On the first day of the first class of my first year in graduate school, the professor began his lecture by writing on the blackboard, “Cash in must exceed cash out.” Everything else, he claimed, was the “how to” mechanics of accomplishing that.

Margin for law firms is, of course, a bit of a squirrelly measure because it involves both cash in (revenues) as well as cash out (expenses), i.e., it is the percentage of revenues that are available for distribution to the equity partners which is defined as:
Revenues – Expenses
Therefore, a firm can change margin either by affecting expenses or revenues. And margin does not necessarily equate to profitability. For example, a firm with one partner and ten associates would have a poorer margin than a firm with five partners and five associates — yet would probably be more profitable.

But even after we clean all of these anomalies out of consideration, we consistently see mid-sized firms operating with margins of 50 percent and large firms struggling to achieve 35 percent. How come? The reasons are probably unique to each firm but let me cite three differences I frequently observe between firms that seem to correspond to their respective margins.

1. Non-equity Partners. Larger law firms tend to have more non-equity partners than smaller firms. In large measure this has occurred over the past couple of years as firms sought to increase their profits per partner by decreasing the number of equity partners. As a result, the firm’s costs are increased without sufficient sustaining revenues and margin is reduced.

A simple way to test the economic value of non-equity partners is to determine whether a non-equity partner’s total originations are at least 33% greater than their compensation and direct expense. That is, does the following formula equal 1.33 or more:

Originations X       Work Atty Revenue
Working Atty Revenue        Comp + Direct Expense

(Comp is the full K-1 or W2 annual compensation plus any benefits provided. Direct expenses are those costs that go away if the non-equity partner leaves. They include the appropriate portion of their secretary’s compensation, CLE expenses and, if malpractice insurance is calculated on a per attorney basis, the individual annual cost of coverage. Don’t include the cost of their office or a pro rata portion of the library and the billing department. Those costs don’t change if the attorney leaves.)

But Working Attorney Revenues cancel themselves out of the equation because for non-equity partners they only have value to the firm if they are entirely originated by the non-equity partner. Non-equity partners who are not supplying their own work are taking work away from senior associates who are the future of the firm. Therefore, the simplified version of the test is whether the formula

Comp + Direct Expense,

is equal to or greater than 1.33. Please note that this is an absolute minimum for non-equities and should not be used for associates. Associates are the firm’s future– you expect to make an investment in them. There is no business reason to be making a continued investment in non-equity partners who are on their way down from equity partnership.

2. Occupancy Expense. Larger firms tend to carry more surplus office space than smaller firms. It is not uncommon to see firms, especially firms with multiple offices, carrying a 20 percent surplus of space. Since most firms spend between eight and ten percent of revenues on office space, surplus space can easily represent a couple of margin points.

The answer here is to run purposefully lean. Firms with too much space are constantly looking for laterals to fill up their vacant offices. This is the path to bad hiring decisions, cultural disruption, deteriorating image in the legal community, malpractice risk – it is just wrong on every possible level. If office space is tight and you have a legitimate lateral opportunity, there is a harder edge that may drive a better decision. Temporary space can always be found somewhere and the need for office space could motivate some long overdue personnel decisions.

3. IT Staff. Larger firms seem to have bigger IT staffs than smaller firms by any equivalent standard of staff per user or per attorney. Larger firms tend to have one (FTE) technology staff member for every 15 or so attorneys, while mid-sized firms seem to average one staff member for every 25 attorneys.

Let me quickly point out that this is not because IT Directors are empire builders or staff members are sitting around with nothing to do. In fact, the demands and expectations of attorneys has driven dramatic increases in service levels offered. Two things seem to have a tremendous effect on the number of IT staff -the demanded response time at the work site and the firm’s number of small decentralized offices. Smaller firms seem more agile in creating “work arounds” that permit slower response times and, as most IT Directors and CIO’s will tell you, 80 percent of floor support costs are spent getting the last 20 percent of response time.

It should also be noted that smaller firms seem to spend more time worrying about costs. Maybe it is that the partners feel more like owners or that small cost savings have a greater impact on a partner’s actual compensation. But there is a decided difference in the management attitude toward cost control between small and large firms.

All in all, logic dictates that large firms should enjoy economies of scale and volume purchasing that permits costs savings, matched with higher revenues that should provide better margin. But it almost never happens.