Cotterman on Compensation » Economics

Financial metrics - look behind the numbers

Jim Cotterman — Mon, 16 Aug 2010 23:46:16 +0000

Howard Schilit’s article, Financial Metric Shenanigans, in the August issue of the AAII newsletter (membership required to view article) provides solid advice on metrics that cover three key business reporting measures — revenue, earnings and cash flow. The article reminds us how important it is to verify what management reports (including consistency in definitions of terms) and to be alert to what management does not report. The article sent me looking for more and I found his book on the same topic. The article and book are useful to anyone reviewing a business’s financial reports.

What Should We Measure, Part 2

Jim Cotterman — Mon, 26 Jul 2010 16:18:11 +0000

As a follow-up to my previous post, What Should We Measure?, I thought three slightly different perspectives would be quite useful.

First, Ron Baker’s post at VeriSage discusses Key Predictive Indicators (KPIs) for professional knowledge firms. It is based, in part, on another executive’s turnaround success leveraging and relentlessly focusing on three key success measures for his company — measures that are important to the customer!

Second, Fred Reichheld’s book, The Ultimate Question, suggests tracking a Net Promoter Score or NPS to understand best how your customers relate to your organization. It is based on his research and expertise in the area of customer loyalty and economic results at Bain and Company. It focuses on accountability for building customer relationships.

And finally there is the Hedgehog Concept in Jim Collin’s book, Good to Great. The intersection of three key “circles” (what can you be the best at; what drives your economics; and, what are you passionate about). Most important to this discussion is the second item - what drives your economics — “the single ratio that has the greatest and most sustainable impact on your economic engine”.

In each of these three perspectives, the focus is narrow. Not one suggested a robust roster of metrics. Technology has given us a means to measure, relate and track just about any activity we care about. Finding the short list of truly important metrics is not as easy, but can lead to greater progress.

What Should We Measure?

Jim Cotterman — Fri, 09 Jul 2010 18:22:01 +0000

You know the old sayings – ”You get what you pay for.” and “You get what you measure.”

In the US legal profession the two most established and accepted partner performance metrics are client following (origination) and personal productivity (personal fees collected). They have been clearly the number one and two compensable factors in legal profession surveys over the years. Scattergrams and statistical testing for the strength of the relationship between a particular performance measure and compensation have repeatedly demonstrated that these two factors explain a significant amount of the variation in partner pay. And it is an inescapable truth that professional service firms that sell their time, expertise and experience are most profitable when their timekeepers are fully utilized with well paying work. Logically we can conclude that having a client following and working hard are necessary ingredients to a remuneratively successful law practice.

But is a measurement system sufficient? For a solo practitioner or pure space sharers it may be. There are no relative considerations to make. But in group practice, is not judgment in making such decisions equally or possibly even more important in a partner pay program? Is it important to understand the nature and extent of each partner’s efforts? How about the differing roles partners accept or should assume as their careers unfold? What value is there in taking strategically smart risks (even if each undertaking is not entirely successful)? These and other factors require judgment, possibly supported by measurement when reliable metrics can be developed, understood and placed in proper context. For example, who is more valuable — the partner with a $1,000,000 practice that puts 25% in the hands of owners or the partner with a $5,000,000 that puts 5% in the hands of owners? Measurement is a tool to be used carefully and thoughtfully.

Yet, even more tools are likely needed as law firms grapple with a changing market. AFAs (Alternative Fee Arrangements) and project management are two hot topics in the profession. Each represent important steps forward in pricing, risk allocation, value and client satisfaction. Successfully implementing these techniques is hard work. Embedding them systemically in the law firm’s processes, including pay programs, will require even more work.

It appears that AFAs designed to provide cost certainty to the client and place greater risk on the firm for efficiency and outcome are the most likely to attract client interest. However, doing so without addressing the service delivery model is a significant risk to firms accustomed to an hourly pricing methodology.

Project management techniques ferret out inefficiencies and strip out unnecessary costs. It appears that undertaking a robust project management effort can yield some impressive streamlining. Fewer people get the same job done in less time with less cost. That is great news unless you are charging by the hour in an environment characterized by work volume constraints and competition for cost conscious clients. In other words, the volumes may be lower (that $2 million practice may end up being $1.7 million) and it may not be possible to raise rates sufficiently to offset the lower volume.

Together, AFAs and project management complement each other if one can price differently and capture some higher measure of profitability while being more efficient and less costly to the client. Now here is the rub, how does the partner establish compensable value when the practice size is smaller and considerable non-billable effort has been expended streamlining the operation? Personal productivity and origination metrics may still be necessary, but are clearly no longer sufficient. So a new set of measurements will be developed, refined, tested, institutionalized and ultimately automated. Yet, judgment will still be required to apply the new metrics fairly.

It is the responsibility of each firm to determine, based on its value system and strategy, what is appropriate. But it will require informed and thoughtful judgment to make it work.

Compensation Perspective

Jim Cotterman — Mon, 29 Mar 2010 12:04:07 +0000

Over the past three decades, compensation issues in law firms have changed much. Back then, benchmarking one firm’s decisions against others across an array of variables such as firm size, location, practice specialty, and experience, comprised much of the analysis. Today law firms must evaluate decision quality for internal proportionality and external competitiveness (both relative to contribution/performance), as well as compatibility with culture and alignment with strategy.

However, one cannot fully understand the broader lawyer pay market if it does not first understand the associate starting salary market. In the 1980s, the profession experienced a rapid increase in starting salaries that cascaded upward throughout the associate ranks beginning a compression problem with younger partners that continues to exist today. The 1990s brought many years of little or no increase in starting salaries as a response to the recession at the start of that decade. However, by the end of the 1990s a hyperactive economy created a demand driven market and increases returned. Then the new millennium brought forth new and daunting challenges and the market slowed yet again. Mid-decade starting salaries again soared, only to be confronted in 2008 and 2009 with the greatest economic collapse since the great depression. This time starting salaries and salaries across the associate ranks were rolled back. Associate layoffs and hiring deferrals reach record levels as the demand for lawyers sank precipitously.

Traditionally, the key metric in lawyer compensation is working lawyer fee receipts. It explains 64% of the change in lawyer compensation over the career of a lawyer. It is almost the exclusive variable for associates, explaining 91.5% of the change in lawyer compensation in the first ten years of practice. After that, the key criterion by which partners are valued takes over – the ability to build relationships in the marketplace that attracts work to the firm. One’s skill at building a practice generally explains 80% or more of the change in a partner’s compensation. A firm’s culture and ownership structure affect the importance of this metric, but only in relative terms. No law firm can exist if its owners are not accomplished business developers.

Let us return to the recession for a moment, which profoundly affected the legal profession as it did nearly all other segments of the economy. Clients push harder then ever on value and there is the perception that pricing power is shifting from provider to buyer. Alternative fee arrangements gain ground over hourly billing as clients demand cost certainty along side of cost reduction. These conditions will likely alter the model for delivering legal services. If it does, then law firms will need to view compensation differently.

Take some time to look at what you are doing:

1. Evaluate partner and associate pay programs to determine if the compensation decisions reflect what is important in your firm (performance, culture, work/life balance, strategy and the like).

2. Examine the profit profiles of your timekeepers (partners, associates, paralegals, etc.) and by experience for lawyers to see if the compensation decisions are economically rational and if the margins are appropriate.

3. Use the compensation process to engage people and seek out opportunities to discuss pay and performance as it relates to strategy and culture.

4. Review your expectations of owners with the owners and consider how your ownership structure affects the vitality of the firm and interacts with your compensation programs and decisions.

AFAs and Tracking Time

Jim Cotterman — Wed, 17 Feb 2010 20:55:17 +0000

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.

Moving away from associate lockstep?

Jim Cotterman — Fri, 15 Jan 2010 18:23:34 +0000

Ok, so you have made the decision to change from your lock-step associate compensation program. What next? Here are five areas and key considerations to ensure success.

First, understand how much you have modified your program from a pure lockstep approach. Did you retain the right to hold associates at any compensation point along the way? Were bonuses tied to factors other then class year? It is likely that you were already incorporating some “merit” concepts in your existing program. This is important because it simplifies the transition somewhat and provides anchors of familiarity for the associates. It also may provide some of the elements of the new program.

Second, determine the elements of your performance evaluation program. What is the frequency — project or time based such as quarterly, semi-annual or annual? Is it a multi-factor evaluation incorporating both objective and narrative ratings? Is it tied to a set of increasing competencies, skills and experience that are level-, practice- and job-specific? Does it relate to promotion criteria? If a partner track position, does it integrate with partner expectations such that it logically builds towards a successful candidacy? Are assessments correlated across the practice group, office and firm to look for grading anomalies? Are the evaluators trained and given feedback on their evaluation skills? Good evaluations need to have a consistent grading perspective — one person’s “A” should not be another’s “C” — which is often a problem. How do you communicate the results of the assessment? Is it a written summary, oral or both? Who provides the feedback and are they provided training at performance counseling? And how does feedback mesh with forward looking individual, practice, office and firm planning efforts? Are your compensation and promotion decisions consistent with the conclusions reached in the evaluation? Moving away from lock-step only enhances the importance of a very robust performance monitoring and feedback program.

Third, provide transparency, which is an attribute of lockstep programs that is well received by the associates. Transparency may be available by publishing (at least internally) the pay scales associated with each grade or tier that you build into the program. This is quite common in wage administration everywhere else. A second means to build transparency is to create a documented bonus program that actually rewards performance well beyond the expectations for the position, and/or rewards group (practice, office or firm) performance in some sort of profit sharing. Remember, simply meeting expectations is what the salary is for. You may have much of this piece already embedded within your lockstep program.

Fourth, stress the importance of communication. There is no reason not to invite associates to participate in this process. They can provide meaningful guidance about what they like or dislike about what you are doing currently and what they would like to see. This provides you with a mechanism to then respond, acknowledging their concerns and addressing each either with a change or an explanation of why the status quo is preferable. They can “test drive” options so that much of the necessary fine-tuning is done before a big roll-out. And finally, this provides a way to ease the concerns that arise when something this important is under review. It takes some time to do this well and an ongoing participation and communication effort will assist to keep it all in the proper context.

Fifth, look at the economics of what you are doing. Are the salaries and bonus appropriate? How will you be positioned in the market? Will the new cost structure allow you to profit on work associates do for clients? Will the clients be willing to pay for these individuals to work on their matters at a sufficient hourly rate or effective hourly rate for an alternative fee arrangement? What is the cost/benefit to the firm of making the change from lockstep to merit-based pay? Model the economics of the program based on your best assumptions and plan elements. Will the partners support the investments contemplated in money, time and training? Continue to monitor and update financial models as experience develops.

Will law firms be forced to give up their best lever to enhanced profits?

Jim Cotterman — Mon, 23 Nov 2009 13:03:07 +0000

Law firms generate profits pushing chargeable hours, billing rates, realization, leverage and margin. Since 1985 (as shown in this table) law firm profits have been driven upwards largely because of increasing billing rates. Rate increases are comprised of three elements — experience, inflation and value. The experience curve of billing rates in the profession is how lawyers increase their productivity over a career when chargeable hours decline after about six to seven years of experience. These graphs illustrate the profession’s billing rate and chargeable hour profiles across a career.

We observed that the market struggled with rate increases (compared to historical patterns), realization (adjustments to pricing for discounts, inefficiencies and the like) and turnover (speed of collections) during the recession. And all of those were to the detriment of the law firm. This began in late 2007 and carried its way in varying degrees through 2009. In early 2009 Altman Weil surveyed law firms on a host of topics law firms were grappling with in response to the unprecedented economic conditions. In Law Firms in Transition we learned that a majority of the law firms participating (which included 32% of the NLJ 250) had made smaller than normal billing increases for 2009. This puts pressure on revenues. Missing a year in rate increases is not so bad in isolation, but when the cumulative effect is considered out into the future the compounded lost increase in pricing is significant.

It will be interesting to see if the law firms hold to the GC expectation of law firms holding the line on billing rates for 2010. In a recent ACC survey, general counsel identified reducing expenditures on outside counsel as their primary concern. They also predicted that law firm billing rates would not increase in 2010. Altman Weil has recently conducted a study on law firm billing rate intentions. With 40% of the NLJ250 participating we will soon know how law firms intend to respond.

And on December 3rd my partners Ward Bower, Tom Clay and Dan DiLucchio will present their thoughts on the changing legal market and what’s in store for law firms in 2010 in a special Altman Weil Advisory webinar. They will discuss pricing and a range of other issues such as service delivery models, staffing structures and balancing value and profitability.

Start Working on AR Now

Jim Cotterman — Mon, 02 Nov 2009 16:44:50 +0000

Today’s Wall Street Journal had an article on corporations hoarding cash. While not directly citing a slow down in paying bills, the mindset of holding onto cash to retain “operational and strategic flexibility” is not a good sign. With two months left in the year it may be prudent to begin that final push to bill and collect a bit earlier this year.

Credit Markets

Jim Cotterman — Thu, 20 Aug 2009 11:02:44 +0000

While not as bad as the 4th quarter of 2008 and the 1st quarter of 2009, credit markets continue to be less friendly. Credit limits are often lower as banks modify their ratios. Loan covenants are more onerous and banks are more strictly enforcing them. Those friendly waivers are harder and more expensive to obtain.

The latest trend appears to be line of credit facilities are commonly being written with variable rates tied to some benchmark rate plus a rate floor (”at no time will the rate be less than…….).

Accounting Firms Cope with Recession Pressures

Jim Cotterman — Fri, 14 Aug 2009 17:22:00 +0000

This article is a good summary of how the recession affected the accounting firms. It may all sound a bit unsettling as I found myself easily substituting “law firm” for “accounting firm” and finding it spot on the money.

A couple of quotes deserve special attention. This first quote is about getting closer to your clients and getting work. Gary Boomer said, “The clients out there need you more than ever. You just need to go talk to them and ask them what’s keeping them up at night and listen. Not go out on a sales call, but go out and find out what’s making them tick. If you talk to a client and sit there and listen for a while, you can find a lot of new work.” This is so perfectly stated, but often not as well executed.

The second quote is more about the perils of not making tough decisions when they should be made. Addressing the cutbacks that were made during the recession, Gary Shamis said, “If we had done what we needed to do when we should have done it, we would have released them into a better environment. I think the recession was good. It forced us to be more proactive and look at workflow.” Unfortunately, this is a lesson that is taught during each economic downturn.

I was also quite interested in the changing dynamic in partner compensation as described by Allan Koltin at the end of the article. Allan said, “The “new school” train of thought instead asks, ‘Who did you recruit to the firm last year?’ ‘On the upward evaluation, how many identified you as the reason they are with the firm?’ and ‘How many current and future partners would identify you as their sponsor?’”