Different Incentives for AFA’s – GC’s vs. Managing Partners

Recently Bruce MacEwan of Adam Smith, Esq. did a great post on his blog on the different incentives that General Counsels (GC’s) and Managing Partners have regarding Alternative Fee Agreements (AFA’s).  GC’s are accountable to their shareholders, while Managing Partners are accountable to their partners.  Bruce’s point was that GC’s are incented by their shareholders to reduce costs and push AFA’s, while managing partners are incented by their partners to run a profitable firm.  I’m paraphrasing a bit, but here’s the full post for your info.

So given the current difference in incentives for GC’s and Managing Partners, is there a way to reconcile the two points of view and come to some agreement for a mutual goal and appropriate incentives for both sides?

I think there is.  I would suggest as a start that law firms start reducing the emphasis on billable hours in their partnership compensation systems.  By doing so, this will encourage lawyers to focus more on the profitability of their practice, not on their own personal billable hours.  It will also incent them to lever more work down to associates and paralegals, or to outsource legal work where it makes sense.  These actions make good business sense whether an AFA is in place or not.  This will make your firm more profitable, produce high realization and reduce the overall cost of legal work.  Any resulting efficiencies from this approach which produce extra profits can be shared with your clients in the context of an AFA.

And there is much inefficiency in the way that law firms produce legal work now.  The fact is that partner compensation systems that incent partners to maximize their billable hours encourage “bloat” in the overall cost of legal work.  It also encourages firms to keep too many partners around billing at high rates.  It’s no wonder that clients are rebelling against this type of system.

Emphasis on partner hours billed has created law firms that are too top-heavy for their own good. Many firms have too many partners compared to associates and paralegals, and partners are “hoarding” work that should be levered down.  As a result, the cost of the legal services goes up due to higher chargeout rates on average.  The answer is that most firms could probably do with, say,  20% fewer partners (admittedly a number totally off the top of my head), and still handle the same work volume, but in a far more efficient way and at a lower overall cost for the client.  The tricky part is that law firms’ overall billings will go down, and partners have a vested interest to keep the compensation criteria as is to protect their own interests.   It won’t be easy, but forward-thinking firms are  addressing this issue now.  And if you don’t address this issue, these forward-thinking firms will steal your clients from you.

So the firm’s partner compensation system is the best place to start.  The smart firms that de-emphasize billable hours and focus instead on value, efficiency and reducing overall legal costs have the opportunity to take work from firms who are simply too lazy or greedy and won’t change unless they have to.

Admittedly, GC’s are incented to reduce the overall cost of legal services, so there is a conflict here with law firms’ incentive to grow the size of their practice.  But, if there is the potential to grow profits in a properly constructed AFA arrangement, then this should satisfy law firm partners who are rewarded for increasing profits for the firm and the client, not just the size of their practice.

And if the choice is to lose a good client playing big annual fees, even at a discounted rate, then partners should really get focused here.  As well,  by the time the client decides that it wants an alternative fee arrangement, it will probably have been approached by several other law  firms offering the same thing, and you’ll be yesterday’s news.

The Top 5 Things Law Firms Need To Do Now To Increase Profitability

Here’s some issues that are common amongst small and midsized law firms that should be addressed now to increase profitability.

1. Management

Too many firms try to run as democracies where partners have full say on which clients they work for and the type of work they do.  They’re not accountable for their actions and effectively act as solo practitioners.  This is a sure recipe for mediocrity and substandard profitability. You need to centralize management with a Managing Partner assigned the authority to screen all significant new clients for potential profitability, say no to high credit risks, and impact partner compensation to ensure all partners are accountable for their actions and performance.  The Managing Partner will also direct strategic planning and execute the Firm Plan.

2. People

You need the right people. Many firms have ill-defined partnership entry criteria and even less understanding of what it takes to remain a partner.  As a result, you end up with mediocre people and risk losing your best people to your competitors.  You need to have high-performing people to move the firm forward and achieve your firm goals and profitability targets.  Ensure your top performers are paid what they’re worth. Define partnership entry and retention criteria and enforce these criteria regularly.

3. Clients

You need to be constantly pruning your client base and upgrading your clients.  Studies show that  80% of your profits come from 20% of your clients.  You need to figure out who these high profit clients are and how to get more work from these clients. At the same time, you need to review and replace low profit clients with better opportunities.  Get a list of your top 50 clients and start reviewing them for profitability and ask them if they’re satisfied.  Do some client satisfaction interviews and you’ll generate more work from your most profitable clients simply by going through the interview process.

4. Vision

You need the “right” vision and a process for initiating strategic planning on an ongoing basis.  Start with a strategic planning process involving all partners and facilitate the creation of a new Vision and Firm Plan.  This will help direct your efforts in the most effective way and will help  increase profitability dramatically if you get all  partners to “buy in” to the new Vision.

5. Systems

You need to reward partners for cash in, not billings.  Many firms focus on volume without looking at the quality of the work being brought in and worked on.  You need to examine realization and profitability of all your clients.  To do that, you need a system to quickly determine profitability of clients and practice areas and services provided.  You also need to determine your cost per billable hour and create strategies to reduce costs and increase your profit margins.

Focus on Prevention, Not Collections

Many firms spend a lot of time trying to collect bad debts instead of preventing them in the first place.  You can change that with a good file opening system, with your Managing Partner approving all new clients and files over a certain size.

Why do this?  Because many law firms’ compensation systems reward partners for volume of billings or hours generated, not quality of billings or hours.  Even firms that reward partners for cash received instead of billings still have to deal with long delays in receiving cash for work billed.  The best way to avoid this is to deal with the problem right at file opening.

You need to give the Managing Partner the authority to say no when a new client presents a high credit risk.  The Managing Partner is not infallible so you also need to build a simple methodology up front to allow partners to take on new clients on  a short leash. This is especially important if they’ve taken on too many flyers in the past and the firm has worn the results.

A credit limit system is the other half of the prevention solution. Combined with a good file opening approval system, the credit limit system works just like Sears or Macy’s in approving your new credit card.  You get a credit check done for all new clients and assess the clients’ credit history.  You then set a total credit limit for the new client which includes total WIP and A/R.  The client is informed of the credit limit system in the initial engagement letter.  If the value of total WIP and A/R for the client goes over the set limit, lawyers cannot record any more time for the client and the client is told that work has stopped on their file until they have paid their outstanding bills.

Simple, right?  Okay, in practice it takes a bit more time to get all partners on board, but once they see the results, they toe the line gladly.  Especially when the reward is more money in their pocket.  If you can reduce the firm’s total investment in WIP and A/R from five months to four months using this system, you’ve just reduced each partner’s share of required capital by one month’s billings – a significant sum.  And that money stays in partners’ pockets as long as they keep the firm’s total investment in WIP and A/R down at four months.  So partners are incentivized to cooperate with the system and do what they can to help prevent future bad debts.  This naturally leads to a significant improvement in the quality of the firm’s clients over time. And that’s the real reward, since that leads to many more benefits for the firm and its partners in the long run.