Pricing legal services

EDITOR’S NOTE: Abridged with permission from Buying Legal Council’s The Definitive Guide to Buying Legal Services

The Association of Corporate Counse released a comprehensive report benchmarking legal operations in March 2020. The law department maturity model (3 stages) surveys 15 functions, with one of the functions being External Resources Management. The findings were telling. Only 11 per cent of the 316 participants reported they were in an advanced stage for this function. Three of the 13 sub-functions are noteworthy when considering the proportion of companies that had no measures / protocols in place.

• 42.8 per cent of companies did not have outside counsel and vendor management as centralized functions within legal operations or involvement of legal ops in RFPs, engagements, pricing and performance reviews
• 65 per cent reported that Alternative Fee Arrangements were not considered and were not heavily used in all matters
• 69.2  per cent of law departments did not rely on systems to smoothly incorporate / support AFAs in billings and metrics.

It is worth remembering that the “best price” for a portfolio of legal work depends on a combination of factors, including:

• multi-year demand forecasting that reflect estimates, not guarantees, of work volumes
• the fewest possible number of firms (convergence)
• agreement on staffing / delegation distributions for each portfolio and category of work
• a commitment to rigorous matter budgeting by task / phase and by timekeeper

When it comes to pricing, managing the expectations of all stakeholders, including law firms, requires considerable preparation. This is essential when the objective is to prioritize non-hourly fee arrangements such as AFAs and make these the predominant rather than the occasional method of pricing legal work. For most companies, and for many law firms, AFAs still represent a significant shift away from variations of the hourly rate. Many law firms introduced the role of pricing specialist to respond to RFPs and ISPs some years ago, and in many cases to lead the firm’s pricing negotiations. Many firms have 5 to 10 years of experience working systematically with dozens of clients on pricing. Their knowledge of law firm economics is sophisticated.

Pricing legal work requires much more than proficiency in AFAs. Companies should possess a practical understanding of law firm economics and the related profitability variables, of law firm cultures, and of law firm compensation systems for partners and associates for the firms that they use.

Unmanaged practice patterns in law firms add at least 10 per cent to the effective rate. The RFP or ISP should prescribe “optimal staffing distributions” for categories and portfolios of work. Firms should be asked to propose compact and stable teams of senior and junior professionals as well as paralegals to cover the reference period. Law firm responses to the RFP / ISP should state the extent of their support and the related conditions for the application of these optimal staffing distributions in pricing legal work.

Some have said that AFAs should stand for “appropriate” rather than “alternative” fee arrangements. This leaves the door wide open to default to traditional variations of hourly rates. It is also at variance with making non-hourly fee arrangements the predominant albeit non-exclusive approach to pricing legal work. Over the years, corporate law departments have selected pricing that they believed suitable for individual matters. Nevertheless, today more than 80 per cent of legal work referred to external counsel is still priced on a variation of hourly rates. This is not surprising, since hourly rates require a minimum amount of change to operating practices in the company and in the law firm. This is not the same as cost-effective pricing.

There are three basic categories of fee arrangements and each has variations - hourly fees, fixed and flat fees, and contingency / percentage-based fees. There are hybrids and variations for each of them. For instance, a fixed fee can be combined with a performance fee tied to a result. Designing an alternative fee arrangement that is effective and appropriate for a category of matters – possibly for hundreds of matters with a broad range complexity levels covering a three-to-five year reference period – requires a credible demand forecast and a critical mass of work.

Getting companies and their law firms “off the clock” and focused on the company’s priorities suggests that the choice of pricing should:

• stimulate efficiency in legal work, enough to reduce the hours needed to support a portfolio of matters by at least 10 per cent over time.
• reward the effectiveness of legal work, as measured by the results anticipated by the client.
• promote innovation initiatives that pass the S.M.A.R.T. test and which improve efficiency and / or effectiveness.

Performance-based fees are a retrospective fee based on value. The performance indicators should be set out in the RFP / ISP and in the terms of engagement with each firm. Performance indicators typically include results, service levels, efficiency and cost predictability.

A few companies have migrated to a more advanced and simpler form of performance fee with their primary firms because they have been satisfied with service levels, with results and cost management over the years. In such cases, performance tends to be more developmental in nature and can take the form of an Innovation Fee that supplements a fixed base fee. From 10 per cent to 15 per cent of the overall legal budget can be reserved to fund innovation.

It has been nearly 30 years since some companies began to use the procurement process to reduce or “converge” the number of law firms relied upon. Some have completed their fourth or fifth procurement cycle. Convergence is a sourcing strategy that creates a larger share of work for the successful firms. This in turn provides the company with more leverage in price negotiations. In the context of multi-year agreements or multi-national coverage, the law firm has access to a critical mass or work and to a dependable but not guaranteed revenue stream.

Ben Heineman’s The Inside Counsel Revolution (2016) traced the continuum of practices and relationships that law departments have had with external counsel over five phases. Phase Three refers to the era of “preferred providers” when preferences for key law firms and particular lawyers become explicit. The largest volumes and most interesting work continue to flow to traditional providers, and it appears that relationships and a good track record continue to trump price. In this phase, law departments do not have the analytical tools, or they fail to use them to their full potential. They cannot determine how much more they are paying than what they would pay to other panel firms.

Assuming a Phase Four relationship is in place with primary law firms, a company should then commit – but not guarantee – a volume of work for several years in exchange for a fixed price. The company secures budget predictability, and the firm has regular cash flow. Provided annual volumes are sufficient, collar arrangements, ranging from 10 per cent to 15 per cent are usually sufficient for the firm to secure predictable cash flow and to stimulate efficiency in the law firm.

If follows that fixed fees for a portfolio of work can easily evolve into hybrid fees consisting of a fixed base amount plus a variable portion tied to key performance indicators. It is still only a minority of companies that systematically evaluate the performance of their primary law firms, with most others preferring a “no news is good news” approach. Heineman discusses the elements of company-law firm partnering arrangement in Phase Five.

Setting aside transitional arrangements with legacy firms which are not retained after a new procurement cycle, companies should prepare a preliminary work allocation of 100 per cent of the RFP / ISP Scope of Work to the smallest number of firms. An example follows for a portfolio of 25,000 hours per year covering employment, labor, benefits advice, affirmative action, and strategic advice regarding Human Resources with requirements in 15 states.

Preparing a first draft of the costing allows the law department to consider the best balance of cost, coverage, and competence (expertise). Additional drafts for different allocations will affect the applicable discounts and the overall cost. A preliminary costing should be prepared before the second (or final) round of price negotiations with the successful law firms. In the example above, Firm D would be paid $ 4,400,000 per year for 8.000 hours. The three-year price would be $ 13,200,000 for 24,000 hours of Benefits and Strategic Advice. The fee would not vary if the worked hours (assuming a 10 per cent collar) ranged from 21,600 to 26,400 over the three years.

A final comparison of prices is carried out after a second round of price negotiations is completed with the successful firms and after the final/provisional allocation of work is made. Experience suggests that firms are eliminated:

• based on the results of the non-financial evaluation
• after a comparative evaluation of prices but before negotiations
• after a first round of fee negotiations
• after a last round of price negotiations and a final/provisional allocation of the portfolio of work