On a daily basis the legal world is flooded with news about legal tech. Not a week goes by without one or the other law firm announcing a fancy new tech initiative. Nine out of ten newsletters contains an article on legal tech and in every major city around the world there is a constant stream of seminars on the topic. Legal Tech seems to be omnipresent, no escaping possible.
All this buzz creates an uneasy sense of nervousness among law firms. We get questions from clients on this topic all the time. Typically there is the fear of losing out. An atmosphere has been created in which it seems that all other law firms are investing in legal tech and that when not keeping up with technology a law firm might go out of business. Will there still be a future for law firms that do not use fancy technology?
In this article I will take a look at legal technology from an investor perspective. So, if I had a law firm, why and when would I invest in legal technology?
What problem am I trying to solve? Time based billing has been the de facto standard in the legal world for the past decades. Notwithstanding the fact that this system is flawed it is favored by both the law firms and their clients. In a situation where clients are paying the lawyers by the hour, it is in the clear interest of the client that the process is as efficient as it can be. Lawyers should not use more time than needed.
In a way, just like all other businesses, law firms have a long track record of integrating new technology to make the workflow more efficient. A couple of decades ago there would be a small army of secretaries and typewriters that since has been replaced by MS Word. Lawyers used to dictate memos, today it will be hard to find even a partner that does not sit behind a keyboard. Incorporating this kind of office technology has immensely increased the capacity of lawyers. The work volume that can be handled in terms of output has increased. At the same time cost for secretaries (and their workspace) went down.
Today the issue is not the optimization of office procedures or workflows. The discussion is pivoting towards the output side, the legal product itself. Should we use technology to – in part – replace lawyers? In order to answer this question we need to dissect the legal product as we know it. The process of producing a legal product whether it be an agreement or a litigation, invariably consist of two components: creation and production. Creation being the fruit of the brainpower, the skills and the experience of the lawyer and production being everything that needs to be done in order to make it happen. In my new book ‘Data and Dialogue, a relationship redefined’ I will elaborate in more detail on this topic.
What we see in the market is that law firm clients are increasingly reluctant to pay a lot of money for production. This totally makes sense since the value is in the creation. We regularly hear law firms complaining that their clients only want partner time. This reflects the theory. As long as there is time based billing, law firms will be under pressure to limit the costs for production. This is exactly where potentially technology could help. It however does not necessary mean that it is sensible to heavily invest in Legal Tech.
What about return on investment?
Most of the technological progress that law firms have made through the last decades has lead to an increased capacity and a reduction of costs at the same time. From an investment perspective this is a no-brainer. Today things are fundamentally different. Investment in legal technology that replaces part of what lawyers are doing could have a strong eroding effect on profitability. Let's examine this in more detail.
Let’s assume we have a law firm and we invest 1 million in fancy legal technology. The 1 million investment will comprise of the purchase and implementation of the software. Typically there will also be annually recurring costs for software licenses, updates, trained staff, data entry and data cleaning. For the sake of simplicity we will assume only the one time fixed investment of 1 million.
The first question will be how the investment will help us make money. For this there are two options: the investment either lowers the costs of production at the present volume or the volume of work needs to increase thanks to the investment. Lowering the costs at the same volume of work would mean that we have to make some lawyers redundant. If we want to invest 1 million, make a return on investment and don’t want to fire lawyers, we need to increase the volume of work.
A method we use to calculate if an investment will be viable is through calculating the IRR. The Internal Rate of Return is a metric used in capital budgeting to estimate the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. I will not bother you with the formula as Excel will easily calculate the IRR for us:
As the table shows, in this example when investing 1 million we make a loss and when investing 500.000 we can make a profit. Please bear in mind that the (fictional) figures are based on additional profit as a direct consequence of the investment.
Assuming a profit margin of 33%, the extra revenue needed would be 3x the amount in profit. So the 350.000 extra profit in Y5 would require a growth in revenue of 750.000 in Y5 only attributed to the investment in technology. So we can only take into account the additional revenue that the firm otherwise would not have made.
The point of the article is that law firms should always look at the potential for return on investment when deciding on legal technology. At TGO Consulting we help our clients to make a realistic business plan that will provide a financial rationale before investing in legal technology. In some situations there absolutely is a strong business case to be made. More often than not, law firms invest because they believe everyone else is doing it and they fear being left behind. Many investments are made without any strategy on how to monetize the investment. In general that is not a smart move.