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Does growth as a strategic goal always make sense for law firms?

Not if you ask Felix Oberholzer-Gee, a professor of business development in the strategy unit at Harvard Business School and a consultant to several law firms. He argues that some firms are wrongly focused on taking market share when they should be paying more attention to increasing profitability. Oberholzer-Gee is co-author of “The Limits of Scale: Companies That Get Big Fast Are Often Left Behind. Here’s Why,” in the April 2014 issue of Harvard Business Review.

“If you start by saying that we want to grow our market share, or we want to be particular size, as a strategic goal that is a terrible choice for a number of reasons,” he said. “ First, and most important, is that market share is not that correlated with profitability. The second is that the most natural way to gain market share is by charging lower fees, which is what we see throughout the industry in this misguided effort to gain size and market share.”

As such, he disagrees with some experts, such as William Henderson, a professor at Indiana University Maurer School of Law, who recently wrote a piece for The American entitled “How To Take Market Share: Lessons for Law Firms.”

Oberholzer-Gee argues that law firms can’t grow their way to prosperity. Instead, they need to focus on the bottom line. “But where we have the biggest disagreement is instead of telling firms you have to watch how profitable you are, he says you have to look at market share. I would say that is very dangerous. Market share doesn’t matter. What matters is are you profitable?” he said.

More firms than ever are seeking growth through mergers to grab greater market share, win new markets or gain greater efficiencies of scale: Consider recent merger news from Dentons Littler Mendelson, Nixon Peabody and other firms. A record 79 mergers were reported as of Nov. 12, according to Altman Weil Inc., the largest number since the consultancy began counting nine years ago.

Other firms continue aggressive lateral hiring, despite mounting evidence that the strategy doesn’t always work as planned. For instance, in its 2015 Client Advisory released early this year, the Citi Private Bank Law Group and Hildebrandt Consulting LLC noted that each year for the last several, the percentage of laterals that law firm leaders rated as above a break-even investment by their own definition had fallen, to just 54 percent in 2014.

One problem with a growth strategy is that in order to get a bigger slice of the pie, law firms often start by slashing fees, but that just puts them in competition with other legal-services providers that clients may perceive to be as qualified, driving work to the lowest bidder, Oberholzer-Gee said.

“So the continued challenge is, why should I hire you? Why is it in my best interest to work with you rather than two dozen other law firms?” Oberholzer-Gee said. Being perceived as a commodity provider can be a trap. “In an undifferentiated market, either the clients or the suppliers get the vast majority of the value that is created,” he said.

Another problem with striving for aggressive growth is that firms often try to get big fast by luring top rainmakers away from, or merging with, other firms. But they often promise such high compensation that the firm winds up paying the new partners any additional profit they bring, he said. Moreover, the high pay used to entice “star” laterals can cause a ripple effect of demand for higher pay from existing partners. The star system “is not a great development if you are worried about profitability,” he said. “Dewey is a great example that chasing after talent with the promise of super lucrative compensation doesn’t work.” (Dewey offered guaranteed compensation, which is on the wane, notes Gretta Rusanow, head of advisory services at Citi Private Bank Law Group.)

So, while grabbing market share may work for technology companies like Apple Inc., or Microsoft Corp., it generally doesn’t help law firms, Oberholzer-Gee argues. They don’t get the benefit of the “network effect,” where having more users increases the value of a product or service to others—that is, their “willingness to pay” for it, he said.

“In Apple’s case, greater market share will lead to greater profitability because there are strong network effects in technology. The more customers who buy a Mac, the greater the value of owning an Apple machine. By contrast, there are no network effects in legal services. Law firms need to be of a certain size to be economically successful but, beyond that size, there is no advantage to being large,” he said.

For instance, Oberholzer-Gee says a small firm may increase profits by growing enough to spread fixed costs like IT and business development over a large enough volume of business to achieve economies of scale and a “minimum efficient size.” But beyond that, profitability tails off, he said. “You have to say, how is being bigger going to make us more financially successful?”

Instead of focusing on growth alone, firms need to focus on increasing their clients’ “willingness to pay,” Oberholzer-Gee said, by strengthening the brand of the firm itself, becoming the go-to firm for something (differentiation) and by being cost-efficient. Everything starts with “value creation” and increasing the willingness of the client to pay, he said.

A different view on growth

Henderson said he believes taking market share is uniquely important for law firms, however. In an interview, he said he doesn’t believe in “growth for growth’s sake,” but that there are important differences between law firm partnerships and the corporations that Oberholzer-Gee mainly studies.

“I don’t think off-the-shelf corporate strategy can be applied to law firms without first making some modification,” Henderson said. “The law firm market is different because of the ethics rules (around) non-compete agreements and non-lawyer investment and the cultural norms that have grown up around partner-associate models. In particular, those cultural norms require growth in order to maintain comfort and satisfaction inside of the firm,” he said.

For instance, Henderson said, associates work hard, long hours in the belief that doing so may earn them equity partnership while clients mainly pay for the expertise of the experienced partners. Without equity partnership as a motivator, firms would stagnate from lack of new associates, their energy and their ideas and eventually wither from lack of successors. In the long run, Henderson said, the legal industry probably has to move away from the partnership model, as so many professional advisory services like tax and accounting firms have done. But in the meantime, law firms remain dependent on growth, he said.

But Oberholzer counters, “if the firm grows larger in a less and less profitable fashion, the incentives to become partner get weaker. Why work hard to become partner in a firm that is large but barely profitable?”

Citi’s Gretta Rusanow argues that market share and profitability are equally important to longer-term firm sustainability. In a Citi survey conducted in mid-2014, based on a sample of 63 large law firm leaders, 78 percent said that revenue growth and profit-margin growth were equally important. In the years since 2009, more than one-third had shifted their view, with more focused on margin growth, she said. “In this environment with so much pricing pressure, you have to look at your cost basis and look to maintain your margin and grow profits as well as revenue, ” Rusanow said.

Despite their differences, Henderson and Oberholzer-Gee are in agreement that more law firm leaders need to use profitability analysis. “It is a very important thing to do and it is something that law firms are only (just now) doing, “Henderson said. Pricing specialists do this, but that is only half right. In reality, you need project managers and process engineers to do it right,” he said. “You can do the work cheaper and better at the same price. ”

Indeed, in its 2015 Client Advisory, Citi and Hildebrandt noted that more firms are analyzing the profitability of specific clients, matters and practice areas, instead of merely tracking the revenue they generated. The trend started after the last recession, Rusanow said.

Increasing firm profit margins isn’t easy, however. Most S&P 500 companies have a difficult time reaching profitability using the benchmark of return on invested capital, Oberholzer-Gee said “If you think that a natural benchmark is returns that are greater than the cost of capital, that is a challenging goal for many companies and many law firms,” he said. The median return on investment among the S&P 500 is 11.7 percent; among the lowest quartile, it’s 7.7 percent. Meanwhile, the companies’cost of capital is close to those values, at 8 or 9 percent.

Formula for success

Oberholzer-Gee said law firms can increase profitability by focusing on what they can do better, more efficiently and more profitably than anyone else. In that, he and Henderson are in agreement.

Developing the capabilities of each lawyer through training also is important, especially training in business development, Oberholzer-Gee said. “Many of the most successful law firms invest in a way that makes the individual lawyers more successful” he said.

Business discipline is a key to profitability, Oberholzer-Gee said. He and Henderson agree that firms must focus on practices and industries where they can excel and provide the most value to clients while remaining profitable. “Imagine that your firm doesn’t exist tomorrow. Who is going to miss (you)? Someone has to miss you, and if no one misses you then you have to compete on fees and you won’t have great financial success.”

The ultimate goal? “We want firms that are highly profitable that are relatively focused and relatively small,” Oberholzer-Gee said. But even he acknowledges there are practices such as mergers and acquisitions that favor larger firms with more resources. The growing volume of cross-border work also requires a larger scale, Rusanow said.

“Ultimately, you want to be a profitable firm that is growing,” she said.