September 01, 2020 The Finance Issue

Parsing the Dollars: Thoughtful Approaches to Compensation

An equitable, transparent and intelligible compensation plan will strengthen the stability of a firm.

Peter Roberts
Time passes, the firm grows and partners change. The need eventually arises for a predictable and transparent system for setting compensation.

Time passes, the firm grows and partners change. The need eventually arises for a predictable and transparent system for setting compensation.

via fizkes / Shutterstock

“No, forget thoughtful approaches to compensation. I am the founding partner. I hired the lawyers who are now my partners. I know their relative contributions to the firm and I set their compensation accordingly.”

This is the “black box” method of determining compensation. The partners have no idea how the decisions are made, but if they perceive fairness, everything is fine. However, time passes, the firm grows and partners change. The need eventually arises for a predictable and transparent system for setting compensation. Law firm breakups and partner departures are often due to perceived inequities in compensation arising from not being satisfied yourself, or relative to your peers, or both.

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This article cannot give you an absolute answer about how to calculate compensation—only you know what will work for your firm. By identifying your firm’s behaviors, values, concepts and financial factors, you can establish or adjust your system of partner compensation. Test question: Do you want to encourage a sense of “firm as institution” competing in the community, or do you and your partners seek to build “competitive silos” within your office?

Broader Risks

Bradford Hildebrandt and Jack Kaufman in their book, The Successful Law Firm: New Approaches to Structure and Management, First Edition, identified the reasons behind concerns about compensation:

  • A feeling that the firm is not managed properly.
  • A lack of communication from management.
  • Little opportunity to discuss compensation prior to determinations being made.
  • A lack of articulated criteria for determining compensation.
  • A feeling that unproductive partners are being overcompensated.

The compensation system must be equitable, transparent and intelligible. These goals, if achieved, will strengthen the stability of the firm. And speaking of goals, the partners should prepare their annual plans in their own words describing the financial, business development, firm administration and community activities they plan to accomplish in the coming year while recounting their accomplishments in the prior year. Let’s look at three compensation methods.

Using Objective Criteria

A very successful law firm in Seattle that outgrew the black box method used only financial results to allocate profit. The firm used a five-year moving average of cash received from originated clients at 75 percent and cash received from client files worked on at 25 percent to create an “indexed” relationship among the partners. The numbers below are hypothetical. For purposes of this example, let’s distribute $950,000 of profit (see chart below).

By using 75 percent credit for origination, the firm of course encouraged origination. But no credit was given for subjective contributions such as management, community service, pro bono service, business development, associate training and so forth. How does this solely numerical “index” method align with your firm’s values and culture?

Partner

Originated Value

Worked Value

Total Credited Value

Percentage Index of Total Value

Compensation

Gonzalez

$45,000

$85,000

$130,000

14.8

$140,600

Greene

$125,000

$125,000

$250,000

28.4

$269,800

Johnson

$75,000

$200,000

$275,000

31.3

$297,350

Vaughn

$200,000

$25,000

$225,000

25.5

$242,250

 

 

TOTAL

$880,000

100

$950,000

Adding Other Criteria

In another example, a law firm in Spokane used an allocation based on:

  • Total origination.
  • Total work in process.
  • Office administration.
  • Minus unpaid costs advanced or written off.

Using 35 percent, for purposes of work being originated by one partner and given to another, the originating partner would be credited 5 percent of the origination. The receiving partner was credited the remaining 30 percent of the origination. This applied to files where the originating partner did not do any work on the matter. In cases of joint representation, partners receive 35 percent of the work in process they generate. One partner generates $5,000 in fees. The other partner generates $10,000 in fees. The first is credited 35 percent of $5,000 and the second is credited 35 percent of $10,000 (see chart below).

First, each partner received an equal share of 10 percent of the total profit. Secondly, the percentages derived the respective annual compensation to allocate the 90 percent remaining profit. I believe using an equal share component such as the 10 percent in this example promotes stability. This method involves more variables than the first example plus judgment was potentially necessary regarding office administration.

Partner

Total Origination

Total Work in Process

Office Administration

Minus Advanced Costs

Total Credit

Percentage for Allocation

Browne

$125,000

$325,000

$0

$3,500

$446,500

30.6

Hernandez

$85,000

$225,000

$4,000

$250

$313,750

21.5

Jacobs

$75,000

$275,000

$5,000

$500

$354,500

24.3

Middleton

$50,000

$285,000

$7,500

$0

$342,500

23.5

 

 

 

 

Total

$1,457,250

100

 

A Novel Approach

Setting compensation should include both objective (numerical) and subjective criteria: A law firm is a group of people (lawyers and other professionals) who should be encouraged to feel part of a larger whole that serves the community. Subjective contributions to the firm’s success are easily recognizable yet can be difficult to measure.

Origination is typically considered a strong factor in setting partner compensation. All lawyers in the firm have an obligation to attract clients. Upcoming generations of lawyers want recognition and want to thrive in an entrepreneurial culture. So, every lawyer in the firm should be compensated in the same fashion to encourage skill development for both attracting and best serving the clients.

The unit method that follows is a novel approach. The distributable total profit is divided by the total assigned units to obtain a value per unit. All the lawyers benefit based on the total profit of the firm. Assign units to each lawyer on Jan. 1 based on (choose your own lists and unit values):

Easy to Measure Criteria

Unit Value

Origination >$25,000 | >$100,000

2 | 4

Collections >$150,000 | >$250,000

2 | 4

Client responsibility (number) >2 | >10

2 | 4

Accounts receivable write-offs <10% | <5%

2 | 4

Realization (worked/collected) >90% | >95%

2 | 4

Billable hours worked >1,000 | >1,400

1 | 2

Hours billed >1,000 | >1,400

1 | 2

Effective hourly rate billed >95% | >98%

1 | 2

Nonbillable hours for activities preapproved >50 | >100

1 | 2

Longevity with the firm >3 years | >10 years

1 | 2

Subtotal

15 | 30

Difficult to Measure Criteria

Unit Value

Major role in management

2 | 4

Interpersonal skills

1 | 4

Reputation

1 | 3

Quality of legal work

1 | 3

Research and writing ability

1 | 3

Ability to work independently and to supervise the work of others

1 | 3

Commitment to follow firm procedures

1 | 2

Community service

1 | 2

Willingness to work hard

1 | 2

Subtotal

10 | 26

Total Units Possible

25 | 56

Experienced an Extraordinary Year Last Year

2

Not achieving the minimum identified threshold grants no units for that criterion. Use a three- or five-year moving average of whatever numerical values you choose. A moving average rewards trends rather than spikes. The trend shields the lawyer from the full impact of a down year. If a lawyer had an extraordinary year, a bonus is appropriate and the performance merits the two units identified at the end of the unit table above. An example might be a lawyer who wins a case in a court of final jurisdiction that creates new law that bodes well for the firm’s future business. Another example is obtaining a major result in a contingent fee matter.

Another numerical measure to consider is “capacity.” Capacity is the number resulting from total billable hours each partner can commit to, times each hourly rate and using 100 percent realization. Deduct actual collections to yield the difference as a percentage of the capacity. Compare this percentage to the last several years to discern (hopefully) a decreasing percentage.

During the year, pay each lawyer a fixed monthly draw based on a percentage of that lawyer’s compensation in the prior year. Next, distribute quarterly profit based on tax obligations or by a fixed amount depending on how the firm is doing. Finally, pay total annual compensation based on the assigned units. In the example below, total distributable profit before deducting any lawyer compensation is $960,000. This amount is divided by the 96 assigned units used this year thereby equaling $10,000 per unit:

 

Total Draw

Total

Quarterlies

Total

Year-end

Units

Total Profit

Partner

$100,000

$40,000

$140,000

28

$280,000

Partner

$80,000

$30,000

$110,000

22

$220,000

Partner

$70,000

$25,000

$95,000

17

$170,000

Partner

$60,000

$20,000

$80,000

14

$140,000

Associate

$40,000

$10,000

$50,000

8

$80,000

Associate

$40,000

$10,000

$50,000

7

$70,000

 

$390,000

$135,000

$525,000

96

$960,000

At year-end, $435,000 is distributed. When a lawyer retires on Dec. 31, the units of that lawyer are retired. The total of the units reassigned Jan. 1 will vary each year.

When a new lawyer is hired, she is paid a salary. She is assigned units on Jan. 1 using last year’s value per unit that equates to her salary paid last year. The total units grow (are diluted), but the expectation is the new lawyer will eventually add to the firm’s profit. If a lawyer leaves the firm during the year, those units are retired so the value of the remaining units potentially becomes greater. Figure 1 illustrates the growing unit value as the year progresses. While a bit whimsical, the changing graphic may capture attention.

A bonus pool gives you the ability to reward individual exceptional accomplishment during the prior year. If no such event occurred, distribute the bonus pool equally. Also, use the bonus pool to smooth small differences in total compensation between partners.

At the outset, assign the units so the resulting budgeted compensation approximates the total compensation of the lawyers the prior year. This retrofit will help to foster the “buy-in” and the trust that must be the foundation of any compensation system.

This unit system engenders a “we are all in this together” culture encouraging the entrepreneurial instincts of today’s younger lawyers and reminds the senior lawyers they must continue to set a leading example.

Potential Horror Stories

What controls are in place that standardize client intake? What prevents a lawyer with a “bleeding heart” from accepting any client? The clients they accept increase work in process and accounts receivable, but may often fall short of adding to profit.

If your firm does not have a legal administrator who can professionally manage the firm’s daily operations, these duties fall to a partner or partners. Does the firm appropriately compensate those partners? If not, you will likely witness a major dip in their morale.

Does the firm now enjoy the revenue from a very large client to the extent the broader practices of the benefiting partners are withering? When that client is gone, what happens to the compensation of those partners with withered practices?

A firm with a major contingent fee practice must address the spikes that occur. Retain some of the spike to build working capital for advanced costs. Use a bonus pool for all the partners. Otherwise, resentment may occur from the other under-compensated partners who “carried” the contingent fee partners until the cases matured.

Circling Back to Thoughtfulness

Can too much thought be put into devising a compensation system? Yes. Complexity obscures transparency, raises obstacles to understanding and can cause mistrust. But please have a healthy discussion with your partners about the several examples, factors and behaviors mentioned in this article as well as other compensation scenarios you may be aware of. Any partner compensation system can evolve over time. A discussion of compensation is, of course, worthy of a comfortable Saturday afternoon off-site retreat! 

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Peter Roberts

Consultant

Peter Roberts is a private practice management consultant for lawyers. He was the former practice management advisor in the Law Office Management Assistance Program (LOMAP) of the Washington State Bar Association for 13 years. He is active in the ABA Law Practice Division and served as the 2019-20 chair of the Law Firm Finance Committee. pete@practicelawadvisor.com

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