Our thesis here at the New Normal is that the legal services that corporations buy will come to look more like other activities inside companies, and the legal services small businesses and consumers buy will come to look like other consumer activities.
My thinking on this is driven by experience, having spent most of my life either running the legal function inside a company or in other operating roles, or trying to be an aggressive consumer of online services.
When lawyers attack the New Normal thesis, the rejoinder usually comes down to three things:
• Because change hasn’t fully happened yet and has been discussed for a while, it won’t happen.
• Experiences of other fields are nonsense and irrelevant, because they’re not law.
• Lawyers play a unique ethical role which would be lost if services were “normalized.”
I’ll address the latter two points on another day. With the winter “earnings season” upon us and financial information coming out of large law firms, we have the chance to explore the question of whether the operating results of law firms reflect an acceleration of the New Normal.
The best source of financial information on large law firms (there really is no financial information on small law firms) is the Citibank Report, which is informed by Citi’s banking relationship with many firms, together with American Lawyer’s numbers.
Let me begin with four observations.
First, having participated in the preparation of dozens of public company earnings reports, I long ago experienced what everyone knows—accounting is not an especially deterministic field, and there is always a lot of gray area to try to tell the story you want. But in the end, the numbers do tell, and small things can signal big trends. If you dress up the numbers now, you will tend to do more the next time, and pretty soon you will run out of room to dress up. Public companies dress up the numbers to keep stakeholders happy, meet management targets and maintain currency for acquisitions and other purposes; law firms do the same things for the same reasons, but subject to fewer checks and balances.
Second, law is a remarkably untransparent field when it comes to numbers. In most industries, you have many ways to validate numbers, including publicly reported financial results subject to audit, industry overviews and independent analysis. In other industries, customers, vendors and peers also report their numbers, so if yours are out of line, demand for explanation is sure to follow. In law, we have none of these sources of transparency, only the American Lawyer trying to the best of its ability to triangulate law firm performance and Citibank able to roll up numbers (but not really disclose them) based on its large market share. What’s more, the nature of partnership accounting and the ability to toggle between cash and book means large law firm accounting is far more subject to confusion than most enterprises (not so for small firms, which will quickly run into trouble if their reported results vary much from what’s happening with cash).
Third, numbers have a point. They communicate to stakeholders what’s going on, and to management what’s working and what isn’t. So while everyone will look for ways to tell a soothing story to stakeholders, management puts itself in peril if it fails to look squarely at the story the numbers are telling and deal with its implications.
Finally, there’s nothing unique about lawyers’ being resistant to change or reluctant to face tough choices. From Kodak to Medicare, it’s the story of our time.
So what do the latest numbers from Citibank and AmLaw tell us? Having been on the other side of these kind of numbers, let me suggest that the tale of the tape is that except for a few large boutique firms doing quite well, most firms are delivering the kind of financial performance you’d expect from an industry undergoing structural change.
I am not going to purport to break down all the numbers, only give you some questions to ask, and explain how those questions can play out in a “normal” public company.
According to Citi:
1) 2011 revenue growth was 4.1 percent.
Do the growth numbers reflect real growth?
Growth is a trend which is generally reflective of economic health, and it is measured by the difference between last year’s numbers and this year’s. One common way public companies achieve growth is through acquisitions. But large acquisitions are visible to stakeholders and get built into the base of last year’s numbers for comparisons. Smaller acquisitions are usually immaterial and do not, so they actually can contribute more to perceived growth.
In the same way, law firms reporting revenue growth that is driven by firm acquisitions or even more by lateral partners joining (which can be thought of as “practice acquisition”) are comparing apples to oranges. Acquisition-driven revenue growth may reflect on the overall size and capacity of the firm, but it doesn’t reflect the type of organic growth that indicates economic success.
2) Expense growth was 4.4 percent, higher than revenue growth.
How is the cost of growth being accounted?
All forms of growth have costs. In a regular company, you have to hire salespeople and add capacity. In law, lateral partners require guarantees and often headhunter fees; new office expansion requires leases and buildups. In any enterprise, there is a lot of room to dress up the cost of growth—it can be capitalized, deferred, offset or put in hard-to-track accounts. But if a firm paid a $600,000 headhunter fee (presumably cash, however it was booked) to acquire a partner with a $5 million book of business and a $1.5 million guarantee (plus some associate and related costs), then much of that expense might not show up in the first year, understating the degree to which the firm is simply paying to acquire revenue in a way that may or may not yield improved profits down the road.
3) Even though expenses grew faster than revenues, profits went up.
Is partner de-equitization a driver of expense growth?
In a public company, the ultimate metric is earnings per share, and so there has been a lot of focus on stock option accounting, because options ultimately become shares, which “dilute” earnings. In law firms, the focus is on profits per partner (PPP), which means if someone ceases to be a partner but becomes, e.g., of counsel, they no longer dilute PPP. But if they’re no longer a partner, their compensation is now part of expenses (partner compensation is profits).
4) “Equity partner head count grew only marginally, reinforcing the view we hear in our travels that it has become a lot harder to become an equity partner and remain an equity partner.”
What are the implications of the declining leverage?
From a client point of view, we have long clamored for less reliance on leverage as a way to generate firm profits, so this is a very positive, New Normalish trend. However, from the associates’ point of view, this means fewer jobs and an even more remote possibility of the brass ring of partnership. Can the fundamental talent/growth model of firms be sustained if associates come into the firm with a 1/50 chance of becoming partner, because profitability is sustained by limiting entry to the partner ranks? They can’t all get in-house jobs or become federal judges.
5) In “the second half of the year … demand … withered away and has yet to bloom again… Revenue growth … in 2011 was due to … a modest shortening in the collection cycle…. [there was] low year-end inventory growth.”
If all the key ratios point down coming into a year, what does that portend for that year’s financial performance?
6) “All said, not a bad year, and we suspect likely to be the new definition of a good year for the legal industry at least for the foreseeable future.”
Is slow or no growth the New Normal?
While not intrinsically a catastrophic problem for organizations that generate a lot of cash and comfortable livings for their owners and employees, history shows that adjusting from growth to stasis is quite hard for most organizations and cultures.
Overall, I think the numbers tell the story of structural change, not just an industry cycle, but I suspect many firms put a lot of energy into dressing them up to obscure that fact.
Will firms be smart enough to look at the numbers and give serious thought to how they can renew themselves to truly grow and outperform their peers? Time will tell. Apple did; Kodak didn’t.
Paul Lippe is the CEO of the Legal OnRamp, a Silicon Valley-based initiative founded in cooperation with Cisco Systems to improve legal quality and efficiency through collaboration, automation and process re-engineering.