Prognosticate or Tempt Fate

I’ll get right to the point – If your firm isn’t already preparing 3 to 5 year pro forma financial statements that conservatively account for predictable and inevitable events (e.g., retirements, normal turnover, rising overhead costs, partner admissions, rate increases, to name just a few) then you are tempting the fate of a predictable, manageable, and perhaps unrecoverable decline in your firm’s profitability and, potentially, survivability.

The core law firm business model — running hard for 365 days, then emptying the coffers and repeating the process — while wonderfully simplistic in its structure, hides an inherent and sometimes existential threat.  The challenges listed above, and others, may not be evident when viewed through the lens of an annual 1-year budgeting process.  However, when projected over time a combination of trends that won’t fully impact the financials until a couple of years down the road starts to jump off the page. If done well, you will be early enough for solutions to be developed and defensive measures taken.

To say that this initiative is impossible due to the unpredictability of truly blind-siding, out-of-nowhere and totally random events puts far too much weight on such outcomes, which are relatively rare.    A global pandemic counts, though the most recent one turned out to be a net-positive for the industry from a financial perspective.  Accidental or early deaths (particularly of key leaders or rainmakers) make the list, although these random events can be modeled based on insurance industry data…and without tying them to specific people, of course.  A major cyber-attack could make this small list although one could argue that such events are preventable.  A destabilizing set of departures makes the list but, if this happens, your firm had bigger issues to address than how to build a forecasting model.  Beyond these black swan events, the data needed for type of modeling is waiting to be mined in most financial and HR systems.  This is a question of willpower.

The most painful scenario, however, is not tied to a major event.  It is the gradual erosion of the drivers of profitability that culminates in a sudden and steep decline in profits that requires major surgery in a short period of time rather than well-considered tweaks across multiple years.  This “death by a thousand cuts” scenario can usually be identified and avoided, if someone is looking for it.

Complicating this type of work, particularly in firms where very high degrees of transparency is a featured element of the culture, is that some Partners will absolutely disagree with select assumptions.  A perfect example of this is retirement dates.  All Partners need to go and transition their books at some point.  Some, for whatever reason, want to hang on.  If it is necessary to muddy up this model to publicly placate those who need to linger then it’s a waste of time.  This is usually a confidential management initiative that reflects a lot of brutal honesty, candid assessments and tough love…a toxic combination that often won’t get a Managing Partner re-elected.  As such, it must be handled carefully, and often confidentially, to be valuable.

Features of an effective pro-forma model include –

1. A set of assumptions (rate and cost escalators; realistic turnover rates) that are built first and are not touched until the initial set of results, which reflect the ice-bath truth, are reviewed.  If the assumptions are done last, it is difficult to resist editing them based on their modeling impact.
2. Staffing counts that account for –
   1. Realistic growth in relation to both cost/compensation escalations and the related impact on existing turnover trends.
   1. Future Partner promotions, and the related de-leveraging that occurs without offsetting non-equity lawyer hiring.
   1. Future Partner retirements, modeled at the time when they need to occur – a point of contention in “public” models.
3. Revenue projections that account for –
   1. The impact of all agreed-upon assumptions on each timekeeper’s net contributions.
   1. Calculated trend data in individual billable hours that can only be overwritten when such events occur with a high degree of confidence.  Trust the data over emotional hopes that individuals will suddenly and dramatically become busy.
   1. Clients who are on the sell-side and will likely be lost, for good reason, as revenue sources.
   1. The true impact of each retirement in two key areas
      1. The percent of the total book retained – assume loss of at least 33% of most books, and perhaps higher of books associated with a highly “trusted advisor”.
      1. The impact of retired books on those dependent upon that work because the full impact must flow through to all related parties.
4. Variable overhead costs that rise/fall with the number of timekeepers supported, with admin staff shifting in terms of ratios and step-functions (e.g., one biller for every ten Partners added/lost and not one-tenth of a biller for every Partner added/lost).
5. Significant investments in resources needed for the future direction of the legal industry (e.g., AI, IT, pricing expertise).

If you’re not realistic with your data and assumptions, then the garbage-in-garbage-out principle applies here.  Furthermore, be very concerned if you find yourself changing the assumptions to produce the desired results.  Future success cannot be dependent upon, as an example, historically low inflation rates.  Miracles are not valid assumptions. 

In addition to being a defensive tool against long-term declines in the drivers of profitability, there is also an exciting offensive perspective to this tool.  Once your pro forma is built and you look at the overall profitability number at the end of the time series, you now have a road map to optimize that number in relation to realistic measures you can undertake.  Use reverse-engineering and evaluate the impact of a 0.5% increase in rates or realization.  See what happens when work is shifted from Income Partners to Associates and the firm’s leverage profile changes.  Watch the impact of a new office space strategy on the bottom line.  Partnerships tend to be very impressed with prioritized initiatives across multiple years that are supported by hard data.

Don’t tempt fate.  Talk of “we didn’t see that coming” or “the future beyond the budgeted next year is impossible to predict” suggests that no one was looking.  The stakes are too great, and our modeling capabilities are growing in sophistication by the day.  It’s time to find and unleash the Nostradamus-like data savant who exists within all law firms.   There is simply too much at stake.