Why your law firm isn’t anywhere near as profitable as you think

By conventional measures, the world’s top law firms are some of the most profitable businesses on earth.

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Norton Rose Fulbright
Quinn Emanuel Urquhart
Wachtell, Lipton, Rosen & Katz

/uploads/sites/378/2017/10/Letter-From-London-TAL-Article-201710082009.jpg"><img class="alignleft size-full wp-image-67999" src="http://www.almcms.com/contrib

Norton Rose Fulbright
Quinn Emanuel Urquhart
Wachtell, Lipton, Rosen & Katz

/uploads/sites/378/2017/10/Letter-From-London-TAL-Article-201710082009.jpg" alt="" width="620" height="372" /></a> By conventional measures,��the world's top law firms are some of the��<a href="http://www.americanlawyer.com/id=1202798544347" target="_blank">most profitable businesses on earth</a>. The average profit margin for the��<a href="http://www.americanlawyer.com/id=1202798544462/The-2017-Global-100" target="_blank">Global 100</a>��is a lofty 39%, according to data published this month by The American Lawyer. The highest profit margin in the group, which goes to Quinn Emanuel Urquhart & Sullivan, is almost 68%. That is��<a href="https://www.gurufocus.com/term/netmargin/AAPL/Net-Margin/Apple-Inc" target="_blank" rel="nofollow">more than three-and-a-half times the net margin of tech giant Apple</a>, and <a href="https://www.gurufocus.com/term/netmargin/NYSE:BRK.A/Net-Margin-/Berkshire-Hathaway-Inc" target="_blank" rel="nofollow">more than nine times that of Warren Buffett��s Berkshire Hathaway</a>, based on each company��s returns in the last quarter. How can that be possible? It is true that law firms have little in the way of fixed costs, beyond staffing and office rent, and that fee rates remain high despite growing pressure from clients. But it��s still a massive difference. It��s also completely false. What if I were to tell you that most big law firms actually have profit margins of less than 15%? Some generate virtually no true profit at all. The crux of this issue is the way that equity partners are compensated. Traditional law firm partnership structures are effectively unable to retain any earnings at the end of each financial year. Except for any planned investments, all remaining profit �� what the��Global 100 survey refer to as 'net income' �� is distributed among the equity partners in full. Compared to companies in other industries, this gives law firms an artificially high profit margin, since from an accounting perspective, equity partners receive no above-the-line salary and therefore represent no cost to the business. It also means that the most popular metrics used to assess law firm profitability �� profit margin and profit per equity partner (PEP) �� are susceptible to distortion by leverage. Take two 100-lawyer firms that generate identical revenue. Firm A has 90 equity partners and 10 associates, while Firm B has 10 equity partners and 90 associates. Assuming its associate salaries and other costs are the same, Firm A will appear significantly more profitable than Firm B, as its bottom line will only be affected by the cost of 10 associates, rather than 90. (This can also cause tension between a law firm��s various teams and practices, where differences in leverage can create the illusion of profit disparity.) Even profit per lawyer, which I personally consider a��<a href="http://www.americanlawyer.com/id=1202724024060/The-Am-Law-100-Introducing-Our-New-Profits-Metric" target="_blank">much better way to assess a firm��s relative profitability than PEP</a>, is not fully immune to this problem. The solution is relatively simple �� in principle, at least: you just assign equity partners with a notional salary and deduct this cost from net income, leaving 'true' profits. Actually setting an appropriate salary for each individual firm is��not quite so straightforward, however, and doing so risks introducing a degree of subjectivity to financial analysis that is designed to be as objective and accurate as possible. <blockquote>Assigning a salary cost of $1m per equity partner sees Linklaters�� profit margin drop from 46% to 24%</blockquote> I��ve experimented with notional equity partner salaries before. It formed part of a formula I created back in 2012 to��<a href="http://www.americanlawyer.com/id=1202579031552/Taking-Stock?germane=1202579031552&id=1202579462042" target="_blank">value law firms as businesses</a>��as part of an��<a href="http://www.americanlawyer.com/id=1202579031552/Taking-Stock?germane=1202579031552&id=1202579462042" target="_blank">article</a>��in The American Lawyer. I used a market-wide equity partner salary cost set at 50% of each firm��s net income, which left a cashflow that was then subject to a multiple that varied depending on the firm's size, its historic growth rates in revenue and profits, and its brand strength. It was an imperfect and somewhat broad-stroke approach that was more designed to shed light on the issues an investor would face when analysing a law firm target, rather than to provide precise valuations. (For those interested in the results, Kirkland & Ellis narrowly edged out Latham & Watkins as the world��s most valuable law firm, with a business worth just shy of $4bn. Quinn Emanuel was the clear leader by value per equity partner, with the effective stakes held by its owners worth more than $17m on average.) I recently broached this subject again with��<a href="http://www.hodgartassociates.com/the-team.html" target="_blank" rel="nofollow">Alan Hodgart</a>, managing director of London consulting firm Hodgart Associates. He shares my frustrations with the way that law firm profits are reported, and has come up with a far neater method of calculating notional equity partner salary costs than my previous one-size-fits-all approach. He suggests either adding a 25%-30% premium to each firm��s highest-paid salaried fee-earner, or matching the compensation packages offered to general counsel at the firm��s core clients. This equates to a notional equity partner salary of about $1m (��750,000)��at an elite firm, $650,000 (��500,000) at a mid-market firm, and about $400,000 (��300,000) at firms focused on lower-margin, commoditised work. Applying these figures to The American Lawyer��s latest law firm financial survey data has dramatic results. Assigning a salary cost of $1m per equity partner sees Latham's��profit margin fall from 50% to 34%; Linklaters�� drop from 46% to 24%; and Jones Day��s crash from 49% to just 2%. (Impressively, Quinn Emanuel and Wachtell Lipton Rosen & Katz��s profit margins both remain above 50%, even after such deductions.) Among the mid-market firms, a notional salary of $650,000 (��500,000) per equity partner sees Baker McKenzie��s profit margin halve from 34% to 17%, and DLA Piper��s drop from 26% to 16%. The same figure wipes out Norton Rose Fulbright��s profit entirely, with its margin plummeting from 31% to 0.003%. It is easy to dismiss this as the kind of self-reflective navel-gazing of which firms are so often guilty. As much as partners like to obsess over and endlessly debate these issues, the truth is that a law firm��s inner workings are of little interest to anyone outside the industry. Clients couldn't care less about financial metrics and partner compensation systems, so long as the service they��re receiving is good, right? Well, not entirely. Hodgart said law firms are actually ��shooting themselves in the foot�� by publishing artificially high profit margins that do��not account for the cost of equity partners. ��Clients see these results, compare them to those of their own business, which are usually much lower, and wonder why they are paying such high fees,�� he said. One might also consider the potential impact on a partnership��s attitude towards costs and efficiency. I go back to Norton Rose as an example. It's not a big deal if clients ask for discounts when your firm��s profit margin is 31%. But at a margin of 0.003%, even the smallest discount would mean that work had effectively been carried out at a loss. I��m very keen to hear readers�� thoughts on this issue. Does the way that the industry measures law firm profitability need to be addressed? What changes, if any, would you like to see? Feel free to get in touch. <

Norton Rose Fulbright
Quinn Emanuel Urquhart
Wachtell, Lipton, Rosen & Katz

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