Originally published in ABA Law Practice Magazine

MANY LAW FIRMS WONDER HOW THEY CAN OFFER alternative fee arrangements (AFAs) to their clients and still maintain profitability. If you approach it properly, you can earn an even greater profit with AFAs, such as fixed-fee billing or hybrid billing options, than with conventional hourly billing. At the same time, you can increase your clients’ satisfaction levels and strengthen your long-term strategic partnerships. AFAs offer great potential for a win-win scenario.

Law firms have been providing AFAs for commodity personal legal services, such as residential conveyances and wills, for years. But that’s not the case for most business law and litigation work. Clients are asking for AFAs in these areas, but law firms aren’t rushing to offer them. This drives clients to look for options, and forward-thinking small firms are increasingly using AFAs to steal large clients away from big law firms.

In a climate where major clients are pushing for—and getting—discounts of 20 percent or more, the legal industry needs to adjust to current trends if it wants to survive and thrive. A New York State Bar Association report issued in April 2011 states that alternative billing will be the legal industry’s dominant form of billing in the future. It’s time to get on board with this concept.

GETTING STARTED

To succeed using AFAs, you need to present a unique value proposition. Unless you offer your clients something your competitors don’t, you’ll soon find yourself in a price war. That’s just a race to the bottom, as there’s always someone willing to charge less.

Start by asking your clients what they value most. Many law firms are afraid to ask this question, as they feel the value of their services is worth less than the price they’re charging. But asking about what they value most, as well as their strategic goals, adds value to your services by showing the client that you really want to be a strategic partner. Once you know your client’s goals, you can organize your legal services to best meet his or her long-term needs.

Another important way to add value is to put the client’s profits ahead of your own. Most law firms start their strategic planning by setting their own profit targets, instead of thinking how they can help their clients increase their profits. When you help your clients achieve their profit targets, they are happier and more likely to give you more work—which means your profits increase as well.

The Association of Corporate Counsel (ACC) offers some great tips for adding more value for clients in the document “51 Practical Ways for Law Firms to Add Value,” available on its website.

Ron Baker, a CPA who has written several books on the concept of value pricing and has thousands of loyal followers, has been using this concept in the accounting industry since the early 1980s. His ideas apply directly to the legal industry as well.

Baker proposes the formula “value = customer profit – price.” In other words, value is defined as the impact your legal work has on a client’s profit, less the price you charge for your services.

In his book Implementing Value Pricing, Baker propounds an eight-step plan for pricing a fixed-fee job up front. Baker’s concept of value pricing is very different from the value-billing concept most lawyers have understood for decades. For example, lawyers working on an hourly basis often try to charge a premium at the end of the file, based on extra “value” as they themselves perceive it. On a $30,000 file, if the lawyer recovers a significantly higher amount for the client than expected, he or she might try to charge a premium of 20 percent, or $6,000. The client might respond, “Why are you charging me a premium? Didn’t we have a contract for an hourly fee?” The lawyer then points out that the fine print of the engagement letter allows him or her to charge a premium on top of the hourly rate—a premium set at the lawyer’s discretion rather than the client’s perception of added value. At this point, the client often just says no, decides to use a different lawyer next time, or both.

Under Baker’s value-pricing system, you calculate the value and price up front, not at the end of the file, as is done under hourly billing. Discussing the premium parameters before you start work on the file ensures that there are no surprises for the client. Rather paradoxically, the client is often willing to pay a premium for certainty about the premium, thus boosting your returns on these AFA files.

Through similar means, pricing up front can also garner you a larger retainer. If you have scoped out the work properly and can give the client a solid idea of what the total legal fees will be, he or she will probably be much more willing to give you a retainer for at least half of the fixed fee up front. Under hourly billing, the client is more hesitant to pay a retainer up front, due to uncertainty. In short, you stand to get both a larger premium and a larger retainer simply by setting clear parameters.

So you need to negotiate both the value and the price of the legal work at the outset in a conversation with the client. Ask the client what he or she values most, and let the client’s perception of value—not yours—determine the price you charge for your legal services.

DETERMINING COST

Once you’ve set the price for your fixed-fee service, you need to determine the cost to do the job. You’ll need to budget costs to arrive at your desired profit margin. If you can’t keep your costs below your offered price, you should simply decide not to take the job right now.

Baker’s value pricing approach suggests that you should do your time sheets up front, not as you are doing the work. It’s true that this lets you determine your costs for pricing purposes in order to achieve your desired profit margin. However, I recommend that you still track time to understand the costs and profitability of previous files. Your time sheets provide important guidelines for costing out future jobs and thus ensuring that you price for optimal profitability.

Clients often try to use AFAs to get a discount on fees. Offering discounts, though, can oblige you to get pretty creative to compensate for the loss in profit. For instance, if you provide the client with a 10-percent price discount and your profit margin is 40 percent, you’re looking at a 25-percent cut in profit. A better alternative is to focus on building your value proposition to attract more premium work.

To keep overall costs to a minimum under alternative billing, you need to use leverage to your advantage by moving the work down to the lowest possible level of staffing. Smart firms are implementing project management techniques to increase effectiveness and efficiency.

Using AFAs may also oblige you to improve your fee-budgeting skills. Most lawyers aren’t very good at budgeting, as they’ve never had to do this under hourly billing. You should be prepared to do more work on this up front to meet your profit margin targets.

Clients want the AFA issue addressed now. So get ahead of the curve: Partner with them, instead of resisting them, and prepare for alternative billing. By providing more value to clients and increasing efficiency, you can offer a better service while increasing profitability. That is the ultimate goal.

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