The latest post from Jim Hassett’s blog Legal Business Development.
Challenge #4 The varieties of realization
A better approach to profitability starts with realization, as typified by this chair we interviewed:
But realization is a lot more complicated than most lawyers think, because it comes in many flavors and goes by many names, each with their own strengths and weaknesses. The best summary of the underlying issues appears in an article by Jim Cotterman of Altman Weil, one of the leading consultants in this area, which explains seven key components that underlie various definitions of realization:
One result of the complexity is the fact that a number of different realization rates could be used to summarize a single situation, as shown in the table below.
Note that in all five cases, the firm is putting in the same amount of work (2,000 hours by a single lawyer) and bringing in exactly the same amount of revenue ($720,000). But the realization rate could be as low as 72% or as high as 95%, depending on which realization formula is used. And there are many other ways that some firms define realization, so there are far more than five options.
If all these formulas and examples seem confusing to you, you are not alone. Indeed, the two major conclusions of this brief overview are:
When it comes to confusion, it is important to note that this can affect law firm leaders’ views of their own and other firms. We recently heard one story about two firms that were considering a merger, in part because one firm was impressed by the other firm’s 90-plus percent realization rate. But when they later looked deeper into the figures, they found that the realization rate would have been much lower if both firms used the same formula.
Cotterman’s article also included a number of examples of ways these differences have important business implications for firms as a whole:
When Cotterman reviewed an earlier draft of this chapter, he noted that it “shows how easily one can become confused in the conversation and the need to examine realization on its individual components—that is where the real work is.”
Another reviewer offered this anonymous example of the problems one can get into when using realization as a measure of profitability:
This confusion is one of the reasons firms are moving away from realization as the sole measure of profitability. As one chair said:
For an extreme example, consider an associate who earns $400,000 and bills 2,000 hours in a year. Now imagine that for competitive reasons that have nothing to do with the associate himself, the work was bid and paid at an average of $175 per hour. This does not cover the associate’s cost under any definition. Revenue of $350,000 (based on 2,000 hours times $175) does not cover a $400,000 salary plus benefits, no matter how you calculate cost. However, under definition 4 or 5 in the table above, that associate’s realization rate would be 100%.
When it comes to influencing behavior, the differences between definitions are not just mathematical subtleties that only a CPA would care about. You get what you pay for, and the realization approach a firm chooses can shape lawyers’ behavior, since firms often measure lawyers’ success and award their compensation based on realization. The lawyer in our table above could be rewarded for high realization if it was calculated at 95% (Version 4) or penalized if it was considered 72% (Version 3), despite the fact that both versions have exactly the same impact on the bottom line from a business point of view.
In today’s rapidly changing environment, the problems can be especially challenging for firms that use standard rates as the base for computing realization. In that case, to improve your realization all you need to do is lower your standard rate, as this senior partner implied:
If partners are rewarded for realization rates based on what is billed rather than what is collected, it will drive them to put in more hours, even when that produces no revenue for the firm, as this senior executive noted:
Or, as a senior executive at a different firm put it:
The next post in this series will discuss the concept of leverage.
This series is an excerpt from my book Client Value and Law Firm Profitability. An edited and abridged version of this series appeared in the March 2015 issue of MP magazine. The MP article can be downloaded from our web page
When I interviewed chairs, managing partners and other leaders of AmLaw 200 firms for my book Client Value and Law Firm Profitability, it quickly became clear that while most agreed that profits are being squeezed by changes in the legal marketplace, they disagreed sharply on the definition of the word profit.
Of all the topics I investigated in this research, the definition of law firm profitability was by far the most controversial and the most confusing, by a large margin. This series of posts describes six different approaches law firms take to profitability, and the challenges associated with each.
Challenge #1 Relying on intuition
An outsider with no knowledge of how law firms operate would naturally assume that all large firms use basically the same accounting procedures and formulas to define profitability. But they would be wrong.
35 participants in the survey answered this question: “If you compare profitability for two lawyers in your firm, is there a software program or formula used to calculate profitability, or is the comparison more intuitive?” 74% said by software or formula, and 26% said the comparison was more intuitive. In other words, about one out of four of our respondents did not have any objective measure of profit, but they know it when they see it.
As one senior executive put it:
The managing partner at another firm put it this way:
A senior executive at a third firm pointed to subjective views of certain types of matters:
The managing partner at a fourth firm listed some of the factors involved in forming an intuitive impression:
Can you think of another industry where one out of four firms analyzes profitability intuitively? Me neither.
A more positive person might see the glass as three-quarters full rather than one-quarter empty. But even that may be too optimistic. According to Research Advisory Board member Steven Manton, strategic pricing leader at Debevoise, “Three out of four is actually a higher number than I would have expected. I’ll bet many are not really using the profitability number, even if they have it.”
Challenge #2 Relying on revenue
In the quote above from the managing partner who listed several factors in evaluating profitability, the first factor he mentioned was gross revenue. As another managing partner pointed out:
The senior executive quoted above about the visceral reaction that IPOs are profitable went on to say that:
Similarly, one anonymous reviewer of an early draft of this report commented:
However, some firms continue to look at revenue as the primary measure of success, like this chair:
One problem with this approach was articulated by a consultant we interviewed recently. He told us a story about a partner who brought in $80 million a year to one firm and was highly compensated for it. But his clients constantly asked for greater discounts and realization went down sharply. Meanwhile, the firm had to hire many more lawyers to do all this new work, which further increased costs and made the $80 million still less profitable to the firm.
People in other businesses also sometimes make the mistake of focusing on revenue alone. There’s an old joke about an entrepreneur who was looking for investors in a farm stand. He needed more capital to keep up with the demand for the watermelons he sold for $2. But he was buying them for $2.10 each, and losing $.10 on each and every one. When a potential investor asked how he would make a profit, the entrepreneur answered, “I’ll make it up on volume.”
The application of this fallacy to the legal profession was well-stated by the managing partner quoted at the start of this section, who went on to say:
Challenge #3 Focusing on profits per equity partner
When lawyers talk about profit, many think first and foremost about profits per equity partner, a figure publicized in the American Lawyer’s annual rankings of the top 200 firms. These figures are widely perceived as a sign of financial health and sometimes used to recruit laterals to higher profit firms.
There are many problems with these figures, not the least of which is that they are unaudited. A New Yorker article about the demise of Dewey LeBoeuf noted that the firm reported high profits per partner before it collapsed and explained that, “Members of the executive committee knew that [the profit figures they publicized] were not the numbers… that appeared in its audited financial statements. The submission was justified as a marketing effort.”
Dewey was not the only firm to exaggerate. A 2011 ABA Journal article entitled “Are BigLaw Firms Inflating Partner Profits? Citigroup Unit Reportedly Finds Fudging” reported that, “More than half of the nation’s top 50 law firms could be overstating profits per partner to the American Lawyer magazine… An analysis by Citi Private Bank Law Firm Group reportedly found that 22 percent of the top 50 firms overstated profits per partner by more than 20 percent in 2010. Another 16 percent inflated partner profits by 10 to 20 percent, and 15 percent boosted partner profits by 5 percent to 10 percent.”
The widescale reliance on profits per equity partner is unfortunate and has led to many misunderstandings.
The dictionary definition of the term profit is, “Money that is made in a business… after all the costs and expenses are paid.” But, as I wrote in my book Legal Project Management, Pricing, and Alternative Fee Arrangements (p. 102):
The American Lawyer figure might better be called “net revenue per equity partner,” because that’s what it is. The fact that the term profit is used continues to lead to much confusion among lawyers and their clients. For example, one managing partner in our study said:
High profit per equity partner figures also lead to client resentment and some misguided negotiating. In my book, Legal Project Management, Pricing, and Alternative Fee Arrangements (p. 209), I described a billing approach to litigation proposed in an ACC Docket article in which the profits per equity partner would be withheld until the end of each case and treated as a “bonus depending on the total amount invested and the outcome of the litigation.” What the authors did not seem to realize is that they were proposing that the partners work essentially for free unless the client chose to award this “bonus.”
Even if the figure of profits per equity partner were not so misleading, it summarizes the total profits of the firm and does not allow management to answer one of the most important questions in a changing marketplace: Which matters, practices, partners, and offices make money and which don’t? In most businesses, companies analyze which product lines and groups are profitable, and they act on that information by fixing or discontinuing unprofitable products or people. The remaining three posts in this series will describe other approaches that law firms are using to answer that question.
This series is an excerpt from my book Client Value and Law Firm Profitability. An edited and abridged version of this series appeared in the March 2015 issue of MP magazine. The MP article can bedownloaded from our web page.
Clients are demanding greater efficiency these days, and efficiency should start before each matter begins. Instead of jumping right in, set aside a little time for planning and ask such questions as:
The first Wednesday of every month is devoted to a short and simple tip to help lawyers increase efficiency, provide greater value to their clients and/or develop new business. More information about this tip appears in the third edition of my Legal Project Management Quick Reference Guide.
An example of a simplified approach to process improvement: How to improve associate and paralegal time entries
Several years ago, I wrote in this blog about lawyers’ confusion about the differences between process improvement and legal project management (LPM). To this day, we often hear from lawyers who think process improvement is the first or the only step in LPM.
In my book Legal Project Management, Pricing, and Alternative Fee Arrangements, I have argued that process improvement is just a small sub-area within LPM, and usually the worst place to start.
The confusion has arisen largely because Seyfarth Shaw has been so successful in publicizing its SeyfarthLean® process improvement programs. What many lawyers don’t remember is that Seyfarth began working on these programs nearly a decade ago, and according to an April 2010 article in The American Lawyer, reported spending over $3 million in just its first few years working on these programs.
There is no question that process improvement can improve efficiency. But there is a huge question about when or even if a particular firm should start down this path.
At LegalBizDev, we believe that few - if any - firms can justify the time and money required for even a “lean” approach to process improvement. It simply takes too long and costs too much. And even after you define a better process, many lawyers will resist following it.
When I interviewed leaders of AmLaw 200 firms for my recent book Client Value and Law Firm Profitability, I asked about their most pressing concerns and “low hanging fruit.” None mentioned process improvement. Instead, they reported that the two most urgent areas for LPM improvement are defining scope and communicating better with clients.
Fortunately, there are some highly simplified approaches to process improvement that don’t require spending millions of dollars, or even attending a half day workshop. Several are described in the third edition of my Legal Project Management Quick Reference Guide (beginning on page 36), and applied in our coaching and other programs. The short guest post below was written by one of our clients who used these very simple techniques.
A guest post by Judith Droz Keyes
Judith Droz Keyes completed our Certified Legal Project Manager Program® and is a labor and employment lawyer and partner at Davis Wright Tremaine. Several months ago, we published her guest post on another topic based on her answers to essay questions from her certification. In the example in this post, she quickly applied simplified process improvement techniques to address a problem faced by many law firms: Associate and paralegal timesheet entries are often written poorly, inconsistently, or not in accordance with firm standards, requirements or expectations. This can result in time wasted to rewrite them and ultimately in time being written off. Judith’s improved process is built around a few short steps:
On June 8 in Chicago, five law firms that have made significant progress in LPM will frankly discuss what has worked and what hasn’t at the fifth session of one of the Ark Group’s most popular events : “Legal Project Management Showcase and Workshop: Changing Behavior within the Firm.” I look forward to chairing this session and discussing the latest developments with:
If you are planning to attend this year’s Legal Marketing Association’s P3 conference (the three Ps stand for Project Management, Pricing, and Process Improvement), you may notice that the Ark conference is scheduled one day before P3, which is also in Chicago. That was not an accident. I hate to travel, and Ark was kind enough to agree to schedule this workshop the day before P3 to save me a trip. I wouldn’t miss P3.
Implementing LPM is more critical than ever. In Altman Weil’s 2014 Chief Legal Officer Survey, the top three things that clients wanted were greater cost reduction (58%), more efficient legal project management (57%), and improved budget forecasting (56%). Since LPM will help meet the first and last requests, you could say the top three things clients want are LPM, LPM, and more LPM.
From the law firm point of view, when I interviewed AmLaw 200 chairs, managing partners and senior partners and executives for my book, Client Value and Law Firm Profitability, LPM was identified as the single best way to provide greater client value while protecting profitability. But many firms have learned the hard way that while it is easy to offer awareness training to lawyers focused on LPM theory (and put out a press release announcing all their lawyers have now been trained in LPM), it is very difficult to get them to change their behavior. The managing partner of one AmLaw 200 firm that invested heavily in traditional training and was disappointed in the results put it this way:
After previous sessions of this program, audience members said:
For more details about what these five firms have done so far, and on the workshop, download the brochure, visit the Ark Group’s web page or contact Ark’s Peter Franken at email@example.com or (312) 212-1301. Readers of this blog qualify for a special 15% discount. Simply write “LegalBizDev Discount” on your order form and subtract 15%, or ask for the discount when you register by phone.