Considering the alternatives

Beyond the theoretical contemplation of more ‘creative’ billing structures, what follows is an attempt at a more tangible analysis of some alternative fee arrangements for law firms.

By Steven R Petrie, director of practice operations and strategy, Faegre & Benson LLP

In recent years there has been an explosion of industry discourse and intellectual prognostication regarding the impending death of the billable hour – the longtime cornerstone of the professional-services economic model. Law firms have had little reason to provide an exception to its uniform application. Busy associates and annual rate increases have provided law firms with a reliable engine for consistent, year-on-year growth, both in terms of revenue and profit margin. Now, however, this state of predictable prosperity may, unfortunately, be coming to a close.

The current economic environment has forced clients to scrutinise all outside expenditures, and legal services are no longer immune to such reviews. These cost-reduction efforts have triggered a rash of convergence exercises and competitive bidding processes. Given this chain of events, clients are squeezing law firms more than ever – demanding deep discounts, challenging future rate increases, and, in some cases, even requesting that previously-accepted rate increases be rolled back. However, the purchasers of legal services are not only seeking reduced cost; they are also fixated on achieving enhanced predictability. Tasked with managing ever-shrinking budgets, corporate counsel have developed an increased appetite for creative pricing arrangements.

Up to this point, very little I have said would constitute ‘new news’. In fact, this is the standard list of observations and assertions that preface a host of pre-existing articles on this very same topic. Unfortunately, the recent discourse on alternative fees has been highly theoretical in nature, and, in many cases, has stopped here; leaving much to be desired from an operational and tactical perspective. For example, how does one intelligently respond to a client request for creative billing suggestions? What data is actually required to craft a viable alternative-fee proposal?

The analytical approach

Through innovation in financial modeling and pricing, law firms can differentiate themselves in today’s competitive marketplace. Lawyers have long responded to questions regarding alternative fee arrangements by affirming their ‘willingness to work with the client to investigate potential fixed-fee opportunities’. Unfortunately, this generic language will no longer be seen as sufficient given the emerging demand for alternative fees. While the creative-pricing question has long been a staple of request for proposal (RFP) templates, clients now seem more genuine in their desire to embrace such arrangements. It is therefore imperative that relationship partners put pen to paper and propose tangible fee arrangements that share risk and lend much-needed predictability for clients in these uncertain times.

In June 2007, this magazine published an article titled 'Spectrum of Sophistication: Strategic Finance and the Modern Firm'. In constructing this piece, I set out to investigate the diverse roles played by so-called ‘financial analysts’ in law firms today. It was my intention to delineate the most common manifestations of the analyst profile and to characterise the relative expectations and requirements. In developing this thesis, I concluded that there were three primary classifications on a broad spectrum of analytical sophistication – reporting, analysis and synthesis. At the pinnacle level of synthesis, analysts are expected to question the status quo, to rethink traditional economic models, and to apply rigorous quantitative and qualitative analysis to the critical business decisions of the firm.

There is a clear connection between this prior work on analytical resources and the topic at hand − alternative fees. Given the global economic downturn, firms that have built-up analytical competencies (in line with the model I previously espoused) are now likely to be seeking ideal ways to mobilise these internal resources. One potential area of focus is the development and review of alternative-fee proposals. When collaborating closely with relationship partners and marketing staff, a knowledgeable analyst team can play a critical role in the construction of creative billing arrangements. Through the use of historical analysis and pro-forma modelling, quantitative rigor can be injected into an otherwise unscientific process. Embracing this analytical approach, and executing accordingly, can lead to new work, fewer surprises, superior realisation and a valuable source of competitive differentiation.

Options and uncertainty

There is a diverse array of billing arrangements that fall within the scope of alternative fees, however. Contingent fees, success fees, fixed fees, blended rates and retainers are just a few. Given the elevated level of budget scrutiny with which corporate counsel are now faced, a significant premium has been placed on the value of predictability. Likewise, fixed fees and retainers have largely become the flavour of the day. The value of a firm’s alternative fee proposal in the eyes of the client varies with the context of the certainty it provides. For example, a proposal to represent a client in all of its employment litigation disputes for US$50,000 per case grants the client a useful degree of certainty in relation to any given matter. However, this same client may wish to achieve even greater predictability through a fixed-fee bid for a year’s worth of employment litigation. If a law firm were to propose an annual figure of US$720,000, the client could lock in a monthly budget of US$60,000 for the next 12 months.

Obviously, as the pricing context expands from an individual billable hour, to a blended rate, to a matter, to a full practice area, uncertainty creeps into the equation, thus resulting in elevated risk for the firm. How many hours does it take to complete one of these cases? How many matters will there be next year? Can historical consistency predict the future, or will the client experience an unexpected spike in litigation? These are just a few of the questions that will undoubtedly be asked. Table 1 illustrates the compounding effect of the inherent variables introduced at each level of the pricing progression.

The billable hour has long been the gold standard for the legal industry, largely due to its simplicity. The sole element of uncertainty is whether or not the lawyer is charging enough for an hour of his or her time. However, as firms now forge into uncharted territory in relation to fixed-fee billing at both the matter and practice-area levels, new variables have presented themselves. Uncertainty regarding the projected volume of hours and matters can be dealt with in three ways:

Through internal analysis of historical results;
Through collaboration and information sharing with clients;
Through skillful crafting of ‘collars’, ‘off-ramps’ and exclusions.

For the purposes of this discourse, we will focus on the first two elements. Internal analysis is an essential tool for the development of matter-based fixed fees that are financially sound and spread risk appropriately between both law firm and client. However, in order to move beyond the matter context, external resources are required. Developing annual fixed fees at the practice-area or service-category level requires an extraordinary level of candor and collaboration between law firm and client. There must be an alignment of objectives and an agreement on volume projections for such arrangements to create value for either organisation. The following offers a deeper look at the resources, tools and tactics required to develop effective fixed-fee proposals at both the matter and practice-area levels.

Matter fixed fees: internal analysis

With the exception of blended rates, matter-based pricing is arguably the simplest and most widely used alternative fee arrangement. In fact, matter-level fixed fees have supplanted the billable hour as the norm for a variety of practices with work that is highly standardised, repeatable and leveraged. In many cases, the quality of such work is considered to be relatively consistent across firms, and matters are frequently awarded on the basis of price. Basic immigration work is a prime example of a legal service that lends itself to a fixed-fee structure on a per-filing basis.

It is not difficult to calculate simple fixed fees for routine matters, given their historical volume and relative consistency. However, clients are now also looking for law firms to extend the scope of alternative fees well beyond this traditional comfort zone.

Let’s return to the employment litigation example used above. At the outset, several of these cases may appear quite similar in nature, but as they progress, their unique twists and turns will require very different levels of investment. In order to apply a fixed-fee pricing structure to this non-routine work, lawyers and analysts must collaborate to derive some level of consistency from a state of considerable variability. This can be accomplished internally through a thorough analysis of historical data: a data-mining process that consists of six basic steps (Table 2).

The key to effective matter-based pricing, as outlined in these steps, is the identification and analysis of a set of representative matters for either the client in question or for comparable entities. It is important to note that these matters should all be closed in order to capture only those cases that are no longer accruing time or expense. Once the data-set is established, it is then time to determine which statistics will be essential to your analysis. Basic metrics, such as hours worked; dollars worked/billed/collected; accounts receivable write-offs; and realisation are staples of this type of review. Once constructed, the queries that support this analysis can be standardised and reused time and again.

With the matter-level data now in hand, it is time to perform a very basic statistical analysis. For one of the core metrics, such as dollars worked, identify the median, calculate the mean and interpret the range across all matters in the data set. Clearly, it is ideal if some level of consistency emerges through this cursory review. Often, there will be several matters that fall within a relatively tight range, with the exception of one or two cases at the extremes. These are the outliers, and it is critical to investigate the nature of their deviation. Speak to partners responsible for these matters in order to obtain detailed explanations for the elevated investment required to complete the cases. These conversations will often reveal critical pricing variables that may lead to fixed-fee exclusions or additional charges. This quantitative analysis of matter results and qualitative review of data-set outliers combines to produce a reasonable assessment of fixed-fee feasibility for the matter category in question. At every stage of this process, the fundamental question should be whether or not there is sufficient consistency to warrant a fixed-fee proposal. If the analysis passes this litmus test, a formal fixed fee can then be established, traditionally at, or around, the data-set mean.

There are pros and cons to this matter-based approach to alternative pricing of course. On the plus side, it is relatively simplistic, can be based almost entirely on internal analysis, and provides the client with matter-level predictability. However, there are still some shortcomings for both law firms and clients alike. If such a proposal doesn’t lead to a sufficient volume of matters, isolated outliers can be problematic for law firm realisation and profitability in the short run. After all, the underlying notion is to arrive at an acceptable mean through multiple iterations of comparable cases. For the client, matter-based fixed fees fail to provide the overarching budget predictability that has become so desirable in this time of economic crisis. As corporate counsel become more and more interested in establishing monthly fixed fees, or retainers for entire areas of law, it is essential for law firms to think creatively about taking matter-based pricing to the next level. Unfortunately, internal analysis is no longer sufficient when it comes to making this leap in strategic pricing. Relationship partners must reach out to their client counterparts in an effort to obtain historical volume data. In order to construct annual fixed fees, a new level of external analysis must be achieved through enhanced partnership and candid information exchange.

Annual fixed fees: external analysis

Annual fixed fees are, in essence, retainers for a particular legal service or area of law. While any legal function can ultimately be molded into this construct, it is most prevalent in relation to advisory services, such as labour, employment and benefits counseling. However, once a matter-based fixed fee is derived, regardless of practice area, an annual fee can be attained through an analysis of the client’s historical matter volume and projected pipeline of cases or transactions. The key to this stage of alternative pricing is moving beyond the data that is readily available, through the firm’s internal legal billing system or business-intelligence applications. The law firm’s ability to provide this innovative level of alternative pricing is truly dependent on the openness of its clients. The clients that conclude maximum predictability in legal spend is essential to their business success will be obliged to partner with their outside counsel in new and productive ways through the dissemination of historical volume data at the practice-area level.

Ultimately, the real quantitative analysis already took place at the matter level, however. Once a matter-based fixed fee is calculated, an annual retainer can be derived through a statistical assessment of historical volume. Needless to say, the past isn’t always a good predictor of the future, and this information remains more relevant to some practices than to others. Likewise, it is critical for relationship partners to sit down with their client counterparts to discuss the projected volume and nature of impending legal work for the practice area in question. Once this is accomplished, the matter-based fixed fee can be multiplied by the expected number of cases. At this point, the aggregate figure should be tweaked, either up or down, in an effort to better reflect the anticipated reality shared by both firm and client.

Getting creative

The true value of alternative pricing is its ability to alter the playing field and change the course of discussion in any competitive bidding situation. When a client requests a ten per cent discount off standard rates from all of its preferred providers, simple discount responses will be compared and evaluated against this hard standard. However, the firm that proposes an alternative fee arrangement relays a unique value proposition through
the introduction of a new paradigm. In the current economic downturn, law firms can deploy their analytical resources to realise the promising potential of alternative fees. Through thoughtful analysis and prudent execution, creative pricing can be leveraged as a valuable source of competitive differentiation.

Steven R Petrie is director of practice operations and strategy at Faegre & Benson LLP. He can be contacted at: spetrie@faegre.com