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The latest post from Jim Hassett’s blog Legal Business Development.


Six challenges in defining law firm profitability (Part 2 of 4)

Challenge #4 The varieties of realization

A better approach to profitability starts with realization, as typified by this chair we interviewed:

We have made a big point to our attorneys that the focus is not revenue, it is profitable revenue. We try to get to realization. We start with the standard rates on a person’s time, and then we can determine, when bills are rendered and receipts are achieved, what percentage of the standard value we collect. It could have been a discount at the beginning. It could have been a write-off along the way. It could have been a billing or payment adjustment, whatever. But we look at the relationship between the standard value and the collection. If you spend $3 million worth of time to produce $5 million worth of revenue, that’s a hell of a lot better than spending $4.5 million worth of time to collect $5 million.

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:

  1. Timekeeper discounting at the timesheet
  2. Write-downs of unbilled time
  3. Client adjustments resulting in write-offs ofreceivables
  4. Pricing variance
  5. Efficiency variance
  6. Turnover of unbilled time
  7. Turnover of accounts receivable

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. 

 Five Different Realization Rates for a Single Situation

The facts: A lawyer has a standard billing rate of $500 per hour and bids on 2,000 hours of work at a discounted rate of $400 per hour. She works 2,000 hours but before the bill goes out, she writes off 100 hours of inefficient time, so she only bills for 1,900 hours at $400 per hour. The client refuses to pay for 100 hours of this, so the firm is ultimately paid for 1,800 hours at $400 per hour.

Version number

Revenue paid to the firm

Realization formula

Realization calculation

Realization rate

1

$720,000

Revenue bid/ Revenue at standard rates

$800,000 (2,000 hours at $400) / $1,000,000 (2,000 hours at $500)

80%

2

$720,000

Revenue billed/ Revenue at standard rates

$760,000 (1,900 hours at $400) / $1,000,000 (2,000 hours at $500)

76%

3

$720,000

Revenue paid/ Revenue at standard rates

$720,000 (1,800 hours at $400 / $1,000,000 (2,000 hours at $500)

72%

4

$720,000

Revenue billed/ Revenue at bid rates

$760,000 (1,900 hours at $400) / $800,000 (2,000 hours at $400)

95%

5

$720,000

Revenue paid/ Revenue at bid rates

$720,000 (1,800 hours at $400) / $800,000 (2,000 hours at $400)

90%

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:

  1. Firms’ different definitions of realization can lead to considerable confusion when people try to compare results across firms
  2. The definition that a particular firm chooses may affect lawyers’ behavior in unintentional and unproductive ways

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:

We had a law firm client that was thrilled with their near perfect overall realization. Upon examination we discovered that their high realization was due to unbelievably low billing rates resulting in lost revenue overall. At the other end of the spectrum, large accounting firms have been known to have realization figures in the low 80%s due to routinely large discounts off high standard rates. These are two examples, one unintended and the other planned, where realization is affected by pricing decisions.

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:

I had one huge litigation where realization was not great, probably 80%. But all the associates worked long hours on the case, including nights and weekends. Effectively they were working overtime, at no additional cost to the firm. Also, the client had a policy that you could not bill for travel time, and there was a lot of it. I felt, in fairness, that they should record all their travel time and I would just write it off as billing lawyer. Other partners would have told them not to write it down at all, so their realization would have looked better, although profitability would have been exactly the same.

This confusion is one of the reasons firms are moving away from realization as the sole measure of profitability. As one chair said:

A lot of times, there is confusion that profit is just realization.

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:

When you look at those realization rates and you compare them to the actual profit margins based on standard hourly rates of the underlying timekeepers, it’s all over the board. There is no consistent profit margin in those rates anymore and hasn’t been for years, because nobody’s gone back and sunsetted them and started them all over again. So what’s happened over time is, as rates have been adjusted, some up, some down, you’ve lost that connectivity. So realization really is no longer an effective measure of profitability.

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:

For evaluating partners we’ve always looked at realization and realized rates, among other things. And some of our internal experts are concerned that those are the wrong numbers to be looking at because they can drive the wrong behavior, especially in an age where they allow people to price low and it doesn’t matter what we charge for it. They’re very concerned that if the project isn’t done on time and on budget, lawyers can be rewarded for putting in more hours, even though we don’t make any money.

Or, as a senior executive at a different firm put it:

I think we've been much too focused on realization and that partners have a skewed view of what’s really profitable. They assume low realization means not profitable and high realization means profitable, and we’re just starting to get them to come around to the idea that that’s not always the case. I think we can go a lot farther down the road of getting partners to understand the impact of leverage on profitability.

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 magazineThe MP article can be downloaded from our web page 

 
      


Six challenges in defining law firm profitability (Part 1 of 4)

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:

We don’t calculate profitability by formula. It’s really seat of the pants.

The managing partner at another firm put it this way:

Profitability is to some extent in the eye of the beholder. We’re still looking for good tools to evaluate what is profitable and what is not.

A senior executive at a third firm pointed to subjective views of certain types of matters:

Lawyers have a visceral association about what kinds of litigation matters or corporate/securities matters would be very profitable, such as an IPO in the corporate sphere or a major, multi-state litigation.

The managing partner at a fourth firm listed some of the factors involved in forming an intuitive impression:

We look at gross revenue. We look at how that compares to standard rates versus discount rates or AFAs. We look at collection problems. We look at staffing. Is it staffed all with partners, or are there staff-staggered billing rates? And then we come up with an impression. But we don’t analyze profitability through any software program or formula.

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:

Law firm partners for a long time equated successful practice with revenue.

The senior executive quoted above about the visceral reaction that IPOs are profitable went on to say that:

Huge matters are associated with larger revenues and I think attorneys associate larger revenues with larger profitability. We’ve just started to be able to look beneath the surface on large and small matters to determine how much of these revenues are winding up being profits. But I think that we are a long ways away from having that be in the consciousness of the average attorney at the firm. It’s just a few people who are looking at that and thinking about those things so far.

Similarly, one anonymous reviewer of an early draft of this report commented:

When I was on our firm’s executive committee, it was always frustrating to me that gross collections seemed to dazzle my colleagues, even when write-offs were significant. I often reminded them that the partner with the biggest collections could also be the biggest reason for a bad year if he used up too many resources. I think we’re better at recognizing that now, but the impact of write-offs on net profits is still given too little weight in compensation decisions.

However, some firms continue to look at revenue as the primary measure of success, like this chair:

We’ve chosen revenue per lawyer as the principal metric that we pursue. It’s important to give your partners something to aim at. Lawyers are competitive and they respond well to goals. So if you don’t set a target, then you’re unlikely to get a very disciplined set of behaviors.

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:

I have a $10 million practice. But that could be a disaster for a firm, because it could cost them $11 million to get $10 million, but nobody ever talks about it that way. We need to get partners accommodated to the idea that we don’t really care what your revenue is, we care what your profit is.

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):

Unfortunately, the term “partner profit” is not typically used this way in the legal profession. “Partner profit” usually refers to the amount of cash remaining to distribute to equity partners after all other expenses and non-partner salaries are paid. Partner salaries come out of the “partner profits” pool. In a large firm, if there were no partner profits, partners would be paid nothing for their work.

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:

As a partnership, everything we make above our cost is profit. I once had a lawyer who stood up and said, “How did we lose money this month?” I said, “We didn’t lose money, we just didn’t make as much money as we would have liked.” It’s very hard for a law firm to lose money, that is, be in a situation where you’re not paying your partners anything.

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 magazineThe MP article can bedownloaded from our web page.

 
      


Tip of the month: Improve the way you plan activities at the start of every matter

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:

  • What deadlines will best align the client’s needs with the firm’s interests?
  • How can this large matter be divided into smaller sub-tasks which a single individual on your team could be responsible for?
  • Which tasks are on the critical path? That is, which tasks must be completed before others can start?

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:

 

  1. I could provide a written set of rules/standards to be followed in all matters on which I am working (e.g., capitalization, punctuation, avoidance of “email to J. Keyes” . . . .)
  2. As part of the project plan, the team and I could agree on phases and phrasing (e.g., complainant vs. claimant).
  3. Before I review a prebill, I could forward it to the associate on the matter, to review and improve it in accordance with the rules.
  4. Before I review a prebill, my secretary could review it for certain things, and she could forward it to the associate to review and improve.
  5. Regarding time:  At the outset of every assignment or task, I could have a clear understanding with associates and paralegals about the time to be spent and billed.
 
      


LPM workshop: Experts from five firms discuss how to change behavior

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:

Andréa Danziger, Director of Business Development and Practice Management, Loeb & Loeb

Stuart J T Dodds, Director of Global Pricing and Legal Project Management, Baker & McKenzie

Michael Nogroski, Director of Knowledge Management, Chapman and Cutler

Scott Wagner, Partner, Bilzin Sumberg

Matt Wahlquist, Director of Practice Management, Stinson Leonard Street

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: 

I think project management probably will have the longest-term positive impact [on value and profitability], but it’s been the biggest challenge, because it’s something that hasn’t been easily absorbed by a lot of the lawyers. When busy lawyers start scrambling around, the inefficiency creeps right up. At our firm, project management has not met expectations.

After previous sessions of this program, audience members said:

This workshop did an excellent job of offering practical suggestions for dealing with the issues law firms encounter when they implement legal project management. The frank discussions between partners and executives at firms that have successfully changed lawyers’ behavior would be helpful to anyone who is trying to get their arms around this challenging transition.

Delilah Flaum, Partner in Charge of Knowledge Management and Legal Project Management at Winston & Strawn LLP

 

This workshop is a great way for any law firm to jump-start an LPM initiative. Jim Hassett has the experience and credentials to be THE leader in this area. His approach is directly applicable to achieving greater efficiency, competitiveness, and client satisfaction and the workshop panelists described how they used LPM to increase revenues and repeat business. I was truly inspired and enabled by this program to achieve higher profitability for my firm.

Pete C. Elliott, Director of Legal Project Management, Benesch, Friedlander, Coplan & Aronoff LLP

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 pfranken@ark-group.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.

 
      



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