Large Firms
Aug. 6, 2002
Growth Costs
Column by Bobbie McMorrow and Ralph Savarese - "Why would you open in Kirkland, Washington, or Austin, Texas?" we asked a managing partner from the Midwest in the winter of 2000. "Your firm is known for complex litigation, Fortune 500 companies and a traditional banking practice.
"Why would you open in Kirkland, Washington, or Austin, Texas?" we asked a managing partner from the Midwest in the winter of 2000. "Your firm is known for complex litigation, Fortune 500 companies and a traditional banking practice.
"Kirkland and Austin are speculative, early growth, emerging technology markets. We don't see the strategic fit."
The managing partner responded, "Well, we don't have the money or drawing power for the Silicon Valley, where the action is. If we don't do something in tech, we'll be also-rans. It's too important a market right now. And how will we grow an IP practice without at least a few small tech outposts?"
Too many firms allow the goal of growth to override or dispense with the need for careful strategic and economic analysis.
Recent months have shone a light on the dysfunction of ill-conceived growth plans throughout the economy, leading all of us to confront the false realities that have led some of the world's largest corporations into disastrous positions.
Sound vision and strategic thinking require ongoing evaluation of several factors, including assessment of services, clients, partners and individual offices.
The appropriate size of an office is a constant question for firms. Microeconomic theory addresses what is called minimum efficient scale. From the economist's viewpoint, minimum efficient scale is the smallest possible size compatible with profitable production. Applying this concept to law firm offices refers to the minimum size that will allow the office to achieve strategically aligned, profitable levels of output consistently. That is, the right scale to attract sufficient and strategically aligned talent and work at competitive price levels. This is also the scale necessary to reduce to a tolerable level the risk of debilitating downward shifts in revenue streams.
Numerous factors must be addressed in conducting this systematic analysis.
Competition and Client Needs. The first step in defining the minimum efficient scale for an office is to conduct a strategic analysis of the firm's strengths and weaknesses relative to the competition. This analysis must be matched against the scope and nature of the client needs that can be served effectively from the new office. These steps will determine parameters for the talent and services required in the office.
Clients will expect to see a level of experience and depth based in the office that is at least equal to the competition.
Nature of Services. If the analysis calls for the office to handle complex, labor-intensive work, more attorneys will be required to perform the work at competitive levels of quality. For example, the capability to handle bet-the-company litigation requires more attorneys than routine commercial litigation.
Number of Distinct Services. The minimum efficient scale for an individual office also depends on the number of different services appropriate for the office to offer. Each service has a minimum efficient scale. The more distinct services offered, the more attorneys who will be required. For example, an office designed to handle corporate, litigation and real estate matters must achieve appropriate scale for each service area.
Reputation, Brand and Location. In most cases, partners in the new office will be required to generate work from locally or regionally based clients to achieve sufficient revenue levels. This will require the firm and the office to possess a reputation and brand that can win clients on a competitive basis.
In general, clients are more comfortable giving important work to an office of credible size and reputation. The minimal size for credibility will depend on the size of the geographic market, the number and size of competitors and the client base. Los Angeles, for example, requires a larger minimum than Orange County.
Talent. It is desirable, if not essential, that the home office send attorneys to the new office. To achieve minimum efficient scale, though, the firm must be able to attract top talent with the right experience and capability, as well as the concrete potential for business generation, given its presumably better brand and platform.
Quality talent will not migrate to another firm or stay with a firm that does not have a well-thought-out vision and strategy that contemplates significant growth by the office. This generally translates to an office of at least 20 attorneys in smaller locations and more in larger ones.
Fixed Costs. Minimum efficient size is also a function of fixed costs. The office must be large enough to spread its minimally required fixed costs over enough attorneys (implicitly, enough revenue) to be competitively profitable. When making decisions about office size and related issues, including office space commitments (a fixed cost), some firms have trouble balancing growth objectives with the potential cost impact of unused space.
Revenue and Profit Volatility Risk. One of the most important but least understood variables in determining appropriate office size is revenue and profit volatility risk. Profitability is necessarily about increasing profits. However, it is also about surrendering optimal profitability to reduce the odds of sharp declines in profit levels from year to year. Good business managers embrace strategic action that will help avoid sharp downward fluctuations in revenue and profit even while lessening the revenue and profit that could be achieved.
The revenue volatility risk of an office is a function of its diversification. The greater diversification of the sources of revenue, the less likely that a single event - such as the outcome of a matter or a turn in a client relationship - will have material effects.
However, not just any diversification will do. It must be strategically sound. Only by adding strategically aligned services, talent, clients, engagements and business-generating partners will an office become less vulnerable to revenue volatility.
An office that relies on one or two business-generating partners, who provide one or two types of services for a small group of clients, is a recipe for trouble. The trouble is doubled if the strategically ordained work is complex and labor-intensive. Such work means fewer engagements per attorney and per dollar of revenue. Therefore, it requires more engagements and more attorneys to protect against the risk of volatility.
The need for steady levels of work raises other questions. Can the existing offices transfer work to the new office? Does the culture and compensation system encourage partners to transfer work to peers in new offices, regardless of whether the work is within the competence of the office originating the work? Or do they encourage partners to retain the work and use the new office only for low-level support such as local counsel and minor court appearances? In addition, to maintain targeted levels of output, will partners in other offices go out of their way to use attorneys in the new office on their matters, regardless of where they are focused geographically?
Law firms are particularly risk-intolerant organizations. Paradoxically, the failure to understand the revenue and profit risk associated with insufficient diversification leads risk-intolerant law firms inadvertently to adopt high-risk growth strategies.
Law firms speak of "critical mass" all the time. But what we know from experience is that firms often open new offices opportunistically and without carefully defining minimum size requirements and how they will be achieved. Opportunism based on the ambiguous encouragement of a single client or without a well-conceived plan is a roll of the dice. Moreover, a failed new office launch can stultify growth in the new market permanently as the tarnished reputation of the firm seals its fate.
On the other hand, management should not cavalierly terminate plans for a new office or divest existing practice areas or offices. The benchmark for judgment should be profitability and cogent strategic reasoning.
Sound strategic thinking includes a clear-headed, objective look at both what is working and what is not, examining at a deep level both the core functions and dysfunctions of the firm. Tough, courageous decisions can be painful in the short term, no doubt. But are they not preferred over the prolonged pain and debilitation that flows from deferring such decisions?
Bobbie McMorrow and Ralph Savarese head McMorrowSavarese, a legal consulting firm that focuses on strategic planning and law firm mergers.
Contributing Writer
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