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As 1999 came to a close, there was a concern that Y2K problems might have a significant and detrimental effect on many businesses. Well, guess what? The New Year didn’t bring computer disasters, but it did have a dramatic effect on law firm finances. Salary costs have gone through the roof in 2000. Skyrocketing new associate compensation plans, coupled with the natural requirements to boost compensation for each preceding associate class, may drive law firm employment costs up by 20 to 40 percent in one year. The primary reason is the challenge to attract and retain talented staff. With little time for meaningful changes in business processes, law firms have three short-term options for funding these accelerating costs: clients, firm resources, and partners’ pockets. Each option has its pluses and perils, and all are likely to play a role as firms adjust to the new economics. INCREASING CLIENT REVENUES Every law firm partner hopes that the major source of money to pay for the salary escalation is increased revenue. Fortunately, the economy remains strong (for now) and demand for legal work remains high. In this market, reasonable billing-rate increases are acceptable. The question is, can firms raise rates to levels required to absorb compensation increases? Some of the West Coast firms that initiated these salary wars are seeing revenue increases of more than 30 percent per year. That level of increase, of course, supports the new salary structure. But based on Legal Times’ annual survey, revenue per lawyer and profits per partner increased a more modest 9 percent at Washington’s top law firms from 1998 to 1999. The results for 2000 are far from complete, but this looks like an equally good or even better year for law firms. Yet, not all firms saw profits increase along with revenues. That alone just about ensures that salary increases will not be supported entirely by client revenues. Most firms expect associate billable hours to increase by 10 to 20 percent to justify the hefty compensation increases. Short-term, this expectation flies in the face of the increased flexibility and control over work and life commitments desired by many associates. Long-term, this places an increased burden on partners and, to a lesser extent, on associates to market more effectively and win more work from clients and prospects. To manage profitability, partners need to change how they operate — increasing delegation and reducing unproductive administrative time. Management of nonbillable time at all levels is more essential than ever to offset the financial drain caused by these monumental compensation increases. Yet, many law firms continue to resist even tracking nonbillable time. This will need to change. Theoretically, to the extent billable hours increase, client revenues will rise. But to achieve revenue increases large enough to support compensation increases, firms need to provide services that increase billable hours across the board. Keep in mind, general counsel will be more demanding of the value of time charges. Simply increasing billable hours may not net additional revenues. General counsel typically can be wary of hour inflation and may want to limit associate time on their matters. They also may seek cost savings by using alternative billing strategies, such as flat fees for particular projects or transactions. Firms need to take advantage of their strongest practice areas to provide services that increase billable hours across the board. Improving engaging management — the way a law firm goes about performing legal services for their clients — and client communication will be critical to achieving both the leveraging of business and the increased profitability a firm will need in this new compensation environment. When most firms developed revenue projections and budgets for 2000, the extreme salary increases were not part of the plan. Firms anticipated stable costs and balanced that with revenue projections based on the pipeline of existing work. Now that firms are grappling with increased employment costs, the temptation to opt for quick, significant rate increases is apparent. But clients are not likely to find those increases acceptable. So, either exceptional practice development efforts are needed to increase the pipeline, or budgeted costs need to be reduced or delayed to maintain profitability. Some partners typically look first at cost reductions as their firm’s path to profitability. Cutting or deferring planned technology investments, re-engineering projects, new satellite offices, or other business development initiatives are initially very appealing to improve short-term cash flow; however, the long-term implications can be risky. While some firms will defer certain planned investments, these initiatives are designed to position the firm for long-term success. Training programs can be reduced, summer associate programs can be scaled back, benefits might be slashed, but each of these is counterproductive to attracting and retaining top legal talent — the whole point behind the compensation increases. Certain projects can be deferred into 2001 and not have catastrophic consequences to the firm’s success. Avoiding a significant immediate reduction in partner profits by deferring some projects is an acceptable alternative for management consideration. Remember, these talented people you are trying to hire and retain don’t want to read about your reduced profits in next year’s Legal Times survey. But ultimately, if the projects have meaningful objectives that are necessary for the survival and success of your firm, they will need to be done. Short-term cost reductions or deferrals will have to be supplemented very quickly with real changes in the way you do business. Business as usual is not enough! Certainly attorney performance — from new associates through partner levels — will need to be carefully monitored and corrective measures expedited. There will be little room in this new environment to carry weak performers. Law firms with lower-end partner profits may need to make significant, short-term cost reductions to retain core partner talent. Those decisions may not prepare the firm for long-term success, but if the alternative is a severe talent drain leading to a complete reorganization or liquidation, long-term success is not the most pressing priority. PARTNERS’ POCKETS Some firms in the hottest practice areas — intellectual property, antitrust — will achieve substantial revenue growth to offset the increased compensation and support a rise in partner profits. But even so, and even if certain expense projects are deferred and costs are reduced in other ways, the compensation increases will force many firms to fund a portion of the increases from partner profits. Every firm should be carefully reviewing operating results and forecasts to determine more accurately the effect on partner profits. The biggest risk, whether on Wall Street regarding earnings projections or in a law firm regarding partner profits, is a dreaded surprise that performance is not meeting planned levels. One way to minimize surprises is to maintain strong business principles, strong management reporting, and effective financial analysis. For instance, the annual pressure for receivable collections just before year-end is bound to be even more significant this year. These efforts should start now! We still see many firms who continue to struggle achieving compliance with daily time entry. More than ever, management needs this information to be timely and accurate. Even as attorneys are busier than ever with client work, compliance with sound business processes is critical for effective management. It will take a talented leader indeed to convince a group of partners that flat earnings or a dip in their 2000 earnings may in fact be the best alternative to achieving short-term success in this competitive legal marketplace. The risk of reduced earnings is also a tremendous carrot for management to use as an incentive to gain partner approval for business initiatives that have been on the shelf the last couple of years. Expanding client revenues, expense reductions, and partner profits are all likely to share in the burden of funding the 2000 explosion of compensation costs. How much of that share is ultimately generated from clients this year is dependent on how well a law firm positioned itself in the preceding year or two. Your business planning initiatives, your market awareness, your industry specialization, your unique high-end services, and the talent you have accumulated are driving 2000 revenues. Ultimately, partners will bear a share of the burden. The question is whether the burden will be funded by the partners’ efforts in the last few years to build an exceptional business organization, or whether it will be funded by a reduction in partner profits. John T. Niehoff, CPA, is a partner in the Washington-based CPA firm of Beers & Cutler. He heads the law firm services group, specializing in providing consulting, tax, and accounting services to law firms. He can be reached at [email protected] or (202) 778-0224.

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