Leadership and innovation – Profession, disrupt thyself?

‘The picture… is truly that of an innovator’s dilemma: the logical competent decisions of management that are critical to the success of their companies are also the reasons why they lose their positions of leadership.’
Clayton Christensen, The Innovator’s Dilemma

Even if you haven’t heard of it, and if you are a managing partner of a sizeable law firm the chances are that you have, the book The Innovator’s Dilemma has had an influence on your profession and the context in which law firm leaders run their businesses.

That influence took some time to be felt within the profession – ten years after it was first published in 1997, it had helped to shape ideas around business in a fast-changing, globalising world thanks to the original dotcom boom and bust, and the rise of the internet and social media. The book by Harvard Business School professor Clayton Christensen had by this stage become one of the most pervasive and influential business texts of the last 20 years, making its mark on wider culture.

Yet its relevance to law became evident largely after the 2008 banking crisis, as the unprecedented squeeze on the profession, combined with the liberalising agenda of the Legal Services Act in the UK, raised the spectre that this most traditional of industries was facing arguably its first genuine existential challenge.

And even if you are unfamiliar with The Innovator’s Dilemma, few will be ignorant of the phrase it popularised, one that became shorthand for the challenge of adapting to a world of frenetic change: disruptive innovation.

Disruption – in some regards an update of Austrian economist Joseph Schumpeter’s notion of creative destruction for a more connected and uncertain age – is now invoked and celebrated in many circles, particularly in tech-driven industries.

For law, such predictions are particularly striking because the mounting chorus predicting an unstoppable wave of alternative law providers challenging incumbents find such resonance in Christensen’s work. It’s hardly a stretch to see how an elitist, high-margin industry that has resisted change is ripe for the shake-up the book forecasts.

Such ideas have attracted a few detractors – Christensen’s work was subject to a widely-read (though somewhat unsatisfactory) critique in a New Yorker cover feature earlier this year. However, in many regards his ideas have only gained currency.

As part of our Insight focus on leadership and innovation, Legal Business decided to assess the book in detail to gauge if it really has significant lessons for at-the-coal-face commercial lawyers or can be dismissed as the latest in a long line of corporate fads.

The model

Judging the relevance of The Innovator’s Dilemma to law requires an outline of Christensen’s ideas. The core notion is that innovation, product development or technical advancement can be divided into two forms:

• Sustaining technology or innovation – these are incremental improvements in products or service that support and renew an established business model and product line and will appeal to core customers of a firm. The book argues that industry leaders excel at such innovation.
• Disruptive technology or innovation – an advance typically using existing technology with lower performance than used by industry leaders, but achieving other advantages that appeal to an emerging customer base. Such technology will typically operate with lower margins than the mature market and colonise small groups of early adopters before going mainstream and rapidly disrupting market leaders as their core clients switch. Such innovation, typically deploying new business models, is the natural territory of small start-ups, whose economics, culture and incentives work with low-cost products.

There are many nuances based on examples Christensen draws from industries, including disk drive manufacturing, steel production, general retailing, motorcycle manufacturing and construction engineering.

In general, Christensen argues there are a host of forces that make large institutions ill-suited to even identifying disruptive innovation, let alone deploying it successfully, including, of course, the fear of cannibalising their own businesses.

Indeed, often invoked is Mahatma Gandhi’s famous quote to illustrate the misplaced complacency of leaders in the face of unconventional challenges that they cannot understand: ‘First they ignore you, then they laugh at you, then they fight you, then you win.’

There is a particular twist to Christensen’s model: he asserts that hitherto successful companies stumble, not despite being well managed, but because the process of conventional good management is the very thing that makes them fail to adapt.

The reasons larger firms struggle include:

• Need for size – larger companies are strongly incentivised to secure sustainable growth, but initially small, emerging markets do not satisfy the need for growth of large companies and are disregarded.
• Resource allocation – successful companies develop processes to direct resources towards products that core customers already want. This strangles disruptive projects that fail to win support inside a company as few internally back such ventures or believe they can further their careers.
• Cost base and the drive upmarket – upmarket products usually require expensive infrastructure and the continual pressure to move upmarket means large companies can struggle to retaliate when attacked from below by lower-cost rivals. Even the attempt to move upmarket can backfire as leaders cede too much strategically useful ground to challenger brands. Conversely, smaller challengers are free to attack larger incumbents as the upmarket climb bolsters rather than weakens their profitability.
• New markets cannot be predicted – while forecasts used by major companies to plan for sustaining technologies provide effective strategic guidance, the inability to predict emerging markets means large companies struggle to respond. Christensen argues small challengers are ready to deploy low-cost experimentation and trial-and-error until they find the right formula, rather than wrongly assuming their initial plan is correct.

A broader way to understand Christensen’s theories is the idea that successful companies are adapted in their resources, staff and processes for an ecosystem defined by their clients and current market dynamics, including costs of input and threats from rivals. This is described in the book as a ‘value network’ – the context in which a firm tries to service clients or customers, solves problems, strives for profit and reacts to competitors.

Very loosely, the argument runs that having adapted effectively to one ‘value network’, major companies struggle hugely to adjust to major shifts in technology or market dynamics that upset the ecology on which they have spent years evolving to thrive in.

The classic example is successful makers of mainframe computers that missed the emergence of personal computers because institutional clients weren’t interested in machines with lower performance.

The case for disruption in law

It hardly takes a huge stretch of imagination to see how Christensen’s narrative can apply to law. The legal profession has evolved to operate on high margins serving institutional clients – nominally between 30%-50% at many firms (though arguably the real figures are more like 15%-30% once accounting for the effective ‘salary’ element of remuneration for equity partners).

In striving to maximise profit per equity partner over the last 25 years, the upper reaches of the profession have deliberately moved upmarket, shed lower-value practices and vacated sizeable sections of the legal economy, while pushing billing rates as high as the market would bear. The profession has, of course, also operated on a model of hourly billing with clear incentives against efficiency. In addition, the limits of the partnership model, and the quirks of full distribution of profits on an annual basis, make it difficult for law firms to stomach large investment in technology and infrastructure or non-legal staff over the medium or long term that would be required to build alternative models of providing legal services.

There is a particular element to partnership that illustrates another point that Christensen makes about the vulnerability of industry leaders – they are prevented from pursuing disruptive innovation because they are engaged in fierce competition with comparable rivals. In law the implication is obvious: top firms are limited in scope to push through aggressive innovation for fear of aggravating their key partners, who could be quickly lured away by arch rivals operating without such distractions or short-term profit dilution.

The clear danger for law firms is, even if management accept the need for a long-term strategic evolution beyond the status quo and partnership, managing partners are heavily constrained by the imperative to avoid sustaining medium-term damage if key stakeholders don’t accept the strategy.

This is not theoretical – anyone who deals regularly with managing partners knows that they spend huge amounts of time trying to cajole their partnerships and often put off initiatives they believe make sense for fear of losing personal support, key partners or both.

As such there is much to support the likelihood that true disruptive innovation will emerge from outside of a conventional partnership. Indeed, there is already considerable evidence to demonstrate that alternative providers, such as Axiom, Lawyers On Demand, Riverview Law or the widening array of ABS-backed businesses and outsourcing firms are currently attacking a market left open by the restrictions and thirst for margin inherent in partnership at leading law firms.

Such providers conform to another of Christensen’s maxims: that, over time, product performance in competitive environments will exceed market demands, shifting customers’ focus to considerations other than functionality to areas such as convenience and value.

In law the idea is that New Law outfits will initially provide services that are good enough rather than the Rolls-Royce service of a law firm. And more threateningly, Christensen’s theory suggests such outfits will likely improve quality and move upmarket from their beachhead, further attacking the core market of law firms.

There is already anecdotal evidence that a significant number of early-adopting major clients are becoming comfortable with such providers – among them BT, Vodafone, Carillion and a widespread embrace of legal offshoring by major banking clients.

An additional factor may prove ultimately as significant in supporting disruption in law – the huge expansion of in-house legal teams over the last 20 years in the UK has given blue-chip buyers more capability to break up work, further de-mystifying the process, and leading in-house counsel to retain more work internally. The long-term implication is that law firms can be pushed down the value chain, making their premium harder to sustain and weakening their defences against alternative providers.

The case against

What is striking about Christensen’s model when applied to law is that it falls into one of two camps: it is either a startlingly precise match or it does not fit at all. So despite all the aforementioned reasons that The Innovator’s Dilemma appears a grimly worrying forecast for traditional partnerships, in some respects the model is an awkward match.

The primary reason is obvious: despite some coverage of retailing, the book is primarily focused on the sale and manufacture of scalable products, not services. It has already been widely noted that services are more resistant to wrenching shifts in technology than the delivery and distribution of products.

The non-discretionary or utility element of legal services – buyers don’t desire legal services, they are forced to buy them as a by-product of doing business – also brings in another dimension not directly addressed in the book, suggesting as it does an inelasticity of demand in comparison to truly discretionary spending.

A related issue with the book’s focus on products and services is that it is dealing with markets with a blurry distinction between what smaller and retail customers want and what institutional buyers covet.

This is relevant because in some of the book’s case studies, institutional clients resist disruptive innovation only for such products to find a toe-hold in the retail market before going mainstream.

Commercial law largely works on a different dynamic in that legal firms generally focus exclusively on the institutional market, with minimal cross-over with retail services. This separation arguably will make it harder – though certainly not impossible – for innovation in retail-focused legal services to cross the divide.

A related issue keeping the divide in place is that companies buying legal services involves professionals spending other people’s money – cutting the incentive to save costs, given that legal fees are a relatively small proportion of company spending, while legal risks are potentially explosive and with personal consequences for GCs and executives.

This doesn’t preclude the possibility of a major breakthrough for a disruptive provider in high-street law having an impact in the institutional market – a similar phenomenon happened in mobile communication where impressed users of iPhones forced companies from their reliance on BlackBerrys within several years – but it would likely slow the pace.

By the same token, trying to apply disruptive innovation to professional services has some complications regarding the book’s description of product lifecycle: the idea that improving the quality of a product will rapidly sate market demand for the primary selling point, leading to other factors becoming prized and the natural ‘death’ of a product as a replacement emerges.

It is not that there isn’t a product life cycle in law; new law is cutting edge until it becomes well established and commoditised, but the fragmented nature of how law is developed, and the frenetic levels of new legislation and regulation, are powerful factors keeping law ‘up-to-date’ and blunting the dramatic shifts that can be seen as technology and fashion push scalable products from high demand to passé.

If law is an industry in decline, the numbers don’t show it yet, though since 2008 there is some statistical evidence in Europe that market share for top firms has been eroded in favour of mid-tier providers.

What cannot be doubted is that Christensen is attempting to address a real phenomenon – a wealth of credible academic and economic research demonstrates the mystifying inability of industry leaders to cope with dislocating market shifts and that large firms are surprisingly ineffective at innovation (organisational rigidity is the most commonly accepted culprit for this). Nevertheless, the highly prescriptive model put forward in the book can be hard to apply to messy facts.

Even taking the central idea of sustaining innovation versus its disruptive counterpart is problematic in that in some cases a product or model may have some aspects of both without fitting into one clear camp.

Take legal process outsourcing (LPO), which fits some characteristics of disruptive technology, but fails a major test in that it has been most enthusiastically adopted by law firms’ current plc customers, not a rag-tag of early adopters, and has been deployed by law firms themselves.

In addition, law firms have been playing around with process-driven, commoditised divisions outside the traditional partnership model since the early 1990s in conveyancing, debt recovery and personal injury, without such innovations sweeping the market.

It should also be noted that New Law providers have often been coy in backing up the hype with hard financials. Indeed, some figures that have emerged have contradicted the sales pitch of dramatic growth. For all the talk of disruption in law over the last five years – even identifying an operation that clearly fits the tag remains challenging.

A genuine dilemma

The Innovator’s Dilemma is unquestionably a significant piece of work with coherent arguments to make about why successful companies fail to adapt at key inflexion points. With global law facing the closest it has come to such an inflexion, it is a worthwhile read for leaders trying to understand a shifting market.

The book inevitably has its limitations, which have been amplified as tech evangelists and a whole disruption bandwagon it helped to create took up its cause. Christensen himself has decried some of the attempts to co-opt his model and stressed that his original ideas were a work in progress and have been developed since its publication, including in his books The Innovator’s Solution and Disrupting Class.

A key point to remember is that the forces the book describes, though present in most or all industries, vary enormously in intensity and frequency. In some industries such upheaval appears near overwhelming and constant; in others it has been barely evident or only manifested on a generational basis. If the technologist’s mantra is that the future is already here, but not evenly distributed, the same can be said for disruption.

It is possible to imagine such forces laying waste to traditional law firms over the next 20 years – it is also possible that such forces will prove largely cosmetic. The best guess on current evidence is that something in between will manifest, though that guess is not worth much. The facts and data in legal services so far do not settle the argument one way or the other and anyone telling you that they do is selling you something.

It may also be that The Innovator’s Dilemma is more accurate in describing the sale of products and industries based more centrally around technology than it is for quasi-utilities or professional services. That level of uncertainty should give some pause for thought in applying its maxims.

Nevertheless, the issues raised by the book are uncomfortable enough, and have already seen enough apparent manifestations in the legal industry, that it would be a rash managing partner who disregards the risk that dramatic, industry-defining change is finally on the horizon.

The areas in which Christensen’s work cuts closest to the bone when applied to law appear in how established institutions channel resources towards their current business and away from new markets, and the extent to which defined processes are the enemy of adaptation. The herd-like and clubby mentality of law firms that makes them excel at refining their model – sustaining innovation if you will – is poorly suited to wrenching change, to say nothing of the risk-averse personality of the typical lawyer.

The sometimes destructive combination of the full-distribution profit model and the emergence of a partner transfer market for law firms also speaks to a genuine vulnerability of global law firms: they are clearly constrained in their ability to make long-term investments on one hand, while pushing their economics towards high-margin structures that allow a dangerous amount of strategic space for New Law incumbents to occupy profitably.

There are also two salient recommendations Christensen puts forward for how leaders can attempt to handle disruptive innovation. The first is in setting up smaller semi-autonomous units in which staff can be properly focused on smaller, emerging markets with more freedom from the parent firm.

This sidesteps the resource allocation problem and creates a smaller division in which teams can get excited about small initial wins. This has already been demonstrated to have some relevance in law with Berwin Leighton Paisner’s successful and much-copied launch of the contract lawyer business Lawyers On Demand (LOD). Allen & Overy (A&O) has, likewise, sought to motivate new division with local profit centres and separate brands, including with its launch last year of its LOD equivalent, Peerpoint. The last five years have seen the idea of the separately branded division rapidly gain favour. As significant has been the grafting on of LPO-style low-cost centres to handle volume work, seen at firms including A&O, Ashurst and Herbert Smith Freehills.

Apply the book’s thinking and law firms may ultimately find success by partnering with New Law providers in joint ventures or themselves acquiring them (this is where law firms will feel their capital constraints).

Christensen also advises market leaders to shift towards a much looser, adaptive approach when trying ventures in an emerging market that accepts a low chance that the original model and forecast will be accurate given the lack of relevant data.

Instead, the model relies on conserving capital and making a number of low-cost bets that can be rapidly adjusted through trial and error before settling on the right formula. There has been less progress in this regard – just as there is little sign of formal research and development teams in law – but some firms have edged towards experimentation.

Still, it has to be acknowledged that the profession in the UK at least has moved on substantially over the last ten years in terms of experimenting with new models.

The UK profession – already at the forefront globally in terms of such progressive thinking – appears to have further widened the gap between itself and the rest of the world to become the unchallenged global capital for legal service innovation.

What has become almost mainstream over the last five years is the idea that a traditional law firm may only be at the core of service provision and will increasingly be supported by an array of wider divisions working on different models.

The Innovator’s Dilemma is not without its limitations, but the book stands up on closer examination and has played a notable part in fostering a more progressive view in the law. This willingness to contemplate its own potential downfall will stand the profession in good stead for years to come.

alex.novarese@legalease.co.uk

For the full Insight report, please see: ‘The partnership dilemma’ in Legal Business.