University of Southern California

What's Wrong with Law Firms? A Corporate Finance Solution to Law Firm Short-Termism

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Article by Jonathan T. Molot
From Volume 88, Number 1 (September, 2014)

88 S. Cal. L. Rev. 1

Lawyers and clients are unhappy with the contemporary law firm. Associates complain of being treated like “leverage tools” and given inadequate opportunities for mentoring, training, client contact, and career advancement. Clients feel overcharged and underserved, and are constantly searching for a better deal from a different firm. Even partners—the ones who profit from associate hours and client billings—have grown tired of a “what-have-you-done-for-me-lately” culture in which they have to bill and earn as much as possible during their productive working years and who, like clients, are all too willing to chase a better deal at another firm.

What is to blame for this discontent? This Article suggests that the cause is law firm short-termism. Law firms place too much emphasis on current revenue generation—the annual “profits-per-partner” numbers—and not enough emphasis on building long-term value. At core, it is this short-term outlook that leads law firms to squander valuable opportunities to build long-term loyalty among their clients and lawyers.

The Article further argues that the most promising solution to law firm short-termism is a simple one: change the law firm’s capital structure. Law firms focus exclusively on the short term because the people in charge of law firms are compensated based solely on short-term performance; they do not hold permanent equity interests that would compensate them for creating long-term value.

Law firm partners share in a firm’s profits only for so long as they are employed and generate revenues. Upon retirement, they may receive a declining draw that resembles an employee pension, but their equity interest vanishes. It is no wonder that law firms favor current revenues at the expense of long-term value. Law firms are structured to be nothing more than transitory associations of individuals who happen to practice law under the same roof for a particular period of time.

The Article explores how an alternative capital structure—one with conventional permanent equity—would change lawyer incentives and improve both the economics of law practice and the cultural experience of all of a law firm’s constituencies. The proposed reforms offer the promise of marked improvements for law firm partners, associates, and clients.

In a permanent equity model, senior lawyers would be rewarded for building lasting businesses, not just for current billings, and their equity interests could grow to be worth many times their annual compensation, thus providing a significant nest egg for retirement. Junior lawyers would no longer be merely a source of leverage in a harsh, up-or-out culture, but rather would be embraced as the future of the firm and the key to its equity value. Finally, clients would benefit because the value of the firm would depend more on the sustainability of future earnings then on billings in any single period, and law firms would have every incentive to win and retain their clients’ continuing loyalty, even if that means accepting alternative billing arrangements and lower current billings.

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