In the early 2000s, in the midst of an extremely strong legal market, a surprisingly large number of law firms failed or restructured every year. Today it is more of the same; numerous firms with varying practices, geographic positions, and sizes, collapsed. Now, as they prepare to enter 2012, an uncertain economic climate has many firms concerned about their short- and long-term survival.
If management of troubled firms had acted when they saw weakness, they might have limited their problems. While there is no simple list of reasons why a firm becomes troubled, consistent signs indicate that a firm will struggle to remain competitive. Following are some observations and recommendations to help firms identify these warning signs before too much damage occurs.
It is a rare business that achieves long-term success by good luck alone, though it helps. Instead, management of most successful businesses understands that, to remain competitive, the company needs a defined business strategy. Why should law firms be any different?
In fact, given the rapidly changing legal landscape, law firms need a strategy just to survive, much less remain competitive. In troubled firms, there is rarely any concrete, implemented strategy. Rather, you would find a collection of lawyers who have some idea of the firm's position, but a much better idea of where their practice is headed and, all too often, how they should be compensated for it.
Of course, this type of self-focused thinking is a harbinger of doom, particularly if it is spread throughout the partnership.
A law firm's strategy should focus on the firm's current position within its market, as well as the position that the firm intends to occupy. Firms that attempt to be all things to all clients in as many industries as possible (i.e., the full-service, generalist firm) are much less competitive than firms that develop a market identity and reputation as the expert in one or a few fields. Successful law firms usually occupy one of three competitive positions:
- Expertise in a narrow range of practices, serving a wide market.
- Expertise in a wide range of practices, serving a narrow market.
- Expertise in a narrow range of practices, serving a narrow market.
As a result, clients will look to other firms that are viewed as the expert within a specific area. When this happens, the full-service, generalist firm will find itself relegated to lower level, commoditized work. Thus, the lack of an active strategy, which may lower the perceived value of a firm's services, is a significant warning sign.
To develop and implement its strategy, a firm needs strong leadership. This person (or team) must command respect, be trusted, and keep the firm focused on its goals. Leaders who follow the crowd, or whose idea of the solution to a problem is the last thing they are told, are doomed to failure. In truth, these individuals should never have been put in charge of the firm.
Unfortunately, partners in troubled firms often choose as leader the partner least likely to make waves. This usually works for a short period. After that, the leader (who may have tried to make change and been utterly ignored) becomes frustrated and the firm falls back into its state of inertia.
A firm's unwillingness to let an individual or a small group take charge of the firm and make tough decisions is a sign that the firm's performance will suffer, particularly in the current economy.
In successful firms, leaders set an example for the firm to follow. This does not necessarily mean that they have the highest level of billable hours or client responsibility. It does mean that they make a significant, consistent contribution to the firm's overall success. These leaders put the firm's interests ahead of their own and ask that their partners do the same.
Strong leadership will engender a sense of trust among the partners. This does not mean partners cannot disagree on many issues. It does mean that they respect, or at least tolerate, each other's views. A healthy partnership is one in which partners meet often to share ideas and identify opportunities to cross-sell existing services.
A firm's size should not be a barrier to such an atmosphere. A firm that lacks empowered, trusted leadership may achieve modest success in the short-term. The firm's long-term prospects are not bright.
Given a law firm's status as a professional service firm, it is troubling when a law firm's clients feel that the firm is not client service oriented. In everyday dealings, many of us make a mental note of positive and negative experiences we have with those who service us.
For some reason, it is always easy to remember those who offended us in some way, regardless of intent. Put yourselves in the shoes of the law firm's client. The client is purchasing assistance for some business or personal matter that requires legal advice. Since the advice is often more urgent than most other day-to-day exchanges (at least to the client), the client wants the lawyer to respond appropriately. Perhaps because there was so much work in most law firms over the last few years, lawyers became less responsive to their clients' needs.
As in everyday transactions, the client may have made a mental note of the firm's lack of attention and decided to take its business elsewhere.
It is clear that no law firm can survive without a strong institutional commitment to client service. A well-run firm maintains a regular, open, non-billable dialogue with clients to continually assess the law firm's performance. These discussions, which should not be performed by the responsible partner, help the firm maintain close client contact, identify areas needing improvement, and put the firm in a position to be a trusted advisor to the client, rather than just a vendor of legal services. Law firms that spend little time learning about their clients and the clients' future needs risk alienating the clients and driving themselves toward extinction.
At the end of the day, very little makes up for a lack of profitability. Firms with poor economic performance—those that are unable to pay market compensation levels—risk losing key partners. Usually, these are the same firms that lack strategic direction, leadership, and a service-oriented culture.
During the past few years, these weak firms have had their financial fortunes propped up by an abundance of legal work and, at times, below-market leases. Today, many of these firms face lower workloads and significantly higher, market-rate leases—a one-two punch that threatens to knock them flat.
Over and over, a few lateral defections have transformed a reasonably successful firm to a failing firm often overnight. The larger the economic gap between firms, the higher the probability that partners will decide to make lateral moves. To ensure that partners remain committed to the firm, the firm's leaders need to quickly identify financial weakness and take corrective action. Some of the warning signs that management needs to identify include:
- Bank Debt. Many firms still rely on bank debt to fund operating cash flow in the beginning of each year. While not necessarily a good thing, operating in this fashion is widespread and unlikely to change. They should maintain modest bank debt, usually in line with the value of their fixed assets.
Unfortunately, some firms, particularly those that are troubled, become addicted to their line of credit and carry a debt load far in excess of industry norms. As many firms experienced in the early 1990s, large debt loads and their associated interest costs can put a significant strain on a firm's economic performance.
If your firm is suffering under the weight of its debt, the short-term remedies are few. At a minimum, the firm should evaluate its fee inventory and actively manage the inventory to increase collections. There is really no reason why clients should be allowed to repeatedly delay paying their bills. Active management of inventory can help the firm lessen its reliance on bank debt.
- Accounts Payable. Any business that regularly uses outside vendors will carry a certain level of accounts payable. Given that payables result from goods already delivered, they are actually another form of borrowing. Management needs to keep its finger on the pulse of the firm's liabilities, both on- and off-balance sheet. As with bank debt, active management of the firm's fee inventory can free up cash to be used to limit the firm's liabilities.
- Realization. All too often, billing partners strike deals with clients to provide the firm's services at some discount off of the firm's standard rates. There are a host of reasons why this happens—including inadequate client intake procedures, a compensation system that awards any kind of origination, and actual or perceived rate pressures.
Unfortunately, many partners fail to realize that a small discount off standard rates often translates to a major reduction in the firm's profit margin. With overall realization rates for well-run firms ranging between 92 and 94 percent of standard rates, there is little room for a partner to offer discounts. In their role, management needs to ensure that partners comply with appropriate policies regarding write-offs and discounts. Failure to do so will limit the firm's overall performance.
- Productivity. Since last year, law firms have been experiencing softness in workloads, particularly in corporate transactional matters. Most law firms are slower now than they have been in recent years.
Firms that fail to deal with under-productive lawyers (at all levels) will find it increasingly difficult to compete. It is easy to say that the firm's leaders should eliminate under-producers; actually doing so is much harder. Firms that are unable to make hard decisions with respect to these lawyers often generate profits that are much less competitive than their well-run brethren. A firm's leaders should be authorized to deal with under-productive lawyers.
Barring an economic recovery, next year will present law firms with some interesting challenges. While a few firms suffered severe financial and operational difficulties every year during the recent boom period, a far greater number of firms will be vulnerable next year.
The combination of an expense structure that increased dramatically in the late 1990s and softening workloads will challenge even the strongest firms. The weaker firms will fall by the wayside.
To avoid finding your firm on the side of the road with other broken-down entities, evaluate and test your strategy, empower your leadership, and take a renewed interest in your clients and their needs. Ultimately, that will keep you on the road to long-term success.
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