Category Archives: Law as a business

Breaking News: Humpty Dumpty falls off wall …

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News just in: “It will come as a shock to many to hear that Humpty Dumpty (also known as the traditional law firm business model) has taken a tumble. Worse still, all the king’s horses and all the king’s men couldn’t put Humpty together again. Yes, it’s true: however you look at it, Humpty is well and truly scrambled.

How could this happen? Well, sources close to the wall from which Humpty fell, say that although he was close enough to the wall to see the writing, he hadn’t actually read it.”

In many ways, the traditional law firm business model has been an accident waiting to happen. For me, a business model is a statement about how the firm coordinates four elements to structure the business and deliver its strategy. They are (a) creating value for clients; (b) resourcing the firm to create that value; (c) financing the firm to secure those resources; and (d) producing and distributing returns on the investment to make it all worthwhile. (For more, see Mayson (2010) Business models in legal services or visit the Downloads section.)

In terms of these four elements, the traditional law firm business model can be expressed in summary as: (a) using a cost-plus, time-based, lawyer-focused charging structure (which often bears no relation to value to the client; (b) a lawyer-driven human leverage model with as many resources as possible internalised within the firm; (c) finance provided by internal equity (partners) and external debt (banks and asset finance) – though much of the internal equity is often also the result of bank lending – and all managed within a partnership structure and culture characterised by confused roles, disdain for professional (that is, effective) management, and inefficient decision-making; and (d) returns created by growing turnover (rather than managing for profit) with rewards extracted entirely as income, usually within 12 months of earning them.

The message that Humpty missed was that, on all four elements, the traditional law firm business model is broken. So to those who say, “If it ain’t broke, don’t fix it”, I say: it is broke, so get on with fixing it as quickly as you can.

On the first element, creating value for clients can’t be done on a cost-plus model, time-based pricing, or where creating value is confused with adding value (most clients really don’t care about legal updates). But negotiate a better deal or outcome for them, or make their personal or business lives easier, and then you’re on track. Understand where the firm sits in the supply and value chain, and who else is claiming part of the value paid by way of fees for legal services, and then work out where the real value lies to the client and deliver it.

For the second element, neither employing lots of qualified lawyers to do things lawyers don’t have to do, nor using people to produce bespoke outcomes when technology or processes could give more consistent, reliable or cheaper results, represents a sensible route to 21st century resourcing for productivity and cost-efficiency. Nor does insisting on doing everything inside the firm when outsourcing or joint venturing are viable alternatives.

The third element relates to finding feasible sources of investment. When firms have been removing under-performing equity partners (who want their capital back) and postponing promotions (and so not admitting new sources of capital), internal equity capital is in shorter supply and debt capacity is constrained by the reduction of people to back the borrowing. Although banks have not stopped lending to law firms, debt is not so easily available and now tends to come with stricter terms and covenants than it used to. Alternative financing (including external public debt as well as public and private equity) should not be lightly dismissed with a wave of the hand and “we don’t need it and we don’t want it”. Maybe firms don’t want it; that doesn’t mean they won’t need it. And it doesn’t mean they’re fit for investment when they do decide they need and want it.

Law firm governance and structure also need reworking to provide better decision-making processes, more disciplined businesses with skilled and effective managers (I don’t much mind whether they are lawyers or not so long as they can do the job), and more attractive vehicles for investment, recruitment and retention. The professional partnership is an increasingly inappropriate vehicle for this. In business terms, professional partnerships are really not that special, and maybe it’s time we stopped exempting them from the requirement to incorporate when they have more than 20 partners (though in Humpty’s case, it will need more than a shell company to fix the problem!).

Finally, the returns need improving and re-thinking. Any business that takes its entire returns as current income is completely missing the point of being in business. Effective business models will differentiate income and capital returns, short-term and long-term rewards, and salaries, bonuses and dividends (whatever labels are applied to them).

And so the breaking news story concluded: “It is remarkable that Humpty Dumpty was able to stay on the wall for so long, and his downfall certainly represents the end of an era. We can’t say that he wasn’t warned. The writing is still on the wall, and it’s not too late to avoid falling off and creating a mess. But then you know what they say about needing to crack a few eggs to make an omelette. The future certainly needs a new recipe.”

PEP talk: beyond the low-hanging fruit

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Most of us realise that profit per equity partner (PEP) is a distorted and distorting measure of law firm success. But its use persists.

It is distorted because its underlying metric (net profit) is perversely stated relative to any ‘normal’ business. The accounting treatment of professional partnerships, combined with the taxation of them, encourages a full income extraction approach – that is, all profits are usually taken out as income within as short a period as possible after the financial year to which they relate.   There is usually no allocation of any element of ‘wage’ or employment cost to an equity partner, and no recognition that some element of the distribution of net profit is a return to invested capital and to entrepreneurial risk.  To some extent, therefore, allocations of net profit represent a short-term income distribution of what in other businesses would be longer-term capital growth.  The ‘net profit’ of a professional partnership is accordingly not comparable to that of most other businesses – and so is relatively (and significantly) over-stated.

PEP is distorting because it drives behaviour that seeks to maximise the numerator (net profit) and minimise the denominator (equity partners).  For example, in many firms, the ‘strategy’ recently has been to appoint new partners not as equity partners but as salaried or fixed share partners (or similar variations on that theme).  In the six years to 2010, figures from the annual Legal Business surveys of the top 100 firms show virtually no net growth (just 2%) in the number of equity partners in those firms.  Over the same period, the number of non-equity partners increased by 40%.

As the financial crisis took hold, and law firm revenues began to fall, managing profit by increasing human leverage and fee income was no longer the name of the game.   Attention turned to cost-cutting programmes to reduce expenses in the (often vain) hope of maintaining profit levels.  Unfortunately, law firm profitability is much more sensitive to fluctuations in revenues than it is to variation in expenses.

With costs reduced (usually by trimming back-office and related overheads, and squeezing suppliers), the profit management project turned from maintaining PEP through cost-cutting to PEP engineering through denominator-cutting.  Having stemmed the influx of new equity partners (as described above), attention turned to removing underperforming equity partners.

All well and good, and often long overdue.  But if a firm chooses the wrong partners to cull – that is, those who have a client following (or book of business) – reducing denominators will also result in a loss of revenues, and the net effect might be neutral (or worse) for PEP.  On the other hand, if the removal of partners does not significantly affect fee income, that rather suggests that net profit has been shared with people who were being allowed to take more than their fair share of this mixed return to productivity, investment, entrepreneurialism and capital.  To put it another way, the PEP was distorted by being available to those who were not worth it.  Removing them is not achieving any true saving to the business but is simply restating the firm’s profitability on a fair and proper basis.

So, by this stage in the economic playing out of the financial crisis, the low-hanging fruit has been taken.  Removing surplus costs from the business, along with equity partners who were not making a net contribution to it, simply puts the firm on to its true footing.  These have been tactics that perhaps bought some time – probably in the hope that by now ‘normal’ practice and PEP would have been restored.  To some extent, it might even have worked: the American Lawyer figures for US law firms’ profitability for the calendar year 2010 show some restoration of PEP.  It will be very interesting to see if English law firms’ results for 2010-11 mirror this.

Unfortunately, it’s not looking as though this creates a sound platform for future profitability in the face of continuing flat revenues for law firms, and a cost base that many think has been pared back as far as it can be.  The old ‘normal’ is still not expected to make an appearance any time soon.  If the right costs have been cut, and the right partners removed (or retained), there is no further scope for maintaining or improving PEP by using the same tactics.  Indeed, to do so would run the risk of jeopardising the business since such an approach would imply removing valuable partners and reducing the firm’s resources and support to (or below) a critical level.

So, where next?  Although the tactics have so far addressed both the numerator and denominator of PEP, arguably, they have not really addressed the fundamentals.  The next temptation is usually to redesign the profit-sharing arrangements, normally with some performance-related or bonus element.  In English law firms, the tendency is to pull up short of ‘eat-what-you-kill’ systems.  What is too often missed, however, is that once the firm’s and partners’ performance is properly managed and underperformers removed, the firm’s problem is not its profit-sharing structure but not enough profit to share.  Changing the way in which profits are shared at a time when there is not enough money to go round is inherently dangerous; a lot of babies are thrown out with the bath water.

My conclusion, therefore, is that with no scope for more of the same, and little point in moving the profit-sharing deckchairs, now has to be the time to look at the fundamentals – and that means returning to the numerator.

Future approaches to PEP management must, in my view, be the result of reinventing the firm’s business model.  The elements of that model are: creating meaningful value for clients in the performance of the firm’s services; resourcing the firm to create that value; financing the firm to secure those resources; and generating sufficient returns to the firm’s stakeholders (and I’m assuming here that the ‘right’ equity partners are now in place).  The first two of these are the fundamental issues that need immediate attention, and both are elements that crucially drive net profit.  It is true that these two elements also contribute significantly to the fourth – returns. By challenging management’s thinking about having the ‘right’ resources (including how many equity partners the business really needs), they will have some effect on the denominator, too.  But value creation and resourcing fundamentally drive the generation of net profit rather than the sharing of it.

First, then, the firm’s revenue needs to be grown by concentrating on creating value for clients.  This requires the firm to be close to its clients, to understand what value looks like to them, what represents success in the transaction or resolution, and to demonstrate how the firm can deliver real benefit.  It isnot the same as ‘value added’, which is usually found in the periphery of the relationship rather than at the heart of the professional service itself.  This exploration is also a necessary part of achieving competitive advantage.

Second, the cost base needs to be revisited – or, rather, redesigned.  This is more far-ranging that stripping out surplus overhead, squeezing suppliers and looking at outsourcing.  What’s required is not so much outsourcing as alternative resourcing.  Thinking about the entire configuration and use of the firm’s resources is necessary, including: lawyers and non-lawyers, professionals and support staff, human beings and technology, craft and process, physical and virtual, internal and external.  Using new approaches to case and project management, and integrating the firm’s business process and support functions into a seamless and more cost-efficient infrastructure, are an inevitable part of the redesign.  This might result in legal or business process outsourcing (LPO or BPO); it might mean using cloud technology, paralegals or professional project managers; it might mean off-shoring; it might mean collaboration with suppliers or even competitors to secure otherwise elusive economies of scale.  In short, the result will be a new way of structuring the delivery of legal services which does not merely adjust the firm’s cost base but designs a very different approach to making profit.

Understanding and delivering value creation and new resourcing approaches are still in their infancy in law firms.  But these must be core to the next wave of managing the PEP numerator.  At the same time, the denominator must not be allowed to drift out of kilter again.  Profit is the outcome of the firm’s business activities, but it is an outcome that needs to be managed actively.  If it is, perhaps then PEP can begin to move beyond distortion and then approach some semblance of a meaningful measure of return – at least in a professional partnership.