Navigating the Acorn Minefield

Amidst all the din in the legal market about the billable hour, alternative fee arrangements and increased discounting by law firms, there appear to be few pricing experts engaged in the debate.  There are numerous lessons to be learned by observing pricing tactics used in other industry segments, even though we all agree that Law is different and special and doesn't follow standard economic theory.  Or so we're led to believe. I recently met with a Biglaw partner who proudly described his role as the primary arbiter of fixed fee engagements at his 500+ lawyer firm.  Apparently any engagement that required, or that the firm believed would benefit from, a fixed fee rate structure had to pass through this partner.  His approach was to study the client's prior year billings for the same type of work, or find similar billings from another client, add a cushion equivalent to 15-25% of these billables, and quote the result as the fixed fee rate.  There was no evident involvement by the Finance team, no cost accounting data available to benchmark relative costs of legal service delivery or whether the prior work was profitable.  And there was no guidance to the timekeepers on how to operate more efficiently lest the new fixed fee engagement become non-economic.  The partner seemed proud of his role, until I made the mistake of questioning whether this sort of formula couldn't be automated, since it didn't appear to be a data-driven exercise.  Not knowing my place, I then questioned whether the clients wouldn't eventually notice that fixed fee engagements were merely prior year billings plus 20%.  I was shown the door.

Lesson one was, and remains, to be gentle when bursting the visions of Biglaw partners who consider themselves sophisticated businesspeople!  In fairness, however, few others in the legal marketplace offer much creativity on this topic.  Biglaw partners in many cases are left to their own devices when constructing pricing methodology.  Even those firms providing sophisticated cost accounting and matter profitability data often rely on the willingness of partners to properly incorporate these data.

While we won't solve all law firm pricing questions in this short essay, we can take a look at a common practice:  the use of discounted pricing to win initial work, in the hopes that future work can be billed more profitably.  I call this the acorn theory because it calls to mind the practice of planting acorns and awaiting the emergence of a mighty oak tree.  As another Biglaw partner put it, "We'll practically give away some early work, but we hope to make it up with more profitable work later on." When asked about the actual conversion rate of this low-priced work into high-profit future work, he had no idea.  To his knowledge, such data aren't tracked anywhere in his firm.  A article today describes another Biglaw firm's approach:  "During the past three years, the firm says it has given away more than $100 million worth of billable hours, but it hopes to make the revenue back through follow-up work from those clients."

Acorn pricing isn't necessarily a bad idea.  Many businesses employ strategic pricing to win new buyers or, in pricing theory parlance, to induce trials.  Nagle & Holden in their brilliant book "The Strategy and Tactics of Pricing" state that "Since only people who are familiar with a product can become loyal repeat purchasers, inducing potential buyers to make their first purchase is a critical first step in building sales." Intrinsic to the success of this approach are two important assumptions:  one, low pricing will lead to loyalty and repeat purchases; and two, future work can be done profitably.

Unfortunately, even strategic pricing with good intentions sometimes falls into tactical pricing.  So that well-intentioned low-fee engagement from a year ago never materializes into future work because the low fee fails to maintain the interest of the key timekeepers.  As a result, they don't spend sufficient time working to expand the relationship.  Or perhaps because of the low fee only junior timekeepers work the matter and the results aren't awe-inspiring.  (Come to think of it, these aren't uncommon outcomes even for high-fee engagements!)  Like the real acorn planted in the backyard, one must nurture and water the shoots until a mighty tree emerges.  Otherwise, you're betting that nature will select your particular acorn for survival from among the many millions that become squirrel buffet.

And let's take a pin to the balloon containing the idea that clients who enjoyed your excellent effort at $200/hour (or for a fixed fee of $50,000) will gladly increase their outlay for subsequent similar efforts to $600/hour (or $150,000).  If you haven't made it clear that your pricing is introductory and not sustainable, the client will not generally pay far more after having seen you do the work for less.  On paper, performing matter 1 at breakeven or even a small loss, but performing matters 2 through 5 at 40% margins, looks like a good tradeoff.  In reality, one doesn't typically follow the other.  So is the answer then not to offer introductory pricing?  Or to place a large red ink stamp declaring "promotional pricing" on the initial invoice?

Setting proper expectations can help.  If it's the firm's intention to demonstrate its capabilities by offering reduced pricing for an initial engagement, make that clear.  But more importantly, demonstrate to the client before, during and after the engagement that they're receiving value far in excess of the fees.  To be clear -- this is very hard to do.  In Biglaw, cyclical logic is common.  If Firm A charges $600 for its work product, then its work product must be worth $600.  If Firm B charges $400 for its work product, then its work product must be worth $400.  Lately, however, we've seen clients challenge whether Firm A's work product is really worth $600, or perhaps Firm B is just as good (or good enough -- remember, clients don't view the sanctity of legal work the same as law firms) at the lower price.  It's not enough to say "We've discounted our usual rate from $600/hour to $400/hour to show you how good we are, and now that we've demonstrated our capabilities, we'll go back to our usual rate of $600/hour."  The client has to perceive the substantial value delivered.

Herein lies the greatest challenge facing Biglaw today:  demonstrating value.  Commodities are generally indistinguishable except by price.  If Firm A and Firm B are not differentiated except by a difference in rates, then how will the client react?  Consider the Biglaw partner who offers a generous discount on all legal work, to new and repeat clients.  His standard proposal letter reads: "We are keenly aware of the legal budgets that our clients confront and seek to meet their needs as effectively as possible... The discounted hourly rates for Biglaw team members are set out below.  These represent a discount of approximately 10% from our standard rates."

Despite all the talk in his firm about how clients are pushing back on rates, this is how he leads every discussion of his services, whether or not the client emphasizes price.  No wonder his clients, and many others, are fixated on discounts.  Referring back to Nagle and Holden:  "When companies replace price policies with price negotiation, they create economic incentives for 'good customers' to become 'bad customers' who never willingly acknowledge value and act as if all suppliers are interchangeable."

As I've written elsewhere, a law firm can differentiate itself on more than price and legal work.  Demonstrating an in-depth understanding of a client's business, undergoing rigorous needs analysis prior to commencing any engagement, being responsive rather than merely prompt when reacting to client demands, setting and then exceeding expectations, are all ways to use a service posture as a differentiator.  Educating timekeepers to speak in terms of value delivered rather than the cost of services rendered will help too.  After all, the client's objective is to advance his business, not to calculate the value of his legal suppliers.

If you're a Biglaw partner with some downtime, first go visit a client.  And ask questions about her business.  If you still have downtime (you shouldn't), run, don't walk, to buy and read the Nagle/Holden book.  Buy a second copy for your CFO.  Buy a copy for every member of your management team.  It's a hard book to read and understand, and even brilliant MBAs are challenged implementing the ideas.  But that's no reason not to try.  I would like to draw your attention in particular to Chapter 8 "Value-Based Sales and Negotiation."  It's summed up in these words: "The key to breaking the downward spiral of negotiated pricing is to anchor your pricing to value." It's that simple.  And that hard.

If your competitors or colleagues are planting a lot of acorns and hoping really hard that one or more or even most turn into mighty oaks, then let's show them some alternatives.  What are you waiting for?


UPDATE:  Many thanks to the thoughtful readers who reminded me of this excellent article authored by the Redwood Think Tank and published in the September 2007 edition of the Legal Marketing Association's Strategies magazine.  Redwood analyzed the source of leading clients to determine how many started as acorns and concluded:

"More than 50% of the clients that currently ranked in the top 5% of the firm's clients started out in the top 5% in the year when they initially retained the firm.  And more than 90% of these clients started their relationship with the firm in the top 20% of clients."

In other words, few acorns grew into mighty oaks.  This calls to mind the analysis a mid-size tech corridor law firm CFO conducted to determine the frequency that its emerging technology IP clients turned into corporate clients.  He learned that few did, turning rather to the usual Wall Street firms at IPO and thereafter.  So his corporate partners' laments about the lack of cross-selling from the IP group were well-founded.  Once they realized they were essentially on their own, it fundamentally changed their business development approach.