A VC (a.k.a. Fred Wilson, a venture capitalist and principal of Union Square Ventures), commenting on a WSJ story, makes a simple, but powerful point about many of the tech startup companies floating around:

As Chris said in his WSJ piece, Facebook has been widely derided for the low CPMs it generates (pennies in Chris’ words). But instead of deriding the revenues that Facebook is generating, maybe we should be in awe of a $350mm revenue stream coming from a company that produces no content of its own. Why does Facebook need 1000 employees? Why does it need to spend $300mm per year?

The web can create incredibly high operating margin businesses. Craigslist has an operating margin of 90%. Google’s keyword business has an operating margin north of 60% (based on net revenues) and possibly higher. Could Facebook and Digg copy those models and create a lot of value on revenue numbers that many think are pitifully small? I think so.

I think that’s an important part of the economics of the web that are left out of most discussions of Internet business models. Yes, we are turning analog dollars into digital pennies in many cases. But we are also doing the same thing on the cost side, maybe even more so. And I think that "operating leverage" is going to create a lot of value.

It’s true for every business except for the hourly-billing law firm: reducing costs improves profit just as well as increasing revenue.

In the hourly-billing law firm, "costs" take on a much more narrow form than in other businesses, since the bulk of them are charged directly to the client, often at a premium. In an hourly-billing law firm, "cost" on the firm’s bottom line usually only represents the money spent keeping the office open — e.g., staff salaries, rent and insurance — and not the money spent actually doing the work, like copying charges, filing fees, and, most importantly, the time spent on the task at hand.

Worse, since these costs, particularly the cost of attorney time, are charged to the client, they actually show up as revenue on the firm’s balance sheet.

Reducing such costs is effectively the responsibility of the client, who is not in any position to know how to reduce them or to improve productivity. The end result is a system that encourages waste and everyone complains about, just as behavioral economics would suggest.

But there’s a hidden problem to this system: the billable hour imposes boundaries on the degree to which lawyers’ profits can be improved by reducing costs.

Bruce MacEwen at Adam Smith Esq. caught this same critical point in response to a NYTimes article ("Billable Hours Giving Ground at Law Firms") talking with Evan Chesler, Presiding Partner at Cravath, about the (long-predicted) demise of the billable hour:

Ultimately, it limits law firms’ revenue. (Clients–you can skip this paragraph.) Each of the variables that goes into revenue under the billable hour model has intrinsic limits: Rates, hours, realization, and leverage.

Exactly right, but I wouldn’t limit it to just "revenue" — the billable hour limits profits as well.

Since I generally work on a contingent fee, it’s easy for me to improve profits by reducing costs: I find ways to improve productivity. It’s why I use digital dictation and voice recognition software, and why I scan everything and use document management. Because that’s how I work faster, so I can both take on more cases and devote more time to each case to improve my results.

That equation does not exist in the hourly-billing firm. A lawyer who, say, comes up with a faster way to get briefs in order is rewarded with marginally less work. Sure, there is a supposed economic incentive towards this improve productivity by making clients happier, presumably enabling the lawyer to increase rates in the future, but that’s not how it works in practice, particularly not at big law firms where it is exceedingly unlikely the client will even recognize minor improvements in productivity.

And that’s where Evan Chesler is going: his clients are tired of him increasing hourly rates, while he and his associates are tired of increasing partner-to-associate leverage or associate hours. So he wants to stop looking at the top number — revenue — and look a line down to costs.

That’s the new frontier driving the demise of the billable hour: alternative fee arrangements enable lawyers to bill clients the same (possibly less!) while taking home more because they’re working faster. A win-win.


After drafting the above, I saw that Patrick J. Lamb had unethically and irresponsibly stolen my idea the day before I had even published it:

If a firm pays associates (or advances them) based on work quality and hours, associates will be committing career suicide by working more efficiently.  (See here for an example.)  If the firm doesn’t reward associates for performing "good enough work efficiently" when that kind of work is all that is required, how can a client have any comfort that the fee proposal reflects the cost savings that such an approach generates?

This telepathic piracy will not be tolerated!