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  • Wisconsin Lawyer
    November
    01
    2013

    Profit Patterns: Maximizing Opportunities in Your Practice

    Michael F. Moore

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    Awareness of financial patterns and forces, both in the economy as a whole and within a single law practice, can help lawyers increase their profitability without taking on more work than they can handle.

    acornsIn May 1997, Gary Kasparov, the greatest chess player of his day, was defeated by Deep Blue, a computer program written by scientists at IBM. To many people, this event appeared to represent the triumph of machine over man, of computers over the human brain. In reality it was something quite different. Chess is a game of patterns, and the IBM team built a machine that could recognize and manipulate every conceivable pattern, including Kasparov’s own patterns of play. Using what was massive computing power for that time, Deep Blue developed cumulative learning and was able to consider every conceivable pattern of play before every move.

    Managing a law practice successfully in today’s legal marketplace requires a similar understanding of patterns as well the ability to adapt to change. New economic requirements driven by client expectations are evolving rapidly and challenging every lawyer’s ability to keep up. From solo practitioners to small firms to large firms, a fundamental transformation in the valuation and delivery of legal services is underway. Attorneys who recognize the unique profit patterns within these changes and their application to a specific individual practice or law firm will have a competitive advantage and more likelihood of future economic success.

    The Business of Law

    For most of us, the practice of law is a noble profession and we still find it challenging, rewarding, and exciting. Our primary goal must always be service to our clients. Our activities sustain the crucial role of our legal system as a fundamental foundation of American society. However, we also have the same economic realities as any other person, whether a professional or a layperson. We need to make a living from what we do. We also must operate our practices and our firms in such a way as to create positive economic results. This provides the necessary solid foundation from which we can do good legal work and provide value to our clients. Therefore, we need to understand the unique business of law.

    Clients have needs. As lawyers we urgently want to satisfy those needs. However, to operate for profit we need to understand the relationship between what it will cost to achieve our client’s needs and what our client is prepared to pay for that service. If we are part of a law firm, regardless of size, there may also be standard procedures that must be incorporated into the delivery of our work product to our client. Even if we are solo practitioners, using standard methods helps us control costs while handling various legal matters.

    Excellent client service is paramount and any perceived delay in delivering that service may appear to jeopardize that. At the same time, operating a law practice and making a profit are also vital. Resolving these conflicts requires a balancing act because we know at the end of the day, all our efforts and time spent on behalf of our clients may be worth zero economically unless they can be billed and paid for.

    Get the Right People on the Bus

    Many lawyers make less money than possible because they either don’t have the right people or don’t help the employees they do have maximize their potential. They struggle with frequent turnover and spend time hiring, supervising, training, and eventually firing people who just aren’t the right fit. Getting a new hire through the door is only the beginning. Substantive training provides a powerful incentive for people to stay with the firm. Firms where people learn to work together effectively and develop complementary skills have an advantage over their competitors.

    Michael F. Moorecom mmoore moores-law Michael F. Moore, is the founder of Moore’s Law LLC, Milwaukee, and helps lawyers and law firms create professional success. He specializes in individual marketing, client development, and leadership coaching and advises law firms on strategic planning, growth initiatives, and resource optimization. His book, The Lawyer’s Toolkit for Creating Both Personal and Professional Success, is available from Thomson Reuters.

    Unfortunately, when faced with recent economic challenges, many law firms eliminated what they needed to get the kind of clients and work that would improve profits. A 2009 Altman Weil survey of law firms found 46 percent had reduced support staff, 33 percent cut paralegals, 32 percent thinned their associate ranks, and 24 percent cut nonequity partners. Lawyers have tried to absorb administrative and management tasks they could inexpensively outsource. This takes them away from billable time and client development, two activities that increase profitability. Many firms also have eliminated training programs and held back on key technology investments. These actions only create a temporary windfall and fail to provide long-term solutions to increase profitability.

    For solo practitioners, there may be similar temptations. Avoiding the overhead cost of staff, whether a legal assistant, a paralegal, or both, could mean missing the opportunity to leverage billable time to handle more legal matters and develop more client relationships. Another example is trying to manage office administration tasks like trust accounting or technology, when outsourcing these activities to other professionals might allow the lawyer to focus and maximize the value of what lawyers do best: practice law.

    Managing Client Expectations

    The initial meeting with a client may be among the most important discussions a lawyer will have with a client. This is because every client develops certain expectations that will guide the client’s thinking as any legal matter proceeds. Client expectations relate both to their perception of the legal work to be done and the economic impact to them of that work. We all hope that these expectations will be based specifically on what we actually communicate to the client during the initial meeting. However, in reality, often the client’s expectations are based on what the client thought he or she heard or interpreted from what we communicated. Therefore, it is important, before moving forward with any legal matter, to clarify to the client what his or her expectations are and how we intend to meet those expectations.

    Some examples may help with understanding client expectations. The client likely will want to know what the legal process for his or her specific matter will involve. This must be explained in general terms, avoiding the use of legal terminology as much as possible. A client will usually want an estimate for how long the legal process will take. Depending on the nature of the matter and the client’s level of sophistication, the client may also want to understand the strategy for addressing the legal issues. This discussion may include outlining a range of likely results, depending on the specific strategy applied. The client will want to know the estimated overall cost of the legal services to be provided and what factors in the process of handling the legal matter may affect those costs. The client will want to know how and when these costs will be billed, including not only the legal fees but also other related expenses such as filing or recording fees, expert witness fees, or extended discovery costs.

    During any initial discussion with a client about the cost of the legal services to be provided, it is also important to define when payment of these costs will be expected. Properly managing client economic expectations will usually result in improved financial results for the lawyer. For example, billing realization (the percentage of billable time actually billed to a client) can be improved if a client understands how much time the lawyer expects the legal matter to take and how much the lawyer intends to charge for this time. This discussion usually includes an estimate of hours and the lawyer’s rate per hour. Collection realization (the percentage of the bill the clients actually pay without adjustment) will also be improved when the client understands the variables that may cause more time to be expended than expected or the additional costs incurred by using a specific strategy to get the result the client wanted.

    For these reasons, it is important to let the client know of any changes in the course of the representation immediately. If at all possible, lawyers should allow clients to participate in any strategic adjustments in their legal process, particularly those that will affect their costs. The goal is to be sure that any client is never surprised with the amount of his or her bill. By improving each of these economic indicators by a few percentage points, a lawyer or law firm can create significant additional revenue.

    Financial Due Diligence

    Once representation is commenced, it is very difficult and at times very costly to extricate from a client relationship or specific engagement. Therefore, financial due diligence as a best practice should be applied whenever a new matter is opened with any client. The specific activities will vary depending on the nature of the matter, the relationship with the specific client, and whether the client is an organization or an individual.

    When a new prospective client appears, lawyers should be cautious before jumping into a relationship. Doing exciting and challenging legal work may be attractive but returns little economic value if the client cannot pay the legal costs incurred. For new organizational clients, the lawyer can check various credit and business resources, such as Dunn & Bradstreet reports, the Better Business Bureau, and the organization’s current financial statements (if public). For new individual clients, the lawyer may want to ask for an initial retainer in advance of the legal work being commenced.

    When considering taking on new work for existing clients, the lawyer should be aware of their previous billing and payment history. Pay close attention to any write-downs of time billed in prior matters and write-offs of time billed but not collected. The lawyer or law firm should also check current amounts in WIP (work in process) for pending work that has not been billed and past-due A/R (accounts receivable) for work completed and billed but not yet paid. These amounts help the lawyer and the law firm understand how invested they may already be with an existing client and whether any adjustments to the relationship may be necessary. The lawyer might ask a client to pay past-due amounts before the lawyer undertakes new matters for the client or to pay a retainer for a specific matter such as litigation or a complex transaction such as a financial reorganization.

    Fee Agreements

    One simple method to help with client expectations and economic results is the use of fee agreements, often as a part of the initial client engagement letter. Wisconsin Supreme Court Rule 20:1.5(b) requires a written fee agreement for any matter in which it is reasonably foreseeable that the total cost (fees plus expenses) will exceed $1,000. Although there is an exception for regularly represented clients, it is good practice to use a new fee agreement whenever a lawyer undertakes a new matter for an existing client.

    An effective fee agreement clearly identifies the client (individual or organization) and defines the scope of the lawyer’s representation of that client in regard to the specific matter. The agreement defines when the representation will begin and when it will end. The lawyer should take care to clearly document the scope of the work to be done pursuant to the fee agreement. Any changes to or extension of the work beyond what is described may necessitate another agreement or perhaps a change order. The fee agreement also outlines the details of how the fees for the matter will be billed and paid. This may be as simple as providing an hourly rate or requiring a specific retainer or as complex as identifying all the details required for an alternative fee arrangement tied to achievement of specific results.

    Improved Time Management

    Frequently it appears that the only thing lawyers ask clients to pay for is their time. This is because traditional billing models usually include billing by the hour at an established rate per hour. Successful lawyers understand that they are offering knowledge and solutions to client challenges and opportunities. However, managing a law practice does require an understanding of the practical economic cycle of any for-profit business. Quality legal work is every lawyer’s finished product but the unique process to create that finished product includes inventory, work in process, finished goods, delivery, billing, and ultimately, payment.

    The cycle begins with the client engagement for a specific matter and becomes work in process as the lawyer undertakes research, analysis, and drafting or negotiation to meet the client’s needs. Once the matter is completed, the lawyer’s work product usually must be delivered to the client in the form of an actual document, a closing, or perhaps a judge’s decision. The client will be billed for these services and expected to pay according to the fee agreement in place. The economic goal when managing a successful legal practice is to shorten the time from the initial client engagement to receipt of payment for services.

    Improving the economic cycle usually requires paying attention to time entry. The most effective method is to record in real time, as it happens. Lawyers should try to avoid the method of using notes and summaries with the intention of going back later to fill in the details. Studies have shown that lawyers lose as much as 30 percent of their billable time if they do not record activities when they happen. Be sure to include time-entry descriptions written in specific language that refers to specific activities. Clients want more details on their bills, and they want to see that work is being done on their behalf.

    For example, a meeting with a client or another lawyer should identify by name the person whom the lawyer met and include the specific location of the meeting and the material topics discussed as well as the amount of billable time. Legal research should identify the details of the research as well as the specific questions or issues being researched. When work spans extended periods, the time-entry descriptions should indicate a development path of progress. The appropriate time entries might include “commenced” followed by “continued” or “revised” and end with “completed.”

    Be sure to send bills every month to clients with outstanding balances, even if no additional work has been done that month. These reminders help keep payments on track. If the legal work requires a substantial advance of costs, be sure to bill this immediately to the client and avoid getting overextended by carrying matter costs on your account. For most clients, the use of a well-designed invoice and a remittance envelope will eliminate the need for a cover letter. The goal is to simplify your billing process and make it easy for the client to send you payment. Some lawyers and law firms accept payment by credit card. Many law firms now email invoices and statements to clients and eliminate mailing costs all together.

    Value Migration

    Value migration describes the market impact when people buying a product or service shift from outmoded business models to those better able to satisfy their priorities. One example is the replacement of travel agencies with websites that consumers can use themselves to purchase airline tickets, hotel reservations, and other travel-related activities such as cruises. Another example is the evolution of coffee consumption, from people making their own on home-style low-quality drip makers at a cost of only pennies per cup to people frequenting coffee shops featuring custom creations of exotic coffees selling for dollars per cup. In the first example, the buyers “migrated” to a lower-cost direct model for services but in the second example, they “migrated” to a higher cost indirect model for a product. Buyers’ value priorities shifted, and successful enterprises responded to meet this change.

    The legal profession is experiencing a similar evolution in how clients perceive the value of legal services. The practice of law has now become similar to other professional services such as finance and engineering, in which efficiency is rewarded as much as skill and success. Clients now expect their lawyers to proactively look for ways to be efficient and offer those options. This often includes offering alternative billing arrangements. This is primarily because current economic pressures are requiring clients to rethink the way they buy legal services. They want predictable costs, not surprises. They want to pay for results, not time. They want alternatives to billing by the hour.

    Opening a discussion on alternative fee arrangements can be an opportunity to cultivate stronger relationships with existing clients, gain new clients from more rigid competitors, and increase profitability. However, implementing alternative fees usually requires lawyers to predict and analyze the effort that will be involved, lay out the plan to be followed, and factor in the likely outcomes. Success with alternative fees favors lawyers who have good management skills and a high level of expertise in the substantive area involved.

    Some examples of alternative fee arrangements include fixed fees for a specific service, contingency fees based on results, risk collars that cap legal expenses for a project, and flat-fee retainers covering specific time periods. A fixed fee may be used for a single project involving expertise and judgment but not much risk, such as writing a handbook or developing a compliance training program.

    Alternative fee arrangements are frequently useful with repeating, routine types of client matters that require expertise and judgment but not much risk. Examples include frequent filing of a certain type of patent or trademark application, monitoring compliance with environmental permits, and handling routine labor matters in arbitration (as opposed to court). Alternative fees may not be the best option when handling more complex matters that involve sophisticated expertise and higher risk, such as a line of product liability cases, a series of venture capital financings, or more complex multiparty contracts for capital equipment sales.

    Identifying Cost Centers

    Understanding and applying effective cost management is a necessary step to be sure billing rates are not only competitive but also create profits. It may be helpful to develop cost models to accurately allocate components of cost among various lawyers or specific practice areas. This is also known as matter-cost budgeting. For example, in a litigation matter, standard cost items would include document and pleadings preparation as well as anticipated discovery and due-diligence activities. The budget should also include a cost for negotiations and developing pretrial strategies as well as expert witness or investigative costs and other support services like court reporting. The amounts of time budgeted are not only expected lawyer time but also all staff and paralegal time. The goal is to create a total projected matter-cost estimate or budget. As the matter proceeds, various time and expense estimates become actual costs and can be measured against the original budget for each activity. Effective client communication will be crucial at each step, especially if the matter appears to be headed over the original budget. 

    True cost is not to be confused with a lawyer’s billing rate per hour. The objective is to identify the actual cost of the lawyer’s activities. The usual components of cost include overhead, such as rent, utilities, salaries, and any benefits expenses. They also include all tangible materials such as paper, forms, office furniture, and supplies. Another major cost component in today’s legal office is technology, which should include not just the computers and software but also any licenses and technical support required. The resulting cost analysis will include an hourly wage cost plus a burden factor to arrive at a true individual cost per hour. The addition of all other costs for materials and support services to the individual costs result in the total production cost for the specific legal matter.

    Some areas of practice lend themselves to accurate costing models because they usually involve a standard set of the same activities to produce the appropriate legal results. Once a clear illustration of the cost of a matter has been created, then the most effective billing structure for that matter can be defined. Estate plans are often one example. By using effective client-intake documents and standard forms, clients can be offered the bundle of services and documents required for a fixed fee. Drafting a standard lease or contract for sale of goods is another example of work for which standard costs can be identified. Therefore, the service can be offered to clients for a fixed fee that covers these costs and produces a profit.

    Competition in many legal markets and within some specific practice areas may require charging a flat fee or a discounted hourly rate for many types of legal services. By using matter-cost budgeting, the fee necessary to make a profit becomes clear and the decision whether to pursue certain types of work can be justified. For example, handling repetitive matters for the same client often requires that the same fee be charged, with the client’s expectation that this fee will represent a discount from the lawyer’s usual hourly fee. Matter-cost budgeting allows the lawyer to set a fair price for each matter and then strive to increase efficiency to increase profitability. Even in complex litigation matters, understanding true costs helps keep retainers current and may impact strategic decisions with clients on specific options for resolution of the dispute.

    Measuring Profitability

    Specific factors are key to measuring and improving the profitability of any legal practice, whether solo, small firm, or large firm. These include the blended hourly rate charged by the lawyer, the use of leverage to increase total revenue, the utilization rate of all timekeepers to maximize capacity, the realization percentage of time billed out to clients, and the profit margin the legal practice creates between revenue and costs. These factors are interdependent, which means that one of them cannot be changed without affecting the others.

    For example, if a lawyer doubles her billing rate as applied to the same hours of work, the expected result would be an increase in revenue. However, existing clients likely would object to the higher cost of services and demand discounts or not pay their bills timely. This would lower the lawyer’s realization percentage. Eventually, utilization would also be reduced as clients switched to cheaper competitors, resulting in less work for the lawyer and lower billable hours. Therefore, understanding the application and impact of each factor becomes necessary before deciding what the right steps will be to increase profitability.

    Frequently, lawyers offer a variety of rate structures to various clients and for various matters. The blended hourly rate is the ratio of total fees earned divided by the total hours charged. While it might seem desirable to increase billing rates annually to avoid devaluing rates due to inflation, current client demands and economic realities may not always allow this option. The real secret to beating inflation actually is not increasing billable rates each year. The better option is increasing personal productivity. Higher productivity increases the margin between costs (which include inflation) and revenue. The higher the margin, the less inflation will have a negative impact on profitability of the law practice. 

    Certain factors have a greater or lesser effect depending on the size of the law firm and the structure of the lawyer’s practice. For example, leverage is the ratio of nonequity fee earners to equity partners. Some small firms may be all partners, while some may be a couple of partners with several associates. Larger firms may have a combination of equity and nonequity partners as well as associates. Solo practices may include one or more paralegals.

    In any situation, the fact is that there are only so many hours any individual lawyer can work or may want to work. Once this level has been reached, billable work will need to be delegated to another fee earner to increase profitability.

    Another example is utilization, which is the percentage of available capacity within a law practice that is being billed out to clients. To increase profitability, all fee earners should be fully utilized. Lawyers who are skilled at client development can build highly profitable practices by maximizing the use of other fee earners within their practice, both lawyers and nonlawyers.

    For most lawyers and law firms, profitability at the end of a financial measuring period may be a fine concept but positive cash flow has the most immediate impact. How efficient is the lawyer at converting his or her work into cash? Realization is the percentage of the lawyer’s billable time actually billed to clients and not written off. Each percentage point lost represents money out of the lawyer’s pocket. Work in process is similar to inventory: it loses value every day it sits on the lawyer’s desk, unattended.

    Effective time-entry practices help capture all work the lawyer has put into a specific matter. Each month bills should be sent out to clients in a timely fashion. These bills should accurately reflect any fee arrangement with the client and include costs expended by the lawyer on the client’s behalf. Lawyers and law firms should track accounts receivable and be sure clients are paying their bills in a timely fashion. By improving the realization percentage of any size law practice, both the cash flow and the profitability of the practice will increase.

    Law practices, like any other for-profit business, can be measured by their profit margin. This amount is frequently identified as the practice’s net income, expressed as a percentage. Frequently the assumption is made that better profit margins in law practices can be obtained simply by reducing costs, increasing hourly rates, and increasing billable hours. Unfortunately, these activities may not only fail to achieve the desired results but also create client dissatisfaction and problems with both lawyer and staff morale. The recent economic challenges faced by many lawyers and law firms may have necessitated cost reductions to survive but as revenues are now slowly increasing, competition for clients is also increasing. Every lawyer’s focus on excellence in client service must also include a delivery of value. Efficiency in legal practices can be created through more effective use of both technology and staff. This provides a foundation for handling more business and the potential for growth in revenue, while maintaining the same expense structure. The result will improve the law practice’s bottom line.

    Sustained Adaptability

    In the current legal marketplace, lawyers and law firms are learning to adapt to several new paradigms surrounding the perceived value and delivery of legal services. Many people have come to regard many legal services as commodities, for which price is the only differentiator. In our knowledge-driven economy, many services once available only from professionals are now easily accessible to everyone who needs them. For example, online provider Legal Zoom now offers legal documents to individuals for simple business formations, trusts, wills, name changes, prenuptial agreements, leases, trademarks, and estate planning. A similar organization, Rocket Lawyer, provides a similar service to small businesses and also includes access to a network of attorneys to consult with. In 2012 Rocket Lawyer generated more than $20 million in annual revenue, which in many markets would make it a mid-sized law firm.

    Another rapidly evolving paradigm is the emergence of disruptive technologies with the potential to dramatically increase the pace at which this transformation in legal practice occurs. In March 2013, more than 400 people attended the Reinvent Law conference outside San Francisco to discuss new models for the delivery of legal services. Wesley Chan, CEO of Law Pivot, observed that “[t]here are inefficiencies in the delivery of legal services, and there is a huge opportunity for a technology-driven disruption in the legal industry. We have created an intelligent online solution that connects companies to the legal answers they need.”

    To maintain revenue growth in this environment, lawyers must be viewed by clients as experts who help clients get what they need in the most efficient manner possible. Excellence in client service is still paramount but must be delivered with an understanding of value and attention to costs. For lawyers and law firms to maintain solid financial success in the future, profit patterns are now a critical factor.

    Do What You Do Best

    Lawyers create professional success by doing what they do best, practicing law. Grappling with the economic factors of the business side of a law practice can be challenging to any lawyer. As lawyers we have an obligation to meet the needs of our clients. However, we also need to operate our practices and our firms in such a way as to provide the necessary economic ability to do good legal work and provide value to our clients.

    In many law practices, there is often lost profit potential within the high level of reinvention common among lawyers. Whether practicing solo or in a firm, lawyers should always strive to increase their collective base of knowledge. The expanded use of technology with such things as effective document-management systems and e-discovery may be one option. The use of standard forms and procedures for repetitive client matters allows lawyers to delegate work, leverage their time, and strategically move beyond temporary solutions.

    The business of operating a law practice is evolving rapidly. New profit patterns are challenging every lawyer to keep up. Now is the time to be proactive. As Will Rogers correctly observed, “Even if you’re on the right track, you’ll get run over if you just sit there.”