Innovation has been the buzzword in the legal sector for several years. These days, there is a seminar or conference on innovation or IT disruption in the legal sector every week. Fueled by these repeated messages, many law firms start building apps, giving models away for free or embark on using software for such tasks as due diligence.
The problem with this is that law firms tend to start at the wrong end. They start with working on a solution without having defined the problem first. Innovation in the legal sector needs to be profit-driven. Maintaining a healthy profitability level in an increasingly commoditized legal sector needs to be the starting point. Innovation should be aimed at lowering the cost of production while increasing the profit margin. Automation can do that, but only if the costs of humans is decreased at the same time. Spending money on an automated due diligence and still maintaining the same level of junior lawyers in the corporate department is not going to work. Furthermore, the increased efficiency that tends to come from innovating with technology is bad news for a business that keeps relying solely on leveraged hours.
Recently I came across an episode of Pound Shop Wars originally broadcast by the BBC between 2012 and 2015. The series focuses on Poundworld, the United Kingdom equivalent to Dollar General and similar chains. Poundworld has more than 350 UK stores selling most of its merchandise at 1 pound. Buying goods and selling them at a profit is the most elementary form of business. Everything Poundworld does is focused on return on investment. No costs are made unless profit will come out of it. Poundworld’s founder and owner is a businessman and entrepreneur and literally every decision comes down to a simple sum.
It struck me how different law firms are being managed from any other business.
Law firms have for decades been one of the most profitable business models in existence. But profitability will be going down under the current business model. While clients are becoming more sophisticated and professional, they find that multiple law firms or lawyers are able to handle the same assignments equally well: Legal expertise is becoming increasingly commoditized. If everything else is equal, the client will make a choice based on the price.
Using this definition, it becomes clear that, per market, a certain legal expertise is commoditized or it is not. The clients either have a choice, without compromising on quality, or they have not. There is no gray area. It is either black or white. Letting this definition sink in for a moment, I should also make clear that commoditized work does not necessarily equal ‘simple work’ or ‘bulk work’. It all depends on the competition. In most mature legal markets, it will be possible to find multiple law firms willing and capable to handle a matter at any point in time. Even if it requires specialist experience and expertise.
Surprisingly, most partners at law firms seem to suffer from “commoditization blindness.” When asked, they admit that such a thing as commoditization exists, but are convinced that it will not affect their practice as what they do is invariably highly bespoke. If Poundworld would have had the same blindness to what was happening in their market, they might have been out of business by now.
Understanding your business model
Unlike the retailer Poundworld, the business model of law firms is quite simple. There is no buying and selling of goods; there is no stock to keep track of, and there is far less volatility in the workforce. Whereas the retail business is not rocket science, the business model of law firms is as simple as it can get: revenue minus costs equals profit. The only thing that one should understand is that in the short term, the costs are fixed. Comprising predominantly of wages, rent and information technology infrastructure, costs do not vary with the revenue. This means that fluctuations in revenue will have a direct and leveraged effect on profit. Since profit is divided between the partners in full, any fluctuation will directly affect their income. As a market average, business law firms will have a cost percentage of about 66 percent thus a profit margin of 34 percent. This means that a 10 percent decrease in revenue will result in a 30 percent decrease in profit. This is why law firms should be worried about commoditization.
I started this article by talking about innovation. Technology is neither the cure nor the culprit to the challenges law firms face. Commoditization is the problem, and technology can help to find profitability. Innovation in the business of law should be solely focused on maintaining a healthy profitability in an increasingly commoditized legal world. Innovation should be strongly purpose-driven. But to survive, law firms must fundamentally change their business model. You cannot just add technology and continue using the same business model based on leveraged hours. Poundworld would never automate its warehouse and still keep the same number of people working there.
Law is a business like any other business
The business of law has been very fortunate over the last few decades. Without any “skin in the game” and with little entrepreneurial skills, we prospered. I would argue that most lawyers do not consider themselves businesspeople or entrepreneurs but professionals—much like doctors, except that doctors operate in a regulated market and do not need to be entrepreneurs.
Now, because of commoditization, the time has come for law firms to adapt their business model. It is time to start acting like any other business. This will require courage, sense of business and entrepreneurial skills. I would recommend for lawyers to take inspiration from Poundworld, where business is still practiced in its most elementary form.
The business of law—where partners charge hundreds of pounds per hour or more—could learn from Poundworld, where every item costs just 1 pound.
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.