Yesterday, we began with the first part of Tim Corcoran’s webinar on the strategic role of alternative fee arrangements. After Tim’s elephant analogy, he gave the attendees a short economics lesson. Using a graph with two parallel arrows, Tim said that essentially, we charge a rate that is higher than our cost to deliver. Price needs to be higher than the cost, and profit is derived from the difference between the cost and the price.
But law firms do a poor job of calculating costs – other than their overhead and real estate, they don’t know the cost of the delivery of their legal services.
So the challenge is, as we saw in the recent downturn when there was downward price pressure, because we haven’t fundamentally changed our delivery costs, our profit turns to loss. In the first part of the webinar, Tim had talked about the inevitable movement from premium and strategic to commodity, meaning that clients will pay less for something over time. That’s what we’re seeing – clients are refusing to pay for work that they believe doesn’t have the same value it once had, but law firms who have not adapted their cost structure for this are experiencing loss.
In the short term, firms can maintain profits by lowering overhead – they can reduce associates, limit travel, eliminate memberships, get rid of free soda and coffee – but they haven’t fundamentally addressed the cost of delivery. So there is still the risk of loss, unless clients decide to pay a lot more for tasks and services that they know don’t have that level of value. So what do most businesses do?
Most businesses incorporate a learning curve. Tim showed us that simply diagrammed, a learning curve is when you strive to lower your cost of delivery, you will always maintain profits even when revenues decline. If a client says that you’ve done the same task twenty times, and wants to know why they’re paying even more for the twentieth time, when the firm still can’t tell them what it costs in advance. Tim challenged everyone to imagine a world in which the lawyer says that they will charge the client less for this twentieth matter, and the firm will be more profitable because it’s learned from its experience and can manage the delivery of those legal services in a way that reduces inefficiency.
He said that this works whether the firm is billing by the hour, or embracing alternative fees. The concept is that profits are derived from lowering the cost of delivery at a rate greater than the revenue decline. However, revenue doesn’t always decline – imagine that it picks up. Imagine that other law firms are desperately waiting for clients to pay more and that’s the way that they’ll generate profits again. But we’ve lowered our costs and continue to do so, so as revenues rise, profits are greater.
These are simple economic concepts, and there is no shame in having a profitable enterprise. Clients want profitable, thriving partners – they want their outside counsel to do well, because they fear that when they’re struggling, their work product suffers. But for law firms to thrive, it shouldn’t be a zero-sum game – clients should also win.
Tim shared some quotes from law firms:
We’ve done more alternative fee proposals in the last four months than in the history of the firm."
It’s difficult for clients to budget legal fees. In the past year, there’s been an increased demand for flat fees. Hourly rates have too many variables in them."
We (law firms) have to get better at budgeting. Clients aren’t looking for us to cut our fee or give them a 10% discount. What they really want is predictability."
So how does a law firm embrace this learning curve? One way is to proactively pursue alternative fees – finding ways to lower the cost of delivery by figuring out what it costs to do different things, and matching that with the clients’ expectations for value.
Tim drew on a couple of slides from a study done by the American Lawyer Media Legal Intelligence team, commissioned by LexisNexis and CounselLink on alternative fees for law firms and law departments. He first acknowledged the obvious, that there’s been an increase in alternative fees in recent years. They’re finding that so many law firms have embraced these at a greater rate that it’s become a meaningful part of their billings.
Though Tim didn’t delve too deeply into the various types of alternative fees, he did offer a slide that broke them down:
- Blended rate – sets an agreed-upon hourly rate that applies to all lawyers working on a matter, regardless of their seniority. Encourages firms to staff matter efficiently.
- Capped fee – Limits the total cost of an agreed-upon amount of work. It is often used in conjunction with an hourly rate arrangement. Provides a degree of predictability to clients who are otherwise comfortable with hourly billing.
- Contingency – specifies that a firm will be paid only if it achieves a financial recovery or other agreed-upon result for the client. Typically, the firm receives a percentage of a total recovery. Provides protection from a bad result for clients who are willing to forgo a large portion of a positive result.
- Defense contingency – establishes an expected outcome for a defendant in a monetary claim and specifies that if the firm obtains a better-than-expected result, it will receive a portion of the savings. Encourages the firm to limit damages.
- Flat fee – sets an agreed-upon sum of money for a discrete amount of work. The firm, not the client, assumes the risk of cost overruns. Encourages firms to perform distinct pieces of work efficiently.
- Flat fee with shared savings – sets a flat fee for a matter while allowing the firm to track the work on an hourly basis. If, at the conclusion of the matter, the hourly fee is lower than the flat fee, the client and the firm share the difference. Provides a guarantee of a low cost to clients who are otherwise comfortable with hourly billing.
- Holdback – specifies that the client will withhold an agreed-upon portion of the total fee unless the firm obtains a particular result. Encourages both the firm and the client to measure successes quantifiably.
- Partial contingency (or success fee) – sets a bonus that the firm receives in addition to its hourly, flat or capped-fee arrangement if the result meets agreed-upon criteria. Encourages the firm to obtain a positive result for the client.
- Phased fee – sets agreed-upon fees, perhaps using differing structures, for discrete phases of a matter. Gives maximum flexibility to both the firm and the client.
Tim pointed out that there are disparate views about what it means to be an alternative fee. The blended rate, and even the capped fee, are based on an hourly rate, so by the strictest definitions, they are not alternative fees. An alternative fee ties the value of the services delivered to what the client is willing to pay and their budget – it has nothing to do with the cost of delivery.
Lawyers on the plaintiff side have embraced contingency fees for years, and have been successful at it, and many defense firms have also embraced contingency fees over the years for certain matters – they were popular during the tech boom, for example. But we’re seeing some others now, such as holdbacks, success fees, or partial contingencies. Tim said that he could spend a lot of time digging into these, but he wanted to illustrate that there are a lot of different models. As to which AFAs are optimal for your organization, it’s a function of your client base, along with your firm’s culture and practice area base.
Benefits and Challenges of AFAs
There are benefits and challenges to alternative fees. As Tim talked about in the first webinar, the number one rule in business is "no surprises." So to the extent that AFAs position your firm as the firm that not only delivers quality legal work, but embraces the notion that predictability trumps almost anything else, then that’s a differentiator that the procurement people can score you on, and this will trump other more subjective factors.
There are downsides to AFAs as well, including perceived and actual risks. It boils down to a comfort level – using the elephant example again, Tim said that if we can overcome our tendencies and habits to embrace the norm, we will find that the benefits outweigh the risks. He added that he’s not opposed to the hourly rate – it has its place and there are benefits to it. The challenges involve looking at the cost of production as a proxy of the value of the services delivered. If the client is happy with the number on the invoice, because it matches their expectations of the value delivered, then they are less concerned with the mechanics of the invoice. If you can find a number that’s commensurate with the value they perceive, it doesn’t matter which method you use.
However, alternative fees provide a much stronger ability to embrace predictability, and to tie value between the clients’ perception and the law firm’s perception. Tim showed a slide that emphasized that alternative fees are here to stay.
R.U.L.E.S. Versus Learning Curve
Tim noted that under the R.U.L.E.S. model:
- Size matters: the more timekeepers we have, the more money we make.
- Inexperience matters: the more we can bill, the more money we make.
- Client satisfaction is incidental to profitability: firms aren’t opposed to it, but somewhere in their analytics, they believe that for a client to be happy, they need to pay less, and for a law firm to be happy, they need to charge more.
- Realization is a lagging indicator: firms only find out afterwards what a client’s perception of value is, because their realization suffers.
- Silo approach: firms are content under the traditional model – it’s about feeding billables.
- Rainmakers matter most.
But under the new model:
- Efficiency matters: firms are more profitable when they’re efficient.
- Experience matters: firms are more profitable when they embrace their experience.
- Client satisfaction is critical for profitability: now it’s about client retention and the long-term value of a client.
- Realization is a leading indicator: firms know in advance – they have a predictable AFA in place, and clients can pay at the beginning of the month, because they know what the numbers are.
- Team approach: efficiency requires lawyers to learn from each other, so they can’t work in isolation.
- Clients matter most.
Tim finished up with a Venn diagram, showing that business people are looking for business performance, the legal function to be in step with the business, managed risk and predictable costs. The legal department is looking for the legal function to be an adviser to the business, managed risk and predictable costs, while outside counsel are looking to be a trusted adviser, have managed risk and predictable revenue. Where these overlap, loyalty is created and AFAs are a way to embrace these concepts.
There were two questions after the presentation:
How can we handle multiple clients with multiple billing formats and ebilling?"
Tim said that this is the challenge of being a service provider. There are multiple platforms, every client has their own version, and the challenge is to incorporate this into your systems. So firms should embrace a mindset that every matter should be conducted as if it’s an alternative fee or ebilling matter – don’t wait for the client to demand it. Operate as if you need consistent descriptions and task codes, act as if it will be analyzed and aggregated. Take on some of the tools that clients use and firms will find that they have the easy ability to export content into multiple billing formats because they’ve already embraced that. Doing it on an ad hoc basis can be challenging – if it’s been adopted firmwide in advance, it’s easier to adapt.
Who should take the lead within the firm on establishing AFAs?
This will differ by firm – Tim referenced an article from a few weeks ago about the increasing role of strategic pricing in law firms. The essence of the article was that law firm accounting and finance people are well-equipped with the traditional model, but they are not experts at strategic pricing. So there is a function growing in many firms, where they’re bringing in someone whose job is to lead the charge to help the partners learn how to make better strategic pricing decisions. Tim said that firms don’t necessarily have to get a pricing director to do this, but there is a big difference between the AFA committee of old, where a group of partners would sit down and talk about an AFA as an investment. Now they have a gating mechanism, and the partners who ask for an AFA have a rigorous process that they go through with their clients. This can be adopted by firms without hiring anyone specifically, but it does involve everyone in the firm getting on board.
This afternoon, we’ll be talking about contract lawyers and outsourcing, so keep an eye out for that recap to come!