Since law firms are for-profit businesses, their shared goal is, ultimately, to make money. An individual law firm’s partnership structure, goals, and other factors determine its specific economics but the basic fundamentals of how a law firm turns a profit hold true for nearly all firms. This article will explore those fundaments in order to lead to a better understanding of law firm financials.
Profit = Revenue - Expenses
Revenue = Client billings – Write-offs – Uncollected money
Stated most simply, law firm revenue is comprised of collected client billings and fees. Not all recorded time is billed, and not all billed time and/or fees are collected.
Client billings are the amount clients are actually billed. The amount is based on hours billed at the effective rate (often discounted) or a fee based on an alternative fee arrangement.
Write-offs are the hours or fees lawyers choose not to bill clients or discounts clients request and receive on a matter. Lawyers might choose to write-off recorded time for a variety of reasons, such as to ensure staying within a client’s budget expectations, or not charging for “get up to speed time”.
Uncollected money is the amount clients do not pay, either because they choose not to or when they are unable to do so. Clients might choose to pay their bills in less than the full amount because they feel that their bill is too high or over budget, the value of the work was not commensurate with the fees, or if they feel the work was off target or did not meet expectations. They also simply may not have the necessary funds.
Money made in excess of lawyer salaries is not pure profit. Businesses cost money to run. Expenses are considered either direct or indirect expenses.
Direct expenses are costs per employee, including:
- Lawyer and staff salaries
- Bar dues
- Unbillable time (hours logged by timekeepers but not billed due to client write-offs, time spent on marketing/business development, pro bono or administrative matters, and unproductive time)
Indirect business expenses are the costs of running a law firm not "directly" associated with an individual employee, including:
- General marketing
- Charitable donations
- Office space
- Firm insurance
- Coffee and snacks
- Recruiting and training
- Debt service
- Internal firm events
Profit = Client fees collected – Direct expenses – Indirect expenses
The revenue cycle encompasses the time between when work is performed and when the firm is paid for that work. A typical cycle might be 60-90 days.
Worked is performed → Work is billed → Fees are collected
Realization is how much the work is worth in relation to how much is billed or collected.
Billing realization is how much the billed work is worth. The standard rate is the “normal” hourly rate a lawyer charges for work. The billable rate is the rate that is used to bill a client. Often this rate is a discount from the standard rate.
Billable Hours*Billable Rate
Billable Hours*Standard Rate
Collection realization is how much the collected amount is worth in relation to how much was billed.
The overall realization is how much the collected amount is worth in relation to the billable value of the work.
Leverage is the ratio of law firm non-owners to owners (equity partners). At its core, leverage is the ability to shift work to the lowest cost and most effective (and therefore most profitable) timekeeper. High leverage can have a dramatic effect on law firm profitability. While a more junior lawyer’s billing rate is less than an experienced lawyer’s, they are also paid less and are usually more profitable to a firm. For example, on the surface, it might seem that a partner billing at $750/hr would be more profitable than an associate billing at $350/hr. However, if the partner makes $1,000,000/yr and the associate makes $200,000/yr and they both bill 1750 hours/yr the associate is actually more profitable ($750*1750 = $1,312,500 - $1,000,000 = $312,500 gross revenue for the partner, versus $350*1750 = $612,500 – $200,000 = $412,500 gross revenue for the associate. Put another way, in a well-leveraged firm partners should not be doing tasks that junior associates are able to perform.
Leverage = Billers (Except Equity Partners)
There are several types of law firm billers.
- Equity partners - Firm owners
- Non-equity partners - Salaried lawyers with a partner title (These lawyers tend to be experienced enough to manage clients but they have not built a big enough book of business to gain firm ownership)
- Optional Service Partners - Non-equity partners who do not have the same requirements as full-time partners, but still counsel the firm and clients; are usually in the "twilight" years of their career
- Of Counsel – Senior lawyers
- Counsel - Very experienced lawyers, some counsel are partner track lawyers, others will remain at this career level
- Associates - Partner track lawyers
- Staff lawyers - Non-partner track lawyers, usually retained to do document review or other rate-sensitive work
Other firm billers might include:
The billing rate per lawyer and biller can vary firm-wide based on:
- Location (Washington, D.C. may be more expense than Seattle, Washington)
- Type of lawyer or biller (Partners are more expensive than counsel and associates, lawyers are usually more expensive than other billers)
- Practice area (The tax practice might charge higher rates than the employment practice)
Biller expenses include:
- Percentage of their secretary's costs
- A portion of the indirect expenses listed above
As owners of the firm, equity partners earn a percentage of firm profits based on their ownership share. They are often paid as a
- Draw - "Salary" per month that is a portion of the firm's predicted year end profits
- Bonus - After a profitable fiscal year partners receive some percentage of firm profits in the form of a bonus
Equity partners' total compensation (salary + bonus) is generally based on some combination of:
- Percentage of firm ownership
- Origination - Business brought into the firm
- Hours billed
- Overall realization
- Firm citizenship - Firm committees and leadership positions, time spent helping the firm business run
- Marketing/business development activities
There are various measures for firm’s to measure their performance against other firms including those tracked by The American Lawyer*:
- Gross Revenue
- Profits per Partner
- Profits per Equity Partner
- Revenue per Lawyer
- Partner Compensation Average
Other measures of firm performance include:
- Profit index (Present Value of Future Cash Flows/Initial Investment)
- Fees and growth
- Profit Margin
- Matter Profit - Profit on a the individual matter level
- Client Profit - Profit on the client level
Law Firm Profit + Effective Marketing & Business Development = Greater Profits
As mentioned at the outset, law firms aim to make money. Marketing and business development professionals can help lawyers make more money. That is why our departments increasingly are highly visible and highly valued. When we are great at our job we become indispensable to our firms as we help increase profits.
*Example law firm rankings (content available to subscribers of The American Lawyer):
- “Firms Ranked by Gross Revenue”, The American Lawyer
- “Firms Ranked by Profits Per Partner”, The American Lawyer
- “Firms Ranked by Revenue Per Lawyer”, The American Lawyer
- “Firms Ranked by Compensation – All Partners”, The American Lawyer
By Helena M. Lawrence, Business Development Manager, Proskauer for the September/October 2014 issue of the Capital Ideas Newsletter.