Focus on value

There is constant discussion regarding legal fees. Many law firm partners ask how best to address growing client concerns about ever increasing fees. These questions become even more salient as firms, seeking to maintain profit margins, push hourly rates above $1,000 per hour and inch ever closer to the $2,000 an hour level. With recent industry surveys reflecting sagging demand for legal services, how does that apparent singular focus on maintaining profitability affect the lawyer-client relationship? Short answer - not favorably.

Absent a re-examination of the fundamental fee structure underlying the standard profitability model, it seems clear that the "relationship" between lawyer and client will inevitably erode and become more attenuated. It will move inexorably away from that of "trusted, long-term advisor" toward that of a transactional association in which legal engagements are event driven. Engagements will be determined on a case-by-case basis, with the primary focus, in counsel selection, being a quantitative cost analysis and a secondary focus being the qualitative assessment of skills, experience and legal intelligence. That calculus raises further questions to consider.

Where do corporate clients and law firms turn in an environment of increasing law firm competition, declining demand for external firm services, rising hourly rates that have neared dizzying heights and unabating management pressure to reduce in-house legal budgets? Several considerations come to mind:

Focus on Value, Not Hourly Rates

Realization rates for many law firms are less than their posted, hourly rates. That reality is not lost on in-house. A never-ending focus on the hourly rate, and the constant attempt to increase it year-over-year, reflects a fundamental mistake. It harkens back to an era when the hourly rate was inextricably linked to law firm reputation and an attorney's own personal prestige. It fails to account for increased competition and declining demand. And it reflects an inward-looking law firm perspective that tends to ignore in-house counsel perceptions and realities.

Value is more critical, and relevant, than rate. That is true not only economically, but also optically. The long-term "optics" of rates trending towards $2,000 an hour are not good. Senior management "buy-in" at most corporate clients for rates exceeding $1,000 an hour is problematic. Other than in the context of the rare "bet-the-company" case, justifying vertigo inducing hourly rates to a chief executive or chief financial officer demands an undesirable investment of too much political capital for most in-house attorneys.

Firms need to pay greater attention to value. They need to invest greater efforts in understanding both where that value may lie and how that value should be determined, calculated and factually supported. There is no established methodology for making that determination, but it must have a credible, analytical foundation based on experience and objective data. And it must be susceptible to explanation in plain English, establishing a clear framework for discussion across the legal, finance and business functions of the client to which those legal services will be delivered (and the related invoices sent). It requires a simple thing -- critical thought.

Assuming that the "value" of the proposed engagement can be determined, its application to matters should be straight forward. If the "fair value" of a project, whether it be a transaction, litigation or other matter, is $10,000, and a firm's typical hourly rate would have otherwise resulted in fees of $9,000, then the firm should receive the added value, achieving a realization rate that exceeds 100 percent. On the other hand, if the firm's hourly rate turns into a charge of $11,000 for a project with a fair value of $10,000, the business savvy firm should absorb the overage and take the short-term loss on the matter. These simple examples offer a guide to engagement terms. If the focus turns to "value," rather than "rate," the efficient, effective and talented firms will succeed and will likely become more profitable in the long-term. At the same time, the shift in focus to "value-based engagements" will allow the client to direct its attention to the strategic aspects of a matter and to the quality of the work product, rather than dedicating its attention to the constant oversight of billing minutiae.

Avoid "Heads I Win, Tails You Lose" Financial Arrangements

Clients are sophisticated. Do not assume otherwise. Many alternative fee arrangements lack creativity or an effective alignment of interests. Clients typically look to alternative fee arrangements to incent firms to work efficiently, to motivate a successful outcome or to share downside "pain." They also use alternative fee arrangements to ensure expense certainty. Firms should understand the motivation, or multiple motivations, underlying a request for an alternative fee arrangement. If "success" is the principal motivating client factor, that may suggest one form of arrangement. If sowing doubt in the market about a competitor's product, whether through patent litigation or otherwise, is a factor, that may influence the tenor of the engagement. If "expense" certainty is critical, that, again, must inform the terms of the engagement. But beyond just understanding motivation, the underlying economics should be well understood.

Take "holdbacks," which remain a law firm favorite within this context. They tend to adhere to a rather plain vanilla formula, quite typically a 10 or 20 percent fee holdback that may be recovered, in addition to some possible premium, if success (however defined) is achieved. In an industry that typically sees built-in minimum profit margins in the range of 30 to 40 percent, how does the holdback arrangement offer client value or shared risk? Assuming a 10 or 20 percent holdback, where is the law firm "pain" in an unsuccessful transaction, even if the holdback is never paid? Offering an arrangement in which the hidden, embedded firm profit margins offset any shared sense of risk, especially in a failed matter, does not properly align interests. An effective form of alternative fee arrangement must ensure a fair alignment of interests and an appropriate financial allocation of both the risks and rewards of the engagement.

Be Aware of Client Seasonality

Many industries experience seasonality that affects corporate revenues. That variability offers opportunities for business savvy law firms. On a fixed fee arrangement, for example, there is no rule that requires fees to remain level throughout the year. There is no reason that fees cannot vary by quarter or month to better align with the client's revenue variability. If first quarter revenues are expected to be low, why shouldn't the fixed fee for that quarter reflect that financial reality? Assuming revenues are then expected to tick up in the second quarter, the fixed fees can similarly tick up in the second quarter. While not complicated, coordinating fees to better accommodate client financial performance and expectations offers a "win-win" solution for both external and in-house counsel. Arrangements like these simply require an enhanced awareness of the client's business and financial model and a willingness to integrate that learning into a fee model that works for both parties.

Understand the Client's Budgeting and >Accrual Process

Appreciating the client's business model offers further opportunities for enhancing the lawyer-client relationship. Ask the client how its budgeting process works and when its budgets are created. This demands effective communication. Having a client that adopts a legal budget in the November/December timeframe for implementation during the immediately following fiscal year raises different sensitivities than a client that adopts a budget in January or February of a calendar year. If the client locks in a budget in November based on then prevailing firm rates, the last thing that client wants to see in January is a rate increase that upsets its recently adopted budget. These are simple issues to address, just like the proverbial late submission of invoices. When those late bill deliveries disrupt a quarterly budget estimate or affect quarterly expense accruals, there is little sympathy from in-house counsel. Understanding the client's budgeting and accrual processes, and becoming sensitive to their implications, is not too much to ask of outside counsel.

There are many ways to enhance the lawyer-client relationship, even in a world in which it continues to face challenges. Effectively addressing the economics of the relationship, evaluating fee arrangements in a more holistic manner, and focusing on the value delivered to the client represent some of the more relevant methods. There are certainly other sensible approaches, but one thing remains constant - they all require an awareness and understanding of the client's business and financial model and a willingness and desire to align the firm's services, fee schedule and engagement with that model.