According to the 2015 Law Firms in Transition Survey prepared by Altman Weil, 2015 began with signs of optimism among law firm leaders. We’ve seen increases in gross revenues, revenue per lawyer and profits per equity partner, with a third of law firm leaders indicating that demand for legal services has already returned to pre-recession levels in their firms. This is an interesting assessment, but not a surprise. Demand is definitely coming back, but with it will come pricing pressures which could potentially affect revenues, and thus a knee jerk to reduce expenses.
Law firms that are prepared to address pricing pressures will have a competitive edge and will differentiate themselves from their competition. With that said, firms need to get a better handle on their internal economics and ascertain what it actually costs to generate the work. You would think based on pricing pressures, the message would be loud and clear, but many firms continue to move forward in a more reactive than proactive manner in addressing this growing trend.
Firms that are proactive and understand their own economics can propose pricing alternatives to clients that will not only prove profitable as the methodologies become more fine-tuned, but will also facilitate capturing business that other firms cannot otherwise take on because they have not explored this ever-growing area. More and more clients are saying they want some form of alternative fee arrangements (AFAs) at least some of the time, but law firms still do not approach AFAs proactively. According to the same Altman Weil survey, only 31% of law firms are actually proactive in addressing pricing pressures. The remaining 69% are reactive and it often becomes hit or miss at best. Law firms that change their strategic approach to lawyer staffing, efficiency of legal service delivery and pricing are consistently more likely to see increases in gross revenues, revenue per lawyer and profits per equity partner than those that have not embraced strategic change.
What kind of AFA structures are law firms using and how do they make them work? How do you put a face value on a piece of work? And how do you ensure continuing profitability?
Clearly, pricing by alternative arrangement is not in most firms’ comfort zone. Many firms struggling with AFAs lack resources which include project management skills, pricing experience and access to historical information. Moreover, these firms also cannot accept the firm sharing in the risk. While firms move to address those struggles, the important question to ask while doing so is “What do our clients want?” Clients are looking for efficiency, cost predictability, transparency, targeted advice, increased use of AFAs and most important, clients want value.
So that begs the question: What kind of AFA structures are law firms using and how do they make them work? How do you put a face value on a piece of work? And how do you ensure continuing profitability? Questions like these force law firms to take a hard look at their business models and the conclusion drawn by many is that in order to remain competitive, law firms must change those models. Fees must align with economic interests of the client and law firm and must create a financial incentive for law firms to reduce cost; and the fee structures themselves must create incentives to accomplish specific, identifiable client objectives. In short, law firms must create relationships between fee structures and the behaviors they want to encourage. Avoiding AFAs is not a strategy.
Before embarking into the AFA arena, it must be understood that fee structures are an incentive to behavior. To draw the distinction, note the following:
It is no longer about the billing rates used in providing legal services, it is now more about the cost rates to produce the work. This is a major paradigm shift for many law firms, that now must be more mindful of cost, efficiency and project management capabilities in delivering legal services under the “new landscape” in a profitable manner. Law firms need to do their homework and understand metrics such as profit margin, overhead costs and be able to answer the fundamental questions such as “How much does it cost the firm to produce a billable hour for each attorney? Each Task? Each practice area?”
When I’ve presented on the subject of AFAs around the country, the audience is made up of mostly law firm partners, legal administrators and CFOs; on average there are usually 90 to 100 attendees at any given session. When the aforementioned question is asked, maybe between just three to five hands go up. That means only 3% to 5% of participants in each audience have these metrics available — an alarming statistic!
In Part 2 of this article, we will discuss in more depth the types of AFA structures that law firms are using, the practice areas where AFAs are being utilized and how firms are achieving profitability — stay tuned!