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Are Law Firms as Profitable as They Could Be?

It is pretty clear that, in the past, lawyers did a great job disrupting themselves.

The term “disruption” comes from Clayton Christensen’s observation that the ability of a company to make a higher and higher performing product always outstrips the ability of customers to make use of these performance improvements. As technology pushes a product’s performance into “performance oversupply,” it changes the circumstances of the market. It becomes harder for to sustain attractive profit margins on the product. Companies in other parts of the value chain can begin to steal market share, or “disrupt” the incumbents. Companies find themselves no longer competing on the basis of performance but on that of convenience.

The law firm partnership model was a brilliant solution to all of the above challenges. Think of lawyers as creating the “product” of legal advice. It uses a collection of techniques, skills, methods, and processes – its “technology” – to provide this service. A lawyer’s ability to perform legal work of increasing complexity eventually outstrips what most clients need, and thus what these clients are willing to pay for. Expert lawyers effectively price themselves out of all but the highest-end legal work. These expert lawyers have reached the point of performance oversupply for the majority of the market.

Lawyers figured out that they can use the law firm partnership model to split their “product” into sub-components. To address performance oversupply, they hire very junior lawyers to bill at lower rates, enabling the firm to compete on price for lower-end work. To compete on convenience, senior lawyers, who have reached the point of performance oversupply, focus on client relationships and compete on the basis of convenience.

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It is truly impressive how law firms figured out to balance these different roles while still keeping all the activity – and profits – under one roof. Lawyers really were doing a great job at addressing the threat of “disruption” decades before Christensen coined the term. Yet, at present, lawyers are often called laggards. What happened?

No industry is inherently profitable or unprofitable; but the locus of profitability does move around. For a long time, law firms enjoyed being the center of that locus by giving others what they most needed – expert legal advice. Eventually, big law firms as a whole became able to supply more legal expertise than consumers could absorb. That moved the locus of profitability and forced changes in the value chain of legal service delivery.

 

Generalists, Specialists, and Project Managers

In his article, Three Generations of U.S. Lawyers, William Henderson of Maurer Law School details how lawyers evolved from generalists, to specialists, to project managers. We can look at Henderson’s account through the lens of disruption theory to see how the locus of profitability has gradually shifted away from individual lawyers, to dispersed across law firms, to outside of law firms.

The rise of the modern industrial state (c. 1900) saw companies’ legal needs grow exponentially as governments began to implement more regulations. As the complexity of clients’ legal issues rose, the level of expertise required to navigate them increased. The profit margins for those capable of performing such complex work rose accordingly.

At a time when most of the legal market was struggling to provide the kind of specialized expertise that companies needed, law firms, whose “work place organization enabled lawyers to become specialists,” could enjoy significant profits. How significant? In 1949, the median salary of lawyers working in large firms was 400% higher than those working in private practice.

Then, around 1970, general counsel positions started to become more common. If a general counsel cannot bring the depth and breadth of expertise of an entire law firm, then what does it bring? It brings the convenience of a company having an internal point person. It also brings the ability to be more aggressive on price. This marks the point when law firms, as a type of business, first started to dip into performance overcapacity because, according to Christensen,

“When the performance of two or more competing products has improved beyond what the market demands, customers can no longer base their choice upon which is the higher performing product. The basis of product choice often evolves from functionality to reliability, then to convenience, and, ultimately, to price.”

The rise of general counsel positions also marks a change in the structure of the value chain of legal service delivery. And it is the first time that money spent on legal services does not go to a law firm.

The locus of profitability started with individual lawyers, then shifted to distributing across a firm. As Henderson discusses lawyers-as-project-managers, you can probably guess that it shifts ever farther away from where it started. In looking at the tech giant Cisco, with its legal knowledge management platform, Henderson observes that, instead of being wholly dedicated to typical legal work, younger attorneys at Cisco “build their profile in the department by updating and annotating content” in the platform. In looking at the document review company Novus Law, Henderson claims “Novus Law’s real comparative advantage” is in “project management and process orientation”. What both of these examples have in common is that the most valuable component is now outside of any lawyer or group of lawyers.

 

The changing architecture of legal service delivery

Once a product or service reliably delivers for customers, individual parts of that product or service become standardized. Standardization enables greater modularity. Consider an electric light. A light bulb and a lamp have an interface between the light bulb stem and the lamp socket. This is a modular interface. The same company does not need to make the light bulb, the lamp, the wall sockets, and the electricity distribution systems. Because standardized interfaces exist, different companies can provide products for each piece of the system.

General counsels, for example, provide a standardized interface for law firms or other legal services to “plug into” a company. This is why companies no longer need to rely on a single law firm but can hire anything from a single lawyer to an alternative legal service provider (ALSP), who in-turn sources the lawyers. Just as legal service delivery went from general lawyers to specialized practice groups, we are now seeing legal service delivery further dis-integrate as knowledge management, litigation support, legal technology, and a variety of other functions all “plug into” a more standardized system of legal service delivery.

While these sub-components or “suppliers” are peripheral to the actual giving of legal advice, they will continue to increase in value. We can deduct from the changing structure of legal service delivery, and from the basis of competition being mostly on convenience and price, that demand for high-end legal expertise is fairly well-satisfied. Once the demand for this certain attribute in the value chain is met, other attributes in that chain become more highly valued. If that is the case, we should expect to see these other attributes become profitable in their own right.

This flow of value from the main component to sub-components is typical of any industry. Christensen describes the computer industry in the 1990s, saying, “initially, money flowed from the customer to the computer makers; as the decade progressed, however, less and less of the total potential profit stayed with the computer makers – most of it flowed right through these companies to their suppliers.” We can see the same thing happening in the legal industry. It roughly looks like this:

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As value shifts to other parts in the value chain, attractive profit margins will follow; and the market will, as one investor described it in 2010, “continue to chip away at every part of a law firm that is not the pure provision of legal advice”.

 

Following the money

In the early 1900s, clients were wholly dependent on the expertise of their outside legal counsel. Money flowed directly to law firms and stayed there. Today, less and less profit and legal spend ultimately reside within law firms. Investors seem to agree, as they continue to focus on sub-components of legal advice such as legal research, memo writing, and contract analysis. We can follow this trend throughout the legal world.

Platforms like Axiom or LegalZoom standardize the lawyer/client interface. This setup follows the trend of increased modularity by enabling consumers of legal services to “plug in” whatever amount and type of lawyer(s) suit their needs. It also allows lawyers to focus simply on what they do best – provide expert legal advice. Of course, even though these platforms are mere “suppliers” of legal talent, they happen to be making a lot of profit.

Document review used to be highly profitable work for law firms. Yet as this work became more standardized it allowed companies who do not provide legal advice to compete on the “pre-legal advice” portion of the work. The challenge of handling electronically stored information is currently more intractable than any piece of legislation or case law. So it would be unsurprising if clients were more willing to pay for improved performance in that area, rather than in paying for someone to draw legal conclusions after the fact. For example, the eDiscovery company DISCO is one of the fastest growing of all companies in North America. Its revenue grew 774% between 2015 and 2018. A lot of that revenue is either by-passing or merely passing through law firms.

Speaking of “passing through”, legal tech budgets of law firms send increasingly more cash outside of the firms. Technology is crucial in order for firms to stay competitive; but it is worth noting where more of a law firm’s dollars are ending up. In fact, law firms are not just paying to use these tools but investing in legal tech companies.

If some new regulation made companies’ legal problems ten times more complex overnight, we could count on law firms to figure out how to help. After all, their core competency is the production of complex legal advice. Yet Christensen warns that “core competence is a dangerously inward-looking notion.” It is good to be proud of what lawyers bring to the legal market; but strategic companies recognize that competitiveness is far more about doing what customers value than doing what you think you’re good at. Ironically, the most heavily protected part of the legal profession – the giving of legal advice – continues to drop in profitability.

Comments

  1. What a profoundly offensive post! Canada has a huge access to justice problem, and we are worried about whether law firms are making enough profit?

  2. I don’t think there’s anything offensive about analyzing the economics. I do think it’s wrong to only look at financial factors, though. For instance, the rise of the billable hour originally dramatically improved law firm profitability, but led to human costs (stress of lawyers and staff) , GCs as noted above (perhaps because law firms no longer on general retainer?) and more profits by interfaces and businesses that limit the time spent and money earned by lawyers, charging clients a premium for the ability to spend less on the lawyers providing the legal advice.

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