This article was first published in Managing Partner in April 2013 and is reproduced by kind permission.(www.managingpartner.com)
Innovative Pricing Approaches
Pricing in the Legal Industry
As we all know, pricing in the Legal industry developed over recent decades to become dominated by the use of the hourly rate. This was not always the case, but the modern “default” has been to price using records of hours spent by lawyers on the matter in question. While lawyers were in demand and firms simply had to “throw open the doors” and work would flood in, this was just fine for the lawyers. No great thought was required to set pricing – one simply referred to the firm’s published rate card and calculated the fee.
Clients effectively had no choice if they were to get the work done. Lawyers undoubtedly missed opportunities to charge premiums when clients got the benefit of years of experience in a few minutes’ advice which saved them large sums, but in general lawyers were the main beneficiaries with high profit levels coupled with very limited commercial risk as clients were effectively paying “cost plus”.
This landscape has of course completely changed since the downturn creating significant challenges for some firms but also opportunities.
While the legal press have focused on “the hourly rate” and lower prices there has been relatively little comment on the way clients are using the change in the balance of power to shift the balance of risk too. This is likely to be a permanent change in the legal landscape and it requires innovative approaches to both the client relationship and pricing – innovative, that is for legal! In this article we will have a look at what it means to be innovative, and what is not really innovative at all.
Impact of the recession
While there is much talk of a “new normal” and how the commercial landscape is changed forever by the events of 2006-2008, history leads us to consider much more mundane interpretations of the situation we find ourselves in.
The recession caused a severe reduction in demand versus supply in the legal industry (as with many other industries). Consequently, prices have fallen dramatically. Demand is contracting too as some firms go to the wall, and others make lawyers redundant. In due course supply and demand will come into balance again and at that point we will see prices begin to rise again.
Not any time soon. This particular recession is, as well publicised, a credit-led recession and again we know from previous recessions that these are particularly slow to recover. In the Great Depression of the 1930s it was a decade before US GDP returned to pre-crash levels. In the current circumstances we are still seeing evidence of debts being paid down and so growth is still flat. We can therefore expect price pressures to continue for some time yet.
The Client Perspective
The shift in the balance of supply and demand has allowed buyers greater influence not only over the level of price but also the nature of the agreement between the client and the lawyer.
As we noted above, lawyers have been pricing with virtually no commercial risk for years, expecting the client to take the impact of all unexpected events. These can range from bad estimating through to ineffective or inefficient work. Also, external events can throw a project off track through no fault of either the client or lawyer. The only risk sitting with the lawyer was the risk arising from poor advice.
There are plenty of examples of clients’ frustration with the overall commercial service provided by lawyers. I see this at many of the firms I deal with. In one notable example, feedback I saw went as follows: “You quoted £100k for the job. There was no further discussion about fees until the bill arrived. When that showed a bill of £400k you made me look an idiot as I had to go back to the Board for authorisation for the extra money after the event.”
This illustrates a number of points:
<![if !supportLists]>· <![endif]>Lawyers need to be good project managers as well as legal experts – and that includes tracking progress and reporting changes early;
<![if !supportLists]>· <![endif]>Lawyers must understand how their client works and adapt to it. In this case the manager had obtained authorisation only for the fees estimated;
<![if !supportLists]>· <![endif]>There is an assumption that the client will take all overruns. If we are seeking to align our interests with clients and build long term relationships, is this sustainable?
<![if !supportLists]>· <![endif]>Unexpected changes either by the client or by third parties are no excuse for slack management of a project or fees.
I understand that in this case the legal team had done a fantastic job in trying circumstances – but was the client satisfied?
What do clients really, really want?
Survey work is starting to show that pricing per se is not in the top 5 concerns for clients – contrary to what we may all have thought. Value for money however is in that top 5. Clients of course increasingly ask lawyers about innovative pricing – and indeed it has become almost de rigeur to include such a question in panel reviews.
What is innovation?
We therefore get to the nub of what innovative pricing really means. There is no point in innovation for innovation’s sake. It may get headlines in the legal press – read by other lawyers – but does not necessarily align you with your client’s interest.
In another salient example, I remember the bidding team responding to a question about innovative pricing with a striking and bold offer which, while containing some considerable commercial risk, offered big opportunities for both the client and the law firm. The response we got was “in the nicest possible way, you’ve called our bluff on ‘innovative’ pricing”. The offer was too innovative for the client to digest, but it did demonstrate the team’s ability to think outside the box, and was viewed favourably.
A great definition of innovation is available on Wikipedia:
“Innovation is the development of new values through solutions that meet new requirements, inarticulate needs, or old customer and market needs in value adding new ways.
Innovation differs from invention in that innovation refers to the use of a better and, as a result, novel idea or method, whereas invention refers more directly to the creation of the idea or method itself.
Innovation differs from improvement in that innovation refers to the notion of doing something different rather than doing the same thing better.”
So, in developing innovative pricing methods we should look first to solutions that meet our client needs more effectively. We do not have to create these methods from scratch but simply use approaches we find elsewhere – perhaps in other industries. Proper understanding of your client is critical. Conversely, simply reducing prices is not innovative.
Critical to the successful development of innovative pricing is a different mode of thought by lawyers. We need to lose the assumptions that dominate thinking in the legal industry. Here are some good principles to follow:
<![if !supportLists]>· <![endif]>Clearly separate price from cost. Using hourly rate cards to price will lead to bad decisions and lost business. The hourly rate includes assumptions about levels of overhead and profit that simply do not reflect the true workings of the law firm business model.
<![if !supportLists]>· <![endif]>Understand the competitive environment. Price should be based on what the output is worth which in turn should be based on what is the market rate for that output.
<![if !supportLists]>· <![endif]>Know what is profitable. Assuming that we cannot do the work “because it isn’t profitable” may lose good business. I have yet to meet a lawyer who, when challenged, could demonstrate how they knew a particular price level was unprofitable.
<![if !supportLists]>· <![endif]>Don’t race to the bottom. Clients don’t necessarily want the cheapest price. Some do, but in many instances a “good” price that the supplier can stick to is much preferable for planning purposes.
<![if !supportLists]>· <![endif]>Know the meaning of “quality”. To many lawyers, this means the best job possible. To many clients this means reliability, consistency, repeatability.
Innovative Pricing Approaches -critique
Let’s now look at a couple of pricing approaches and consider whether they really are innovative, then identify the key elements of real innovation.
This is the solution most commonly offered as the alternative to hourly rates. In its favour, it is already widely used – more than perhaps many realise – with a number of law firms large and small doing the majority of their work on this basis. Key benefits are:
<![if !supportLists]>· <![endif]>Simple and easily understood – by both client and lawyer;
<![if !supportLists]>· <![endif]>No requirement for detailed tracking of time. If the job is done, the bill is known;
<![if !supportLists]>· <![endif]>Some key risks – notably inefficiency on the part of the lawyer – passed to the lawyer.
However there are disadvantages:
<![if !supportLists]>· <![endif]>Inflexible when things change – leaving either party potentially out of pocket;
<![if !supportLists]>· <![endif]>Pressure on lawyers to compromise quality by utilising underqualified resource.
In many cases true fixed fees are not actually used as lawyers agree to bill “what is on the clock” if the matter finishes early. This is not really a fixed fee at all but more akin to a capped fee. Arguably the lawyer loses both ways being unable to earn extra profit if costs are less than expected but still stuck with the fixed fee if the matter overruns.
There is much discussion about value pricing as a way forward. The idea is that the price is determined by the value of the output delivered rather than the work done. In principle this seems very attractive as it means that the lawyer is able to extract a price related to the difference their work has made to the client and appears to play to client’s requests for “value for money”. Many consultants are promoting this approach as the means to resolving the pricing dilemma. Some of these solutions are very complicated.
Pricing, however, has to exist in the real work and value pricing has a number of flaws in this context:
<![if !supportLists]>· <![endif]>It misrepresents clients’ true requirement. When clients look for “value for money” this does not mean they want to pay lawyers the full value created by the lawyers’ input; it means they wish to maximise the net value achieved for their shareholders. Clients will not necessarily go for the cheapest option, but the one that leaves the most net value with the client after paying the lawyer’s bills.
<![if !supportLists]>· <![endif]>It ignores the true competitive environment. When in competition with other providers a value-based solution risks seriously either under or over pricing the solution. Clients are unlikely to choose a higher price because it is innovative!
<![if !supportLists]>· <![endif]>Measurement of value is difficult. Sometimes there can be significant effort to establish the value added robustly. In one consulting example I remember a competing firm spending more time on determining agreeing and measuring the metrics than actually doing the work!
One key positive of value pricing is that it is getting us to separate price from cost.
So what does constitute innovative pricing and how do we achieve it?
Clearly, each truly innovative arrangement will be specific to the parties involved and the circumstances of the deal. The terms are frequently confidential, and it isn’t easy to describe these examples even after redacting names without disclosing intellectual capital. I have provided here, though a couple of examples which are already in the public domain, and illustrate the key principles.
For me the key elements of an innovative pricing solution are:
<![if !supportLists]>· <![endif]>Proper understanding of the client’s requirement and the law firm’s requirement translated into the commercial agreement between the parties;
<![if !supportLists]>· <![endif]>Value for money in all outcomes taking into account appropriate reward for risks taken;
<![if !supportLists]>· <![endif]>Clear and simple so easily understood;
<![if !supportLists]>· <![endif]>Takes account of the competition, their capabilities and their competing prices.
Finally any pricing decision should then test whether the work can be done profitably, and more particularly how the work can be organised to maximise profit.
Case Study 1 – Pfizer
While not all the specifics are available, anyone interested in innovative arrangements would do well to search the internet for details of the Pfizer panel arrangements. In general terms, a series of law firms have been invited onto this panel. In return for a “guraranteed” fee they are required to co-operate with each other and to take on whatever work Pfizer requires of them. This is innovative because there is no direct relationship between the work done and the fee, but also that much of the administration of the supplier relationship is swept away. There are some key points to note here:
<![if !supportLists]>· <![endif]>While the arrangement seems alien to the legal market it is quite common in engineering supply and servicing arrangements – see our own rail industry for examples;
<![if !supportLists]>· <![endif]>The change was clearly driven by the GC of Pfizer – law firms either took part or left the panel;
<![if !supportLists]>· <![endif]>Much of the admin and conflict over billing is swept away;
<![if !supportLists]>· <![endif]>Law firms have a mutual interest in co-operation;
<![if !supportLists]>· <![endif]>The arrangement not only promotes, but is dependent upon long term working relationships – so it will be difficult for new firms to enter the panel.
This is a clear example of a client using the panel arrangement to re-engineer the supply of legal services. This was only possible because of the buying power that the client was able to exert – but we should also acknowledge this is the case for many clients. UK law firms should also note this type of arrangement is coming to the UK and some clients are actively considering similar arrangements right now. Law firms must be in a position to be able to proactively deal with such challenges by understanding properly the services and cost of services provided to clients, and be able to manage the client relationship effectively if they are to take part. Those who are unable to take part – or choose not to – can expect to be locked out of the panel for a prolonged period.
Case Study 2 – Cameron’s “Future of Fees”
A short while ago, Cameron McKenna published a document entitled “The Future of Fees”. Again this is publicly available online. It lists a number of different pricing methods. One worthy of note is the idea of accepting payment in barrels of oil from a client. Here are some key points to note about such an idea:
<![if !supportLists]>· <![endif]>It is innovative because it transfers the risk of oil price movement from the client to the law firm – presumably this reduced risk for the client because they dealt in oil;
<![if !supportLists]>· <![endif]>The law firm has clearly understood one of the main constraints for the client to proceed with the work and sought to alleviate it.
<![if !supportLists]>· <![endif]>This is really an innovative funding arrangement rather than innovative pricing as it simply addresses the method of payment;
<![if !supportLists]>· <![endif]>It is a risky arrangement as law firms do not generally have any expertise in or method of managing an oil price risk. A better risk transfer would be one where a risk that the client cannot control is moved to the law firm who can control it.
What these cases demonstrate is the need to understand the situation as viewed by both the client and the law firms, and importantly how the risks and concerns in that situation can be translated into a hard pricing agreement. Arguably, however, the first example also shows that law firms are still behind their clients on this issue and that without change from the law firms, clients can and will impose that change.
By Chris Howe
Chris Howe is a Director at Raedbora Consulting Ltd
Q&A – are you able to generate innovative pricing methods?
Pricing – which method is most common in your business?
Hourly rates 5pts
Fixed Fees 15pts
Flexible models 20pts
Don’t know 0pts
Comment: Step 1 in innovative pricing is ensuring you know what options you already have. Lowest points for hourly rates – these are not innovative. Fixed fees – a quick fix, and may be appropriate in some cases, especially retail, but quite inflexible.
How do you decide your pricing?
Individual partners 5 pts
Client teams of partners 10 pts
Business support role 15pts
Comment: Key to good innovative pricing is the old adage “two heads are better than one”. Best results of all will be obtained by involving those with different experiences and perspectives, so draw on the accountants and business developers in your business.
Do you track your pricing successes and failures?
Yes – within teams 10 pts
Yes – across the business 25 pts
Comment: After all the analysis there will still be an element of trial and error and much can be learned from prior successful and also unsuccessful bids. You need to track these.
<![if !supportLists]>0- <![endif]>25 pts: Plenty of work to do. You may be hitting on the odd innovative method, but it might be hard to deliver innovation consistently.
25- 50 pts: The ground work is there but you need to make better use of the experience you have in the business.
50 pts: You have the wherewithal to deliver good innovative solutions!