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Practice Made Perfect 1.12.15

John Fitzgerald 01.12.2015 | Practice Made Perfect 1.12.15

Alternate Fee Arrangements — Finding What Works Best for Your Clients

By John Fitzgerald, CPA

Historically, the fee structure between client and law firm had been the billable hour. The world changed with the massive sweep of the Great Recession when firms faced huge fee reductions. Today, in-house legal departments continue to apply pressure on law firms in the form of fee reductions or risk-sharing agreements with clients.  More than ever, clients expect firms to provide legal services in the most efficient and cost effective manner.  While the billable hour remains the predominant fee arrangement in the legal industry, Alternate Fee Arrangements (AFAs) are becoming more commonplace.

What’s the Attraction?

Many clients prefer AFAs to the billable hour because they allow legal fees to be managed to meet departmental budgets. Flexible arrangements may enable clients to recognize lower fees on certain agreed upon levels of legal services and also offer the law firm milestone payments as certain matters are completed.  Under AFAs, the client perceives value for their legal fees.

Nevertheless, there is some risk. Both client and firm must recognize that not all AFAs will succeed. The AFA is just one part of their overall relationship and, as an experiment, it may be necessary to change course or make modifications if one or both parties become uncomfortable with the outcome. 

Before You Consider an AFA

AFAs can be your pathway to build new business, establish a relationship with a particularly attractive client, and provide flexibility to a client. Nevertheless, when offering AFAs, you need to develop a mutual level of trust with the client, understand and define the objectives of each phase of the engagement, and constantly stay on top of budget matters.  AFAs can reduce billing and collection disputes with clients and, when combined with excellent legal services, build a foundation for a strong client relationship. 

Your AFA Options

Contingent Fee. Occasionally referred to as a Contingency or Conditional Fee.  With this approach, your firm collects a percentage of the money won at trial or on settlement.  The downside:  The client generally pays nothing should legal action prove unsuccessful.

Fixed Fee. Your firm takes on the matter for a pre-negotiated amount.  This works well when the cases are routine. However, it could lead to difficulties should you incur unexpected costs requiring a separate negotiation.

Flat Fee. With this arrangement, the firm takes on a book of cases for an agreed upon amount. Provisions could be made for a specific number of cases or for certain types of cases that occur during a set time.

Bonus Arrangement.  You firm receives an extra payment depending on how the case is resolved.  Payment conditions could rest on:

  • Level of success
  • Speed of resolution
  • Degree of cost savings

Discounted Fee With Performance Bonus.  You offer a discount on your normal hourly rates in exchange for a performance bonus or award for success. The performance bonus can be a percentage of the fees saved below budget, a multiple of the discounted fees, or a dollar amount.

Blended Rates.  All time is billed equally without regard for attorney seniority. The tendency is to use less experienced attorneys which may impact the outcome of the case.   

Volume Discounts. Your rates are based on the volume of the work you receive from the specific client.  

Capped Fees.  These are also referred to as Collared Fees.  You set a maximum amount above which the client no longer pays fees. Depending on where the cap is set, this arrangement can encourage efficiency.  You are at risk, however, if your estimates were not calculated efficiently.  If possible, insert a safety provision which allows you to revisit the arrangement should the cap exceed a certain amount or percentage.   

Holdback Fees.  You and the client agree on a specific amount or percentage of the fee that will be withheld until you reach certain milestones or achieve defined results. Sometimes the holdback can be up to the end of the engagement. This will depend on your confidence in the client’s willingness and ability to pay. This type of “progress billing” is helpful for your firm in managing cash flow.  For the client, it may be preferable to paying one large bill at the end of a matter.

In any of these arrangements, communication with the client throughout the matter is key.  By regularly reporting on progress and milestones, any problems that arise can be discussed as they occur as opposed to when the engagement is complete.  Also, it is not required that you stick to one particular AFA. It might be useful to try a combination depending upon client, case circumstances, and your desire to build a long relationship, among other factors.   


Capital Planning: Envision the Future and Make it Happen

By John Fitzgerald, CPA

Capital planning and retention can be a contentious topic among law firm partners — often because the issue involves just how much will be coming out of each individual’s pocket. Nevertheless, it is a process that is crucial to the short- and long-term well-being of your firm. To ease the planning along, it is useful to break the process down so that all involved will see clearly what is necessary and important for their future. 

Identifying Your Needs over the Next 1,3,5 Years

Your firm’s capitalization needs turn on a number of variables which you will need to consider as part of the long-term strategic business plan. These include:

  • Firm strategy and growth initiatives such as laterals and potential mergers
  • Projected operating cash flow
  • Real estate, additional office space, and equipment needs — particularly technology costs
  • Unfunded pension obligations
  • Maintaining competitive compensation for partners and essential staff
  • Risk tolerance of your organization — loss of major client, rainmaker departs, practice area declines

Considerations and Opportunities

Once you have sorted out the needs that are most important to the partnership, you must now weigh factors that will influence your decisions.

Phantom income. Meeting your needs should be weighed against the phantom income that capital retention generates. Phantom income often occurs when income is passed to the partners whether or not the cash was actually distributed to them.  The cash may have been retained for firm costs, but the onus of paying the taxes on that income falls to the individual partners.

Financing.  Decide whether you will finance costs from working capital or through debt — capital/operating leases or bank lines.  The current low interest rate environment provides an attractive option for firms to use debt to finance equipment, technology, or real estate needs.  This can allow the firm to spread the cash flow effect of such investments over a period of time to minimize the effect to the firm’s capital structure and to partner’s distributions.

Partnership Agreements. 

Consider amending your agreements to include a ceiling on distributions to retired/departing partners not to exceed a percentage of revenue in a given year. This will enable the firm to retain capital to effectively manage the business and potentially reduce your need to borrow.

Staying Flexible

Any capital plan should remain fluid, be reassessed periodically, and adjusted as firm policy changes and unanticipated challenges and opportunities present themselves. Consider a target capital account balance by partner. This can be a percentage of earnings, excluding bonuses. Industry benchmarks for this approach range from 35% to 40%.