When it comes to pricing BigLaw’s services, play off the front foot or perish

The 2017 “Report on the State of the Legal Market” was published in mid-January by the prestigious Center for the Study of the Legal Profession at the Georgetown University Law Center and Thomson Reuters Legal Executive Institute.

The whole report is well worth a read and we warmly encourage you to do so but, for now, we want to quote some aspects that shed light on the three core themes of this blog.

“Death of Traditional Billable Hour Pricing” One of the most potentially significant, though rarely acknowledged, changes of the past decade has been the effective death of the traditional billable hour pricing model in most law firms…

This change has been overlooked principally because of a definitional problem. In much of the writing on this subject, the focus has been on so-called alternative fee arrangements or ‘AFAs’, pricing strategies that are based on fixed-price or cost-plus models that make no reference to billable hours in the calculation of fees.

Since other pricing models typically incorporate some reference to billable hours, it has often been assumed that only AFAs are genuine non-billable hour alternatives and every other approach is simply business as usual. That conclusion, however, overlooks a major shift that has occurred over the past decade: the widespread client insistence on budgets (with caps) for both transactional and litigation matters.

Plainly, the imposition of budget discipline on law firm matters forces firms to a very different pricing model than the traditional approach of simply recording time and passing the associated “costs” through to the client on a billable-hour basis. In fact, from a law firm standpoint, a budget approach is in some respects worse than an AFA, since it imposes a fixed price (in the form of the budget cap) but forces firms to “earn their way up” to the fixed price through recorded billable hours (which may themselves be deeply discounted).

In other words, a significant proportion of arrangements that are ostensibly hourly billing based, are in fact fixed fees in all but name only.

Although today AFAs probably account for only 15 to 20 percent of all law firm revenues, budget-based pricing is much more prevalent. Indeed, in many firms, these two methods combined may well account for 80 or 90 percent of all revenues.

AFA Profitability

The Georgetown report goes on to note, “In its 2016 Law Firms in Transition survey, Altman Weil asked the leaders of 356 U.S. law firms about their practices concerning alternative fee arrangements. Among the 97 percent of firms that bill at least some of their work on a non-hourly basis, 72 percent of respondents indicated that their firms take a reactive approach, addressing AFAs only in response to client requests.

Only 28 percent said that their firms were proactive in initiating conversations about AFAs. The key finding, however, was the difference in financial results for firms taking a proactive rather than reactive approach. When asked to compare the profitability of non-hourly based and hourly based work, 84 percent of the proactive firms reported their non-hourly based matters were at least as profitable as their hourly based work. This was true for only 51 percent of the reactive firms.

Moreover, 40 percent of the proactive firms indicated their non-hourly matters were more profitable than their hourly projects, as compared to only 10 percent of the reactive firms.

Altman Weil summarized these responses in one of the key findings identified in its survey:

“We see a seven-year trend of compelling success enjoyed by firms that take a proactive approach to alternative fee arrangements. We think this is a good indicator that proactive change in other areas could be equally effective in accelerating law firm performance relative to competitors.”

Fixed fees, caps, ho hum…

We don’t want our slightly flippant subheading to give the impression that fixed fees, caps and their various iterations are no longer important or relevant. They most certainly are and should continue to constitute part of every partners pricing conversational repertoire.

What we mean is that firms that do pricing particularly well are not satisfied with the status quo and are constantly exploring new ways in which to price their offerings. Unfortunately, looking for inspiration from within the profession can, with notable exceptions, be relatively unrewarding for the simple reason that in contrast with most other sectors of the economy (retail, manufacturing, energy, shipping, pharmaceutical, hospitality, aviation, etc.) we are comparatively unsophisticated and have a lot of catching up to do.

The good news is that we have found over the years that a lot of pricing science and psychology is sector agnostic. In developing our resources and capabilities over the years, there have been rich pickings from many of those other sectors.

The challenge is understanding them at both an intellectual and a practical level and then figuring out how to repurpose them for application to the legal sector. In some instances, it is relatively easy, and in others it is challenging if not out of the question practically, legally or reputationally, e.g., surge pricing (Uber) and dynamic pricing (airlines).

But there is a common theme that we advocate as being central to the new breed of AFAs and that is increased commercial risk-sharing in both contentious and non-contentious work.

The subtleties and nuances of such pricing arrangements are literally infinite but what they all share is a much stronger alignment of the firm’s and the client’s interests, manifesting itself in pricing arrangements where, “if this doesn’t go well for you, we will take a haircut but if it does go well then we not only want our usual remuneration, we want some of the upside”.

There are many challenges associated with crafting, defining, documenting, articulating, negotiating and delivering on such arrangements but the rewards can be considerable, not simply financial but in terms of client loyalty and retention to say nothing of business development opportunities.

Over the past decade, there has been a discernible bifurcation of the market into highly successful and less successful firms, and the performance gaps between those categories have been widening. There will be many reasons for this but based on the Georgetown report, those firms that continue to significantly outperform their competitors exhibit two characteristics; strategic focus and proactive response to the needs and expectations of clients are the standout contenders.

To paraphrase the report’s conclusion, in keeping with Darwinian theory, those firms that are most likely to survive and prosper will not necessarily be the oldest, largest or smartest, they will be those that amongst other things, find ways to imaginatively, creatively and flexibly price and deliver their work in a way that is profitable and firmly aligned with the clients’ commercial interests.