Future Firm: How to set prices under a fixed fee model
With the inevitable demise of the billable hour, law firms must start determining viable fixed fee policies that are more than just a marketing gimmick, write Jeffrey Carr, Edwin B. Reeser, Patrick Lamb and Patrick J. McKenna
Fixed fees obviously provide the budget certainty sought by most clients.
One of the most oft-heard criticisms of fixed fees, however, is that lawyers have an incentive to push work down to lower-priced attorneys and to stop working when the maximum fee is reached. The best way to address this concern is to require outside counsel to have ‘skin in the game' - that is, to make a certain percentage of the fee dependent on the result obtained.
This approach is commonly referred to as a holdback model, and typically requires a minimum of 20 per cent of the fee to be placed into a ‘holdback bucket'. Depending on the result obtained, anywhere from none of the bucket to a predetermined multiple of the holdback amount is paid when the result is obtained.
The bucket amount is a compelling incentive for counsel to have the work performed by the best, experienced talent rather than downstreaming work to inexperienced lawyers.
Perhaps the most oft-asked question is how to determine the appropriate amount of fee. The easiest way to determine a fixed fee is to mine historic data and use historic averages for similar cases as a starting point. For this fee structure to yield savings, historic data must be the starting point from which reductions are negotiated. Not modest reductions, but material ones - on the order of 20 per cent to 30 per cent.
How can these reductions be justified? First, the historic numbers have the law firms' profit included. In cases where hourly rates were paid, those rates had the firm's profit built in, and the firm did not take on any financial risk. The second reason for downward movement off historic averages is that the fixed fee structure should cause the firm to behave differently. Firms billing by the hour tend to do more work than is necessary because the billing model motivates that behaviour.
Firms applying the fixed fee with results incentive do what is necessary, but eschew all unnecessary work as it eats into their profit margin. Firms also work harder to settle cases earlier within the targeted range in order to reduce transaction costs, thus increasing profit margin. With these behaviours fully incentivised, one would expect transaction costs to be lower than historic averages.
What to watch out for
In the absence of enough data, there is some uncertainty about how to set a fixed fee. In this situation, many firms resort to the approach used to budget a case: figure out the tasks to be done, how many hours those tasks will take and who will perform them, multiply hours by the relevant hourly fee and then add the results.
Many firms add a cushion, either in terms of the number of hours or simply by adding some percentage to the preliminary total. That number becomes the firm's proposed fee.
The problem with this approach to determining the amount of the fixed fee is that it locks in the firm's profit, sort of a ‘heads-I-win-tails-I-win' approach that is an utter anathema to real fixed fee protagonists. If the client's sole goal is budget certainty, this approach suffices. But if costs savings, better results and risk-sharing are objectives, this approach reveals the proponent to be nothing short of a bad pretender. For this reason, it is essential that any potential buyer ask its firm how the firm calculated its proposed fee.
Here are some other hints. Do not include the cost of trial in the fixed fee proposal. Ninety-five per cent of all cases settle. A trial component only drives up the total the client will have to pay. If you are uncertain as to the real value of the case, structure the fee into subparts so you do not have to pay additional pieces if the case settles early. Ask for references. Firms that are committed to fixed fees and use them to save their clients money should have a large supply of cheerleaders who will proclaim great economic results.
Finally, look for project management details. A firm that does not excel at project management cannot maximise its profit margin. The absence of such skills is a tell.
Model, model, model
In real estate, it is location, location, location. The alternative fee version is model, model, model. A law firm's business model will determine whether a fixed fee proposal is bona fide or a marketing gimmick.
Fixed fees place a premium on senior, experienced lawyers. Experienced lawyers are much more efficient and capable of differentiating work that is critical to the outcome and work that is not.
In a traditional law firm, power flows to ‘rainmakers', the lawyers who generate revenue. There is little concern about profitability, because hourly rates have the firm's profit built into them and realisation rates show how much profit the firm is retaining. As a result, the firm's rainmakers are motivated to extract more from their clients' wallets. At the same time, associates are indoctrinated with the need to meet billable hour targets, that good enough is not acceptable and that more hours in the pursuit of perfection, even on simple, routine issues or matters, is excellent lawyering and not only justifiable but essential to making partner.
These days, the message to associates is even starker: meet your billable targets or lose your job. Over time, these institutional and cultural messages have become integral components of most firms' DNA. A firm that does not aggressively seek to alter this institutional DNA will find it impossible to embrace the model on which effective alternative fees are based - experienced people doing those things necessary to a successful outcome, but nothing more, looking for ways to reduce time on a matter, not increase it. A firm cannot have partners seeking to advance and accumulate power based on the revenue billed scorecard while another group is focused on profit margins and cost control.
This schizophrenia is no healthier in law firms than it is in humans. The hallmarks of firms that have made the kind of client-focused commitment to alternative fees that will pay off for the client are those that have dramatically altered their leverage, focusing on experience and production instead of body count. In these firms, senior associates and young partners are the foundation on which a team is built because they are starting to have the experience needed to provide value.
The benchmark firm will not be bringing in legions of rookies and then suffering through turnover at double-digit figures. The firm will invest heavily in the training of its people because it will be relying on them to produce results quicker and thus improve the firm's profit margins. The lawyers in the firm will have extraordinary insight into the firm's cost structure, because no one's costs is critical to being able to determine one's profit margins. These firms will be relentlessly focused on lowering costs and streamlining work and work processes because these things also will add to the bottom line. The differences are ones business people know well as the difference between a business that must continuously become more efficient and those that engage in cost-plus billing, which do not face the same pressure.
Conclusion
The relationship between business and its lawyers is on the cusp of tectonic change. That this chance will come is certain. As is true in a period of great change, some will take advantage of the situation to improve themselves and better position themselves for the future.
Others will simply seek to take advantage of the situation for more immediate gain. Still others will hope that the inevitable change is not inevitable at all - or at least can be put off to another day (when they are no longer so personally affected).
The challenge to business is to align with those firms which are using the current environment to remake themselves into a business based on a model that aligns the firm's interest with that of its clients and not be victimised by firms looking to extract the last dollar from the old model.
This article first appeared as part of a series in The Los Angeles Daily Journal in September and October this year. The second part of the story will appear in the January 2010 issue of the Australasian Law Management Journal. The articles are reprinted with the permission of the four authors: Jeffrey Carr, vice-president, general counsel and secretary of FMC Technologies Inc; Edwin B. Reeser, a business lawyer in Pasadena specialising in structuring, negotiating and documenting complex real estate and business transactions; Patrick Lamb, founding member of Valorem Law Group, a firm that represents businesses in disputes using non-hourly billing arrangements; and Patrick J. McKenna, who works with the top management of premiere law firms to discuss, challenge and escalate their thinking on how to effectively manage and compete.
