Driving Predictability and Certainty in Outside Counsel Billing
Since the dawn of commerce, willing sellers and buyers of goods and services have transacted in a certain and predictable pricing environment that derives from a simple equation. On one side of the equation, a seller establishes an asking price that takes into account the cost of producing and delivering goods or services plus a desired profit margin. On the other side, a buyer determines whether to buy at the asking price, presumably after some price comparison and negotiations. Each side strives to make an informed and calculated decision on pricing and lives with the commercial risk of the agreed upon price.
Clients and outside counsel still have not cracked the code when it comes to pricing legal services with any modicum of certainty or predictability. Clients routinely approach outside counsel for a fee estimate on a well-defined matter only to be met with a wide-ranging fee estimate with a myriad of caveats affording outside counsel considerable latitude on the final bill. Needless to say, this outcome is entirely counterproductive for clients that must operate within an established legal budget.
As a general proposition, pricing legal services with certainty and predictability should not require complex, string theory computations. In theory, the pricing process for legal services need not deviate from the same path taken by nearly everyone else in the commercial world that has figured out how to set fixed pricing metrics and live with the results.
A widely held sentiment amongst legal industry experts is that alternative fee arrangements, or AFAs, are the solution to market demands for legal fee predictability and pricing certainty. AFAs come in a variety of flavors ranging from fixed fee arrangements to phase-based billing to success-billing or other outcome-based fee arrangements. Clients readily embrace the concept of AFAs because pricing certainty facilitates legal fee budgeting and legal department financial hygiene. In commercial dealings with other third party vendors, clients bear contractually-allocated pricing risk and are often left confounded as to why AFAs are not more widely embraced by outside counsel given the market and clients demands.
Even though AFAs present the natural, market driven solution to unpredictable and uncertain legal fee billing arrangements, AFAs have simply not gained traction at the expected pace. There are a myriad of reasons underlying this market anomaly, but the fundamental obstacle to the slow adoption of AFAs squarely centers on the legacy economic model and operating challenges of most law firms discussed below. It is critical for clients that are pushing outside to undertake engagements on an AFA basis to understand outside counsel’s aversion to AFAs and to employ the tips below to optimize AFAs.
Challenges with Reconciling and Analyzing Incongruous Economic Models
As Abraham Lincoln said, “a lawyer’s time and advice are his stock in trade.” Quite understandably, the economic model of most law firms continues to focus on the billable hour. The hourly billing model is unlikely to disappear anytime soon presumably because it is a pervasive, simple and objective methodology by which to compensate an attorney for his or her time.
The enduring prevalence of the billable hour, however, poses challenges for law firms when it comes to AFA pricing and measuring profitability. Reconciling and blending a billable hour economic model with an AFA economic model is likely the biggest impediment to widespread adoption of AFAs. This is because the billable hour economic model operates as the only meaningful reference point for law firms when pricing and measuring the profitability of an AFA. In practice, a law firm that is asked for an AFA proposal usually estimates the number of hours required to complete the matter and then calculates the AFA fee using its standard hourly rates. If the estimate of hours required on a matter or phase is inaccurate (and it is usually underestimated), the AFA pricing is suboptimal for the law firm from the outset.
The equation becomes even trickier upon completion of a when a law firm analyzes profitability of the AFA. Usually, timekeepers at law firms must record billed time on the AFA engagement as if it were on an hourly fee schedule. A law firm then compares fees generated from the AFA with the fees that would have been generated under a billable hour arrangement. In practice, engagements undertaken on a billable hour basis need to be managed with less efficiency than AFA matters and tend to drive greater profits to a law firm as more hours are billed. As a result, when comparing AFA revenue with legal fees that would have been generated on an hourly basis, the AFA will often appear less profitable. Until law firm managers devise profitability metrics for AFAs that bear no reference to the billable hour economic model (and the underlying cost structure discussed below) or move entirely away from the billable hour model, the billable hour model will remain the only reference point for the profitability of an AFA.
Complete migration away from a billable hour economic model is virtually impossible for most law firms so an apples-to-apples comparison of AFA profitability will continue to present challenges. It is difficult, though not impossible, to reconcile and analyze two incongruous economic models.
Significant Fixed Costs
For most major law firms, the primary expenses are real estate expenses and fixed compensation for associates and other legal professionals. In order to attract marquee clients and the best and brightest associates, law firms frankly have no choice but to absorb these sizable fixed costs. Presumably, real estate costs can be curbed through effective space management, outsourcing and technology, but smart money would never bet on the best and brightest associates with massive student loan debt willingly agreeing to work for less compensation.
When setting annual budgets and profitability goals, law firms make revenue assumptions based on projected hours billed multiplied by anticipated realization of hourly rates offset by the expected fixed costs. Given the magnitude of their two major fixed costs, revenue projections must be accurate and met in order to reach profitability goals. As discussed above, AFAs can create a murky revenue picture when placed into the revenue calculus of hours multiplied by hourly billing rate. For the law firm, projecting the time invested in a matter is fraught with uncertainty and overruns in hours spent on a project are frequent, especially when the tasks are performed by attorneys typically inclined towards billing more rather than less hours.
Imprecise estimates and time overruns in AFA projects depress revenue realization and create major profitability headaches for law firms given their sizable fixed costs. This causes law firms to think twice about taking on unpredictable economic risks inherent in an AFA. If too many AFAs prove to be uneconomic in a billable hour based budget with sizable fixed cost, law firm managers realize that the only thing to suffer is profits per partner.
Matter Management Challenges
Any attorney handling a matter under an AFA should recognize that profit optimization will require keen attention to process management, optimal staffing efficiency and effective communication and collaboration with clients. By their very nature, attorneys have been trained to attend to the details, troubleshoot remote risks and are calibrated to do things the “right” way even if it is less efficient. For many attorneys, process management and efficiency are learned behaviors, not an innate predisposition. Coupling those character traits with the fact that the prevailing billable hour economic model can discourage efficiency, effective process management challenges many attorneys. As outside counsel continues to hone process management skills and instills in all legal professionals the need to operate with greater efficiency, the inclination to take on more engagements under an AFA model should grow. Until that paradigm shift occurs on an industry wide basis, client demands for AFAs will continue to be met with tacit resistance.
Upside Potential vs. Downside Risk
With the possible exception of law firms which opportunistically and successfully take on contingency matters, law firms historically have not enjoyed the proverbial economic “home runs” associated with success-based compensation arrangements that are pervasive in the investment banking and venture capital industries. Most law firms simply have approached the business world in a more conservative manner.
As a result, AFAs that are success-based or outcome-based tend to be uncharted territory for risk-averse attorneys who have not historically experienced “windfalls” from those economic arrangements. Most recognize that a considerable investment of time is required to undertake a success- based AFA with an uncertain payout and the risk tolerance of many attorney lawyers steers them towards a stable hourly billing engagement instead of a riskier success-based AFA. Moreover, many lawyers at larger law firm often perceive the “upside” afforded a law firm in a success-based AFA to pale in comparison to the “windfalls” realized by their counterparts in the business world so as not justify the investment risk or opportunity cost of a more secure hourly engagement.
On the flip side of the equation, law firms frequently perceive themselves as being on the losing end of fixed-fee AFAs, having to continue representation of a client on uneconomic engagements. Unforeseen circumstances or complications arising in a lawsuit, transaction or other matter or inefficiencies by timekeepers on a matter often leave a billing partner with the unpleasant task of writing off time in order to fall within AFA billing guidelines. When comparing the realization rate for hours worked on a fixed-fee AFA engagement with what would have been billed on a straight hourly engagement, a law firm will find itself wondering why it agreed to the AFA in the first place. The perception by outside counsel of limited upside potential and considerable downside in AFA arrangements discourages them from undertaking such engagements. This is punctuated in law firms where an AFA’s upside is shared amongst many partners, but the downside risk tends to be borne by a single engagement partner who made a bad economic deal.
Pricing Challenges for Law Firms
Law firms hold within their financial engines enormous amounts of billing data accumulated over decades, a keen insight into what is needed to handle a client’s matter and a working knowledge how to most efficient staff a matter. Yet, only recently have law firms realized that they must put this knowledge and information to work when pricing matters, particularly in an AFA context.
Historically, lawyers have focused on attracting clients and handling legal matters. Law firm economics and financial matters have resided outside of the typical lawyer’s bailiwick and fallen to a law firm’s business manager or CFO. Quite understandably, many lawyers are not entirely conversant with the profitability metrics and economic drivers of their own law practice. Virtually every lawyer can readily understand the economic aspects of their practice but few have been forced to do so. Attorneys also correctly believe that every matter is different with different challenges, twists and turns.
Against this backdrop, it is not surprising that many law firms have not been ideally equipped to effectively analyze and price AFAs. Despite the availability of internal data and external legal spend data from third parties, AFAs are often priced by law firms without reference to, or use of, that information with the consequence that many firms find themselves in uneconomic AFAs. Until law firms leverage the data available to them to effectively price AFAs, the widespread adoption of AFAs by law firms is likely to continue at a slower than desired pace.
Variant Cost Structures
With the rise of “Big Law” over the past decade, law firms are now comprised of hundreds or thousands of attorneys in multiple locations throughout the world. This evolution of the legal industry has resulted in incongruous profitability metrics and disparate cost structures for different offices within the same law firm. The economics of the New York, London or Hong Kong office of a multi-national firm can look vastly different from the economics of the same law firm’s Kansas City or Dallas office. As a result, the same AFA which is extremely profitable for a law firm’s Kansas City office may not translate into an equally profitable AFA for its New York office. This does not mean that suggest that AFAs cannot be undertaken by multi-office firms with appropriate adjustments based on an office’s cost structure, but clients must be mindful that AFAs may need to be individually tailored to account for the economic differences arising from the nature of large, geographically diversified multi-office law firms.
PRACTICAL TIPS FOR OPTIMIZING ALTERNATIVE FEE ARRANGEMENT.
As the legal industry continues its transformation, AFAs should continue to gain traction, albeit at a slower-than-desired pace. In order to optimize an AFA’s benefits, clients are well-advised to employ the following strategies and tactics:
1. Understand Outside Counsel’s Challenges. Without question, the challenges discussed above do not apply to every law firm or every attorney asked to undertake an engagement using an AFA pricing structure. It is a non-exhaustive list of systemic obstacles impeding the broader adoption of AFA by the legal industry as a whole. Nevertheless, a client that understands law firm economics and primary challenges faced by law firms asked to use AFAs will have more success persuading outside counsel to do so. More importantly, the informed client that understands outside counsel’s perspective will likely end up with an AFA engagement that simultaneously implements a successful and effective legal strategy and outcome and provide legal fee predictability.
2. Use Data to your Advantage. A natural inclination of many clients may be to use legacy data from historic matters to guide pricing for a new AFA arrangement. While the legacy data can provide some valuable pricing guidance, it lacks currency and tends to benchmark an AFA against an incongruous billable hour economic model. Legal spend data has become widely available from a variety of companies in manipulable formulations based on practice area, geography, matter type, phase and duration, staffing mix allocation, and timekeeper experience, hours and rates. By procuring current legal spend data, clients can level the playing field with law firms which have (but fail to effectively use) superior pricing data and matter management knowledge, resulting in more accurately priced AFAs consistent with today’s market rates.
3. Create Well Defined Tasks and Phases. Many legal matters handled by outside can be compartmentalized into discrete phases and tasks (e.g., litigation analysis and strategy, discovery, pre- trial motions, trial preparation, trial and so forth). The lines sometimes can become blurred, but experienced outside counsel can assist with the effort to create well defined tasks and phases for AFA purposes. When an AFA clearly and explicitly defines tasks and phases and attaches a cost to each, a client is better armed to make cost-effective strategic decisions on how or whether to proceed. Admittedly, it takes more time at the outset, but the certainty and predictability of a successful outcome, both strategically and economically, is dramatically enhanced.
4. Discuss “Release Valves” Up Front. No legal matter ever proceeds exactly as planned or expected at the outset. As a result, a client or outside counsel may experience economic, strategic, operational or time pressures. Outside counsel is masterful at creating caveats, limitations and exceptions to the scope of representation. If the pressures are not discussed at the outset of an AFA engagement and “release valves” are not implemented the address those pressures, the certainty and predictable expected in an AFA pricing structure can go for naught or, even worse, the alignment of interests can become misaligned to everyone’s detriment. These “release valves” can be in the form of accelerated, delayed or otherwise adjusted fee payments, pre-agreed expansion or contraction of the scope of work or disengagement arrangements. To be sure, every eventuality cannot be addressed, but handling reasonably foreseeable pressures upfront allows a client to avoid later discussions with outside counsel about caveats, limitations and exceptions to scope.
5. Carefully consider deadlines. When engaging outside counsel on an hourly basis, clients frequently set aggressive deadlines in order to drive efficiency and avoid the “work expands to fill the time” conundrum that inflates legal fees. When formulating AFA structures, clients should reconsider the approach of setting aggressive deadlines, particularly where an AFA utilizes a fixed fee or is unrelated to billable hours. Where less aggressive deadlines are set, clients stand to benefit from outside counsel’s natural inclination to be thorough, thoughtful and meticulous. Substantively better work product, advice and outcomes may follow at no additional cost. Of course, if business or strategic objectives dictate another approach to deadlines, those objectives should take precedence. Either way, deadlines should be given careful consideration when architecting AFA engagements.
6. Request and analyze a line item invoice. Typically, timekeepers at law firms are asked to record time on an AFA engagement as if it were an hourly fee schedule for their own internal purposes. Clients that have engaged outside counsel on an AFA basis should insist on reviewing the back-up line items entries entered by law firm timekeepers and not simply accept an invoice showing the AFA fee amount and a single line item invoice that says “For Services Rendered” or the like. By requesting and carefully reviewing and analyzing the back-up line item entries, clients will have greater visibility into how the matter was staffed and managed and gain a better understanding as to whether the AFA was a favorable or unfavorable economic arrangement. For the clients lacking the resources to scrutinize the underlying time entries, outside counsel cost management firms can effectively assist with that process.
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