by Cary Burch, COO of Elite

The severity of the current economic downturn has impacted the legal industry—particularly law firms— in two very remarkable ways. First and foremost, law firms have always been looked upon as recession-proof businesses. The expression on the street has been “No matter what happens to the economy, law firms always get paid.” Unfortunately, this recession is different.

The Peer Monitor Economic Index (PMI), which tracks law firm performance over time, clearly demonstrates a long-term, downward cycle, and while demands for services and rates are in a positive trend compared to the same period in 2010, these are partially offset by increased overhead expenses and head count. According to the PMI Executive Report issued in July, 2011, “Individual firm performance is uneven, suggesting that gains are not being seen across all firms, and indeed some firm strategies are producing weak results amid choppy economic conditions.”

This brings us to the second and perhaps most important change in this New Normal. For the first time in the modern era, clients are in charge. This statement may seem elemental at first, but in today’s economy it has taken on a more nuanced definition in that it reflects a fundamental shift in the association between client and firm, as well as a redefinition of the successful law firm business model. The billable hour is no longer the basis of the relationship rather cost containment is the new mantra for business. As the dynamic between lawyers and corporate counsel continues to unfold, there is one trend that reflects this new relationship: Alternative fee arrangements (AFAs).

AFAs are popular because they offer a new way of doing business, and more law firms now offer AFAs as more clients demand them. There are challenges and risks with AFAs alongside the benefits. There are also many different types of AFAs, which we will now discuss. Each requires data and organizational controls for maximum benefit.

Fixed and Capped Fees
The most common type of AFA is the fixed or flat-fee matter. This type of arrangement is popular with clients, because it gives them a known cost up-front that can be weighed against the benefit of the legal services provided. An alternative to the fixed or flat fee is capped fees, where the firm bills by the hour until an agreed amount is reached. No more fees can be billed after that–additional work will be done for free. Therefore, for fixed or capped-fee work to be profitable, it is critical that the scope of what is and is not included be written out clearly in the client agreement. A considerable burden is placed on the firm to manage the matter according to the tenets of professional project management. This type of work shifts the risk of overruns to the firm, so a poorly written agreement or a poorly managed matter can expose a firm to significant liability.

Contingency Fees
Contingency fees are very common in some practice areas and are often used when there is limited or no ability for the client to pay. However, these types of arrangements are often regulated, so if the arrangement is a new type, it’s worth researching local rules. These types of matters are also risky, so it is important for firms to limit the nature of cases they are willing to take on contingency. Matters should also be carefully vetted. Typical contingency fee matters involve third parties, either as expert witnesses, co-counsel or discovery vendors. Firms need to understand and budget for third parties and for anticipated disbursements before entering into an agreement with the client. As we will see, there are tools entering the marketplace that allow firms to incorporate third parties easily into the planning, budgeting and management process.

Volume Discounts
This is the simplest form of AFA, because it involves discounting the standard hourly rate based on the overall volume done with the firm. This is a great tool for firms to gain more business from a client. Discount targets are often tiered, and the highest tier should be reserved for new billing targets from the client. In many cases, the volume discount is applied not to one matter, but to a large portfolio of matters. As these matters may be managed by several different partners and may cross multiple practice groups, it is imperative that all stakeholders be able to monitor and manage the entire portfolio in a single system or process.

Value-based Billing
The most talked about and least-used form of AFA is value-based billing, in which the fee is based on the value to the client. The client needs to reveal the value of the services, and the firm needs to agree what would be fair compensation, regardless of the effort involved. While value-based agreements are built on attractive incentives, they often contain penalties for missing critical milestones or exceeding the agreed-upon budget. Firms need to carefully evaluate the risk vs. the reward of each engagement prior to opening a new matter.

Leveraging AFAs as Tools

Alternative fee arrangements are tools that the firm can develop and market to gain business and, if managed correctly, increase profitability. There are three steps to success with AFAs:

•    Metrics: AFAs are about risk management. To understand the risks involved, you need to mine your financial system for metrics and information on similar matters. You need to gather statistics and understand what standard deviations occur with this type of work with mathematical rigor.

•    Tracking: Law firms need the tools in place to track their alternative fees matters. It is critical that firms’ finance and management teams establish budgets and track actual progress, so trends can be identified before it becomes too late to manage them.

•    Accountability: The most difficult aspect of managing alternative fees successfully is holding partners accountable for their failures. Firms should have clear policies on how to manage challenges such as cost overruns and associate over-billing. Many firms are now training attorneys and client teams in the concept of legal project management and providing tools to help them create AFAs and to help ensure that these matters stay on time and on budget.

Law firms are entering a new era of pricing flexibility, but well-managed firms can turn this to their advantage—by knowing what to offer clients to meet their internal budget challenges, while still producing a successful outcome for the firm.

Best Practices for Creating Successful AFAs
The one thing that any firm must consider before embarking on AFAs is that some measure of profitability must built into each arrangement. And this is where many firms struggle with both the concept and execution of AFAs. There are, as described above, many variables that must be taken into account, many statistics and activities that must be tracked, and many what-if scenarios to consider. Some firms rely on a specially designated AFA team, often composed of financial systems staff, paralegals and attorneys to design, measure and monitor AFA activity. Others use complex spreadsheets and require detailed reporting from the time and billing system. Many rely on the experience of their practice group leaders and their best guesses.

There is a better way.
A new class of software known as Engagement Planning and Management solutions (EPM), has recently emerged. As an example, ENGAGE, a new tool offered by Thomson Reuters, combines budgeting, planning, resource management and legal project management into one solution integrated within the firm’s technology environment. It can be linked to financial management, time and billing systems, human resources, document management and other segments of the firm. With such a one-stop-shop, it is possible for lawyers to plan-out a matter in minutes; assign tasks to attorneys, paralegals or third parties; and create an accurate budget that can then be negotiated with the client.

EPMs should let the attorney run what-if scenarios to test the budget and measure risk against reward in creating AFAs. The better EPMs allow firms to manage not only single matters, but entire portfolios of matters. They incorporate the principles of legal project management in tools that support rather than inhibit lawyer working behaviors. Most importantly, they let the firm set profitability metrics according to its own rules for regions, practice areas, industries, and so forth.

And, in this new normal, remaining profitable while meeting client expectations is what being successful is all about.