September 01, 2020 The Finance Issue

I Guarantee It! The Role of Guaranteed Compensation in Lateral Hires

Some law firms will find opportunity in this economic downturn to more effectively compete going forward.

Natasha Innocenti
A red ribbon is sealed with a red wax number three.

A red ribbon is sealed with a red wax number three.

via Gerenme / iStock / Getty Images Plus

Many aspects of our personal and professional lives are different due to the economic impacts of the COVID-19 pandemic. In economic crises of the past, law firm recruiters prepared themselves for an expected related downturn in recruiting; however, while recruiting slowed down, savvy firms (with cash) used transitions to buy and to build.

This crisis is different. For one, firms serving Big Tech in the Bay Area can no longer fly in to meet clients. And we have already seen both a flight to quality and a race to take market share in the San Francisco Bay Area and Silicon Valley.

Nowhere is the competition tougher for law firms than in the fast-paced, youth-obsessed, yet provincial in its own way Silicon Valley and San Francisco Bay Area. Davis Polk opened its Silicon Valley office in 1999, just as the internet bust began. Kirkland & Ellis opened its San Francisco office shortly after, in 2002. Jones Day opened an office in San Francisco in 2003 and Ropes & Gray did the same in 2003, just as the economy showed signs of life again. After those openings, the legal industry experienced several strong years of economic growth, and the legal market was becoming more sophisticated. In 2005, the economy was strong. The economy remained strong for several years thereafter. Lawyers were working harder than ever, billing rates were rising precipitously, and the longest sustained period of growth in life sciences balanced the technology industry.

The financial crisis of 2008 came suddenly, although in hindsight, the signs were there. That downturn saw more opportunistic moves, particularly in private equity, then a burgeoning new source of capital in the Bay Area. In the current downturn, which was much more unexpected, it is likely that some law firms will find opportunity and use it to more effectively compete going forward.

We have already seen firms taking advantage of COVID-19 disruption. Freshfields dominated the headlines in July with a large Bay Area office opening, announcing top hires from Davis Polk, Latham & Watkins, Sidley and Wilson Sonsini. In July 2020, Paul Weiss also publicly announced plans to open an office in the Bay Area as well, a move that argues that without a presence in the Bay Area a firm cannot claim to be global.

There are a variety of tools that law firms can use to capitalize on disruption. This article explores the use of guaranteed compensation when hiring a lateral partner, a group of partners or when opening a new office in a new geography; creative use of compensation systems in recruiting; and what other aspects of compensation help firms compete for talent.

Guaranteed Compensation Packages

When top litigator Sandra Goldstein moved from Cravath, Swaine & Moore to Kirkland & Ellis in April 2018, she reportedly received a guarantee of $11 million per year for five years. Of course, the size and length of this guarantee is not the norm, but guarantees do play an important role in lateral hiring.

Guarantees may be required in some lateral hiring situations. For example, while the post-government employment statute, 18 U.S.C. § 207, does not prohibit former federal employees from working for any particular employer, statute 18 U.S.C. § 203 may prohibit a former employee from sharing in profits earned by others if the money was earned from having contact with the government on behalf of third parties (e.g., clients) while the former employee was still in government. As a result, all lateral partners coming from government into a private practice environment are effectively put on a guarantee.

But there are other situations where a guarantee can be very useful, such as when a firm is opening a new office or making a big strategic move into a practice area in which the firm is not currently strong. The firm should assess the long-term return of an investment into the region or practice area, rather than the immediate, accretive value.

As a generality, opening a firm’s new office in a new city can be a risky business, more so during a pandemic. A useful strategy for a firm opening an office in a new city is for the firm to demonstrate its commitment to success of the new office by providing guarantees to the partners who open and launch the practice. The same can be said for a firm successfully acquiring a practice area that is strategically important, but where that firm may not be the obvious first choice. As more and more profitable firms move into a particular market, guarantees may lengthen.

Each lateral partner is joining a new firm and, therefore, its compensation system. Firm compensation systems differ. For example, if a partner joins a firm with a lockstep system (one that progresses each year and is determined entirely by tenure), the lawyer is essentially joining with a guarantee. The lawyer knows that he or she will rise with his or her class year in a predictable way.

However, most law firms value more than tenure. They will pay for a specific skill set, network and specific client relationships. Many firms have creative ways to give bonuses to high performers in any given year, so that they aren’t bringing them up in equity shares too quickly. They can reward performance while lowering the risk that they will have to lower equity holdings in the future. For example, a law firm might pay a big bonus to a particular lawyer for landing and leading a major litigation matter in the prior year, but his or her path to equity shares only rise as they would in normal circumstances. That way, if that same lawyer doesn’t land a similarly outsized matter the following year, the firm isn’t faced with the choice to cut the comp of a top performer or have the lawyer overpaid relative to her peers.

Some small and midsize firms have a formula compensation system. The “eat what you kill” systems get a bad rap, in my opinion. A pure meritocracy can eliminate at least some unexamined bias. Successful partners thrive in such firms. Some reward collaboration and don’t lead to a sharp elbowed culture. However, a formula system is anathema to multiyear guarantees, which are much more often the currency of the most profitable, bigger law firms.

Firms want the flexibility to reward hard work, high revenues and outstanding performance.

If you join such a firm with a three-year guarantee, you risk being either overpaid or underpaid in the third year. If the system is transparent, then your partners will know this, too. High performers that year may perceive your guarantee as cannibalizing their bonus. Respectively, if the lateral outperforms in the third year, as one would expect a successful lateral to do, the lateral would be relatively underpaid for his or her performance. Either way, three-year guarantees can undermine firm culture.

And during a time when joining a new firm is done via Zoom and new partners have no visibility into their own unit/share value for 2020, the last thing you want is to be seen as having overreached for a guarantee none of your new partners enjoy.

A more typical structure is to guarantee a compensation number, pro rata, for the year the partner joins the firm. Many firms will also offer to pay the lateral the upside if the firm performs over budget. Then that same amount is guaranteed as a floor for the following year. After one full year at the firm, the lateral is put into the same system, either at that level or the next logical equity position above it. If there is outstanding performance, additional equity or bonus may be paid out. This partner is now “in the system” with his or her peers, as he or she should be.

Getting Creative

Occasionally, a firm will have an unusual, creative perk. For example, if a firm is a professional corporation, rather than a limited liability partnership, the firm can fully fund benefits for its attorneys. Benefits for a law firm partner often run $150,000 to $175,000 per year. Partners in partnerships pay their own benefits.

Another creative perk is to pay interest on a partner’s capital. With the current low interest rates, it is even possible for a partner to finance their capital at a rate lower than the firm is reimbursing them. They are making money on their own capital contribution. Another hot topic in partner compensation is the signing bonus. Rampant use of signing bonuses occurred in the first big expansion in the late 1990s as firms tried to take market share during the internet boom. Signing bonuses disappeared with the internet downturn. However, make-whole bonuses continued to be given during that time.

A make-whole bonus is the hiring firm reimbursing the lateral for some or all compensation earned, but not yet paid, by his or her current firm. Most partners get a small portion of their compensation paid out in the form of a draw. They may get larger distributions close to tax deadlines so they can pay their taxes.

But most firms withhold a significant amount of compensation from their partners until their fiscal year is closed and they have established the profitability for that year. For the most part, the later in the year, the more likely a lateral could be walking away from significant compensation. In order to hire that partner, many hiring firms will make up some, or all, of that compensation. Incidentally, when there are mass departures from a firm that later reports strong financial performance, the undistributed money to the departing partners contributes to that financial performance.

Minding the Market Trends

In 1996, the legal market in Northern California was exciting and innovative. But it wasn’t particularly sophisticated. It wasn’t until Oracle acquired PeopleSoft in 2005 that there existed regular, high-stakes civil antitrust work coming out of Northern California. Over time, while Facebook, Oracle, HP, Google and then the unicorns grew into global tech giants, the market’s legal needs more closely mirrored those in New York, London and Washington, D.C. Slowly, as competition with these firms intensified, the Valley started to specialize.

More and more firms opened offices and hired laterally. First make-whole bonuses, then signing bonuses and then really big signing bonuses made a comeback. The market hit peak froth in 2018 and 2019 as the competition for talent became the number one strategy for firms to take market share.

This business evolution, which led to legal services evolution, trends along with the rise of private equity in California. With a fully funded, destination private equity industry in California, there is likely to be a new wave of disruption with economics that don’t quite reach, but are catching up to, New York’s. If that is the case, we may see the resurgence of the multiyear guarantee as firms view building highly profitable, highly strategic practices as investments, rather than hiring a partner or group. And, as share/unit values fluctuate in the wake of COVID-19, risk-averse laterals may insist on guarantees going forward, despite the caution cited above. 

Natasha Innocenti

Partner

Natasha Innocenti is a partner with Macrae where she has more than 20 years of experience in placing successful law firm partners across most practice areas. She has helped open 15 law firm offices in California for Am Law 100 and 200 law firms. natasha@macrae.com

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