One of the worst mistakes that small law firms make is to hold onto clients that are not profitable and probably never will be profitable.
This is the second in a five-part series of posts that focuses on profitability in small law firms and solo practices.
The most dangerous profitability mistakes that these law firms make usually fall into four categories. They also apply to larger firms, but the tolerance for these mistakes in small firms is much less, and the consequences can be much more severe.
1. A firm continues to serve unprofitable clients when there is no reasonable prospect that they ever will become profitable.
2. A firm continues to invest time, attention, and resources in offering unprofitable services for which there is no reasonable business case.
3. A firm continues to tolerate unprofitable performance by partners.
4. A firm fails to make minimal investments in quality assurance tools and methods to improve productivity
the "80-20 rule" ... with a vengence
Many law firm partners have heard of the "80-20 rule." In most law firms, roughly 80% of the firm's fee revenue is produced by approximately 20% of its clients. This ratio can vary, depending on the nature of the client base and the services that the firm offers. We occasionally have measured even greater fee concentrations -- even higher than 90%-10% -- as well as less intense ones. However, in most cases our measurements have tended to fall in a relatively narrow range centered on 80-20.
This typical level of concentration should never be assumed as a benchmark or "best practice." To the contrary, the 80-20 phenomenon poses risks for all law firms, but especially for small firms, for whom the loss of even one major client can be a financial disaster. Moreover, the small firm's potential profitability usually is dragged down -- with much greater adverse impact than in larger firms -- by a large group of clients who, as a group, have never been profitable and probably will never be profitable.
looking at the bottom of your firm's client base
The dark side of the 80-20 rule is that roughly 80% of the clients produce only approximately 20% of the fees. In fact these small clients, as a group, usually lose money for the firm. Small firms, with their much tighter tolerances for unprofitable work, frequently spend an inordinate amount of time, resources, and attention in marketing and client relations activities for clients who have very little probability of ever becoming profitable. These investments usually produce no returns, not even "good will." (We exclude pro bono clients from this analysis, because, by definition, they produce no fee revenue.)
We usually recommend that law firms of all sizes -- and especially small firms -- begin their efforts to improve profitability with an examination of the bottom of their client base. This involves some tough questions, such as:
- Notwithstanding the small fees, has this client's work been profitable?
- Is there any evidence that you could increase fees from this client in the foreseeable future?
- Is there any evidence that you could develop more profitable work from this client?
- Has this client referred any more profitable clients to you?
Note that the answers to these questions require evidence, not wishful thinking. In other words, is there a substantiated business case to invest any of your limited resources to retain this small client? If you are unable to articulate a credible business case for retaining this client, you are faced with two final questions that can be particularly difficult for small firms:
- Should you invest any time, effort, or resources at all in retaining this client?
- In the unlikely event that this client asks you to perform similar work in the future, should you decline the engagement and refer the client elsewhere?
Of course, the answers will be highly specific to your firm's financial structures and performance, your internal resources, and -- very importantly in a small law firm! -- your relationship with each client.
What is important, however, is that you invest the time needed to ask these questions, as well as the intellectual discipline needed to develop well-informed answers.