AI and The Business of Law, Part 1:  Lawyers, Apps, and Money  

Apologies upfront to the late Warren Zevon for playing off of his seminal classic, “Lawyers, Guns, and Money” as the title of this blog post.  It is appropriate, as legal professionals look for new ways to leverage a rapidly changing technology landscape to engage clients and develop new revenue streams.  As anyone who has ever had P & L responsibility knows, increased revenue is the great eraser of strategy flaws, which makes revenue growth critical for many law firms.

Over the past 8 years, the legal profession has undergone changes that initially appear minor, but have had a profound impact on the the legal profession, creating the need for most law firms to adapt to the changing market and discover new methods to generate revenue streams.  Matters are increasingly moving away from the traditional billable hour to various types of alternative fee agreements.  Buyers of legal services now utilize metrics, analytics, and data to gain insight into their legal spend, evaluate counsel, and benchmark fees and staffing.  Outside counsel guidelines are more restrictive than ever, and clients are keeping an increasing amount of legal work in-house, creating a situation where the buyers of legal services can also be the primary competitor for the law firm.  These are just a few of factors forcing many firms to look beyond traditional client development and fee engagements to discover new methods for revenue generation.

This is the perfect storm that has AI, cognitive computing, expert systems, and machine learning at the forefront of disruption to the legal profession.   As law firms continue searching for ways to identify and leverage a competitive advantage that increases revenue, they are, at the same time, are being forced to increase efficiency and lower their COGS (cost of goods sold) for matters on fixed or flat fee agreements to increase profitability.  This is where technology-enabled services provide the answer.

First, a little background.  The legal profession is not slumping the way the Oil and Gas industry is.  In fact, it’s quite the opposite.  Since 2003, the collective revenue for the Am Law 200 has risen more than 104%, from $49.9B in 2003 to $101.9B in 2016.  By comparison, the collective revenue of the Fortune 500 has seen a 73% increase in gross revenue during the same period.

But a look inside the numbers reveals some eye-opening markers that signal the need for change.  For example, in 2003, the Am Law 50 collectively accounted for roughly 52% of the total Am Law 200 revenue.  By 2016, their wallet share has grown to 60%, which means that a segment of 150 firms – or 75% of the Am Law 200 – are getting a decreasing share of a rapidly increasing market.  Now, to be clear, not every firm in the Am Law 50 is producing record-breaking numbers each year, nor is every firm in the Am Law bottom 150 producing equally stagnant years.  But looking at the broader segmented view, the year-over-year results are showing a consistent pattern of a widening gap between the two groups.

The underlying metrics are similarly imbalanced, illustrating the widening gap between the two segments.  Since 2003, the Am Law top 50 has seen their average overall attorney headcount increase 51%, their average revenue per lawyer (RPL) increase 66%, and their Profits per Equity Partner (PPEP) increase a whopping 124%.  Compare that to the average of the firms ranked 51-200 in the Am Law 200 over the same period, who have seen just a 20% increase in attorney headcount, a 44% increase in RPL, and a 68% increase in PPEP.

Add to all of this the fact that rates continue to rise.  According to Wolters Kluwer ELM Legal Analytics, pre-2008-9 recession rates were rising closer to 7% annually, while post recession rate growth has slowed, it’s still around 3.7% per year.  Their Legal Analytics team also uncovered another interesting trend that aligns with the aforementioned headcount numbers: Along with matter type and timekeeper location, firm size was the biggest driver of law firm rates, as well as total matter costs.  In their 2014 Real Rate Report study (author note: I was a contributing author to this report), they noted that when firms grow beyond 500 attorneys, staffing models shift to matters staffed with more associates than paralegals, leading to increased per matter costs.

With numbers such as these, it’s no wonder that buyers of legal services started pushing back.  Many companies now require budgets on all matters, and are utilizing analytics to track the budget to actual spend, and forecasting additional spend where appropriate.  Companies like the previously mentioned WK Legal Analytics, Thomson Reuters, LexisNexis, and more are amassing billions of dollars of global legal spend data to enable both the buyers and sellers of law firms to benchmark rates, staffing, and total matter costs more accurately.  Newton’s Third Law of Motion often comes to mind when news such as increased first year associate starting salaries is met with the equal and opposite reaction of revised outside counsel guidelines that ban first and second year associates from billing on matters.  And more and more matters are moving to various types of fee engagements that depart from the traditional billable hour.

The terms “predictability”, “cost certainty”, and “transparency” are frequently used by buyers of legal services who are faced with the unenviable task of curbing legal department spend while maintaining regulatory compliance and minimizing the exposure to risk their companies face.  Law firms, too, are looking for new ways help their clients achieve these goals without consistently writing off work performed in small increments, like quick phone calls or emails for  frequently asked questions. For the law firm, this can seem like a quest for the proverbial “win-win” — engagements that provide transparency and predictability for the client, while hitting the profitability target of the firm.

Many strategies have been deployed in an attempt to achieve a “win-win” for the client and the firm, from client teams to aggressive pricing strategies to the implementation of technology, with varying degrees of success.  A number of factors contribute to the successes of these strategies, from compensation structure to a firm’s leverage model. Unfortunately, each of these strategies share a fatal flaw: an inability to perform at scale.

Internally, firms are also often cutting budgets for non-practicing staff and departments, increasing the workload for finance, business development, IT, and research professionals.  Meanwhile, the buyers of legal services are facing similar issues, from controlling outside counsel spend to deciding what work to keep in-house, and what work to outsource as a byproduct of the mandate to reduce spend without increasing risk.   A solution to both sides’ problems on both sides of the ledger is rooted in the ability of a professional to scale their expertise.

Artificial Intelligence software platforms, like Neota Logic, connect complex content and the expertise, judgment, and interpretation and leverage that content at internet scale.  One of the most recognizable examples of this type of solution is Turbo Tax.  Tax professionals, like attorneys, often benefit from complexity.  As I’ve said repeatedly over the years, complexity is an attorney’s best friend.  The greater the perceived (or real) complexity, the less fee pressure typically exists.  Conversely, matters that are less complex face increased fee pressure and budgetary oversight.  The opposite is often true, however, for software.  There is significant valuation in companies whose products simplify complexity. Turbo Tax is one of two great examples of what can happen when the unstoppable force meets the immovable object.  The other is, of course, peanut butter and chocolate.  Intuit hires hundreds of tax professionals each year to interpret the various state and federal tax codes, capturing their expertise in a way that enables it to be used in response to plain English questions that are asked of the user.  How is Intuit doing? In 2016, total TurboTax units increased 12% over 2015, pushing the forecast for full FY2016 consumer tax revenue growth of 8-9%, surpassing the the initial estimates of 5-7%.

The TurboTax example provides a useful blueprint for law firms looking to grow revenues with niche applications that can quickly be deployed to solve very specific, repetitive problems.  Does TurboTax attract clients to tax software that would normally not seek the advice of a professional?  There is no known data to reliably answer that question, but forward-looking law firms recognize that there is a market for applications that attract clients that are unreachable in a traditional model.  Firms like Foley & Lardner, Husch Blackwell, Akerman, and more have already launched applications designed for markets where, historically, their normal rates may have been a challenge to client development.  In using AI platforms, firms are able to both lower the barrier to entry for clients of all sizes, providing consistent, predictable pricing, as well as scale their services in a one to many format that drives both revenue and profitability.

Historically, firms didn’t really have to pay attention to scalability strategies.  There are 8,760 hours of total time in any one year.  While there are a few stories of extreme amounts of billable hours (feel free to search Google for those), the average amount of billable hours per year for partners is roughly 1,686 hours, with an additional average of 526 hours per year of non-billable time per partner, according to Major, Lindsay, and Africa’s 2014 Partner Compensation Survey.  For associates, the National Association for Law Placement (NALP), in their 2016 update on Associate Hours Worked, benchmarked the overall average associate billable hours worked as 1,806 in 2014.  Averaged out, billable and non-billable time account for only about 25% of the total time in a non-leap year.  Many would look at this and say there is room for growth without scale.

Traditionally, for firms to grow their revenue, they needed to do one or more of the following:  A) increase the number of producers (timekeepers); B) increase the rate of production (billable hours); C) increase the unit price (hourly rate); D) A combination of A, B, and/or C.  As we’ve established, clients are pushing back on both B and C, by pushing for fewer billable hours and lower rates, and increasing the number of producers is not always a profitable option for many firms.

Firms that are focused on increasing revenue, profitability, and competitive differentiation will embrace A.I. platforms.  They will rely on the expertise of their attorneys to interpret complex content and develop applications that solve specific problems their clients face in a manner that is accessible on-demand at fixed annual fee.  Like most disruptive forces, today’s competitive advantage is tomorrow’s price of admission.  In other words, it’s no longer the big that eat the small, but rather the fast that eat the slow.

Bill Gates once remarked that “Success is a lousy teacher. It seduces smart people into thinking they can’t lose”.  We only need to look at Porter’s Five Forces to realize that the threat of substitutions and new entrants can have a profound impact on the bargaining power of suppliers and buyers.  The pace of change continues to accelerate, ironically with law firms representing the companies that are driving the rapid pace of change.  One of my favorite questions I’d often ask at the beginning of most consulting agreements was “borrowed” from Bill Taylor’s brilliant book “Practically Radical”:  “Are you learning as fast as your clients’ world is changing?  And if so, how do they know?”.  I love this question for a number of reasons, but most of all because it forces many firms to engage with their clients in ways that demonstrate expertise and knowledge upfront.

As my colleague Michael Mills remarked to a roundtable of Managing Partners, “We enable law firms to leverage without associates and bill without hours.”  Given the challenges addressed earlier that both the buyers and sellers of legal services are facing, my assessment is that we are standing at the doorstep of a shift that will alter both the business and practice of law tremendously.

This is just the beginning.