Realising revenue: Using realisation to determine lawyer compensation

 

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Three things you will learn from this Masterclass:

1. The impact of realisation on firm revenue

2. The pricing decisions which affect realisation

3. How to factor realisation into compensation decisions

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In the United States, the key statistic in managing a law firm and compensating its timekeepers has traditionally been revenue. But, aside from profits per equity partner, there is no metric used consistently across the legal sector to compare the performance of all timekeepers (i.e. equity partners, non-equity partners, associates, paralegals and litigation support staff). Some firms measure revenue per partner and per lawyer, while others measure revenue per timekeeper and per person. This article looks at realisation, one of the three components of revenue, and how it can be factored into compensation decisions.

Suitability for partnership is usually determined by the person's book of business, as measured by the fees collected (revenue). Meanwhile, the distinguishing ranking for compensation purposes is originations and personal production, both of which are measured
by fees collected.

That is beginning to change. Firms are examining the profitability of practices, clients and partners. Managing to profit margin is the new initiative law firm leaders are talking about. Firms are developing profit tools internally or acquiring analytics packages to bolt onto their financial systems. Partners are being given these tools to assist them with pricing, staffing and other aspects of managing their practices. Once accepted, the metrics generated by these tools are integrated into compensation programmes, along with the other factors considered when making those decisions. The profit margin looks at the relationship between profit or individual contribution to profit and revenues.

Challenges of realisation

Let's begin with a bit of background. There are three components that make up revenue - demand, pricing and realisation. The recession ravaged all three of these metrics. Demand for lawyers' services collapsed in some practice areas and weakened elsewhere. Recovery in demand has been inconsistent, with demand for litigation continuing to lag, largely as a result of a shift in client approach and the use of alternative service providers.

Rising hourly rates, once the driver of revenue growth (with increases easily outstripping inflation and expense growth year over year), now barely match inflation.
A decline in realisation (which had been very gradual over the long term) has accelerated and, combined with slowing price increases, has resulted in nearly no net gain on a realised rate basis since the recession.

A good working definition of realisation
is fees collected divided by the standard value of the time worked. It is a conversion metric telling us how well one converts time value into cash receipts. Time value is the product of demand (billable hours) and pricing (hourly rates).

These metrics are interdependent.
For example, one law firm had near-perfect overall realisation but, upon examination, it was discovered that its high realisation was due to unbelievably low billing rates, resulting in lost revenue overall. At the other end of the spectrum, large accounting firms have been known to have realisation rates in the low 80 per cent range due to routinely large discounts on high standard rates. These are two examples, one unintended and the other planned, where realisation is affected by pricing decisions.

Another law firm operated an aggressive time-capture philosophy - throwing every interaction with or thought about a client into the time and billing system. In other firms, low work volumes led to a slower work pace, designed to stretch the work to meet time recording expectations. Both of these choices affected realisation later in the cycle.

Realisation is also affected by staffing decisions. When work volume is down, some timekeepers hold onto their work to keep busy, rather than assigning it to the individual with the most appropriate experience and expertise. At other times, when assignments are made, there may be poor delegation or case management decisions, which lead to the wrong people doing the work. If the partner does not adjust the bill, the clients will most assuredly push back.

Components of realisation

Some firms treat realisation as a monolithic metric. However, realisation is anything
but that (see Figure 1). To improve this metric, one must first understand its
various components.

The metric most often published in surveys and law firm reports is overall realisation, which is the product of billing realisation and collection realisation. There are also two versions of realisation that
many billing systems track: realisation using actual billing rates; and realisation using standard billing rates. Finally, there is an insidious hidden realisation factor of unreported or underreported time. Let us explore each of these sub-groups.

1. Timekeeper deductions in timesheets

Sometimes an inexperienced individual may reduce the amount of time recorded, believing that he/she took too long to complete a task. Other times, sloppy time capture habits, such as waiting until the
end of the day (or longer) to record time, result in fewer billable hours recorded than were actually worked.

It is hard to quantify something that exists only in its absence. The availability of electronic time capture and recording software should, if used properly, greatly reduce sloppy time-capture habits as well as some of the unreporting and underreporting. The higher realisation resulting from this phenomenon leads to false conclusions about process efficiency and timekeeper skills, and equally faulty decisions regarding pricing. All of these can be deadly to good profitability.

2. Pricing discounts

Say a client asks for a 10 per cent price discount. This is a common request and appears innocuous; therefore, it is granted. However, what does a 10 per cent discount mean? It means that likely 40 to 60 per cent of the profit for work assigned to others under such an arrangement is given away. When expressed in those terms, it is no longer innocuous. Figure 2 shows that such discounting has increased over time. More and more clients are asking for larger and larger discounts, depending on the work
and the circumstances.

Generally, standard billing rates are used to calculate realisation. Law firm time and billing systems also maintain alternate/actual billing rates for each timekeeper and matter. Standard rate realisation reflects the results of pricing decisions, as well as the consequences from matter management, service efficiency, staffing decisions and client perceptions of value for the matter.

Actual rate realisation only reflects the matter management, service efficiency, staffing decisions and client perception of value for the matter. One can report both realisation figures (standard and actual rate) and calculate the difference between the two realisation rates. The pricing variance
is the result of that calculation.

In tackling a pricing variance problem, consider the following questions.

• Is pricing clearly communicated to clients?

• Is there a mechanism to adjust pricing (periodically or if material facts of the representation change)?

• Does the pricing reflect risks assumed by the firm?

• Is pricing competitive to what others charge for similar services?

• Does the pricing consider constraints imposed on the firm (time requirements, exclusivity in representation, use of developed work product and the like)?

• Does the pricing consider the client's payment history?

• Do you employ the large CPA firm model of high standard pricing with significant contractual discounts?

3. Write-downs of unbilled time

Realisation suffers the most during billing. Some lawyers are reluctant to bill fully in fear that the client will not perceive the value of the work done and push back on the amount or not pay for it in its entirety.

However, a lawyer's perception of value may not comport with his or her client's, or with what the client will accept after a conversation explaining what work was done and why. Each firm should establish and enforce policies that limit the adjustments taken, without additional authorisation, prior to billing. The policies should also address how to record
write-downs.

The typical methods that affect how adjustments are allocated among timekeepers are:

• specific time-entry identification;

• pro-rata reductions based on proportional time value; and

• billing subordinates at full value,
  while the billing partner takes the
  full adjustment.

Methods of adjusting the accounting records include lowering billing rates (adjusting pricing), reducing time (adjusting utilisation) or reducing fees. The latter is preferred as it more accurately reflects
what has happened.

Consistency across billing professionals facilitates analysis and control. By isolating write-downs of unbilled time, the firm can calculate
billing realisation (the percentage of
the time value recorded lost at the
time of billing).

Figure 3 depicts billing realisation
data for the US legal profession in 2001,
2007 and 2013. It shows the deteriorating trend in realisation. Both standard and actual rates of realisation declined, but
the actual rate of realisation held up
longer and dropped less while discounting took off. This is the result of increasing client pressures on pricing and value.
The data will be different for different law
firm size ranges, as well as for different practice specialties.

Efficiency variance

Efficiency variance is the difference between 100 per cent realisation and the realisation rate calculated with actual billing rates. This measure looks at non-pricing issues affecting realisation. It includes staffing decisions involving experience
and expertise, as well as the efficiency of the process used to deliver the services.
It also reflects the nature and success
of supervision on the matter.

In taking on an efficiency variance problem, consider the following questions:

• Does the firm have the proper staffing profile (expertise and experience) for
  the work it does?

• Is there a work plan/budget against which you compare actual progress?

• Are those supervising the matters trained and proficient in project management techniques?

• Are you leveraging technology effectively?

4. Client adjustments resulting in
write-offs of receivables

Aggressive billing practices may result in greater client oversight of the firm's invoices. This can slow down payment and increase the adjustments as clients wade through every time entry and cost item. Client adjustments provide the basis to calculate collection realisation (the percentage of the bill actually paid by
the client).

Clients do not like surprises, especially a surprise in the invoice amount. Firms need to keep clients informed about what is happening and why. If the firm has established a plan and budget, then it must discuss significant changes as they arise, update the plan and budget based on material changes and secure the client's agreement to proceed.

If the invoice contains items the billing lawyer believes the client may not be expecting, it is important to discuss the reasons in a cover letter or have a conversation with the client about the status of the matters before sending
the invoice.

Also, if the pre-bill has been adjusted, show those adjustments on the invoice. Clients generally understand that not all goes according to plan and appreciate the partner's consideration of what an appropriate charge should be. This can smooth the way to request some additional consideration from the client for those items that the firm feels should be paid.

Figure 4 depicts collection realisation trends in US law firms. Realisation for adjustments taken after billing the client have improved marginally, but are likely within the survey's margin of error. As above, sub-groups within the profession
will have different collection realisation rates.

Overall realisation

The overall picture is that law firms are experiencing declining realisation. Realisation has been slipping over the
long term and the pace has accelerated with the recent recession. The recession brought with it greater price discounting
and scrutiny of matter management,
service delivery and staffing.

Figure 5 depicts overall realisation trends in US law firms. Some might wonder at the significance of this - so what if realisation dropped from 88 per cent to 85.7 per cent? It is only a 2.3 point decrease. However, it is 2.3 points off the equity partners' margin (the money available to the owners). And, it significantly blunts the effect of billing rate increases - leaving net rate increases below inflation.

Remember that pricing has been the primary driver of revenue and profit growth in the profession, with year-over-year increases well in excess of inflation. (As noted earlier, sub-groups within the profession will have different collection realisation rates.)

Aside from the basic elements of realisation already discussed, the speed of collections is an important factor directly affecting collection realisation. Slower billing and longer payment cycles result in less money being collected, lower realisation rates and higher working capital requirements. Two additional metrics that indicate the speed of collections are turnover of unbilled time and turnover of accounts receivable.

1. Turnover of unbilled time

This measure looks at how many months of revenue are sitting in unbilled time inventory. Typically, there are about 1.75 to 2.5 months of revenue locked up in unbilled time inventory. This includes about a quarter to half a month of revenue locked up in contingent fee matters.

If a firm is trying to effectively manage
its unbilled time value inventory, the following questions may help:

• What provisions are there for retainers and advance billings?

• What percentage of fees is determined on a contingency, end of matter or
  other basis?

2. Turnover of accounts receivable

This measure looks at how many months of revenue are sitting in fees receivable. Typically, there is a pattern similar to unbilled time, with about 1.75 to 2.5 months of revenue locked up in fees receivable.

Most lawyers will say that the only issue they dislike more than telling a client how much the service will cost is asking the client to pay for that service once a bill has come due. Questions to ask in working through a build-up of older accounts receivable include:

• What policies are in place to follow up?

• Are there stop work thresholds (within the constraints imposed by legal ethics and responsibilities)?

Consider this example of how working capital is affected by the speed of collections: a 500-lawyer firm averaging $650,000 in revenue per lawyer would
save approximately $13.5m in working capital requirements, with a half-month reduction in inventory.

Examining realisation is important to maintain good fiscal health in a law firm. It is essential to examine realisation at its component level. The appropriate remedy will vary based on the cause; the only way to get to the cause is to get into the details.

Realisation and compensation

Once a financial management tool is developed, rolled out to a test group,
refined and instituted across the firm, it is ready to be introduced into the compensation programme. This is a best practice to achieve compensation that is proportional to performance. It is not advisable to use financial metrics in compensation decisions until they are
fully integrated into firm operations.

How important is realisation in the overall compensation decision? Currently, financial metrics (other than collected fees) are relatively minor factors in most law firms' compensation decisions. Each firm will need to decide for itself. The weight accorded to realisation in compensation decisions should parallel its importance in firm operations and the overall success of the firm.

The following questions will assist in positioning realisation into a compensation programme:

• Does the firm want to put this
  metric into a formula?

• Should it be part of a formal
  scoring system? ?Should it be considered a ranking or rating?

• Will it be combined into a
  broader basket of factors
  such as speed of billing
  and collections?

One way to consistently determine
relative performance is to assign each partner a performance profile. For example,
a partner scoring system for realisation and management of the value of unbilled time and accounts receivable might look like Figure 6.

 

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Figure 6: Sample partner scoring system

5 Points: This partner is considered a valuable resource on fee and financial metrics. This person regularly realises premiums above standard rates and overall collects above 95% of standard rates. Only 10% of unbilled time and 5% of receivables are more than 90 days outstanding. He/she uses retainers and advance payments on a consistent basis to reduce working capital requirements, maintains time records contemporaneously and submits daily, and returns pre-bills to accounting within 48 hours of receipt each month.

4 Points: An effective and efficient manager of fiscal matters, this partner averages 90% to 95% of standard rates. In addition, 20% of unbilled time and 15% of receivables are more than 90 days outstanding. He/she maintains time records contemporaneously, submits them with a one-day lag and returns pre-bills to accounting within 72 hours of receipt each month.

3 Points: A competent fiscal manager, this partner discusses the economic arrangement with clients before a matter is undertaken, including establishing budgets and milestones. The partner averages 85% to 90% of standard rates. On average, 30% of unbilled time and 25% of receivables are more than 90 days outstanding. Time is recorded contemporaneously, with two days’ lag, except at month-end. Pre-bills are returned to accounting within 72 hours of receipt each month.

2 Points: A struggling fiscal manager, this partner regularly has realisation challenges and client payment issues. The partner averages 80% to 85% of standard rates. In addition, 40% of unbilled time and 35% of receivables are more than 90 days outstanding. Time is submitted weekly and may or may not be maintained contemporaneously. Pre-bills are returned to accounting promptly after they ask for them.

1 Point: This person does not adequately discuss economic arrangements or budgets with clients such that clients are regularly surprised by the costs being incurred, staffing and other factors affecting their bills. Realisation is below 80% of standard rates. Worryingly, 50% of unbilled time and 45% of receivables are more than 90 days outstanding. Time is not maintained contemporaneously and the accounting department regularly chases the partner for time submission and to return pre-bills.

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While the example scoring system provides a consistent rating of each partner across the firm, it may be advisable to modify it with more nuanced considerations of performance versus budget, performance progress and performance against the market. Of course, adding these considerations raises the effort required.

The following questions provide
the basis for a more nuanced look at
a partner's efforts and results when managing realisation.

• Does the firm have sufficient
  information to set practice, client
  or partner realisation budgets?

• What is the current condition of
  each realisation component for
  each practice, client and partner?

• What are the short, intermediate
  and long-term targets for each?

As law firms move to measure profitability - revenues less allocated expenses -
it is important to take the same effort
to understand the impact on profits from pricing, efficiency and value adjustments
to the revenue stream.

James D. Cotterman is a principal at legal management consultancy Altman Weil (www.altmanweil.com). He advises law firms on compensation, capital structure and other economic issues.

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