Beyond the box: How to realign your firm's business model

Three things you will learn from this Masterclass:

1. The tensions in the standard business model in law firms

2. The impact of the ‘five forces’ on the legal industry

3. Five things you can do to realign your firm’s business model

 

Much ink has been spilt on the need for law firms to change their business models. Bill Henderson, a professor at the Maurer School of Law, has noted that Dewey’s collapse had less to do with individual moral failings than with aging organisational structures that have worked remarkably well for over a century, but now inhibit law firms’ ability to adapt to a changing legal marketplace.

The structures to which Henderson refers are well understood. It has been 21 years since Marc Galanter and Thomas Palay wrote their seminal book on the transformation of big law firms.¹ Tournament of Lawyers describes how law firms were able to grow from tiny partnerships into large firms by blending the talents and experience of older partners with those of enthusiastic ?young associates driven by a powerful incentive – the race to win the promotion-to-partner tournament.

Demand for high-quality legal advice, coupled with a finite number of firms that could deliver it through the intervening years, led to law firm PEP that partners in the 1970s and 1980s would not have anticipated in their wildest dreams.

Increasing demand for senior talent and the need to expand into new areas made mergers more common. Lateral hiring became essential to supplement homegrown talent. The need to maximise PEP in order to attract and retain senior talent led to tighter management of equity.

For associates, the prize of equity partnership became ever more distant. Talent retention needs at junior level drove associate salaries skywards, along with the billable hour targets required to justify those salaries.

The Tournament of Lawyers model is perfectly suited to hourly billing. As we all know, though, the billable hour model of pricing is under increasing pressure from clients concerned about cost versus value. Many alternative fee arrangements are thinly-disguised fixed fees that enforce limits on legal spend.

Efficiency was not prominent on the radar of law firms in the decade up to the global financial crisis, when increases in law firm profitability resulted exclusively from hourly billing rates rising faster than the rate of inflation.

Since then, the focus of most law firms on this topic has been intense. The scope for much more efficiency improvement within current business models may be running out, though. In that case, changes are required to the business model itself.

This is easier said than done, though. ?A lack of understanding exists about what law firms must actually do to reinvent ?their business models.

Indicators exist. Many of us are old enough to remember the 1990s, when the ‘big four’ accounting firms grew to be among the largest law firms in the world, and very successfully too.

Radically new business models like Axiom (which already employs over 1,000 lawyers worldwide) and a whole range of legal process outsourcing (LPO) firms have already made their mark today.

Newcomers to the market like The Co-op Legal Services, LegalZoom and Rocket Lawyer provide early indications of even more radical business models that are emerging.

In the UK, the Legal Services Act will no doubt spawn more experiments, some of which will probably fail, perhaps spectacularly, but others may thrive to the point that they displace Galanter and Palay’s model.

Large law firms especially have an enormous amount of inertia to overcome, even as clearer understanding emerges of what is needed. For now, many such firms seem to be taking comfort in the belief that changes will affect only the low-cost, high-volume legal services market and perhaps a few specialist niche firms.

In time, they believe, economic growth will return and so too will demand for sophisticated mainstream legal services – if not in western markets, then in new emerging markets. Clients will then again buy legal services on terms dictated largely by the law firms.

Are they right? A lot rides on the answer!

Impact of the five forces

At the core of all this lies an uncomfortable truth. The winds of change that have blown through other professions are now blowing hard through the legal sector. Its fundamental competitive dynamics ?have changed.

Every business school graduate student will be familiar with Michael Porter’s ‘five forces’ model that analyses the inherent attractiveness of an industry.² Some industries are more attractive than others. Given the choice, says Porter, it is better to establish or invest in a business in an industry that is more attractive than in one that is less so.

Used as Porter intended, his model can create a comparison of the competitive dynamics of the legal profession over two five-year periods a decade apart, namely 2002 to 2007 and 2012 to 2017.

Porter’s hypothesis is that the attractiveness of an industry lies in the relative strength of five forces that act on and within that industry, as follows:

1. Threat of new competition

2. Threat of substitute services

3. Bargaining power of clients

4. Bargaining power of suppliers

5. Intensity of competitive rivalry

Considering how each of these pressures has evolved since 2002-07 gives a perspective into how the business of ?law may evolve further in 2012-17.

 

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Figure 1: The five forces that define industry attractiveness

 

Note: Based on Michael Porter’s ‘five forces’ model

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1. Threat of new competition

This threat has increased significantly in the UK, especially since 2002-07. The Legal Services Act explicitly encourages the entry of new competitors to the market. At the low-cost, high-volume end of the spectrum, this has already manifested itself through intense competition on small legal providers and sole practitioners – the so-called high-street firms, from new competitors. Thousands are expected to go out of business.

At the upper end of the market, the statutory barrier has also been diluted since 2002-07. New competitors have also emerged. In-house legal departments have increased in prominence, becoming competitors in their own right.

Other kinds of legal service providers such as have already been noted, including LPOs and the big four accounting firms, may also significantly increase market share in 2012-17. In addition, globalisation is allowing law firms to reach into other jurisdictions, competing with firms already in those markets.

2. Threat of substitute services

While some say that LPOs and other radical business models like LegalZoom and Rocket Lawyer reside under this threat, that is not true to Porter’s intent. They are competitors, albeit emergent competitors with radically different business models.

Legal services themselves are not likely to be replaced by any completely new kind of jurisprudential construct. However, DIY law is becoming more prevalent and is reaching levels of sophistication that displace services which have traditionally been delivered by law firms.

Drawing an analogy from another profession, a recent article in ?The Economist describes how medical doctors are increasingly being bypassed ?in more routine issues, with the result ?that they are focusing more intently on complex, life-threatening situations.³ ?This reduces treatment costs overall, without sacrificing quality.

This competitive pressure in the legal industry is therefore probably similar in intensity today, as compared to 2002-07, but it would be dangerous to assume that it will not increase.

3. Bargaining power of clients

That this pressure has become significantly more intense since 2002-07 is well enough known and understood not to require further comment.

4. Bargaining power of suppliers

Law firms do not have suppliers in the same sense that many other industries do, but it has become commonplace to put the firm’s employees into this category, for the purposes of this model.

In 2002-07, the demand for talented lawyers at all levels and also for business services staff was high and supply low. Today, this has reversed at junior levels, where the pressure has eased. However, demand for lateral hires with good books of business has never been stronger. Overall, therefore, this pressure has remained constant or increased slightly.

5. Intensity of competitive rivalry

The pressures induced by the other four pressures and the state of western economies generally have increased the level of rivalry between law firms. This ?has manifested itself through cost-cutting, reductions to sometimes dangerously ?low levels of internal business services, delays of essential investment in systems and infrastructure (such as IT) and increased competition for lateral hires ?with books of business.

All of this has significantly reduced the attractiveness of the legal industry generally in 2012, as compared to 2002-05. Significant changes in the attractiveness or competitive dynamics of any industry are very commonly accompanied by an evolution of the business models employed by the most successful businesses in that industry.

What can law firms do, right away, to help ensure that they thrive in 2012-17?

Realigning business models?

1. Treat clients the same as investments

Clients, services and geographic markets are the three core building blocks of any law firm’s strategy. Law firm leaders must understand, with great clarity, what the drivers of competitiveness are for each.

• Which clients are the most valuable and so warrant the most attention to relationship building? Law firms usually determine this based on past performance, which is wrong. Value can only be assessed on the basis of the net present value (NPV) of profits (i.e. fees less costs) likely to be generated by that client over the foreseeable future. ?

• Given that NPV is inextricably linked to longevity of the commercial relationship, what would it take to sustain that? ?

• How can barriers to exit be deployed in ways that are comfortable to the client? ?

• What risks exist that could decrease fee flows or the profit that they yield? How can these be managed?

2. Optimise service delivery processes

Strategy should be firmwide, but tactics need to be developed at practice group level if the firm is to deliver services as profitably as possible.

A wide continuum exists across the services that law firms sell. At the one extreme are difficult, complex matters that cannot easily be disaggregated and where experienced, skilled senior talent and low leverage are key.

At the other extreme are more repetitive matters, where leveraging the firm’s know-how, more junior lawyers, paralegals and perhaps also technology ?is the source of competitive advantage ?and profit.

It is ludicrous to try to manage both extremes and all in-between against a common set of practices and metrics. Yet, surprisingly, sophisticated law firms continue to try to do so.

It is equally ludicrous to measure partner contribution on the basis on top-line fee revenues rather than bottom-line profitability, when such diversity of service delivery models exists. Yet, again, many law firms do just that.

As pressures intensify over the next five years, the firms that thrive will be those that pay more attention to understanding and reconciling these tensions.

3. Rethink sourcing, with a long-term view

Well-managed law firms are becoming increasingly sophisticated in the way in which they source both business services and the practice.

LPO providers suggest that the solution is easy. Simply disaggregate the processes involved and outsource the less valuable components to them. Unease exists, however, about LPOs becoming more prominent legal service providers in their own right and the competitive threat that they may pose in future.

Some firms are experimenting with business models where this kind of work is done within the firm, through less expensive employees. If LPOs can deliver such services profitably, the argument goes, then so too can law firms.

Understanding the costs and best practices of delivering a service across ?the whole value chain from pre-instruction to paid invoices is clearly a key issue ?in 2012-17.

4. Keep the radar switched on

If fundamental new business models emerge that displace the Tournament of Lawyers model, then they will probably do so slowly. They may even be out there already, hidden in plain sight.

Law firms that pick these up the quickest will be those that are attuned to what competitors are doing – especially those with radically different business models. They will also be watching trends in other kinds of businesses that may be relevant. They will be thinking openly and objectively about how emerging new ideas might impact upon their businesses.

They will be cautiously experimental in their own approach to trying out new ideas within the firm, seeking deep and candid feedback internally and from clients. Where possible, such experiments will directly involve clients.

5. Open channels of communication

Change is most effectively achieved through open communication, the leveraging of diverse perspectives and ongoing feedback. The firms that will prosper in 2012-17 know this and have formal systems and structures that encourage and facilitate the sharing of information across the firm. This is also easier said than done.

The Tournament of Lawyers model emphasises individual contribution, which is why silos can be so persistent even in law firms with lockstep partner compensation.

Lateral hiring exacerbates this ?because lawyers hired in from other ?firms frequently continue to keep one ?eye on the exit and want their books of business to remain portable. If channels ?of communication are not hardwired into the fabric of the firm, then they tend not ?to deliver the results required.

Taking action

Law firms are not hamstrung by vast investments in machinery or other ?capital equipment. It should therefore ?be easier for them to change direction ?than for businesses where change ?needs to be accompanied by high ?capital expenditure.

Where this is not the case, it is usually less to do with the difficulty of the transformation than the people factor. Much scope exists for firms with acuity ?and agility to improve their market positions and performance, even in ?today’s moribund markets.

The first step, though, is to move beyond mere tweaking and cost ?cutting. It is to develop a deep understanding of the trends that are underway and what needs to be done at the most fundamental, practical level to capitalise upon them.

rob.millard@cambridgestrategygroup.net

Endnotes

1. See Tournament of Lawyers: The Transformation of the Big Law Firm, Marc Galanter and Thomas Palay, University of Chicago Press, 1994

2. See Competitive Advantage: Creating and Sustaining Superior Performance, Michael E. Porter, Free Press, 1998

3. See ‘Squeezing out the doctor’, The Economist, 2 June 2012