Law Firm Economics

Continuing my live-blogging from International Legal Technology Association’s Annual Conference. . . .
This session builds on last year’s session by Bruce MacEwen and John Alber. They will review the basic economics of law firms – what makes them similar to other businesses and what differentiates them – and then explore particular applications of these principles with special emphasis on deciding where best to make technology investments. Included in this session will be some exposure to statistical analysis techniques that help you understand which practices can benefit from additional investments – including technology investments – and which cannot.

Speakers:

  • John Alber – Bryan Cave, LLP
  • Bruce MacEwen – Adam Smith, Esq.

My Notes:

The market conditions today:

  • clients are unhappy with the level of service
  • clients are reducing the number of firms that service them
  • purchasing agents are key players in law firm selection
  • clients are driving change like Legal OnRamp
  • extraordinary price and budget pressure
  • clients are banding together to band together on issues like associate compensation, diversity, etc.

What are law firms doing in response:

  • A lot of business as usual
  • Some growth in fixed fee engagements, risk sharing proposals
  • Some creative technology responses
  • Some increased use of business analytic tools to refine pricing, staffing models (see Redwood Dashboard)

Interview with Jeremy Hand
Chairman of British Private Equity and Venture Capital Association
Quoted in LegalWeek June 19, 2008 on the failings of law firm management

“Very often the managing or the senior partner does not actually control, run and manage the firm in a way that other professionally run organizations would expect to see. In fact, making quick, effective, efficient, and in some cases bold commercial decisions to take advantage of opportunities like the Legal Services Act is simply beyond the capabilities of the partnership group as a whole to make. I do not necessarily think that the best outcomes are going to be delivered by lawyers who happen to have been promoted into senior management roles.”

Someone has to propagate knowledge of business fundamentals into the decision-making process on pricing, staffing and growth decisions. A starting point on the decision-making process is to understand law firm economics.

The income statement of the “P and L” has three variables:

  • Rates
  • Hours
  • Realization

All three of these variables have a ceiling. They are not unlimited. You can only at so high a rate, work so many hours and only reach 100% realization.

The expense side consists of:

  • people (65%)
  • rent (26%)
  • everything else (9%), including IT which ranges from 1% to 7%

The percentages are rough averages.

Law firms cannot compromise on talent (people) or being in Class A downtown space in financial capitals. Law firms should be able to budget their expenses very accurately.

Profit Margins. The AmLaw 100 averaged a profit margin of 36%. The downside is that a 10% discount on rates leads to a 28% drop in profits. The expense side is very fixed.

What does an equity partner cost? They have the cost as a worker. You have to pay them what an equally talented non-equity partner would be paid. They are managers. You have to pay them what you would have to pay a professional manager to do the job. They are owners and have a residual claim on profits after everyone else gets paid. The “Profits Per Partner” figure combines all three costs into one.

Where does IT fit in? Every penny spent on IT comes out of the partners pocket. If you are going to make an investment decision, you need a compelling case that it will pay for itself in full or better this year. There is not concept of “retained earnings.” Law firms strip cash out and distribute to the partners.

Every professional services firm (including law firms) has a mix of revenue creating groups and expense creating groups. The working lawyers create expense and rainmakers create cash. That is comparing hours billed to fees billed.  This is a touchy issue inside law firms. Lots of lawyers do not like to talk about profitability.

In looking at profitability, you need to analyze the relationship between revenue and expense. It is not always linear. If they are linear, the opportunities for profits to increase are limited. If they are non-linear, with revenue increases not tied to expenses, then profits can rapidly increase.

You can break the linear relationship by not being tied to hourly billing. That has a built-in cap on profitability.

There are also three time-tested ways to influence the relationship between revenue and expense:

  • Brand – For example, wall street firms. Can you be the go to firm and charge a premium
  • Lifetime client value – Not thinking matter by matter, but as a flow of revenue and experience
  • Transactional costs

IT, Finance and other law firm business functions can strongly influence the relationship between revenue and expense by creating a kind of “information gravitation” that makes decision-making information transparent and accessible.

Transparency questions that can help be answered with technology:

  • Am I making money now? 
  • Where is the break-even point?
  • How can I disassociate income from expense?
  • How can I increase lifetime client value?
  • Are my service levels appropriate to my price model?
  • What supply/demand conditions are we operating in?

Make this information is the key to getting better decision-making inside the firm.

Law firm matters/transactions/cases are essentially projects with resources, tasks to be accomplished and a critical path to the desired end.

One way to show transparency is to show the margin per partner per hour. 

Download the session materials.

My ILTA Schedule

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