The New Normal
Lawyer Comp: The Third Rail of Legal Value Conversations (Part II)
Posted Jan 31, 2012 11:21 PM CST
By Susan Hackett
In Part Two of this article, Susan Hackett, the former general counsel for the Association of Corporate Counsel, and now the CEO of her own consulting practice, Legal Executive Leadership, explores new ways to assess lawyer compensation in the New Normal. In part one, she discussed her concerns with law firm comp as it arose in conversations at the end-of-year—namely focused on end-of-year large law firm bonuses and frantic partner efforts to realize work billed but not yet collected in preparation for partner comp conversations in 2012. In this concluding segment, she offers a framework for sustainable and better-incented lawyer comp strategies, using valuation principles that focus us on what legal work is worth, rather than billable requirements or hourly rates, to set more meaningful and appropriate expectations about lawyer comp and pricing of legal services.
So now we move from theory to practice—from a discussion of what’s missing in lawyer comp conversations that focus exclusively on hours billed and realized, and bonus structures that reward the very practices that many corporate clients revile, to a conversation that allows us to think about the relative worth of what lawyers do for clients and how that might allow us to create more sustainable and meaningful lawyer compensation strategies.
If the predominate wisdom in all of business—and life, for that matter—is that people tend to do what they are paid or rewarded for doing, and we agree that the challenge for firms in the New Normal is to stop selling what they’d like to sell and start offering what clients want to buy (at a price that is commensurate with service value), then let’s talk about better connecting lawyer comp to what clients suggest they would like their lawyers to do and what they think it is worth.
How is it that we can better link lawyer compensation and fee valuation into something as amorphous as the true value of legal work?
In a 2009 article I coauthored with Fred Paulmann of the Counsel Management Group, we created a discussion framework for valuing legal services based on three core principles of real estate valuation—comparables, replacement cost, and economic value added.
Looking for ‘comparables’ in legal services
Comparables seek to identify options having similar qualities or characteristics, and then use those as reference points in determining pricing. In legal services, as opposed to real estate, we might look for comparables per stage, per outcome, per process deployed, per the reliability of the options examined (rather than the real estate comparables of square footage, improvements like a house with a number of bedrooms/baths, location, etc.).
It will be important going forward to help a client—whether the client is an individual hiring a solo to help her through her nasty divorce or a multinational company hiring a megafirm to beat back an unwanted takeover—to understand whether the price he or she is paying is either above, below or on a par with market comparables. It will be important going forward for large firm management or smaller-practice lawyers to set reasonable and achievable compensation expectations that are connected to the value of the services in the marketplace and not so much to simply what a lawyer thinks he or she is worth or would like to make.
In order to truly assess comparables, I’d like to suggest that a broad range of service providers be considered, including medium-size and smaller firms, firms from other jurisdictions, legal process outsourcers, consultants and legal industry service vendors. While it is critical to compare like things, in order to drive value in this kind of analysis, lawyers must unbundle and objectively examine the criteria, results and qualities they want to compare among a variety of providers.
I find that quality, process, outcomes, and reliability are as good in a large number of “alternative” providers—indeed, a number of large law firms use these providers themselves. So, if in-house counsel want to do meaningful comparatives, they will have to open themselves to considering all qualified entrants, not just the best-known contestants. If a client chooses more expensive services, hopefully it will be because the client has done the analysis to support an assertion that more expensive services brought higher value to the client in the matter.
Cost vs. value
The replacement cost approach to valuation asks: “How much would it cost to replace or re-create this asset?” This requires a computation of the cost of raw materials (the legal service inputs), the cost of refinements (such as specially retained labor and technology needed to accomplish the task), plus reasonable profit. The benefit of this assessment is that you get a reverse-engineered figure of what something should cost: But this this approach doesn’t necessarily calculate the value of the thing.
In the context of legal services, replacement cost analysis could assess how much it would cost the law department to provide the service were it to staff and deliver the outcome itself; or it might focus on the firm’s assessment of the cost of delivering the service.
If the latter analysis is selected, clients and firms with a trusting relationship really should agree to open the firm’s books and the department’s honest assessments, and share overhead information, cost of labor, and reasonable profit margin expectations, incentives and disincentives. But that’s rare. Many firms aren’t comfortable with that level of transparency into their operations, and many clients don’t really want to know how the sausage is made—just that it’s priced on a market average.
Some law firms opening their books are offering to do so only on the basis of an agreement for an expanded relationship that allows the firm to spread the risks and costs of innovating a unique strategy of service over the longer-term commitment. In the future, many more firms will have the capacity to confidently set prices for certain kinds of services to any client—ad hoc or long-term—because they will be operating based on a stronger knowledge of their internal costs of providing services in similar matters over time, having creatively trained and dedicated teams that are expert in delivering just that service most efficiently, and being able to offer legal products priced for matter-over-matter sustainable profitability.
Get out your calculators
EVA asks: What is the true economic value produced, in terms of marginal revenue generated or liabilities avoided? EVA measures net cash flows over time, discounted to present value. Corporate finance groups frequently use this method in the capital budgeting process to determine which projects to fund. Aspects of this approach are also used in calculating key financial metrics for projects, like internal rate of return and return on investment.
The same analysis can be most helpful (perhaps yielding better results overall than the previous two methods) in the context of legal services. After receiving or collecting enough details and assumptions to orient themselves with the matter, in-house counsel may ask their firm, or in the case of an RFP, several law firms, to lay out a strategic plan, a staffing plan, a projected range of liabilities or recoveries, and a projected range of fees (with expenses and fee incentives included).
The client would then internally assign a confidence multiplier to each proposal representing in-house counsel’s suggested adjustment to the firm’s projections. If the law firm is perceived to be overly optimistic in its assumptions or has a history of not completing work within budget, the confidence multiplier could be 1.2, for example, to increase the projected total resolution cost by 20 percent. If the proposal is likely overestimating costs (maybe the projection was designed to be very conservative in its expectations), then based on the client’s experience, the multiplier might be .8. The EVA thus seeks to insert a more subjective “value” assessment on top of the objective numbers that the firm or department culls; and the result will be the ability to attach incentives, disincentives, success fees, and other kinds of behavior motivators that drive better performance.
Adjustment to new realities
Quite a few firms are beginning this work by moving away from lockstep and toward considering performance-based compensation adjustments based on demonstrated core competencies and service improvements. For instance there was McKenna Long & Aldridge’s decision in 2009 to cut $20,000 off its associates’ starting salaries to “better reflect client needs”—they took a huge hit from many commentators who suggested they were not keeping up with the Joneses. But their clients and many firm leaders felt strongly that this level of comp was more closely connected to what the services these associates provided was worth to clients, and they’ve still be able to attract the associate talent they want to hire. McKenna Long’s leaders have noted that now their value and competency-related assessments are reaching into partner evaluations, especially as the firm integrates more laterals and hundreds of lawyers from diverse firms they’ve merged with—it’s no longer possible to base comp on just hours and rates.
It will be interesting to see how different firms make difficult (albeit necessary) transition into assessing competencies and comp for lawyers—both in hiring and also in evaluation of existing leaders. So many large firm lawyers have been judged only by their ability to bill and bring in work. Will client satisfaction play in? What about leadership in the firm’s administration? Investment in firm lawyer training and personal competency improvements? Leadership within practice group teams?
Will public service, pro bono, and diversity investments be assessed as something more than simply a tie-breaker? Will performance to budget or matter turnover targets or delivery of a certain client result begin to determine bonuses? (And BTW—this assessment is just as important for general counsel to instill in law department evaluations: I go back to my opening statement—lawyers will do what they’re paid or rewarded for doing.)
So what to think about firms considering rate increases and bonuses in this highly sensitive environment in order to keep raising comp? What will clients’ budgets and perspectives accommodate in 2012? I believe that when you dig in to discuss increases in legal costs with clients, most clients think that firms that are focused on profits from increased rates and hours are tone deaf. indeed, an increasing number of clients think that rates and hours are largely irrelevant; clients are focused on the all-in cost to the business of the right outcome. And that means they’re seeking to assess what the work is worth.
My prediction is that lowering legal costs and improving cost predictability and controls will continue as a top-of-mind issue for in-house counsel, and that there will be less work for large corporate law firms overall as clients explore more alternative service providers that get their work done at more predictable and reasonable (value-based) prices. But that statement should not be confused with an assertion that there won’t continue to be plenty of highly compensated lawyers in the world: just probably not as many of them making quite as much.
It’s time for a New Normal hard truth: A lot of lawyers are going to need to adjust their expectations. They will make less as the market continues to adjust to new realities, increased competition, automation, and globalization. But it will also offer new opportunities to profit, as well, for those who seek to leverage change in their favor. In the race to succeed in the New Normal, being the highest priced, the most-hours-billed, or highest-rate law firm will not be the key to strong profitability or success. Being the most efficiently profitable firm is the surest and fastest path to enjoying sustainable (and even increasing) profitability. And that is accomplished by billing what the work is worth to the client, paying lawyers what their services are worth, and cornering carefully defined core practice markets by delivering the most certain return on investment (results).
No one ever suggested that value in legal services is “cheap” or cheaply come by. Even the least expensive Legal Zoom or Rocket Lawyer standard form doesn’t come cheap (and may not provide value) to the client who can’t afford a lawyer. The New Normal suggests that value is what value delivers: its price must be grounded in results based on competence, efficiency, and alignment of expectations and goals, whether the client is an individual or a multinational company.
Susan Hackett, CEO of Legal Executive Leadership, is the former senior vice president and general counsel of the Association of Corporate Counsel.
Editor’s note: The New Normal is an ongoing discussion between Paul Lippe, the CEO of Legal OnRamp, Patrick Lamb, founding member of Valorem Law Group and their guests. New Normal contributors spend a lot of time thinking, writing and speaking about the changes occurring in the delivery of legal services. You’re invited to join their discussion.