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Big corporations are growing faster than the rest of the economy. It is not hard to figure out where this is going. Lawyer acceptance is different story.

Many lawyers and law firms claim to serve the middle market, often describing how they deal directly with owners and executives rather than in-house counsel. Although these clients aren’t the Fortune 500, the lawyers and law firm leaders take enormous pride in this type of practice and discuss it in ways that suggest it’s a stable and permanent market niche. I’m not sure that’s right.

Above is a treemap chart of U.S. businesses grouped by annual revenue. The key takeaway is that $100M+ companies comprise the vast majority of U.S. business activity (71.6%). Remarkably, all this purple is generated by 22,400 businesses, a mere 0.4% of the 5.7 million businesses in operation in the U.S. in 2012 (the most recent year that contains total receipts).

Companies in purple tend to have legal departments as do a meaningful number of companies in orange (>$25M-$100M). We can deduce this from a number of sources.  For example, according to the Legal Executive Institute, companies with less than $1 billion in revenue were classified as “small.” See 2018 State of Corporate Law Departments at 10.  Yet, these companies had, on average, nine in-house lawyers, or one attorney per $65M in revenue. Likewise, a 2016 report by Barker Gilmore, a national recruiting firm, classified companies into four groups: >$10B, $1B-10B, $100M-$1B, <$100M. Yet, even in the smallest category (<$100M), there were sufficient data to calculate separate salary, bonus and equity averages for three different in-house roles: general counsel, managing counsel, and senior counsel. See 2016 In-House Counsel Compensation Report at 14-22.

Defining “middle market” turns out to be surprisingly difficult — is it somewhere in the purple? The orange? The gold?  The managing partner of a successful firm near the bottom of the AmLaw 200 recently told me that all his partners agreed that the firm served the middle market. Yet, that consensus broke down during a strategic planning process when partners were asked to define middle market using specific criteria. Finally they gave up. The firm was still middle market, but each partner was free to follow his or her own definition.

Although consensus on the middle market is bound to elude us, not everything is so ambiguous. This Post addresses two interrelated topics regarding the future of law:

  1. The Journey to Big.  Large corporations are the fastest growing segment of the U.S. economy. This trend started several decades ago and will continue into the future.
  2. How Big affects the practice of law. Once one sees and accepts the journey to Big, several consequences for the practice of law come quickly into focus.

Journey to Big

Every day the global economy becomes a little more interconnected and complex. In contrast, our mental models for the practice of law are very sticky. This is because we need common, coherent and tractable mental models to coordinate organizational goals and effort. Thus, we only change our mental models when they become a source of competitive disadvantage, essentially pitting the pain of building new models against the pain of imminent failure.

The middle-market law firm discussed above is in that uncomfortable in-between state where the need for new mental models is building but the organizational benefits of such a change remain out of focus.  This likely describes most lawyers and law firms.

Below are charts regarding the more rapid grow of large businesses. Yet, these data are supported by our own intuition if we take a moment to reflect on the enormous advantages that accrue to very large companies. These include:

  • Significant economies of scale and scope, which translate into cost and pricing advantages
  • Portfolios of familiar brands that send signals of quality and value
  • A plethora of low-cost sales channels they either control or can readily influence
  • Ample cash on hand to develop new products and services
  • If internal R&D fails, the financial resources to acquire smaller, more innovative competitors

If you’re wondering how important large companies are to the overall economy, review your credit card statement or the bills you pay online each month, such as your mortgage, car payment or student loans.

The graphic below shows how the mix of U.S. employment is steadily shifting to companies with large employee headcounts.

Companies with 500+ employees (purple bars) comprise the largest category in the SUSB data. This is the only group growing in proportionate size, increasing from 45.4% of total US employment in 1988 to 52.5% in 2015.  If the change looks quite subtle, that’s also it’s experienced — so gradual it’s barely noticed. This makes it more difficult to keep our mental models up to date.

The magnitude of the change is easier to observe through a trendline analysis that starts with 1988 as baseline:

The absolute numbers underneath the purple trendline are striking.  Between 1988 and 2015, the total number of companies with 500+ employees increased from 12,800 to 19,500. The total number of employees in the 500+ company category increased from 39.9 million to 65.1 million. Further, total payroll for these companies increased from $958 billion (51.4% of total US payroll) to $3.7 trillion (59.2%). Purple companies, by dint of their sheer size and scale, generate substantial and ongoing legal work for lawyers.  Thus, they are very desirable clients for law firms.

Finally, the trend toward bigness is compounded by the growing portion of purple, orange and gold companies that are partially or wholly owned by private equity. Below is graphic showing an annual count of U.S. companies in private equity-backed portfolios.

Source: Pitchbook, 2017 Annual US PE Breakdown

In our journey to Big, more and more successful businesses with regional roots are becoming assets in multi-billion dollar private equity funds.  According to a recent McKinsey report, even the largest funds ($5B+) are growing faster than the rest of the PE market, increasing from 5% market share in 2010 to 25% in 2017. See “The rise and rise of private markets,” McKinsey Global Private Markets Review 2018 at 14 & Exhibit 9.

What makes all of these trends so powerful is (a) they are all moving to Big and (b) the pattern is near certain to continue. Alas, this is the path of globalization.

How Big affects the practice of law

Once we accept that the legal industry is on a journey to Big, several predictable consequences come into focus. In this post, I’ll discuss three.

1. Legal departments are law firms with structural features that favor efficiency and innovation. Thus, they are taking market share.

Our journey to Big produces legal departments that are comparable to AmLaw 200 law firms or specialized boutiques. Yet, legal department “firms” have several features that favor efficiency and innovation.

To illustrate this point, consider the statistics below from a recent CLOC survey of 156 member legal departments.

Large Companies ($10B+)

 Mid-Size Companies ($1B-$9.9B)    Small Companies  (< $1B)
Avg. attorney headcount 188 41 9
Avg. legal ops headcount 21 6 1
Avg. attorney to revenue ratio 1 / $585M 1 / $195M 1 / $65M
Avg. internal spend per legal dept FTE* $225K /  FTE $236K / FTE $175K / FTE
* Legal Dept. FTEs include attorneys, paralegals, legal ops professionals, administrators, and all other members of the department.

Although the per-FTE cost of staffing a legal department appears to be higher in large and mid-size departments ($225-$236K vs. $175K), it hardly matters because the overall cost structure of legal departments gets significantly lower with size, moving from one attorney per $65M (small company) to one attorney per $585M (large company).

Part of the declining cost structure is economies of scale that apply equally to in-house and outside counsel. For example, the legal work for a loan or other type of financing is not ten times more labor-intensive because the monies raised are ten times larger.  Yet, another part is surely greater operational efficiency.  The larger and more mature a company, the more it must rely upon lower per-unit costs to meet its financial targets.  We see this in the CLOC survey above.  When asked to identify their department’s top priorities, the top response was “Controlling outside counsel costs” (76%) followed by “Using technology to simplify workflow and manual processes” (41%). See 2018 State of Corporate Law Departments at 8-9.

Although law firms and legal departments may be doing very similar work, their internal incentives run in opposite directions. Most law firm partners are strongly incentivized to maximize the revenue, either through originations or working receipts.  Likewise, high-billing partners can stifle innovation and efficiency measures by threatening to leave the firm.  In contrast, when a general counsel commits to similar initiatives, in-house lawyers have limited leverage to push back.

[click on graph to enlarge]
These favorable conditions are why the number of in-house lawyers has grown so rapidly. In 1997, there were 35,000 lawyers working in-house. By 2017, the number was more than 105,000.  The chart to the right (updated from Post 003) shows the trendline compared to lawyers in government and private practice.

A recent American Lawyer article by Hugh Simons and Gina Passarella modeled the financial cut point for bringing work in-house.  See “The Rise (and Fall?) of In-House Counsel,” Corp. Counsel, Feb. 25, 2018.  According to their analysis, roughly 45% of the AmLaw 100 were performing the type of work that could generate a 2x financial return if brought in-house.  In asking how far insourcing might go, the authors offered a startling benchmark: “70 percent of accountants and auditors work in-house.”

Cost, however, is not the sole reason to insource.  In-house lawyers have an enormous advantage in acquiring essential knowledge regarding client goals and needs. This physical and organizational proximity reduces communication overhead and creates conditions where legal work can be better defined, scoped and managed.  As a result, some of the insourced legal work will eventually be outsourced again, but this time to lower-cost NewLaw service providers.

2. Specialized tranches of work go to law firms and other service providers

Although the journey to Big leads to in-house “law firms” that become very good at process and efficiency, there remains a significant class of work that, for reasons of cost or quality, will continue to go to law firms.  What are the criteria for these decisions?

Below is a graphic that Mark Chandler, the GC of Cisco, showed during the final plenary session of the 2018 CLOC Institute:

[click on graph to enlarge]
Chandler refers to this model as the “Core vs. Context Resource Allocation Model.” It is adapted from Geoffrey Moore’s book, Dealing with Darwin (2005). According to Chandler, this is how Cisco’s legal team makes resource allocation decisions.

The top-right quadrant consumes 65% of the department’s internal resources. The high percentage is warranted because (a) these are mission-critical activities that (b) bear on the competitive advantage of Cisco, a $48 billion technology company that manufactures and sells networking hardware, telecommunications equipment and other high-technology services and products.

The second biggest area of internal resource allocation (20%) is the bottom-right quadrant, which enables business units to more efficiently conduct their activities in a legally appropriate way. Note, however, that “Tools/Processes” are in every quadrant, not just in the self-service green. That is the result of Cisco’s very advanced legal ops function led by Steve Harmon.

Law firms are mostly likely to get work from the left side of the matrix. The work in the top-left pays the most because it is mission critical and Cisco’s in-house staff lacks contextual knowledge to perform the work at the necessary level of quality. Nonetheless, 15% of the department’s resources are dedicated to managing out-tasked work. This is to ensure that the department achieves its cost and quality objectives. The goal in the bottom-left is to lock-in a combination of quality-cost-reliability for low-stakes matters. The best outcome is one that require little to no department oversight.

Under this type of decision matrix, traditional law firms have two clear paths for winning work:

  1. Be best-in-class in an area of law that is mission critical. Cf. Henderson & Parker, “The Five Strategies of Highly Effective Firms,” Am. Law, Jan. 2017 (statistical model showing that practice area specialization is the single most important factor in law firm profitability).
  2. Be outstanding at doing volume legal work.  Cf. Henderson & Parker, “Your Place in the Legal Market,” Am Law, Dec. 2015 (discussing how three firms climbed into the AmLaw 100 by focusing on price-sensitive labor and employment work).

Some law firm partners might dismiss Cisco’s resource allocation matrix as this year’s gimmick. That’s wrong for at least two reasons. First, Cisco has been using this system for 12+ dozen years. I first saw Chandler present a 1.0 version of this model at a 2010 Georgetown Law conference. That slide was dated 2006. Second, this type of resource allocation matrix was featured in a 2018 CLOC Institute session taught by Nancy Jessen (SVP of Legal Business Solutions at UnitedLex) and Elizabeth Lugones (Dir. of Legal Operations, DXC.technology). See DCX-UnitedLex allocation matrix. This session was attended by roughly 300 people. The presenters, however, are innovators or early adopters. See Post 007 (discussing adopter types).  The success they were sharing is what other professionals in the social system will to try to replicate.  This is how innovation diffusion works. See Post 004 (innovation diffuses through social systems).

3. In the long-term, there is no middle market

Because the journey to Big is a very gradual process, it’s easy to confuse slow change with no change. Further, there is a generational effect, with both buyers and sellers of legal services sticking with what they know until external events force them to change. It’s certainly true that a no-change approach will work many lawyers in the last decade or so of their careers.

I have never met a law firm partner who told me that he or she planned to ride out the clock rather than adapt to changing times.  Instead, I hear a lot of lawyers 50+ years of age tell me their “middle market” clients just want excellent service at a cost-effective price.  These lawyers continue to stay busy, or busy enough, because there is demand for what they offer: (1) a personal relationship with a knowledgeable, responsive lawyer who makes difficult legal business issues go away (2) at rates that do not carry the expense and overhead of AmLaw 50 or Global 100 law firms.

Many lawyers like this type of practice because it puts them in control, giving them autonomy and security within their firms. They don’t have to collaborate with anyone if they don’t want to. Arguably, when the business world was itself more middle market and less influenced by private equity, this described the bulk of private law practice. Less so now.  And less so in the future as economic activity is increasingly driven by larger, more complex organizations that have the resources to build out their own sophisticated legal departments.

[graphic from Post 048]
Not only are clients on average getting bigger and thus destine to change their buying habits, but law firms are upping their game, trying to lock-in tranches of work based on some combination of efficiency, expertise, and national or global reach.  Likewise, there is a good chance that emerging businesses that start life in the 3.9% portion of the treemap chart above (<$1M in revenue) used LegalZoom or a similar service to incorporate their business and educate them on things like intellectual property.  How does the middle market lawyer disintermediate LegalZoom? And what is he or she selling beyond a promise of responsiveness?

Strategy and the Fat Smoker (2008) was the last book David Maister, the preeminent law firm consultant, wrote before he retired. Maister starts Chapter 17, titled “The Trouble with Lawyers,” by conceding the point that lawyers are, in fact, different. “The combination of a desire for autonomy and high levels of skepticism,” wrote Maister, “makes most law firms low-trust environments” (p. 231). Thus, according to Maister, firms struggle to execute on strategies that require collaboration and sharing of risk.

If this is true, why do most firms do so well financially?  Maister opines that it’s because lawyers “compete only with other lawyers.  If everyone else does things equally poorly, and clients and recruits find little variation between firms, even the most egregious behavior will not lead to a competitive disadvantage” (p. 239).

This passage invariably garners a good laugh among lawyers, but less so in the future. Law firms inside large legal departments increasingly rely on systems and process. Likewise, to capture a tranche of the legal work that is sourced using a resource allocation model, some law firms are executing on a strategy that requires collaboration and risk sharing. Although most firms struggle with this approach, a firm only has to do marginally better to win.  This is because the most able mid-career lawyers will eventually lateral out of firms unable to offer anything beyond a pledge of great service.

As discussed in Innovation in Organizations, Part I-III (015, 016, 017), firm size is correlated with innovation, not because of size per se, but because size brings with it specialized expertise, financial resources, and better access to a diverse stream of clients. Cf. Post 062 (Jae Um discussing how innovation require high-quality access to buyers and users). Further, the service offerings of marginally more innovative firms are destined to create value that is controlled by the firm, reducing the tyranny of partners with portable books of business. As portions of this legal work get productized, middle market lawyers will have very little left to sell. Thus, as it turns out, the middle market is but a waystation on the journey to Big.

Coda.  The journey to Big has significant consequences for entry-level law graduates and thus legal education. But that is a topic for another day.

Photo by Jimi Filipovski on Unsplash

2018 has been a watershed year for capital flow into legal markets.  Will it be enough, at last, to push legal innovation forward?

It’s an age-old saying: money can’t buy everything.  The most common examples include happiness and love.  It’s time to add “legal innovation” to this lofty list.

In the past few years, we have seen unprecedented levels of capital flow into the legal space.  The partial views of funding activity we see from various sources imply an already high level of energy as well as money invested into legal innovation. Further, those investments (and one would presume, attendant efforts) only appear to be increasing:

Click to visit / “Legal Tech Startup Financings Take Off As Automation Hits White-Collar Industries” (Oct 2017)

And yet the market appears awash in disillusionment.  Many established thought leaders and influencers remain skeptical about the actual impact (or lack thereof) of these developments.  Pinpoint signals from corporate buyers indicate a glacial pace and highly uneven distribution for meaningful improvements in service experience and value delivered.  And the PeopleLaw sector remains woefully underserved, even as legions of practitioners outside the strongholds of Big Law struggle financially. See, e.g., Post 037 (presenting data).

So what gives?

A Roadmap to Innovation Woes: Key Innovation Drivers

In my first post on Legal Evolution, I addressed a few of the structural attributes that make legal a particularly unfavorable ecosystem for innovation. See Post 051 (legal innovation as an extreme sport). That discussion zoomed out for a broader view at the makeup and composition of legal service providers.

Now it’s time to zoom in.  This is Part I of a three-part series about systemic barriers to innovation maturity in legal markets.  In this series, I’ll pose a new set of hypotheses about the current state of our industry — to explore whether would-be innovators and visionaries have sufficient access to the ingredients that are necessary to make innovation actually happen.

Click to enlarge / Money can’t buy innovation, but it can and often does buy poor substitutes.

The above graphic lays out the roadmap, along with a brief description of the critical function of each component.

  • Part I (062) provides an overview of recent trends in capital investment into legal innovation. While several valuable directories, listings and analyses have already covered this topic from many different angles, the aim of this post is to explore why we are seemingly stuck in the “early days” of legal innovation despite an overarching trend toward expanded access to capital.
  • Part II (063) probes a critical problem facing all new offerings in every permutation of legal innovation: the difficulty of identifying and understanding the customer.  Part II summarizes the various customer roles in B2B service environments and the common reasons that new offerings fail to achieve problem-solution and product-market fit.
  • Part III (066) addresses the people side of the equation for teams and businesses trying to drive change to the status quo in legal markets. Whether the goal is (a) to drive incremental improvements to existing offerings or (b) to develop and bring to market a wholly new service or business model, legal evolution is a team sport that demands differing configurations of specialized skill sets.  Part III will summarize the necessary competencies and capabilities, with the goal of evaluating whether it is feasible for most legal businesses – whether incumbent or new entrant – to assemble a winning team.

Posts 062 – 064 are not intended to pose an exhaustive, definitive, or controlling theory of legal innovation.  Instead, the goal is to provide a useful framework, by endeavoring to draw attention and focus to factors that can be influenced and changed, once examined and understood, by economic actors in the marketplace.  As a counterpoint, I have previously criticized narratives that hinge on personality traits of lawyers, in large part because it is not a tenable proposition to ask a group of millions of adults to change stable aspects of their disposition. See Post 051 (“because lawyers … ” riff).

Here, the hope is to better equip innovators and change agents who find this analysis compelling and to enable them to perform more structured evaluations and make more rigorous decisions.  For everyone else, this series invites constructive dialogue.

Regulatory Constraints Affect Capital Flow (in Obvious & Non-Obvious Ways)

Like many other features of the legal industry, the flow of capital investment in this space is littered with idiosyncrasies.  The regulatory barriers to non-lawyer ownership has been debated ad nauseum elsewhere by wiser and more knowledgeable minds, but it bears one more mention here.  The blindingly obvious implication is that this severely limits the pool of available sources for equity capital into businesses that practice law.

The current regulatory scheme has three less obvious implications on legal innovation as well as the mechanics of how innovation efforts are funded and governed:

1. The Role of Incumbents (Yes, That Means Law Firms and Lawyers)

It secures for incumbents (law firms owned and largely operated by lawyers) a material role in deciding when, where, what and how the entire industry will change. This, of course, is a feature, not a bug: protectionism is intended to establish clear and insurmountable advantages for the artisan guild.

It is true that law firms have resisted change and thus bear full responsibility for the current state of the industry.  The fact remains, however, that incumbents must be included in any serious dialogue about legal innovation.  Regardless of their performance to date, law firms are both financial sponsors of, and direct participants in, legal innovation.

2. Practice vs. Business of Law

The requirement of lawyer ownership calcifies unhelpful divisions between the “practice of law” (the domain of lawyers, with limited access to capital) and the “business of law” (a set of enabling activities for legal practice, in the domain of… everyone else with varying non-lawyer titles). These divisions extend deep into our collective consciousness and they do serious harm not only to workplace cultures but also the rigor and clarity of our thinking about legal innovation.

This distinction creates an artificially binary model that fails to accurately represent the reality of how legal teams serve clients in the real world.  Ultimately, this type of thinking favors incremental improvements to the status quo and R&D based on misguided and antiquated assumptions. It’s akin to exploring a closet with the lights off.

3. Follow the Money

The requirement of lawyer ownership also diverts a great deal of available capital into non-core segments of legal services. This has a dramatic effect on the experience of the end-users and shapes their expectations and appetites. This is, at least in part, why “legal tech” receives a disproportionate share of both capital and attention in the legal innovation dialogue: A lot of money is going into a disproportionately small part of the value chain.

The aforementioned wiser and more knowledgeable minds continue to discuss the desirability and feasibility of changing the regulatory moat around lawyer ownership.  In the meantime, this discussion will remain premised on the status quo, in the spirit of focusing on factors that can be influenced by individual market actors.

Who Funds Innovation & Why?

Due to the idiosyncrasies of the legal markets, it is helpful to think about innovation in two simple categories: the typical/conventional financial sponsor vs. atypical sponsors unique to the legal innovation ecosystem.

Traditional Sponsors: PE Firms Are All About That Multiple 💰❌💰

The archetype for the traditional financial sponsor of a new venture is the private equity firm.  PE firms (inclusive of angels and venture capital shops) are themselves commercial enterprises.  Essentially, they offer specialized expertise in the strategic deployment of capital for wealth creation.  To put it as simply as possible, PE firms invest capital to buy part or full ownership of companies, apply their expertise to make those companies more valuable, and then sell those companies (hopefully at a higher price point than at purchase).

PE firms attract capital from investors (typically institutional or ultra-high net worth) with investment theses that communicate a unique viewpoint about market opportunities; they retain investors through sustained performance in generating high returns.  The below chart is an extremely simplified and theoretical comparison of PE returns against the S&P 500. See “Does Private Equity Really Beat the Stock Market?,” Wall Street Journal, Feb. 13, 2018.  There are many caveats about the difficulties inherent in comparing apples to oranges but suffice to say that the ROI expectations are high.

Source: Preqin via Wall Street Journal

Of course, the ultimate returns to investors are abstractions in that they aggregate the outcome of the PE firm’s many activities, both successes and failures alike.  To put this into more concrete context, it is helpful to think about private equity investments at the company level (again, a simplified, theoretical exercise).

  • Holding times. On average, PE firms hold portfolio companies for about 6.5 years, although early-stage venture capital investments will have longer holding periods (sometimes much longer).
  • Returns/exit multiples.  Target multiples are more difficult to generalize than holding times.  Venture capitalist Fred Wilson of Union Squares Ventures is famous for saying often that he looks for one investment that “will return the whole fund.”  This is a different way of indicating that VCs usually make many high-risk investments with the expectation that most will fail, with a few wins that will make the losses look minuscule.  Still, it’s probably a safe and meaningful rule of thumb to say early stage VCs will seek something in the neighborhood of 10x returns while mid-stage investors will be looking for a 3x to 5x range.

Funding innovation is both a means to effectuate and a happy byproduct of the PE firm’s raison d’être: generating returns for investors.  As we will see, things are not so simple in legal markets.

Simply put, most legal startups require a long bake for a relatively small pie. In addition, the vast majority of legal startups are point solutions targeting niche markets that are far too small to ever reach the size & scale needed to attract traditional venture capital interest — at least in part due to the highly fragmented composition of the legal services market, as well as the added layer of geographic silos imposed by jurisdictional differences, see Post 051 (legal markets are especially balkanized and opaque).

Big Law Both Funds AND Manages Innovation (And It Sometimes Works 😲)

The innovation theater that often happens (inadvertently or otherwise) across the law firm landscape is more analogous to the recent explosion in corporate innovation.  With technology driving a faster pace of change and startups eating into every major sector, mature businesses of all shapes and sizes have embraced the mantra: “what got you here won’t get you there.” This has fueled mystique around the “intrapreneur”, a rash of innovation “labs” housed within staid and stable companies, and the rush to co-opt startup-style innovation and strategy tools, all with mixed results.  (Enjoy a moment of relief and schadenfreude: innovation theater was not created by the legal industry.)

As always, there are lessons to be gained from the mistakes of others, even those outside our own domain.  Drawing from the hard-earned lessons of corporate innovation programs outside of legal, two reliable litmus tests emerge to gauge the innovation maturity of established firms:

  • Why?  Clearly articulated strategic objectives for innovation investments, tied to financial KPIs that measure the impact on the core business or progress toward profitable exit
  • How?  Process and governance around build, buy or partner decisions
A few bright spots exist

Yes, many law firms engage in some level of innovation pantomime for hype and awards, simply to keep up with the Joneses.  (Award submissions in 2018 that tout a successful migration from Office 2007 to Office 365 would fall into this category.)  And other law firms often get in over their heads in innovation endeavors that are beyond their core capabilities (more on this in Post 064).

But a few law firms do think and act with the recognition that they are future-proofing their businesses against emerging threats.  Allen & Overy is a good example of an outlier firm displaying both indicators of innovation maturity.  In 2016, A&O partnered with Deloitte to bring to market MarginMatrix, an “IT solution for compliance with the mandatory variation margin rules that now apply to the USD500 trillion OTC [over-the-counter] derivatives market,” now deployed for 8 global investment banks with over 20,000 negotiations completed. See Allen & Overy Annual Results Factsheet for Fiscal Year 2017.

MarginMatrix shows interesting signs of innovation maturity in that it is hyper-focused in product design and target market. The solution design also displays a high degree of customer-orientation, around which coalesces (a) complementary technology components (expert system, workflow, document automation) and (b) a managed services play that leverages (presumably) lower-cost staffing from Deloitte’s deep bench.

Most importantly, however, MarginMatrix makes strategic sense for A&O.  OTC derivatives are important to global investment banks (a key market segment for the firm) because the customization flexibility of off-exchange products provides banks with highly sophisticated means to hedge risk.  A&O also has comparative advantage to produce and maintain the high-value content that drives MarginMatrix: the legal analysis of multi-jurisdictional regulatory requirements imposed on OTC derivatives.

In the below visualization of potential strategic objectives for innovation investments, MarginMatrix fits comfortably into the “add new offerings box,” which enables the firm to anchor existing key accounts with a tranche of work offering relative revenue predictability.

Click to enlarge / Before innovating, firms should establish clarity on what they are trying to accomplish from a strategy standpoint.

The notion of packaging expert knowledge into a productized subscription model is not a new idea.  Many firms continue to flirt with this idea, and mapping some of those efforts to the above strategy matrix gives some sense of the variation in motivating drivers for innovation investments.

Apart from these examples, countless firms are now engaged in serious efforts to integrate process, technology and legal operations to both manage costs and improve service delivery.  But a sustained product/solutions focus to spin up new offerings to the market remains more the exception than the rule.

The wide variety of motivations for incumbents to invest in innovation explain, at least in part, why it is difficult to generalize about legal innovation.  Some of the variation can be explained by the extreme fragmentation of the marketplace and the resulting dispersion in market position and thus strategic opportunities available to each player.  The fact remains, however, that rigorous attempts to measure and compare innovation investments, maturity or performance will need to consider these differences.

Capital for Legal Innovation: Current State & Emerging Trends

A survey of the current market landscape as well as recent developments/dialogue suggests there are four key trends to watch in the next 3-5 year timeframe.

  1. Liquidity events suggest sorting/matching behavior by market participants
  2. Platform + bolt-on strategy by serial acquirers and mature scale-ups
  3. Smart money eyeing legal, to the tune of $500m+
  4. Capital gets creative: working around the regulatory moat

1. Liquidity Events: Not Necessarily a Silicon Valley-Style Bonanza

2018 has already seen a number of deals that have raised many questions (and inspired many hot takes).  The below graphic picks out a small selection of headliners. Given that financial terms are rarely disclosed, the LegalZoom secondary investment attracted a lot of attention by virtue of deal size and resulting valuation. See, e.g., “LegalZoom Gains $2B Evaluation in Funding Round,” Bloomberg, July 31, 2018.

Click to enlarge / Like Sean Parker said, a billion dollars is cooler than a million dollars, but it is also easier said than done.

Liquidity events have a generally pleasing air of a positive development; some of that may be due to the glorified stories of founder exits vaguely reminiscent of the trailer for “The Social Network.”  Certainly, liquidity events usually involve some people coming into a large lump sum of money.  Without raining on anyone’s parade, it bears mentioning that the overall texture of recent liquidity events in legal markets indicates that a few different forces may be in play:

  • The Avvo, BAL and Riverview Law deals give indications of a strategic sorting in which major players with strategic goals acquire specific assets; in contrast, the Lawyers On Demand and LegalZoom deals feel more like capital churn/injections that will lengthen the runway for these companies to prove out an independent scale/growth strategy that may still be in the works while providing liquidity back to the early stage investors.
  • Traditional PE exit strategies favor strategic acquirers and IPOs over financial sponsors, who tend to be more sophisticated and able to negotiate a lower purchase price.  Those dynamics may or may not hold in legal markets; the available data is too scant to speculate.
  • The exits by BCLP and DLA Piper raise an interesting question about the optimal role of most law firms in the midwifery and nurturing of new ventures.  For reasons we will cover in upcoming installments, law firms have unique assets that make it a fertile environment for experimentation and testing — whether they are well positioned to hold their equity positions to a late exit remains to be seen.

2. Platform + Bolt-On: Next-Level Serial Sorting

The activities of serial acquirers and emerging platforms deserves some mention.

  • Unsurprisingly, Thomson Reuters and LexisNexis remain most active acquirers as they supplement internal innovation agendas with strategic M&A. LexisNexis, in particular, has been aggressive in sourcing new product & service innovations through recent acquisitions of Ravel Law, Intelligize, and Lex Machina — all prominently on display at the recent AALL conference.  in contrast, Thomson Reuters’ recent launch of WestLaw Edge appears to be powered much more heavily by internal innovation and R&D.
  • Epiq, Consilio, and Mitratech are all PE-backed and have access to the capital to continue bolt-on deals to round out their market offerings.  Most recently, Mitratech acquired ThinkSmart for an undisclosed sum.
  • Relativity may emerge as a likely platform looking for bolt-on acquisitions: the company has invested in Heretik and HealthJoy, signaling financial commitment to extend its platform beyond eDiscovery into contracts and highly regulated data stores.
  • Earlier this year, Elevate announced that it had secured a line of credit from Morgan Stanley Expansion Capital to fund its growth. See Press Release. Elevate did disclose that the proceeds would be spread out across strategic acquisitions as well as investments in product and service expansions.

3. “Smart Money” from Silicon Valley Continues to Eye Legal Vertical

Independent research conducted by Six Parsecs indicates that “Smart Money” VCs (the Silicon Valley elite, as identified by CB Insights) have invested in almost 30 legal tech companies in funding rounds totaling over $500m.  This list includes some of the most recognizable names in legal tech, including Avvo, Clio, DocuSign, LegalZoom, and Ravel, as well as some newer names to watch like Atrium LTS, Casetext, Ironclad, Judicata, Modria, and SimpleLegal.  Famed Valley seed accelerators Y Combinator and 500 Startups have been fairly active as well, funding over 20 startups in rounds totaling almost $180m.

An interesting counterpoint to the “Smart Money” portfolio are the investments made by Ulu Ventures.  While Ulu’s legal startup portfolio is small, it includes Lex Machina and Ravel Law, both acquired by LexisNexis.  Ulu founder Clint Korver was part of an early cohort of VCs who were early adopters and customers of legal startups as an alternative to incumbent firms (and expressed intense skepticism about the waves of change washing over Big Law); that cohort included Foundry Group founder and ex-Cooley lawyer Jason Mendelson, whose claim to fame included, among other things, hating on startup lawyers.  See “These Venture Capitalists Skip Law Firms for Legal Services Startups,” ABA Journal, May 2014.  This raises some interesting questions about what legal startups might need more: capital to fund growth or advisors with a keen understanding of the domain.

4. Capital Gets Creative: Workarounds for Regulatory Barrier

While only orthogonal to this discussion, the emergence and growth of litigation finance must be noted.  Litigation finance is a rare bird in legal innovation that fits into Marc Andreessen’s “huge, if true” paradigm.  According to BTI Consulting, litigation made up nearly 30% of the demand for all outside counsel services in 2018; while a rough proxy, the share of litigation spend in all outside counsel budget still gives an idea of the significant addressable market size for litigation finance. See BTI Practice Outlook 2018 (forecasting market size by practice).  Since 2014, litigation funders have raised capital in excess of $3bn. See “Litigation Funders Face Their Hardest Sell: Big Law,” The American Lawyer, June 28, 2018.  While still in its early days, litigation finance has the potential to reshape the current landscape for a huge segment of the legal services market, and represents a creative channel for outside capital to influence and ramp up investment into legal data handling and predictive analytics.

Access to Capital: Could Be Better, but Not the Choke Point 

Research by Six Parsecs suggests that the total amount of hard capital invested into legal tech, legal services and adjacent spaces is in all likelihood much, much larger than the $998m estimate reported by CB Insights in 2017.  Further, is impossible to account for all of the soft investments made by existing players to fund strategic projects, initiatives, feasibility tests, as well as the ongoing payroll of the growing roster of internal innovation teams across the legal space.

The aggregate amount of capital invested in legal isn’t the issue — the more serious problem is the inefficiency in finding and funding the right opportunities.  However, emerging trends suggest that access to capital is getting and will get more efficient over time.

Upcoming installments will make the case that inefficient access to markets and talent are much more serious barriers to innovation maturity in legal markets.  That said, a rigorous look at capital flows in our industry is still important.

Why?  Because there is no better accelerant for #realtalk than the topic of money.  Discussion of capital must necessarily address the question of returns. Too often, we across the legal industry use innovation as an emotional lift: workshops and brainstorming sessions usually make us feel better and more hopeful about the future.  Where accountability mechanisms are absent, good feelings often provide sufficient returns for these costs.

To culturally co-opt an obnoxious catchphrase of one Ben Shapiro, “money doesn’t care about your feelings.”  Looking at the current state of the legal innovation landscape through this unforgiving lens can produce unexpected clarity.  For the industry to mature beyond isolated experiments at the edges, we must engage in more rigorous thinking about (i) what innovation experiments actually cost, (ii) what returns they generate, and (iii) how both sides of the equation fare as the endeavor scales.  Not all the inputs and outputs of innovation efforts will be quantified in dollars, but much of it can and should be.

The capitalists will enter the U.S. legal mainstream sometime between a few years from now and never.  But in the meantime, those on the inside could stand to take a page out of the capitalists’ playbook, starting with the notion that investable ideas must focus on value rather than novelty.  Not all new things are better than the status quo, and not all old things are bad enough to be discarded: much like handsome and stupid, innovation is as innovation does.

What’s next?  See Legal Innovation Woes, Part II: TBD Markets + MIA Customers (063)

We lack the experience and vocabulary to describe what is happening in the entry-level legal job market.

Below are four charts that provide context to NALP’s recently released Class of 2017 data. But first, here are some key highlights from NALP’s press release and Selected Findings:

  • Overall employment: 88.6%, up from 87.5% in 2016.
  • Bar passage req’d jobs: 71.8%, up from 67.7%
  • Private practice jobs: 54.4%, up 1.5%
  • Median salary:  $70,000, up $5,000
  • Law firm median: $117,000, up $13,000
  • Hiring in 500+ lawyer firms: 4,606, up 368 jobs

These favorable statistics account for the press release headline “Class of 2017 Notched Best Employment Outcomes Since Recession.”  Similar headlines followed in the legal press.  See, e.g., “Median salaries for new law grads jump to $70K as BigLaw boosts hiring of newbie lawyers,” ABA Journal, Aug. 2, 2018; “Job Market for Law Grads ‘Surprisingly Strong,’ NALP Finds,” Law.com, Aug. 1, 2018; “Law grad salaries rise as big firms up their hiring,” Nat’l Jurist, Aug 3, 2018.

A simple, positive story, right?  The NALP materials contain other other facts, figures, and observations that reveal a much more complex market.  However, they can’t be reduced to pithy takeaways that are both accurate and helpful. To truly understand these data, we have to invest quite a bit of additional time and effort.

The four charts below are designed to partially bridge this gap. (Charts can be downloaded on Slideshare.)

Chart 1. Jobs in private practice continue to decline

Drawing upon the NALP press release and select findings, the news reports cited above all emphasize the increase in BigLaw hiring. In Chart 1, the supporting data are inside the orange circle.

Yet, when the Class of 2017 is viewed in a longitudinal context, the most striking feature is the continued decline in the total number of private practice jobs. Granted, jobs are down, at least in part, because the supply of entry-level talent is down.  Some employers hire more when talent is plentiful and cheap. However, it is not accurate to say that law firm hiring has rebounded from the recession. The recession was 10 years ago, yet the number of private practice jobs is lower now than at any time since the beginning of the recession.

Those of us in legal education need to understand why this is happening. See Post 057 (solving difficult problems require accurate understanding of root causes).

Chart 2. “Good news” is produced by fewer grads

As shown in Chart 2, over the last seven years, law school has become a lot less attractive to prospective law students. The class of 2017 had 34,922 graduates, which is the lowest level since 1982.

The higher employment rates for the Class of 2017 are due to smaller classes rather than an increase in the total number of jobs.  The complexity of this job market can be seen in the first paragraph of the Commentary and Analysis written by NALP’s executive director, Jim Leipold:

[Good news:] The employment outcomes findings for members of the Class of 2017 are surprisingly strong. Most notable is a bar passage required employment rate that jumped more than four percentage points from the previous year, and a private practice employment rate that has now increased for six years in a row. [Complexity:] Undergirding the strength of the employment outcomes, however, is a smaller class and not more jobs. For the fourth year in a row the employment rate has been shaped by a smaller number of jobs and a smaller graduating class size. The employment rate has risen because the falloff in the size of the graduating class has been larger than the falloff in the number of jobs secured. Notably, like the two classes that preceded it, this class secured fewer private practice jobs than any class since 1996.

This is important information, but what exactly are we supposed to do with it? It’s great that a higher proportion of students are getting better employment outcomes. But does the continued slide in law firm jobs require some type of collective action or response?  If so, who would make this call and what would they advise?  Unfortunately, we have no ready answers.  This is our conundrum.  Cf. Post 056 (discussing likelihood that law is entering a period when we will need lawyer-leaders to handle very difficult organizational and industry-wide problems).

Based on fall enrollments in 2015-17, we can forecast with reasonable accuracy the graduating classes in 2018-2020. All of them are likely to be smaller than 2017.  Thus, in terms of employment rates, we can expect three more years of “good news.”  We should use that time wisely.

Chart 3.  Relationship between law school debt and lawyer salaries

Chart 3 shows the relationship between law school debt and starting salaries, which are useful proxies for cost and perceptions of future earning potential. Since 2010, average student debt has rapidly outpaced entry-level salaries. This divergence is the simplest explanation for the massive drop-off in law school enrollment.

Fortunately, we are finally at a point where debt loads are headed downward while median salaries are tilting upward. The remaining gap, however, remains very large compared to the early to mid-2000s. Until these lines are brought closer together, those of us in legal education are going to struggle to grow our enrollment. This is very hard work, as it requires increasing the value of legal education — in the eyes of students and employers — without increasing our base costs.  In short, this is a design problem. A good number of law faculty understand this; hence the growing emphasis on innovation. See, e.g., Law School Innovation Index.

Chart 4. BigLaw will not save us

One of the NALP findings latched onto by the legal press was the increase in hiring among 500+ lawyer firms — up 368 jobs, or 8.6% from the prior year.  However, the data in Chart 4 suggest that BigLaw is unlikely to power a recovery for law schools.  Although the number of lawyers working in 500+ lawyer firms has increased significantly over the last 11 years (+36%), associates appear to be waning in importance. We see this through the shrinking proportion new-hires within large law firms.  Why is this happening?

A partial answer is that firms are finding it harder to sustain organic growth. See, e.g., Georgetown Law, “2018 Report on the State of the Legal Market” at 14 (“Since 2008, the overall growth trend for demand for law firm services has (with certain spikes and dips) been essentially flat to negative in every year.”); MacEwen, “It’s [not] The Economy. Stupid,” Adam Smith Esq., Aug. 5, 2018 (showing large drop-off in annual revenue growth after 2008). Because many lawyers and firm managers associate size with safety, growth through mergers and lateral partner hiring has become a dominant strategy.  The idea is to focus on groups of lawyers who can pay their own way in the current fiscal year.

One of the primary consequences of this strategy is that firms are relying less on associates and more on staff attorneys, counsel, and non-equity partners. See Henderson & Parker, “The Diamond Law Firm: A New Model or the Pyramid Unraveling?,” Lawyer Metrics Industry Report No. 1 (2013). First-year associates require higher salaries; more training and supervision; engender greater client pushback; and often leave before the firm recovers recruitment costs. Thus, large firms are finding ways to get by with fewer of them.

The orange trendline in Chart 4 also reveals another factor that is likely impacting entry-level hiring in the 500+ lawyer category: the number of 500+ lawyer firms is increasing.  In 2010, there were 76 firms with 500+ lawyers. By 2016, the number increased to 87.  A year later, it jumped to 91. Indeed, in 2007,  65.5% of the lawyers in the AmLaw 200 worked in 500+ lawyer firms; by 2017, this percentage increased to 75.5%.

Are the largest firms hiring more entry-level lawyers? Or are the mega-firms just taking up a larger share of the total corporate market? The latter trend would explain why entry-level hiring in 500+ lawyer firms is up while the total number of private practice jobs is at a 22-year low.

Conclusion

For many of us working in the legal field, we treat the NALP data as something we passively consume. Every year we do so without much thought or effort.  This is a conditioned response based on several decades of uninterrupted prosperity. In our experience, things have always worked out, so we can count on that pattern to continue.

Yet, the practice of law is changing in very significant ways, primarily because clients are changing how they buy legal services. There will be no shortage of opportunities for lawyers, legal educators, and recent law grads who get out into the field and obtain insight into what these clients really need. Those insights will tell us what to do.

(Charts can be downloaded on Slideshare.)

Legal innovators yearn for a big payday. The obstacle course in their way? A messy, fragmented, and chaotic legal market.

Why is the legal industry so slow to change? This question gets asked all the time – particularly during conference season – but it gets more than its fair share of airtime year-round. It is ever-present in the blogosphere and hotly debated on Law Twitter at least once a week.

However, the most frequently given answers are largely unsatisfying and the ensuing discussion often recursive. If the legal industry is on tape delay, the change conversation may be stuck in a Delos-worthy loop.

Legal innovation stands at a critical juncture. With mounting momentum comes heightened scrutiny, and though we may be on the cusp of significant breakthroughs, we also stand on the precipice of an industry-wide chasm.  It’s time to acknowledge that we are working within an environment of extraordinary complexity and inefficiency, where innovation offerings are at clear and overwhelming risk of faring poorly.

(Market) Context Matters More Than (Lawyer) Character

One popular fallback is a narrative that I’ll call “because lawyers.”  Because lawyers are skeptical, because lawyers are conservative, and the list goes on (and on and on). The “because lawyers” train of thought goes something like this: because lawyers are different, the legal industry must also be different, and what has worked to advance positive change in other industries will not apply here. I disagree.

How “Because Lawyers” Fails the Industry

The “because lawyers” narrative can offer insights of value to would-be change agents, but I tend to think it suffers from two limitations that are closely related:

  • Firstly, it is better at explaining failures than explaining successes (and there have been some successes). This suggests that the “because lawyers” narrative lacks explanatory power: designing around lawyerly tendencies is likely a necessary but insufficient condition to driving systemic change.
  • Secondly, “because lawyers” is an intrinsically blame-based narrative, built on hypotheses about highly stable aspects of lawyer disposition and personality. This is especially problematic where it invites proactive defensiveness from lawyers and engenders cumulative resentment in change agents. These two consequences conspire to erode rather than promote collective psychological safety. Cf. Laura Delizonna, “High-Performing Teams Need Psychological Safety. Here is How to Create It,” Harv Bus Rev (Aug. 24, 2017).

Instead, I think we (legal innovators and change agents) would reap greater benefit from thinking and talking more specifically about target markets. For example, which buyers have underserved needs that they are willing to pay to address now? And what, precisely, are those needs?

Buyers Rarely Beat the Proverbial Path to Your Door

Developing new products and services is hard – in any industry.  Even when there is a proven customer base with clearly articulated and well-understood needs, incremental improvements do not readily and reliably translate into profit.  Disruptive products and services are another order of magnitude difficult: they occur because of discovery of a whole new set of needs not yet known or understood by anyone (we want 1000+ songs on demand at all times); or because of a wholly new configuration of value creation and delivery that substantially displaces the current solution (we want to order every book and eventually every product under the sun and have it delivered tomorrow).

In either context – incremental improvement or true disruption – would-be innovators must proactively define a reachable target market. Because new things take time to refine and scale, the survival of new ideas often depends on identifying and addressing the correct market first.

This implies a deep understanding of buyers and markets:

  • how buyers currently organize and identify themselves into groups;
  • how each group might differently perceive their needs and potential options to fulfill those needs; and
  • how they prefer to buy and consume products and services that present a solution.

This is especially tricky because markets for new things are fluid and sometimes cut across existing or obvious demographic segments.  Indeed, as this publication has well established, receptiveness to new things – in any context – are more dependent on psychographic attributes than demographic ones. See Post 007 (covering the basics of adopter types).

Ideas Need Market Feedback to Become Real

In the legal industry or anywhere else, ideas are rarely in short supply. Ideas are necessary but insufficient for meaningful progress – what we need are effective and reliable means to validate and refine ideas into tangible products and services that will survive contact with reality.  This almost always requires the participation of potential buyers.

Unfortunately, optimal buyers in early markets do not always self-identify or congregate conveniently in a physical marketplace that innovators can visit to announce or demonstrate their idea.  Instead, as the graphic above suggests [click to enlarge] the innovation team has to think creatively and undertake all manner of legwork outside the lab, to discover or pull together niche markets or sub-segments who will provide feedback and stress-test hypotheses about how the new process, product or service should work.

The onus to find the right prospects and convince them to try new things rests with the innovator, entrepreneur or intrapreneur. Yet, how often do we revert to the “because lawyers” narrative to explain away the many promising ideas that have stalled without achieving significant adoption?  If a product or service is actually effective in addressing a problem that matters to the customer, the change management burden can be reduced (although perhaps never fully eliminated). Cf. Post 008 (49 to 87% of the rate of adoption typically turns on just five product attributes–relative advantage, simplicity, cultural compatibility, trialability, observability).

Unfortunately, “going to market” has become shorthand for any number of sticky problems and nebulous questions to work through. When we use that phrase, we need to acknowledge the enormous time, effort and difficulty that lies ahead.

As an industry, we are not yet mature in our collective ability to define and size new markets for innovative offerings. In simpler terms, our most critical gap isn’t ideation and it probably isn’t change management either.  We have a commercialization problem, and to improve our industry-wide win rate we need to address the actual choke point.

Legal Innovators Face Extreme Conditions

In a recent discussion, Bill offered this insight: the legal industry isn’t different; rather, it’s extreme.  I think this is a superior framing device to drive constructive dialogue and to advance our thinking about legal innovation.

Two distinguishing features of the legal industry’s structure contribute to make it an unusually unfavorable ecosystem for innovation: (1) extraordinarily balkanized and (2) fractally opaque.  That sounds highly academic and esoteric, so I explain in plainer English below, with some supporting figures and visuals.

Balkanized and Isolated

Many industries are fragmented (i.e. crowded without a clear or dominant market leader), but legal is something more: extremely fragmented into many smaller units that are mutually hostile or uncooperative.  This is true at the establishment level (individual firms) and at the segment level (the categories and subgroups into which firms roughly organize themselves).

The above diagram [click to enlarge] conceptualizes the evolving landscape of legal service providers, along the two-hemisphere model advanced by Heinz and Laumann and Susskind’s bespoke-to-commoditized continuum. See Henderson, What is more important for lawyers: where you go to law school or what you learned? (Part II), Legal Whiteboard (July 19, 2015). The left side of the chart captures the broad categories of incumbents (“the artisan guild”). The middle and right regions capture the broad categories of emergent competitors who seek to leverage new technology or process innovations to offer a different value proposition. This graphic is effective in communicating the increasing complexity of the legal marketplace.

However, it’s important to note that the above depiction of market composition is conceptual and categorical – it is not a scale representation of current market share along any quantitative measure. To add a more quantitative dimension, the below chart [click to enlarge] relies on U.S. Census data to show the composition of the legal services market by establishment size:

While this is an incomplete view of the market and a fairly imprecise mapping of segment to firm size, it still offers added quantitative support to the idea posited first in Post 005 “Six Types of Law Firm Clients” and clarified recently in Post 048 “Confusing Conversations with Clients”: namely, that we talk past each other because we each bring varying perspectives from different work contexts.

Most market composition analyses are based in revenue share. On infrequent occasions, the point is made that the vast majority of firms are solos or small firms (over 90% in the Census data above). But it is an analysis of job share that gives a more accurate sense of our industry as well as the best real-world explanation of why we often talk past each other.

Roughly 1,200 of the largest companies in the legal market account for about a third of all jobs, with small firms and solos splitting the remainder fairly evenly. If a Martian visiting Earth to learn about our legal ecosystem were to randomly select 3 people who work in legal services, the most likely scenario is that he will end up with 3 people who come from dramatically different work contexts and have almost no consistent information to offer.  Even if our Martian were to beat the odds and pull together a focus group of 3 individuals who at least work in similarly sized organizations (he has about a 3.7% chance of getting that lucky), it’s also likely they come from firms with different specializations serving different client segments, who are accustomed to completely different workflows, technology environments, and compensation and incentive schemes.

Like any balkanized region comprised of hostile states, the legal market is difficult for outsiders to navigate or understand. For those of us on the inside, we should remember that each of us brings to the table a labyrinthine set of customs and experiences that create significant divisions and critical barriers to cooperation.

Fractally Opaque → Perpetually Lost in Translation

By and large, we remain in our silos and fail to cooperate. The “lone wolf” proclivities of lawyers (so autonomous and so competitive!) have been cited frequently as a primary barrier to open communication and collaboration. However, I think the phenomena is subject to more contextual explanation. Some legal work is intrinsically adverse and nearly all of it is highly confidential in nature. These factors serve to anchor a high baseline of opacity and create communication infrastructures that are designed to impede, rather than promote, the efficient sharing of information.

Despite the efforts of some forward-thinking corporate law departments to drive deeper collaboration across their supply chains, firms within each category tend to engage in vigorous competition, which in turn drives even greater opacity. The intensity of that competition has only increased in recent years as corporate budget pressures and insourcing strategies have depressed demand growth for the “artisan guild.”  Subsequently, an open exchange of new ideas or practices within categories is more the exception than the rule, and usually only happens under diligent and hands-on management by a shared client.

In the current state, we also see very little systemic cooperation across segments (e.g. sustained strategic alliances or partnerships across service provider types). The artisan guild tends to regard newcomers with suspicion, and many forward-thinking incumbents are embarking on long-range initiatives to future-proof their businesses against down-market threats. In this, the incumbents engage in completely rational competitive behavior: many new entrants seeking entry points into the corporate buyer ecosystem are essentially positioned to displace corporate legal spend that has historically been held captive by the artisan guild.

In the legal industry, very real differences are present at many different resolutions: across segments, firms, practices, case teams, and individual roles. The resulting translation barriers add opacity to an already complex ecosystem, and that opacity is fractal in nature. In other words, you can take any subpart of the legal industry and it will display structural features that make each part just as opaque as the whole.

Even when we want to, many of us working in legal businesses find it challenging to relate meaningfully to each other. The emergence of new types of businesses and the continuing proliferation of new roles for allied professionals add more dimensions of complexity and friction in communication:

If innovation is a process by which new ideas spread across a social system, see Post 004, then legal innovators and change agents would be well served to recognize that the legal industry is not one single monolithic social system.  Rather, it is a complex and complicated network of distinct and disparate subsystems, with almost every organizing principle conspiring to create friction in the diffusion process.

In an illustrative comparison, our close cousins in accounting have a slightly easier time. About 50% of accounting jobs are concentrated in firms of 500 employees or more. The perennial focus in legal press on the fates and fortunes of the richest firms, see, e.g., “The Super Rich Are Getting Richer” in American Lawyer (April 2018), also conspire to give a broad sense that the legal market is exceeding top-heavy.  In short, the legal market appears to be a textbook example of the top 1% claiming the lion’s share of clients, revenue and profits, but this turns out to be a distortion of reality. The legal market most likely suffers from a slower pace of innovation because it is not top-heavy enough.

Though an apples to oranges comparison, the Big 4 enjoy much greater advantages of scale and scope relative to even the largest global law firms because they’ve consolidated a much larger portion of market share. Collectively, the Big 4 clocked about $130bn in global revenues in 2017 – more than revenues of the Am Law 200 combined.

Historically, the Big 4 draws roughly 40% of its revenues from the Americas and about 30% from audit.  To match the Big 4’s Americas topline, the largest 32 Am Law firms would need to pool their collections. Because each of those 32 firms is organized into its own unique matrixed structure of regions and practice areas, the adoption decision must be made many times over, whether on a collective or authority basis, see Post 008 (type of decision affects rate of adoption). Either way, overall cost and effort required to spread new ideas through law firms are exponentially greater.

Market Inefficiencies → Innovation Inefficiencies

These structural barriers to the spread of new ideas are very real, even for the vast majority of the market conducting business as usual and merely looking for ways to drive incremental improvements to how they work. However, their adverse effects are perhaps felt most keenly by those trying to drive significant change in the industry.

In the aggregate, these structural barriers are experienced as friction in the procurement process and as inefficiencies in the marketplace. What do I mean by inefficiencies?  In classic economic theory, an efficient market is one in which asset prices accurately reflect true value. Clearly, the ongoing dialogue around the need for pricing innovation – as well as the anecdotal evidence of high price dispersion for similar services – suggests the legal services market is highly inefficient.

But I also think the current makeup of the legal services market makes it highly inefficient in the literal and colloquial sense of the word: it takes too much time and effort for buyers and sellers of specific services to find each other, and once they meet up it also takes a great deal of time and effort to agree upon a fair rate to exchange money for services.  More often than not, buyer and seller arrive at some accord using highly technical methods best described as “eh ¯\_(ツ)_/¯ looks about right.”

Assessment and evaluation of new substitutes implies an even greater burden of time and effort, along with the added element of risk in what is defensibly an environment of exceptionally low tolerance for failure. Moving fast and breaking things is great for startups… until Cambridge Analytica happens.  Generally speaking, breaking things is less great for lawyers who are often hired to prevent bad things from happening or to argue over liability for bad things that have happened.

To succeed in this unforgiving ecosystem, innovations must offer an undeniable value proposition that functions as a complete solution to a material customer problem.  In the next post, we will revisit the five adopter types with the goal of understanding the specific and unique contributions each type can offer to the would-be change agent seeking to cross the chasm.

What’s next?  See A playbook for innovation magic (052)

The graphic above tells a simple, painful, and important story about the U.S. legal profession that we can’t afford to ignore.  The graphic compares the receipts of U.S. law firms in 2007 and 2012 based on “class of customer” data from the Economic Census, the U.S. Census Bureau’s official five-year measure of American business.  Although total law firm receipts increased from $225 billion to $246 billion, receipts from individuals declined by almost $7 billion. That’s a staggering sum.

Ordinarily, with such a large and sudden drop (10.2%), I worry about data quality.  Yet, these data appear to be continuations of trend lines that are several decades old.  Further, recent data published by Clio, the cloud-based practice management and time-keeping system used by a large number of solo and small firm lawyers, reveal that the economics of small firm practice are under severe stress.

As a society and a profession, we are heading to a place that none of us wants to go. Our biggest risk factor is failing to acknowledge the full magnitude of the problem.

The two hemispheres of practice

The structural significance of lawyers’ clientele — individuals versus organizations — was first noted by Jack Heinz and Edward Laumann in Chicago Lawyers: The Social Structure of the Bar (1982) (popularly known as Chicago Lawyers I).

Based on a randomized sample of 800 Chicago lawyers, Heinz and Laumann observed that lawyers tend to serve either individuals or organizations, but seldom both.  Further, type of client was strongly correlated with lawyer income, ethnicity, religious background, law school attended, home address, work address, and bar association membership.  “Only in the most formal senses, then, do the two types of lawyers constitute one profession” (p. 384).  This was the basis for their famous two-hemisphere theory of the legal profession. See also Deborah J. Merritt, Two Hemispheres, Law School Cafe, May 2, 2015.

Twenty years later, Heinz, Laumann and other researchers replicated the study based on a sample drawn in 1995.  See Heinz et al., Urban Lawyers: The New Structure of the Bar (2005) (Chicago Lawyers II).  One of their key findings was a dramatic surge of prosperity within the organizational sphere, with real incomes of large firm lawyers and in-house counsel nearly doubling.  Conversely, among solo practitioners, who disproportionately served individual clients, incomes fell from $99,159 (in 1995 dollars) to $55,000. By 1995, 32% of solo practitioners were working a second job compared to only 2% in 1975.

These are startling and sober statistics generated by careful social scientists. These findings are also 23 years old.

From stagnation to decline

The Chicago Lawyers I and II studies reveal stagnation taking hold within the PeopleLaw sector. Yet, more recently, we’ve moved beyond stagnation to a period of actual decline.  I do not use these words lightly. Yet this is the picture that emerges when the graphic above, which reflects U.S. Census Bureau data from 2007 and 2012, is combined with findings from Clio’s 2017 Legal Trends Report.

Clio is a cloud-based practice management and time-keeping system that has obtained enormous traction with solo and small firm lawyers. The 2017 Legal Trends Report is based on anonymized 2016 data from more than 60,000 U.S. timekeepers.

  • The total sample covers 1,026,000 matters, 10,981,000 hours, and $2.6 billion in billings.
  • Approximately 84% of matters are billed by the hour.
  • The average hourly rate for a lawyer is $260.
  • The average matter garnered slightly less than $2,500 in fees, with traffic offenses the lowest average (~$700) and personal injury the highest (~$3,300).

Yet, what is most striking about the Clio Report is that the average lawyer is billing only 2.3 hours per day.  Of that total, 82% is actually invoiced to the client; and only 86% of invoiced fees are collected. This translates into $422/day per lawyer ($260 x 2.6 x 82% x 86%), or $105,000 in gross receipts over a 50-week year. This is a sum that needs to cover office overhead, healthcare, retirement, malpractice insurance, marketing, and taxes, etc.  And note, these are averages, not the bottom decile or quartile. Further, these are lawyers at firms that have invested in practice management software.

Of the remaining 6 hours in the workday, lawyers are spending 48% of their time on administrative tasks (e.g., generating bills, configuring technology, client collections) and 33% on business development.  The report notes that lawyers spend roughly the same amount of time looking for legal work as they do performing legal work (p. 13).

The danger of not saying the obvious

In Post 006, I reported on statistics from The Landscape of Civil Litigation in State Courts report published by the National Center for State Courts (NCSC). The most startling statistic among many is that 76% of cases involve at least one party who is self-represented. The Report frankly states:

The picture of civil litigation that emerges from the Landscape dataset confirms the longstanding criticism that the civil justice system takes too long and costs too much.  As a result, many litigants with meritorious claims and defenses are effectively denied access to justice in state courts because it is not economically feasible to litigate those cases (p. v).

These are not the conclusions of a fringe group. The NCSC’s research agenda is set in collaboration with the Conference of Chief Justices and the Conference of State Court Administrators. This is the body formed at the urging of Chief Justice Warren Burger.

I’ll now state an obvious truth:  Our legal system as it pertains to ordinary people is unraveling.  Hundreds of millions of people can’t afford to hire a lawyer to solve their legal problems. As a result, they go it alone or give up altogether.  In turn, as the PeopleLaw sector shrinks, a large number of lawyers are under tremendous economic stress.  No amount of tinkering at the edges is going to fix or reverse these trends. Instead, we need a series of fundamental redesigns.

This needs to be said clearly and emphatically. This is because the collective and societal solution to the declining PeopleLaw sector is not for lawyers and legal education to pivot toward corporate clients who can still pay the freight, though this is undoubtedly the direction of drift if we fail to forcefully acknowledge the woeful imbalance of our current legal system.

Redesign or failure

As a law professor, I support innovations that make legal problem-solving more cost-effective.  Indeed, that is the purpose of Legal Evolution. See Post 001 (discussing the problem and consequences of lagging legal productivity).  In the segment of the bar that serves corporations, there is tremendous momentum building to make this happen, primarily because corporations feel an urgency to find cost-effective ways to manage the relentless rising tide of legal complexity.  This is what is driving the legal operations movement. Yet, I’m confidence that very few lawyers want to live in a society where corporate efficiency has become our primary goal. There has to be something more.

As Gillian Hadfield wrote in her recent book, Rules for a Flat World (2017), “People who feel as though the rules don’t care about them don’t care about the rules” (p. 79). The withering of the PeopleLaw sector is moving us closer to a place we don’t want to go.  We have entered a period where we are either going to redesign our legal institutions or they will fail. It’s time for lawyers and legal educators to find creative ways to restore the balance. Step one is acknowledging the magnitude of the problem.

What’s next?  See Student Capstone Presentations: Visitors Welcome (038)

lawgraduates006The ABA just released 10-months out employment data for the class of 2016.  The percentages of grads employed in full-time/long term Bar Passage Required and JD Advantage jobs is up (72.5% compared to 70.1% in 2015).  However, the total number of these jobs is down (28,029 to 26,923).

Is this good news for law schools?

Not really.  The employment percentage is up only because the number of law grads is dropping faster than the number of jobs. But both numbers — grads (supply) and jobs (demand) — are declining. A true recovery would show the opposite.

A 28% Drop in the Number of Law Grads

The graph above reveals a dramatic drop in the number of law grads.  The green bars reflect historical data.   The orange bars are projections for the next three years based on incoming 1L classes that have already enrolled. (Based on a 10-year historical average, 90.1% of entering 1Ls receive a JD three years later.)  Between 2013 and 2019, the size of graduating classes will drop 28.0%.

This may be the bottom of the trough, as the number of projected graduates is essentially identical for ’18 and ’19 (33,667 versus 33,658).  Yet, it would be mistake to assume that things are headed back to normal.  We have to go back to 1978 to find graduating classes this small.  At that time, the US population totaled 223 million.  Since then, we’ve added another 100 million people.

A population gain that large should translate into a lot more divorces, wills, contract disputes, DUIs, and personal injury claims, etc. And likely it has.  But it may be the case that a growing proportion of these legal problems cannot be cost-effectively solved by lawyers (more on this below).

The Old Era of Bad Employment Data

94percent2010USNAs the job market collapsed in ’08-’09, law schools came under intense pressure to provide higher quality employment data. At the time, the only metric collected by the ABA was employment 9 months after graduation. Yet, the definition of “employed” did not distinguish between jobs that were legal versus non-legal, or full-time versus part-time or temporary.  Because US News used this metric in its ranking formula, it became normal for schools to aggressively count all jobs regardless of quality.

In the 2010 US News rankings, the median employed-at-9-months figure was a remarkable 94.4%.  In contrast, NALP data published in the spring of 2010 showed only 82.0% of law grads obtaining either Bar Passage Required or JD Preferred jobs. Terms of use with member law schools prohibited NALP from reporting school level data. But obviously the numbers weren’t adding up.

As the job market continued to stagnate, law schools got hammered in the press and blogosphere for publishing unreliable, self-serving data.  Former students and alumni filed lawsuits against more than a dozen ABA accredited law schools alleging various theories of consumer fraud.  Industrious law students at Vanderbilt Law used the bully pulpit of the Internet to create Law School Transparency (LST) and demand that law schools release more granular information on employment. And eventually it worked.

The New Era of Data Transparency

The ABA Section on Legal Education and Admissions to the Bar responded to the public pressure by agreeing to collect, publish, and periodically audit granular information on employment outcomes. That information can now be readily downloaded from an online database.  Several other outlets now incorporate these data into online tools to improve decision making for prospective law students. See, e.g., Law School Transparency (LST), AccessLex Institute (Analytix), Educating Tomorrow’s Lawyers (ELT), Above the Law (ATL).

The chart below reflects employment outcomes (i.e., demand for new law graduates) since the ABA stepped into its new role as collector and disseminator of high-quality market information.

ABAjobs2011_16

The key takeaway is that the entry-level market for law grads remains very soft.   Of the six reporting years, 2016 had the fewest number of FTLT Bar Passage Required or JD Advantage jobs. The numbers look better when they are expressed as a percentage of total class size, as in the table below:

2011 2012 2013 2014 2015 2016
63.0% 65.7% 67.1% 71.1% 70.1% 72.5%

Yet this trend is moving up only because we are at a 40-year low in the number of law grads. See Green/Orange chart above.  Enrollments are down because entry-level employment for law grads is down.  That’s the impact of the new era of transparency.

When will law school enrollments increase?  When there is a surge in high quality employment for law grads. It’s just that simple.  Legal education now operates in a real market.

Legal Problems and Legal Productivity

I created Legal Evolution because I became convinced that the biggest problem facing the legal profession and legal education was stagnant legal productivity.  Stagnant productivity is bad because it means that solving legal problems is becoming, in a relative sense, more expensive over time.  Thus, as practical matter, fewer people and businesses can afford to hire a lawyer to solve a legal problem.  Those are the economic forces driving the green/orange chart above.

The problem of legal productivity will be recurring theme here.  But a brief, concrete illustration is especially helpful for this post, as there is a systemic breakdown occurring in the practice of law.  This is a substantial root cause of underemployed law grads, flagging starting salaries, and lower law school enrollments.

The NCSC Landscape Report

NCSC_landscapeThe illustration comes from the Landscape of Civil Litigation in State Courts, a 2015 study published by the National Center for State Courts (NCSC). The study compiled data from over 925,000 cases disposed of in state courts in ten large counties that encompass major U.S. cities (Chicago, Cleveland, Honolulu, Houston, Indianapolis, Miami, Phoenix,  Pittsburgh, and San Jose).  The sample was constructed so that it would be representative of the nation based on geography. The NCSC also wanted a mix of general and limited jurisdiction courts.

Below is Table 6, which breaks down the judgment size for the 227,812 cases that resulted in judgments exceeding $0.

Judgment amounts

Remarkably, the median judgment was for $2,441, increasing to $5,595 for matters in general jurisdiction courts. These small sums make it very difficult for lawyers to ethically serve clients and also earn a living.  Thus, perhaps it is not surprising that only 24% of cases had the benefit of attorney representation on both sides of the dispute.  Stated in the alternative, 3/4 of cases involve a party that is going it alone without a lawyer.

The Landscape report acknowledges the sharp divergence between “Justice (with a capital J)” and what actually goes on in state court. The only way to fix it, the report concludes, is through “dramatic changes in court operations … to control costs, reduce delays, and improve litigant’s experiences with the civil justice system” (p. 38).  The problem of affordable legal solutions is so big that non-lawyer entrepreneurs are engineering their business models around Rules 5.4 and 5.5 to access the market opportunity.  In the mean time, the organized bar — judges, lawyers and legal educators — wonder why our numbers are falling.

Related Post:  A Measure of Overcapacity in Legal Education (002)

What’s next?  See Units of Analysis and Adopter Types (007)

A lot. The trend is large and longstanding.  Over the last two decades, the number of lawyers working in corporations has more than tripled, growing from 34,750 in 1997 to 105,310 in 2016. The chart above shows the trendlines.

Most people working in the legal industry know that in-house legal departments have been growing, but has there been an accurate sense of the magnitude — 7.5x faster than law firms over the last 20 years?

It took a fair about of time to pull these data from the Bureau of Labor Statistics and put them into the right format to generate the above chart. Yet, the chart itself raises more questions than it answers.

  • Why are corporations in-sourcing a non-core function? During this same period, outsourcing of various business processes has been growing.  Why is legal treated differently?
  • How long into the future will this trend continue? What might curtail this trend?
  • What are the age demographics of in-house legal departments compared to law firms? Law firms are graying. Will in-house departments avoid this same problem, or will it hit over the next 5 to 15 years?

The orange “in-house line” is so far above the other two sectors that is obscures another unexpected finding.  Since the mid-2000s, government has been growing faster than law firms – what’s causing this rise?  Either the government’s been on stealth hiring binge, or law firm hiring has flattened out in a way that cannot be characterized as cyclical.

Subsequent posts will return to these questions.  Before doing that, however, I want to time build out a simple theoretical framework that we can apply to legal industry data. This framework in rooted in diffusion theory.

What’s next?  See What is the Rogers Diffusion Curve? (004)

Between 1971 and 2010, the average entering 1L class at an ABA-accredited law school was 246 students with a very narrow band of fluctuation. The high-water mark was 262 in 2010. Every year since 2012 has set a new historical low. As the chart above shows, the average has tumbled by a staggering 31%.

When I made these calculations, the decades-long stability of entering 1L class sizes grabbed my attention. Economic downturns, shifts in the legal landscape, and even the fallout of ’08 didn’t initially deter enrollment. Yet, what was changing in the background throughout this period was the total number of ABA-accredited law schools. Here is the data in ten-year increments:

  • 147 in 1971
  • 172 in 1981 (+24)
  • 176 in 1991 (+4)
  • 184 in 2001 (+8)
  • 201 in 2011. (+17)

The peak for ABA-accredited law schools was 204 in 2014, though mergers and closures have reduced the number back to 201 in 2016.

Imagine if a hotel, airline, or restaurant experienced a 31% decline in the number of paid customers.  The price competition for marketshare would be disastrous, leading to industry consolidation that would improve pricing power.  Higher education is different, however, in a way that complicates the analysis. Specifically:

  • The biggest cost-driver in higher ed is labor. Because of the extensive protections on professor tenure, most of these labor costs are fixed rather than variable costs.
  • Universities have little experience with shutdowns or reductions in force; further, such actions would likely create severe cultural turmoil.
  • Unlike in private industry, there is no well-established playbook for divesting, acquiring, and merging academic units across universities.

How does the overcapacity resolve itself?

This is conjecture on my part, but based on the analysis above, I think we will see a few more law school closures, but not nearly as many as the grim economics might suggest.  Why? Some law schools have responded to the applicant downturn by creating new non-JD programs. Law bears on virtually all realms of human activity – bringing about the opportunity to create one-year Masters degrees, which appear to have significant demand, particularly in large urban centers.  Other schools are specializing in online education. To the extent such programs are successful, they will be copied by other law schools in different regions.

Will the overcapacity be resolved by a boom in demand for legal services?

This is unlikely.  The sharp decline in law school applicants was due to extensive media and blogosphere coverage of the entry-level meltdown.  This commenced in 2010.   Markets are driven by information.  Over the last few years, the public information on the legal job market became much better.

Also, there is a strong argument to be made that the downturn in the entry level jobs is due to structural factors.  For example, we know from the data presented in Post 003 that for 20 years corporations have been moving lower-level work in-house. In most cases, the workforce has been law firm associates willing to step off partnership track. Profitability has remained high at law firms because the more complex work can’t be cost-effectively in-sourced. During the 2000s, corporate clients began exerting their market power by refusing to pay for junior associates. Not all clients applied pressure, but enough to create uncertainty and turmoil within law partnerships. The solution was to hire a lot fewer associates – something they could do because the mix of work had become more specialized and could be staffed by a mix of staff attorneys, of counsel, and non-equity partners. Because so many firms converged on this same solution, the BigLaw entry level labor market was cut in half.

If corporations are reluctant to buy associate time bundled together with skilled senior partners, the boom in demand for legal services will have to come from a different source.  I think such a demand exists, though legal education will have to retool to tap into it.  That is a topic for another day.

What’s next?  See How Much are Corporations In-Sourcing Legal Services (003)