All signs are pointing to trying times ahead in the legal profession. Anyone paying even the least attention to macroeconomic news knows that 2022 has been a difficult year. The S&P is down over 20% year-to-date, inflation remains rampant, gas prices continue to remain high, and overall consumer moods continue to remain sour. The Federal Reserve’s historically aggressive interest rate increases are as much a sign of the difficulties ahead as they are hopefully a contribution to their eventual end.
The headwinds on the larger economy appear to be felt in the legal industry as well. Global M&A activity has dipped by around 34% year-over-year, including a major drop in activity in Q3 as compared to Q1 and Q2. This overall decline in activity could easily be seen as a leading indicator of an economy battening down the hatches overall, but it also signals a significant drop in work to be done by the firms who service those deals.
And those firms appear to have taken notice. The hiring frenzy of 2021, where associates and laterals were in such demand that they could attract massive salary, bonus, and perk offers, appears to be at an end. Demand and supply have evened out, or in some cases potentially inverted, meaning firms that were previously desperately struggling to keep their matters staffed are now faced with potentially idle timekeepers.
Hopefully, your firm has been planning for a potential downturn for some time, if it hasn’t, it needs to start today. And there’s no better way to start planning for the future than going back to the basics: how does a law firm actually make its money?
The RULES Of The Game
Luckily, we’ve had a good answer to that question for about three and a half decades. Robert Arndt created the RULES model of law firm economics back in 1988, and it has remained a valid, useful model for analyzing your own law firm’s performance ever since. In fact, with the software analytics and measurables available to firms of all sizes today, it’s easier to analyze the RULES than it’s ever been before.
RULES stands for Rates/Realization, Utilization, Leverage, Expenses, and Speed of Collections. By taking a hard look at each of these metrics in turn, law firms can understand where their revenue is coming from, where their expense items are flowing to, and how the firm’s structure helps (or hinders) its success.
Rates/Realization. Rates may be one of the trickiest challenges firms face in the coming year. Firms have been aggressively increasing their rates the past few years on the backs of intense client demand for services. Demand is flagging, but inflation is putting the pressure on to keep rates going up, leading to a complicated balancing act. Firms that don’t raise their rates enough risk pinching profit as costs increase, while those that increase too much risk alienating their client base at a time when clients have significant leverage to take their business elsewhere.
So, what do you do if your firm doesn’t have a pricing specialist to dive into price elasticity in your markets? The solution for many, I expect, will be to keep rack rates increasing, but negotiating discounts as appropriate. But firms engaging in that strategy need to carefully monitor the other half of the R, realization. Your sticker price might be $2,000 an hour if you’re a coastal attorney at a top tier firm. But that rack rate doesn’t mean anything to the bottom line if it’s not what your clients are actually paying. Firm leaders need to focus on realization, how much an attorney’s work is actually translating into dollars and cents. To really understand if you’re capturing value, you need to examine what you get after baking in unrecorded time, discounts, pre- and post-billing write-offs and write-downs, and collections issues.
Utilization. You can’t understand whether your firm is appropriately staffed if you don’t understand how your people are using their time. In an economically ideal world, timekeepers are utilizing every hour of their workday to bill clients who will happily pay a full, undiscounted rate, and they’re being supported in that effort by the absolute minimum number of nontimekeeping staff as possible. If there’s a firm that has achieved this goal, even for a week, I’ve yet to hear of it.
The real world is messy, full of necessary-but-unprofitable things like meetings, nonchargeable legal work, sick days and leave, onboarding new members, marketing and client development, and myriad other items that take up people’s time without directly putting dollars back in the firm’s coffers. Even billable time isn’t all equal, as some clients pay different rates, and others struggle with timely payment. Firms need to measure and understand where their people’s time is going, what it’s contributing to overall firm goals, and how it might be better spent.
Headcount is also an unfortunate component of the utilization analysis, and one that many firms are going to have to take a hard look at in the coming months. New hiring requests should be strictly scrutinized even in the best of times. If the work that needs to be done could be performed by someone already within the firm, figure that out before committing to bringing a new body aboard.
Leverage. The basic economic model of most law firms is leverage: partners bill out the work of nonpartner timekeepers (generally associates and paralegals), and the partners make a margin on that work after paying their nonpartners. The more nonpartners generating profit for the partnership, the more highly leveraged the firm is said to be.
Understanding your firm’s leverage strategy is essential to making high-level strategy decisions. Most firms would agree that increasing leverage is generally a good thing for the partnership, because it puts more cash in the partnership’s pockets. But as in all things there’s a balance to be struck. Bringing in legions of associates who aren’t utilized helps nobody. Similarly, having a culture where associates routinely bill 3,000 hours per year may be great for driving up short-term margins but terrible for retention, culture, and longer-term profitability. Understand how you’re leveraged, then make a plan to increase it in smart ways.
Expenses. I’ve spoken about the importance of corralling expenses at length in this column before, so I’ll try not to repeat myself here. Suffice to say, it’s a lot harder to cut expenses than it is to simply not take on bad expense items in the first place. As we’re heading into turbulent economic times, firms should be aggressive about finding ways to lower their spending, and appropriately skeptical about requests to take on new spending. You can’t make money without spending money, but you absolutely can spend money without making it.
Speed of Collections. Imagine you’re a client, and you have two law firms’ bills sitting on your desk. One is for work performed in the past 45 days, and it’s from a firm that sends your bill promptly the same time every month and diligently checks up on the status of unpaid invoices. The other is for work performed several months ago that the firm only now got around to billing you for, and if it goes unpaid you probably won’t hear anything for another few months. If you could only afford to pay one of these bills off, dear reader, which are you more likely to pay?
Diligent billing practices beget stronger collections, and stronger collections mean more revenue and profit for your firm. Firms need to pay attention to getting time recorded, bills out the door, and invoices followed up on, especially as we head into uncertain economic times that may force our clients into tougher payment decisions. Projecting diligence is good for business generation, and it’s good for getting payments in the door. If you’ve got a weak link in your collections process, it needs to be identified and corrected ASAP.
Law Firm, Know Thyself
The better we understand how our firms function, the better we’re able to shore up weaknesses, emphasize strengths, and plan strategically. Of course, knowledge is nothing without action. Once a firm’s management team has identified what needs to be done to survive and thrive, proactive communication of those findings and strategies to the partnership is essential.
If you want to rally the troops, align your teams’ vision, and start honing your firm into the profit-generating machine you know it can be, it’s not all that hard. It’s simply a matter of following the RULES.
James Goodnow is the CEO and managing partner of NLJ 250 firm Fennemore. At age 36, he became the youngest known chief executive of a large law firm in the U.S. He earned his JD at Harvard Law School and attended Cambridge Business School (UK), where he wrote his master’s thesis on how to use entrepreneurial strategies to infuse innovation in law firms and established businesses. James is the co-author of Motivating Millennials, which hit number one on Amazon in the business management new release category. You can connect with James on LinkedIn, Twitter, or by emailing him at firstname.lastname@example.org.