February 26, 2007

LAWBALL

I never saw an ugly thing in my life: for let the form of an object be what it may - light, shade, and perspective will always make it beautiful.

- John Constable (1776 - 1837)

Much in life is a matter of perspective, not just beauty.  Two people can look at the same set of facts and reach different conclusions simply because they have different perspectives.  Stephen Covey described this phenomenon as:

We see the world, not as it is, but as we are – or, as we are conditioned to see it. . . [C]learheaded people see things differently, each looking through the unique lens of experience.

Sometimes it helps to bring a different perspective to something in order to understand it better and to benefit from the mistakes of those who don’t.  In Moneyball, Michael Lewis wrote about a different perspective that has been brought to baseball.  Lewis said that he began his writing with a simple observation:  “Some baseball executives seemed to be much better than others at getting wins out of dollars.” When he finished the book (one about baseball and business that I highly recommend), he had captured how the Oakland A’s in a manner more akin to exploiting inefficiencies in financial markets had set about looking for inefficiencies in baseball and, by using a form of systematic scientific investigation to separate data from perception that was based on long-held individual images and beliefs, developed both a different way to value baseball talent and different metrics or key performance indicators for baseball.  These new metrics took advantage of what behavioral finance scholars have noted in the cognitive psychology part of their discipline – people make errors in the way they think and make decisions.  The A’s found that, just like financial investors, baseball talent investors generalized wildly from their own experience playing the game, were overly influenced by the most recent performance by a player, and were biased toward what they’d seen (or thought they’d seen) with their own eyes.

Recently (Metrics!  We Don’t Need No Stickin’ Metrics and Metrics! We Don’t Need No Stickin’ Metrics (Part II)) having bombarded the readers of this blog with a series of financial metrics for the business of practicing law, which I readily admit can be a powerful and sure-fire cure for insomnia, I thought it might be helpful to look at these legal industry metrics from a different perspective.  This different perspective is not one based on academic research or study – it’s just one based on an analogy that hopefully will make the metrics and their importance simpler to understand. 

Think of the business of practicing law as being the game of football – LawBall, if you will.  Like football, LawBall is competitive.  And, like football, there is a final result – in LawBall, it’s profit per partner (the functional equivalent to return on equity or ROE).  Just as a football team’s strategy must be in sync with its assets (its players) and what it does best in order to be successful – for example, be a running or a passing team on offense of play a 3-4 or a 4-3 on defense – LawBall requires that, in order for a “team” (or law firm) be able to achieve its best final result, its assets (lawyers) and what it knows and what it does must be configured in support of its strategy.   Finally, as football has 3 major team components that must be managed and executed well in order to win – offense, defense, and special teams – so does LawBall.  LawBall’s 3 major components are asset turnover (think offense), profit margin (think defense), and financial leverage (think special teams).

When one looks at what it expects from a football team’s offense, it expects it to score as many points as possible (think the 2006 San Diego Chargers or the Indianapolis Colts almost any year with Peyton Manning).  With a law firm, the expectations should be the same – the highest asset turnover (revenues per lawyer) possible.  When one looks at what it expects from a football team’s defense, it expects it to hold the opponent to a few points as possible, thus preserving as many of the points its offense scored and creating as big a margin of victory as possible.  Law firms should expect the same from its “defense” – profit margin – the firm should seek to keep its costs per lawyer as low as possible, thus creating the highest profit margin possible.  Most times in football, when your offense and defense combined are better than the competition, you should win; and, if the teams are relatively equal in those 2 areas, special teams can make the difference (think the New England Patriots when they had kicker Adam Vinatieri).  The same holds true with LawBall – remember, profit margin x asset turnover = return on assets (or ROA), and ROA is a good measure of the efficiency with which a business allocates its resources – but if the competition in LawBall as measured by ROA is tight, financial leverage can be the winning difference for ROE (ROE = profit margin x asset turnover x financial leverage).

Let’s take another look at what happened with Firm B by comparison to Firm A in the prior postings through the eyes of LawBall.  First, Firm A’s 2005 offense (asset turnover of $790,698) was much more explosive than Firm B’s ($518,116 asset turnover), despite the fact that the 9-year compounded annual growth rate (CAGR) of Firm B’s revenues was greater than Firm A’s (10.65% to 9.18%).  Over that same 9-year period, Firm B’s number of lawyers grew at nearly twice the rate of Firm A’s number of lawyers, resulting in Firm A’s asset turnover growing at a 9-year CAGR of 6.16% to Firm B’s 5.12%.  The effect of Firm B’s lawyer growth was like the effect of a high number of quarterback sacks or run attempts for losses on gross offensive yardage (revenues) – the negative plays result in a lower net offensive yardage output.  At the same time that Firm B’s offense was sputtering compared to Firm A’s, Firm B’s defense also was falling apart – it let much more of its net offensive output (asset turnover) be dissipated than that of Firm A’s:  Firm B’s 2005 profit margin had plunged to 34.84% from its 1996 level of 46.26%, while Firm A’s 47.84% profit margin for 2005 was slightly above its 47.10% level for 1996.   The combined effect of Firm A’s offensive and defensive dominance was a 2005 ROA (profit per lawyer) of $378,295 compared with Firm B’s 2005 ROA of $180,507.  Firm A’s 9-year ROA CAGR was 6.34%; Firm B’s was 1.86%.  Another way this offensive and defensive domination by Firm A is captured is to look at the asset turnover growth rate vs the growth rate of costs per lawyer (a major element of the “points given up” by the defense):  Firm A’s 9-year CAGR for its asset turnover was 6.16%, while its cost per lawyer CAGR was 5.99%; Firm B, on the other hand, had a 9-year asset turnover CAGR of 5.12%, while its costs per lawyer CAGR was 7.40%.  From 1996 to 2005, Firm B’s defense was giving up points at a faster rate than its offense was scoring.  A small bit of solace can be found for Firm B though – its special team play (financial leverage) improved from 1996 to 2005 to the point that the relative margin of its ROE defeat (Firm A’s ROE was 2.0192 times greater than Firm B’s) was slightly less than the relative margin of its ROA defeat (2.0957).

In LawBall, Firm A clearly outplayed Firm B.  Why?  Firm B’s performance probably was the result of a combination of actions and non-actions by it.  First, regardless of the type of “defense” Firm B played – the 3-4 or the 4-3 – it did a poor job of tackling its costs per lawyer.  Second, despite the rate at which it gained gross yardage (its 10.65% CAGR for gross revenues) on offense, it had too many “bad plays,” including growing the number of its lawyers too fast, resulting in a net yardage (asset turnover) growth rate below that of Firm A.  Firm B’s game plan – its strategy – likely wasn’t in sync with its assets (players/lawyers) and didn’t mesh with what those players did best.  Best guess:  the field of play for Firm B changed over the years, as the rate of specialization accelerated causing Firm B’s business to move from one that required a lot of complex problem solving to one that was more standardized or more “fungible.”  Instead of changing its pricing strategy to one that was more appropriate for its new fungible business base, it likely tried to move its rates up to the highest level it could, as if it still were doing complex problem solving, costing it business.  And, It probably kept the same mix of assets (type of players) that it had when it was doing a greater volume of complex problem solving.  Just like in football – in LawBall, a bad strategy and poor execution leads to poor performance relative to the competition.

February 21, 2007

METRICS! WE DON’T NEED NO STINKIN’ METRICS (PART II)

Wow!  Just when I thought it was safe to go back into the water – I read an article this morning at Law.com in which a law firm consultant was quoted as saying:

The key determining factors in large law firm profitability are getting billing rates to the highest price the market will bear and getting the realization rate as high as possible.

Guess I better send a blast communiqué to every business school in the country – the schools obviously just don’t get it.  Their curriculum just got much shorter and much simpler:  no longer do businesses have to worry about such operating concerns as increasing the rate at which the business generates money through sales, lowering inventory, or lowering operation costs, much less worry about any strategic or marketing concerns such as delivering value to clients.  Just jack up those rates!

The above quote provides a great lead-in to today’s posting.  Two postings ago, I began looking at legal industry metrics and their significance.  I illustrated the metrics and the importance of examining them over time with public information from 2 real firms, which I called “Firm A” and “Firm B.”  Today, I’ve put a link to a *.pdf version of the illustration, with a few additions, in the upper right hand margin of this blog under the category heading “Posting Attachments.”  Return on assets (ROA) has been added to the illustration, as has “cost per lawyer.”  And, finally, to make the first “what if” example clearer where the key element being managed is the growth rate in lawyers, the heading above that example has been changed to “Lawyer Growth” from “Leverage.”

At the end of that earlier posting, I started focusing on the power of return on equity (ROE) metrics not only to answer “What happened?” but also both to address “Why did it happen?” and to show the way to manage for better performance.  To recap, the illustration shows Firm B narrowed the ROE (profit per partner) gap between Firm A and itself from 1991 to 1996, primarily on the strength of improving its margin.  But from 1996 to 2005 Firm A’s financial performance left Firm B in the figurative dust even though Firm B’s revenue grew at a higher compounded annual growth rate (CAGR) than, and its financial leverage grew to exceed, Firm A’s.  By “drilling down” into the ROE components, some of the reasons for this disparity in relative financial performance start to surface, including Firm B’s faster lawyer (or asset) growth rate (contributing to Firm B’s slower growth in asset turnover) and deteriorating margin.  The illustration’s “what if” examples show that if Firm B had managed its growth in lawyers to be at the same CAGR as Firm A, while still achieving the financial leverage that it actually did, the improvement in its asset turnover would’ve led to an ROE that was $122,825 better than it achieved; or that if Firm B had managed its margin so that its actual decline had been only to the average margin it experienced from 1991 to 1996, it would’ve led to an ROE that was $104,527 better than achieved.  I want to continue drilling down into the illustration’s metrics in today’s posting.

ROA is a simple equation:  ROA = net income ÷ assets.  To put it in the context of its principal components, it’s:  ROA = profit margin x asset turnover.  Remember the algebra:  ROA = (net income ÷ sales) x (sales ÷ assets).  For the legal industry, with terminology changes ROA = profit ÷ lawyers; or, ROA = margin x asset turnover, with the algebra being:  ROA = (profit ÷ revenues) x (revenues ÷ lawyers).  ROA is a good measure of the efficiency with which a business allocates its resources, as it eliminates the effects of financial leverage on operating results.  Just as with ROE, Firm B narrowed the ROA gap between Firm A and it from 1991 to 1996, as its ROA, fueled by its margin improvement, grew at a CAGR of 7.64% to Firm A’s 5.77%.  But by 2005 Firm A’s ROA again had left Firm B in the figurative dust.  Firm A’s profit growth and its asset turnover growth both exceeded Firm B’s CAGR.  As a result, Firm A’s ROA grew at a 6.34% CAGR from 1996 to 2005, while Firm B’s ROA grew at an anemic 1.86% CAGR for the same period.  Firm A’s ROA grew from 1.4232 times that of Firm B in 1996 to 2.0957 times in 2005.  The relative disparity between the firms’ 2005 ROE (2.0192) was slightly less than that of the firms’ 2005 ROA due to Firm B’s relative financial leverage improvement.

What happened with Firm B?  Let’s look at revenues, cost per lawyer, and business base requirements.  Revenues generally grow from price increases, volume increases, or a combination of both.  They are a product of the rate achieved (price) and the units produced and sold (volume).  For a law firm, this concept is:  total revenues equal a firm’s realized billing rate times the hours billed.  Drilling down into asset turnover can help us understand revenue changes.  Asset turnover = revenues ÷ lawyers (or revenue per lawyer).  Another way to look at asset turnover is:  asset turnover = price (sales ÷ billable hours) x volume (billable hours ÷ lawyers).  We don’t have any information about Firm B’s billing rate or its billable hours, so let’s use an example.  Assume that in 1996 Firm B’s lawyers billed an average of 2,160 hours per year.  As a firm, the aggregate hours billed would have been 375,840.  Using Firm B’s 1996 revenues, its realized billing rate would have been $152.9906 per hour.  (Just for grins, multiply 2,160 hours/year x $152.9906/hour.  The answer is $330,460 – just what the illustration shows for Firm B’s 1996 asset turnover – the asset drill-down math works!)  Now, let’s assume that all of Firm B’s revenue growth from 1996 to 2005 was the result of rate increases (let’s get the highest rate possible!) – although in the real world that’s not likely to happen.  At Firm B’s actual 10.65% CAGR for its revenues from 1996 to 2005, it’s realized billing rate in 2005 would’ve been $380.4811 (a price increase).  If that’s the case, its 2005 aggregate billable hours would’ve remained constant (no volume increase) but the billable hours per lawyer would’ve decreased to 1,361.7391 as the firm’s number of lawyers grew at a CAGR of 5.26%.  Or, if the billable hours remained at 2,160 per lawyer in 2005, then the total billable hours would’ve had to increase by a 5.26% CAGR (volume increase) due to the increase in the number of lawyers and the realized billable rate would’ve increased by a 5.12% CAGR (price increase) in order for Firm B to achieve its actual 2005 revenues.

The actual line item costs for Firm B aren’t public, so we have to do some simple extrapolation to get to cost per lawyer.  In 1996, Firm B’s revenues were $57,500,000 and its profits were $26,600,000.  That leaves $30,900,000 as costs for 174 lawyers or $177,586 per lawyer.  In 2005, Firm B’s costs per lawyer were $337,609 – a 7.40% CAGR.  Think about that - Firm B’s revenues from 1996 to 2005 grew at a 10.65% CAGR; but its asset turnover (revenue per lawyer) grew only at a 5.12% CAGR. Its costs per lawyer grew at a 7.40% CAGR.  The business result was an anemic 1.86% ROA CAGR.  By comparison, Firm A’s revenues grew at a 9.18% CAGR and its asset turnover grew at a 6.16% CAGR, while its cost per lawyer had a 5.99% CAGR.  The business result was its 6.34% ROA CAGR. Holy Cow, Batman!  I think that if your costs per lawyer grow at a faster rate than your revenue per lawyer, you’re not efficient in the way you allocate and manage your resources and your returns aren’t going to be very good.

We don’t know the requirements necessary to adequately service Firm B’s business base.  But, law firms must match their assets (lawyers) with the requirements of their business.  As lawyer-tasks become more standardized and require less complex problem-solving, the experience level and pricing for the lawyers in the firm must be managed to match these changing business requirements.  If you have a real estate project that can be handled by a $300/hour lawyer but you only have $500/hour lawyers to do the project, today’s client is more apt to push back – either bill it at $300/hour or lose the business.  My best guess – what it took to service Firm B’s business did become much more standardized and did take less complex problem solving.  But, instead of managing its mix of assets and pricing to reflect that change, Firm B focused on raising its rates as high as it could.  It probably lost business as a result, while at the same time growing its number of lawyers.  It likely got lulled into a false sense of security because its revenue and profit both grew; it didn’t actively manage its business through the ROE component operating levers; and it didn’t realize that its costs per lawyer were growing at a faster rate than its revenue per lawyer or that its ROA was anemic. It didn’t, and probably doesn’t still, understand that business is competition – and by comparison to at least one competitor, Firm A, it’s not even in the game.

February 15, 2007

MUCH ADO ABOUT NOTHING

That Billy Shakespeare – he really was something when it came to lawyers, wasn’t he?  Putting aside one of his most, if not his most, famous quotes about lawyers – "The first thing we do, let's kill all the lawyers" - here’s another that often jumps to mind for me:  “Silence is the perfectest herald of joy: I were but little happy, if I could say how much.”  This latter quote, from Act 2, Scene 1 of Much Ado About Nothing, captures well my feelings about the “emotional response” generated on The Wall Street Journal’s Law Blog under its postings, The Law: A Profession, a Trade or Both? and The Law: A Profession, a Trade or Both, Part II.  These postings and the subsequent, related comments were generated by an OpEd piece in the WSJ on January 26, 2007 by Cameron Stracher entitled Meet the Clients.  What I hoped would be a serious discussion about the flaws in the current system of legal education somehow became a debate about whether the practice of law is a “profession” or a “trade” and quickly turned into an exercise in the blustering that Stracher lamented and that Professors Frankel and Gordon don’t teach.  It was such a large rabbit trail that dealt with a symptom and not a problem that I expected to run into Grace Slick’s 10-foot large Alice along the way.

For about 30 years now, I have said, and continue to believe, that law school taught me only 2 things:  how to think like a lawyer and how to do legal research.  It didn’t teach me how to practice law, and it certainly did not teach me anything about the business of practicing law (the latter subject which, of course, is the focal point of this blog).  From what I can tell, not much has changed in that regard with respect to legal education.  When Professors Frankel and Gordon say, “But the best practice will come after law school, with maturity, with watching the senior partners and with learning from mentors,” most people in other lines of work call what they’re describing as “on-the-job training.”  Whether you call the practice of law a “profession” or a “trade” is irrelevant; OJT is how lawyers actually learn to practice law – and, it’s the only job I know where you can be paid around $145,000 a year to learn how to do what it is that you’re being paid to do and have your employer’s customers/clients effectively reimburse your employer for its costs to train you via submission of bills that include the “billable hours” you spent on client matters to learn how to practice.

In a recent posting on this blog, I focused on the pressures being exerted today on law firm business models and the need to change.  I drew heavily in that posting from a recent speech by Mark Chandler, Cisco’s general counsel, and from a case study by Harvard Law School Professor Clay Christensen and Scott Anthony.  In his speech, Chandler said,

The growing scope of knowledge availability will endanger this system.

. . . [T]he greatest vulnerability of the legal industry today is a failure to make information more accessible to clients, to drive models based on value and efficiency. The present system is leading to unhappy lawyers and unhappy clients. The center will not hold.

In their case study, Professor Christensen and Anthony said,

. . . The growth of specialization means that most corporate legal work does not involve complex problem-solving. With the right experience, specialists can easily recognize patterns and apply familiar tools so that they do not need to “reinvent the wheel.” Pattern recognition dramatically increases efficiency. Hourly rates assume everything requires complex problem-solving.

I concluded by saying,

Faced with the prospect of innovations that likely will be disruptive to their business system that “looks like the last vestige of the medieval guild system to survive into the 21st century,” access to what law firms know, how they get it, how they use it, how they deliver it, and what they get paid for it, is under attack.

It seems to me that we’d all be better served if the debate isn’t on whether the practice of law is a “profession” or a “trade,” but instead focuses on how does a system under such pressure get fixed, starting with the education that lawyers receive.

By the way, Professor Christensen and Anthony also commented that,

. . . But because corporations accept the sole-source market, law firms play a cat-and-mouse game with the billable hour and cost-plus pricing, hoarding productivity gains and saddling clients with both cost and outcome risks.

. . . It is extremely difficult to avoid wasting corporate assets within the confines of the sole-source/billable hour/cost-plus market. With one hand, law firms give discounts on hourly rates to their largest clients. With the other hand, they take back what they have given by raising the base hourly rates to which the discounts are applied and increase the number of hours they bill to do the same work. Law firms are masters of the cat-and-mouse game of the billable hour. As long as they respect the procedures mandated by the law department, law firms can circumvent any attempts at cost reduction by controlling the two key variables—the base rate and the number of hours spent.

Seems to me that a lot of lawyers must’ve missed the law school course(s) where, according to Professors Frankel and Gordon, future lawyers are trained “to be trustworthy even if there are no police around.”  But, then again, values like honesty, trustworthiness, and integrity were things I was taught by Professors Mom and Dad long before I even knew what a lawyer was.

February 13, 2007

METRICS! WE DON’T NEED NO STINKIN’ METRICS

During a recent speech, Cisco General Counsel Mark Chandler said, “The legal department in Cisco is as metrics-driven as manufacturing, HR or sales.”  (Emphasis added.)

I imagine most (if not all) lawyers are thinking, “So what.  We practice law.  Metrics!  We don’t need no stinkin’ metrics.”

Let’s start with a simple truth – eloquently stated in The Goal - the goal of a business is to make money.  Every thing else, from producing quality products to hiring good people, is essential to running the business successfully; but each is a means to make money and is worthless if the business isn’t making money.  For those who argue that practicing law is different – it serves a “higher purpose” – I direct you to the mission and vision statements of companies like  Each expresses a lofty purpose and helps generate what Gary Hamel and C.K. Pralahad in Competing for the Future call the fuel for the journey to the future – “the emotional and intellectual energy of every employee.”  But if the business doesn’t make money, the higher purposes will be for naught.  The Goal sets out 3 basic financial metrics – net profit, return on investment, and cash flow - that are central to knowing if you are achieving “the goal.”  It also lays out 3 basic operations metrics – throughput, inventory, and operational expense – that facilitate managing operations to achieve the goal.  I’ll spare you a recitation of what they mean for now.  Instead, I just highly recommend the book.

The importance of metrics was underscored in a November 27, 2006 article in Fortune, “Private equity, private lives.”  Authors Geoffrey Colvin and Ram Sharan said of private equity fund-owned companies:

More than others, they insist on identifying the measurements that are most important. Many companies call them key performance indicators, or KPIs.

At AZ Electronic Materials . . . CEO von Krannichfeldt uses about 80 of them, covering all the critical areas - finances, growth, productivity, quality, safety, market position.

In Analysis for Financial Management (another excellent book), Robert Higgins says the most popular financial performance metric among investors and senior managers is return on equity (net income ÷ shareholders’ equity).  ROE is the product of, and can be viewed through, its 3 principal components:  profit margin (net income ÷ sales), asset turnover (sales ÷ assets), and financial leverage (assets ÷ shareholders’ equity).  ROE = profit margin x asset turnover x financial leverage.  If you remember your high school algebra, this necessarily is true, as like numerators and like denominators each cancel out the other:  ROE = (net income ÷ sales) x (sales ÷ assets) x (assets ÷ shareholders’ equity).  The ROE components have a close correspondence with the financial statements of the business - profit margin summarizes the income statement, while asset turnover and financial leverage do the same for the left side and the right side of the balance sheet, respectively. But, to look at them simply at a given point in time is interesting but not very helpful. They can tell you what happened at that point in time, but not why it happened.  Their importance is in examining them over time.  ROE looks at the business as a whole; how did ROE change over time?  And, what happened in the 3 components that contributed to the change?  Finally, you can drill down into the components to find what led to their changes; e.g., was a revenue increase the result of increased volume, increased pricing, or both?  As Higgins notes, ROE and its components give management the ability to manage financial performance through its operating decisions affecting the components and to facilitate analysis of the business and its competition.   

Interesting – but what does this have to do with the business of practicing law?  With a few terminology adjustments, the same methodology exists to manage law firm performance and to analyze a firm’s business and its competition.  “Assets” become “lawyers”; “shareholders’ equity” becomes “partners” (equity partners only); and, “net income” or profit is what’s left after sales (revenues) are used to pay all costs, but with no money having been paid to the partners.  ROE = Profit ÷ Partners.  ROE = profit margin (profit ÷ revenue) x asset turnover (revenue ÷ lawyers) x financial leverage (lawyers ÷ partners).  Algebraically, it works:  ROE = (profit ÷ revenue) x (revenue ÷ lawyers) x (lawyers ÷ partners).

Actively managing by ROE (profits per partner) isn’t a new idea – David Maister pointed it out in his 1993 book Managing the Professional Service Firm – but the legal industry seems to have ignored it.  Even The American Lawyer, a great source of industry information, presents ROE as disparate, rather than linked, information points and only gives an annual snapshot, not a “panoramic” view.

Let me illustrate what this means.  Below is information for 2 firms, Firm A and Firm B.  They are real firms, and the information as to lawyers, partners, revenue, and profit is from in The American Lawyer and The Texas Lawyer for 1991 and 1996 and in The American Lawyer for 2005.


By 1996, Firm B had closed the comparative ROE gap.  Its margin improved from 36.92% to 46.26%, and its profit grew at a 7.89% compounded annual growth rate.  By 2005, Firm A’s ROE was nearly out of sight even though Firm B’s revenue had a higher CAGR (10.65%) and its leverage passed Firm A’s.  What happened?  Firm B’s lawyer growth rate exceeded Firm A’s, so its asset turnover had a slower growth rate.  Its margin fell to 34.84%.  Why?  Without drill-down information (e.g., cost per lawyer), we can’t tell. Firm B could; but I bet this information would shock Firm B.  Two “what ifs.”  If Firm B had managed just its growth in lawyers to be the same rate as Firm A, but still achieved its leverage gain, its asset turnover would’ve improved and its ROE would’ve been $122,825 better despite its margin decline.  Or, if Firm B had managed just its margin so its decline was only to the average margin it had from 1991 to 1996, its profit would’ve improved by nearly $10 million and its ROE would’ve been $104,527 better.

February 06, 2007

WHAT’S ALL THIS GARBAGE ABOUT BUSINESS MODELS?

In his recent speech at Northwestern School of Law’s 34th Annual Securities Regulation Institute (a link is in the margin under the heading “Articles of Interest”), Cisco General Counsel Mark Chandler made a couple of points about business models.   In discussing what he considers to be the legal industry’s “business model under distress” (emphasis added), Chandler said:

The systems exist today to change the delivery of legal information to clients. But that change would challenge a model that today delivers high profits. Every big company, including Cisco, is using those systems to make our support services more effective, and to drive down the costs of providing service. Law firms are not . . . Today, there is little incentive for law firms to apply risk-reward logic to the amount of legal services provided. And General Counsel know that.

The growing scope of knowledge availability will endanger this system.

. . . [T]he greatest vulnerability of the legal industry today is a failure to make information more accessible to clients, to drive models based on value and efficiency. The present system is leading to unhappy lawyers and unhappy clients. The center will not hold.

I’m sure many, if not most, lawyers who read this or who have read Chandler’s speech are thinking, “What does all that talk about business models have to do with the practice of law as a business?  And, more importantly, what does that garbage have to do with me and why should I care?”

An easy way to put this into perspective is to think of law firms as service sector businesses whose single largest asset is intellectual capital.  Some of that intellectual capital is structural capital (e.g., technology, systems, data, documents, processes, methodologies, and processes); some of it is customer capital (e.g., strategic relationships, client relationships, and client contacts); and, some of it is human capital (e.g., the knowledge, experience, and skills of the organization’s people).  Like, say, a financial institution that makes loans with its assets, law firms charge others for temporary access to and the right to use their assets.   The scarcer, or more difficult it is to gain access to, such assets, the more such access costs.  The more plentiful, or easier it is to gain access to, such assets, the less such access costs.  (Think about the effect of the advent of real estate mortgage securities on the home loan industry.)

I’m going to go out on a limb and say that most law firms probably have some form of a business model, whether tacit or explicit, and it is captured for the most part by what Chandler calls the “one to one client relationship with a lawyer who bills by the hour.”  Gary Hamel, a leading strategic and management “thinker,” says, “[A] business model is simply a business concept that has been put into practice.”  However, in his book Leading the Revolution, Hamel goes on to note that the business concept embodied by the business model includes 4 major components:  Core Strategy (business mission, product/market scope, basis for differentiation); Strategic Resources (core competencies, strategic assets, core processes); Customer Interface (fulfillment & support, information & insight, relationship dynamics, pricing structure); and, Value Network (suppliers, partners, coalitions).  These 4 components are linked together by 3 “bridge” components, defined by Hamel as being:

“Configuration” - the unique way in which competencies, assets, and processes are combined and interrelated in support of a particular strategy”; the link between Core Strategy and Strategic Resources; great strategies and their business models are the product of a unique blending of competencies, assets, and processes.

“Customer benefits” - the particular bundle of benefits actually offered to the customer; the link between Core Strategy and Customer Interface; refer to a “customer-derived definition of the basic needs and wants that are being satisfied.”  (Emphasis added).

“Company boundaries” – the decisions the business has made about what it does itself and what it contracts out; the link between Strategic Resources and Value Network.

Think about each of the bridges - configuration, customer benefits, and company boundaries - as they typically exist in law firms today.  And then contemplate that, as Hamel warns:

In a discontinuous world, business models don’t last forever.  And when they begin to decay, the temptation is to pour human energy and capital into improving the efficiency of the operating model [what people actually do on a day-to-day basis].  But better execution won’t fix a broken business concept.  Ultimately, you need to invent new business concepts or dramatically reinvent those you already have.

In an interesting 2004 case study of eLawForum (a link to the study is in the margin under “Articles of Interest”), Harvard Law School Professor Clay Christensen and Scott Anthony summarized:

Law firms are among the most profitable and least risky businesses in the world.

. . . By granting law firms what amount to exclusive relationships, corporations have created a sole-source market that sacrifices their ability both to shift risk to their law firms and to reduce legal fees significantly. Insulated from price competition in this closed environment, law firms have kept profitability high by raising their hourly rates while simultaneously dramatically improving productivity through specialization.

. . . But because corporations accept the sole-source market, law firms play a cat-and-mouse game with the billable hour and cost-plus pricing, hoarding productivity gains and saddling clients with both cost and outcome risks.

The authors go on to say, in more detail, in talking specifically about specialization and the accelerating impact that information technology through proprietary retrieval systems such as those developed by CCH, Lexis-Nexis, and Westlaw has had on such specialization and the business of practicing law:

. . . The growth of specialization means that most corporate legal work does not involve complex problem-solving. With the right experience, specialists can easily recognize patterns and apply familiar tools so that they do not need to “reinvent the wheel.” Pattern recognition dramatically increases efficiency. Hourly rates assume everything requires complex problem-solving.  While few industries have experienced greater productivity gains from specialization, the absence of a competitive market enables law firms to hoard cost savings instead of passing them along to corporations.

. . . It is extremely difficult to avoid wasting corporate assets (emphasis added) within the confines of the sole-source/billable hour/cost-plus market. With one hand, law firms give discounts on hourly rates to their largest clients. With the other hand, they take back what they have given by raising the base hourly rates to which the discounts are applied and increase the number of hours they bill to do the same work. Law firms are masters of the cat-and-mouse game of the billable hour. As long as they respect the procedures mandated by the law department, law firms can circumvent any attempts at cost reduction by controlling the two key variables—the base rate and the number of hours spent.

Chandler’s point, which builds upon the legal market excesses identified by Christensen and Anthony that long have been manipulated by law firms, is that technology is transforming the nature of knowledge accumulation and distribution and that the growing scope of knowledge availability will force law firms to change the way they do business.  Faced with the prospect of innovations that likely will be disruptive to their business system that “looks like the last vestige of the medieval guild system to survive into the 21st century,” access to what law firms know, how they get it, how they use it, how they deliver it, and what they get paid for it, is under attack.  That’s why all this garbage about business models.

Chandler also mentioned “metrics” in his speech.  I’ll get into metrics in my next posting.

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