Is Bigger Necessarily Better?

A look at growth strategies for second- and third-tier firms.

‘Second- and some third-tier firms’¹ face considerable challenges in today’s legal market. Some consider them doomed, neither large enough to command the work and profits that are generated by the first tier and not small enough to maintain sufficient profitability due to their overheads. Many partners in such firms feel ‘trapped’ by their overhead structure and have profit ambitions more appropriate to much larger, or at least different organisations.

Others, however, are achieving high levels of profitability by systematically addressing their ‘shortcomings’ and pursuing strategies that recognise that a second-tier firm should not simply apply strategies that assume it is simply a ‘smaller version’ of its ‘first-tier’ cousin. There are fundamental differences in capabilities, systems, and their approach to satisfying client needs and intentions.² In particular, there are historical factors that are ‘firm specific’ to these firms that must be understood before any profit enhancing strategy is pursued.

What is the typical profile of these firms?

How Do the Firms Line Up By Size?

The breakdown according to Law Society of Singapore³ reveals.

Comparison of size of law practices from 2000 to 2006

Size of Law Practices       1 to 5                      6 to 30                   >= 31

in 2000                                  663                         80                           17

in 2001                                  697                         88                           15

in 2002                                  684                         79                           16

in 2003                                  704                         82                           16

in 2004                                  701                         83                           15

in 2005                                  711                         74                           15

in 2006                                  712                         78                           16

The primary focus of this article is on those 78 firms that fall in the middle band, which would commonly be regarded as ‘second tier’. Much, of course, is still relevant to third-tier firms.

Characteristics of the Second Tier

Typically, these firms have been founded by one or two partners who have, as the years advanced, added staff and partners. Most have grown organically but some are the result of mergers or are created when partners exit larger firms. A handful have multiple offices.

The smaller firms tend to have a single partner with one or more juniors active in each particular area of legal specialty such as property, litigation or commercial advisory. It is common to find that the larger the firm, the greater the number of areas of legal expertise offered.

It is also common to find that the partners in such firms become impatient with the ‘plateauing’ of their incomes or become bored with the nature of their work and look to their larger brethren for guidance in moving ‘to the next level’. The ‘next level’ could well involve entering new geographic markets, providing different services but most frequently, the driver is for increased profitability.

The path to profitability is closely correlated – in most partners’ minds – with size. The conventional wisdom is that the bigger the firm, the greater the possibility of achieving higher levels of leverage and hence profitability. In many cases, this assumption is the cornerstone of the firm’s ‘strategy’ ie ‘… we will only become more profitable if we can attract new partners who provide additional areas of legal expertise and who can build large teams of juniors …’.

Australian experience where comparisons were between firms of differing sizes (measured by way of the number of working principals), reveals an interesting pattern.

Profitability is not necessarily linked to size although size is often seen in conjunction with high profitability. Interest in merger activity between firms in the second tier is driven by the same implicit assumption that ‘bigger is better’.

This attitude may be due to the long held belief that there are ‘economies of scale’ to be achieved in larger firms but there is little evidence to support this in the professional services environment.⁴ The contrary may well be true. The extent of the ‘co-ordinating’ bureaucracy and the cost of employing the management expertise to drive the additional profits out of the larger unit soak up a disproportionate amount of profit. Nor, it seems, does increased market share necessarily correlate with higher profits due to difficulties caused by the potential conflicts it creates.

Further, the transition from one level of profitability to another requires the firm to undertake a journey down many paths, only one of which may require an increase in size.

The difference in a whole range of factors between the ‘first tier’ and the rest is very great indeed and raises significant questions about the applicability of many of the ‘first tier’ strategies in a second- and third-tier environment.

What are the factors that are relevant for firms considering profit-enhancing strategies?

The ‘Manager’s Perspective’

The traditional view of firm profitability revolves around three concepts:

1    Margin – the difference between gross revenue and expenses requiring control of overheads relative to hourly rates.

2    Utilisation – the level of hours ‘sold’ to clients from the potential bank of hours represented by the total number of fee earners multiplied by hours in attendance at work.

3    Leverage – the ratio between partners and other fee earners. Leverage can generate higher profits per partner due to the relatively higher levels of contribution to profit made by ‘cheaper’ juniors.

How many times have you heard the firm’s accountant pointing out that, ‘… if only you could get the juniors and the partners working an extra 30 minutes a day, all your financial worries would be over?’ In a similar vein, cutting costs (increasing margin), or increasing the number of juniors, or reducing the number of partners (leverage), are also frequently mentioned. Significantly only one of these indicators is indicative of size, ie leverage and then only if partner numbers are not attacked!

There is no doubt that all these indicators are capable of reflecting key weaknesses in a firm’s operations but are not often in themselves, causes of poor profitability or the place to start in considering strategic alternatives that the firm may have. They are merely outcomes of a much wider range of underlying factors at work. It is these underlying factors which need to be considered and changed. It is they which should be the focus of careful scrutiny and evaluation.

Firms, in trying to get the ‘manager’s measures’ ‘right’ without giving sufficient attention to the underlying causes, fail to appreciate the constraints imposed by several other crucial factors that are more proximate causes of depressed profitability. Often, quoted benchmarks such as leverage ‘should’ be 1:3, solicitors ‘should’ bill four times their salaries and do more than six billable hours’ work a day, are of dubious relevance to many firms. They are, however, given undue weight, mainly because the information from which the benchmarks are derived comes from firms which usually have a very different profile in other critical dimensions. They may be indicative of the outcome of a successful strategy but do not of themselves offer any guidance on how to devise such a strategy.

What are these other critical factors or dimensions?

The Critical Dimensions

The critical dimensions, which actually underpin the outcomes measured by the ‘management perspective’, are:

1    The history of the firm – how did the firm arrive at the current ‘status quo’?

2    The nature and intentions of the firm’s client base.

3    The capability or ‘talent’ of its lawyers.

4    The firm’s ‘systems’ both ‘hard’ and ‘soft’.

How does a consideration of these factors help guide the choice and implementation of profit enhancing strategies?

The Firm’s History

Many strategic plans look as if they have been prepared without an understanding of ‘why the firm is where it is now’. A good strategic plan is not prepared in a vacuum; it does not commence with a blank page. The firm will enjoy both strengths and weaknesses, which are rooted in the firm’s history and the partners’ experiences. These should not be underestimated. Any strategy will recognise those influences as it will be implemented in an environment where the ‘default’ position of the partners will be to ‘revert to the old ways’ and abandon the new strategy and its disciplines.

Much has been written about the importance of ‘culture’ when contemplating change in organisations. In the law firm environment there are very different ‘mindsets’ to be considered – between litigators and those for instance, who provide commercial advice; and between those who represent plaintiffs in personal injury matters and those who normally undertake the conveyancing work. These must be borne in mind when profit enhancing strategies involving the development of new services, mergers or the acquisition of new partners are being considered.

The history of many firms is one of growth through the progressive addition of individual partners who add different areas of expertise. In these firms, there are usually few clients who are large or provide instructions complex enough to require the attention of more than one partner. As the firm grows, it usually acquires perhaps two or three such clients but the majority of the clients are much smaller and require very different services and support.

These firms have grown up in accordance with no particular strategic imperative. Often, the founding partner(s) set up in relatively cheap office space, add staff and partners driven by more personal than any strategic considerations, and often attempt to offer as wide a range of services as there are partners. If there ever was a guiding strategy, that strategy has become entirely overlaid by the addition of so many ‘barnacles’, as to make any original strategy barely discernable.

For a firm in that position to embark on any profit enhancing strategy, many ‘barnacles’ will need to be scraped from the hull but then, what is revealed may not be worth preserving. To simply pursue the ‘manager’s mantra’ of margin, utilisation and leverage will achieve little. There is a fundamental mismatch between the poor depth of expertise, the relative smallness of the clients and the lack of their need for many of the services now or ‘soon to be offered’ by this emerging ‘full service firm’.

The Firm’s Client Base

This should be the first port of call in a consideration of the firm’s options. Any pursuit of a profit enhancing strategy has to be achieved with minimum disruption to the firm’s current clients and with a clear focus on the (new) clients and/or services it intends to provide. It is seldom sufficient to simply rely on a ‘build it and they will come’ approach. It should not be assumed that simply because the firm now boasts a tax partner for instance, that existing clients will choose to use that service.

Did the firm choose its current clients or did they choose the firm? How many of the clients are profitable? How many are likely to need, or be able to afford, the additional services you are intending to provide or need the highly leveraged teams that you are building?

In considering strategies for growth, examine your current client’s profitability, needs and likely intentions. Might you generate more or new work from these sources rather than from pursuing new clients and launching new services? If, however, those prospects look poor, what sorts of clients do you aspire to serve and what services might they want? Can you provide and support such services now or is new ‘talent’ required?

The preferred approach is to construct your options for growth around the answers to these questions rather than to mimic what others have done without appreciating the mix of factors that might have led them to make their choices.

Decisions about pricing, geographical location, staffing, systems and the mix of services to be offered are all critical elements of any strategy. They must be aligned and focused on specific client needs and intentions.

Firms often seek to widen their client base to include larger ‘corporate’ clients, for instance. They may be simply seeking to provide a basic ‘commodity’ type service to that client, eg handling its employment issues, but if the aim is to offer more sophisticated services then a careful ‘needs’ assessment is required. Such clients commonly need not only corporate law advice but also finance or banking advice and will not happily use different advisors for those ‘core’ areas. Reporting lines and the need for systems integration or at least compatibility will also be different from those required in the employment or litigation arena.

Conversely, if a firm is already acting for a corporate and providing ‘commodity type’ advice, it will usually prove difficult to lever that position into doing the client’s more lucrative corporate work. This realisation, together with an understanding that even if the firm does have the necessary talent to offer those services, the firm’s standing or ‘brand’ may not be sufficiently strong to make the in-house counsel switch the work. Unfortunately for less well-known firms, brand and ‘market place clout or reputation’ are important – particularly in the company’s ‘core areas’.

Recruiting and Retaining Talent

Fundamentally, the key to the client’s purse is through the talent that you can deploy to attract and service that client’s needs and intentions.

The correlation between the firm’s talent and the needs and intentions of its clients should point the way to the firm’s next move. A careful assessment of the strengths and weaknesses of a firm’s capabilities or ‘core competencies’⁵ will open up or constrain the firm’s range of strategic options. To focus on core competencies is not only to simply focus upon legal or technical expertise. The outstanding capability firms of this size have is their relationship with key clients and their ability to replicate them. Such firms are often found in surveys to be the most ‘client-friendly’ or to most closely identify with their client’s issues.⁶

Such an analysis often translates into a decision to recruit additional partners or staff to supplement thin expertise or build whole new areas of practice. Care, however, is required.

Professionals are notorious for being more allied to their particular area of expertise than to any broader firm-strategic objectives. There will be little hope of recruiting or retaining such talent unless there are partners with reputations that stand up to peer scrutiny. ‘Ah!’ I hear you say, ‘We have recruited a “star” and we will build on that ...’. When I hear that, I am immediately on my guard!

Why would such a star be attracted to what he or she would no doubt consider a ‘second-tier’ firm? The star is currently well set-up in a ‘big name’ firm with access to substantial clients and is supported by talented juniors. Additional money and a perceived ‘friendlier environment’ may well provide sufficient inducement to move but that is only the beginning. Your existing professional staff (who will not likely have had the training the ‘star’s’ old firm provided), will likely be found wanting, necessitating the hiring of additional juniors, again at a premium to entice them to ‘come across’. Any disparity in incomes will disaffect current partners and the influx of higher paid juniors may cause existing staff to grumble or worse still, leave.

Further, the ‘star’ may wane as he or she finds that work does not readily follow. The ‘star’s’ prior clients may be attracted by the lower rates on offer but are aware they require a mix of talent for their core areas that may be hard for the new firm to supply.

These same factors continue to play an important role in the difficult process of implementing strategic choices, particularly with respect to systems that support recruiting, training, team management, partner appraisal and reward systems.

Systems

Systems relating to personnel are undervalued by firms considering the cost or more accurately, the investment required to achieve their growth objectives. The need to create and keep these systems aligned with the ambitions of the underlying strategy is critical. This is particularly so when new recruits are introduced to the firm or when the firm is seeking to upgrade its profile, range of services or client base.

A firm needs not only to protect itself particularly where new staff is concerned, but it needs to be able to justify to its existing partners and staff how equity in rewards will be maintained. Appraisal and reward systems should not only guide income expectations but also ensure adherence to the firm’s strategic objectives.

Similarly, the firm must ensure that it has the necessary data collection systems in place through its practice management system to capture easily information on billings, time, client and work type to enable it to measure the key performance indicators relevant to its strategy.

Implementation and Alignment

As we all know, implementation is the most difficult phase in any process of strategic planning. As David Maister⁷ has observed, ‘I have seen just about everyone’s strategic plan and to a large extent they are all very much the same – the difference between the winners and losers is not the plan but its successful implementation’.

Putting it All Together

Representing all this diagrammatically is a challenge but the essential elements are illustrated below. In addition to the axes previously described, a number of ‘firms’ (represented by the ‘bubbles’), have been positioned on the chart. The names selected for the firms are indicative of the extent to which they have aligned the priorities represented by the managers, clients and profitability axes and are explained below.⁸ The size and shape of the ‘bubble’ represents the ‘spread’ of profitability of the work that the firm performs as well as its relative size in revenue and partners.

The path from ‘On the Way to Where’ to ‘Happy Here’ positioning would be achieved by progressively managing change on both the ‘management’ and the ‘client’ axes simultaneously. To move to the right, focussing too heavily on the ‘managers perspective’ without addressing the needs of the firm’s client mix may well improve profitability in the short term, but leave the client axis so devoid of investment that any lasting improvement in profitability is unlikely. Similarly, to move vertically from ‘On the Way to Where’ to ‘Wasted Potential’ by winning clients without building or managing the infrastructure to service them efficiently is to fritter away the firm’s chances to improve its profits by taking advantage of those new clients.

The path to increased profitability is not necessarily ‘onward and upwards’. It is more akin to a game of ‘snakes and ladders’. A firm can often find itself in a position such as ‘Big and Balanced’ only to find that due to poor alignment and loss of major clients, it slips to the position of ‘Happy Here and Partners’.

Conclusion

Achieving higher levels of profitability does not necessarily require greater numbers of large clients or necessarily, a larger number of solicitors. A few large clients providing a diet of largely similar and relatively non-complex work can generate high levels of profitability. In fact, that situation might well represent the best of all possible outcomes – a relatively small, well-administered firm, with good utilisation, low overheads and few partners serving a handful of large clients who provide relatively non-complex work.

Certainly, this is a far cry from a typical first-tier firm model which:

1    provides closely integrated cross functional services;

2    has many large clients;

3    assigns complex work to large, highly leveraged teams;

4    operates in multiple jurisdictions with high fixed costs and fees.

The reasons for high levels of profitability in first-tier firms extend well beyond mere issues related to size. Their clients have a different range of needs that require the firm servicing them to master a diverse range of skills, only one of which might have required increasing the size of the firm. Systems, talent and the necessary skills to manage such a client base are all required.

Any path to a more profitable future will require a trade-off – short-term profits for long-term gain. Attempts to embark on any movement along either axis will inevitably require investment in talent, systems and marketing. Progress will more likely be a series of ‘steps’ where the transition to a new position is more akin to movement on a staircase than the flight of an arrow straight at the new ‘target’ position. Any improvement in profit will require a series of investments resulting in progress on the vertical ‘client’ axis and alignment on the ‘management’ axis. Once that investment ‘pays off’, progress can be anticipated along the ‘profit axis’.

Firms which understand their culture in its broadest sense and whose leadership can devise and implement a compelling vision of the future positioning of the firm may well achieve that vision. To realise that vision, however, will require an equally compelling roadmap or strategy which maintains the required degree of alignment.

Duncan Hart

Duncan Hart Consulting

E-mail: dh@duncanhartconsulting.com

Notes

1    One of the problems in defining this group of firms is that these firms are in some way ‘second’ let alone ‘third’ tier. In this article, these terms denote size, either in revenue terms or partner numbers, or both. To others, the name suggests that such firms fall short in some unspecified way of a preferred standard represented by the so-called ‘first-tier’ firms.

2    The term ‘intentions’ is preferable in referring only to client ‘needs’. I first became aware of its use in Robert Baldock, The Last Days of the Giants? (John Wiley, 2000) New York.

3    © 2006 Singapore Law Society.

4    Jay W Lorsch and Thomas J Tierney, Aligning the Stars: How to Succeed When Professionals Drive Results (Harvard Business Press, 2002) Boston, pp 46–47.

5    Gary Hamel and CK Prahalad, Competing for the Future (Harvard Business School Press, 1994) Boston, p 245.

6    See LexisNexis Legal Profiles, 2002 ‘Industry Review’.

7    David H Maister, 1993, Managing the Professional Service Firm and True Professionalism, 1997.

8    Big, Balanced, Aligned and Partners – Very large firm spanning a wide range of profitable work from larger clients demanding a ‘name’ brand, highly leveraged teams on high value transactions.

      Half + Half and Partners – Smaller firm which is on the ‘right’ side of the profitability measures but caters for mid-range clients who demand less rather than more complex services.

      Happy Here and Partners – Smaller firm enjoying a good mix of profitable work from mid- to upper-sized clients – where better leverage is possible.

      Intellect and Partners – Small firm pursuing mainly their own interest in the law on complex legal issues – high leverage is not possible but fees are high.

      On the Way to Where and Partners – A firm whose direction is unclear.

      Profitable Niche and Partners – Small firm enjoying very high profitability – concentrating on performing high value work for one or two types of large clients at very high margins.

      Tradition and Partners – Firm with a wide mix of low margin work, has no brand to speak of and takes all comers as clients. Locked into low value clients whom partners continue to service with little or no leverage possible.

      Wasted Potential and Partners – A firm with a good client base – has grown ‘fat and happy’ in the sense that it has not managed its overheads nor managed to extract higher margins from clients who have the capacity to provide more complex work and pay for it.

      Scrooge and Partners – A small firm with reasonable margins, some leverage which will not invest in its talent or marketing to improve the average value of the work it is doing, the size of client or the complexity of work. It may, of course, be quite happy in this position!

      Sweat Shop and Partners – Small highly profitable firm that specialises in high volume, low complexity work, probably of only one type for one or two major clients, and runs a very tight ship.

      Lost the Plot and Partners – Serves neither its clients nor its stakeholders well. Performs a wide range of work for an extremely diverse client base resulting in them being ‘Jack and Jills’ of all sorts of law and master of none.