By Alan Hodgart, principal, Hodgart Associates
The profitability of a law firm is a key competitive tool. It is not the only performance measure but its importance should not be underrated. A firm that underperforms its competitors on profitability over a sustained period is likely to face a decline in performance relative to competitors. It will be difficult to maintain competitive remuneration levels and to make the investments necessary to sustain competitiveness. An important piece of competitor data is therefore a firm’s relative position in terms of profit performance, but it is vital that the comparison be made on an equal basis.
Using the financial results published by law firms, we hear people state that their firm’s profit margin is better than that of a competitor and that their performance is better even though sometimes their firm’s average profit per equity partner (PEP) is lower. We also hear others expressing concern that the profit margin is below that of a competitor and become worried about their firm’s financial viability even though their PEP is higher. The profit margin alone is not an accurate indicator of a firm’s performance.
The problem is that the published financials of firms (as in The Lawyer UK 200) do not include any cost for the equity partners although the revenue they generate is included. (Firms do not include it in their published numbers.) A difference in leverage will create a difference in the profit margin that is unrelated to performance. (The same point applies inside many firms when they compare the profitability of the different units inside the firm.) Differences in leverage will distort the total amount of cost recorded for fee-earners when no cost is inputted for equity partners.
Take two firms, both with 11 fee-earners. Firm A has one equity partner and 10 staff lawyers, so the financials will include a cost incurred for the 10 lawyers but not for the equity partner. If Firm B has 10 equity partners and one staff lawyer then its numbers will only have the cost of the one staff lawyer and nothing for the 10 equity partners.
Assume the revenue of both firms is £3m and the average salary cost of a staff fee-earners is £150,000 in both firms. The total cost shown in Firm A would be £1.5m while it would be only £150,000 in Firm B. If both had an overhead cost of £600,000 then the total cost for Firm A would be £2.1m and its profit would be £900,000 or 30 per cent. Firm B would have a cost of only £750,000 so a profit of £2.25m or 70 per cent. The profit per fee earner (PPFE) in Firm A is £81,800 and £204,500 in Firm B, so again Firm B looks better than Firm A. Of course the average PEP in Firm A would be £900,000 and in Firm B it would be £225,000.
The situation changes when we insert a market cost for a partner in both firms at £400,000 per annum. Firm A’s total cost would be £2.5m, leaving a ‘real’ profit of £500,000.The partner’s earnings would still be £900,000 being £400,000 salary and £500,000 in profit. Firm B’s cost now would be £4m plus the fee-earner cost of £150,000 and overheads of £600,000, a total of £4.75m against a revenue of £3m: a clear indication of under-performance at their leverage level, given we assumed earlier that they were doing the same work as Firm A. The PPFE in Firm A after partner costs would be £45,500 whereas in B it is a loss of £159,000. Firm B would need to generate revenue of £9.75m in order to achieve the same PEP as Firm A.
There are two ways to think about a market salary for an equity partner. The first is what might be the appropriate loading on the salary of the highest paid salaried lawyers given, on average, the additional responsibilities, skill and experience required. This tends to be 25-30 per cent on average in many firms, while there might be different percentages for junior, mid-level and senior partners (with the latter being the highest).
The second way to estimate this is to consider the salaries paid to equivalent-level lawyers working in-house, especially within the type of clients with whom the firm tends to work. This is difficult for some firms as the work they are doing might be for clients with no or few lawyers, or the work being done is out of line with the skill and experience of the senior in-house lawyers. (For example a firm might be doing lower-value contracts for a FTSE100 company where the GC is very highly qualified to handle major transactions.) In this case a firm will tend to rely on the percentage loading formula.
A few firms use a third method. The average PEP over five years is calculated and a percentage, often around 80-85 per cent, is determined to be the salary component and the balance is profit share. The problem with this method is that it assumes a profit margin whereas the other methods assume a cost. It must be recognised, however, that no number will be strictly accurate: all measures are estimates but a good estimate is better than no estimate at all.
There are ways to estimate a comparable margin for firms with a different leverage using the published data. The first is to impute a market salary for equity partners in both firms. Assuming the firm with which the comparison is being made is a direct competitor, then the market salary will be similar to that of the firm making the comparison. Unless detail is available of the seniority of partners, one average number will have to be used, but that will still give a good indication of the comparison. When the firm with which the comparison is being made is not a direct competitor, it becomes a little harder to get a market salary without some research first.
An alternative calculation can be made without inputting a cost for equity partners. Assume a firm has a profit margin of 22 per cent and leverage of 1:9 and is seeking a comparison with another. The other firm has a profit margin of 30 per cent but a leverage of 1:5. The way to neutralise the impact of leverage is as follows. Convert the firm making the comparison to the same leverage as the competitor without increasing the number of fee-earners. So a firm of 300 fee-earners, with a 1:9 leverage would have 30 equity partners and 270 other fee-earners. If it were to have a leverage of 1:5 with 300 fee-earners then it would have 50 equity partners and 250 other fee-earners. An estimate is then made of the average salary cost to be deducted from the fee-earner salary costs to reflect having 20 fewer fee-earners. (This could be an average salary cost across all fee-earners or weighted towards a more senior group from where the partners would be drawn.) This produces an estimate of the profit margin on a comparable basis to the competitor firm.
With no market salary for equity partners a comparison of performance between firms (or business units within a firm) requires three variables to be analysed as well as PEP: the profit margin, the PPFE and the leverage. Inputting a market salary for equity partners helps to align these variables and the profit margin does become a better indication of performance, although it still needs to be seen along with the leverage impact. Two firms might have a similar PEP but one does so on a high leverage, lower PPFE model and the other achieves it on a lower leverage, higher PPFE model.
This is a vital piece of competitor information as firms need to understand the means by which other firms are generating their profitability if they are in a similar part of the market. On the other hand, it might indicate that despite PEP being similar the two firms are in fact not competing directly but operating in different market segments. In either case it is useful business intelligence.
The latter part of my military career was in military intelligence. The analysis Alan describes is valid – as you would expect from someone with Alan’s expertise. The challenge is “so what?”. Once the firm has discovered it is 3rd/7th/19th , what happens next? A useful exercise – before doing the math – is to ask the partners “if this exercise shows us we are in the top third/middle third/bottom third – or perhaps the bottom of 4 chosen competitors – what would we do?” More often than not, there is no plan. Data into information is good, but the next stage is crucial. I believe that many firms already intuitively know where they stand – where the inefficiencies are – but lack the drive/courage/consensus to make the necessary changes.
why not to follow Big4 standards?