Since 2000, law firm PEPP (profits per equity partner) have increased on average 11% for Amlaw 100 firms and 8% for Amlaw 200 firms.  Some observers fear that, like other markets that have sustained growth periods at or near double digits in the past 10 years, the law firm partner profit "bubble" may soon burst as well.

Looking at Amlaw 200 data, PEPP increased by 2% in 2001.  In 2002, the increase was 7%.  2003 saw an increase of 11%, 8% in 2004 and 2005, and 10% in 2006.

This increase doesn't only apply to Amlaw 200 firms.  Looking at the differences from 2005 and 2006 for the top respondent firms in the Law Firm Economic Survey  by Juris Inc. and LexisNexis, respectively (the only two years available), firm PEPP increased 11%.  It is likely that most firms in the mid-market and small market increased incomes by respectable if not similar percentages over the same period.

What can you do to prepare for a stunt in the growth (or decline) of PEPP?  Bruce MacEwen posted an article May 5th  on his blog Adam Smith Esq., titled A "Bubble" in PPP? that looks at some short term ideas to help "mitigate the downward trend" and predicts a change in the las firm business model over the long term:

Short term ideas:

• Redeploy lawyers in troubled practice areas to healthier ones;
• Use the opportunity of "shared pain" with your key clients to get closer to them;
• Adroitly stand by while the normal waves of attrition take their toll;
• Build or at least safeguard capacity in selected practice areas that you anticipate will emerge strongly from the downturn;
• And always, always, keep a sharp eye on costs–although, truth be told, you don't have much material flexibility here. You're not moving your offices to Brooklyn and you're not paying less than market for partners and associates.

Long term predictions:

• the billable hour, lamented by many but eliminated by few, will eventually replaced with a more "value-based" model, though MacEwen stresses that he is not "holding [his] breath" on this;
• the traditional associate/partner model changes to include more non-equity partners and more contract attorneys;
• at least fundamentally, "the core processes by which law firms manage cases and deals must and will change" (ie, more project management, more team philosophy centered around practice groups to become more efficient).

Ultimately, MacEwen believes that due to increased demand (at least for Amlaw 100 firms), finding work won't be the problem.  However, he sees the traditional model as being unsustainable based on the limits placed on things such as productivity (>2,400 hours?), rates (>$1,000 per hour?)and realization (>100%?).  Because of this, if PEPP does suffer a downturn for an extended period of time, the long predicted changes to law firm dynamics may happen.

If this occurs in large law firms, it is incumbent on smaller firms to adapt quickly.  The predictions above are all point towards efficiency that allow firm profits to increase through efficiency rather than increased rates and worked hours.  Much has bee written about the "unmanageability of law firms".  Despite this, firms have continued to make exceptional profits - due in no small part to their enviable margins.  With good management, law firms can see profits that far exceed anything that firms receive currently.   And if partner profits start decreasing, your firm will be in crisis -  just as it is not a good idea to go to the grocery store on an empty stomach, it isn't a good time to contemplate an overhaul in processes during a crisis.

Much of the allure of smaller firms is quality service at a lower price.  Some large firm partners charge rates in excess of $1,000 per hour.  If large firms realize they can offer similar services at lower prices and still increase profits, smaller firms can be squeezed out of the marketplace.

Think Walmart.  As Walmart entered the scene, small businesses were unable to compete based on their lack of purchase power.  Walmart could offer more product selection at a lower price.  Home Depot and Lowes did the same to small hardware stores.  The small shops that survived did so by using their secret weapon - customer service and personal engagement.  Still, you won't find many of these shops who don't struggle on a monthly basis and have to watch as their clients often come to them for advice, then go to Home Depot to buy the big-ticket items.

For small and mid-size firms to compete in this changed environment, they will have to embrace workflow efficiencies that meet or exceed that of the larger firms - and use their "secret weapons" of personal engagement with clients and responsiveness.  However, without the fundamentals of an efficient business in place, your firm will suffer under the weight of your processes.  

There will always be individual clients available, but more dependable sources of income often come from business clients and their leaders.  These clients are already demanding more cost certainty.  If larger firms are able to provide this value to business clients first at a price that isn't so different than yours, your firm may be in trouble.

The time to act is now.

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This is the second in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis.  The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability.  This article is focused on pitfalls of some firms' methodology in allocating costs to partners.

Some firms have chosen to exclude costs all together from billable hours worked by partners.  Generally it has been requested for one of two reasons: the firm would like to keep actual partner compensation out of the profitability model (a closed compensation system), or the firm is thinking about a P&L model where partner compensation is simply a distribution of firm profits.  While this methodology does accomplish those goals, from a client profitability perspective, it introduces its own set of issues.   

What results is a model where client profitability is maximized by only using partners to perform the billable time.  In the example below, there is a timekeeper with a 66% profit margin and two partners, both with 100% margins.  Any hour that the Associate performs for a client will in essence drag down that client’s profitability and a matter manager might be tempted to use a Partner where an Associate would suffice in an effort to ‘game’ his clients profitability.  This is contrary to the proper use of leverage and economic theory which would have the partners working on tasks for which lower level timekeepers are not qualified such as originations and the management of matters and attorneys.  For this reason alone, there needs to be some cost associated with each billable hour of a Partner’s time, if not for any other purpose than to represent the opportunity cost of them not performing these other tasks.  Besides, every firm that we have encountered expects their partners to perform a certain quantity of billable hours for their clients which would imply that some of their compensation should in fact be allocated to the client.

Another methodology that has been requested in an effort to support a closed compensation is what we call a fixed (or capped) partner cost.  In this scenario, every partner is given the same direct costs.  Aside from the privacy of actual compensation, firms make their case by stating that above a certain point, all partner compensation is for contributions besides the billable hour.   However, since billable rates vary significantly even in the upper echelons of partners, it is hard to justify those hours having the same cost rate.  Regardless, like the methodologies we have already examined, this too creates some unfortunate outcomes. 

The biggest concern with this methodology is the reversed leverage that it creates (similar to having no costs at all).  In the example illustrated below, we see a firm that has chosen $270,000 as the partner direct costs.  Any partner whose compensation exceeds this threshold has their compensation limited and as a result, all have a $150 cost rate for their time.  The result is that the highest rate timekeepers have the highest profit margin, 40% in the case of the Rainmaker, while those with lower compensation, like the Jr. Partner, have minimal (or zero) profit margin for their work.  Certainly, the cost to the firm for these 3 timekeepers is not the same.

The alternate version (and preferable to the former) is to use the dollar amount as a limit to partner compensation and not a flat amount for every partner.  In the example below, we see the Jr. Partner whose actual compensation is below the $270,000 mark.  In the fixed methodology his profit margin is 0% but if it were capped, his direct costs would be his actual compensation and therefore would have a more favorable profit margin of 44%. This still does not relieve the cost similarity between the Dept. Manager and the Rainmaker but it is a slight improvement over having all partners at one cost rate.  Of course this methodology does not meet the requirements of a closed compensation system (unless the firm is primarily interested in the privacy of Sr. Partner compensation).

The next installment will focus on better ways to calculate partner cost in measuring client profitability.

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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.  

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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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A guest blogger for JDBliss writes on March 20th about a 3L law student at Standford Law School who has built a new organization trying to influence how Big Law firms treat their associates.  The law student

"was disturbed by the stories he heard from lawyer friends about 60-hour weeks poring over mind-numbing documents, young associates getting little feedback on their performance, and the small percentage of associates who made partner after years of toil."

Instead of accepting the "status quo", he started an organization focused on reforming law firms.  According to the post, the group has already made an impact on firms as many have started to:

• provide more flexibility for lawyers who are parents,
• offer mentorship programs for newer attorneys,
• change or eliminate the billable hour in favor of fee and compensation arrangements that reduce pressures on associates,
• evaluate newer lawyers based on the skills they have developed rather than their longevity at the firm, and
• give employees credit for pro bono service and other firm-related work such as recruiting.

Wait a second.  Something is missing from the above.  Where is the "reduction of obnoxiously high starting salaries for graduating law school students"?  Must have been an oversight.  I have little worry, though.  Through the commitment of this brave group, I am certain law firms will respond by lowering associate salaries from their current ridiculous levels through the group's "influenc[ing] the employment practices of law firms by highlighting firms' commitment to their lawyers' work-life balance, to diversity, and to professional development during the lawyers' careers."

If this too is not a goal of the group, the membership of "more than 1,000 students" may have unwittingly given firms a reason to do so.   

One of the above bullet points does appear, in principle at least, to validate findings in a recent Harvard Business Review article about which I wrote on March 14th.  The desire to move away from billable hour requirements in exchange for other arrangments that are more task oriented fits into the HBR argument of "Gen Y"'s focus on results rather than method.

I also can't argue with the need for mentorship programs and merit-based promotion.  Both of these needs help the firm increase revenue and value not only to clients but firm professionals as well. 

If the group wants others to take it seriously, though, it may want to consider a few things:

• If you want a work-life balance, you have to understand that your salary will not be as high.  There are costs to balancing your life.  Make the same argument for reducing pay for associates.
• Clean up the site.  I can't take seriously a movement to drive down work standards written with such a lazy approach.  No capital letters starting sentences?  The grammar is so bad that it reads like a rambling manifesto rather than a reasoned argument.
• Highlight your pro bono initiatives and how it has affected the life of the members who participate. 

I can't help but think of what those in other industries would think reading that site (besides the poor drafting).   Imagine a coal miner or construction worker or any other type of industry where long hours are required reading it.  Attorneys who get paid upwards to hundreds of thousands of dollars a year starting pay complaining about their plight.  

As they say in the south, "bless your heart".

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It is easy to make predictions, but who is brave enough to revisit them to see how well their predictions are holding up?  It's time to be held accountable for my predictions and review the clairvoyant performance to date:

1.The effect of the market "correction" will lead to a rise in bankruptcies and foreclosures.  It doesn't take a mind-reader to make this prediction; nonetheless, there is ample evidence of both.  Bloomberg reported on March 6th that foreclosures are up as owners "give up".  The Boston Globe reported that Massachusetts foreclosures were up 128% in January.   The New York Times reports that bankruptcies were up 18% in February.  No surprises here - clairvoyance rating:  10

2. Increase in mergers and/or lateral movement.  Too early to tell on this one.  Clairvoyance rating:  5

3. Business Intelligence Tools will be showcased more in tech shows.  If LegalTech New York is any indicator, I am dead wrong on this one.  E-Discovery won the day then.  Next week is the ABA TechShow in Chicago - we'll see. Clairvoyance rating:  1

4. Election year lawsuit opportunity due to claims of voters.  This one is too early to tell as well, but given the rising prospect of the Democratic Party getting mired in an election year lawsuit over the Florida and Michigan delegate disqualification debacle, I may give myself points for being in the ballpark.  Clairvoyance rating:  6

5. Calls for the death of the billable hour continue, but to no avail.  I have had to write in defense of the billable hour a few times this year (see posts on January 7th and February 19th) but I certainly see the value in alternative fee arrangements - so long as firms know the cost of their services.  Even so, I feel compelled to respond when others claim that the billable hour is the cause of frustration with clients.  I understand the desire for cost certainty, but trust is the issue to me, not the billing method.  That hasn't stopped many from writing about it (see the posts for the links).  Clairvoyance rating:  10

6. Lawyers won't be lacking for work in 2008 even if economy is bad.  Even though Citibank and Hildebrandt claimed in their 2008 Client Advisory that firms faced a "Perfect Storm" of indicators leading to financial hard times for law firms, reality isn't abiding by their predictions - at least so far.  David Lat at Above the Law ran a survey asking associates what areas of practice were hot and which were not.  Not surprisingly, transactional law, particularly real estate, is lower than it has been the past 3 years.  However, litigation is up, particularly commercial and patent litigation.  The next highest area was bankruptcy.  Clairvoyance rating:  10

Just like any forecast, circumstances dictate some review and modifications of the predictions.  Measure and adjust.  Since I am doing well with both #1 and 6, they stay as is.  I would like to see more return on question 2, but will let it slid until 2nd quarter review.  #3 is in need of some changing but I am holding on to this for at least one more show.  The election year prediction should be broadened to any party litigating anything related to the election.  That includes the Democratic Party if they so decide to self-destruct.  Finally, the calls for the billable hour to die will never die - and neither will the billable hour - so that prediction stays as is.

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A friend of mine practices in firm that specializes primarily in transactional work. Much of the work is billed flat fee but they still track their time so the firm can determine profitability. Recorded time is set against an attorney's budgeted hours for the year so that they are credited for their flat fee work. My friend lamented associates padding their worked hours for flat fee work so they make their budget numbers. In this case, padding hours doesn't affect clients since the fee is pre-set but it does affect reporting of profitability.

Aric Press, Editor-In-Chief of The American Lawyer, wrote in the December, 2007, In-House article that 2008 may well be the year when clients start to demand alternative fee arrangements:

One of the unintended consequences of electronic billing is that clients can now easily compute and compare the cost of tasks. Soon there may be other technological threats based on knowledge management that can convert once complex acts of lawyering into rather commoditized routines.

I have been pretty adamant in my defense of the billable hour. That doesn't mean that I am against alternative fee arrangements when the use of them will improve the efficiency of the firm and thus increase profits. Recording time, regardless of fee arrangement, is still a good idea. However, sometimes it just makes more sense to bill using fixed fees for certain tasks.

Why not take advantage of this and place an internal value on the task as well? You can do this by determining the time it takes to perform the task, then mark it up to the market price (perhaps based on the hourly rate times the time it should take to perform it). When a task is routine, standardization gives firms opportunities that can revolutionize a firm's business model. Not only will attorneys have a value based on their billable hour, but certain repetitive and reproducible tasks can be valued as well. Your firm will diversify its product offerings to clients, giving them more options for services and giving you more options to strengthen the client relationship. You could ostensibly set a price list for legal products - in effect competing with the emerging online forms market.

In the example of my friend's firm, creating a standard task that is reproducible and given a proper value reduces the inaccuracies in reporting due to "padding time" by associates trying to make their numbers. In the example of the firm whose client has already placed billing guidelines on a firm, this has the equal benefit of both providing cost certainty to the client and saving the attorney from repetitive time entry.

There is also the benefit to the general practice firm. The firm can market package transaction services at a set rate, and tack on billable hours beyond the scope of the repetitive (and priced) task. Sound a bit like value-billing?

How would this work? For transactional work, it would be as simple as setting a value upon a routine task, such as creating a will. For a simple will, attorneys will determine what the variables are, determine what it has cost in the past, agree upon an acceptable price based on market acceptance and variables, then price it.

In a litigation matter, it is no different. Many firms are already required to provide budgets based on tasks for the benefit of client cost allocation. Each task that the firm performs can be priced. Litigators can anticipate the course of the suit and determine a cost for the entire matter. There should be a value placed upon every legal task, whether it be writing a status letter, reviewing a file, etc. The price can take into consideration variance in time it takes for different attorneys to perform the task. That is up to the firm to decide.

By standardizing the value of certain tasks, it also opens another opportunity for building firm expertise: giving royalties to attorneys who create reproducible work product. Firms spend years building up forms. Forms are rarely created again - they are typically modified. Yet no one gets credit for creating the forms.

By giving an attorney a royalty for a form, you encourage expertise to be passed on to the rest of the firm. You can position attorneys who have a talent for researching and integrating current law into forms as work product creators and attorneys who are better at managing relationships and matters representing clients. Both have value. Both can be compensated based on the work they perform. Form writers would receive a percentage of the cost of the task as a royalty for a certain time period whenever their form is used. Just as you should place a time limit on origination credit, you should only provide royalties on forms for a certain time.

How can this be advantageous to the firm? Several ways:

• It encourages information sharing within the firm.
• It compensates those who provide value to others in the firm.
• It can further a strategy of increasing leverage by giving credit to partners while reducing their billable hours.
• It transfers the wealth of knowledge gained at the firm's expense back to the firm.
• It can aid the strategy of succession planning by providing a route to semi-retirement while ensuring that the firm maintain its areas of specialization.
• It allows partners to spend more time on what they excel in most: rainmakers focused on marketing efforts and strategic planning and grinders developing work product.
• It gives firms an opportunity to give associates responsibilities that will benefit the firm as well as the associate.

Of course, with any change in policy, there are uncertainties that have to be addressed. For example, what if another attorney within the firm finds a problematic provision in the form and proposes to change a few clauses? What if the attorney proposes an entirely new form? Although in theory it would be a good thing to have several different forms from which to choose, logistically it may make more sense for your firm to settle on a preferred form from which attorneys may receive a royalty. That along with determination of the royalty percentage is sure to provide lively discussion in the partner meeting.

Whatever direction your firm goes when applying new policies, it should conform with a universal requirement of periodic measurement and adjustment.

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"Is the billable hour dead, as many like to proclaim (whether wistfully or presciently?)" So starts the Executive Summary for the 2007 ALM Billing Rates & Practices Survey. The relentless assault against the hapless billable hour continues. Here is yet another blog post arguing against hourly billing. Yet if you look at billing rates, they continue to increase. The 2007 ALM Billing Rates & Practices confirms this, but also drills down into respondent's use of alternative fee arrangements.

According to the ALM survey, the average billing rate nationally is $240. This is in line with the 2007 Law Firm Economic Survey from LexisNexis, where nationally, attorney rates were at $249 (broken down: equity partner rates were at $263 and non-equity partners billed at $235 on average). In the ALM survey, "[a]ll but a small percentage were the leader, managing partner, shareholder or owner of their firm", so I didn't include the firm effective rate that includes associate and paralegal rates in calculating the $249 (for those of you thumbing through the LexisNexis survey). Only 8% of the ALM respondents were associates, so it may very well be that average rates were lowered to $240 in the ALM survey by the associates (who in the LexisNexis survey billed at $175 per hour).

The survey is heavily weighted to small firms, with about a third of respondents being solo practitioners and 58% from "small firms" defined as between 2 and 39 attorneys. Why ALM decided to include mid-sized firms (Juris defines mid-size to include firms with attorneys with over 10 attorneys) in the small firm category, I don't know, but it might be due to a small amount of respondents in that 11-39 range.

As further comparison, the average national billing rate for equity and non-equity partners in the 2007 Altman Weil survey was $315. The National Law Journal Billing Survey partner average was $427. Both the Altman Weil and NLJ surveys target larger firms.

One of the observations of the survey was that size of the law firm matters and the above figures certainly indicate this. However, in the LexisNexis survey, the observation was different: it isn't the size that matters, but "that law firms that outperform with regard to per-partner income do so because they excel in performance on the key law firm profit drivers." The ALM Billing survey doesn't profile the firms for per-partner income and thus only looks at part of the picture.

In the chart above, each quartile was ranked for the following key profit drivers: productivity (billable hours), leverage, billing realization, effective rate, and operating margin. The highest performing firms ranked the lowest in all of the indicators.

Size, on the other hand, didn't make as much of a difference. For example, the per partner income of the top performing firms with 25 or more attorneys in the LexisNexis survey was $609,548. Income per partner for firms with 11 to 24 in the top quartile was $548,557 and with 10 or fewer attorneys, $512,896. However, the difference between quartile 1 and 2 across all sizes is substantial: $325,986, $322,876, and $294,871 respectively. While there is less than $100,000 that separates the smallest surveyed firms from the largest ones, there is nearly $300,000 difference between quartile 1 and 2 across firms of all sizes.

Which brings us back to the ALM Billing & Practices Survey. 88% of respondents to the 2007 ALM Billing Rates & Practices Survey reported that they offer "alternatives" to the billable hour and it made up an average of 37% of their revenues. That is a pretty substantial number. Given that the survey is made up of smaller firms, you may be tempted to conclude that smaller firms are moving away from the billable hour in order to compete better with larger firms.

That may well be the case, but it is just as likely that some small firms that continue to not operate like a business could be getting caught up in a trend that in the long run will drop their profits even lower while the solo practitioners next door is making half a million. If you don't measure performance, you won't know.

Morepartnerincome.com is sponsored by Juris®. For information about Juris products and services for increasing law firm performance and partner income contact Juris National Sales Center:

877/377-3740, e-mail info@juris.com or go to www.Juris.com.

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The January California Lawyer (page 8) reports that lacking comfortable alternatives, lawyers and clients are staying hitched to the billable hour.

The article, Driven by the Clock, notes that C-level executives on the corporate side seem more reluctant than law firms to abandon the status quo—the traditional hourly bill.  Offered an alternative arrangement, one corporate executive rejected it, explaining, “I need someone watching my back. I already have an investment banker whose only interest is this deal is collecting his commission.”

The client did not want legal advice biased toward a certain outcome. One of the complaints against the “billable hour” by the business world is the perceived conflict-of-interest that may result in the lawyer finding things to do just to increase the bill. The article illustrates that alternatives to the billable hour can interject their own versions of perceived and real conflicts-of-interest into the lawyer/client relationship. 

As observed by Brad Brian, past chair of the ABA’s litigation section, “There is an interesting dance going on. A lot of clients want attorneys to think about billing alternatives, but they’re nervous about them too because there are risks on both sides.”

There is no single pricing solution that will make everyone happy all of the time.  It follows that a law firm should not have a single pricing model.  Where alternative pricing fits, alternative pricing is a road toward more partner income and happier clients.