Profit Boosting Band-aids for Troubled Firms

A great deal is being written about income disparity between the highest paid corporate executives and “middle class” workers.  Similarly, there is a growing bifurcation among larger law firms.  Firms in capital market cities are generating profits that average in the seven figures per equity partner.  At the same time the vast majority of regional firms, particularly in the 100 to 400 lawyer range are performing at less than half that level.

It’s easy to understand why major law firms in New York, Chicago and San Francisco do so well.  They work hard, have top quality clients who generate highly sophisticated legal work that justifies premium hourly rates.  But profitability issues are more complex for regional firms in secondary capital market cities.  We see them troubled by four difficult trends:

1. Many simply have too many lawyers for the work available.  The result is a decline in billable hours.
2. Some are seeing their most lucrative transactional work and litigation matters being sent out-of-town to national firms in capital market cities.
3. Firm’s response to these issues is to lay off associates and de-equitize partners, resulting in a lack of lower cost lawyers to perform work.
4. To remain competitive without pyramidal leverage, firms find themselves discounting rates and writing down time.

Certainly, such regional firms can develop strategies to attack these problems but the solutions often require vast cultural shifts that may take years.  Unfortunately, for some firms the problems may be so advanced that short-term solutions are necessary to combat their loss of partners or inability to attract new laterals.

In any business the key to making money is to stop losing it.   Here are three short-term profit building tactics that firms may employ to buy some time while they attempt to rebuild themselves:

1.  Restructure Timekeeper Costs.  Midsized law firms routinely pay too much for their timekeepers, particularly their lawyers.  For a long time it has been a credo of the legal profession that the firm with the best talent wins and, to attract top talent, a firm must pay top salaries.  This is perhaps true for law firms at the highest level that are recruiting Order of the Coif graduates of the top tier law schools.  But, most firms do not have the sophistication of work to justify hiring top gradates, nor could they keep the most talented graduates intellectually engaged if they were able to attract them.  With less than half of 3L’s expecting to obtain jobs that require a law degree, we have a buyers market that provides mid-sized law firms the opportunity to hire at extremely discounted levels.

But the real problem is the compensation level for non-equity partners.  On average, 20 percent of lawyers with firms in the lower half of the Amlaw 200 are non-equity partners – and that percentage is often higher for sub-Amlaw firms.  Certainly there are non-equity partners who are laterals that are temporarily labeled as non-equity, and some are associates who are transitioning to equity partnership.  But, in most firms, the non-equity ranks is the “land of broken toys” made up of associates who the firm doesn’t want to terminate but can’t justify making equity partners.  And, sadly, the longer they remain as non-equity partners the lower the likelihood they will ever become equity partners.  In some firms this category includes de-equitized partners, former equity partners be were demoted due to their failure to perform.

Regardless of how they arrived at the status, law firms routinely over-pay the “broken toys.”  There simply isn’t a market for 11^th year lawyers without any business unless they have some unique skill.  And being a good lawyer is not a unique skill.  The world is full of very good lawyers who don’t have enough business to support themselves.  Why pay a premium price for a lawyer you can replace in kind at a third lower cost?

2.  Maintain Rate Pressure.  Law firms are high overhead businesses with virtually no variable costs.  Therefore, the win is to maximize the revenue achieved from hours worked.  But troubled firms can myopically focus themselves on finding work – any work – to keep their lawyers busy.  In the process managers take their eye off hourly rate management.  Law firm partners always follow the course of least resistance and when a business gives them unfettered control over price and credit terms, effective hourly quickly go into a downward spiral.  The key is for management to clearly communicate that the firm needs new business, but not at any price.  To do that, keep reporting focus on effective hourly rates at the client level.

3.  Manage Receivables.  Most law firms pay little attention to accounts receivable until year-end.  They figure that the time value of money these days is cheap and borrowing rates are low, so as long as it comes in during the current year, who cares.  Sadly, big chunks of receivable money don’t come in at year-end.  In fact, most firms close their books with about a third of their total receivables over 6 months old.   Even more sadly, there is typically less than a 15% collection rate on over 180 day receivables.  But, because law firms are on a cash basis and receivables never show up on balance sheets, there is no reason to ever write them off so there is no recorded impact on realization.  That works out to the disappearance of a little over 5% of annual revenues, which comes directly out of distributable income.  New business takes months to be worked, billed and collected.  If you need money in the near term, take receivables away from your lawyers and go crazy about collections in the 30 to 60 day window.

None of these actions represent silver bullets that will save a law firm.  But they do represent relatively minor culture shifts that can give a firm some breathing room and help prepare the partnership for the much more major changes that will probably need to occur over the long run.