go to the opposite extreme of a manufacturing business in which it would take an order and promise delivery in six weeks once it got the proper parts and people in place, he says. But they can rely on a flexible workforce of contract lawyers, legal process outsourcing and other alternative models. The “grocery store” can look like it has 37 lines open at 2 a.m., but the law firm is only paying for five of those cashiers as salaried employees, Corcoran says.

“Downsizing isn't a big, traumatic affair,” Corcoran said. “Every business on the planet ramps up for an initiative and then moves on. It's perfectly OK to rely on a flexible workforce.”

That means the number of lawyers on the stable payroll might be smaller, but the size of the overall workforce could fluctuate based on need, he says.

Clay adds that it is “staggering” the number of firms that say they have equity and nonequity partners who are not busy. Nonequity partners are the biggest “overstaffed, undercapacity position” in firms and firms need to start managing it by replacing that group with cheaper talent that can do the same thing, he said.

“Everybody knows it in their heart,” Clay says. “The nonequity group is a real vexing problem I think, and they are also the biggest hurdle, problem, challenge, for up-and-coming lawyers who need that work and need the exposure.”

He agrees that firms don't need as many lawyers.

“How long are you going to let somebody who you don't want to be a partner hang on? What ills does that cause?” Clay asks.

The reason this area hasn't been addressed in the way it needs to be, Clay said, is that firms “haven't fallen off the cliff.” Lawyers still make more money than almost any other profession, he said.

When firms do go to hire, they may want to reassess the skill sets they are looking for. Many consultants noted that firms should look to hire more business professionals to help run operations.

Silvia Hodges, quoted earlier in this article, teaches courses at Columbia and Fordham law schools on law firm management. She says law students should be required to take that education a step further to include coursework in legal project management.

“It's not just something that you pick up,” she says.

Billable Hour

The fastest way to developing a new law firm model, Corcoran says, is to change compensation plans and not rely so heavily on the billable hour. Shunk agrees, describing moving away from the billable hour as “a long road to hell.” With the billable hour, she says, “the objectives [of the firm and the client] don't align.”

Corcoran thinks the billable hour devalues the law firm's contribution far more than it impairs the buyer's ability to buy services. He describes it as a “self-imposed restraint on revenues and profits.”

“Once firms realize this, they will run from the billable hour,” Corcoran says.

Raymond E. Bayley, CEO of legal services firm Novus Law, says firms are just starting to think less about how many hours they can bill and more about how productive they can be. Millennials are starting to force that issue through their vision of work-life balance, he says. That generation doesn't have the interest in working a few more hours if they can get the task done faster and move on to something else.

“As we see a generational shift, we'll see more alternative fee arrangements,' Shunk agrees.

But that may bring firms back to the compensation question.

“If your remunerative system is so that you still pay on how many hours they bill, until then, nothing will change,” Hodges says.

Bayley says firms are beginning to focus less on inputs, such as law school education or hours billed, and more on outputs, such as the quality of the work product and the productivity of the lawyer.

“That begets a change [from] focusing on the top to the bottom line,” he says.

Is This Real?

While many suggest law firms are averse to change, others said it's the clients themselves ' despite all the talk of technology, bigger in-house departments, smaller firms and legal outsource providers as threats to the law firm model ' who are not quickly embracing the trends. Aric Press says that in his conversation with clients, he has not gotten the sense that general counsel are jumping on those particular bandwagons.

“Their appetite for alternative legal service providers, technology and down-market firms is relatively small,” he says.

But Shunk says that at a recent GC panel at the annual Legal Marketing Association conference, all of the panelists “indicated these trends are alive and well ' and gaining traction.”

“The GC from 3M indicated they have brought the middle 80% of their work in-house and are leveraging technology and LPOs for the lowest 10%,” she says. “This is especially true of the largest companies with the biggest legal spend and most sophisticated in-house departments.

“As one client told me, he feels as a public company it is his fiduciary duty to consider lower-cost alternatives and options to traditional law firms. There is also quite a bit of evidence showing that clients are shifting work to smaller and midsized law firms ' including complex work.”

And they are doing the work themselves too. Clay says clients had been crying out for firms to adapt their service models and now the clients are just doing it themselves.

“It's really here now,” he says.

Where to Focus

In order to change, firms need a clear strategy, strong leadership, buy-in from the partners and commitment to the vision.

“It's a slow process,” Desmarais says.

Press suggests that, more important than radically altering their models, firms should focus on their clients.

“What law firms most need to do is stay close to their clients,” he says. They need to be a part of solutions for the clients and they need to be responsive.

Leadership is a challenge, Shunk advises, which is one of the reasons why firms are emphasizing leadership training now the way business development training was the rage a few years ago.

“The first step in John Kotter's 'Leading Change' is to establish a sense of urgency,” Shunk said in an e-mail. “I think many firms have a hard time doing that before the situation gets dire. It's more difficult to energize the troops in good times, or even mediocre times, than when they're in the last leg of battle. The impetus for change, though, is usually right in front of them ' it's in feedback from their clients or a slow, downward trend in financial metrics. The key is in getting the right information and being able to weave together a story. The presentation of information can be the difference between a firm energized to change and one that simply thinks [its] going through another 'firm initiative.'”

Gaulin says there is an increasing chunk of law firm revenue that is now being captured by other service providers or clients themselves.

“That is going to continue to evolve and what is innovative and cutting-edge today is going to be very commoditized tomorrow and … the time it takes to go from innovative to commodity is much shorter now,” he continued.

Firms have to start evaluating where they want to be and carve out a niche that can sustain the business disruptives of today and in the future, he says.

“Sooner or later, everyone will catch up,” Corcoran says. “But right now, those that are really changing, what an opportunity to grow market share.”

The next installment of this series will examine what the law firms of the future might look like.

Hank Grezlak is Group Editor and Associate Publisher and Gina Passsarella is Senior Staff Reporter at The Legal Intelligencer, an ALM sibling of this newsletter in which this article also appeared.

Editor's note: This is the second installment of a series examining the shift in law firm business models and the issues law firms must address to remain competitive in a new age of providing legal services. A wealth of information, little market growth, and increased competition have created an environment where many firms need to consider changing, but significant obstacles, particularly compensation structures and reliance on the billable hour, remain in the way.

In order to make the necessary changes to stay competitive, consultants say, law firms need a clear strategy, strong leadership, buy-in from the partners and strategic discipline in order to succeed. Strategic discipline in a partnership, however, where culture and partnership equality have historic roots, can often be difficult to maintain. But in some cases, it has separated the winners from the losers.

“The highest performing firms have a very low tolerance for chronically underperforming people, practices and offices. They shed them,” says Kent Zimmermann of the Zeughauser Group. “Many law firms that are not high performing don't have the stomach to make those decisions.”

But decisions on compensation, fee structures, staffing and profitability goals are in some cases glaringly in need of attention across the country's largest law firms. Those firms were shielded from facing many of these issues by the ease with which they could increase billing rates, says David Gaulin, co-chair of PricewaterhouseCoopers' law firm services practice.

“I don't think that the primary determinant for quality in the past, which has been size, is going to be as much of a factor going forward,” according to Timothy Corcoran of Corcoran Consulting Group. He was referring to size of revenue, profits, head count and hours billed.

“It is so tied up in everything related to Big Law and yet it is a red herring,” Corcoran said. “Most businesses would not equate size with success.”

Compensation and Profitability

Perhaps the most obvious theme that stood out from any consultant who spoke on these issues was the need to address compensation models. After all, people do what they are financially incentivized to do.

“How do [firms] motivate people and get them to perform the work and do all of that and keep them happy?” LawVision Group consultant Marcie Borgal Shunk asked. “That is the piece that is most challenging.”

A large firm can have a greater level of variety in compensation structure, she said.

Many point out that, with fewer partners and more challenges to growth, profitability becomes more important than revenue growth and that eventually runs headfirst into compensation.

However, Aric Press, the former longtime editor of this newsletter's sibling publication The American Lawyer and now a consultant with Bernero & Press, pointed out that many firms have already altered their compensation models and have gone away from lockstep systems. But there is more that can be done on this front, some consultants said.

As Gaulin says, “You can't feed your family on maximizing revenue.” Firms have to maximize profitability of their practices. And when firms approach compensation with that mindset, more stratification occurs in regard to compensation across the partnership.

“Firms used to spread the peanut butter pretty evenly across the board,” Gaulin says. “It needs to be much more defined so that you are driving ' and rewarding behaviors that are most beneficial to the overall organization.”

Corcoran said he knows of partners who could double their books of business, but choose not to do so because their firm compensates them for billing hours. The fastest growing segment of Corcoran's practice is compensation redesign, he says. For several years, he has worked with firms on project management and alternative fees, but “sooner or later you run into a brick wall.”

“And it's simply that, when you put a lawyer in a position of choosing between his economic self-interest and what is good for the firm on a long-term basis, [he] will oftentimes choose what benefits [him],” Corcoran continues. He says he doesn't blame the partners for that.

“In any business, if you have a compensation plan that is in conflict with your strategy, the compensation plan becomes your strategy,” Corcoran comments.

He says firms can reward hunters and farmers ' rainmakers and service partners. But right now, many firms have compensation strategies that are in conflict with the cross-selling initiatives most firms espouse, particularly the focus on origination without accounting for sharing the credit or without a willingness to move credit to a new partner who has taken over the bulk of the work. Corcoran says having different formulas to compensate different behaviors is where firms should go.

“That will very likely result in income disparity and that is not, in and of itself, bad,” Corcoran advises.

Silvia Hodges, executive director of the Buying Legal Council, says the corporate world often pays salespeople more than executives who are technically above them in the organizational chart. If a firm values rainmaking, it can pay on that basis. It remains to be seen, however, whether that will be done through rainmakers or sales teams, she says. What firms should not pay top dollar for, consultants advise, is a book of business that isn't profitable.

“Too many people are overpaying for books of business and this really causes rifts,” Altman Weil consultant Tom Clay says.

A $3 million book of business with a thin profit margin is not as valuable as someone with a $1 million book of business and a 25% profit margin, he says. Clay refuted the counter-argument that the $3 million book is keeping more people busy. He said firms shouldn't be in the business of keeping people busy, but of being profitable. Firms also have to address who is being kept busy.

The data on how much business baby boomers control is “compelling and scary,” Clay said. “We've got to figure out how to pay them to let it go,” he said.

Kim Desmarais, a client consultant with Thomson Reuters' Peer Monitor, agrees that the age of the leadership at many law firms is part of the problem.

“They're a few years from retirement,” Desmarais said. “They don't want to lose their pensions.”

Downshift on Staffing Up

The law firm business model is maturing, with some help from the recession, but is really just facing the same business questions that other industries have already had to answer, Corcoran says.

When demand was high, law firms would have a staff that looked like a grocery store with 37 checkout lines open at 2 a.m. even though there were only four shoppers in the store. The idea was that firms would be ready for anything, Corcoran explains. Law firms can't go to the opposite extreme of a manufacturing business in which it would take an order and promise delivery in six weeks once it got the proper parts and people in place, he says. But they can rely on a flexible workforce of contract lawyers, legal process outsourcing and other alternative models. The “grocery store” can look like it has 37 lines open at 2 a.m., but the law firm is only paying for five of those cashiers as salaried employees, Corcoran says.

“Downsizing isn't a big, traumatic affair,” Corcoran said. “Every business on the planet ramps up for an initiative and then moves on. It's perfectly OK to rely on a flexible workforce.”

That means the number of lawyers on the stable payroll might be smaller, but the size of the overall workforce could fluctuate based on need, he says.

Clay adds that it is “staggering” the number of firms that say they have equity and nonequity partners who are not busy. Nonequity partners are the biggest “overstaffed, undercapacity position” in firms and firms need to start managing it by replacing that group with cheaper talent that can do the same thing, he said.

“Everybody knows it in their heart,” Clay says. “The nonequity group is a real vexing problem I think, and they are also the biggest hurdle, problem, challenge, for up-and-coming lawyers who need that work and need the exposure.”

He agrees that firms don't need as many lawyers.

“How long are you going to let somebody who you don't want to be a partner hang on? What ills does that cause?” Clay asks.

The reason this area hasn't been addressed in the way it needs to be, Clay said, is that firms “haven't fallen off the cliff.” Lawyers still make more money than almost any other profession, he said.

When firms do go to hire, they may want to reassess the skill sets they are looking for. Many consultants noted that firms should look to hire more business professionals to help run operations.

Silvia Hodges, quoted earlier in this article, teaches courses at Columbia and Fordham law schools on law firm management. She says law students should be required to take that education a step further to include coursework in legal project management.

“It's not just something that you pick up,” she says.

Billable Hour

The fastest way to developing a new law firm model, Corcoran says, is to change compensation plans and not rely so heavily on the billable hour. Shunk agrees, describing moving away from the billable hour as “a long road to hell.” With the billable hour, she says, “the objectives [of the firm and the client] don't align.”

Corcoran thinks the billable hour devalues the law firm's contribution far more than it impairs the buyer's ability to buy services. He describes it as a “self-imposed restraint on revenues and profits.”

“Once firms realize this, they will run from the billable hour,” Corcoran says.

Raymond E. Bayley, CEO of legal services firm Novus Law, says firms are just starting to think less about how many hours they can bill and more about how productive they can be. Millennials are starting to force that issue through their vision of work-life balance, he says. That generation doesn't have the interest in working a few more hours if they can get the task done faster and move on to something else.

“As we see a generational shift, we'll see more alternative fee arrangements,' Shunk agrees.

But that may bring firms back to the compensation question.

“If your remunerative system is so that you still pay on how many hours they bill, until then, nothing will change,” Hodges says.

Bayley says firms are beginning to focus less on inputs, such as law school education or hours billed, and more on outputs, such as the quality of the work product and the productivity of the lawyer.

“That begets a change [from] focusing on the top to the bottom line,” he says.

Is This Real?

While many suggest law firms are averse to change, others said it's the clients themselves ' despite all the talk of technology, bigger in-house departments, smaller firms and legal outsource providers as threats to the law firm model ' who are not quickly embracing the trends. Aric Press says that in his conversation with clients, he has not gotten the sense that general counsel are jumping on those particular bandwagons.

“Their appetite for alternative legal service providers, technology and down-market firms is relatively small,” he says.

But Shunk says that at a recent GC panel at the annual Legal Marketing Association conference, all of the panelists “indicated these trends are alive and well ' and gaining traction.”

“The GC from 3M indicated they have brought the middle 80% of their work in-house and are leveraging technology and LPOs for the lowest 10%,” she says. “This is especially true of the largest companies with the biggest legal spend and most sophisticated in-house departments.

“As one client told me, he feels as a public company it is his fiduciary duty to consider lower-cost alternatives and options to traditional law firms. There is also quite a bit of evidence showing that clients are shifting work to smaller and midsized law firms ' including complex work.”

And they are doing the work themselves too. Clay says clients had been crying out for firms to adapt their service models and now the clients are just doing it themselves.

“It's really here now,” he says.

Where to Focus

In order to change, firms need a clear strategy, strong leadership, buy-in from the partners and commitment to the vision.

“It's a slow process,” Desmarais says.

Press suggests that, more important than radically altering their models, firms should focus on their clients.

“What law firms most need to do is stay close to their clients,” he says. They need to be a part of solutions for the clients and they need to be responsive.

Leadership is a challenge, Shunk advises, which is one of the reasons why firms are emphasizing leadership training now the way business development training was the rage a few years ago.

“The first step in John Kotter's 'Leading Change' is to establish a sense of urgency,” Shunk said in an e-mail. “I think many firms have a hard time doing that before the situation gets dire. It's more difficult to energize the troops in good times, or even mediocre times, than when they're in the last leg of battle. The impetus for change, though, is usually right in front of them ' it's in feedback from their clients or a slow, downward trend in financial metrics. The key is in getting the right information and being able to weave together a story. The presentation of information can be the difference between a firm energized to change and one that simply thinks [its] going through another 'firm initiative.'”

Gaulin says there is an increasing chunk of law firm revenue that is now being captured by other service providers or clients themselves.

“That is going to continue to evolve and what is innovative and cutting-edge today is going to be very commoditized tomorrow and … the time it takes to go from innovative to commodity is much shorter now,” he continued.

Firms have to start evaluating where they want to be and carve out a niche that can sustain the business disruptives of today and in the future, he says.

“Sooner or later, everyone will catch up,” Corcoran says. “But right now, those that are really changing, what an opportunity to grow market share.”

The next installment of this series will examine what the law firms of the future might look like.

Hank Grezlak is Group Editor and Associate Publisher and Gina Passsarella is Senior Staff Reporter at The Legal Intelligencer, an ALM sibling of this newsletter in which this article also appeared.