How do law firms make money?


Law firms are pretty simple businesses! Conceptually, law firms sell their fee earners’ time. As such, you can think of that fee earners’ time as the firm’s raw material, much like cloth is the raw material for clothing companies. Now, in practice, law firms enter into various fee arrangements with clients, ranging from "time spent" fees to capped or fixed fees to conditional fees. It all goes back to time, though: (an estimate of) the required fee earners' time underpins most of those arrangements.

Gross profit

Most businesses come down to the concept of ‘buying low and selling high’ - and law is no exception! Fee earners’ charge out rates are (often much!) higher than their hourly wages. The difference between fees earned and fee earner salaries is called gross profit (gross margin, a sibling term, denotes gross profit as percentage of revenues).

Operating profit

Gross profit is then used to pay for the operation supporting fee earning activities - think business services teams, premises, marketing, etc.. Whatever remains is called ‘operating profit’. That can be used to pay interest on debt (if any) and the remainder distributed to the tax authorities and the partners. Note that equity partners usually don’t draw salaries and instead rely on profit distributions. Available profit divided by the number of equity partners produces the famous profit per partner (PEP) metric.

Cash flow

Thanks to the wonders of modern accrual accounting rules, showing revenues and profits is not tantamount to generating cash. In fact, there is usually a significant disconnect between accounting results and cash flow. There are good arguments for that, by the way! It just means that assessing a law firm’s financial health is a more nuanced exercise.

Measuring law firm performance: selected key metrics

Utilisation is the proportion of fee earners’ time spent on billable client work. Inevitably, fee earners spend a portion of their time on non-billable tasks. Those might include firm, matter and client management, as well as business development.
The more time lawyers spend on chargeable tasks, the higher the firm’s revenues! Importantly, higher utilisation leads to a better gross margin (i.e: the margin on fee earners’ salaries).

As ever, it’s a team effort! Whilst partners focus on bringing in business that keeps the firm busy, salaried fee earners focus on remaining engaged in gainful projects. Utilisation rate of over 80% is seen as a gold standard.
In a £100m revenue practice, reducing the time spent by fee earners on daily admin (non-chargeable) tasks by merely 6 minutes results in a £1.4m.
Realisation shows what proportion of headline fee earner rates clients actually pay. In other words, realisation shows an average “discount” applied to headline rates. Discounts (or, more precisely, time write-downs) can be applied at both the bill issuance and the collections stage.
The less time is written off, the higher the firm’s revenues! Like utilisation, realisation impacts gross margin as well as the top line. Realisation rate over 90% is seen as a great result
Managing client expectations (e.g. with respect to scope and budgets) on one hand, and carefully allocating resources to matters on the other, are key to maintaining strong realisation.
In a £100m revenue practice, every 1 percentage point improvement in realisation results in a £1.1m revenue increase
Lock-up days is the number of days it takes to convert advice (fee earners’ time) into cash. Technically speaking, lock-up is the sum of cash trapped in work-in-progress (WIP, or fee earners’ time booked, but not yet billed), and debtors (bills issued, but not yet paid).
The faster the cash materialises, the more the firm can do with it (e.g. re-invest in its people, tech and growth). Good cash conversion also minimises the need for short-term borrowing from banks which can be expensive.
Good client expectation management is key, as are more mundane things such as well kept timesheets submitted on time. In general, whichever action supports good realisation tends to also support good cash conversion. 90 day lockup is seen as the ‘platinum standard’; the City average is closer to 150 days.
In a £100m revenue practice, every 1 week of lockup is equivalent to c.£2m in cash collections. Use the calculator below to see how much the "excess" lockup is costing your practice.
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