One of the most overused words by law firm leaders is entrepreneurial.  It has become a synonym for “being business like.”  But this ignores the critical element of the definition of an entrepreneur: assuming risk to achieve the opportunity for financial reward.  Accordingly, it is pretty well impossible to be both entrepreneurial and risk averse.

This doesn’t mean that entrepreneurial law firms are wild gamblers putting their firms’ capital accounts on red at a Las Vegas roulette wheel.  Indeed, the most successful entrepreneurs are those who are better at assessing risk than their competitors and are therefore willing to take risks that provide greater rewards than those competitors.

The Concept of Risk

Risk actually involves two questions: how much could you lose and what is the likelihood of loss.  If you bet on the flip of a coin, the amount at risk is 100% of your investment and the likelihood of loss is 50%.  The balancing feature is the 50% likelihood of a 100% reward.  But law firms often have a less principled view of risk.  I have watched law firm management committees agonize for an hour over whether to sponsor a $3,000 advertisement in the symphony playbill and then approve a large contingent fee case with minimal discussion.  Worse, there is often no analysis of the likelihood of loss, the investment in lawyer time at risk and what constitutes an appropriate reward.

The Concept of Reward

Entrepreneurs seek rewards that significantly exceed the risk.  Others that seek inadequate rewards are simply daredevils.  There are two important issues about rewards that are often overlooked by law firms.  The first is that the reward must take into consideration the value of the risk involved.  It’s akin to betting $100 on the flip of a coin but only winning $5 if it comes up heads.  Certainly there would be a $5 reward but to get it you would have to put $100 at risk – hardly an appropriate reward.  The second issue is the value of the law of large numbers.  In probability theory, the more times something occurs, the more likely it is to achieve an expected outcome.  For example, if you flip a coin once, there is an equal chance that you will take a loss.  If you flip the coin 1,000 times, it is probable that you will break even.  Therefore, when there are a greater number of similar risks being taken, the required reward can be less.

For example, during the recession many larger law firms became more aggressive in building contingent fee practices.  The theory was that lawyers had empty plates, therefore, if the contingency could be given to otherwise underutilized lawyers, there would effectively be no cost in handling the cases, ergo, less risk.  But many firms that pursued this strategy failed, in part because their expectation of reward (nothing more than the value of the time invested) was inadequate to justify even a reduced level of risk.  At the same time, most felt they were minimizing their risk by only taking a few cases which, in fact, prohibited the law of large numbers from kicking in.

Dealing with Risk

There are all sorts of risks that law firms take on but the four most common are:

  1. Normal business risks – the firm buys a software program and the program doesn’t work or it hires a legal assistant who is incompetent.
  2. Liability risks – a lawyer commits malpractice or a partner sexually harasses his or her assistant.
  3. Credit risks – a client refuses or is unable to pay their fees and disbursements.
  4. Investment risks – the firm takes on an unsuccessful contingent fee matter, hires a lateral who doesn’t perform as expected or opens a branch office that doesn’t pan out.

The first two of these risks, basic business and liability risks, are pretty well handled by law firms by hiring professional management and using the risk management services of their insurance carriers.  The latter two are where the problems come in.

Credit Risk.  Every business has some degree of credit risk but law firms have the unique situation of not being able to do much to remediate the problem.  Most firms refuse (or are prohibited by their professional liability carriers) to bring collection actions.  As a result, the average large firm eats five to 10 percent of billings each year in written off receivables.

The entrepreneurial firm does two things to deal with credit risk.  First, it seeks to understand the risk.  You do this by taking a look at what is in the over 180 day bucket on your receivable report and what your firm has written off over the past couple of years.  Odds are your delinquent accounts are going to be individuals, small companies and investor deals that went south.  Then, run aging by the billing partner.  Don’t be surprised if 80 percent of your write-offs come from 20 percent of your partners.

Second, armed with this information, entrepreneurial firms set up programs to reduce risk.  It’s amazing that firms that consider themselves to be risk averse will allow partners to run up hundreds of thousands of dollars in uncollected time and disbursements.  Firms wouldn’t consider giving partners a blank check to spend the firm’s money, but freely give them that kind of authority over revenues.  And don’t be like the TSA searching little children and grandmothers.  Profile your clients and partners to focus your risk management on the problem areas.

And third, entrepreneurial firms balance risk and reward.  Require a retainer of high risk profile clients or charge them a premium fee.  If they balk and walk out the door, the firm is probably dollars ahead.

Investment Risk is all about the reward and whether it is sufficient to justify the risk.  We see this in three primary areas.  The first are contingent fee cases.  Entrepreneurial firms understand the time value of money and the law of large numbers.  They analyze cases not just on the legal issues but also on the present value of likely awards that may not occur until after a lengthy appeals process.  By the same token, they appreciate the necessity of spreading the risk and attempt to manage a diversified portfolio of cases.  Of course, they also supervise their investment so their rewards are not eaten up by the cost of over zealous lawyering.

The second form of investment risk (and perhaps the most complex) is the hiring of lateral partners.  I have heard it argued by some highly entrepreneurial law firms that the risk on all laterals is roughly the same, only the reward is different.  An element of that is true.  Firms that hire laterals with only enough portable business to keep themselves busy, may be looking at a very small reward after the lateral’s compensation, overhead and the present valuing of the time to break-even are considered.  On the other hand, laterals with large books of business offer a greater proportionate reward if successful.  One extremely active firm in lateral markets uses the philosophy, “We assess the reward based on our doing nothing to support a lateral except giving him an office.  If the numbers provide a sufficient reward, then we move to decrease our risk by actively integrating him.”

Take Away

An entrepreneurial law firm is neither risk averse nor a group of daredevils.  The distinguishing feature of entrepreneurial firms is their ability to accurately identify the reward they want to achieve and the risk they are willing to accept in its pursuit.  In doing so, entrepreneurial law firms make better decisions and enjoy more profitable results.