As an MD at a private equity firm, I obsessed over getting the incentives right for our investments. Now that I’m running PartnerVine, I help law firms sell their own Legal Tech, and I get to consider the incentive structure for law firms doing Legal Tech often. The incentives are wrong at many firms: law firms produce annual income for their partners; Legal Tech targets capital gains. I think that's a major reason law firms don't innovate.
As an example, last December I was speaking to the decision-maker of a Global 100 law firm about joining PartnerVine. When he asked me how he should convince his partners, I didn’t have a good answer. I told him that partners are incentivized to maximize annual income, and that is the wrong incentive for Legal Tech. I told him that the best way forward for a law firm is either a skunkworks or consolidated decision-making authority. That was a deal breaker. He was facing a partnership committee, and I was telling him he should move forward against the interest of his partners. As I said, I didn’t have a good answer.
I gave it some more thought, and here's what I think is a better answer.
While disruptive tech may be a good strategy for a partnership, it’s a bad strategy for any one partner. If a law firm does tech successfully, there are a few results that are against the interests of each of the partners making the decision to pursue Legal Tech:
- The investment period required for tech means that one set of partners makes the investment but another set of partners gets the revenue. That’s a fundamental mismatch of benefits and burdens, particularly if you ask for an investment from partners that are uncertain if their billing pyramid will be as big in the future as it is today—there are always plenty of those.
- If technology is successful it shifts the value drivers of the business from services to products. For a partner, that means value moves away from that partner’s provision of services towards the partnership as the owner of the product. As a result, that partner has less control over his or her share of the value of the business.
- Finally, the core of any law firm partnership is the incentive to maximize annual revenue, and that does not match the investment period required for Legal Tech. Law firms have endless versions of how they put together that incentive to maximize annual revenue, but the key element of a partner’s share of profits is the annual review of the partner’s billing pyramid. When you’re investing in disruptive technology that slims that pyramid, that’s the wrong incentive.
Since many law firms have people making decisions for Legal Tech that have the wrong incentives, many law firms just don't make decisions. It's the Innovator's Dilemma, but worse because most law firms make decisions by committee.
Law firm partnerships need to get the incentives right to be successful at Legal Tech. The proposal here is to treat investments in disruptive tech differently so that the benefits for partners match the burdens. Here are the key elements:
- Ownership. You can’t ask partners to make a long-term investment in disruptive technology if their share of the rewards is based on their billing pyramid at some uncertain date in the future. Partners that make the investment should have a clear stake in the rewards, unrelated to their billing pyramid. As with other business ventures, there should be equity and sweat equity, as further described below. I’ll call this vehicle the “Legaltech Project”.
- Control. You also can’t ask partners to make a long-term investment if they don’t have control. We suggest that the equity owners of the Legaltech Project have control of the project unrelated to their billing pyramid. As with other businesses, the equity owners would determine the terms for the issuance of new equity, preferably on an annual basis.
- Services Agreement. Now that there’s a sub-group of partners investing in the Legaltech Project, there should be a Services Agreement to incentivize all partners in the firm to work for the Legaltech Project. The Services Agreement would cover the terms of compensation for employees and partners working on the Legaltech Project. For partners, the terms of any sweat equity and discount to external billables would be set annually by the equity owners of the Legaltech Project.
- Voluntary Investment. Since ownership and control have been separated from the main partnership, law firms can consider making the investment in the Legaltech Project voluntary, particularly if pursuing Legal Tech is held back by a sub-set of partners.
There's plenty to unpack there, but that's the way I'd convince my partners. The worst outcome for a law firm is no action, and an important part of treating the Legaltech Project separately from the main partnership is to enable decision-making. It is also a better way to match the risks and rewards for law firms pursuing Legal Tech.
On tax structuring. There are many forms the Legaltech Project could take as a tax matter—either as a special profit-and-loss sharing arrangement within the partnership, as a separate partnership or as a separate company. Tax considerations should drive the discussion of form. My colleague Paul Millen has written an interesting article on one of the new tax incentives for Legal Tech under the 2017 Tax Cuts and Jobs Act called US Tax and Law Firm Legal Tech.
On when to invest in this type of structuring. We think there are only a few tech opportunities that threaten to disrupt the business of a law firm, including platforms and proprietary technology in AI/machine learning. That is where law firms really need to overcome the mismatch of incentives discussed here. For more on this topic, see Law Firm Strategies for Legal Tech.
On consolidated decision-making for Legal Tech. We have also written about law firm decision making for Legal Tech here: Law Firm Strategy: Decision Making for Tech.
Disclaimer: You should not interpret the statements in this communication to be tax or legal advice. This communication is for discussion purposes only and you may not rely on the statements in this communication for any purpose.