Legal Budgets and Corporate Budgets - Why Predictability Matters

I recently met with a group of law partners to discuss the feasibility of increasing the firm’s billing rates for the coming year.  Normally this doesn’t require a discussion; the firm traditionally raises its rates 5-6% every year.  And normally this takes place in January once the prior year's books are settled.  This year, however, and to the partners’ credit, they questioned the optics of raising rates at a time when most of their clients are still suffering from the impact of the global economic meltdown, or the Great Reset, as Bruce MacEwen calls it. As we debated the pros and cons, it was apparent that the partners had very little understanding of the impact an increase to their billing rates might have on a client.   In fact, none of the partners had worked in a corporate setting previously so they had no real insights into the typical corporate budgeting process.  Perhaps a peek behind the curtain may help inform this discussion, as it’s a process full of surprises to law firms that often have rudimentary budgeting processes in place, if at all.

The first surprise is when budget discussions commence.  Assuming the fiscal year corresponds with the calendar year, most businesses start preparing budgets in August.  Yes, in August prior to the budget year.  It takes time to develop a budget from the ground up.  In days past budgeting may have been approached as an exercise in what’s different or, in other words, starting with last year’s budget and merely adding new items and deleting old items.  No more.  Now there’s an expectation that every budget must start at zero, and from this starting point we add in each and every cost until we identify the total budget needed.  And then we start paring it back.

Many lawyers operate under the delusion that the practice of law is inherently and infinitely variable, meaning that unlike other business functions one cannot predict legal costs with any certainty.  This opinion is often held by outside counsel and in-house counsel alike.  Imagine the plight of the General Counsel:  she doesn’t know how many deals the business executives may initiate in advance when even they don’t know.  She has no insight into what product liability suits the company may face, or what type of employment actions will be raised.  For litigation already underway, she can’t possibly predict the next move the adversary may make, so by definition she can’t budget for how she’ll react.  And even acquisition due diligence may reveal complications that are impossible to predict.  These are reasonable concerns, but they fly in the face of the number one rule in business: no surprises.

One can make mistakes when climbing the corporate ladder.  One can make some mistakes again and again.  One can even make colossal mistakes that cost the business money.  But the one mistake anyone aspiring to reach the board room can’t make again and again is surprise.  Corporations, both public and private, thrive on certainty.  Forward-looking statements to shareholders and analysts must be based on a reasonable estimate of future performance, or else the stock price will suffer in the market.  Even private companies that don’t publish earnings must have predictability to properly allocate capital.  For business leaders to establish priorities they must have the facts, and the worst crime is to provide inaccurate information because this leads to making poor business decisions.

Another surprise may be that erring on the side of caution can be as egregious a mistake as overestimating performance.  Imagine the Senior Vice President of Marketing who submits a revenue forecast estimating $275 million in sales, knowing full well that the business is on track to deliver $280 million in sales.  On paper this looks clever, because bonuses increase with overachievement, and everyone looks good when we beat the targets, right?  However, it’s not uncommon for the CEO and CFO to punish the business leader who builds in too much revenue cushion, because we might have made different decisions about our allocation of capital if we knew that we had more to work with.  A critical project with great long-term potential may have been delayed or tabled because we didn’t have sufficient investment available.  (The worst offenders allocate a reserve that benefits only themselves.)  Obviously there’s also punishment for missing the targets, particularly when it results from poor planning rather than external market events.

But how do they do it?  How do corporate executives weigh numerous variables to establish an accurate forecast?  After all, don’t most business functions carry some level of uncertainty?  Think of the head of manufacturing who must predict costs despite the possibility of critical supplies being hijacked by Somalian pirates, or labor unrest in the fields of South America, or political unrest in the Middle East impacting oil prices which in turn have a material impact on the costs of transportation in our supply chain.  And what about the corporate treasurer who has to predict the impact of currency fluctuations or interest rates on the company’s cash flows, in order to hedge against this.  Our head of Marketing has to examine multiple products across the spectrum of the business cycle, use a little game theory to predict what the competition might do in response to our new product launches, potentially even identify which customers are at risk before the customer even begins to explore substitutes, and build a revenue forecast amidst ever-changing market demand.

There’s no magic formula.  These business leaders build their forecasts block by block, inch by inch, starting first with the known – in the case of sales, perhaps we first identify guaranteed revenue from committed customer contracts, or in the case of manufacturing maybe we look at commodity materials where we have multiple suppliers to ensure sufficient flow and predictable prices.  We then move on to the harder calculations, one by one looking at product revenue in each jurisdiction, perhaps customer by customer; or examining links in our supply chain where we have limited redundancy and therefore greater risk.  Piece by piece we establish a forecast that builds from certain to less certain, but even with the less certain we identify the likely ranges and provide confidence levels based on identified risks.

So you can imagine the amused chuckles in the board room when the Chief Legal Officer throws up his hands and tells his colleagues that the legal function contains too many variables to possibly establish a budget, so instead he’ll take last year’s budget and add 20% -- to accommodate law firm rate increases and other variables – and he’ll only come back and ask for more if something changes.  Gone are the days when this was amusing.  Now a General Counsel may be shown the door if he can’t apply some rigor to the legal budgeting process.  This also explains the increased involvement of procurement officers in the selection, and management, of outside counsel.  This is a clear sign that CEOs and CFOs don’t fully trust their lawyers to extract more value at a lower cost from the in-house legal staff and suppliers, so they’re putting someone at the table whose sole objective is to reduce costs.  Or they wish to, as the saying goes, trust but verify.

These budget calculations and conversations start in August, are debated endlessly through September, and begin moving up the approval chain in October.  There are numerous revisions, typically, as you might expect, requiring all cost estimates to go lower and all revenue estimates to go higher.  But there’s a balance to be achieved between optimism and realism.  Newly anointed business leaders tend to believe that they can extract unnecessary costs that their predecessors overlooked, or that they can rally the troops to commit to higher revenue performance.  Entrenched civil servants throughout the corporation strenuously object to these stretch goals, and work diligently to maintain the status quo, with sufficient safety valves in place for when something goes wrong.  This can be invigorating, and it can be confounding, but in the end the corporation signs off on its revenue and expense budget for the coming year, typically by early November.

As my group of law firm partners discussed corporate budgeting, a few light bulbs appeared above their heads.  One corporate partner recalled receiving a letter in late October from a key pharmaceutical client indicating that they would not accept fee increases from any outside counsel in the coming year.  She recalls wondering why the letter was sent in October, months before most law firms issue rate increases, but it now occurred to her that the corporation’s budgets must have been locked by then.  Another partner realized that even when the economy is humming along nicely and law firms have the latitude to increase rates, the fee increase letters are potentially six months out of sync with the client’s budgeting process!  “No wonder clients claim we don’t understand their business,” he observed.  One of the partners added some levity by suggesting that the annual fee increase letters should go out earlier, say in July.  Another had us rolling in the aisles when she suggested that since law firms always raise rates, and clients know this, perhaps it’s the client’s obligation to build in these expected increases in their August and September forecasts.  When we realized she was serious, we ended up rolling our eyes.  In some segments in some industries, the suppliers can set the price and require the buyer to meet the price, or else not get the product.  (Have you ever tried to haggle significant savings on a Mercedes?)  There are a few law firms with such pricing power.  Let’s be clear: despite your desire to occup this space, the odds are your firm is not one of these.

But does this budget process really result in certainty?  After all, we’ve all seen – or we’ve owned stock in – companies that miss earnings forecasts.  In reality, one never eliminates surprise.  But we can get a lot closer by minimizing it.  There’s a formal process to deal with the inevitable changes that occur in most corporations.  It’s called a reforecast.  It may come as a surprise that most companies begin revisiting their revenue and expense budget numbers in early January.  After all, what can go wrong in the first few weeks of the year?  However, think back to when we began compiling our forecasts.  We weren’t even done with Q3, let alone Q4, so many of our assumptions for the coming year relied on assumptions for how we’d conclude the current year.  And guess what, things have changed since we incorporated those assumptions.

A reforecast is a formal process to revisit our assumptions, to look at costs that exceed expectations and revenues that fail to meet expectations.  And vice versa.  In many corporations this process repeats itself several times a year, often corresponding with the quarterly earnings report in public companies, and in recent years this process might happen 6 or 7 or even 12 times a year.  And it’s not simply indicating that revenues are falling short or that expenses are trending high and then receiving forgiveness on the goals.  That would be cool.  No, instead every functional leader has certain levers to pull to meet the agreed-upon expectations even when there are material changes in costs or revenues.  On the revenue side, perhaps we launch a sales contest, or lower prices to increase penetration.  On the cost side, perhaps we seek alternative suppliers, squeeze the suppliers we have, or reduce costs elsewhere by reducing staff.  Often the reforecast process surfaces significant trouble in one division that will be impossible to make up, so other divisions receive an involuntary revenue or cost surcharge to make up the difference.  This can be painful.  No business leader in the midst of stellar performance, overachieving on every goal, or even those barely meeting expectations, likes to terminate valued employees or table a valuable project because some other division failed to meet expectations.  But it happens.

To add more enjoyment to the budgeting process, most corporate executives have a portion of their annual compensation based on their ability to manage to their budget.  For example, the company may exceed its revenue and profit targets, the share price may exceed analyst expectations, the division may have enrolled a record number of new customers, but the divisional leader will lose 30% of his bonus because costs were over budget.  Those running the legal function are late arrivals to this party, but it’s becoming a material factor in their compensation now.

Recently I observed a panel of General Counsel discuss their likes and dislikes with outside counsel.  One GC remarked, much to the amusement of the roomful of outside counsel: “If my legal budget goes over plan, at least we’ll save money on my bonus.”  The GC didn’t laugh.  He was deadly serious.  The message he was trying to convey is that the late invoice, the one you generate only at the end of the billing period, the one that reflects billings 40% over the original estimate, the one that you’ll accompany with a brilliant, well-crafted memo explaining the 58 reasons why costs exceeded your original estimate, may literally cost him his family’s summer vacation rental, or a semester of his daughter’s college tuition, or the swimming pool he planned to install in the Spring.  Just as with the General Counsel who remarked, “If I don’t find a way to manage the legal function with a lower budget and without compromising quality and throughput, they’ll find someone who can,” your client needs you to be part of the team.

Perhaps these insights into the corporate budgeting process will shed some light on why your clients are so darned insistent on predicting legal costs.  In many cases, predictability trumps total spending, or, in other words, you can charge premium rates as long as you ensure that the fees are not surprises.  You may also question whether a fee increase is necessary this year, particularly since your client has fewer levers available to adjust for your increased cost.  Perhaps you can do a better job of estimating legal costs for your next project.  The project management techniques used in other business functions apply to predicting and managing legal costs, but that’s a topic for another day.

As another General Counsel said to me recently, “I know a lot of firms that are capable of handing my legal work.  I’m sure there are many more that I don’t yet know.  What wins me over isn’t always low rates or discounts, it’s finding a firm that really understands that challenges I face in my business – and this includes not just the legal issues I face in my marketplace, but how I have to manage my legal department as a business.  If I can find a firm that understands what life is like in my shoes, that firm will win my loyalty.”

What do you say, are you up for it?

Procurement for controlling cost - the cure or the affliction?

There are few topics that generate universal outcry in mixed company, but among these are the number of poor drivers clogging our roadways and the vexing role of the procurement function in modern business.  Curiously, another trait these two share is that each of us, at one time or another, is the object of anothers' ire when we're the poor driver or the buyer, but we tend not to notice. Wikipedia offers a sound albeit unsourced definition of procurement:

Procurement is the acquisition of goods and/or services at the best possible total cost of ownership, in the right quality and quantity, at the right time, in the right place and from the right source for the direct benefit or use of corporations, individuals, or even governments.

Taken in this light, who could argue that procurement doesn't serve a vital role in the conduct of business?  Too often, alas, procurement draws fair criticism as the business function that values cost savings over long-term relationships; that reduces all goods and services, no matter how value-added, to commodities which can be differentiated on price alone; and that relies on negotiating tactics one can imagine being employed by Attila the Hun when dealing with vanquished foes.

But these are epithets we typically direct toward the procurement managers negotiating the value of the services we offer.  How dare our client's procurement manager not recognize the clear distinction between what we offer and the sub-standard offering of our inferior competitors.  On the other hand, when we're negotiating with our suppliers, those charlatans who try to drain away our hard-earned profits, then by all means our own procurement manager needs to take an aggressive negotiating stance to protect our business.

Can't we all just get along?!

Procurement is a necessary and important function in the conduct of business.  But there is an inherent tension in carrying out this mission.  The Institute of Supply Management, an association of procurement professionals, asserts that its members must promote positive supplier and customer relationships while upholding one's fiduciary responsibilities and deliver value to one's employer, but do so without the appearance of unethical or compromising conduct.

Spend enough time in business and you'll encounter an evil procurement manager.  I have fond memories of the procurement manager who was hired several months after my team negotiated a mutually successful long-term agreement with our client.  She called our accounts receivables clerk to demand assurances that the contract would be abandoned in lieu of one more favorable to her employer, then threatened a lawsuit when the frightened clerk squeaked that she needed to speak to someone higher up the food chain.  By the time I was engaged, the procurement manager was practically frothing at the mouth, spouting sobriquets like "But you have to do what I say, I'm the customer!"  We were sure to carefully document our conversations for future use when, as sure as night follows day, she proudly announced to her superiors that she had won concessions that we hadn't even discussed let alone agreed to.  "I'm not singling you out, you understand" was her explanation, "My job is to reduce our vendor costs no matter what it takes."

Therein lies the challenge.  This procurement manager did not have a full understanding of the total cost of ownership.  As we've written in this space previously, the cost to an organization for any product or service is more than merely the price tag.  Selecting Product A because it has a lower sticker price than Product B is hardly a wise choice if Product A is incompatible with our existing systems and therefore incurs significant customization to function effectively.  Likewise, a lawyer charging $425 per hour but who has a terrible track record of staying on budget may be a worse bargain than the lawyer charging $650 per hour but whose budgeting capabilities are precise.

And one must consider switching costs too.  If I hire a plumber to fix a major leak from my hot water heater, and in a fit of pique over high costs I fire the plumber while the parts are scattered across the floor, the leak will continue to generate costs in the form of water damage while I seek a replacement plumber at a fraction of the cost.  Changing lawyers mid-trial, relocating your office across town to save a few dollars per square foot and scrapping a software implementation after a significant investment in training in order to find a lower per seat license cost are examples of business decisions that run the risk of emphasizing price tag shopping over the total cost of ownership, if we don't fully think through the implications and downstream impacts of our decisions.  In our above anecdote, the procurement manager demonstrated no understanding of the concept and therefore damaged valuable business relationships in her quest to save a few dollars.  If your supplier is fungible, damage away.  If you may need that supplier again, take a long-term view.

Those who sell services which aren't commodities, or at least those who aren't willing to admit they sell commodities, fear the procurement manager who reduces all potential suppliers to the lowest common denominator -- namely price -- without understanding the context.  But many service providers are lazy and unhelpful in demonstrating why their services are different and therefore more costly than the alternatives.

A well-trained procurement manager will seek to unpack the value in an offering.  For most products and services offered in a moderately efficient market, there will be a base cost to deliver services below which no supplier can reasonably sell its product and still make a sustainable profit.  And in most competitive markets, there isn't wide disparity in profit margins between competitors.  So if we can assume that within reason everyone can make and sell the same product for roughly the same cost, then why are there differences in price?  This is the procurement manager's quest -- to understand and quantify these differences without the undue influence of past relationships or conventional wisdom.  Just the facts, ma'am.

In this visual, we see the base cost.  A good procurement manager can even identify the increased cost of a comfort brand.  In many lines of business there's that one reference point, a supplier at the high end of the food chain, one whose prices are higher but whose reputation is impeccable, so that if I purchase from them, I'm immune from criticism for making a poor choice of suppliers.  Let's call that the "brand safety" factor.  There's no shame in acknowledging that sometimes we make safe purchases and that we pay extra for that safety.

What remains is an "X" factor, or an unexplained difference between the costs of two apparent substitutes.  A good procurement manager will seek to explain and potentially reduce this difference, first by ensuring that the product offers what is needed and not more, nor less.  This is the true function of an RFP (a request for proposal), to ensure an apples to apples comparison of alternatives.  Absent clear guidance on what is needed, it's a challenge to compare alternatives.  A favorite tactic of some former colleagues of mine who should be elected to the Sales Hall of Shame is to "throw in" as many unnecessary items as possible, allowing them to reflect a much higher starting cost and then apply discount after discount to achieve what appears to be a compelling and substantial "effective discount" off list price.  In the end the customer may get what he wants but at a higher price, and by the way he wins a lot of crap he doesn't need.

A law firm that can demonstrate its prowess in managing to a budget through effective project management, that keeps the client fully informed of any changes to expectations, that staffs appropriately and doesn't "overwork" matters or expect clients to subsidize young associate training, is in a better position to present clear, quantifiable evidence of its higher rates.  A software vendor that has documented compatibilitywith existing legacy systems, thereby keeping integration costs down, may have a strong case for higher license fees.  In each case, the approach reduces total cost of ownership.

Those sellers who have the most to fear are those whose price points cannot be reasonably be justified, or quantified by an independent outsider.  It's not enough that my CEO and your managing partner are golf buddies.  It's not enough that we've done business for a long time.  If I cannot unpack why your rates are significantly higher than some apparent substitutes, and you can't articulate it either, then I'm compelled to explore alternatives.

But let's not kid ourselves.  We sometimes forget these principles when looking at our own cost structures.  It's a sad but not uncommon situation that large buyers will squeeze their defenseless suppliers.  Some years ago I hired a consultant to handle a project when the internal resource dedicated to the task resigned abruptly.  I had moved on by the time the project was complete, but I learned that my former law firm employer gave the consultant a 60 cents on the dollar take-it-or-leave-it offer to settle the final invoice.  The law firm's procurement manager reportedly dimissed the injustice: "We're a global law firm.  What are you going to do, sue us?"  The sad irony is that the law firm took this action as part of a massive cost-reduction effort, initiated in part because its own corporate clients were spending less, at the recommendation of the corporate procurement managers.  Justice served?  Or just a sad cycle of frustration?

When your organization comes up against a procurement manager, this is a good opportunity for some self-examination.  Are we able to articulate why our costs are higher than our competitors?  If not, why not?  Rather than assume our competitors are using predatory or lowball pricing to steal work away, is it possible that we've failed to recognize the inexorable march to commoditization of our products and services?  Do we assume our brand carries with it more prestige and "safety" than the market?  Maybe our competitors have devised some innovative ways to deliver more for less.  Their lower pricing may reflect this innovation, suggesting they can remain profitable at a lower price point.  And yet we assume they're losing money because we can't offer similar savings.

When hiring a procurement manager, focus them on total cost of ownership.  Saving pennies on discrete costs is fine, so long as the impact of these choices doesn't result in higher fees over the long run.  In organizations with many silos, a procurement manager may be in a unique position to recognize opportunities to consolidate services, to seek lower-cost alternatives, to adjust business practices to save money.  This means they put a spotlight on us as well, and not just on our pencil vendor.  If we're serious about controlling costs, it has to start with us.

If you're a procurement manager, please stop issuing RFPs asking 127 questions for which you have not a clue what you'll do with the responses to 120 of them.  Be clear that your role is to maintain positive business relationships with valued suppliers, but help identify those whose costs are not aligned with the value delivered.  Times change, prices increase, needs fall out of synch with what's sold, but except in a few cases the sellers aren't charlatans and the buyers aren't ignorant weasels trying to extort kickbacks.  Shine the light of day on the commerce of your business and start with those areas which are most easily recognizable as commodities.  As your colleagues begin to trust your process, you can then move on to the more sensitive areas, where we business managers tend to protect our turf.

Let's all be prepared to take our medicine.  For some of us, the increased use of procurement managers may be a miracle cure leading to lower costs and new business opportunities.  For others, well, the cure may end up killing us.

Compassion and Change are not Opposing Principles

By now you may have learned that there was a shooting in Pittsburgh last night, and several people were killed and even more were injured.  The shooter was one of the dead.  He was a single, middle-aged IT professional at a large Pittsburgh law firm.  Despite the legal connection, that doesn't normally qualify as newsworthy for this space.  However, Above the Law discovered a troubling online diary by the shooter that detailed, long in advance, his intentions to take his life and to take others with him.  I spent a few moments reading the diary and it was tragic and sad.  I imagine it will be pulled offline at some point, but one doesn't have to read it all to realize this was one very troubled guy sorely in need of professional help. In the diary he discusses the several rounds of layoffs taking place at his law firm.  He appeared to understand the necessity of the first round, but with each subsequent round his temper flared as he was convinced he would unfairly lose his job.  Ironically, he survived all the layoffs and was even recently promoted.  But this didn't deter him from his course.

I've written at length in this space and elsewhere about the need for reform in the legal marketplace.  Whether it's large law firms' colossal inefficiency and feigned client focus, corporate law departments' tendency to complain without taking action, or the large divide between legal vendors' great products and their fumbling and sophomoric execution, there are plenty of teachable moments to choose from.  These issues existed long before the recent global economic downturn, but the challenges are now more acute and finally we're seeing organizations taking long overdue action.  However necessary it might be from a macroeconomic perspective to cull the ranks of underperformers, or outsource tasks or entire functions to lower-cost suppliers, or stop doing business altogether with poor suppliers, there is always a real cost to the man on the street.

Opinion polls may confirm that most Americans feel the automotive and health care systems are in need of an overhaul, and all of us would like to spend less for a doctor visit or a new car, but it has a whole different meaning when someone you know or care about loses his livelihood as a consequence.  In the legal marketplace, demand for legal services is undeniably down and so the logical reaction is to eliminate excess capacity.  This means idle lawyers and staff are let go, in the same way that gas guzzling SUV manufacturing plants were idled and workers sent home during the recent gas price crisis.  This makes sense from a business perspective.  But let's not lose sight of two important considerations:  there's a right way to let people go, if not for their sake then for the organization's reputation; and owners and managers whose incompetence or inattention contributed to poor performance shouldn't get a free pass while others suffer.  Some businesses have increased sensitivity to these optics, while others remain blind.

So without delving into the reasons why, for the purposes of this exercise let's stipulate that the correct course for a business is to lay off a handful of employees.  How should this be accomplished?

Look, I'm not a credentialed and certified human resources professional, whatever that might be.  I've worked with far more over-promoted buffoons in senior HR and personnel roles than those whose contributions demanded respect.  I've sat in board rooms with senior vice presidents leading the corporate HR function who couldn't articulate the company's value proposition, name more than 1 or 2 products, identify a competitor or tell the difference between NPV and NOC.  Yet because layoffs are messy affairs we turn to them to run the show.  Large law firms, who time and again hire middle managers from the corporate sector and give them senior titles and responsibilities, or promote valued employees from functions where they excel to functions they know nothing about, shouldn't be surprised when these duties tax their capabilities.

Years ago a fellow manager and the head of HR conspired to lay off one of my colleagues.  This 18-year veteran, whose primary failing was allying with the wrong political faction, and whose contributions included training all salespeople, including every top performer for the prior 10 years, was given 15 minutes to collect her personal items into a box, with building security hovering conspicuously in the open doorway, and then escorted to her car at midday in full view of the lunchtime crowd.  There was no particular reason to fire her on that day and at that hour, but due to an obvious lack of compassion and perhaps a bit of a mean streak, they chose a timetable and an approach guaranteed to obliterate any sense of dignity left in this loyal employee.  Some years later a new head of HR, smoother on the outside but just as inept, counseled managers to conduct the periodic terminations on their own, then hid in her office as they took place.  When it came time to fire one of her own direct reports, she flew in another subordinate to do the deed!

The point is that the supposed experts don't have a perfect formula.  I've had to terminate or layoff multiple people over the years, and I relied primarily on common sense.  My experience might be helpful.

When a layoff must be conducted, use a scalpel instead of a broom. Too often a layoff results in the loss of good people Productivity Bell Curvein one area while known incompetents in another area are unaffected.  Break through the artificial barriers we erect with org charts and identify the poor performers across the board, and let them go first.  This requires a certain business-first attitude that is sadly lacking in many managers, but in the long-run it's better for the business when every layoff shifts the productivity bell curve to the right rather than eliminate high performers due to some misguided sense of fairness.  (The concept of fairness is often misused by managers.)

Performance metrics should be standard across the business and should be compiled long before the layoff. I've been asked to participate in a charade where managers evaluate and rank layoff candidates who have been previously, and sometimes mysteriously, identified.  The task is ostensibly to pick the poor performers but the real intent is to have a paper trail showing proper due diligence, which presumably insulates the organization from charges of unfairness, discrimination or wrongful termination.  The problem is, the easily discoverable paper trail also shows that the managers only evaluated the likely candidates, not all employees.  A little selection bias perhaps?  Also, there is quite often disparity between an excellent performance review conducted some months prior and a sudden and undocumented downturn in productivity.  If the organization has a performance management system, use it!  Measure and track performance on a regular schedule, use a consistent methodology, and don't shy away from capturing tough comments when performance is sub-par.  Law firms are criticized for allowing powerful partners to protect their favorites, using vague performance measurement criteria if at all, but the fact is this behavior is prevalent in the corporate sector as well.  The best way to eliminate favoritism and truly identify poor performers is to implement and adhere to a standard evaluation process.  And use this as the basis for the layoff, not a new, isolated and suspect vetting process two weeks before the termination date.

Don't confuse poor financial performance with poor job performance. Let's be clear:  sometimes -- whether through our own missteps or due to market turmoil -- a reduction in the workforce must take place, even though those affected haven't been poor performers.  It's unprofessional and caustic to an organization's reputation to label financial victims as poor performers.  Call a spade a spade and move on.  There are few stakeholder groups -- clients, the press, alumni, recruits, etc. -- who will harshly judge the organization for declaring that "Demand in our core market sectors has declined to a point where we must reduce excess capacity and unfortunately let some of our valued employees go" rather than the obvious fabrication "While our competitors and clients are suffering we are doing quite well, thank you, but we coincidentally decided to use this time to terminate the many poor performers who have somehow escaped our notice previously."

Layoffs are costly, so expect to spend a few more dollars to do it right. In the long-run, the intention is to save the ongoing payroll and benefits costs of the departed employees, so offsetting that savings with outlandish severance packages isn't sensible.  But neither is conspiring to shave every cent off the severance package to save a few dollars.  I've had to negotiate with fellow managers and HR professionals over half-days of vacation, an extra month of pay for a long-time employee who had the misfortune to be laid off just before a pivotal anniversary date, and whether to pay a package at all when the departed employee was lucky enough to find a new job before all the paperwork was signed!  I'm well aware of the tired HR objection that on an individual basis doing the right thing seems cost-effective, but on an aggregate basis the costs become unwieldy.  But even a cursory read of the many books on viral marketing and customer service reveals that a happy workforce, happy alumni, happy clients, serve as multipliers to the firm's own marketing and sales efforts.  Imagine the low cost of sales when a valued former employee who left with her dignity intact ends up in a new role with influence or even decision authority over the purchase of her former employer's services or products.

It really all comes down to dignity. It's appalling the manner in which good people, otherwise unsullied by a vindictive nature, turn on their former colleagues when it's time to let them go.  I've let people go in person and on the phone, one-on-one and in a group setting, so there's no perfect approach.  Open, honest communication should acknowledge the potential trauma and disruption, while firmly guiding the employee to the inevitable conclusion.  There should be a script to ensure that the key points are covered, but it's okay to go off-script and address unforeseen questions.  However, there's a point at which compassion becomes drama.  I learned of a fellow manager who dissolved into tears as she terminated a long-time employee.  The terminated employee ended up consoling the manager who was too distraught to proceed.  In my view, the wrong person was shown the door that day.

Let's close by addressing directly the circumstances that our Pittsburgh shooter calls to mind, that a terminated employee will become violent.  This is a real dilemma.  Does the organization build all termination procedures around such an extraordinarily unlikely outcome, meaning that security guards are on hand, and terminated employees do a perp walk as they depart?  What impact do such measures have on the departing employees who don't deserve such treatment?  The risk of getting it wrong is potentially high, as evidenced by the occasional anecdote of a disgruntled employee becoming violent in the workplace.  But the earlier point about misguided fairness applies here as well:  conduct a risk assessment of the terminated employees and handle the exit discussions differently with some; everyone doesn't have to be treated in the exact same manner.

This discussion refers to making rational but compassionate choices when conducting the inevitable layoff.  I don't purport to provide legal advice on what approaches are more or less likely to generate an accusation of wrongful termination.  The underlying thesis is that organizations taking the high road, that find ways to marry sound business judgment with compassion for employees and clients, will generate better financial returns and maintain a positive image in the marketplace.

There are plenty of examples of organizations performing poorly in these situations.  If you are involved in planning for a layoff, tack a photo of your kindly grandfather, your beloved mother, and your free-spirited child on the bulletin board.  As you plan each action you're about to take,  consider how you'd explain yourself to them.  Better yet, consider how you'd feel if one of them called you to describe the manner in which they were laid off today.  There are pretty good odds that this conversation will take place at some point... though I can't predict whether you'll be the one making or receiving that call.

Welcome to Law Firm, Inc.

In today's Law.com, American Lawyer reporter Brian Baxter quotes a Bloomberg story discussing the increased level of interest by private equity investors in purchasing large stakes in UK law firms, once such an investment is allowed in 2011.  Savvy readers already know of the UK's Legal Services Act of 2007 which opened the door for private investment in traditional closed law firm partnerships, a process already underway in Australia.  The Magic Circle, the handful of leading UK law firms, feign disinterest.  "Why would we need the money?" asks Wim Dejonghe of Allen & Overy. “Law firms are pretty attractive investments as they have stable cash flows, long track records of business operations and increasingly are much better run,” claims one PE investor. “You would expect them, like any professional services business, to provide a pretty good return.”

Let's put this on the table right now:  I don't believe the practice of law should be equated with a business whose sole purpose, in b-school parlance, is to produce a profit.  The rule of law is more than a theoretical concept and there is a clear and undeniable need for increased access to justice worldwide.  That said, the business operations of law practice can be improved and the profession can pursue both its noble mission to enrich humanity while simultaneously turning a profit.  A handsome profit, I might add.

Let's also acknowledge that large law firms are, by any standard, already very profitable enterprises.  In my many years of coaching salespeople catering to law firms, one challenge we've encountered time and again is partner motivation.  We've written here about law firms' reluctance to drive change unless forced to by the clients.  There's also an innate conservatism which hinders any disruption to the status quo, let alone bold change.  As one salesperson put it, "The partner can't seem to muster up the energy to push for the adoption of my recommendations, probably because he earns $2 million today and the new approach will take him to $2.5 million, but that payoff isn't worth the headache."

Indeed, during a stint at a global law firm I observed to the chairman that eliminating the colossal and unnecessary waste I observed in my first 3 months on the job alone could easily generate a double digit annualized increase in profit margin.  That's an astounding statement, whether or not you back it up with the math, as I did.  Trouble is, most law firm leaders view this statement in terms of discretionary expenses.  And we had these -- including the many tens of thousands of dollars hastily spent by one partner mere weeks before the bi-annual partner conference to create large tapestries of bridges representing each country where the firm had an office (around 35 as I recall), with the implication that partners would see these draped about the Waldorf ballroom and feel more inclined toward cooperation and teamwork.  In another example, a practice chair required all handouts at his monthly meetings to be printed in full color and bound, though not once when I was in attendance did a speaker refer to the materials and most often these were left behind on the table or in the conference room garbage bin.

But there was far larger waste through process inefficiency.  I was asked to provide input into a new conflicts checking system, though the input was limited to suggesting better questions to ask at new matter intake.  A quick chat with the very competent conflicts team revealed that the firm ran the same conflict check on the same clients multiple times every year, year after year, sometimes hundreds of times over the course of several months.  Furthermore, there was no coordination between the conflicts system and the strategic planning process, so the team ran countless conflicts checks for client targets that had already been deemed unsuitable, and the practices continued to pursue client targets that had already been conflicted out.  The firm had no understanding of the cost of this inefficiency, no latitude for the staff to address such issues without partner oversight, and no interest by any partner to wade hip-deep into operational issues such as this.

But it's not just about databases and back-office technology; there is similar inefficiency in the practice as well.  Not so long ago it was a badge of honor for a large law firm to recruit numerous associates, regardless of current market demand, and rotate them around the firm, encouraging them to re-learn items commonly known to other lawyers, and billing clients for this training.  Every firm talks about cross-selling but few have embraced the DNA-altering approach that values -- and compensates -- team or firm performance over individual contributions.  Many firms have launched client teams, but few clients would readily agree that team members know their business at any significant depth, and even fewer would characterize their outside counsel as trusted business advisers.  Fundamentally altering the firm's recruiting strategy?  Establishing true associate training and apprenticeship?  Re-designing compensation systems to drive collaborative behavior?  Which Biglaw partner wants to raise his hand and dive deeply into these issues?  Who wants to look at his colleague and say, "No, you may not unilaterally decide on behalf of all of us that expensive pictures of bridges will foster teamwork,"

It's unlikely that your average private equity investor has the know-how of law firm operations to solve this sort of thing either.  However, any investor accustomed to shepherding his capital will want eyes and ears on the ground, and these challenges -- nay, opportunities -- will quickly come to light.  If a PE firm purchases a significant stake in a large law firm, rest assured that the investor representative they install on the management committee, whether this is a COO, CFO or some derivation, will be able to do the math justifying why process improvement will lead to substantially better returns -- for the investors, for the partners and, oh yes, for the clients.  This isn't rocket science, and cost containment programs based on ROI, investments based on NPV and even formal business process improvement programs like Lean Six Sigma are really not much more than common sense ideas backed up by math and a governance structure which places the good of the firm above the desires of individuals.

Color me crazy (you wouldn't be the first!) but some of us enjoy surveying the paved cow paths, identifying where new approaches can shorten the time from A to B, removing obstacles and impediments that serve no purpose, demonstrating through simple math that speed, quality, profit and client satisfaction are not opposing objectives.  Of course it will be hard.  But the PE investors who truly want to unlock the value embedded in Biglaw will understand the potential return on delving into the tough issues.

At the other end isn't necessarily a "corporate law firm" where partners are senior executives taking paychecks from absentee investors.  Nor does a new and improved law firm have to eliminate all profit-dilutive practices and "fire" longtime clients that no longer generate significant revenues.  However, these will be conscious choices made in the full light of day.  A well-run law firm differentiates between its premium and commodity practices, lowering rates in some and expecting (and realizing!) higher rates in others where true, demonstrable expertise can be quantified.  Pundits say that associates and partners alike have lost the "quality of life" battle and clients are losing the diversity battle, as cost trumps all other concerns.  But imagine a law firm that clearly understands how to derive profits and client satisfaction from lawyers with more flexible schedules, or how to supervise work outsourced to others in order to address client concerns over cost and diversity and quality.

The fun part comes once the first couple of firms are pushed in this direction.  Others will see that it doesn't require a private equity investment, which carries with it an obvious cost, to derive similar returns from process improvement.  The tools are available today, the people who can manage the process, run the numbers and hold the partners' hands are out there already.  Some are in law firms, many are not.  But given the right precedent to show the way, I'm prepared to believe that a strong law firm leader can take on such an initiative without the offsetting dilution of a private equity investment.

This calls to mind the movie Die Harder, in which airport hijackers turn off the runway lights and sever all electronics, keeping incoming flights circling because poor weather prevents the planes from diverting to alternate destinations.  As government officials work to meet the terrorists' demands, the flights circle and circle above, their fuel dropping dangerously low.  When the hero finally destroys the terrorists' escape plane, leaving a trail of burning jet fuel along the runway, the ingenious pilots above use this as a beacon to guide their approach and landing.

Law firm leaders, will you be the first to land?  Will you be following someone else's trail?  Or will you be circling endlessly, awaiting the return of familiar lights and beacons before you take the safe route home?

Calculating the Cost of Doing Nothing

In any business school finance class you learn capital allocation techniques, whereby you reduce competing projects to a single measure in order to more easily select the capital project with the highest potential to add value to the business. Examples of these measures include NPV (or Net Present Value) which reduces multi-year cash inflows and outflows to a single value in today's dollars; and RI (Residual Income) or EVA (or Economic Value Added) which both reflect the value created from a project after achieving a required rate of return; or the more simple ROI (or Return on Investment) which is the ratio of money gained relative to money invested for a given project.  Inherent in these calculations is the notion that there are alternatives for the investment of the firm's capital.  There is no such thing as a good or bad rate of return in isolation.  Only by comparison to alternative uses of the capital can a business deduce what investment returns the maximum long-term value. In each of these calculations assumptions must be made, particularly with regard to future cash flows.  When a law firm calculates that an hourly rate increase of 10% will lead to a 10% improvement in top line revenue, the partners have assumed that other factors will remain constant, such as demand for their legal services.  And in a price-insensitive (or inelastic) market, this is true.  In other words, when a client is faced with the proverbial "bet the company" litigation, price is far less important than quality in the selection of outside counsel.  Given constant demand, an upward adjustment in hourly fees will increase top line revenue.

Similarly, a prominent legal vendor with which I have some familiarity tends to treat annual price increases as a mechanism for printing money. In one product line it issued annual price increases at about three times the CPI for a very long time, with a continuing assumption that these increases would directly correlate to increased revenues.  As the business innovated to reduce internal costs, the marginal profit on the new revenues was significant, leading to a perpetual assumption that increasing prices will lead to significant increases in profits.

However, each has experienced steep revenue decline and customer attrition, to the consternation of the baffled leaders.  Can you spot the critical mistake made by both the law firm and the legal vendor? It's not rocket science. Obviously each overestimated the price sensitivity of the market. By assuming that buyers will continue to buy at the same pace even as the price increases, each made a fatal miscalculation. Each assumed that its product was of such high quality, was so unique and special, that buyers didn't want and wouldn't seek alternatives. Of course we now know this isn't true. BigLaw partners everywhere are getting a crash course in microeconomics. After a generation of near unlimited demand for legal services -- as close as one gets to the very definition of a mathematical constant -- clients are refusing to pay the high rates, realizing that a good portion of their legal needs are closer to commodity than "bet the company," and they're running, not walking, to find lower-cost alternatives.

The legal vendor is similarly challenged.  Whether it's a backlash to high prices, or the rise of alternatives and substitutes in the marketplace, buyers are pushing back, even canceling their purchases.  The vendor is caught in a vicious spiral.  By baking its perpetually flawed assumptions into its annual profit expectations, every cancellation or significant downward renegotiation creates a gap which it tries to make up by -- surprise! -- increasing prices to other customers or in other product lines.

But law firms and legal vendors aren't unique.  Every industry, even government, has its own flavor of flawed assumptions.  Pharmaceutical manufacturers lobby Congress for trade protection to prevent consumers from buying lower-cost prescription drugs from Canada.  The music industry laments the millions of dollars in lost CD revenue due to unauthorized music file sharing.  Government officials rail about lost tax revenues from individuals and corporations aggressively seeking tax havens.  In each example, buyers are doing nothing more than logically and legally seeking lower-cost alternatives.

Okay, I guess music file sharing is illegal, but the sentiment's the same.  None of us who used to pay $12.99 for a music cassette and who now pays $19.99 (or more!) for a music CD really believes that the cost to produce a CD is higher than than the cost to produce a cassette.  Some would say the music industry created its own demise by positioning CDs as a premium purchase and therefore limiting its potential buying audience, rather than lowering the price and dramatically increasing the addressable market, which is exactly what Apple did with iTunes.  (Personally, I believe music file sharing is a backlash against the typical music CD's inexplicably confounding security wrapper!)

In my years leading a business, my team and I developed the most precise forecasting methodologies and as a result year after year we achieved our revenue goals while others floundered.  Our approach was simple:  we always included a line to reflect expected losses due to rejection of our price increases, and we developed a sophisticated predictive index to identify which buyers were at risk.  Most organizations have a contingency for bad debt but this is reflected on the balance sheet and not at the product level.  We were required to increase our prices by corporate mandate, even though we demonstrated time and again that it impaired our brand equity, resulted in emotional total losses (buyers who would refuse to do business with us again in any product line) and unfairly assessed penalties on good customers who didn't complain (because when the bad customers left, who do you think had to pay an even higher price to make up the difference?).  The leaders were tone deaf, and today that product line has experienced monstrous losses which, in the usual manner of corporations, the present management blames on past mis-management.

Among the many questions law firm leaders and business leaders should be asking is whether or not they have properly considered their customers' alternatives.  Many BigLaw partners are astonished to learn that the pedigree of the firm truly doesn't justify fees that are substantially higher than smaller competitors in most cases.  This isn't a character flaw and their myopia is shared by many others.  However, those that do nothing now to address the change in circumstances should be held accountable.

You don't have to be an experienced economist or financial analyst to lead a large enterprise (though it helps to have some chops).  What you do need is a healthy understanding of the mathematical drivers of your success.  In your revenue calculations, use different assumptions for those products and services which you can charge at any rate and those for which buyers have numerous lower-cost alternatives.  Assume the services you believe to cater to a price-insensitive buyer to be shorter-lived than they used to be.  Look to grow your top line as much by offering an innovative new product or service  as by increasing your prices for your present offerings.  When marginal profit contributions from price increases are elusive, look to achieve your profit objectives by reducing internal costs through outsourcing or business process improvement programs.  But do something.

Seth Godin recently described the calculus of change:

"Do nothing is the choice of people who are afraid. Do nothing is what you do if too many people have to agree. Do nothing is what happens if one person with no upside has to accept downside responsibility for a change. What's in it for them to do anything? So they do nothing."

In the legal marketplace we have relied on assumptions that are no longer true.  We can roll up our sleeves and re-work the underlying math in our assumptions.  Or we can conduct a few layoffs, cancel the annual meeting, put a freeze on hiring and travel, and wait for the old assumptions to revive.  Or we can do nothing.  Your call.