ILN Webinar Series - Alternative Fee Arrangements Part II

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. 

Alternative Fees

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. 

Questions

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! 

ILN Webinar Series - Alternative Fee Arrangements Part I

Part II of our Business of Law webinar series with Tim Corcoran took place in November, but things have been so hectic with travel and hurricanes and holidays that I'm only just getting to the recap! So without further ado...

The topic of the second webinar was the strategic role of alternative fee arrangements, which was a natural sequel to the first session on legal project management. Tim re-emphasized that the industry has changed, and we need to adapt to the changing times. 

He shared some results from Altman Weil's Chief Legal Officer Study, the one prior to the most recently released iteration, which shows that the top concerns for clients continue to be outside legal costs, lack of predictability, and the inefficiency of the hourly billing system. The difference between in-house counsel perceptions and outside counsel perceptions can be pretty great - outside counsel tend to think that the quality of legal work should rank more highly for in-house counsel. However, in-house counsels' perspective is that the quality of work is a given, so they're measuring their firms on additional factors. 

Tim delved into a recap of the first webinar, discussing client and law firm reactions to the economic downturn, budgeting and legal project management. For a full explanation, check out my part I and part II blog posts. 

Commoditization: Shift Happens

The word "commodity" has taken on a touch connotation within the legal industry - but in the pyramid of legal services, there are a set of tasks that are repetitive in nature. Using the pyramid to illustrate, Tim showed these repetitive tasks on the bottom. 

Following them are important tasks, which clients are willing to pay more for, but they're not necessarily looking for the best or most expensive law firm. Then, there are the strategic tasks, or the "bet the firm" work - and those are where the real opportunity is. That's what firms all seek, and they often plot their firm's course straddling somewhere between these strategic and important tasks.

The challenge is that in the last few years, clients have determined that even the most critical "bet the company" work has in itself some components that are tactical or repetitive in nature. And over time, there will always be a shift from the strategic to the routine - what we were doing ten years ago, we're not doing anymore because it's become a commodity task, and clients are no longer willing to pay premium rates. 

It's a simple face of business nature - and legal services are not any more immune to this than any other industry.  As Tim noted on his slide, "There is an inevitable and inexorable migration of products and services from leading edge to common place, whether the provider likes it or not."

Along with this, clients are involving additional people in the conversation, those Tim called the "arbiters of commoditization." He referred to a recent study by Dr. Silvia Hodges, who looked at the role of procurement in the selection of outside counsel. Although procurement has always been on the scene, in recent years, there has been an increased in involving them in the selection of outside counsel. Dr. Hodges study revealed that 41% of the budget for outside legal counsel is influenced by procurement. 

Law firms fear that when procurement is involved that they are not sophisticated enough to understand the subtle or even massive distinctions between law firms, and they're only concerned with finding the lowest cost provider. For the most part, however, a good procurement person is focused on finding the right provider to meet specific demands for a specific use case - this doesn't necessarily mean the cheapest. Procurement is always looking for other factors upon which to measure providers - not just price. Unfortunately, law firms do a poor job of differentiating on these other factors. 

Asynchronous Information

Tim used an example to illustrate the concept of asynchronous information. Not knowing much about wine, when attending a dinner party, he would be likely to choose an expensive bottle of wine, thinking that price is a proxy for quality. His point is that there are certain markets where only one party has the information about where the value lies. In the law firm business, the shift from a sellers market to a buyers market means that the law firm used to have the information about the value of services delivered, but now the buyer has as much, if not more, information. This is why alternative fees have become so important. 

Clients are using companies such as TyMetrix to quantify the role of their outside counsel.  Tim showed a few examples of what these scorecards and analytics might look like, and said that the challenge today is knowing that the client has a relative sense of what they're willing to pay, and the value of certain services, but not knowing what they know. 

Tim showed a rate analyzer, provided by a company that has collected, aggregated and anonymized e-billing data over multiple years. They can now produce reports for in-house counsel that show for certain SIC codes, industries, practices, timekeepers, etc. the various ranges for billing data so that they can make benchmark comparisons against the proposals they're receiving. This will inform their tolerance for their budget, and have a downstream impact on law firms. 

In-house counsel will also be able to compare law firms over various rates, look at the trends over time, and make assessments, not only about which firms are more or less expensive, but their relative value. Clients know that an hourly rate is not an indicator that should challenge them - they're willing to pay a high rate if they can get a good value, which is why the trending information, coupled with other analytics, is so helpful. 

All of this shows that clients now have as good, if not better, information about the value of services that law firms deliver - so how do firms collaborate with them to make sure that they maintain their profitability as a law firm?  Tim added that firms have every right to be a profitable enterprise, but that they need to look at their practices that are commoditized versus those that aren't, to get a greater understanding of the value of those services. By using hourly billing for everything, firms don't necessarily have that level of precision. 

R.U.L.E.S.

This acronym stands for Realization, Utilization, Leverage, Expense and Speed (or Speed of Collection). Tim said that these are the things that law firms grew up with - they understood that profits are a function of these elements. If we have timekeepers that are busy, and we capture that and invoice their time, and clients pay those invoices, that's realization. On each matter that we perform, if we have the right ratio of timekeepers, that's our leverage, and we can manage profitability.

If we manage our overhead (expenses) and keep these low, and if we bill and collect in a timely manner (speed), those factors will all reduce to that profits per partner or equity partner that firms strive for at the end of each year. 

Tim likened this to our belief that home values would always rise - law firm partners grew up under a model where they believed that the only way to achieve profitability was through these metrics. However, the rest of the world embraced a different concept - the "learning curve." This is where if you're good at something, you can continually lower your cost of delivery and achieve profits, even when revenues are flat or declining.

Tim asked the attendees to think about the challenges at a law firm - when lawyers become an expert at something, they charge a higher and higher rate. However, a client is saying that if the lawyer has done something multiple times, they should be charging a lower and lower rate. Tim suggested that it would be nice if we could reconcile these two views, and say that we're going to be more profitable by leveraging our experience, rather than our inefficiency. 

There is an anecdote about training a young elephant not to run away - if you tie its leg to a stake with a rope, the elephant will learn that no amount of pulling will free him.  So then as an adult, he's conditioned to not even try to pull the rope, and the same small rope and stake can be used to secure him. The point behind this is that if lawyers break out of the mold of how they learned that law firms make profits, they can achieve higher profitability through these methods.  

Tomorrow, we'll continue the discussion of alternative fees, and we're also hosting our third and final webinar on contract lawyers and outsourcing, so I'll be recapping that in the coming weeks as well! 

Are you Thinking...Alternatively?

Now, as I mentioned in my summary of the GC Panel at the LMA Conference this year, Jeff Carr says he's banned the word "alternative," because there should be nothing alternative about alternative fees.

But, for the sake of this recap, we're going to use it, as that's what the session focused on.  Tim Corcoran shared with us the salient points from the alternative fees session that he attended at LMA (and often speaks on himself). 

  • Most law firms are reactive when it comes to offering alternative fees because they're concerned that they're dilutive to profits. But the firms that have figured this out and are acting proactively are seeing business development opportunities and more work. 
     
  • There's a correlation between value and charging - lawyers need to understand this. 
  • Firms that are more proactive have a toolkit - there's recognition of what they use for various patterns, and a gating process for approval.

    • Firms still don't have the greatest monitoring. They need to meet threshold levels, so monitoring is critical. 
       
    • Continually revise this toolkit - after each matter, figure out what worked, what didn't, and what the scope was. 
       
    • Clients also have creative ideas - talk to them. 
       
  • Fees are moving from a last minute drop-in in the proposal stage to being done up front, with the rest of the proposal built around the billing. 

    • Don't even start the process until billing is in order.
       
    • This is still driven by lawyers, but it's becoming more symbiotic with marketing. 
       
  • Clients are coming to the table with much more information on billing (as I mentioned Janet Dhillon of JC Penney said), so be prepared! 

What trends are you seeing in alternative fees at your firms?