Tuesday, October 26, 2010

Margin, Volume, and the Long Tail

Private law firms naturally focus on high margin services—bet the business work—where cost is less of a concern and fees are high. However, such work is small in volume. While mostly shunned, there is significant opportunity in more routine factory work. While it carries a low margin, the smaller profits per transaction are more than made up in volume.

The topic was addressed in one the best presentations at ILTA. Gerard Neiditsch, Jeffrey Rovner, Mary Abraham, and Ron Friedmann took A New View of the Automated Law Firm and contrasted the nature of bet the business and factory work from a wide range of perspectives, including: (a) how work is produced, (b) how it is managed, (c) who does the work, (d) how business is developed, (e) how it is priced, and (f) how the work is packaged.

Margin, volume …

With an hourly rate, profit margins tend to be similar for bet the farm and factory work, because profit margin today is based more on the staffing ratios and hourly rates than the nature of the service.

While more hours and higher priced attorneys will likely be applied to a merger transaction compared to drafting an employment agreement, meaning that the gross receipts will be higher for the merger, the profit margin for each hour worked will be equivalent where staffing ratios of partners, to associates, to paralegals is about the same. In the absence of a successful document automation or legal process management solution designed to delegate work to less costly resources, the employment agreement will still be handled by a partner and an associate working in about the same ratio of hours compared to the merger.

As a sidebar note: an employment agreement is less standardized compared to a merger agreement, so on a page-by-page basis, it will likely take longer to review and negotiate.

The price for legal services is unresponsive to market forces due lack of automation and process management. As a result, the supply curve is inelastic because of inability to scale or realize any economies of scale.

Economics would argue that since there is a much greater demand for employment agreements, there should be more service providers competing to meet market demand: and, all things being equal, more demand and increased supply will lower the price. Law, however, is high price piecemeal work that requires more workers and hours to produce more services. Lacking innovation, it cannot serve commoditized markets.

Big law serves the narrow market of high-margin, low-volume legal work—good work if you can get it.

Plotting margin and volume on a grid shows that big law operates in the lower-right sector. Few businesses will have any interest in occupying the lower-left sector, and economics will rarely allow the upper-right sector to exist for long periods. In its heyday, credit swaps and derivatives may have been an example of this segment, but most firms continued to price their services by the hour and therefore did not realize higher profits.

The remaining sector is the upper left—low-margin, high volume legal services: a virtually untapped market for private law firms.

... and the long tail

Due to inability to realize economies of scale, big law services fewer and fewer of the transactions executed by their clients because they have priced themselves out of the market. This work has moved in-house.

High margin legal services represent the rarified end of the long tail. For every merger agreement executed by a large corporation, it will negotiate a handful of procurement and license agreements, hundreds of employment agreements, and perhaps thousands of confidentiality agreements. As GCs seek to reduce their outside counsel expense by as much as 25%, this trend will likely accelerate.

The opportunities for law firms (big or otherwise) able to introduce efficiencies are significant. Moreover, this untapped market is likely far larger than the market currently served.

There are many good reasons why firms may not choose this path. It will require change and investment. It may also be perceived as less challenging commodity work. Having spent years drafting and reviewing legal documents, I would argue that is just as challenging to identify contract standards and negotiation ranges for employment agreements based on thousands of documents, compared to drafting one merger agreement.

Friday, October 1, 2010

Contract Analysis -- Commonality and Consistency

In response to my last Post, Ken Adams returns to a familiar theme to question the contract analysis approach. His post, http://www.adamsdrafting.com/2010/09/30/for-optimal-contract-language-dont-follow-the-herd/ suggests the purpose of contract analysis is to find the most popular clauses.

This is an opportunity to clarify how kiiac works. In creating a reference set, kiiac creates an aggregated outline (similar to a table of contents for the collection) and a clause library for each outline branch. The outline captures the standard transaction elements and all deal-specific variations. It does, indeed, measure clause commonality, showing how frequently particular terms appear in the collection. The clause library, however, is organized not by commonality, but by language consistency. Our goal is to find the core, non-negotiated language for each provision. We then group the library by conformity to the standard, highlighting deal-specific or divergent terms in each clause. Typically all the clauses are slightly different, so it is difficult to determine which would be the most common.

kiiac proposes the core language as a starting point. You can select a different clause if it contains language you prefer, or you can quickly review the full range of alternatives and supply your own language for the provision.

Ultimately, the difference in approach between Koncision and kiiac may not be that different. kiiac’s approach is to start with a document structure and set of clauses that are familiar to the attorneys, identify the best precedent in the collection and enable a process of continuous improvement. As I understand it, Koncision will use existing precedent as a guide and may re-write terms where existing language is not optimally suited for its purpose. I think it is fair to say: we are both trying to get to the same point.

Figure 1 shows the outline created for a merger agreement, showing the organization of the agreement of the agreement and how frequently each provision occurs (the more common the clause, the more filled-in the icon).

Figure 2 shows the clause library for the governing law provision, identifying the core clause with the least or no deal-specific or negotiated language, and grouping the clauses by divergence to such standard.