Today, a column from Janet Stanton, inviting us (with her) to take a fresh view of Law Land with a brain uncorrupted by having lived her entire life in Our World:

A challenge to our readers:  Just how profitable are law firms?

Having spent most of my professional career in Corporate Land, I was innocent of the Alice-in-Wonderland business practices that abound in Law Land.

For today’s discussion of the Corporate/Law Land divide, let’s focus on law firm profitability.

Again, some perspective: I spent a good deal of time working with or for some of industry’s most successful and respected consumer-oriented companies: J+J, P&G, Colgate, Kraft, M&M Mars, Pfizer, etc.  (OK, I also spent some time on such duds such as the New York Racing Association, a diet dog food brand and a product that alleviated sexually-transmitted diseases.  ‘Nuff said.)   And I had the pleasure to work on some significant brands: Johnson’s Baby Powder, Colgate Toothpaste, Scope Mouthwash, Snickers, etc.

In this realm—both at corporations and their ad agencies—consistently attaining a 20% PBT (profit before tax) on any business I led was considered strong performance.  It is attainable, but it requires tradeoffs, re-jiggering and a dash (or more) of luck.   Much less than 20% profit meant significant components of the business plan weren’t firing on all cylinders.  Much more might indicate that we weren’t investing enough in the business—in terms of R&D, product development, human capital, training, technology, etc. and that we might be setting ourselves up for a fall.

Consistent with that, following are the most recent annual profitability for the public companies I mention above.  All figures are pre-tax profit as a percentage of revenue. We chose this metric as it seems most directly comparable to what Law Land figures since, as we all know, law firms themselves pay no taxes:

  • Johnson + Johnson: 21.0%
  • Colgate: 20.5%
  • Kraft: 13.4%
  • Pfizer: 30.5%

Having benefited from the rigorous business and marketing acumen such experiences instill, I marched into Law Land bristling with confidence that I had a very sound, even somewhat  nuanced, understanding of the principles of good business.  And a none-too-shabby appreciation for and facility with the financials.  I spent a lot of time at the feet of the CFO of any organization I was at and sponged up as much learning as I could.  I really liked this stuff.

Once in Law Land, one of the first (among many) perplexing metrics was law firm profitably.  How could it be that on average the reported profits for the AmLaw 200 is 36.5% (median of 35.0%) – even after The Great Reset?  There were even some firms reporting profits in the 60% range.  I’d worked at large professional services firms—heck, I even ran a mid-sized one.  I know how professional services firms work.  I know how they make (and lose) money.

I know the components of their P&Ls and within a certain range what proportion each component of income and expense should account for.  For the record, professional services firms’ financials are just not that hard or mysterious, especially when compared to corporations (which actually aren’t all that hard, either; there are just more moving parts).

How could it be that law firms were so much more profitable than other professional services firms?   For example, the average pre-tax profit margin for CPAs is 17.1% and for the big communication agency holding companies, 12.0%.

Standing back, I realized that the primary reason law firms look so much more profitable is that profits are reported before equity partners are paid. The rationale is that equity partners are entitled to everything that’s left over after other expenses are paid, since they own the firm.

As an aside, law firm profitability as it’s currently reported most likely annoys the stuffing out of your clients.  When they compare their (real) profitability against the (inflated) profitability at law firms, it simply exacerbates mistrust and their feeling of being ripped off due to the perception that law firms are generating outsized profits on the backs of their clients.  They don’t say to themselves, “Oh this makes sense because….” They just see the eye-popping numbers.  Maybe that alone is a good reason to re-think this.

Here’s what’s wrong with that.  Equity partners wear two and sometimes three hats at a firm.  Yes, they are the owners.  Some have management responsibilities of varying degrees.  But first and foremost they are workers (or, as an irreverent friend of ours likes to say, “day laborers”): The vast majority of their hours are spent servicing, advising, litigating for clients.

What this means is that law firms are reporting profits before taking into account a huge proportion of their labor costs.  Were their work  done by equally competent lawyers who were not equity partners, the labor costs would fall into the expense bucket.

If we go back to Corporate Land, it would be as if a wide swath of middle to senior management’s  labor were not counted as costs.  Et voila´!  Profitability would balloon.   But not really.

So: Here’s my question to our gentle readers.  On average, what proportion of equity partners’ comp is really and truly labor costs and should be counted as an expense?  And, for extra credit: What impact would this have on firm profitability?

I eagerly await your inputs and observations.

—Janet Stanton, Partner, Adam Smith, Esq.

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