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Finance

Beyond Today's Income - What Constitutes a Firm's Future Earnings Potential?

September 2006

Are your long-term investment projects focusing on building the firm's future earning potential? Will your firm be able to attract the best and the brightest by demonstrating how safe their investment of sweat equity will be in the future?

Financial management in a law firm context is often very short-term oriented. Rarely do CFOs and finance directors around the world have to look beyond the profits of the current financial year. This is mainly for two reasons:

  • The partners as owners, to whom the financial executives ultimately feel responsible, are mainly interested in the profit draws of the current financial year. Mostly, partners have invested little or no financial capital into the firm; even if there is a significant contribution, few partners would argue that they see this as an investment that they bank on in the future;
  • The development of a business model with cost-plus pricing (hourly fees) means that careful monitoring of both utilization and lock-up levels accounts for 80 percent or more of financial management;

This situation culminates, of course, in a lack of significant long-term investment projects that focus on building the firm's future earnings potential. The owners' short-term focus bars professionals from devoting their time to such investments: they are more useful to the short-term gains, if they keep billing their time. The low capitalization resulting from the business model means that law firms simply do not have the reserves to finance such investments. The most significant investments are those that can be financed from the cash flow without having to lower partner profit expectations.

Questions beyond today's income

Let us assume for a moment the situation of a lateral who is about to join a firm. Her investment is – traditionally – considered to be the time she invests – her sweat equity. The three most significant questions in relation to her remuneration or ROI are:

  • What determines how much money I will make here?
  • How much money will I therefore be able to make next year?
  • How certain am I that I will make more money two years from now?

If the firm requires capital contributions for partners or makes the partners underwrite a share of the firm's debt, she may also ask

  • How safe is that investment?

Now, she may also ask about the dividend on the capital contribution, but quite obviously in most cases she would be told that this would be dealt with by her remuneration. Nevertheless, it is the last two questions that deserve so much more attention than they usually get. What insurances are there that the firm as well as she will make more money in two years and how safe is her financial contribution to working capital? Just to be clear, in most cases where we put these questions to firm managers, we are told that partners do not, or at least should not, worry about that: "The firm is growing strong. Look at our revenue and profits growth over the past five years. Anyone should be honored to share in this money-making machine," explained one chairman.

It is most likely that a number of recently imploded law firms told their last laterals the same sort of story. Anyone who has followed the demise of Coudert Brothers, the once proud icon of internationalization, will know how likely it is that the partners who held out until the end will receive more than a fraction of their capital contributions. Could one have seen this coming by looking at the firm's recent profit data and its remuneration system?

In fact, let us put it even more bluntly: The fastest way to disintegrate a law firm is by planting the seeds of mistrust amongst partners about positive answers on the future earnings' potential and the security of their financial commitments. A first wave of doubtful partners leave and put the firm in liquidity dire straits, leading to current profits being withheld, leading to more partners becoming doubtful – and off goes the vicious circle. Long lock-up periods for the repayment of the capital contributions as well as pension incentives may delay that process, but they cannot stop it. Eventually, all the potent partners realize that their firm has no positive answers to the two questions and pack their bags. Their firm, they have decided, does not have enough future earnings' potential. As one administrator of a demised law firm's estate put it brutally, "Left behind are the old, the fragile and the idealists."

The future earnings' potential of a firm belongs to the core of firm management and thus financial management. It is, if you like, the management of the balance sheet as opposed to the P+L statement. It is the management of the firm's assets that it needs to increase its ability to survive in the future, i.e. perform better than last year.

A firm's assets are – as we all know – not very tangible. The balance sheet looks pretty boring to any auditor; the key to tomorrow's performance lies in the firm's intellectual capital. While much has been written about the concept of intellectual capital, only few have broken it down to the practical level or addressed the specifics for law firms. We will attempt to do just that in the space that we have available and add a few of our considerations on the implications for financial management in law firms. However, we should point to two further sources from luminaries and colleagues to whom we owe our gratitude and whose work has been the basis for our work:

- Leif Edvinsson and Michael S. Malone, Intellectual Capital: Realizing Your Company's True Value by Finding Its Hidden Brainpower, 1997;

- Paul Dunn and Ron Baker, The Firm of the Future: A Guide for Accountants, Lawyers, and Other Professional Services, 2003.

Determinants of future earnings potential

A firm's future earnings potential is determined by two factors:

- Its intellectual capital which breaks down into human, structural and relational capital

- Its investment capacity, i.e. the amount of cash and professionals' time available to the firm to develop its intellectual capital. We will address each of those in turn.

Human Capital

It has been said so many times, it must be true: Any firm will argue that its most important assets are its people – partners, associates, paralegals, assistants and management support staff. It is the firm's capital takes the elevator down to ground level and walks home every evening and – hopefully – returns the next day.

Often, though, the human capital is misunderstood as simply the firm's principal production factor. Logically, proponents of this view reduce human capital increases to the development of a specific aspect of the human capital – mainly the production related knowledge, skills and experience. For associates and paralegals that means fee-earning; for partners it means both fee-earning and client attraction. However, such a view falls short of necessary qualifications when assessing any partner or staff in the firm. It becomes most obvious in the partners' human capital contribution. As owners of the business their professional sophistication is equaled by their management capabilities – managing engagements, managing people, managing groups. We will argue that the professional and management capabilities are necessary in every person in the firm; being an associate, partner, management staff or assistant are just differences of degree. The firms that have understood this create people development programs that look beyond the fee-earning capabilities, that include partners amongst participants, that see management staff not as an overhead, but as an equal asset without no fee-earning, but plenty of management obligations.

Structural Capital

Right after we understood that we needed to develop our people, we figured out that we should also make sure we captured what they knew already and what they learnt in their daily work. Knowledge management was born – unfortunately into times where professionals hedged almost religious beliefs in the capabilities of computers to do their job for them, but that would be a story for some other occasion. Over time, this discipline began to include also the harmonization of processes and workflows – creating consistency in the look and feel of documents, in the way a due diligence was done. In the more advanced firms this also includes the innovation labs, where new solutions for the desired clients are developed, tested and then scaled up for market attack, in really advanced firms this form of innovation happens together with clients and other collaborators. The business case for such measures is immanent. They contribute to the professionals defining themselves as a collective. Client engagements also become less dependent on the people involved; for example, associates could be parachuted into matters run by partners they have never worked with before. Finally, innovations always carry the best margins.

It should come as no surprise that this understanding of structural capital is way beyond what most firms consider know-how management. The real benefits of structural capital are not developed, if one tries to maintain and grow a huge database of precedents. Structural capital is about the firm's number of solutions (and new solutions), the degree of consistency across the firm and the institutionalization of workflows that leads to a market perception of something being a typical approach by a particular firm.

Relational Capital

Human capital and structural capital may be familiar concepts in law firms, but the development of relational capital is usually unheard of. But, of course, it is practiced today. While the former two components of intellectual capital are addressed by a firm's professional development program and its know-how management system, relational capital is the core area of the firm's marketing activities.

Relational capital is made up of a number of factors, but most importantly its client base, its brand and its network. The clients' willingness to retain the firm (or individuals who practice as part of the firm) is at the heart of every firm today. The threat of them leaving or simply axing the firm of a roster following a consolidation of legal service providers has been keeping partners, practice leaders and managing partners awake for the past decade. Much of the efforts to institutionalize relationships with key clients belong into the area of relational capital. Here it is important that one differentiates between the firm and the collective of partners that currently owns the firm. If individual partners "own" a client, the firm's relational capital may be well developed for as long as the partner is with the firm. However, in a day and age where partners are increasingly willing to change firms, the risk of losing that relational capital is paramount. That risk devalues the firm's relational capital significantly. Let's just remember the lateral asking the question about future earnings potential. If she is being told that the firm has all these wonderful clients today that is of little long-lasting value to her, if she finds out that these clients will never retain the firm, if a small number of key partners leave the firm. Beyond clients, a firm's clout with governmental, financial and other institutions, industry associations and lobbying groups, courts and arbitrators is part of its relations capital as it constitutes the firm's network; it is its ability to get things done – in ethically proper ways.

Less obvious is that the firm's brand forms part of its relational capital. However, the brand is nothing more or less than what the others perceive the firm to be. And this brings us to a very important realization about the components of intellectual capital: the degree to which they belong to the firm. Relational capital does not belong to the firm at all; much rather the firm depends on a decision by outsiders to maintain that capital. If a client does not want to remain a client of a firm, there is nothing the firm can do to stop that. Human capital is tied to the firm only by way of a contractual relationship – either an employment contract or the partnership agreement. If a professional does not want a firm to benefit from his human capital, he will simply withdraw it. While there may be a contract in place that obliges him to serve the human capital to the firm, there is little means of enforcing such an obligation. Finally, the firm does own the structural capital as this capital stays with the firm irrespective of changes in the relational or human capital. We will address this again when turning to the issue of managing intellectual capital in a law firm.

Investment Capacity

The value of intellectual capital, whether human, structural or relational, does not depend on its presence and performance today alone. If you do not develop it, it will decrease; it requires constant attention to even keep its current value, let alone increase it. Furthermore, its value may be severely reduced by a threat of loss. This is the catch 22 situation many law firms find themselves in after having made individual performance at partner level a condition precedent for future partnership rights. As a partner who is under constant scrutiny one is less willing to contribute to both the firm's relational capital and structural capital. After all, this increases the individual partner's ability to survive in the future – at the current firm or any other firm. The partner ensures that any firm depends on him/her to have access to clients and know-how and thus keeps him/her in the realm of partnership.

To be able to develop the intellectual capital and to reduce the threat of loss, a firm needs both cash and people's time (whereby one can substitute the other to a certain degree). The availability of cash is largely a result of the firm's profitability and its liquidity management – both core areas of today's financial managers. The investment time of partners and all other professionals, however, is largely neglected. In many firms the non-billable time is not managed at all – to their profound detriment. Even if it is measured, monitored and analyzed, the ultimate challenge lies in optimizing the value that this time delivers. In few firms the non-billable time is equally strictly accounted for as the billable time. The accountability difference stems from the fact that the billable time is – ultimately – monitored by the client. The equivalent for non-billable projects is the budgeting and controlling of investment activities by one "internal client", such as the firm leadership, industry group leaders etc. As initiatives and activities are volunteered by members of the firm or group, the "internal client" has the right to veto the suggestions, if he/she is of the opinion that the likely results do not justify the time (and money) investment. The non-billable time, to use a termed coined by our friend and colleague David Maister, is the investment time, while the billable time is the income time. The non-billable time needs to be equally well managed and coordinated, if the firm is to advance its intellectual capital deliberately and not by accident only. Firms, where the billable requirements for partners and associates reach levels of insanity, the lack of investment time needs to be replaced by additional capacity in the form of non fee-earning personnel. However, there is only so much a non fee-earner can do to develop the relational, human and structural capital of the firm. Clients want the partners; professionals are best developed on the job and know-how only stems from daily practice.

It is immanent that firms optimize the mix of cash and professionals time as well as manage the use of both investment tools to maximize the potential of developing the firm's future earnings potential.

Managing the future earnings potential

All of the above seems somewhat distant from the more immediate tasks of financial management in a law firm. Yet, it is nothing other than the management of the balance sheet side of the business. The question then becomes how to manage the firm towards growth of its future earnings potential. There is no general solution for this; it depends on the individual firm. However, it is well worth stating that the customized management approach is most effective, if the firm has clear strategic goals to which the organization's activities can be aligned. Then the leaders of the firm as a whole and the groups as its business units have a reason to argue why certain activities and initiatives aimed at increasing the balance sheet side of the business are worth pursuing while others are not.

Are financial managers the right people for the management of the firm's intellectual capital? Financial management has been catapulted into the heart of law firm management with some CFOs and Finance Directors as members of their firm's overall steering committees; when the Clementi reforms take effect, some of the more senior financial managers are tipped for partnership in their firms. But to do the job of managing the firm's future earnings potential as well as its current earnings, they need to broaden their horizon and skill set significantly. They must leave behind their accounting and controlling legacy and anticipate how the firm's strategy translates into requirements for human, structural and relational capital. They must look beyond the yearly cycle of satisfying profit-hungry owners and build an institution that works irrespective of its current partnership composition. They must manage and unite the functions of professional, knowledge and business development (or training, know-how and marketing) as they must interact to develop the firm's intellectual capital by working closely with the fee-earners. In doing this they must manage the entire organization to increase the firm's chances of surviving in the future by increasing its intellectual capital and that means driving the development of intellectual capital from relational through human to structural capital – as this cannot be lost as easily as the former two.

You might ask what the role of the managing partner would be in such a scenario. We ask that as well. If these are the tasks of the managing partner, the financial managers will be reduced to running the firm's accounting and controlling function, which has little relevance beyond today's operations and as such is prone to being outsourced (like IT, infrastructure, etc.). Whoever seizes the role of developing the firm's future earnings potential is at heart of financial management without having to deal with number crunching.

About the Author

is a Principal with Edge International working from both Toronto, Canada and Frankfurt, Germany. His core competencies are transformation and change processes in law firm governance and management. In 2005 he served law firms in eight countries with offices in more than 30 jurisdictions.