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Making Partner

It's Up or Out No More as Alternatives Shake up the Traditional Partnership Model


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Business

Profitability

Looking Partnership in the Mouth: How to Examine the Underlying Metrics

by David Bilinsky & Laura Calloway

In his great poem Hudibras Samuel Butler wrote, "He ne'er consider'd it as loth, to look a gift-horse in the mouth." The same would be wise policy for any lawyer considering signing on as a new partner in a "highly profitable" firm. When something looks too good to be true, it often is.

When it comes to indicia of profitability, some law firms like to brag, although they would never willingly refer to it as such. They tout financial metrics for comparison purposes to show that their firm has left the competition in the dust. But are they really performing as well as the numbers seem to indicate? How each metric is calculated, and even which ones are used, can tell the real story. Among other factors, organizations such as AmLaw typically use three metrics when ranking firms: profits per partner (PPP), gross revenue per lawyer and average compensation of all partners (ACP). In A Guide to Our Methodology the American Lawyer (compiler of the AmLaw 100 and 200) defines these three metrics as follows:
Profits per partner is calculated by dividing a firm's net operating income by the number of the firm's equity partners. Revenue per lawyer is calculated by dividing the gross revenue by the number of lawyers.
Average compensation of all partners is calculated by adding the firm's net operating income to the compensation paid to nonequity partners and then dividing that sum by the number of equity and nonequity partners.

The dirty little secret, though, is that because these three metrics all rest on several variables, they can each be manipulated—particularly the holy grail of them all, profits per partner.

Profits per Partner

A lawyer joining a firm as a partner obviously wants the firm to have a high PPP. But who, exactly, is a partner for purposes of this calculation? In arriving at PPP, firms can take steps to remove partners as equity-sharing partners or can create nonequity tiers for junior partners to improve the numbers. If one firm has only equity partners and another has tiers of equity and nonequity partners, then comparing the PPP of the two is like comparing apples and oranges.

The American Lawyer says: "Our figures reflect profits among equity partners only: net operating income after deducting compensation for nonequity partners." Still, notwithstanding AmLaw's best attempts at "getting at the right numbers," there are many ways to ensure that firm rankings in the AmLaw 100 or 200 remain high.

Here is an example. Let's say the firm of Weare Richer & Yu has 11 lawyers. In a given year, 10 of this firm's lawyers each bill $500,000. The 11th lawyer bills $330,000. Total billings are $5,330,000. If we assume operating expenses of $2,000,000 (exclusive of any salary or draws to lawyers), net income is $3,330,000.

Let's assume that all 11 lawyers are partners. The firm's PPP is:

$3,330,000 ÷ 11 = $302,727.27

But now let's assume that of the firm's 11 lawyers, 10 are partners and 1 is an associate, and the associate is paid $150,000. PPP is then:

($3,330,000 – $150,000) ÷ 10 = $318,000.00

The underlying profitability of the business has not changed, but the PPP certainly has. This is a relatively minor adjustment, yet it has a noticeable effect on PPP.

As you can see, firms can influence the numbers by how they classify their lawyers among equity partners, nonequity partners and associates, often encouraging lawyers to join the nonequity partner ranks rather than become full equity partners—which, thus, enables the firm to preserve a high PPP.

Gross Revenue per Lawyer

If you have been following this column regularly (and we know you have), you are aware that we try to encourage less thinking about revenues and more concentration on profitability (income less expenses). In that vein, gross revenue per lawyer is an easy way for a firm to puff up like a peacock—without showing the true financial state of affairs. Here's how it works.

Let's take our hypothetical firm Weare Richer & Yu again. We already know that the total billings for the year under consideration are $5,330,000 and that there are 11 lawyers in the firm.

The firm's gross revenue per lawyer is calculated as:

$5,330,000 ÷ 11 = $484,545.45

In this example, though, let's assume that instead of the $2,000,000 in operating expenses cited in our earlier scenario, the firm's expenses are $4,000,000 this year. (They just completed an unsuccessful contingency matter that ate up lots of lawyer time and expenses.)
The firm's profits in this situation are then:

$5,330,000 – 4,000,000 = $1,330,000

So assuming that the profits are shared equally, each lawyer receives only:

$1,330,000 ÷ 11 = $120,909.09

Hardly an earth-shattering amount and a far cry from the reported gross revenues per lawyer. Accordingly, any metric that is based on revenue (and not net profit) per lawyer should be viewed with a grain of salt. Often, such metrics will not accurately reflect the true state of the firm's financial health.

Average Compensation of All Partners

Now let's turn to ACP. As we know, this metric is derived by taking the net operating income (NOI) plus compensation to nonequity partners and dividing it by the number of equity and nonequity partners.

The first thing to note is that because law firms are not publicly traded, there is no resource that lists the NOI of different firms calculated according to standard accounting methods (known in the trade as generally accepted accounting principles, or GAAP). Second; assuming that law firms accurately report their NOI, that NOI may vary according to the approach that a firm takes with respect to expenses.

For example, one firm may be quite strict and not allow any ostensibly personal expenses (entertainment, bar activities, political contributions and the like) to be run through the firm's accounts. Another firm, however, may allow its partners great latitude in paying all sorts of expenses with firm funds. The income statements of two given firms may also be quite different if one uses the accrual system and the other operates on the cash system.

In addition, there may be inconsistencies introduced based on how a firm handles the retirement obligations owed to the older partners. Some firms may be transferring funds out of income to create a retirement fund, while others are simply treating these obligations as unfunded liabilities that they hope to be able to meet from current income when the obligations actually fall due.

Yet another variation would result from the firm's approach toward compensation. Some firms keep back funds to reinvest as capital to fuel future firm growth. Others treat income as a flow-through and seek to strip out every cent earned in any given year for partner compensation. This will obviously distort the average compensation per partner.

Lastly, the distinction between nonequity partners and associates again comes into play. A firm that does not believe in tiered partnership status and has only full partners will have a very different ACP profile than one that implements a multitiered partnership structure.

A New Metric: Value per Lawyer

As if all the potential variations involved in calculating the preceding metrics weren't enough, newly added to the AmLaw 100 and 200 rankings is another metric: value per lawyer.

This metric is calculated by taking the compensation paid to all partners and dividing it by the total number of lawyers in the firm. Suffice it to say this—by now you can see how several variables will affect the value per lawyer calculation:

  • How a firm treats expenses (as in, one firm may take a liberal view toward running personal expenses through the firm's accounts, while another may be much more disciplined)
  • The firm's views on capitalization versus compensation
  • The firm's approach to the partnership structure

The Underlying Message

If you are thinking of joining the partnership ranks at a firm, particularly a very large one, you need to look at more than just PPP, gross revenue per lawyer or ACP. You want to closely examine the firm's income statement, balance sheet and statement of changes in financial position, too.

You should also determine how the figures are calculated and examine the assumptions under which income and expenses are calculated. You should be looking at the firm's capitalization to see if you will be called on to provide an infusion of capital at some time in the future, particularly if any large contingency-fee cases do not go as planned. Another consideration is how much debt the firm is carrying and what its future obligations will be, particularly unfunded retirement obligations to current partners. (And don't forget that those of us in the baby boomer generation will be looking at retirement in the next few years.)

Other key considerations: What is the overall revenue and expense side of the business and what would happen to it if a few key rainmakers left the firm? What would it take to be paid more at the firm? Do some scenario planning to determine the profitability, or potential lack thereof, of the partnership under different economic situations.

You should also take a look at matter leverage per file. It's calculated by taking the total hours the lead partner works on a matter and dividing that number by all the hours worked by all lawyers assigned to the file. This produces a leverage index that will let you see which partners push down work to associates and which do not. The matter leverage index should be less than 0.5—which means the partners leverage more work downward than they perform themselves. As we know, leverage greatly affects profitability.

In sum, when it comes time to examine PPP figures and other reported metrics; remember that all may not be as it seems and that much deeper (and rigorous) financial analysis should be undertaken by any associate who is considering joining a partnership.

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