The Complex Conundrum of Cash and Lawyer Compensation

October 16, 2014
Edward Poll

There are two ways to address an economic model: you can look at your revenue and figure out what your cost structure should be so you can turn a profit, or you can look at your costs and determine how much revenue you need to cover them and make a profit. In either model, the question becomes, “Can I sell enough to cover all my costs and have something left over?” This question goes to the heart of “The Business of Law®” for law firms.

Model One: Cut Cost to Increase Revenue

Begin with economic model number one, which proceeds from revenue to cost. Consider a law firm where the revenues from a given client are $40,000, while the costs to service that client in lawyer and staff compensation are $48,000.

This is an obvious warning sign in which the law practice is like an athlete who is exercising in hot weather. Maintaining hydration with adequate body fluids is critical to an athlete's performance and health, but unfortunately, the body's ability to detect dehydration is slow. There is a lag between the time the body becomes dehydrated and when it sends the thirst signal to head to the nearest water supply to do something about it.

Law firms often react in the same way. Lawyers often see only the intake – the cash “hydration” of revenue – and do not realize the dehydration that dissipates cash faster than the money comes in.

In this critical situation a decision must be made. The choices are hard, but each one must be considered in turn. Here is a suggested order of assessment.

Terminate the client relationship and the revenue it represents. This is the most difficult, because it raises not only cash flow problems but ethical ones (lawyers cannot suddenly cease representation when the client’s interests will be compromised, such as right before a court date, and otherwise must give reasonable notice of withdrawal).
Consider whether a technology purchase can reduce the amount of time being dedicated to the client. Paradoxically, when a firm makes an investment in technology, its immediate cost of operation increases due not just to the equipment cost but also the value of the time needed for training. If this is not approached carefully, more technology will create client and staff dissatisfaction rather than greater efficiency.
Assess whether fewer people can handle the same client workload. But be aware that additional work assignments can cause attorney burnout and decrease the level of service. The only feasible way to do this may be to take some services now being performed out of the mix of what the client receives.
Adjust staffing and leverage ratios. This represents an important tool that deserves special consideration.

Staffing and Leverage

The critical cost analysis factor for serving a client is staffing levels. Do you need two senior lawyers, each with high hourly rates and likely with personal assistants, to handle the work? Can you involve an associate, or even a paralegal, and get by with one senior partner? Do you even need a senior lawyer involved? If the work is mostly of a routine nature, can two associates or a mix of associates and paralegals do it, with proper partner oversight?

The questions here relate directly to the issue of leverage—hiring and using associates as a cost-effective way to do billable work in a team setting while boosting partner profitability.

A number of law firms are increasingly letting go of older partners who may have higher billing rates but bring in less business, in order to increase leverage and thus remaining per-partner profitability. It’s a phenomenon called de-equitization and, while it is often criticized, it is in fact astute financial management.

Failure to use leverage increases costs of operation. No wonder that a law firm unhappy with its profitability would seek to adjust a key economic factor of its operation by elimination of some of its partners. That instantly adjusts the leverage. Other non-financial considerations may also be considered in this analysis.

Leverage also applies to associates; they cannot remain with their firm unless it is profitable for the firm to keep them. While the new associates may not earn more than they cost the firm in the beginning, at some point that situation must change. In fact, large-firm managing partners agree that it takes, on average, from three to five years to break even on the investment in a new lawyer.

Here is another conundrum. Requiring associates to have six billable hours a day seems like a lot in one day, yet times five days times 50 weeks provides only 1,500 hours per year—well below what most firms target for associates. Raise the target to eight hours of billable time a day and you get to 2,000 hours a year, which is close to what most firms expect. How many associates can get that many billable hours per day and learn their craft, do pro bono work, take training and eat lunch? The answer shows which associates are keepers, and how much leverage they add.

Model Two: Determine Revenue Needed to Cover Costs

It’s obvious at this point that there is no easy way to adjust costs to revenue. Certainly it can be done, but the strategies for doing it each have drawbacks that are hard to overcome. That brings us to the second economic model: determining how much revenue you need to cover your costs.

In a law firm, revenue is a highly personalized commodity because it is the product of each person’s individual effort—as Abraham Lincoln observed long ago, a lawyer’s time and advice are his only stock in trade. One measure of that effort is billing rates and related fees, so increasing revenue puts the focus on whether to raise rates. And because billing rates determine a partner’s compensation, revenue generated is inseparable from how that compensation is determined.

Raising Rates

Raising rates is always a tricky thing to do, and the general ability to do it hinges on two factors:

Qualitative considerations for a fee increase generally involve ethical questions of professional conduct. Is the amount of the fee reasonable and in proportion to the value of the services performed? Does the lawyer have the skill and experience to justify the fee? Does the client understand the amount and nature of the fee and consent to it? Answering no to any of these questions means a fee increase is not warranted.
Quantitative factors typically come down to marketing considerations. Your new fee must be competitive with others in your geographic and practice areas. You must know the current market conditions and the competitive pressures on legal fees. Each local market has its own characteristics. National trends are interesting, but they do not control your situation.

It’s important to determine the higher fee in the context of all the labor being devoted to client service, including paralegal and staff time as well as lawyer time. There is no perfect time to raise fees. Those clients who do not want to pay the higher fee will seek other counsel. Those who believe your service to be of value will accept the higher fees and remain with you. Make sure you have tangible arguments that can support your case, and that the client understands the amount of and reason for the fee increase and consents to it.

Partner Compensation

Partner compensation from hours billed will be governed by those metrics that define how the firm views itself and how work is done for clients. Such metrics could emphasize:

Origination (percent of new business that the partner brings in)
Total hours worked
Hours assigned to other lawyers in the firm (a traditional hallmark of rainmakers)
A base compensation figure for all partners with a bonus decided from various other factors, such as contribution to firm governance, profitability of work brought in, and realization rate (percent of billable hours actually collected).

The problem with bonuses is that they are too often subjective, and thus do little to enhance the revenue stream. The best approach to law firm bonuses is creating a pool that reflects the firm’s year-end financial statement. One approach is to identify the net profit after all expenses and all attorneys are paid, and then assign a fixed or variable percentage of that pool. Another approach is based on revenue, by assigning revenue increases to the pool and then paying bonus percentages from that. This has the advantage that most people understand the concept of revenue and believe it cannot be “manipulated” as can profit.

The firm could also forego a specific formula, instead looking at performance against a moving multi-year average and rewarding individual efforts by bonuses of varying amounts. Measurements for success must be clearly defined—profits per partner, revenue growth and number of clients, among others—and it must be clear what contributions to the outcome are being rewarded.

Determining Revenue-Compensation Metrics

It will be apparent that some metrics will do more than others to increase not only the partner’s compensation, but the firm’s revenue stream. This should be the ultimate goal. Everyone must know how the system works, and everyone must view it as fair. Members of a firm will accept that they are not receiving the top compensation as long as they recognize the criteria used. While money must be competitive (everyone cannot be on the high end), the firm must ultimately be seen as the beneficiary. Rainmakers can be rewarded as long as the benefits to all are apparent.

That is the best argument for making explicit the tie between individual compensation and the firm’s overall revenue. Firms that service major clients with teams (not just a single rainmaker) can identify and provide needed practice specialties that reflect a full range of client concerns. A billing attorney coordinates the service provision according to a strategic plan, and can give clients a complete and virtually seamless service package. The client receives “one-stop shopping” from a group of lawyers who are chosen to address specific needs, both in terms of practice specialties as well as billing rates.

Teams represent a cooperative effort to increase revenue. That requires a compensation model that depends on and contributes to the success of the organization. Base compensation must be tied to the effectiveness of involving other firm lawyers as part of the team delivering legal services to clients. Compensation is based on what is generated for the organization – not for any one individual – because the organization’s revenue is maximized, and so too are profits, the lifeblood of organizational survival. In “The Business of Law®,” as in the business of life, a rising tide does indeed lift all boats.