Rethinking pricing: Why fixed fees and value pricing are not pricing innovations

Pricing in the legal industry has become dominated by the use of the hourly rate. While lawyers were in demand and firms simply had to throw open their doors for work to flood in, this was fine. No great thought was required to set pricing - one simply referred to the firm's published rate card and calculated the fee. Clients effectively had no choice if they wanted to get the work done.

Lawyers undoubtedly missed opportunities to charge premiums when clients got the benefit of years of experience in a few minutes' advice, which saved them large sums. But, in general, lawyers were the main beneficiaries, with high profit levels coupled with very limited commercial risk as clients were effectively paying 'cost plus'.

This landscape has of course completely changed since the downturn, creating significant challenges for some firms, but also opportunities. Clients are using the change in the balance of power to shift the balance of risk too. This is likely to be a permanent change in the legal landscape and it requires innovative approaches to both the client relationship and pricing.

Impact of the recession

The events of 2006-08 caused a severe reduction in demand for legal services (as in many other industries). Consequently, prices have fallen dramatically.

Prices will undoubtedly begin to rise again at some point, but it will not be anytime soon. This particular recession is credit led and, as we know from previous recessions, these are particularly slow to recover. In the Great Depression of the 1930s, it took a decade before United States' GDP returned to pre-crash levels. In the current circumstances, we are still seeing evidence of debts being paid down, so growth is still flat.

The shift in the balance of supply and demand has allowed buyers to have greater influence not only over the level of the price but also the nature of the agreement between clients and law firms.

Under the pre-recession pricing model, lawyers took virtually no commercial risk, expecting the client to take the impact of all unexpected events. These can range from bad estimating through to ineffective or inefficient work. Also, external events can throw a project off track through no fault of either the client or lawyer. The only risk sitting with the lawyer was the risk arising from poor advice.

There are plenty of examples of client frustration with the overall commercial service provided by lawyers. In one notable example, a client gave the following feedback: "You quoted 100k for the job. There was no further discussion about fees until the bill arrived. When that showed a bill of 400k you made me look like an idiot, as I had to go back to the board for authorisation for the extra money after the event."

This illustrates a number of points:

• lawyers need to be good project managers as well as legal experts - and that includes tracking progress and reporting changes early;

• lawyers must understand how their clients work and adapt to it. In this case, the manager had obtained authorisation only for the fees estimated;

• there is an assumption that the client will take all overruns. If you are seeking to align your interests with clients and build long term relationships, consider if this is sustainable; and

• unexpected changes either by the client or third parties are no excuse for slack management of a project or fees.

In this case, the legal team had done a fantastic job in trying circumstances - but was the client satisfied? Clearly not.

What is innovation?

Client surveys are increasingly showing that pricing is, contrary to what we may all have thought, not in their top five concerns. Value for money, however, is. Clients of course increasingly ask lawyers about innovative pricing - and indeed it has become almost de rigeur to include such a question in panel reviews.

But, there is no point in innovation for innovation's sake - but it does not necessarily align you with your client's interest. One bidding team responded to a question about innovative pricing with a striking and bold offer which, while containing some considerable commercial risk, offered big opportunities for both the client and the law firm.

The response received was "in the nicest possible way, you've called our bluff on 'innovative' pricing". The offer was too innovative for the client to digest, but it did demonstrate the team's ability to think outside the box, and was viewed favourably.

Innovation is defined by Wikipedia as "the development of new values through solutions that meet new requirements, inarticulate needs, or old customer and market needs in value adding new ways.

"Innovation differs from invention in that innovation refers to the use of a better and, as a result, novel idea or method, whereas invention refers more directly to the creation of the idea or method itself.

"Innovation differs from improvement in that innovation refers to the notion of doing something different rather than doing the same thing better."

When developing innovative pricing methods, you should look first to solutions that meet your clients' needs more effectively. You do not have to create these methods from scratch, but simply use approaches you find elsewhere - perhaps in other industries. Proper understanding of your client is critical. Conversely, simply reducing your prices is not innovative.

Critical to the successful development of innovative pricing is a different mode of thinking by lawyers. This means losing many of the assumptions that dominate their thinking when it comes to pricing. Below are some good principles to follow.

• Clearly separate price from cost. Using hourly rate cards to price will lead to bad decisions and lost business. The hourly rate includes assumptions about levels of overhead and profit that simply do not reflect the true workings of the law firm business model.

• Understand the competitive environment. Price should be based on what the output is worth, which in turn should be based on the market rate for that output.

• Know what is profitable. Assuming that you cannot do the work 'because it isn't profitable' may lose good business. I have yet to meet a lawyer who, when challenged, could demonstrate how he knew a particular price level was unprofitable.

• Don't race to the bottom. Clients don't necessarily want the cheapest price. Some do but, in many instances, a 'good' price that the supplier can stick to is much preferable for planning purposes.

• Know the meaning of 'quality'. To many lawyers, this means the best job possible. To many clients, this means reliability, consistency and repeatability.

Pricing innovation myths

Let's now look at a couple of pricing approaches and consider whether they really are innovative, then identify the key elements of real innovation.

Fixed fees

This is the solution most commonly offered as the alternative to hourly rates. In its favour, it is already widely used, with a number of large and small law firms doing the majority of their work on this basis. The key benefits are that:

• it is simple and easily understood by both the client and lawyer;

• there is no requirement for detailed tracking of time - if the job is done, the bill is known; and

• some key risks are passed to the lawyer (including the lawyer's own inefficiencies).

However there are disadvantages, which include that:

• it is inflexible when things change - leaving either party potentially out of pocket; and

• there is pressure on lawyers to compromise quality by using under-qualified resources.

In many cases, true fixed fees are not actually used, as lawyers agree to bill 'what is on the clock' if the matter finishes early. This means that it is not really a fixed fee at all, but more akin to a capped fee. Arguably, the lawyer loses both ways, being unable to earn extra profit if costs are less than expected, but also being still stuck with the fixed fee if the matter overruns.

Value pricing

There is much discussion about value pricing as a way forward. The idea is that the price is determined by the value of the output delivered, rather than the work done. In principle, this seems very attractive, as it means the lawyer is able to extract a price related to the difference his work has made to the client and appears to play to clients' requests for 'value for money'. Many are promoting this approach as the means of resolving the pricing dilemma and have developed some complicated 'solutions'.

However, pricing has to exist in the real work. Value pricing has a number of flaws in this context.

• It misrepresents clients' true requirements. When clients look for 'value for money', this does not mean that they want to pay lawyers the full value created by their input; it means they wish to maximise the net value achieved for their shareholders. Clients will not necessarily go for the cheapest option, but the one that leaves the most net value with them after paying their lawyers' bills.

• It ignores the true competitive environment. When in competition with other providers, a value-based solution risks seriously either under or over pricing the solution. Clients are unlikely to choose a higher price just because it is innovative.

• Measurement of value is difficult. Sometimes there can be significant effort to robustly establish the value added. For example, one competing firm actually spent more time on determining, agreeing and measuring the pricing metrics than on doing the work.

One key positive of value pricing is that it is making law firms separate price from cost.

Real pricing innovation

So what does constitute innovative pricing and how do you achieve it? The key elements of an innovative pricing solution are:

• proper understanding of the client's requirement and your firm's requirements, translated into the commercial agreement between the parties;

• value for money in all outcomes, taking into account appropriate reward for risks taken;

• a clear and simple approach so that it is easily understood; and

• a model that takes account of the competition, their capabilities and their competing prices.

Finally, any pricing decision should then test whether the work can be done profitably and, more particularly, how the work can be organised to maximise profits.

Clearly, each truly innovative arrangement will be specific to the parties involved and the circumstances of the deal. The terms are frequently confidential and it isn't easy to describe them, even after redacting names, without disclosing intellectual capital. Below are a couple of examples that are already in the public domain that illustrate the key principles.

Case study 1: Pfizer

Anyone interested in innovative pricing in the legal sector would do well to learn about Pfizer's panel arrangements.

In general terms, a series of law firms have been invited onto this panel. In return for a 'guaranteed' fee, they are required to cooperate with each other and to take on whatever work Pfizer requires of them.

This is innovative not only because there is no direct relationship between the work done and the fee, but also because much of the administration of the supplier relationship is swept away.

There are some key points to note here.

• While the arrangement seems alien to the legal market, it is quite common in engineering supply and servicing arrangements (see, for example, the UK's rail industry).

• The change was clearly driven by the GC of Pfizer - law firms either took part or left the panel.

• Much of the admin and conflict over billing was swept away.

• Law firms have a mutual interest in cooperation.

• The arrangement not only promotes but is dependent upon long-term working relationships, so it will be difficult for new firms to enter the panel.

This is a clear example of a client using the panel arrangement to re-engineer the supply of legal services. This was only possible because of the buying power that the client was able to exert - but this is also the case for many clients.

This type of arrangement is coming to the UK and some clients are actively considering similar arrangements right now. Law firms must be able to proactively deal with such challenges by properly understanding the services and cost of services provided to clients, and be able to manage the client relationship effectively if they are to take part. Those who are unable to take part - or choose not to - can expect to be locked out of panels for prolonged periods of time.

Case study 2: CMS Cameron McKenna

CMS Cameron McKenna's report The Future of Fees lists a number of different pricing methods that are worth considering.

One that is worthy of note is the idea of accepting payment in barrels of oil from a client. This is innovative because it transfers the risk of oil price movement from the client to the law firm - presumably this reduces risk for the client because it deals in oil. It also shows that the firm has clearly understood one of the main constraints for the client to proceed with the work and has sought to alleviate it.

However, this is really an innovative funding arrangement rather than innovative pricing, as it simply addresses the method of payment. It is also a risky arrangement, as law firms do not generally have any expertise in or methods of managing oil price risk. A better risk transfer would be one where a risk that the client cannot control is moved to the law firm which can control it.

 

 

Different perspectives

What these case studies demonstrate is the need to understand the situation as viewed by both the client and law firm and, importantly, how the risks and concerns in that situation can be translated into a hard pricing agreement.

However, it seems that law firms are still behind their clients on this issue, as is demonstrated by the Pfizer example. Clearly, without change from law firms, clients can and will impose that change.

Chris Howe is a director at Raedbora Consulting (www.raedboraconsulting.com)