I often look for knowledge outside of the legal profession to help me develop strategy for our [Microsoft’] legal business. I recently came across Warren Buffett’s 1992 Berkshire Hathaway shareholder letter, and this passage on franchises vs. businesses caught my attention:
An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.
In contrast, ‘a business’ earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then, unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.
The legal profession today has many attributes of a franchise. Using Buffett’s definition: many clients need legal services; prices are market driven without direct price regulating upper limits; and although there are ‘substitutes’, regulations do impose limits in the US and most global markets on those service providers. On that last point, in Rules for a Flat World: Why Humans Invented Law and How to Reinvent It for a Complex Global Economy, Gillian Hadfield details the American Bar Association’s master stroke from the 1930s that bootstrapped the self-governing regulatory moat in the US. These regulations limit who can offer legal services to third parties and how they can construct the ownership of their businesses. An AmLaw 100 colleague recently shared the belief that competition from substitute providers in the US would continue to be limited by the regulatory moat and the constraints caused by conflicts.
But maybe not. There could be a false sense of security that underappreciates how susceptible legal services are becoming to new substitutes. Case in point: the Big Four’s move into legal services in non-US markets. The US’s regulatory moat may become increasingly porous in the coming years as competitive pressure increases. As that barrier becomes less effective and consumers of legal services are presented with more options, will it become increasingly important to run a ‘tight business’ rather than relying upon existing franchise dynamics? If so, how might law firms prepare their business for the future?
Large platform law firms should focus on the potential value of their data and legal architects for genuine differentiation. Because they serve many clients, law firms have something that corporate legal departments cannot replicate: access to more sources of diverse information. Most law firms monetise that knowledge by metering it through the productive time of the people who deliver services directly to clients. An alternate approach would be to consider what Clayton Christensen describes as customers’ ‘jobs to be done’ and examine how the firm’s information, combined with the expertise of its domain architects, can be replicated into processes and tools that do those jobs and create customer value.
Creating value using a leverage model with rapidly diminishing marginal costs is disruptive – and in some cases, anathema – to most legal services providers. But this approach can unlock a new realm of customers. It can also scale to meet demand that extends far beyond the productive waking hours of your experts and offers a potential self-reinforcing benefit. If you can drive more consumption of your solution, the data that enters your platform can create a value-based moat built upon that superior data volume. Your system is smarter and attracts more data that keeps making it smarter. Starting the flywheel can create an advantage that requires competitors to innovate to compete on value. Superior value that causes customers to believe there is no close substitute starts to sound like a franchise again.
One other part of Mr. Buffett’s letter is interesting. In the Mistake Du Jour section, he focused on the potential cost of inaction: ‘the approximate gain that Berkshire didn’t make because of your chairman’s mistake: about $1.4bn.’ The biggest risk when investing is losing your investment. But the biggest risk of not investing is all the potential upside, which can be orders of magnitude greater. Too often, lawyers fixate only on the downside risk. It is how we are trained, and it is an important part of our job. But, if we are going to think and behave like business owners, rather than franchise owners, we need to think differently about investment and risk. This can help us overcome the classic Innovator’s Dilemma traps that await us if we fail to adapt and innovate.
I look forward to sharing more of our journey.
Jason Barnwell is assistant GC, law firm engagement strategy and legal operations at Microsoft