Profitability and financial structure

The 2006 Survey of Law Firms in Scotland, published in March, suggests static profits per partner in 2006 for the profession as a whole of £83,000, with some firms actually seeing a fall from the previous year. In particular, the 2-4 partner firms had seen a decline from £91,000 in 2005 to £83,000 in 2006. The figures are highlighted in chart 1, which also shows the trends for the last few years for firms with less than 10 profit sharing partners. Profits have risen steadily from 2001 to 2005 , but now appear to be stabilising at the higher levels that have been attained.

The levelling out in profitability could have been due to differences in the sample. However, as in previous years, a high proportion of the firms – 75% – had participated last year, with about 67% having contributed in each of the last three years. The introduction of UITF40 may also have had an impact this year with some firms reporting a one-off boost in profitability. Despite the standstill in 2006, it should be noted that profits have risen significantly across the board over the last three or four years, and the profession is in a very healthy state generally.

Given the plateau in last year’s profits, it is perhaps useful to revisit the main factors that determine profitability, and this article does so in particular in the context of 2-4 partner firms.

The profitability of a firm of solicitors – the difference between its income and its expenses and salaries – is a result of many factors. Profit per partner, which is still the all-important figure for many firms, is obviously very closely related to the number of profit-sharing partners a firm has. If there are too many profit-sharing partners relative to the profits available then the profit per partner will be low. In smaller firms in particular, it is often necessary to make solicitors up to partner in order to keep them, but having too many partners can often be a difficulty. Some firms of course will make newly assumed people “salaried” partners so as to offer them the kudos of being a partner without the same financial rewards as the equity partners, and this can also help to raise the status of the firm in the eyes of clients.

Some of the main factors that would be assumed to determine a firm’s profitability will include:

• The type of clients the firm acts for – if the practice is predominantly legal aid it is likely to be less profitable than a firm that undertakes some commercial work, or acts for better quality private clients;
• The quality of your lawyers – to have technically strong people who have particular expertise can help differentiate your firm from others. Having personable people that clients and contacts enjoy working with is similarly a real benefit;
• How hard everyone works. Do you have a 9 till 5 mindset, or do people work hard – not necessarily long hours, but do they work effectively: are they “smart” in how they work?
• Your location – a practice in an affluent area could expect to do better than one in a poor area.

These are just some of the factors that can impact on profitability. They can all be important; however, as participants in the survey will know, the actual financial structure of your firm can be just as important. There are plenty of firms around undertaking relatively routine work for “normal” clients that make good levels of profit – primarily due to their structure. They also often have good financial management.

There are four aspects of structure that it is especially useful to consider. The first is “gearing” – the number of other fee earners you have in addition to each profit-sharing partner. Chart 2 indicates that the 2-4 partner firms achieving profits per partner above the upper quartile had a gearing of better than 1.8 – in other words each profit-sharing partner had, on average, just under two other fee earners working with him or her. If there were four partners in the firm, there were another eight fee earners – and chart 3 indicates some consistency over time.

The second is fees per profit-sharing partner as illustrated in chart 4. This is a very similar concept to gearing. For the most successful 2-4 partner firms this figure was approximately £350,000, so if there are four equity partners the total fees of the firm would be £1.4m, as opposed to the £600k of the least profitable practices. The main cause of this variation is likely to be gearing. Once again, this figure has been remarkably consistent over the last three years: £334k, £341k and £350k for 2-4 partner firms, for 2004, 2005 and 2006 respectively.

It can take some time for firms to improve these two benchmarks. However the key point is to be clear about your direction of travel. If you are a four partner firm with just two or three other fee earners, and total fees of perhaps £700,000, draw up a plan. What might happen over the next five years? What changes are on the horizon? If there is a partner retirement coming up, does he or she have to be replaced? Could the department be restructured so that the work is done by a lower level of fee earner? These issues can be very difficult to achieve, especially in a small rural practice; however the starting point is usually a plan. Try to agree your direction of travel.

The second article, to be published next month, discusses the other two important aspects of structure – salaries and other overheads – and also considers departmental profitability.

• All participating firms receive a free copy of “The 2006 Survey of Law Firms in Scotland”, the detailed report upon which this article is based. They also receive a free confidential individual report. Other firms can obtain a copy of the full report, which contains a wide range of useful statistics and performance indicators, from Lisa Hamilton at the Society on 0131 476 8164 (lisahamilton@lawscot.org.uk).
• In April the President will be writing to all firms inviting them to participate in the 2007 survey. Participation is free and this year carries a three-hour CPD credit as well as an individual report on cost rates in the firm and a copy of the survey report.
• In recent years there has also been a prize draw. This year the £700 prize was won by Charles Sharkey. The Society is again grateful to Alex Quinn and Partners for sponsoring the prize in 2006.
• Andrew Otterburn is a management consultant and for many years has run practice management seminars on behalf of the Society. He has helped in the development of the Cost of Time Survey since 1999, working initially with Professor John McCutcheon and now with Dr John Pollock. His book, Profitability and Law Firm Management, is published by the Law Society in London.
• Dr John Pollock, a consulting actuary, has been responsible for the administration and statistical aspects of the Cost of Time Survey since 2002. John is well known to personal injury, employment and family law solicitors in Scotland through his expert witness work at Pollock & Galbraith Consulting Actuaries.