It looks just like a law firm, but smaller!

We’ve almost all done it in the past 12 months – a degree of re-financing, an element of downsizing, a revision of ownership structures and, maybe, even spent a moment or two trying to make contact with the almighty.

The economic landscape in which most law firms operate has required most of these actions to be both contemplated and completed over the past year – only very lucky or very sleepy firms will have avoided these challenges.

The question that interests me is how many firms have focused their activity on a clearly identified outcome and how many have just been fighting for survival?

Is survival more important than working to a plan?

I suppose the answer to this question can only really be explored in the context of timescales.

Undoubtedly, the speed with which the global financial crisis hit general economic activity towards the end of 2008 left few businesses with time to luxuriate over three to five year re-alignment strategies. Most law firms were faced with an overnight problem of rapidly falling demand for their product.

At that time, and in the months that immediately followed, the protection of cash reserves, rigorous management of working capital balances and focused activity to maximise whatever work opportunities existed, all seemed like perfectly logical priorities to work to. For many firms, this approach will have provided a convenient bubble of denial to live in, confident that the good times would soon return. Indeed, many firms have become so relaxed about these issues during the boom years that the initial benefits of heightened management activity will have seen their firm perform quite well.

The more pessimistic among us were considering what activities would be required to make firms fit to compete in a radically different market when the good times did not return.

The depth and breadth of this recession, coupled with the long-term consequences of the Legal Services Act 2007, offer far-reaching challenges to our interpretation of the historic market for legal services and how things will change in the future. One thing is very clear – the significance of the consumers’ views on price and quality, in short ‘value’, have now reached an unprecedented level of significance.

Anybody who, over the past 12 months, has not been orienting their business towards the long-term importance of these changes has realistically just been fighting for survival and not working to a long-term plan for maintaining a viable business.

Why bother surviving, with or without a plan?

Most firms are currently funded in their entirety by a combination of personal debt from partners, bank overdrafts (often personally guaranteed by the partners) and term loans, again often secured on the partner’s personal assets.

However one looks at it, any form of insolvent termination of the business is going to be regarded as a bad outcome for the partners personally. They stand to lose value in their personal assets, reputation in professional circles and possibly even the ability to practice.

With all this at stake, perhaps the overwhelming force that drives most firms to survive is an intense fear of the alternative and how it will impact on individual partners. Maybe the notion of long-term prosperity and the opportunity for a glorious legacy in succession is just that – a notion.

Despite these hard times, there is clearly still a good living to be made from a legal business. It just requires some attention to the margins and an understanding of how to be successful in a marketplace where the customer will rely on purchasing criteria broader than just custom and habit. It also requires a re-basing of the concept of what a good living is, in the context of a world where the incomes of highly paid professionals are unsustainable at historic levels.

Some might even say that these are truly exciting times for mid-tier firms who have long been overshadowed, to some extent, by the industry giants in terms of client perceptions. The opportunity to establish a new market position and raise expectations about future client developments, coupled with an unprecedented number of talented lawyers available for hire, is surely worth surviving for.

How can a plan bring success?

Simply cutting costs and reducing the scale of operations is unlikely to prove a long-term solution to the challenges thrown up by this recession. Similarly, pumping new money into a business whose margins of return have been fundamentally undermined is not a long-term solution either.

The only realistic way to deliver long-term sustainability is by operating at sustainable margins with an adequate level of working capital. Having a plan to achieve this is both essential, and technically quite demanding to deliver.

The past 12 months have been a tremendous opportunity for finance professionals working in and with law firms. From capacity modelling to terms of business, right-sizing to tax strategies, the range of parameters requiring examination and understanding has been vast, even for the seasoned campaigner. For those who have mastered these variables, this period has heralded a new order of commercial prudence, scientific modelling and development of internal commercial practices that will drive some law firms dramatically further and faster than others in the future.

Thorough examinations of the businesses margins, coupled with a determined effort to drive the operating cost base to its lowest sustainable level, are fundamentally important preparations for responding profitably to a new pricing and demand model in the industry.

Maintaining momentum within the business, while right-sizing and re-financing, will prove very difficult without a clearly articulated and accepted plan. Similarly, these activities are simply part of the journey, not the destination, so a plan is required to define how the business will make a competitive advantage of its new lean shape and replenished working capital.

There can be no doubt that the industry faces a revolution in terms of the ‘hourly rate versus fixed price’ debate, and, as this unravels, the real issues will all revolve around operating cost. Until very recently, the industry did not give much serious thought to what long-term market existed for its product; rather, most law firms’ annual financial strategies were based on increasing units of production on the assumption that they would just be sold. In the historic market, this approach usually worked, as demand did generally exceed current supply.

The significant challenge for the future must be in planning for both market volume and price variations in establishing successful financial strategies.

How do volume and price variables affect law firms?

Before considering the technical points that flow from this question, pause to imagine the cultural impact that the past 12 months have had on most law firms. When was the last time firms saw entire departments sitting with little or nothing to do, unable to attract new work, even at the most knock down price conceivable?

While the industry has become accustomed to the concept of competition being healthy to gain access to the most desirable or well-remunerated work, it was generally possible to lose out to a competitor on one job and still find sufficient elsewhere to keep the team busy.

Not knowing, with any certainty, what share of the market is being targeted by a particular team, or even what level of market exists, is a fairly new phenomenon for most firms, and is both culturally and commercially de-stabilising. Take away relative certainty in this area and confidence will soon follow. Ironically, the finance professionals are, at this point in the analysis, becoming responsible for shoring up the egos of their legal colleagues.

Joking aside, this situation represents a fundamentally wholesome opportunity for a firm’s non-legal professionals to interact and be creative with their counterparts at the coal face. Right-sizing need not be a euphemism for redundancy; the opportunities are far more important and diverse than that. The scalability of teams and firms as a whole must be very carefully established and implemented if client service and capacity are to be protected.

The trusty hourly charging rate has also taken a beating in recent times with firms experiencing significant drops in average recovery rates over the past 12 months. Since most firms still rely on a capacity-based model to establish headline financial strategies, significant movement in this parameter will be causing much concern to many. The industry may well be witnessing the dawn of a ‘cost plus’ pricing model, replacing the (historically far more gentlemanly) commonly accepted ‘value’ model. Most firms will have had experience in recent months of clients simply demanding a re-evaluation of pricing, based on a new world view on value.

Again, the consequences of this grim economic reality do not stop at the door of the FD and CEO. The cultural impact on the legal teams is huge as partners’ incomes tumble, salaries are frozen, bonuses are cancelled, recruitment is put on hold and colleagues lose their jobs.

But, as with every negative, there is a positive to this situation and a re-basing of team level economics seems to be both an acceptably pragmatic and strangely cleansing experience once completed. Here again is an opportunity for the non-legal professionals to lead the way and seize the initiative. The deployment of enterprise resource planning (ERP) techniques is a great example of how a fundamentally proven management science can be used to inform and support effective scaling and pricing activity at team level.

So, does size really matter?

In the past 12 months, the only parts of the domestic economy that don’t seem to have shrunk in the wash are unemployment and the national debt.

It is clear that the market for legal services has been ravaged by the global economic crisis and that the long-term effects of this are likely to prevent any short or medium-term recovery of that position.

Most law firms in the UK have reduced their scale in the past 12 months, either through astute planning or by survival instinct. Fundamentally, this must have been the right reaction to a diminishing marketplace, especially when one stops to consider what constitutes the historic base cost of operating a law firm (high salaries and even higher profit expectations). Now that we are being coached by the government to believe that earning more than £100,000 per annum is gratuitous, it will be interesting to see how the legal profession assimilates this information.

If the scale of most law firms was, in some respect, related to the ego of its partners at some level, I suppose recent events will have dented many egos. That said, size surely isn’t everything and operating a truly scalable and profitable business must be what most of us really aspire to.

Patrick Harwood is the chief operating officer at Watson Burton LLP. He can be contacted at patrick.harwood@watsonburton.com