Are Law Firms Ready For Rate Deflation?

After hitting 5% in July of 2008, inflation has dropped rapidly and is now in negative territory (annualized) for the first time in 54 years.  This creates tremendous spending opportunities but there are many risks.  One of the risks to law firms is a deflating billable rate.  With deflation hitting most aspects of the economy (food and energy being notable exceptions that at least in the latter case isn’t expected to deflate for a while and in fact may be the next credit “bubble” if, err, I mean when cap and trade is passed), it is only a matter of time when clients will either request more discounts or a reduced rate – and if clients don’t ask, other attorneys will offer lower rates to lure new clientele.  Many businesses will be working from much tighter margins while the cost of doing business, including defending lawsuits, won’t lower with their margins.  Something will have to give – either longer A/R outstanding or reduced rates.

It may not come.  But there is reason to believe it will.  Attorneys from large law firms who have been laid off are finding themselves entering the mid-firm market and some enterprising ones will start their own firms, determine a model that maximizes profit, and “Wal-Mart” some out of business while still raking in incredible profits.  All it takes is better efficiency in serving clients (and, in my view, an unprofessional but very business-like approach to targeting and accepting clients).  The relationship you have with your clients puts you at an advantage right now.  However, in forecasting models you should prepare for a fight for your business based on  rate.    

If you are faced with reducing rates to keep clients, efficiency is key to making up the lost revenue.    Don’t rely on volume alone as it can fool you into thinking you are in a better financial position than you are.  You may end up hiring excessive numbers of attorneys, especially as the costs of attorneys goes down (another inevitability that is already happening – salary reduction for new associates).  If you are still making minimal margins because you are too busy to implement efficient processes and you get undercut by someone willing to lower their rates, your firm will be in for a rather intense correction.

Even assuming rates don’t increase, there is a high probability that any planned rate increases will be difficult to implement.  Firms have been contracting for several months and most have already cut costs as low as they can.  A reduction in rate is an unplanned occurrence that can place even more pressure on firms to reduce costs.

From the firms I have consulted, most are still unwilling to invest in efficiency – rather, they are placing more emphasis on productivity and staff reductions.  There are a few firms who are changing their model to streamline processes – those who invest in better procedures will not only be in a better position to absorb rate stagnation (or deflation) but will be in a better position to increase profitability later this year when the economic numbers start to improve.  The test will be whether they retain earnings, a concept that is anathema to many firms.

Please note that due to the activism of the Federal Government to re-inflate the credit markets, there are arguably two possible results:  massive inflation or another asset bubble (which will lead to a result similar to what we are experiencing now).  Either way, the pattern of erratic markets is not likely to end anytime soon and with trillions being poured into the economy, money may get loose for a while – smart firms will invest in their firms (take advantage of the deflation) and set aside sufficient amounts to take short hits on revenue rather than make distributions (in case of a rapid spike in inflation or another asset bubble).  We are in for a long period of uncertainty.  Universal health care, carbon emission taxes, and of course the obvious tax increases to pay for the action taken already and to sustain the new entitlements.

Law firms will not be needed less (and in fact in some areas they will be needed more) but they are not immune to shifts to the economy.  There will be areas of rate inflation but your firm may not be one of the beneficiaries.  Some areas of law that have flourished for decades will suffer greatly and some boutique firms will cease to exist entirely.

Prepare for it.  If your firm flourishes and all the doom and gloom above doesn’t come to fruition, great.  Your bottom line thanks me for helping you have such a strong equitable position during your time of saving – go buy a new touch screen whiteboard or make a distribution so you can pay for all those projects at home.  If the firm struggles, however, you may avoid having to make decisions that are not only uncomfortable but can lead to a fracturing of the firm.

False Sense Of Security Still Prevalent Among Law Firms

In spite of overwhelming evidence that the booming economy enjoyed practically uninterrupted for the past 20 years has ended, at least for the near term, many law firms are still optimistic of their 2009 prospects.  I beg to differ.  I believe 2009 will start a strong shift in the make-up of many law firms due to the lack of any planning for the economic conditions.

Who can blame attorneys for being optimistic?  Regardless of the economy since at least the early 1980′s, lawyers have enjoyed consistently increased business and profits.  This has led to a complacency and a denial of the economic conditions that are facing the country.

Law firms aren’t alone.  In fact, the “big three” auto makers (Ford perhaps excepted) are acting out of a similar denial as they attempt to scare Congress and the President into paying for their internal problems.  Who didn’t see the failure of GM coming?  Was no one noticing the extravagant pensions being offered to the employees?  Did anyone who dared notice believe the ever slimming margins would cover the ever growing benefits?   Not likely.  As the Legislative and Executive branches delve deeper into the phantom pockets of our tax base, a  nice summary of the fallacy of “avoiding acting like Herbert Hoover” has been inked in an opinion piece by Todd J. Zywicki in the Wall Street Journal.

Law firms, though not nearly in the long-term slide as the domestic auto industry, is more sensitive to this economic downturn than many attorneys would like to admit.  Many firms have been spoiled by margins that exceed 50% without spending more than a passing glance at the indicators that led them to such bounty.  The issue isn’t so much a drop-off in business, though some firms who specialize in areas that are in the midst of collapse will certainly feel the pain.  Rather, the issue is how firms will retain good talent, retain their expected incomes and avoid layoffs of associates.

These are regular issues for most industries but are foreign to the mid-size law firm.  Many firms pride themselves in their “family” atmosphere, which includes the bratty sibling rivalries that are tolerated when times are good.  Salary incongruousness may seem a bothersome itch when profits are high, but once the deadwood becomes heavy the scratching becomes intolerable.  Some may panic to find their balance sheet showing a loss without ever seeing it coming.  Drastic change is put into place – at a time no worse to prepare.  No more is it wise to visit a market when hungry than to suggest change while in the midst of a spiral.

Yet our economy has afforded all of us time to prepare.  It was suggested by many (myself included as far back as March) that our economy was in for some hard times.  Firms with the foresight and gumption to plan and hold timekeepers accountable for providing not only quality service to their clients but ensuring prompt billing and payment for the betterment of the long term financial health of the firm are in a position now to profit over the firms who were complacent.

It’s not too late, however.  Many firms are just now seeing the first bumps in the road.  It is my opinion that the economic downturn is just now really beginning to hit middle America.  The massive layoffs (over 533,000 in November) are an indicator that the many months of body blows caused by the collapse of the credit and housing markets (not so unlike what happened in the late 1920′s, speaking of Herbert Hoover) are finally taking its toll.  The question now is, where is the bottom?

No one knows.  That is a troubling concern that should make you want to hug every dollar your firm receives and not let go of it.  In times such as these, power goes to those who hold cash.  This may change if our government attempts to over-spend its way out of our economic downturn (thereby devaluing the dollar, leading possibly to hyperinflation combined with stagnant productivity – a prescription for the “d” word), but as of right now, many believe that the economy should rebound sometime in 2010.

In my opinion, firms need to pay more attention to the profitability of each fee earner and place more emphasis on marketing activities and their key profit drivers.  Please feel free to email me (by clicking here) if you would like some ideas on how to not only retain your current income, but increase profits during an economic downturn.

Simplifying the Law Firm Business Model

The law firm business model, as defined by David Maister, is made up of the following equation:

1. Leverage
2. Rate
3. Productivity (Utilization)
4. Realization
5. Margin

If you are not tracking these profit drivers, it doesn’t matter how many reports you are thumbing through – they won’t measure the keys to per-partner profits and are thus, as far as profitability is concerned, irrelevant. The good news is that it doesn’t take much to track these drivers.  You can derive a simplified financial statement by just plugging in your numbers.  The below graph shows how tracking these key indicators can help you see exactly what drives your firm’s profits.  To download and plug in your own numbers, click on the graph.

 

I will be going over each of the drivers in more detail over the next several weeks.