The following is the first in a series of posts on compensation written by Ron Paquette, an analyst with Redwood Analytics, now part of LexisNexis.  Ron is a new contributor to the blog who we hope will write regularly.

Most law firms want to evaluate client and matter profitability. When deploying profitability models, one of the most common questions Redwood receives has to do with determining the cost of partner time on billable work. Since most matters in the legal industry today are billed on an hourly rate, the most effective means of allocating costs is on an hourly cost basis. There are two components to costs, direct and indirect (overhead) – the focus of this discussion is on the direct component, e.g. partner compensation. And since most firms set billable hours expectations for their partners, the question becomes:  How much of a partner’s compensation should the firm consider when calculating this “hourly cost rate” allocated to each billable hour he/she works?

• Billable hours;
• Originations;
• Matter & client management;
• Attorney management & development;  and
• Their status as a co-owner of the firm.  

Related posts

• Partner Cost and Client Profitability (Part VI)
• Partner Cost and Client Profitability (Part V)
• Partner Cost and Client Profitability (Part II)
• Partner Cost And Client Profitability, (Part IV)
• Partner Cost And Client Profitability, (Part III)

One of the observations in the 2007 Law Firm Economic Survey by LexisNexis and a focus of the 2008 Survey (in progress) relates to cash flow.  According to the 2007 Survey, all firms had a slow billing cycle.  On average it took firms 170 days from providing a service to collecting payment on it.  In non-service industries that would be a recipe for bankruptcy.   Law firms enjoy high margins, so once the firm initially weathers the 80 or so days before the cash starts coming in, it can survive the slow cycle.  Unless the cycle stops.

How will you know when clients stop paying?  How long do you have until your cash flow reduces to a trickle?  Measuring your billing cycle times is critical in answering these questions. 

Long billing cycles hide what may be slowly killing your firm - inefficiencies, declining business, etc.  If you aren't measuring your performance in converting work to cash, you may not know that your firm is in a crisis for several months, wasting valuable time to act.

Below is an example chart that shows how you can measure the billing cycle by just tracking your unbilled fees, billed fees, and collected fees. 

 To determine unbilled fees, take your work in process that is currently unbilled and not subject to mark-down (to the extent known) for the prior "rolling" 12 months.  Do the same for fees billed and fees collected.  From that you can determine your average days to bill, days to pay and average AR days fees outstanding.  Lowering any of these numbers will increase cash flow and provide additional liquidity to the firm. 

The above takes a look at the billing cycle from the firm perspective.   You can also do this analysis on a timekeeper or practice area.  Tools such as Juris' Active Information can not only track your billing cycle but can also drill down into the "why", exposing inefficiencies that are hampering your ability to maintain liquidity and giving you an opportunity to act to increase cash flow before it slows.

Click on the graphic above to download a spreadsheet to use with your firm's numbers.  You must be a registered user to download content.

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The April 2008 Scientific American contains an article titled Why Things Cost $19.95:  What Are The Psychological "Rules" Of Bartering? (hat tip: Matthew Homann, in his blog the [non]billable hour).  The article explains the effects that initial pricing has on a potential buyer based on a series of tests.  The results found:

people appear to create mental measuring sticks that run in increments away from any opening bid, and the size of the increments depends on the opening bid. That is, if we see a $20 toaster, we might wonder whether it is worth $19 or $18 or $21; we are thinking in round numbers. But if the starting point is $19.95, the mental measuring stick would look different. We might still think it is wrongly priced, but in our minds we are thinking about nickels and dimes instead of dollars, so a fair comeback might be $19.75 or $19.50.

 The authors of the tests then looked at five years of real estate sales in Florida to see the difference between the list price of real estate and the actual sales price.

They found that sellers who listed their homes more precisely—say $494,500 as opposed to $500,000—consistently got closer to their asking price. Put another way, buyers were less likely to negotiate the price down as far when they encountered a precise asking price. Furthermore, houses listed in round numbers lost more value if they sat on the market for a couple of months. So, bottom line: one way to deal with a buyer’s market may be to pick an exact list price to begin with.

Homann, in his post on the subject, took it a step further:  Why not charge $297 per hour rather than $300 per hour?  Then if a client wanted to negotiate, ostensibly the negotiations would be in single dollars rather than tens of dollars.

In the case of firms who are competing with other firms for business, this tactic may work well to secure a deal. 

It may not work as well when clients are asking for a discount.  Many times when it comes to discounting rates, clients look at percentage discounts of the whole bill rather than dollar discounts.   Therefore taking a few dollars off the charge per hour may end up costing you a lot more than anticipated.  Where it may work better is in flat fee or value-bill situations, where you are adjusting only the final price of the service.

So, if you have priced a certain task at $1,500, try advertising a price of $1,497.96.  On top of making the client look at penny increments, it also makes it look like you have calculated the exact value of the service.  Before making wholesale changes to your pricing, try on a specific area that may have a higher average of discounts (or lost potential clients due to pricing) than other areas.  Track whether the change in pricing has an effect.  If so, please feel free to post your results here.

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In the April, 2008 issue of CFO magazine, the cover story reads:  "Goodbye GAAP:  It's Time To Prepare For the Arrival Of International Accounting Standards".  These international standards, called the International Financial Reporting Standards (IFRS), are being sought to replace generally accepted accounting principles (GAAP), an evolving set of accounting standards in the US since the Securities and Exchange Commission (SEC) was established in the 1930's.

What started as a reconciliation of the two is now seen as "more of a takeover than a merger of equals - many who favor a single global standard hope to wipe out GAAP altogether".

Grant Thornton has a paper outlining the major differences between GAAP and IFRS that can be viewed by clicking here.  James Turley, Chairman and CEO of Ernst & Young, also makes an argument for the move to IFRS that was published by the Wall Street Journal in November of last year.

How does this affect firms who are currently not even using GAAP?  Many small and mid-size firms have historically kept their books on a cash basis.  In the  2007 Law Firm Economic Survey by LexisNexis, the failings of cash basis accounting were exposed - in particular, the lack of reporting on work in process gives firms only half of their financial picture.  And, based on the respondents in the 2007 survey, there is no correlation between per partner income and cash basis accounting.  The fallacy of having to report to the IRS on an accrual basis if you reported internally in this manner were reiterated.

Many of the requirements of GAAP and IFRS apply only to publicly traded companies.  This lack of mandate is tempting to law firms, who are not forced to change their accounting methodology.  However, one of the main management priorities respondents in the 2007 survey reported was better benchmarking.  What are other firms doing?  How do we compare? 

Using tools such as Lexis® Insight helps.  But these tools are meant to be starting points for analysis.  As Stephen Collins noted in the Introduction of the 2007 Survey:

"Without applying the accrual concept, law firms can't reliably forecast cash flows or anticipate funding needs.  The unrealized value of unbilled fees and accounts receivable are clouded.  In fact, cash basis accounting may contribute to the industry-wide experience of very slow cash flow cycle times.  Key financial metrics such as realization cannot be accurately measured by matching the appropriate revenue to the related adjustments.  As a result, many firms are losing significant amounts of fee revenue to adjustments and they don't even know it it."

 For nearly 80 years, the answer was generally accepted accounting principles.  It appears that due to the expansion of free trade agreements and globalization in general, there may be a new standard.  For firms who want to improve profitability and are looking to move from cash basis accounting to accrual to help measure performance, take heed.

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A reader emailed me with a question related to the compensation of a non-practicing equity partner whose responsibilities include only the investment of capital in the firm and bringing in new clients.  The firm has a niche practice and is looking to expand.  Their plans require more capital than the existing partnership can manage.  They are in a position to bring in another partner who will be responsible for infusing additional capital in the firm.  The partner will also do some rainmaking.  The new partner will not be responsible for any management or production and will not be expected to manage any of the clients in which he brings. 

Because of the rainmaking responsibilities, I wouldn't classify the partner as a "silent partner".  However, since the partner won't participate in the day to day management of the firm nor will be responsible for any production, it may be better to classify him as "muted".

I asked several attorneys I knew and didn't get very good answers.  Thus I am taking the question to More Partner Income readers.  What ways would you suggest this firm compensate an equity partner whose responsibilities are only investment in the firm and rainmaking?

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As I sat in a terminal in Chicago O'Hare after a week of ridiculous delays and cancellations, I finally believed I was almost home.  Instead it was dripping water for the forehead, dirty carpet for a bed.

This week was a long travel week for me, as I had presentations to give in Chicago, Dallas and Minneapolis, respectively.  Getting to Chicago was pain-free, but then the news broke of FAA inspections of MD80 planes, of which American Airlines owns 300.  My colleagues and I knew we were going to have our flight cancelled.  As luck would have it, our flight was the only one going to Dallas that wasn't cancelled.  However, we suffered the "chinese water torture" of delays.  As the time neared to board, another delay.  First the flight was to leave at 6:15pm, then 7:45, then 8:00, then 9:00, then 9:39 (which we all thought was odd), then 10:00, then 10:30, then 11:00, then 12:00am, then 12:30, then 1:00. 

Finally, at 1:24am, we boarded the plan, under the sound of the gate attendant stating to "hurry up and get seated or else the flight would get cancelled" - yes, the group of passengers that were being seriously inconvenienced by the airlines were being threatened by cancellation if we didn't rush to board.  There was mild pandemonium on board as people rushed to get their seats and not be the person who caused the cancellation.  However, after working up a sweat to get in our seats quickly, the pilot, in his soothing and assured voice, came over the loud speaker, "well folks, we are just about ready to get going - just need to get the luggage to get loaded.  We should be on our way in a few minutes."  We sat at the gate for another half an hour as cargo was being loaded (it was referred to as "luggage", but the windows gave clear view of large palletes of cargo being loaded). 

Finally we left Chicago and made it to Dallas around 4:30am.  However, since no ground crew were at our assigned gate, we had to go to another gate and didn't get off the plane until after 5am.  By the time we made it to our hotel, it was almost 6am.  The presentation was at noon, so the best of us only received about 3 hours of sleep before heading to the luncheon around 11am.

Before I even started my presentation, we learned that our flight to Minneapolis was cancelled.  We felt pretty lucky to learn of this early enough to rebook on a flight that left at 5:30 am Thursday.  

After finishing the last presenation of the week on Thursday, we hoped for the best.  I was skeptical:  after all, we had to go through Chicago to get back to Nashville.  The delay from Minneapolis was minor - about 1 hour.  Once at Chicago O'Hare, however, the water torture started again.  Delay from 7:45pm, to 8:15, then 8:30, then 9:15, then 9:45, then 10:00, then 10:30, then 10:55.  Amazingly, we boarded around 11pm.  As we sat on the tarmac, the pilot addressed us to let us know that due to storms just south of us, we had to change the flight pattern, which would just take a few minutes.  I was half unconscious by this point, lured to sleep by the familiar hum of the jet engines.  At what appeared to be 10 minutes later, the pilot came back on with the bad news:  since there were still a few jets ahead of us, it looked like they wouldn't be able to make it to Nashville before their limit of 16 hours expired.  We had to return to the gate.  Grumbles abounded. 

Personally, I wasn't surprised.  I was already prepared for a cancellation - it is O'Hare and we had a double dose of bad signs:  the problem of 300 planes and a weather system that was already dumping snow in Minneapolis and thunderstorms just south of Chicago.  As we were about to get off the plane, though, the crew asked us to stay on board as they attempted to get another crew.  A gentleman in front of me lamented that the pilots purposefully delayed takeoff because they knew their 16 hours were coming up.  I have to admit the thought crossed my mind as well.  Why not alert us to this possibility earlier, like the kind gate attendant did a few days before? 

Needless to say, no crew was available.  We were led out and told that they were not cancelling the flight, just delaying it until 6:20 am.  This allowed them to provide us a hotel and food vouchers, but nothing else.  I was offered a room at a Holiday Inn 30 minutes away.  Considering it was after midnight and the flight was to leave at 6am, I didn't find this acceptable.  I wasn't offered a voucher either - instead being told to ask for one when I got to the gate in the morning.  I was then booked on a separate flight, not the same one.  This happened to several others as well - the passengers walked aimlessly around in confusion.  Were we delayed or cancelled?  Were we to get rebooked on another flight or the same one?   

Finally we were able to find an attendant who gave us boarding passes to the same flight, except the date showed April 10 at 6:20am to leave, then below it said boarding started at 7:45pm.  Most of the passengers opted not to take the hotel voucher.  Those that did described to us later the difficulty in getting through security with their confusing boarding passes.  We were all upset that at the very meager accomodations and compensation for this inconvenience. 

I stuck it out at the airport and meandered around the airport until submitting to my exhaustion around 3am for a few hours' nap on the unfresh-smelling carpet in the gate area.  Once the sun rose (and it was as beautiful as the sunset just a few hours before), the familiar drip, drip, drip started its maddening splatter on the forehead again.  6:20am . . . no, 6:30am . . .no, 6:50am . . . no, 7:05am . . . finally, we board and after sitting on the tarmac for 30 minutes, we lift off to applause and land in Nashville just after 9am.

My experience is probably not the worst that has happened to people over the past week.  However, it does expose major issues facing American Airlines - and I am not talking just about FAA compliance.  The experience reeked of crisis mismanagement and flaws in customer service.  Many of the attendants were rude and condescending, such as one that was rebooking customers on a different flight who ignored everyone who advised that we were supposed to be given a new boarding pass for the same flight.  He just repeated that there was no other flight and that this is the flight you are going to take.

American Airlines will lose tens of millions of dollars from this fiasco.  Not only are they having to pay customers for their inconvenience (even if some of their offers are paltry), they are losing the trust of tens of thousands of travelers.  There were several who said "I won't be flying American Airlines again."  Though I doubt that will be the case for most - I know the powerful tonic of time - it will take a while before confidence will be restored.  I don't think there could be a worse time for this to have happened, for more than my own personal reasons.

As with most crises, there are stories of hope.  In this case, there was a friendly American Airlines attendant who stayed with those of us camping at the gate and finding blankets for people and advising of areas where cots were available.  She also helped others who needed to get rebooked, regardless of whether they were at her gate or not.  She had tremendous patience and was generous with her time even though there were many who demanded it.

Although I can understand the frustrations of attendants having to answer to unhappy travelers (which wasn't confined to American Airlines - we found rudeness in other airlines' staff who were absorbing the displaced passengers), it was good to know that there are some (unfortunately few) who commiserate and go out of their way to provide customer service.  Without any management in sight, will this woman attendant get the recognition she deserves?  From me, yes.  Her name is Ramina Zomaya, based in Chicago.

We have begun taking submissions for the 2008 Law Firm Economic Survey.  If your firm is interested in participating, please contact Brian by clicking here.

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There are differences in opinion on regulation of financial markets.  On the one hand, Alan Greenspan takes a mostly hands-off approach to financial markets, except when risks to the economy appear.  Martin Wolf, among others, have criticised Mr. Greenspan for his policies that they believe contributed, even caused, the current credit crisis.

They both seem to enjoy sparring via the Financial Times.  For a little background, read what Mr. Wolf wrote of Mr. Greenspan after he retired as Federal Reserve Chairman (requires registration to read).  It was written about in the New Economist blog with a summary. 

In March, Mr. Greenspan opined in the Financial Times that regulation won't create a "perfect model of risk".   He concludes:

"Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition."

Mr. Wolf responded in his forum with nine points in opposition to Mr. Greenspan (read through the comments to see Mr. Wolf's response).   He and others criticised the former Chairman for keeping interest rates too low for too long after the brief recession of 2001.  This, they maintain, led to the massive asset bubble fueled by great liquidity.  Mr. Wolf also aludes in one of his points that far too little attention is still being given the "excessive savings outside of the United States".  Some fear global inflation in excess of 5% will be the result.

Mr. Greenspan answered in the Economist's Form section of the Financial Times that was published in print April 7th in an Op/Ed piece.  Again, Mr. Greenspan set the rules of the game as black and white: 

"My view of the range of dispersion of outcomes has been shaken, but not my judgment that free competitive markets are by far the unrivaled way to organize economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?"

Mr. Wolf responded on April 8th in an editorial titled, "Why Greenspan does not bear most of the blame".  He grants many of Mr. Greenspan's arguments, but finishes:

"Regulation cannot be perfect.  But the worse the outcomes now become, the more difficult it will be to defend free financial markets at all.  Without a credible design for regulatory improvement, it will prove impossible."

The arguments on both sides are well worth the time spent reading and provide a better understanding of the likely debates to be held later this year contemplating additional regulation of the financial markets.  The breadth of reach that resulting legislation will have affects just about every area of the legal market in some shape or form.  The thought leaders are debating it right now.  Take some time and read the opposing views.  On whose side do you favor?

We have begun taking submissions for the 2008 Law Firm Economic Survey.  If your firm is interested in participating, please contact Brian by clicking here.

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No matter how much you work, until you convert it to cash it is worthless.  The average days in the law firm cash flow cycle (from worked to collected) is 169 (source:  2007 Law Firm Economic Survey from LexisNexis).  Shortening your cash flow cycle has a positive impact to liquidity and thus your cash flow cycle should be measured.

There are two metrics that need to be measured:  days to bill and days to collect.  Determining these numbers on a timekeeper level identifies those timekeepers who are efficient and those who aren't.  The opportunity then is to set a standard and work towards compliance by all timekeepers.

What is this standard?  It depends on the area of practice.  Many insurance companies just won't pay under 60 days of accepted electronic invoice and will only accept these invoices quarterly.  In this case, 150 days isn't so bad.  Some areas of law (many domestic relations situations come to mind)  should, by default, be prepaid.  Any work in process should be billed immediately and applied against the prepayments.  In these cases a cash flow cycle of 60 days should be cause for concern.

Tools such as Juris from LexisNexis' Active Information can help you track this key performance indicator so that you can improve your liquidity. 

We have begun taking submissions for the 2008 Law Firm Economic Survey.  If your firm is interested in participating, please contact Brian by clicking here.

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I received an email from Brendon Carr, foreign legal consultant and host of the Korea Law Blog, regarding a recent post of his, “I Don’t Care What You Charge; Whatever It Is, It’s 15% Too Much”.  The post discusses a request from a new client for an across-the-board 15% discount for his services. 

In my experience working with law firms, discounting is the most difficult thing to change.  Where mark-downs to work performed can be addressed internally, discounting becomes an entitlement to a client.  The only ways to recoup the loss in value is to increase rates at a higher percentage than other clients, pad your hours by billing for things you may otherwise not charge to a client, tie the discount to high volume, or tie the discount to fast payment of invoices  The first two are not conducive to a positive trust relationship with the client.

In my opinion, discounting should be avoided at almost all costs - the exceptions being:

•  In return for high volume of business that compensates for the reduced value of your time.  There is nothing shameful in requesting from a client who asks for a discount to provide estimates of business it will provide and tying the discount to their ability to provide that level of business.  Then you can agree to the discount, but will provide it once the threshold business the client sends you is met. 
• In return for fast payment of invoices.  This encourages fast payment and thus a positive effect on cash flow.

When in a situation such as that of Mr. Carr, several questions come to mind:

• Is asking for a discount up front damaging to the relationship between attorney and client?
• Does mandatory discounting encourage mark-up of hours?
• If it becomes known that your firm discounts, does it create a perception by clients that your firm expects rate negotiation and thus overcharges for its services?

What do you think?  Add a comment below to share your thoughts.

We have begun taking submissions for the 2008 Law Firm Economic Survey.  If your firm is interested in participating, please contact Brian by clicking here.

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In the February, 2008 Managing Partner Magazine, a case study was published regarding the international firm Herbert Smith, who recently implemented a financial management system that focused on measuring performance.  The case study mimics everything we promote on More Partner Income and thus deserves highlight.

The study begins with a quote from William Thomson (Lord Kelvin), who said "if you cannot measure it, you cannot improve it".  They may have done well to also quote "don't reinvent the wheel", since most of the sweat put forward in devising their system is already developed by software vendors such as LexisNexis.  It is the process, though, that bears note.

The firm adopted a "phased approach" to implementation that focused on basic needs first, then expanded to add functionality as the basic needs were met and a comfort level established by the users.  The firm initially only gave access to the system to the partners and used three phases:

1. Easy access to key financial reports
2. Financial planning and reporting
3. Time recording and "universe" design

The first phase entailed providing easy access to the important financial reports that had previously been distributed on paper.  This not only provided the partners with the information they needed, it helped them become accustomed to viewing this information electronically.

Phase two was focused on budgeting and management accounts.  They also placed some forward-looking indicators of performance and trend analysis.  This helped the firm make future projections through modeling.

Phase three provided real-time information for fee earners, including alerts when time entries were late or incomplete.

In my opinion, phase three should have been phase 1, phase 1 should have been phase 2, and phase 2 should have been phase 3.  However, whatever works is the right solution.  The important thing is that the firm set up their implementation with the highest probability of success by not cramming an entire new method of consuming information to all fee earners at once.  Instead, they focused on getting partners on board first, then eased them into the solution by first getting the most important information (read:  what they had already been getting) to them first.  Then incrementally adding new value to the system until it became an indispensable tool for managing the firm.

When your firm is looking to invest in a software solution: 

• If considering to develop it internally, which will require specialized staff to maintain, make sure you research to see if software vendors have already developed the solution you need;
• When you implement the solution, make sure you do it in phases to ensure adoption by all those who will benefit from it.

We have begun taking submissions for the 2008 Law Firm Economic Survey.  If your firm is interested in participating, please contact Brian by clicking here.

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