This is the second bulletin in a two-part series exploring issues facing small and medium-sized firms in the context of the broader competitive market and with specific reference to Hong Kong.
In the first bulletin, we highlighted a series of strategic and operational considerations for small and medium-sized law firm leaders and how these are changing with intensifying competition. In this bulletin, we explore what law firm leaders need to do in response.
In most legal markets, there are three types of firms in the SME segment: commercial firms, whose core client base is small and medium-sized businesses; retail firms, whose core clients are individuals; and specialist firms whose core client base spans different businesses based on their area(s) of focus. Inevitably overlaps exist between these categories. As discussed in the first bulletin, this is particularly the case in Hong Kong where some clients have traditionally bought legal services from a single trusted adviser (often a smaller firm) across commercial and private client matters. Hence, SME firms are often more generalist than in other developed markets.
However, as buying behaviours change according to the value that clients ascribe to specific services and the providers available to them in the markets in which they operate, competition inevitably segments firms according to their particular capabilities. Small and medium-sized businesses may continue to use the same local firm for lower value commercial as well as family matters but increasingly move higher value commercial matters to a larger or more specialist firm with specific expertise in a particular area.
In other markets we have seen over time how more of the commercial work from the same clients migrates to different types of firms for a variety of reasons including where a trusted relationship has developed and the firm has proven capability, or the firm has demonstrated that it can perform the same services more efficiently (increasingly through the use of technology-led processes), or where there are legal needs in another jurisdiction in which it has a presence or geographic reach, etc. In other markets some buyers of legal services prefer to keep their business and personal legal requirements separate and give the work to different firms. Generational transition in some small and medium-sized or closely held family businesses can also act as a catalyst in changing buying behaviour.
Against this backdrop, firms need to take account of the changing competitive environment and buying patterns of their clients. The following four steps are critical for all law firm leaders regardless of the size of their firms.
Choose Your Strategic Focus
The first issue that the leader of an SME firm needs to address is what the firm’s strategic focus should be (ie, where it aims to compete). This requires a decision about:
- A set of core clients and core services (or worktypes);
- How the core clients buy these core services (the value they place on each service and the volume of the work involved); and
- The firm’s competitive capabilities and those required in the future given the above, who it is they are (and will be) competing with, along with other possible changes in its market.
This will determine the firm’s strategic positioning. As discussed in the previous bulletin, strategic focus does not necessarily mean that all firms will choose to become specialists although some will choose to be at least more specialist than generalist. A strategy, say, focused on providing a mix of commercial advice to small and medium-sized manufacturing businesses and independent retailers is legitimate if those clients continue to value the competitive capabilities that a firm has relative to other firms in its market. The competitive advantage here will be less about technical expertise and more about a strong relationship incorporating real depth of knowledge about the client’s business and the issues it faces such that the legal advice provides effective commercial solutions. If clients do not see this advantage, then the target clients/market and the firm’s services are not sufficiently well aligned and the firm is at risk of losing market position.
A firm’s focus should differentiate it from its competitors in terms of how it generates added value for its clients. This will be a combination of service delivery, relationship depth, client knowledge and pricing. Focusing on a select range of clients enables a firm to build stronger relationships, to better understand each client’s business through the relationship, and to provide advice that is more commercial. This is a “value-add” for clients who are seeking commercial solutions as much as technical advice from their lawyers. Having a defined range of practices, selected on the basis that the chosen client types will use them often, and in which the firm can build a real depth of experience and expertise, will support this.
Deliver on the Focus
Once the strategic focus is clear, the firm must ensure that it operates in such a way that the added value that the strategy is intended to generate is delivered to clients. The first step is to build relationship teams around the firm’s major clients. While this is often seen as an activity solely for larger firms, smaller firms can also use the technique, albeit on a smaller scale, through involving associates as well as partners in any relationship. (A relationship team can be as small as three people.) While a partner is likely to “own” the relationship and be the prime contact, others who provide services to that client should also maintain a relationship with at least the client’s key decision-maker. Working as a team with a client tends to generate more work, better knowledge of the client, and a better quality of advice than where each lawyer operates individually.
Alongside this is the need for an effective business development programme, in which all partners participate, directed at the types of clients targeted by the firm’s strategy. We contend that each partner should spend, on average, the equivalent of one day per week developing client relationships and new business, in order to retain its market share.
One of the characteristics of small and medium-sized firms in many markets is a tendency to focus on cashflow management rather than revenue generation. A business that prioritises cashflow management will behave differently from one that is focused on revenue generation.
In this case, a firm that is focused on revenue generation will actively manage the way in which cash comes into the business and other factors contributing to cashflow rather than focusing entirely on the work-in-hand, completing it and moving to the next matter. The factors contributing to cashflow include: an effective business development programme (reference above) including client development; lawyer utilisation as a whole and individually rather than on a matter-by-matter basis; by extension, recruitment (both to replace natural turnover but also aligned with growth projections and revenue targets); pricing both in winning work and in achieving target profitability (reference below).
Know Your Numbers
The next step is for all lawyers (especially, but not only, partners) to understand the cost structure of their work processes, and the firm’s targeted profit margin. This allows the firm to quickly provide prices that clients find acceptable, while ensuring that the firm achieves its profit margin. This may require a technology-based tool to assist with budgeting (breaking the work down into the tasks and time required per task), together with defining the most efficient processes for each work type. It also requires a capability to capture the time being spent in doing the work against each task in the budget, and effective scrutiny to ensure the work is brought in on budget.
Fundamental to this is whether the economic structure of the firm is suitable for the type of work, the type of clients the firm is targeting, and the pricing options envisaged to achieve the desired level of profitability. This can be separated into overhead costs and cost structure/remuneration:
- Overhead costs: is the existing expenditure effective in ensuring the firm operates at the right level of performance and competitiveness?
- Operational Cost structure: is the fee earning cost structure (including the mix of partners and non-partners) appropriate for the type of work and type of clients the firm is targeting? Is the fee-earner structure being used effectively (including non-partner utilisation) to generate competitive levels of revenue? (As a rule of thumb, higher performing firms generate total revenue 2.5 to 3.0 times the total remuneration of fee-earners, including a realistic notional salary for equity partners.)
We Not Me
Leverage is not a guarantee of profitability. Both high and low leveraged law firms are among the most profitable in the world. A one-partner IP practice with a large number of lawyer and non-lawyer fee earners can generate the same Profit Per Equity Partner (“PEP”) as a high value Corporate/M&A boutique with a much lower leverage. In their markets and given their product focuses, they are appropriately leveraged for the work that is core to their strategies.
However, leverage is only one of two principal levers of profitability, the other being Profit Per Lawyer (“PPL“) as determined by the Revenue Per Lawyer (“RPL“) – based on the available hours, utilisation, chargeable rate and realisation rate – and the Cost Per Lawyer (“CPL“) – based on salary and overhead costs. Hence, leverage is important regardless of the size of the firm.
The issue facing firms that are more focused on cashflow management than revenue generation (reference above) can be compounded in a low or underleveraged firm in which the partner(s) by necessity is heavily or overly involved in “production” that in a more highly leveraged firm would be carried out by less expensive non-partners. (In the latter model, partners are able to simultaneously cultivate client relationships and build their revenue pipelines whilst supervising production, and recruiting and developing talent.) This also has the effect of creating “lumpy” (uneven) utilisation and hence revenue flows, and generally results in lower profit outcomes. Low leveraged SME firms tend to face the problem that with the partners doing much of the work there is insufficient time to do the business development and client relationship work required.
Founder-led firms often struggle to scale their businesses or may choose to remain small. At its extreme a single “partner” practice is limited in the number of files and matters that can be supervised simultaneously. Single “partner” firms also need to weigh up the opportunity cost of partner time spent on files compared with investment in business development and/or client relationship activities. The addition of one suitable partner has the potential to increase both a firm’s supervisory as well as its revenue generating capacity.
The overall performance of a firm is a result of the cumulative performances of everyone within it. Establishing an effective performance management system, even in a small firm, can take time – but can pay dividends. The starting point is to define the main activities to be undertaken for each role in the firm and then put a performance target on each activity. The process should start with partners, and then flow to all fee-earners and other staff, so that all activities in the firm are covered.
Setting clear targets for each person (aligned with the firm’s targets) and then providing training and support to assist people in improving their performance is vital. (One hallmark of a successful firm is the development of its people.) Finally, it is crucial to be able to capture performance data, and feed it back constructively to each person.
Competitive pressures operate at all levels of the market; the SME segment is no exception. Firms that wish to be successful within this segment need effective management processes if they are to remain competitive over time. The same principles and disciplines that apply to larger firms are true for SME firms and those that choose to be guided by these will perform better (and survive longer in some cases) than those that do not. Size should not be used as a differentiator when it comes to the need to manage a firm effectively and to employ the best management practices and processes.