Abandoning hourly pricing for legal services

I recently discussed pricing legal services with Dr. Silvia Hodges Silverstein, CEO of Buying Legal Council – the global trade association representing procurement professionals focused on sourcing legal services for companies.

Dr. Hodges Silverstein began by asking how a multi-year forecast of a company’s demand for legal services fits in, especially when none of us knows the future.

Fixed fees with a collar accompanied by a fair review and adjustment mechanism have been shown to work when applied to a critical mass of work for a law firm. The risk and rewards can be balanced. But all of this depends on a multi-year forecast of the demand for legal services. To begin, the forecast should examine historical data and then incorporate legal’s estimate of future volumes for each category and jurisdiction of work. The estimate (±10%) reflects business requirements, insourcing, and a productivity dividend that come from the use of matter plans/budgets in combination with the right Alternative Fee Arrangement.

Estimates are expressed as the number of hours for each specialty and jurisdiction where a company is likely to retain counsel in the future (three years). The estimate then serves as the SoW for the RFP. Finally, the RFP makes it clear that the projections are estimates and not a guarantee of work.

As part of my discussion with Buying Legal Council, we polled companies about their use of multi-year forecasts of the demand for legal services.

• 43% of companies say they do not prepare a demand forecast.
• 52% of companies prepare a forecast but express it in terms of budget and only for internal purposes.
• 0% of companies prepare a forecast and express it as the number of matters and/or number of hours by category of legal work.
• 5% of companies include the forecast as part of the scope of work when sourcing external counsel and negotiating fee arrangements. 

During our discussion I explained why I recommend that Alternative Fee Arrangements be prioritized as the dominant form of pricing in Requests For Proposals.

Last year, a national benchmarking report surveyed 15 law department functions, one of which was External Resources Management. Two points were noteworthy:

• 65% of the 316 participants reported that AFAs were not considered and were not heavily used in all matters, and
• 69.2% of law departments did not rely on systems to smoothly incorporate/support AFAs in billings and metrics.

This tells me that variations of hourly billing arrangements continue to be the default practice/mindset for both procurement and law departments. Fixed fees, flat fees, contingency fees and the related hybrids are better tools to align law firm business objectives with company objectives for all types of legal work. And they provide superior cost control. RFPs should state that AFAs are a company priority and will be the dominant pricing arrangement because this represents a commitment that generates the necessary momentum for change.

Dr. Hodges Silverstein asked why I believe it is essential to set firm pricing targets internally that are aligned with RFP objectives.

I prefer pricing targets that are applied to multi-year budgets for legal services, and to all categories and complexities of legal work. A sourcing program that is agreed between procurement and legal should be explicit about what the company wants to pay for an anticipated volume of work in the future. Targets must be Specific Measurable Achievable Results-oriented and Time-limited.  They dictate the sourcing strategy, the approach to fee negotiations, and ideally – the optimal AFA. Targets should influence the number of firms that are retained, their geographic coverage, changes to work allocation practices by the company and within the law firm, and the use of legal matter plans and budgets. But pricing targets are not disclosed to law firms.

We polled companies to find out what percentage of their total legal spend is an alternative fee arrangement, excluding discounted and blended hourly rates.

• 0% to 5% - 26% of companies
• 6% to 10% - 30% of companies
• 11% to 25% - 22% of companies
• 26% to 50% - 17% of companies
• Over 50% - 4% of companies

Dr. Hodges Silverstein asked me to discuss optimal staffing distributions for various categories of legal work. I recently co-authored the book: Buying Legal Council’s The Definitive Guide to Buying Legal Services.  In the chapter on “Scoping Legal Services” I suggest that “unmanaged practice patterns” in law firms add at least 10 per cent to the cost of legal services. Every sourcing initiative should start with real data about how a company’s law firms allocate tasks for each type of matter. A formal Request for Information covering at least 24 months quickly reveals everything a company needs to know about law firm staffing patterns, including its delegation of work.

Our research found that about 20 percent of tasks are under-delegated to the next experience level: senior partners, junior partners, senior associates and so on. There are always significant differences among the firms doing the same kind of work. However, one will find firms that have worked hard to achieve and maintain the right leverage. They should serve as the precedent the company requires from its other firms.

A well-developed RFP will prescribe optimal staffing distributions for each category of legal work and account for matter complexity. Law firms bid with these distributions in mind.

 I asked companies to what extent they consider law firm staffing distributions in pricing.

• 22% of companies conducted detailed analysis of firm staffing distributions post-2019.
• 61% of companies use staffing distributions for individual matters but not in RFPs.
• 17% of companies apply staffing distributions by category of work in the Scope of Work (SoW) when sourcing external counsel.
• 17% of companies reduce baseline legal spend +10% by changing staffing distributions.

Dr. Hodges Silverstein asked whether blended hourly rates can be used instead of individual timekeeper rates as a building block for AFAs for each category of legal work.

It is not enough anymore to secure a 15 per cent discount on individual rates. At a minimum, blended rates should reflect optimal staffing patterns. Initially, the new blended rates are typically 10 per cent lower than historical (blended) rates. Those savings are greater than the next level of discounts. I should add that the optimal staffing distributions are always front and center during price negotiations with each firm.

Blended rates are a building block for fixed fees or for other AFAs applied to a portfolio of matters over time. Some companies will accept a discounted blended rate as a billing arrangement when it is not able to estimate or share the anticipated volume of work with a firm. Even then, the volume of work affects the level of discount more than the blended rate.

Blended rates shift the responsibility for managing delegation to the law firm away from the company that no longer wants to autopsy invoices. Blended rates provide increased predictability about legal costs because they reflect appropriate leverage (delegation) and rates. The number of hours can be managed with a combination of legal matter budgeting and a fixed fee with a collar.

What can be achieved by setting aside 10 percent of projected legal spend to recognize law firm performance with Key Performance Indicators such as effectiveness, innovation and efficiency, and then make this part of a hybrid AFA.

Some law departments have concluded that the only way that they will make innovation headway is when they pay law firms to help them do so. Nearly 10 years of legal innovation awards testify to the opportunities for innovation in all facets of a company’s legal activity.

The company reserves at least 10 per cent of the legal budget to recognize performance as measured by results, service levels, efficiency, and cost control. A few companies have migrated to an 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%-15% of the overall legal budget is then be reserved to fund innovation. To be clear, the innovation fee is a sub-set of the legal budget and not an add-on.

Specific projects are developed by the law firm and the company – effectively these are a list of “research and development” initiatives that can benefit the company in the short term. A specific budget is proposed for each project. Under the guidance of the law department, each project is evaluated upon completion. The extent of success determines how much of the project budget is paid to the firm.

Companies describe the hybrid pricing plan in the RFP and ask law firms to commit – at least in principle – to this type of AFA. 

I asked companies about the extent of performance pay with when retaining law firms.

• 52% of companies do not have performance pay for any of their law firms.
• 43% of companies use performance pay on individual matters only and very selectively.
• 0% of companies apply performance pay on an annual basis to the overall work of some of their law firms.
•  4% of companies say few law firms have approached them to discuss performance pay.
• 0% of companies target innovation in legal services with a performance pay program. 

Companies can take a number of bold and specific steps to abandon hourly billings for legal work.