To ensure profitability, law firms need to come to grips with the way the rates they charge clients for legal work can get degraded, resulting in lost revenue over time
Law firms, like so many other businesses, aren’t always able to collect the entire amount that they bill their clients. Indeed, there is almost always a difference between the rate clients agree to pay (what we often call the worked or agreed rate), the effective rate clients are billed, and the actual rate clients pay.
The difference between these figures is called realization, and over the past 10 years, it’s been remarkably stable or even improving a bit for many law firms. However, that changed in the first quarter of 2022, when realization for the Am Law 100 began to slip. To the surprise of many, it’s been declining ever since. Am Law 100 firms realized 89.2% of their agreed rate in the first quarter of 2022; but by the first quarter of 2023, it was down to 87.1%.
Realization typically drops a bit in the first quarter of the year, when clients see the effects of law firms’ rate increases, but realization typically recovers by year-end. In 2022, that didn’t happen. Instead, what at first looked like a periodic dip soon became the start of a trend.
At Am Law Second Hundred and Midsize law firms, rate realization has been much stronger, but still trending the wrong way. In the Am Law Second Hundred, rate realization was 92.6% in the first quarter of 2021; it’s now at 91.2%. Midsize firms have seen a smaller decline, moving only from 91.7% to 91.5%.
It can be tempting to attribute these declines in realization to client pushback or uncertain economic conditions and believe that it’s largely beyond the control of law firms.
It can be tempting to attribute these declines in realization to client pushback or uncertain economic conditions and believe that it’s largely beyond the control of law firms.
When we look closely at the data, however, we see something interesting: realization is something that law firms have the ability to control — and, when it comes to declining realization, to fix.
The causes of declining realization
There are two components of rate realization. The first is the gap between the agreed rate and the billed rate: what law firm partners decide not to bill. The second is the gap between the billed rate and the collected rate: what their clients refuse to pay.
Ideally, the agreed rate and the billed rate should be one and the same. The agreed rate is exactly what it sounds like: the rate the client has agreed to pay. So why would any attorney charge the client anything less?
Let’s look at an example in which a partner brings in a large legal matter. Four months later, they are looking at the bill and, frankly, it looks big — perhaps too big. When the partner thinks about it, they realize their associate was still coming up to speed on this type of work, and often took too much time to do it. Anticipating client scrutiny, the partner shaves a bit off the bill. It’s also likely that the partner did some work on the matter that never got logged into the timekeeping system — such as, when the partner might have felt the time was not as productive as they would have wanted, so they opted not to even report it to time and billing.
That’s how rate degradation starts.
Then, rather than applying data analytics based on past matters to the bill — or any sort of analysis, for that matter — the partner decides that the amount on the invoice needs to be something that “makes the bill work for the client.” They don’t want to risk angering the client over the amount, so they proactively revise it. It’s not even that the client has pushed back, it’s that the partner is afraid that the client might. Essentially, it’s fear-based pricing.
Unfortunately, most attorneys don’t learn about pricing in law school — and the current economic uncertainty doesn’t help. Lawyers, like everyone else, hear plenty about how clients are getting fed up with rates, even if they don’t get that feedback directly from their own clients. By reducing the bill, the partner thinks they’re providing client service. However, it’s an odd type of client service, because the client is completely unaware of it.
When we look closely at the data, however, we see something interesting: realization is something that law firms have the ability to control — and, when it comes to declining realization, to fix.
The data shows that this is a far bigger problem for realization than actual client pushback on invoices. Despite a lot of chatter in the market about client pushback, what the data actually tells us is that law firms keep raising rates and clients keep paying. The collection rate tracks remarkably closely to the rate the client is billed.
Protecting rate integrity
There are two actions law firms can take to stem this slide in realization. The first is to protect their own rate integrity. Firms need to limit the self-inflicted damage that is hurting their profitability. Partners should remember: the client has already agreed to pay the rate. So, is charging a client 95% of the agreed rate — rather than cutting it to 93% — going to put the client relationship at risk? That’s questionable, to say the least. But that difference in billed rate, multiplied across every timekeeper at the firm, will make a difference.
The other strategy is to reconsider how lawyers convey their value back to their clients. I’ve spoken with general counsels about the extent to which rate increases are driving a migration of work. Inevitably, the conversation is the same. Yes, general counsels say, law firms are expensive. But when a law firm brings true value to the table, they’re worth it. In mergers and acquisitions and private equity work in particular, the general counsels will call out specific firms. Yes, their rates might be double someone else’s, but they get the job done in one-third of the time, and their expertise is so valuable that actually, the rate doesn’t really matter.
If you’re leading a law firm or managing client relationships, do your clients say the same thing about your value? At the end of the day, the best way to preserve your firm’s rates and improve rate realization is not to talk with clients about fees — it’s to talk to them about the value you provide.
For more on how law firms can better protect their revenue, listen to the Brent Turner from Thomson Reuters Institute Advisory Services on the recent Thomson Reuters Institute Insights podcast.
