Balancing act

Most law firms have done well over the past few years, increasing their fees, billing and revenue. That is notwithstanding geopolitical disruption and economic downturn, digital transformation, and the shift to hybrid working. However, last year profitability began to slide.

Do firms need to tighten up their financial management, or even improve their communication and negotiation skills, in order to recover their margins?

First, a look at the latest numbers and trends.

PwC’s Annual Law Firms’ Survey 2023: Bold steps to sustainable transformation reported 8.2% average fee income growth across top-100 firms and optimism about future growth. Yet 44% of the top-100 reported falling profits.

The BDO report A new era for law firms highlighted three developments that will impact the financial liquidity of law firms: hybrid working, investment in artificial intelligence (AI) and changes in how partnerships are taxed. These and other factors, notably consolidation within the legal sector (with a 23% increase in law firm mergers and some high-profile failures) have increased financial pressure across the profession.

Financial management software supplier BigHand has just published its 2024 Annual Law Firm Finance Report. This surveyed 800 respondents in senior legal finance roles, CEOs and managing partners in the UK and the US. It found that 96% of participating firms increased their billable hours in the past 12 months – 44% by more than 10%. However, the report also highlighted challenges to profitability: 59% of participating firms reported increased write-offs and 67% were experiencing escalating costs. Client expectations have changed too, with 75% responding that clients are demanding financial transparency, reporting and discounts.

So what is the key to law firm profitability, and to what extent does a firm’s choice of fee model make a difference?

Robust financial management certainly helps. Several studies found that lock-up – the period between completing work and getting paid – is increasing. Reducing lock-up is important for both cashflow and profits; and although most law firms have dedicated financial management teams and software, it remains a perennial challenge. This may reflect lack of clarity in the fee model, the billing model, or simply the reluctance of lawyers to discuss money with clients.

Time-based billing is still the most popular fee model. Notwithstanding repeated assertions that the billable hour is dead, just 15% of respondents to the BigHand survey plan to shift from billable hours as their main KPI (key performance indicator) to focus on profitability. Even when lawyers do not charge per unit of time, the estimated time spent on a matter tends to be the benchmark for fixed and capped fees.

While the billable hour remains popular because clients are comfortable with it, it creates financial uncertainty. The client cannot know the final bill, so is more likely to query it. While lawyers can decide how long to spend on a matter, they may well have to invest extra time in providing estimates at the outset and a detailed breakdown of the final bill, particularly as larger firms are increasing their rates.

The Thomson Reuters Institute’s 2024 Report on the State of the US Legal Market shows fees increasing at a higher rate than demand, with corporate clients pushing back by moving work to more cost-effective firms.

By contrast, fixed and capped fee models provide certainty around billing, and incentivise lawyers to work faster and more efficiently. Meanwhile, alternative legal services that are leveraging sophisticated, time-saving technology have produced models based on speed, efficiency and customer service.

Fixed price, fast turnaround

'Everything we do is designed to create value for clients, which is not about lawyering, but about understanding what they need and delivering an amazing experience, product and outcome'

Alex Hamilton, Radiant Law

Alex Hamilton founded commercial contracting firm Radiant Law in 2011 with the mission of optimising contracts while ‘effortlessly delighting the client’. The model focuses on enhancing customer experience using operational efficiency and continuous improvement to deliver fast, high-quality services at a fixed price.

Hamilton explains that while hourly billing means that firms are selling the value of lawyering, more lawyering might not necessarily produce a better outcome for the client, and it might even produce a slower outcome. ‘Everything we do is designed to create value for clients, which is not about lawyering, but about understanding what they need and delivering an amazing experience, product and outcome.’

Fast turnaround is important and Radiant turns around commercial contracts typically in half a day. ‘By getting rid of the billable hour, we got rid of the idea that spending more time is necessarily a good thing. Rather than clocking up more hours, the lawyer’s job is to figure out how to add efficiency and value.’

This is achieved through a culture of continuous improvement – smarter ways of working that speed up service delivery and enhance the client experience.

How does Radiant balance client value (for money) with profitability? ‘We are very good at getting the price right, and we have never gone back to a client and said we need to charge more [for the same piece of work],’ says Hamilton. ‘Of course we’ve made mistakes and we’ve learnt from them, but the client knows they will never get a bill that’s different from what they agreed in advance. We don’t charge more if a contract goes back and forth, so we’re incentivised to close deals faster. Our clients trust us, and trust is sacred if you want to build long-term client relationships.’

Last year Radiant implemented the Shingo [operational excellence] model. Says Hamilton: ‘We had to reinvent [our approach to] ERP (enterprise resource planning), knowledge management and contracting.’

Value pricing

Paul Bennett is a partner at Bennett Briegal, an adviser to law firms. It operates a value pricing model based on sector expertise and service levels – making buying legal services a bit like buying technology. This was developed to give clients clarity over pricing.

However, Bennett Briegal has not moved away from the billable hour entirely. ‘We charge a premium for sector expertise,’ he explains. ‘For example, when we advise on M&A transactions involving professional practices or conflicts of interest under the SRA rules, our prices reflect our expertise and experience rather than the time we spend – not just knowing the rules, but understanding potential pitfalls and knowing how to find the best possible solution. In our specialist sectors, which are largely reputational, our clients are paying extra to minimise professional risk.’ Although value pricing may mean losing mainstream work to a less expensive competitor, it enables specialist firms to focus on projects where their skills and expertise add value.

Like Hamilton, Bennett underlines the importance of clarity at the outset. ‘Retainer and engagement letters need to set out exactly what work is included, and what steps are excluded because the client is doing it themselves, or it is part of a separate project.’

Allowing lead partners to set pricing is empowering, but this requires pricing confidence, Bennett explains: ‘If partners set their own fees, people who lack pricing confidence will tend to shoot low [impacting profitability]. By allocating margin to each value-added task, pricing departments can consistently align pricing with expertise. For smaller firms, the key to profitability is training those negotiating and setting fees, and giving clients the ability to choose a fee package they are comfortable with.’

Time recording lives on!

'Subjectivity is a major challenge – lawyers deciding whether to record time sparingly or excessively depending on factors like how quickly they think they’ve worked'

Glyn Morris, Higgs

For some firms, time recording is still sacrosanct. Glyn Morris, project partner at Higgs and the firm’s finance director for 14 years, acknowledges that although time recording is not always related to billing, he considers it fundamental to understanding the cost of service delivery. ‘People want to get rid of the billable hour, but they need to record time to capture the cost of the work that has been done,’ he says. ‘In order to understand the profitability of different types of work, you have to apportion lawyers’ salaries to another key metric, and the most plausible and sensible metric is cost per lawyer per hour.’

However, the cost of service delivery also includes legal support, comprising secretaries, and business services teams. ‘Subjectivity is a major challenge when it comes to time recording – lawyers deciding whether to record time sparingly or excessively depending on factors like who’s managing them and how quickly they think they’ve worked. So during the pandemic we introduced time recording for secretaries to be able to apportion the cost, and to understand the remote workforce,’ Morris explains.

One aim was to better understand the source of the firm’s profitability. ‘When you have the recorded hours, you can allocate the time spent (the proportion of the various salaries) on a matter and all the other costs against the billing and build a cost model for calculating the profitability of lawyers, teams, departments, work types, client groups, matter types and so on.’

On the link between pricing and profitability, Morris believes that lock-up and write-off are often due to poor pricing decisions and ‘dissonance between value, service and price’ – for example, if a lawyer offers a best estimate of hourly billing for a service that should have been offered at a fixed fee. ‘When you understand costs, and you can monitor them well enough to know where there are inefficiencies, and you know the structure of your legal services, you know which services should be offered as fixed fee, which should be value billing and which should be variable. You can then align the price to the cost of production and maximise profit margins without attracting client pushback.’

West Midlands-based Higgs is a broad practice, handling fixed-fee work like wills, conveyancing and personal injury claims. The rest of its practice charges are based on an estimated number of hours, sometimes with a value element, or an hourly rate, depending on work type. Some more complex business transactions might involve all three pricing components. Beyond fee models, Morris references high interest rates making capital less obtainable, and affecting growth and profitability.

Reducing lock-up and write-downs

It seems that law firms need to work on their financial management, especially the elements that impact profitability. The BigHand report found that firms are aware of the contribution of commercial focus, performance incentives and financial rigour, with 51% of participating firms planning to train lawyers to have more commercial awareness, and 90% introducing remuneration measures designed to increase profitability. Sixty-four per cent plan to bill and collect more frequently, while 46% hope to implement advanced business intelligence technology over the next 12 months.

But right now, things are moving in the opposite direction. Lock-up is increasing, with 47% of respondents admitting that missing/late time entry and poor-quality timecards influence profitability.

Write-downs are another challenge. The Thomson Reuters Institute report found that while rates were increasing, collected realisation against those higher rates softened. By the end of last year, law firms were collecting an average of 90.5% of their worked rates.

Tony Williams, principal at legal consultancy Jomati and a former managing partner at Clifford Chance, believes increasing write-downs and lock-up are symptoms of a deeper seated cultural issue. ‘Lawyers are passionate about doing a good job but they are late at billing and poor at collection,’ he says. ‘The longer you leave billing the less you bill, and the longer you leave collection, the less you collect. If you had agreed monthly billing with a client, you would normally bill on the first business day of the next month. But law firms bill on the last day of the next month, so they’ve already lost 30 days.’

He adds that higher interest rates mean that the cost of outstanding money has increased, impacting on profit margins, while tax changes in the form of basis period reform mean that tax reserves that many firms used as working capital in the past will be smaller.

Steve Rowan, outgoing chief financial officer of RPC, references an interesting phenomenon: ‘During the pandemic, law firms got very good at billing quickly, and doing it online. That continued for a couple of years, then as law firms and client organisations emerged from lockdown and business went back to normal. There’s been a fallback in billing, which has become less efficient. And in the last 18 months or so, with high interest rates and inflation, clients are taking longer to pay and lock-up has increased.’

Rowan believes the way to address this decline is to work on communication and transparency rather than financial rigour: ‘The best law firm partners treat billing as part of providing excellent client service which includes transparency and trust, but it is always a challenge to get lawyers to bill their clients, because they don’t always want to have that conversation.

‘If you build a partnership of trust, and the client is happy with the service, they are likely to be happy with the fee,’ he concludes.

Joanna Goodman is a freelance journalist