Compensation, Billable Hours Limiting Law Firms' Success

Legal Intelligencer reporters Gina Passarella and Hank Grezlak have authored a series of articles on the changing law firm business model and how law firms must adapt to compete. The first article in the series, "Law Firm 3.0: Information Changing Law Firm Models", can be found here. The second, "Compensation, Billable Hours Limiting Firms' Success," can be found here. In this second article I was quoted extensively, so here is some additional context for my comments.

 

"I don't think that the primary determinant for quality in the past, which has been size, is going to be as much of a factor going forward," according to Timothy Corcoran of Corcoran Consulting Group. He was referring to size of revenue, profits, head count and hours billed. "It is so tied up in everything related to Big Law and yet it is a red herring," Corcoran said. "Most businesses would not equate size with success."

Many law firm management committees and equity partners equate success with size. Bigger is better, in large part because the traditional law firm economic model requires additional timekeepers to grow revenues and profits. Want to make more money? Acquire a firm or a practice or recruit laterals. Want to be considered one of the elite attorneys in town? Establish the highest billable hour rate. Want to secure first place in your preferred ranking? Represent the most clients on the most matters in your chosen specialty. Want to secure front page coverage in the American Lawyer magazine? Secure the highest PPP (profits per partner) in the American Lawyer rankings. Yet few clients claim to value law firm size above all else. Experience matters, of course, and with transaction volume comes experience. But it's not the volume itself that delivers value -- it's the efficiency and predictability and comfort that comes with experience that clients seek.

Corcoran said he knows of partners who could double their books of business but choose not to do so because their firm compensates them for billing hours. The fastest growing segment of Corcoran's practice is compensation redesign, he said. For several years he has worked with firms on project management and alternative fees, but "sooner or later you run into a brick wall. And it's simply that, when you put a lawyer in a position of choosing between his economic self-interest and what is good for the firm on a long-term basis, they will oftentimes choose what benefits them," Corcoran said. He said he doesn't blame the partners for that. "In any business, if you have a compensation plan that is in conflict with your strategy, the compensation plan becomes your strategy," Corcoran said. He said firms can reward hunters and farmers—rainmakers and service partners. But right now, many firms have compensation strategies that are in conflict with the cross-selling initiatives most firms espouse, particularly the focus on origination without accounting for sharing the credit or without a willingness to move credit to a new partner who has taken over the bulk of the work. Corcoran said having different formulas to compensate different behaviors is where firms should go. "That will very likely result in income disparity and that is not, in and of itself, bad," Corcoran said.

Enduring businesses encounter different economic cycles, sometimes simultaneously. Product A is in a mature market with dominant market share, with high prices and high profits, but looming on the horizon are disruptive entrants offering more benefits at a substantially lower cost. Product B competes with a dozen similar offerings and while sales volume is high it offers very slim margins. Product C is a creative new entrant offered at an introductory price and is taking the market by storm, shifting significant market share from long-entrenched and higher-priced competitors. Product D is a luxury product offered in a market with a down economy in all sectors. Product E is a commodity product offered in a boom economy where consumer demand and discretionary spending as at an all-time high. Product F is a high-end product with a very limited addressable market, say multi-billionaires. Now... which one compensation plan can be imposed on all stakeholders -- salespeople, manufacturing, account managers, executives -- that perfectly aligns and drives appropriate behavior so that each product line secures the optimal balance of revenue, profit, and market share?

The corollary to law firms is that most firms rely on one compensation plan that applies equally to all equity partners, regardless of the economic cycle facing individual practices, the varying tenure and experience level of individual partners, or the particular business objectives of the firm this year. Absent a strategic plan and a compensation plan that are inextricably linked, particularly in an organization which retains no earnings, partners are likely to take actions that maximize their short-term income. And who can blame them? Issuing vague platitudes regarding the "firm as a family" culture but only rewarding individual billable hours isn't an indictment of self-serving partners; it's a management failing.

The law firm business model is maturing, with some help from the recession, but is really just facing the same business questions that other industries have already had to answer, Corcoran said. When demand was high, law firms would have a staff that looked like a grocery store with 37 checkout lines open at 2 a.m. even though there were only four shoppers in the store. The idea was firms would be ready for anything, Corcoran said. Law firms can't go to the opposite extreme of a [just-in-time] manufacturing business in which it would take an order and promise delivery in six weeks once it got the proper parts and people in place, he said. But they can rely on a flexible workforce of contract lawyers, legal process outsourcing and other alternative models. The "grocery store" can look like it has 37 lines open at 2 a.m., but the law firm is only paying for five of those cashiers as salaried employees, Corcoran said. "Downsizing isn't a big, traumatic affair," Corcoran said. "Every business on the planet ramps up for an initiative and then moves on [when it's over]. It's perfectly OK to rely on a flexible workforce." That means the number of lawyers on the stable payroll might be smaller, but the size of the overall workforce could fluctuate based on need, he said.

Corporations eschew the carrying cost of under-utilized resources. The reason law departments aren't huge -- and why many that are staffing up today will outsource those jobs under the next leadership regime -- is that the cost of recruiting and maintaining non-core assets presents an opportunity cost to the business. The local grocery store doesn't own apple orchards or cows because it can more efficiently purchase these items wholesale and resell them at a profit. And apple orchards don't rely solely on their own storefronts because they can earn greater profits selling produce to grocery stores. Businesses can hire law firms periodically at a far lower cost than employing a full staff of lawyers in all specialties who stand around waiting to be called. Law firms in turn, are expected to mobilize quickly. Traditionally this meant hiring a large staff of lawyers who scramble to look productive by billing time whenever they answer the phone or review a memo, some of which adds little value to a client matter. So law firms struggle to balance utilization (or how to keep lawyers busy without over-billing clients) and realization (what clients are willing to pay vs. what they've been billed). The most obvious lesson is lost on many law firm leaders: many law firms exist because they represent a good outsourcing opportunity for clients, so a sensible law firm staffing strategy should also rely on outsourcing to minimize carrying costs and provide maximum flexibility. There are many excellent lawyers available!

The fastest way to developing a new law firm model, Corcoran said, is to change compensation plans and not rely so heavily on the billable hour. Corcoran said the billable hour devalues the law firm's contribution far more than it impairs the buyer's ability to buy services. He described it as a "self-imposed [con]straint on revenues and profits. Once firms realize this, they will run from the billable hour," Corcoran said.

I'm surprised this is still a debate. And it is, even by those who should know better. Look, if you want to bill by the hour, go for it. If the services a law firm renders are priced within a range the client has established as tolerable, and the quality is measurably acceptable, then it may not be productive to quibble over the mechanics of the invoice.  But don't be surprised if the client recognizes the inherent conflict of interest, particularly when linked to a compensation system rewarding billable hours, and questions everything. If changing because the clients want you to isn't enough incentive, why not do it because it's a stupid economic model? If my daughter announced an interest in launching a lemonade stand in the front yard and came to me for capital infusion, the first caveat in her business case would likely not be "And I've imposed an absolute ceiling on the revenue I can earn." Yet this is what law firms do by adhering to the billable hour: "We have determined, on January 1st, that our number of timekeepers, multiplied by their respective billing rates, multiplied by the finite number of hours in each workday, will be our absolute cap on revenue. Hopefully we can continually find ways to reduce overhead costs if we wish to pocket more profits, otherwise we're forced to add more timekeepers to bill more hours... even though those timekeepers also come at a high cost."

In business we learn how to make money while we sleep. In many law firms, however, the sleeping is happening behind the wheel. The beauty of AFAs is that once the client agrees to a price, the law firm has every incentive to boost profits by finding lower-cost ways to deliver the same quality outcome, and the client doesn't need to meddle in the production or the invoicing or the staffing or the hours. This is why legal project management and process improvement are, and have always been, far more beneficial to law firms than to the clients.

"Sooner or later, everyone will catch up," Corcoran said. "But right now, those that are really changing, what an opportunity to grow market share."

This, in a nutshell, is the challenge and the opportunity. Clients and laggard competitors are providing the economic catalyst for change, and lessons from other business sectors provide the roadmap for thriving, not just surviving. Yet so many law firm leaders are reluctant to take action. Eventually, the ability for law firm  leaders and individual partners to control their own destiny will diminish. Why not act today?

Timothy B. Corcoran is the immediate past President of the Legal Marketing Association and an elected Fellow of the College of Law Practice Management. He delivers keynote presentations, conducts workshops, and advises leaders of law firms, in-house legal departments, and legal service providers on how to profit in a time of great change.  To inquire about his services, contact him at +1.609.557.7311 or at tim@corcoranconsultinggroup.com.