There is no economic requirement for public companies or law firms to grow. There is a requirement that they provide a robust return to shareholders: failure to do so results in shareholders taking their capital (public companies) or labor (law firms) elsewhere. In the public company world, growth drives shareholder returns; hence growth is a means to achieve the superordinate goal. Many law firms assume growth must similarly be good for them. This is misguided. The linkage between growth and shareholder returns at public companies doesn’t hold for law firms. Good growth for law firms centers on a narrow set of opportunities.
The Public Company Rationale for Growth
For public companies, growth enhances shareholder returns through stock price appreciation. This linkage rests on two economic fundamentals: One is that companies typically have significant excess cash flow that they can deploy from one business to another; the other is that equity markets allow shareholders to realize value today for anticipated future earnings. Neither applies in the law firm world.
On the former: Companies can be thought of as portfolios of businesses, where each has different cash flow characteristics—some generate more cash than they consume; some consume more cash than they generate. Management directs the net cash flows across the portfolio. The growth-share matrix, developed in the 1970s by The Boston Consulting Group, describes how to do this: Excess cash is taken from the “cash cow” businesses and invested in “question marks” so as to turn them into “stars.” Law firms can likewise be thought of as portfolios of businesses where partners in different practices or offices comprise the distinct businesses. Here the similarities end. There is no excess cash flow in a comparable sense at a law firm. For such to exist, a partner would have to be paid less than the economic value of their practice. If such a shortfall pertained in a significant or sustained way, the partners would become susceptible to departure to rival firms. This dramatically limits the amount of cash that can be taken from “cash cows” and that can be repaid by “stars.”
On the latter economic fundamental: when a public company makes an investment it effectively takes cash from current shareholders (as the cash invested could have been used to pay a dividend or buy back shares) and invests it in a “question mark” opportunity. If the equity markets perceive the “question mark” as a good investment then, because a stock’s price is a reflection of anticipated future cash flows, today’s stock price will rise. Thus, the shareholders who forgo the cash to make the investment are the same as the shareholders who benefit from the investment.
This is not the case with law firms. Consider, say, a law firm investing today in building a China practice. The office costs, local lawyer salaries, ex-pat packages and subsidized partner compensation are borne by today’s home-market partners. It will likely take many years for the China practice to generate more cash than it consumes. Thus, any return of the cash invested by today’s partners will be paid out to a future, different, group of partners. For other than investments with fast payback, wealth is being transferred from today’s partners to some future generation of partners. Risk of departure of, and a sense of fairness to, today’s partners limits investments with such long-term payback.
The Law Firm Rationale for Growth
These differences require that for growth to be “good growth” at law firms it should entail modest outlays that are recouped quickly. Some such opportunities do exist.
One is to grow commensurate with growth in demand from existing clients. To be precise, this means growing with the volume of demand (i.e., exclusive of billing rate increases), and it applies only to net growth. (That is, while demand volume from some clients increases, demand from others contracts; only the net growth pertains.) As net volume growth is low, the up-front sum invested in lawyer capacity is moderate, and because there is no time lost in business development, etc., the payback is quick.
Another opportunity for growth comes from exploiting inconsistencies in the market. For example, if a firm is paying a partner significantly less than what is consistent with the economic value of her practice, she can be picked off by a competitor with a better compensation offer, but one that is below that suggested by the worth of her practice. In such cases, a portable book ensures relatively low investment outlays, and the gap between compensation at the new firm and the worth of the practice ensures fast payback. An example of this occurred when high-end U.S. firms arrived in London and lured partners with very economically attractive practices away from the Magic Circle firms, whose lockstep compensation systems undercompensated them.
A third way is to grow behind existing “increasing returns” positions. This requires some explanation. Consider a company like eBay, which is a two-sided business—it competes for buyers and for sellers. It makes itself attractive to buyers by having lots of sellers, and vice versa. Two-sided businesses with these mutually-reinforcing characteristics exhibit what is referred to as “increasing returns.” Competitors who are ahead tend to get further ahead, and those who get behind tend to fall further behind. Once established, the winners in an increasing-returns dynamic effectively lock out would-be competitors and thereby enjoy strong price realization and above-normal profitability.
Law is similarly a two-sided business. Firms compete for the best clients and for the best lawyers; they make themselves appealing to clients by having the best lawyers (in the segments they serve) and to lawyers by attracting the best clients and matters in those segments. This mutual reinforcement leads law firms to exhibit increasing returns: Once a firm gets ahead in a segment, it tends to move further ahead, and when a firm gets behind, it falls further behind. These positions reduce competitive intensity for the winners, leading to strong price realization and profitability.
Growth in increasing returns positions requires modest up-front investment as there is relatively little marketing and business development to be done—the firm is essentially capitalizing on its established renown. As the ramp-up period to full utilization for lawyers added to the position is short, the payback is quick. Leveraging this dynamic enables simultaneous growth in revenues and profitability, consistent with the justifiable rationale for law firm growth. An example of this dynamic in action is Quinn Emanuel Urquhart & Sullivan and its singular focus on business litigation. From 2004 to 2016 the firm climbed the Am Law 200 from No. 199 to No. 86 while climbing the profit per partner (PPP) rankings from twelfth to second. Similarly, Kirkland & Ellis, with its strong emphasis on private equity, bankruptcy, and litigation, rose over the same period from ninth to second in revenue, and from 10th to fifth in PPP. It is not only high-prestige segments that can exhibit increasing returns. The same dynamic can be seen in any well-defined segment with the opportunity for lowered competitive intensity and heightened profitability.
All this is to say that law firms should be chary of simply co-opting the public company view of growth as vital or even a virtue. Law firm leaders have to be particularly conscious of their own motivations. After all, it’s a lot more fun to talk with headhunters and potential laterals than to deal with ornery incumbent partners who are not doing all they could to further their firm’s collective agenda. Addressing the latter, though, is likely to do more for the firm’s health and longevity than is growth. Alas, leading just isn’t easy.
Hugh A. Simons, Ph.D., is an ALM Intelligence fellow. He is a former senior partner and chief financial officer at The Boston Consulting Group and former chief operating officer at Ropes & Gray. The ALM Intelligence Fellows Program is a collaboration between ALM and leading thought leaders in the legal industry. The program aims to foster the development of data-driven research on key topics related to the business of law.