The billable hour has been the foundation supporting law firm business models and the yardstick by which attorneys have been evaluated and compensated for more than six decades.

Meanwhile, as the demand for legal services has increased, so has hourly rates. And because clients continue to pay them, there has been no real incentive on the law firm side to change the practice or explore alternative fee agreements (AFAs).

That’s been changing, though, since the economic recession of 2008 made AFAs less of a novelty and more of a necessity as general counsel increasingly seek competitive fees and cost certainty.

Even so, AFAs haven’t seen the kind of rapid growth that some expected. Even throughout the COVID pandemic and economic downturn in 2021, CounselLink data shows that less than 15% of legal matters incorporated some form of AFA, up from 12% in 2013, and only 9.6% of all fees were non-hourly.

CounselLink defines an AFA as a billing arrangement that is non-hourly in nature, so AFAs do not include matters with volume or other discounts or arrangements such as blended hourly rates where a single rate has been negotiated that is billed by all timekeepers on a matter.

The obstacles to overcome

So why aren’t clients demanding more AFAs?

The primary obstacle is comfort with the status quo. Even though many in-house counsel ask for alternative pricing as part of their RFP process, they typically fall back on the billable hour as the mechanism to which they are most accustomed.

A related obstacle is the perception that neither in-house nor outside counsel have the data and metrics to evaluate whether a price is reasonable. In fact, most law firms and legal departments have a goldmine of data they could use to evaluate pricing.

Law firm billing system data from enterprise legal management platforms can be mined to compare and break down matter costs in a myriad of ways.

Meanwhile, legal departments that have enterprise legal management solutions in place have access to similar data provided to them by a multitude of law firms.

A lack of data is not a valid excuse. A more viable one is that some organizations may not have the analytic skills on staff to perform the necessary data mining and interpretation.

Clearly there is room for improvement, but what can law firms and their clients do to find common ground and implement more AFAs?

Achieving alignment

Although corporate legal departments should always drive the AFA conversation, law firms should proactively approach clients with options for innovative fee structures.

Investing the time and focus required to build a mutually beneficial AFA ensures that corporate clients and outside counsel achieve their objectives without introducing unnecessary complications.

Corporate law departments can use data from an enterprise legal management (ELM) to analyze total outside counsel spend, negotiate fees, establish spending thresholds and identify areas where AFAs (or implementation of other legal efficiency tools, such as contract lifecycle management) could deliver value.

Comparing internal performance data and external benchmarks against law firm performance data ensures that all parties remain on the same page and fosters greater transparency, communication and collaboration.

To remain competitive over time, legal service providers will have no choice but to offer a range of client friendly AFAs because that’s what clients are unambiguously demanding. Those that fail to invest in the technology required to perform the analysis needed to evaluate scenarios will struggle in the long term.

The over-arching consideration for any AFA involves determining what outcome the client wants and fashioning a fee structure that maps to that outcome while preserving profitability and mitigating undue business risk.

Types of arrangements

If a company hires a firm to manage patents — which is usually a routine, high-volume matter — they might consider a flat-fee arrangement to curtail costs.

In this case, the client benefits from predictability because there are no expense overruns. The law firm benefits from predictability of revenue, and unbeholden to the billable hour, is incentivized to work as efficiently as possible to maximize profitability.

Capped fee arrangements involve an hourly billing arrangement with a limit on the total amount that will be paid. While a capped fee structure can be applied to an entire matter, it can also be applied to a subset where there is a limit as to what will be paid for specific activities.

Legal service providers often use a capped fee structure when there isn’t enough data or certainty to have confidence in using a fixed fee.

Collared fee structures reflect a variation of capped fee arrangements where clients receive a deep discount for work performed beyond a predetermined limit.

A collared fee arrangement may lead to some cost savings for the corporate customer and provide some limited incentive for a firm to be efficient. Such fee structures often require greater administration and oversight, which can offset some of the benefits.

In some litigation cases, a company might tie compensation to the outcome of the case. Such contingency fees are paid only if the lawsuit is successful, with a fixed percentage of the recovery negotiated beforehand.

If the lawsuit is unsuccessful, the client is not obligated to pay anything. Such contingency arrangements are examples of AFAs that do not equitably share the risk but can be equally beneficial when successful.

A variation of the contingency structure, the holdback fee arrangement is most often used for complex litigation.

In this case, companies pay law firms a percentage of their invoices upon completion of a matter or stage, and then typically award an additional payout if the litigation is successful. In either case, the legal service provider assumes the risk.

Building the infrastructure

Because building and managing AFAs introduces a new set of variables and parameters, careful planning is essential, particularly with respect to process, technology, and analytics.

For example, when you’re building an agreement, be mindful of the impact on time-consuming manual processes and make sure that administrative staff understand their role in servicing a novel fee arrangement.

Further, your technology needs to support easy invoicing for AFAs, and the client organization must be able to process them using their systems. Your fee structures should be designed with data collection in mind — without this measurement, you won’t be able to assess the viability and profitability of matters operating under AFAs.

The slowly increasing use of AFAs over the years shows a growing appetite by corporate counsel for such arrangements, and a willingness by law firms to provide them.

Since law firm billing rate increases show no signs of slowing, we can expect to see an uptick in AFAs in 2023 and beyond.

The key to increasing AFA use is for both in-house counsel and outside counsel to understand the needs of the other party and to structure billing arrangements that are easy to administer and supported by data-driven insights.

Doing so will enable both sides to see AFAs as a win-win scenario and could lead to more mutually beneficial and longer-lasting relationships.