Cotterman on Compensation: Billing Rates

Cotterman on Compensation:
Searching for Better Associate Bonuses

June 23rd, 2014 by Jim Cotterman

Pricing

Pricing should reflect a fair value to the client for the product/service/result provided and the market in which they are provided. Thus hourly rates vary by location, practice specialty, practitioner experience and work/issue sophistication. They are also sensitive to market factors. For example, insurance defense rates are less and slower to move for a given practitioner than rates charged for similar work paid by the client directly.

Hourly rates have long been augmented by alternatives such as contingent fees and fixed fees for certain practice/market specialties. And interest in moving beyond the hourly model is accelerating. Law firms are investing resources in more sophisticated tools to understand cost of services and in people to analyze and structure pricing options.

The key is finding a means to best address a client’s needs for predictability, cost reduction and risk sharing in its legal spending. How does the client define value and how can the firm better define the value it provides to the client? Conversations with clients are critical as needs, issues and priorities vary.

The Trouble with Billing Rates?

June 9th, 2014 by Jim Cotterman

The long historic ability of the legal profession to raise rates well in excess of inflation year over year has largely ended. Two factors combine to raise a practitioner’s hourly rate:

1) an elevator lift of all rates to reflect an overall increase in pricing structure (pre-recession averaging each year 4.5% and higher than inflation’s 3.2% and post-recession from a bit more than one-third to a bit less than one-half of that which was pretty close to inflation), and;

2) the up escalator increase reflecting an additional year of experience (2% to 5% for each additional year depending on where the practitioner is in their career).

Realization, a law firm’s ability to collect those rates and the opposing force against increases, has been on a long steady decline from 95% in 1985 to 82% recently. With pre-recession increases well in excess of inflation, the minor one-half of one percent annual decline in realization was largely ignored. However, now that rate increases are modest the decline in realization is more noticed. Increased price discounting at the front end and more aggressive push back from clients on bills on the back end reflect increased pressure for lower cost and better value.

Collected hourly rate increases fueled revenue growth on a per timekeeper basis. Thus making it possible for high year over year compensation increases. Concurrently, demand, at least as measured by average billable hours, is diminished. Result: Modest revenue per timekeeper growth and in some pockets real challenges at holding the status quo. The consequence is that unless overhead and the service delivery model are radically altered, there will be little room for the historic annual compensation increases.

Changing the Rules on Associate Compensation

June 26th, 2009 by Jim Cotterman

Maybe this time the profession is serious about associate pay changes. I’ve been a bit skeptical because the clamor for change is not new. What is new is the breadth of the realignment of pay scales and the corresponding announcements of apprenticeships (the boldest moves to address client resistance to hiring newly minted lawyers), training programs and other activities. All of these are positive steps.

However, associate compensation still appears out of line. The reductions announced so far are about half of what is probably required (i.e. going from $160,000 to $145,000 should probably go much further to $125,000 or even $100,000); thus, resetting the wage scale by a decade. This is a painful reality and one that surely will fire up emotions. But the tide has changed; clients are moving quickly and assertively to reduce legal spend. This goes beyond alternative fee arrangements (AFAs). Costs of outside legal bills are going to come down, and from the early signs — down dramatically. Services will be competitively bid, outsourced, offshored, converged, internalized, re-engineered, and even forgone. Now add the AFAs to create greater certainty regarding total cost along with a healthy measure of risk transfer from the client to the law firm. All of this will bring the major line item in any law firm — the cost of people — under assault. This will affect total employment, wage scales and job expectations. The pace of the salary change is directly affected by the pace of change in what clients will pay for legal services.

Once the scale is in line, what’s next? Pay packages are likely to be less generous on the upfront money (say goodbye to signing bonuses), with reduced salaries and more modest benefits. Bonuses, possibly semi-annually or quarterly, will ease some of the pain. But expect the eligibility performance thresholds to be rigorous. There is likely to be more emphasis on skills and competencies, particularly as they relate directly to delivering valued advice and counsel to clients. But do not for a minute think that those criteria will overshadow revenue generation. It’s where the money to pay associates comes from. There is also going to be a concerted effort at looking beyond what associates know and do to how they conduct themselves. All three (skills/competencies, revenue, behavior) will be expected.

To do this, firms will define what they want from an associate over many years, build metrics and methods to grade performance, and determine what that performance is worth. Hopefully this will set milestones for career progression and even multiple career paths. Time to rethink up or out, tiered ownership and the array of tactics deployed over the past twenty years. The trade-off for associates — lower remuneration hopefully mitigated by better career development and opportunity.

Calculating Internal Hourly Rates

March 22nd, 2011 by Jim Cotterman

Law firms have an increased interest in understanding internal rates as AFAs (alternative fee arrangements) take hold with clients. Understanding costs at a firm level is easy once you sort through the differences between cash and accrual accounting. The hard part is allocating costs to various sub-groups within the firm — such as individuals, classes or groups of individuals, matters, clients, offices and practice groups.

For those of you who are precision minded it is possible to devise a cost accounting system so detailed as to take any activity and assign it to multiple cost centers — each of the aforementioned sub-groups. The account numbering schematic for such a system would be quite complex as would the coding and verification tasks. We will forgo the obvious political challenges involved in selling such a system. So while such precision is a possibility, it is largely not a practical approach.

Simplification is preferable, although not altogether without its potential political challenges. And there are some, probably acceptable, higher risks for analysis error. But let’s use simplification at its best for this posting and reserve a more in-depth discussion for an upcoming article. We will use the following assumptions:

1. A single office law firm partnership with a collection of practices that are reasonably similar in their economic models.

2. Partners and associates use/share resources (offices, secretaries, technology and the like) without any significant distinction from group to group. This means that office sizes are very similar, secretarial sharing is equal across groups and that all timekeepers use a similar technology package.

3. Paralegal use/sharing of resources is about one-half that of lawyers. Thus each lawyer will be counted as one fee-earner and each paralegal will be counted as a one-half fee-earner. This convention is commonly found in most economic surveys of the profession.

4. Expenses include the net effect of cost advances and recoveries on the behalf of clients.

5. Compensation deductions from total expenses for determining firm overhead define compensation as salary, bonus, benefits and associated payroll taxes.

Accordingly, we can take the total expenses of the law firm and subtract the compensation costs of the associates and paralegals. The remaining expenses represent the overhead of the firm. Divide this remainder by the total full-time-equivalent (FTE) fee-earners to determine the overhead per fee-earner.

Once overhead is sorted out, we can turn to compensation. Here there are three assumptions for our posting.

1. We are looking for internal hourly rates for each group of individuals — partners, associates and paralegals — so average compensation for each group is used.

2. Compensation for development of internal hourly rates includes only salary, benefits and the associated payroll taxes. Including bonuses (with their associated benefit and payroll tax costs) is an option depending on your firm’s particular philosophy on bonuses.

3. A partner’s compensation consists of a fair exchange for his/her labor (the portion we need) and the profits earned on the work done by others. There may also be a return on capital component depending on whether interest is paid on partner capital or not. Again, for simplification, we will use the partners’ draw as a proxy for the fair exchange portion we are interested in for our purposes. There are other proxies that could be substituted, such as extending the lock-step associate pay scale into the partner ranks or using an outside reference point such as a senior in-house lawyer.

So we now have the total average cost of the group to include allocated overhead and compensation before bonuses. Divide the total average cost by the expected billable hours to obtain a preliminary internal hourly rate. Divide that rate by the expected realization factor for the group to obtain a required internal hourly rate.

Slower Billing Rate Increases May Limit Compensation Adjustments

December 10th, 2010 by Jim Cotterman

The 2010 NLJ Billing Rate Survey results indicate a 2.7% increase over 2009. This is a significant departure from pre-recession increases. But it is roughly consistent with inflation, which may offer some measure of solace.

In the past, rate increases alone were sufficient to largely fund increased compensation levels. Absent rate increases, lawyers will need to work harder (more billable hours), work more efficiently (better realization), and discount less (also better realization) to fund equivalent pay hikes. How likely are each of these?

Peak billable hours for lawyers occur during the 6th or 7th year of practice and exhibit a steady decline for the remainder of their careers (rate increases largely fuel the ever-rising revenue curve of a lawyer over a career). Add an aging lawyer population and the increased effort required to develop business to that hours profile and working harder is unlikely. It is also unlikely that associates can sustain a much more aggressive work routine. Many would argue that the job already has extreme hour expectations at all levels. And there needs to be sufficient additional work to absorb the additional billable hours.

Improving practice skills and methods is an ongoing process. Legal project management and more aggressive use of technology will aid in this area. Some experts have postulated that 15% greater efficiency is achievable. If you charge on an hourly basis this benefit inures to the client, unless you can raise rates. Alternative fees may offer the provider some means to retain some of that benefit without an obvious rate increase. Otherwise the full revenue loss from efficiency gains must come from more work volume.

How about fewer discounts? An argument can be made that increased efficiency should allow the provider to hold the line on discounts. But this is a market populated with aggressive clients eager to negotiate discounted rates.

To increase compensation, revenue must increase or costs must decrease. Revenue increases are going to be harder to obtain when the primary driver — rate increases — is constrained, and the remaining drivers are significantly more difficult to improve. My bet is on improved efficiency, greater use of AFAs and restructuring.

Cost reductions are also going to be harder to realize. During the recession firms cut everywhere they could. Much of what’s left to exploit will likely primarily benefit clients — the outsourcing of certain legal services.

The forecast for increased per timekeeper revenues is probably the bleakest it has been in some time. The easy adjustments have been made. In this environment, compensation expectations need to be equally muted. And the job of making compensation decisions will be equally more challenging. Or as one partner told me, “Playing Vegas is easier than making some of these decisions.”

AFAs and Tracking Time

February 17th, 2010 by Jim Cotterman

As much as we would like to set aside the disruptive recession, it is a factor that has accelerated change within the profession. One of those changes is the interest in alternative fee arrangements (AFAs), which are essentially pricing mechanisms other than hourly rates times billable hours. For some lawyers such arrangements have been the norm — fees calculated as percentages of a deal or a recovery and fixed fees to conduct a closing or prepare a document such as a will or tax return are examples. But for a much larger portion of the legal market, the hourly rate and billable hour dominate pricing, which feeds into reporting and remuneration schemes.

Most law practices have leveraged technology to simplify the task of recording time. At the extreme some law practices have had to elevate time recording to a detailed coding process similar to medical billing. In others, where hourly pricing is not the norm, the regimen of recording time is not followed as carefully. It is possible that only associates or paralegals keep time. Or that time is recorded in blocks by activity or client but not by individual task for each client/matter. In those instances, fees are allocated among the timekeepers who worked on the matter using a purchase of work system or other agreed upon fee credit system. If partners do not record time, but other timekeepers do, then fees are often allocated first to the other timekeepers as determined by their time value recorded to the matter. The balance of the fee is then allocated to the partner. There are many permutations possible, such as whether time is allocated at standard, actual or realized rates; or if premiums and write-downs are allocated on proportional time value, allocated solely to the billing partner or allocated to individual timekeepers.

Key here is that time recording is important, whether it is used in the billing or compensation systems or not. It serves as the primary method to look back and learn how efficiently time was used to deliver services to clients. It aids in understanding how long a task takes, possibly leading to better future pricing decisions or re-engineering of how the service is handled. And it permits a review of non-time-based allocation systems to ensure they reasonably and fairly reflect actual activity. Using AFAs to price legal work could, but should not, relax time recording.