Business Model Part II: The Rise and Fall of the Billing Hour Empire

In the “2016 Report on the Legal Market” that I mentioned in my previous Insights and Perspectives (“The Times They Are a-changin´:Looking into our business model”) I intentionally omited one significant aspect of that excellent work, but only to deal with it specifically. The report calls it the “billing hour mentality” and it correctly observes that the billing hour invades most aspects of the law firm´s business and management: pricing, profitability, budget, performance evaluations of both partners and associates, resource alocation and firm´s productivity. Even when billing hours is not the system used to charge clients, they are always behind our minds measuring how efficient and successful we are.

The report says “It seems doubtful that law firms will ever be able to respond fully to client expectations for more efficient and cost effective delivery of legal services unless and until the stranglehold of the billable hour mentality is finally broken”. I tend to agree.

The sustantive changes the market has brought in the last few years, turning it into a buyer´s market, makes the billing your system –so attractive during several decades- dangerous, misleading and innefective to address the new challenges. It is true that most clients continue to use it and demand it from their firms, but now it works in their favor unlike in the past. Given that we are talking about a professional service, the effective use of time is of considerable importance, but that is only one variable among other important measures of effectiveness and quality. It is worthwhile digging a little into this topic since, from my perspective, this is going to be one of most significant issues that will change the legal business in the following years and decades, and those falling behind in dealing with it will pay severe consequences.

Rationale of the billing hour

The billing hour began to be used intensively in the US market in the 60´and 70´with the intention of improving profitability in law firms. The professional service is notably “opaque” and ambiguous, meaning that it is difficult to assess its quality. From that perspective, discussions about value could become cumbersome. The billing hour came to solve that problem, and it was so successful that firms started using it as an essential management tool. Everything could be measured in hours. This approach became very useful when the industry started a skyrocket growth in the 80´and 90´. In a seller´s market, it was easy and very profitable.

As explained by Huseyin Leblebici from University of Illinois (“Your income. Determining the value of legal knowledge: billing and compensation practices in law firms”, chapter in “Managing the Modern Law Firm” edited by Laura Empson) this system produces a very strong set of practices that tie to each other and makes it difficult to change. Those are, in addition to the hourly billing, a cost-plus pricing practice, a deferred compensation system based on seniority and partnership, and the up-or-out mechanism to reach partnership.

The cost-plus pricing assumes that an hourly rate is defined so that it can pay all costs, plus the margin for the partners –traditionally considered at 30%-. This implies a deferred compensation system, where lawyers receive a lower value for their work in terms of market value but with the promise to get compensated at a later stage, if they make partners. But of course, not all associates make partners. The up-or-out works as a monitor system that, in theory, only allows the best associates to reach to top and enjoy the benefits of the deferred compensation.

This business model is clearly firm-driven since it only attends the needs of the firm and the partners, but does not consider the needs of the clients and of a more competitive market. In a system based on hours is difficult to focus on efficiency and value, and incentives can easily get missaligned with those of the clients.

Will the “Hourly Billing Empire” fall?

When you consider how law firms work and how tight their traditional business model is built, it is really hard to think that the hourly billing will not continue to be the main management tool in defining and implementing strategies. However, the new trends in the market, which shifted the balance from the seller to the buyer, create severe constraints for an effective use of the hourly billing system.

As mentioned before, many clients continue to prefer this system but only to use it in their benefit by lowering rates, asking for caps, discounts and other arrangements that many times look unfair for law firms. An honest discussion of value should be fostered between law firms and clients, where time is not the only variable. Fixed fees and other more creative schemes should be used, where law firms need to work hard in becoming more efficient in their service and taking the risk of their mistakes.

This will take away progressively the cost-plus approach, which is internally focused but disregards efficiency and competitive service.

Also, the deferred compensation and up-or-out arrangements are being questioned by younger generations that do not easily enlist for long-term careers. Loosing valuable human resources in an up-or-out structure might not be the wisest strategy in a competitive market where you need to be increasily innovative and flexible. The whole structure proposed by the traditional piramid-model might not work so well in the future.

As Leblebici suggests, law firms in the future might need to look more like professional corporations. Although this might appear to be applicable only to big firms operating in more developed markets –and therefore not affecting smaller markets like Latin America-, I argue that the fundamental issues that this trend raises will be relevant for all jurisdictions where law firms engage with international clients and firms. Maybe small firms with a family model could hold to traditional structures, as long as they do not compete for clients and talent with more modern and efficient firms.

The “Billing Hour Empire” will continue to show their strength for some time, but firms should start working on a new model before the changes become so significant that there is not an alternative, and then it might be too late.