Compensation: How to Be Fair, Yet Provocative

Vol. 31 No. 3

By

Edward Poll, JD, MBA, CMC, is one of the nation’s most sought-after experts in law practice management. The third edition of his book The Attorney & Law Firm Guide to The Business of Law was published by the ABA GPSolo Division in 2014.

Compensation, or how to divide what is left over, is one of the most difficult challenges facing any law firm management committee, whether a two-person firm or a 2,000-person firm. There are several objectives one needs to address in making the ultimate decision of division. First, the system must be fair and must be perceived to be fair. Second, the system must be provocative; in other words, the system must encourage the attainment of the goals set by the firm, whether they be hours worked, dollars collected, new clients attracted to the firm, or any other goal.

The goals of the firm may be future looking, such as providing for succession to the next generation and creating a legacy; or the goals of the firm may focus on the here and now, taking as much money from current revenue as possible.

In thinking about this subject, there are at least three levels to consider. First, we must consider the staff; second, we must consider associates and non-equity partners; third (and what should be the last in order of importance but is often put first in the thinking of equity lawyers), we will consider “what is left over” to be distributed to equity partners.

Staff

As in the case with most employment, there are several factors that both sides will look at. Obviously, the actual cash compensation must be competitive with the marketplace in the profession and specific geographic community. In many cases, the availability of benefits such as health care has also played a major role in employees’ thought process. As of this writing, with access to federal and state affordable health care, this factor will likely diminish in importance. Non-cash factors often rise to the top of the list of reasons to select employment. Factors such as reputation of the firm, camaraderie of one’s colleagues within the firm, education and learning experiences, and freedom to engage in professional association activities such as bar associations, paralegal associations, and/or legal secretaries associations all bear different weight depending on the circumstances involved. Succeeding in attracting qualified personnel is only the first step. Retaining these employees next becomes of paramount importance. To do so, one must constantly pay attention to their needs.

Listening to one firm manager, I was struck by his comment that he treats everyone in his employ as family, meaning that he knows about their family, knows when they get into trouble, and knows when and how to offer assistance. This truly is a “family” and one that will stay together for a long time. Although this may sound altruistic, it is based in economics. Turnover of personnel is one of the highest cost items in any business operation, equally true in a law firm. Many law firms, especially larger ones, could significantly increase their bottom-line profit by paying more attention to their personnel issues.

Associates

In the boom of the 1990s, many associates developed an “entitlement mentality”; they believed that a solid education, graduation from a good law school in the top of their class, and passing the jurisdiction’s bar examination entitled them to a job at a major law firm with a high compensation package. Considering the impact of recent economic events and changes in law firm finances, this mentality may be changing. Law firms, even large ones, must provide value to their clients. And they must be profitable in order to open their doors each day.

Although the new, high-priced associates may not earn more than they cost the firm in the very beginning, at some point within the first three to five years, on average, these lawyers must be profitable. The issues for law firm managers in these cases are how quickly new lawyers can learn about the culture of the law firm, and the expectations of the firm’s clients, and how quickly they can attain the technical skills of lawyering that they did not receive at law school. In fact, it is these kinds of issues that often persuade a lawyer to join this firm as opposed to that firm.

When I was a new associate with a law firm, and having come from the business world, I knew and believed in the philosophy that every employee must be a profit center for the employer in order to keep his or her job. And I did want to keep my job. I liked the people, and I was eager to learn as much as I could about the practice of law. This was a good firm, and it was a good opportunity for me. That’s why I kept track of my own “profit and loss” in order to be assured that, assuming a rational employer and no personality conflicts, this law firm would want to keep me. When the management realized that I was concerned about their well-being first and my advancement in the firm second, I was soon invited to become a partner, a dream come true.

To track their own profit and loss, associates need to know certain information and use the right numbers. They need to know their total billable hours. How many hours did they record for the month? This is clearly known to every associate. They may have to ask someone in the firm’s management how many hours were billed, in other words, how many hours were written off. On the other hand, they may need to guess at this number by asking what percentage, on average, does the firm write-down associates’ work product when it prepares its billings. Newer lawyers may be more specific by asking if there is a difference in the write-down percentage based on the “class” of the associate (first year, second year, etc.). Then, based on seniority with the firm, they can use that percentage for estimating purposes.

The more difficult part of this process is to determine the expenses attributable to the associate. For example, what is the cost of the compensation package (gross salary, profit sharing/pension plan contributions, car allowance, etc.); cost of the secretary or secretarial allowance if in a “pool” environment; cost of the physical space occupied by the lawyer and the assigned secretary; other expenses that can be called “direct expenses”? In addition to the foregoing, one must estimate the amount of office overhead, by percentage, that each associate accounts for. Overhead includes rent, insurance, utilities, entertainment, and education. In the past, a one-third ratio would suffice. However, in today’s world overhead has increased considerably, and this percentage may be higher for a particular situation.

Armed with this information, you and your associates can now come up with a personal financial formula that would look like this: Billings (of the associate) minus the associate’s total compensation (direct and indirect expenses) equals net profit. The net is the profit available resulting from an associate’s effort. This is the bottom line in determining an associate’s value to the firm.

When analyzing the value of a partner to a firm, management will frequently talk about “realization.” Realization focuses on collected billings, not just billings. In the discussion about the value of associates, I have said nothing about collections. Normally, an associate will not have any power to deal with a client directly to collect billings. Because the firm generally selects the client and sets all billing policies, the responsibility to collect the fees should belong to the firm, not the associates.

Partners

Equity partners in the Am Law Top 50 law firms recorded average profits per partner of $1.6 million in 2012. The contrast to the typical sole practitioner’s experience could not be more dramatic. According to the U.S. Bureau of Labor Statistics, the median annual wage for lawyers was $113,530. The lowest 10 percent earned less than $54,310, and the top 10 percent earned more than $187,200. The disparity is dramatic. However, in California, where I live, the numbers are even more startling. One-quarter of all lawyers earn $50,000 or less; one-half earn $100,000 or less. In Florida, half of the solo attorneys earn $80,000 or less. The earnings are comparable elsewhere in the United States.

There are, of course, various formulae for determining compensation among partners. As suggested earlier, it’s not important what formula is used, so long as all involved perceive that the process of determining that number to be fair.

In general, people will accept a great deal less than the top compensation to which they might be entitled as long as they like the colleagues with whom they work, they think the work they do is interesting, and they enjoy the clients for whom they work. In some circles, this is called a “firm culture” or “life balance” law firm.

Typically, there are two general models for compensation: “lockstep,” in which the firm’s overall success each year is averaged out to determine the standard rate of compensation increase for most lawyers at each level of experience, and “eat what you kill (EWYK),” in which all attorneys are rewarded based on how much business they personally bring in. Each of these has advantages and disadvantages, admirably summed up by attorney Bruce MacEwen and his blog on law firm economics, “Adam Smith, Esq.” (adamsmithesq.com), as follows:

  • Lockstep is good at building collaboration, client service teams, and institutionalizing clients.
  • Lockstep is bad at rewarding exceptional performers or penalizing subpar performers.
  • EWYK is good at developing new business and new markets and spurring entrepreneurship.
  • EWYK is bad at cross-selling services and promoting firm harmony.

Any firm that encourages lawyers to maximize their individual compensation may have fast near-term growth. Approaching compensation as an institution makes for greater firm harmony and longevity. The problem is that both lockstep and eat-what-you-kill systems generally depend on the same metrics: hours worked per year, origination credit, supervision credit, and other formulaic measures based on the billable hour, and that’s not where the money is.

Corporate Model

Traditional law firm compensation models overemphasize billable hours. In the largest law firms and for sole practitioners alike, collecting the money you are owed (realization) is far more important than the number of hours you bill. This lesson is hard for lawyers to grasp. Our hunger is to do the work and see the billable hours go up month by month. Yet our inventory is not billable hours; it’s the cash that those hours represent.

If the firm wants to promote the kind of cooperative effort that increases collections, it must change to a more cooperative corporate compensation model that depends on the success of the organization. Base compensation must be tied to the effectiveness of involving other firm lawyers as part of the team delivering legal services to clients. This allows for blended high and low rates on client work, which maximizes profitability and collections. The corporate model says that compensation is based on what is generated for the organization, not for any one individual.

Value-Driven Work

Firms grow based on their clients. Thus, lawyers must look for clients who have growth potential. Highly focused and “high-end” work will result in higher revenues and profits. When clients perceive the work of the firm as having high value, the firm can charge more, even a percentage of the value of the work. This shifts the billing perspective from one of time (hourly rate) to one of value. The profits are significantly higher when this is done right. It’s simple Business 101.

The corporate compensation model supports this kind of work because it reflects the approach of corporate clients. Corporate clients live in a world that favors and rewards continuous improvement. The corporate goal is not simply to cut legal costs by a stated percentage. Corporate clients are willing to pay for quality work and efficiency. The best compensation approach rewards those individuals who help the firm perform better by providing better client service and gets away from the star system that rewards only the individuals who stand out from the crowd. This reflects John F. Kennedy’s comment that a rising tide lifts all the boats in the ocean, not just one.

In the long run, neither lockstep nor eat-what-you-kill systems are healthy. Profit-based systems are the best solution because they give everyone the incentive to work for the financial health of the firm.

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