jumping-for-red-arrow
()

Setting the next year’s billing rates follows a simple formula at most firms: last year’s rate plus a common percentage increase across all lawyer cohorts. A more disaggregated approach is needed. Specifically, firms should set higher percentage increases for senior lawyers and lower increases for junior lawyers. Why? Because, over the next 10 years, hours leverage (i.e., the number of associate hours per partner hour) at elite law firms will decline as more of the lower value-added work is handled not by junior lawyers but by enhanced technologies, in-house counsel, and alternative service providers. To maintain profitability, the margin that was earned on the displaced junior lawyer time has to be recouped through higher margin on senior lawyer time. Failure to increase senior billing rates differentially, and thus to rebalance the source of margin from junior to senior lawyer time, will result in a calamitous decline in profitability. It can be avoided if firms start now to gradually change their billing rate structures.

Today’s Billing Rate Structures

Law firm billing rates are perverse. Normally a business charges a higher markup on a higher value product—for example, jewelry sells for twice its cost while milk sells for a few percent above its cost. Not so in law: most firms charge out their junior associates at a higher markup of their cost than they do their senior associates. Table 1 shows the numbers: the billing rates are those for a typical elite firm and are translated to equivalent annual time charges assuming 1,800 billed hours per attorney; the associate base and bonus compensation follow last-year’s Cravath scale. The “markup” is the number of times annual time charges exceed annual compensation. As the data show, the markup declines from about 4.5 times in the junior cohorts to 3.4 times in the senior cohorts, a sharp contrast and the opposite of the pattern one would expect.

At first blush, this might not strike one as a cause for concern. After all, clients should care only about the total price they pay and law firms should care only about the total revenue they earn; neither should care about the composition of these by lawyer seniority. However, this changes if one looks ahead a decade. Over that timeframe, advances in technology and in the capabilities of in-house counsel and new-breed legal service providers will reduce the demand for junior lawyer time at elite firms. This will lower the number of associate hours per partner hour (i.e., the leverage) of a typical partner’s practice.

The Profitability Consequences of Lower Leverage

The effects of the lower leverage on profitability are dictated by the margin structure across lawyers of different seniorities. This probably sounds like consultant gobbledygook; Table 2 should provide more insight. It lays out how the practice of a model partner generates profit. The partner bills 1,700 hours annually and deploys on her matters 1,600, 1,750, and 1,750 hours of senior (seventh year), mid (fourth year) and junior (first year) associate time, respectively. Thus, the partner’s practice has leverage of 3 (i.e., three associate hours per partner hour), typical of a corporate partner at an elite firm. The billing rates are those from Table 1 and are translated to the equivalent margin per hour shown by subtracting the hourly equivalent of the associate’s annual compensation. Multiplying the billed hours by margin per hour gives the margin generated per year by the lawyers of different seniorities; summing these gives the annual margin of the partner’s practice, a healthy $4 million in the model shown. This amount goes to cover office and firm fixed costs, typically about $1 million per partner, with the remainder contributing to the partner profit pool.

The reason to look at profitability in this way is to allow us to assess what happens if leverage declines. Table 3(a) presents this assessment. For illustrative purposes, it models a decline in associate hours deployed in our model partner’s practice that reduces leverage from 3 to 2. Billing rates, and hence hourly margin, are unchanged. The margin generated by the partner’s practice falls to $3.3 million, an 18 percent decline. The percentage hit to firm profit is sharper, about 23 percent, because there is no change in the office and firm costs that have to be subtracted from this margin to define the partner profit pool.

Table 3(b) looks at what would happen if the same decline in leverage were accompanied by restructured billing rates. The associate billing rates shown are those that result from applying a constant 4.5 times markup on compensation costs; the partner rate is increased 20 percent. This billing rate structure restores the margin on the partner’s practice to the original $4 million; the higher margin, relative to today, on the partner and senior associate hours recoups the margin lost on the eliminated midlevel and junior associate time.

 

Transition to a New Billing Rate Structure

This kind of change in billing rate structure could not be made overnight; rather it would have to be feathered in slowly. What might this feathering-in look like? Well, imagine a firm that set itself the goal of having a constant markup across its associate classes in five years and wanted this markup to be the same as the average markup that would result from increasing today’s rates 5 percent annually over the same five years. In order to achieve this, the firm would have to increase rates on a sliding scale from 2 percent annually for first-years through to 8 percent for seventh- and eighth-years. Partner rates would increase at rates similar to those of senior associates.

While increasing billing rates in this way is consonant with ubiquitous client complaints about the rates charged for jejune junior associates, 8 percent may strike some readers as aggressive. It could be lowered if the restructuring were done over a longer timeframe. For example, if the feathering-in period in the example above were extended to 10 years, then the sliding scale would be from 3 to 6 percent for juniors through to seniors. Fundamentally, however, billing rates at the more senior end do have to increase robustly if the profit loss from erosion of junior associate hours is to be mitigated.

The changes proposed here will be difficult for many firm leaders to embrace. They’re necessitated by the twin inexorable forces of technology and competition. There’s no value in denying these forces, or railing against them—far better to turn them to advantage by adjusting to them more quickly than competitors do.