Technology

The Profitability Trap

How a thriving business model might actually undermine your firm’s future.

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If you ask most law firm lawyers what they think of the billable hour, they’ll give you a response along the lines of that apocryphal Winston Churchill quote about democracy: it’s the worst system out there, except for all the others. You’d probably hear that the billable hour is the best of a bad set of options, a necessary evil. We don’t have to like it, but it’s the system we’ve got, and we do all right by it.

In-house counsel have a different opinion. A recent panel discussion of in-house legal leaders at the CLGO Global Institute highlighted once again the huge appetite legal departments have for alternative fee arrangements outside the billable hour system, a need that by and large remains unmet.

The debate around the billable hour has been raging for decades. Clients hate the budgetary unpredictability of billable hour matters and loathe how billables don’t reward efficiency. Yet firms have struggled to move away from the billable hour­­ — for understandable reasons. Billable hours are difficult to budget because the problems lawyers get hired to address are often tricky and unpredictable. If they weren’t, you wouldn’t need a lawyer. The billable hour ensures the trickiest problems get the care and attention they need.

There aren’t many industries where client needs go unmet for decades at a time, yet here we are. Law firms and their clients understand well the desire to move away from the billable hour, but anecdotally the shift to adopting alternative structures has been slow to nonexistent, depending on the area of practice. It seems as if it’s only in the past few years that broad-scale alternative fee structures have started making headway, and alternative fee arrangements still only account for a small percentage of most firms’ gross revenue. What is it that’s causing the future to take so long to arrive?

It’s Not That We Can’t …

If you’d asked me this question 10 years ago, I and many others would have likely thought of it as a complex problem paired with insufficient technology. Quantifying the intrinsic and extrinsic value of legal work can be a huge challenge. It’s easy enough to track time spent on tasks, and with a robust coding system we can analyze that time on a pretty granular level, but generalizing those findings into a mathematical model still required a huge amount of assumptions and difficult-to-reproduce value judgments. How many witnesses will be deposed? How much due diligence does a merger really require? All those highly contextual valuations can make developing general predictive models very, very hard.

Technology no longer seems like the obstacle it once was, though. Our industry has gotten better at developing metrics to analyze our work with, and our clients have gotten very good at pulling in pricing data from across their industry to better understand and predict their legal spend. As Rachel Barnett, chief legal officer of the IEX stock exchange, put it in the panel discussion linked above, “We know how much a trademark patent costs. We know how much it costs to draft a brief. We know how much the last 50 mergers cost, so certainly we can figure out how much the next 50 mergers are going to cost.” It remains easier to apply this learning to some areas of law than others, but our data sets and analysis tools have overall matured enough that modeling a client’s legal spend and building an alternative fee structure around it is no longer the daunting task it once was.

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Netflix And Bill

Yet despite having the capability of making those changes, the large law firms that have the tools to give their clients the alternative structures they crave haven’t fallen all over themselves to do so. I think part of the problem is more structural than we’ve previously recognized.

Think for a moment about how other industries approach unmet client needs. Back in 1997, entrepreneurs named Marc Randolph and Reed Hastings identified a public appetite for rented DVDs sent direct to our homes, as opposed to going down to Blockbuster to pick something up. They founded a company to meet that need, spent a number of years building their idea out, and today Netflix is as ubiquitous as any app with a market cap of over $200 billion.

Yet the funny thing about Netflix is that although it’s obviously a wild success story, it’s not yet been particularly profitable for a company its size. Netflix has historically burnt through cash like it was going out of style in pursuit of growth and shoring up its content library. The bet obviously has paid off, but it might easily have cratered. Most companies seeking to forge new paths understand that they’re going to spend some time in the wilderness, losing money, failing, iterating and pivoting, and generally trying to keep afloat long enough for the new idea to take off.

That sort of gamble makes sense for a 20-year-old coder with minimal debt and responsibility. It’s easy to take a few months or years making little-to-no money when the end result might be that you’re a billionaire. And if you fail, you’re basically just back where you started.

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It’s a lot harder to take that kind of gamble as an attorney. Younger attorneys fresh out of law school don’t often have the experience, connections, or client base to take a big swing on a new business model, especially with their school loan payments coming due. Yet once we’re established and secure enough in our careers to contemplate a drastically new direction, we’ve likely figured out how to make some good money under the existing system, and likely have families to support.

The Profitability Trap

In short, law firms have a profitability problem. From our summer internships to our retirement parties, law firm attorneys both can, and must, make a comfortable day-to-day living. At no point in the lifecycle of a law firm lawyer does it usually make financial sense to quit drawing a salary to try to experiment on a completely new business model. Our existing model works well enough, so we keep it in place, take home our profits, and hope the world doesn’t notice we’re falling farther and farther behind the times.

The structure of law firms further compounds this problem. It’s not hard to align a few founders of a new tech startup around living off ramen and popcorn for a few years given the possibility of decades of wealth on the other side. But law firm partnerships are far broader, and the partners are generally at differing stages of their careers. Why would a senior partner making huge money off the existing system, who plans to retire in the next few years, want to blow up their existing, highly profitable setup for the possibility of future benefits they’ll never see?

Where there has been forward movement on alternative and flat-fee structures, much of it has been spurred by Alternative Legal Service Providers like UnitedLex or Elevate, companies that exist in that more traditional business space where stomaching a few years of unprofitability is acceptable, and frankly expected. ALSPs are increasingly eating law firms’ lunches when it comes to these alternative fee structures, and will continue to do so if law firms don’t find a way to break out of their comfort zones and experiment.

Profitability is a critical goal for any business, but it can also be a gilded cage. Being profitable a decade from now will require us to make sacrifices today. There’s an all-you-can-eat buffet of clients out there for firms that are willing to move nimbly, experiment outside the billable hour structure, and reinvest their resources into developing the next great business model. Those that don’t may end up stuck eating the leftovers.

James Goodnow is the CEO and managing partner of NLJ 250 firm Fennemore Craig. At age 36, he became the youngest known chief executive of a large law firm in the U.S. He holds his JD from Harvard Law School and dual business management certificates from MIT. He’s currently attending the Cambridge University Judge Business School (U.K.), where he’s working toward a master’s degree in entrepreneurship. 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 Twitter (@JamesGoodnow) or by emailing him at James@JamesGoodnow.com.

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