Partner/Shareholder Compensation Techniques

Review of the Basics

There is no perfect compensation system guaranteed to function well in all law firms. Compensation systems establish status and define each partner's reward and value to the firm. A good compensation system will be perceived as fair and equitable by those who are subject to it.

The late Reginald Heber Smith of the Boston Bar, in a series of articles published in the American Bar Association Journal in 1940, defined the objectives of a profit division plan: "The whole purpose is to let the work in the office flow where it will be done best, most quickly, and at lowest cost. The lawyer having too much business must not be afraid to part with it. He must be encouraged to do so, and when he does so, the system must protect his natural and proper interest in the case and the fruits thereof." Clearly, not all firm's would agree with all of these objectives. Also, things that worked in 1940 may not work today. In fact, improperly used, Mr. Smith's system may work against specialization in some circumstances.

It is necessary to define the firm's goals as a first step in devising a compensation system. The compensation system can provide the incentives to reach those goals. Examples of such goals might be firm stability, growth, diversification, or specialization. More narrowly defined goals may be the establishment of specific client relationships, establishment of new offices, or other objectives.

There are a number of factors that enter into the compensation issue, including the following:

1. Billable Work (Production). Law partners usually wear many hats, including as production workers, as managers, as marketing and sales people, and as owners. Although a partner's compensation is not necessarily limited to the amount of his or her collected billable client work efforts, a partner's work can have a considerable effect upon the economic results of the firm. This is particularly true in smaller law firms.

2. New Business Development (Sales). The performance of billable work is easily measured with proper timekeeping and a timekeeping system. Measuring the results (success) of generating new business or holding on to existing clients of the firm, is not as easily or accurately measurable. Many firms recognize the value of these important functions and maintain records to allocate credit (compensation) for generating new business and/or maintaining ongoing business with existing clients.

3. Partner Seniority. Seniority has had a strong influence on the compensation of lawyers. Some compensation systems, although fewer today than in earlier times, are entirely based on length of service either with the firm or in the profession.

4. Professional Expertise. A "hot" legal specialty can add to an individual's value as a partner. The client demand for a partner's specialty may outweigh any lack in client billings, associate training, or other factors.

5. Associate Training. Some partners have a knack for and are willing to take the time to train younger lawyers. Other partners may shun such activities or are terrible trainers. Many law firms make substantial investments in recruiting, compensating and providing office space and support facilities to the novice lawyer. Since the quality of supervision, monitoring and training the young lawyers' receive is of significance importance in their development, a law firm should be prepared to pay the partners willing to train.

6. Stature in the Community or Profession. Some partners are prominent leaders in various charitable, professional or other organizations in the community and/or profession. Such activities are generally regarded as having a value to the law firm in the form of favorable visibility and may help to attract new clients. This contribution, assuming the partners have agreed that the activity is beneficial to the firm, is a factor considered in compensation.

7. Firm Management. It is recognized in corporate America that management is highly compensated and at a level far above the production workers. Some law firms don't recognize the contribution of effective law firm management on the firms' overall success (or lack thereof). In many law firms, management is not a factor in compensation. Any organization unwilling to pay for proper management will have little, long term effective leadership. Effective management should be recognized and compensated.

8. Firm Ownership. Law partners providing the working capital, en- cumbering themselves with long-term leases, accepting the liability for the firm's activities, and meeting the employee payroll, are indeed entrepreneurs. While the most important assets of a law firm are its professional staff and clients, law partners are entitled to some reward for their investment and risk.

1. Subjective System. Subjective, performance-related systems are those in which the partners, acting through an individual, a committee, or as a whole, review the performance of each partner, possibly considering management information (e.g., production, new business generated, profitability, etc.), and subjectively determine a relative value for each partner.

2. Lockstep System. Firms with a lockstep compensation plan generally assign interests on an annual basis, based on the number of years each lawyer has been a partner, up to a maximum number of points after fifteen or twenty years.

3. Objective (Formula) System. Formula systems use various criteria (such as production, profitability) to arrive at a numeric value to be used to determine compensation.

The subjective compensation system is usually based upon a percentage (or points) of the earnings of the firm. In the consultant's experience, some 70% to 80% of all law firms use some variation of a subjective system. The percentage (points) may also reflect, to some degree, the ownership of the firm. Under this method of income division, a percentage of the earnings of the firm is allocated to each partner. This system works well in many small law firms. Problems may arise, however, when a partner joins the firm. If the firm wants to remain on a percentage basis, each partner gives up some percentage of interest to allocate income to the new partner. This can be emotionally difficult for some people.

An alternative to allocating percentages of earnings is the point system. According to this system, the firm assigns varying amounts of points to partners based on seniority, technical skills, profit contributions, and similar criteria. To determine the value of each point, the firm divides its available profits by the total number of points.

It takes great compromising skills on the part of the firm leadership and management to keep partners from confusing ownership with compensation.

The difficulty with the negotiated percentage or point system is how to determine the share for each partner. One approach, which is confrontational and often "bloodletting" is to have all partners participate in a meeting at which income distribution is voted on. Many lawyers are generally reluctant to discuss each others strengths and weaknesses in a face-to-face setting.

In some firms, a Compensation Committee is designated. The Committee typically interviews each partner, considers objective management information, and makes a recommendation to the partner- ship. Depending upon the make-up and personalities of the personalities involved, the Compensation Committee approach can work well.

A variation of the Compensation Committee approach is to have the highly-respected senior partner (i.e., the benevolent dictator) deliberate and make compensation recommendations to the partner- ship. Given the stature of the senior partner, this system also can work well.

Another approach to determining the percentage/point allocation, incorporates attaining certain subjective levels of performance. This system provides that certain performance levels must be achieved by each partner in order for the partner to participate fully in the income opportunities which are available.

An alternative approach to determining the percentage/point allocation is the mutual rating system or peer-evaluation. This approach attempts to value the worth of a partner by using criteria that the partners as a whole determine are important. Each partner rates each of the other partners using these criteria. The system can work well in small firms when each partner has sufficient knowledge of the other partners' contributions. In larger firms it becomes more difficult to have a good understanding of the contribution of each partner. The individual ratings are kept confidential and only the summarized tabulations are reported to the partners.

A lockstep compensation system tied to objective performance criteria is illustrated in our article entitled "Illustration Of A Lockstep Progression Incomee Distribution Plan Tied To Objective Performance Criteria."

With any compensation system it is necessary to determine if the system will be prospective or retrospective. Under the prospective approach, points or shares are determined at or before the beginning of the year and apply to that year. Likewise, retrospective systems determine the allocation at the end of the year for that year. Most law firms use a prospective approach.

Firms with a lockstep compensation system generally assign points or shares on an annual basis, based on the number of years a lawyer has been a partner, up to a maximum number of points after fifteen or twenty years. Some firms operating under the lockstep system find that it serves them well and avoids controversy. This is particularly true where all partners are perceived to be making an equal contribution to the firm's overall economic success.

There are a number of drawbacks to the lockstep system, the major problem being that it rewards only seniority. The system also is lacking in accountability and tends to unfairly favor the least energetic, least aggressive, and least capable. The system does not reward hard work, new client business generated, firm management, legal expertise, and the like.

A number of refinements can be made to the lockstep system. For example, criteria could be established so that progression to the next level is not automatic. Billable hours, collections or profitability could be required to move up to the next step. Partners on the top steps would have to meet specified criteria or would go back a step. The superstar could either move up two steps in one year or receive a one-time bonus to award stellar performance.

A number of law firms have compensation systems that use formulas based on the production and profitability of work. Firms that use these formulas sometimes function more like groups of individual practitioners than as law firm partners. These systems require that firms maintain careful records of the contribution of each partner. The shortcomings of the formula system are that they fail to adequately measure other important contributions, such as management, planning and training young associates. Consequently, some partners may be unhappy because they make valuable contributions to the firm without receiving any recognition in the form of income. The result of such systems can often be the neglect of functions that are critical to the firm's long-term growth and ultimate survival.

Whatever system selected should make sense for your firm, should be understood by all partners, should promote partner harmony, enhance your ability to serve clients and maximize synergism within the firm.

We have helped firms select and develop the most effective partner compensation system for their law firm for nearly 30 years. We have also been a leader in the difficult tasks of implementing a new compensation system and, when necessary, transitioning ownership.