How Alternative Fee Arrangements (AFAs) are Profitable for Law Firms

David Falstein

David Falstein

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Alternative Fee Arrangements (AFAs), when executed right, can lead to lower fees for the client, greater profits for the law firm and better results overall. But how?

The brain twister – How can Alternative Fee Arrangements simultaneously yield less cost less for the client and yield higher profits for the firm? 

On the surface, this doesn’t make sense. Let’s take a pause from Alternative Fee Arrangements. If I pay less for a pillow, how can a pillow manufacturer make more money? Well, if the pillow manufacturer increases its manufacturing prowess and reduces its manufacturing costs by $2 a pillow, the pillow manufacturer can reduce the price by $1 and still make an extra $1 on the pillow. (Not to mention, if the pillow is $1 cheaper, more people will buy these pillows!) 

Okay, your Business 101 professor would be proud. But how does this apply to legal services? And how can this apply especially if firms don’t have clean units from which they can cut costs? (Cases are more complicated than pillows.) 

What are the primary costs for law firms?

Let’s start with the primary costs for legal services. The primary costs for a pillow are the raw materials (feathers? unsure). Buy the raw materials from, say, a supplier in closer proximity to the plant and you’ve got a golden cost-cut opportunity. What about legal? It’s a little more complicated. Legal services certainly have primary costs; they’re the people who are providing legal services. Each lawyer has a finite number of hours that they can work (“capacity”). A firm’s profitability depends on filling each lawyer’s capacity. If a number of lawyers at a firm have unfilled hours at a given time, there are opportunity costs. 

How can we apply this concept (reducing costs to increase profits) to legal services?

You must look at primary costs and aim to reduce them by lowering the number of hours a lawyer needs to work on a given task. You do this by automating certain legal processes and creating operational efficiencies. But to be clear, you’re not JUST reducing hours. 

You must also ensure the right lawyers are working the hours in accordance with the complexity of the task. Because certain hours cost more than others (the cost to pay a partner vs. an associate per hour), allocating hours to tasks appropriately can also yield savings. If done well, the firm can profit and give the client a discount. 

(much like $2-cheaper pillows sold for a $1 discount and $1 added profit). 

What cost/payment structure directly incentivizes that optimization process? Alternative Fee Arrangements (AFAs). AFAs require firms to set a total price for their service such that revenue is more fixed or certain. Without a reliance on billing more hours to increase revenue, firms are challenged to create efficiencies for profit, which – if executed well – consequently allows for discounts to be given back to the client.  

How are these efficiencies produced and profit generated through AFAs with law firms? 

  • Eliminate “Duplication of Effort” by Lawyers

When billing under a Fixed Fee, the firm is incentivized to implement technology and processes that allow the firm to better utilize prior work product (e.g., automation of motion drafting, machine learning to assist with repetitive tasks) and reduce the number of hours and other costly resources to accomplish a task.

  • Law Firms look to the Leveraged Staffing Model. 

What is a Leveraged Staffing Model (“LSM”)? It’s when the ratio of work done by junior resources vs. senior resources increases. This happens when partners give more work to associates, associates give more work to paralegals, etc. LSMs lower the firm’s COST to serve the client, since partners (who have higher rates) can pass work and time off to their junior resources and spread their own resources across a greater number of clients.

  • Legal Value-Based Success Bonuses become possible. 

Since internal costs are reduced by LSMs, clients are more likely to agree to value-based success bonuses. Because LSM leads to a fixed fee discount, the client thus feels comfortable awarding the firm in the event of a positive outcome. This aligns cost with value, which otherwise may not occur with an hourly-based model. 

Example:

Year 1 – Firm bills client $150K under hourly billing model. 

  • Internal costs for law firm: $100K
  • Client’s overall fee: $150K
  • Law Firm Profit: $50K

Year 2 – Firm bills client $100K under a fixed fee with a $30K success bonus.

  • Internal costs for law firm: $70K
  • Client’s overall fee: $130K
  • Law Firm Profit: $30K; Profit with success bonus: $60K

Note that in Year 2 the client pays $20K less, and the firm profits $10K more after earning its success bonus!

What does all of this mean for service quality? Do Alternative Fee Arrangements impact quality of work?

Contrary to the fears of some in-house lawyers, the AFA does NOT lead to lower service quality. The partner is still accountable for the work quality of the team. Since clients can hire different firms on future projects, quality is effectively table stakes – the minimum offering required to compete

What about a deviation in scope of work? 

Deviations in scope may happen, but this shouldn’t lead to increased fees or a retreat back to hourly billing. Only where deviations are MATERIAL, i.e., based on an increased number of tasks/activities should the fixed fee be adjusted upward or downward. The number of hours worked shouldn’t change the fee amount. Thus AFAs – because they can fix the incremental cost of added activities – are less likely to result in large price increases when scope changes than hourly-billing models. If working efficiently, firms can increase profitability and pass savings onto clients under an AFA. 

In Summary: 

  • Fixed fees create outcome-driven practices at firms, since they are incentivized to use their resources efficiently. Savings can be passed to clients. 
  • While the firm is saving and the client is saving, the firm can ask for a success bonus – which may not otherwise happen in an hourly rate model. 
  • Fixed fees allow firms and clients to exchange based on value rather than time, which means both parties are getting more from the arrangement. 

→ What else have we debunked about AFAs? See here

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