Law Practice Management Asked and Answered Blog

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April 2011

Apr 27, 2011

Contingency Fee Profitability: Can You Make Money From Contingency Fee Work

Question:

Our firm is a 12 attorney general practice firm located in the Phoenix metropolitan area. In additional to general practice, we do a fair amount of insurance defense work as well. In an effort to improve firm profitability we have been considering alternative fee arrangements – particularlly contingency fees – with some of our existing clients as well as venturing into personal injury plaintiff work. Can we improve profitability by doing more contingency fee work?

Response:

The CEO of the Howrey LLP, when interviewed about the law firm's recent dissolution, advised that deferred profits from contingency fee work led to the firm's demise.  Howrey is a good illustration of what can happen when the risks of contingency fee work is not considered or managed. Contingency-fee work can pose major risks for law firms, as they earn no fees if they lose those cases and sometimes have profits deferred in protracted litigation. In addtion, cases can be lost with no fee whatsoever recevied. Whether your firm is considering "big deal" litigation or bread and butter run of the mill personal injury litigation you may want to consider the following:

  1. Don't dabble in contingency fee work. Take it seriously and insure that your case portfolio is adequately diversified.
  2. Reduce case portfolio risk and improve case profitability by implementing a sound case intake system to insure that you are selecting quality cases.
  3. Realize that you have to spend money to make money and that you simply may not have the financial resources to take on certain cases. Learn how to say no and when to refer these cases out to others.
  4. Insure that you have an adequate portfolio of cases (number of cases, size and type) to insure diversification and manage risk.
  5. Analyze the profitability and return on each case and ascertain what can be done differently on future cases. Typical metrics include effective rate and/or LODESTAR.

In essence the fundamentals of risk and return is at work and should be considered when accepting contingency fee work. You are betting that you can beat your hourly rate that you receive (or would receive) on hourly work. Contingency fee work often involves the risk of no fee at all, financing the case, long time periods before the case is concluded and fees are received, client advance investments, etc. For these risks the firm should be able to expect a premium. In other words – the effective rate on contingency fee cases should (on average) be greater than that for hourly work.

Many law firms are not receiving a "risk premium" at all and are often, on average, obtaining an effective rate close to their bill rate. So, do consider the risk involved and evaluate methods of mitigating the risk as much as possible. In general – don't dabble – but work to a portfolio of cases large enough to diverisfy your risks.

Herbert Kritzer has done extensive academic research over the years on contingency fees which can be found in his book – Risks, Reputations, and Rewards: Contingency Fee Legal Practice in the United States. The book can be ordered from Amazon.com. Link to Amazon

While I have outlined a cautious approach here I want to also clarify that I have many clients that are doing very well and making a lot of money doing contingency fee work. It is the firms that did not grow up doing contingency fee work that "dabble" where I see the problems.

So proceed with caution – but go for it if it makes strategic sense for your firm.

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John W. Olmstead, MBA, Ph.D, CMC

Apr 20, 2011

Law Firm Financial Statements

Question:

I was just elected by my other partners to serve as managing partner of our 17 attorney firm. We are based in Nashville, Tennessee. I do not have an accounting background and I have questions about our financial statements:

  1. Why does the income statement not reflect all disbursements for the month? For example it does not reflect partner draws, client advances, or payments on the firm line of credit?
  2. I have only been receiving the income statement. Should I been receiving other financial statements?

Response:

Getting a handle on the financial aspects of your firm will be your most important role – whether you have a firm administrator or not.

You should also be receiving a balance sheet which reflects the firm's financial position as of a particular point in time. The income statement only reflects income and expense accounts and reports net income for a reported period of time. The income statement is different that a statement of cash flows which reports cash flows during the period. Partner draws, client advances, and line of credit payments are not expense accounts (they are asset, liability, and capital accounts respectively).  Consequently, they will not be reported on the income statement. These accounts will be reported on the balance sheet.

Other than reviewing the balance sheet for activity in accounts such as discussed above the balance sheet (without adjustment) has limited use. It's purpose is to reflect the firm's financial position as of a point in time. However, since most law firms maintain their books on a cash basis – the largest assets – accounts receivable and unbilled work in process – are not reflected. Accounts payable and other such liabilities are not reflected either. If you are interested in a true picture of the firm's financial position as of a point in time you must take these items into consideration.

Another report that you may wish to receive is a statement of cash flows. This statement will report actual flows of all cash – in and out of the firm – regardless of account time.

There are additional schedules and reports that you should receive as well. Suggest you review your system and create a report distribution policy as to which reports you and the other partners receive each month.

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John W. Olmstead, MBA, Ph.D, CMC

Apr 13, 2011

Balancing the Law Firm Trust Account

Question:

I am the managing partner with a 14 attorney firm in Chicago. We recently hired a new accounting manager/bookkeeper. While she has worked in a few other law firms these firms did not require her to manage a high volume trust account. Our firm has a high volume of transactions that flow through the firm's trust account. We have had problems in the past with prior bookkeepers and outside accountants that did not balance/manage our trust accounts properly. What suggestions do you have or resources do you suggest?

Response:

Failure to properly manage, balance, and reconcile the firm trust account can be a major problem for law firms - from professional responsibility, accounting, and tax aspects. From a bookkeeping standpoint – failure to maintain a trust account sub-ledger for each client that has money in the trust account and insuring that all of the sub-ledgers balance and reconcile back to the trust account bank statement in the biggest problem that I see. You must do more than simply maintaining a checkbook journal register – you must have a sub-ledger for each client. If the firm reflects the trust bank account on it's balance sheet there should be either a contra asset account or a liability account relecting the same amount reflected in the cash account. The total of all of the sub-ledgers should also equal the number in each of these two general ledger accounts. All should reconcile back to the trust account bank statement. If the firm does not reflect the trust account on the balance sheet – then the trust account bank statement should be reconciled to the sub-ledgers.

Many time and billing programs have trust accounting modules that fully automate the trust accounting management function, maintain the sub-ledgers, write trust account checks, and reconcile the bank statement against the client trust sub-ledgers.

There are a whole array of issues that you need to be aware of and stay on top of concerning retainers generally, firm trust accounts, and other matters. You, your bookkeeper, and your CPA need to get educated on all of the ramifications.

Here are a few additional suggestions:

  1. Get a copy of your local rules and read them. For Illinois lawyers – get a copy of the Illinois Rules of Professional Conduct of 2010 published by the Attorney Registration and Disciplinary Commission of the Supreme Court of Illinois. www.iardc.org.
  2. Insure that your bookkeeper and CPA read these rules and implement appropriate systems to ensure compliance.
  3. Get your hands on a copy of the book – ABA Guide to Lawyer Trust Accounts, by Jay Foonberg. Book can be obtained from the American Bar Association website. www.abanet.org
  4. Reconcile monthly.
  5. Use appropriate software to write checks, record deposits and transfers, renconcile bank statements, and maintain the client trust sub-ledger.
  6. Maintain a journal.
  7. Maintain a client trust sub-ledger.
  8. Insure that funds are transferred to the firm's operating account when fees are earned and appropriate accounting entries made at that time in the firm's books.
  9. Stay on top of the trust account.
  10. Insure that your bank and credit card company are following proper procedures. Insure that your bank takes services charges, charges for printing checks, etc. from your operating account rather than the trust account.

You are right in desiring to get a handle on this sooner than later. Sit down with your bookkeeper and CPA, get educated on the rules and procedures, and implement appropriate policies and systems now. It is always easier to prevent a mess than to clean up one.

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John W. Olmstead, MBA, Ph.D, CMC

Apr 06, 2011

Law Firm Succession – Transitioning and Grooming the Next Generation

Question:

I have a general practice firm in Southern Missouri. I am the sole owner and I am 64 years old. There are three associates in the firm and four staff members. I have recently been giving some thought to my future, what to do with the practice, and how to salvage any sweat equity or value from the practice when I am ready to retire. The problem is that I love my work and really want to work forever. Suggestions?

Response:

Succession and exit questions are a hot topic in law firms of all sizes today. I find that in small firms it is not unusual for partners and owners to want to work as long as they can. In fact, in approximately 75%-80% of the firms that I am working with this is the case. Many attorneys enjoy their work and obtain great fulfillment from the work that they do.

The key is to start early and develop a transition strategy and plan. In your situation since you, health permitting, want to practice as long as you can, a sale of your practice is not really your best option. I would think that you need to focus on grooming your associates and gradually, over a phased basis, transitioning interests to them. Get a feel for the value of the practice, put together a firm financial profile and a quality proposal, dress up your financials, and sit down with you associates and discuss your ideas and plans with them. Determine their state of readiness. If they are not interested – keep your succession plans in mind when hiring others and screen for new hires that have an interest in owning a law firm.

As you look toward grooming the next generation keep in mind that you must find ways to get your associates invested in ownership both financially and emotionally. They need to believe that they are part of the firm and that down the road that it is in their best interest to someday own your firm rather than start their own. This will mean gradually giving up some control. You can't have it both ways.

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John W. Olmstead, MBA, Ph.D, CMC

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