By Jaap Bosman
Depending on the market, commoditized work can be quite complex. For instance, project finance is one area of specialization for which you need a lot of expert knowledge and experience. The problem is that in a sophisticated market like New York or London, there are just too many good project finance lawyers around who can do the work perfectly well. Hence, in those markets all but the most complex or innovative project finance matters will be considered commoditized.
To better understand let’s look at the definition of commoditization in the legal market:
Commoditization is when for a particular matter, the client can choose between multiple lawyers and multiple law firms without sacrificing any aspect of quality. In other words, when from the client’s perspective, the process and the final product are the same.
It is important to understand that commoditization is not measured from the law firm’s perspective. It is the client who decides. It is also important to understand that commoditization is black or white. A certain legal service or product is either commoditized or not. The consequence of commoditization is ultimately, and unavoidably, pressure on price. If everything else is equal and the client has a choice, price will become the decisive factor.
When I discuss the topic of commoditization with lawyers, the first response is always: “There might be commoditization in the market, but what I do is 100 percent bespoke.”. This phenomenon is called “commoditization blindness.” The second-most common remark is that the lawyer has a unique and trusted relationship with the client—a relationship that is so strong and special that price alone will never destroy it. Who am I to judge this? So I spoke to a general counsel from a sizable international company and asked him how often he worked with lawyer that he did not like.
The answer did not come as a surprise. Almost all of the lawyers he had worked with during his long career were highly qualified people who did their best to deliver excellent client service and were very pleasant to work with. Basically, all lawyers were equally nice and managed to build a trusted relationship pretty fast. We might think our relationship with our client is unique, but from the client’s perspective, even that ‘unique relationship’ they can get elsewhere.
Commoditization has become a fact of life for law firms, and commoditization will lead to pressure on price. Because of its eroding effect on profit, commoditization might well be the single-most disruptive factor in the legal sector today. To fully grasp the seriousness of this effect, we need to first fully understand a law firm’s financial model. The basics are simple: revenue minus costs equals profit. Since profit is distributed amongst the partners, there is a direct linear relationship between profit and partner compensation.
|Cost: 65||Profit: 35|
Revenue: 110 (+10%)
|Cost: 65||Profit: 45|
|Change in profit: +30%|
Revenue: 90 (-10%)
|Cost: 65||Profit: 25|
|Change in profit: -30%
The important thing to understand here is the fixed nature of the costs. For a law firm, fixed elements like salaries, rent, insurance and IT can make up to 90 percent of all costs. All of these are invariable in the short term. In most markets, cost will be about 65 percent of budget revenue. So the equation would look like the accompanying chart. As you can see, a 10 percent drop in revenue will result in a 30 percent drop in profit. This leveraged effect is one of the main reasons why commoditization is so dangerous for law firms.
To make things worse and even more threatening, this effect will be amplified by today’s increased partner mobility. Loyalty between partners and their firms is at an historic low, and many partners feel free to pick up their books of business and move to another firm—an event that could easily be triggered by profits declining at the firm they are with. When the most profitable partners leave the firm, taking their books of business, revenue again drops while costs remain the same (salaries, housing, insurance, IT, etc.). Consequently, for the remaining partners, profit will drop even further. This could easily lead to an unstoppable downward spiral with more and more partners leaving.
Eventually this could even lead to the collapse of the firm as we have seen at SJ Berwin, the European branch of King and Wood Mallesons at the end of 2016.
Commoditization will quickly erode profitability. Understanding and accepting the concept of commoditization will help us to understand that in order to maintain our profitability, we will need to adapt our business model. There are several ways to do that. The traditional business model is based on the markup we make on our associates and on time spent. So if a client is billed $3,000 for an associate to complete a task, the profit for the firm will be (based on industry average) $1,000. What if we replace half of what the associate did by a computer, and at the same time charge the client 30 percent less? The calculation will now look more like this: Revenue $2,000, cost $1,000 (only 50 percent time of the associate’s time spent), profit still $1,000.
Making lawyers more efficient with the help of technology is only one of the solutions. Other measures include reducing the number of equity partners, making costs more flexible, or making the services more valuable though brand building and positioning.
But whatever the solution, it all starts with accepting the situation. We need to stop sticking our heads in the sand and stop believing that what we do is so unique that it cannot be done equally well in every aspect by another lawyer or another firm. As my friend the general counsel said: “Typically, all lawyers do a pretty good job and are pleasurable to work with.”
Jaap Bosman is a leading strategy consultant, investor and one of the founding partners of TGO Consulting, a boutique consultancy focusing on the legal sector operating from New York, The Hague and Hong Kong. In 2015 he published Death of a Law Firm, recently translated into Chinese. Jaap is a regular speaker on the future of the legal sector.