We’ve said it before: Investing in people is critical for law firm growth. Lateral hiring, particularly for partners with established books of business, is a proven strategy for maintaining and increasing profitability, driven in large part by its impact on realization rates.
At last fall’s Decipher Talent Economics Roundtable, hosted by Baker McKenzie in Chicago, William Josten, Director of Pricing & Legal Project Management at Thomson Reuters, shared recent trends in law firm profitability and the critical issue of declining realization, including insights into why the problem rests more with law firms collecting increased rates rather than client pushback.
The RULES of Profitability
Why is realization the key issue driving profitability for most law firms? Pay attention to the rules. Bill referenced the RULES acronym for measuring profitability — first referenced in the 1988 book by Robert J. Arndt, “Identifying Profits (or Losses) in the Law Firm.”
- R: rates and realization
- U: utilization
- L: leverage
- E: expenses, and
- S: speed of billing
As Bill walked through each step, it became clear why realization is the sticking point. First we’ll cover the other four “rules”:
Utilization: Productivity is historically down over the past 15 years but has been mitigated by growth in headcount — lateral hiring — and rates. Hours billed don’t matter nearly as much as the money behind them.
Leverage: This model hasn’t changed much in 15 years, with associates building the bottom level of the pyramid under partners who are bringing in clients and work. Lateral hires fill gaps in the pyramid and bolster it. With the advent of generative AI, there has been talk of a “rocket ship” model with technology replacing first- and second-year associates, but that model really can’t take off without lateral movement. Wings of the pyramid are needed to develop talent who can replace outgoing partners. AI shouldn’t be viewed as a replacement for people — your utilization would drop even further if used in that manner. Instead, AI is a value-added feature that can be used as a lever to justify increased billing rates.
Expenses: Beyond talent, law firm expenses include rent, technology, and other operational costs. While firms have generally managed these expenses effectively, further cost-cutting measures are unlikely to significantly impact profitability. Even investments in new technologies, while essential, represent manageable, often phased, expenses.
Speed of billing: Speed alone won’t make your firm profitable, Bill says. If your firm bills clients quickly but isn’t paying attention to the underlying rates, productivity, and leverage, speed won’t help you. But if your firm doesn’t bill in a timely fashion, that will kill profitability.
So that brings us back to the start: Realization.
As we’ve seen above, traditional profitability levers have largely been exhausted, with rate increases playing a prominent role. Since the Great Financial Crisis, rates have been the primary driver of profitability. As Bill’s DTER data demonstrates, despite a 15-year decline in hours worked per lawyer, there hasn’t been a corresponding drop in profits because rates have continued to rise, even if just 1 percent above inflation.
But it’s not that rate increase that’s keeping profitability afloat, but rather the increase in rates relative to the collectability of those fees in each market. It’s one thing to bill that dollar amount, it’s everything to know that your firm has a high likelihood of collecting all or nearly all of it: Maximizing realization. That takes discipline.
Discipline is key
Outside of crisis situations, it’s challenging to create discipline in billing and collections. For example, Bill’s data shows a temporary improvement in billing speed in Q2 of 2020 as law firms became cash conscious because of the uncertainty created by the coronavirus pandemic. But once the effects of the pandemic subsided, billing practices reverted to previous patterns starting in Q1 of 2022. Because other factors of profitability are limited, a small drop in realization can significantly impact the bottom line.
As Bill noted, there’s often a disconnect between what clients will pay and what law firms assume they will accept. This is often driven by fear of client pushback, leading to preemptive discounts. This is where good data and a skilled firm operations team comes in. Asking your attorneys to directly address payment with clients is not easy. It’s challenging for lawyers to have a serious financial conversation where a personal, albeit business, relationship has been established. Many attorneys naturally prioritize the relationship, sometimes at the expense of optimal financial outcomes.
Operations teams can actively help their attorneys build discipline for these difficult financial conversations by providing data that demonstrates the market value of their expertise. By arming attorneys with the right data, operations teams can mitigate anxieties and improve realization rates.
How to learn more
Last year’s DTER concluded with a roundtable discussion that gave our attendees an inside look into real-world growth strategies in action. Kristina Gajewicz, Director of Recruitment at Baker McKenzie; Susan Hollender, Chief Growth Officer at Michael Best; and Angela Floessel, Global Director of Strategic Pricing and Project Management at Morrison Foerster, shared what they’ve learned in supporting lateral hires, team lift-outs, and firm mergers.
If you’re interested in discovering how data can power a sustainable future, join industry leaders at this year’s DTER, where you can explore innovative solutions and network with experts. Contact Decipher today to learn more.
