Cotterman on Compensation

This blog, authored by Altman Weil’s Jim Cotterman, focuses on lawyer compensation and law firm finance. For 20 years, Jim Cotterman has advised law firms on compensation system design, capital structure and other economic issues. He is the lead author of the definitive book on law firm compensation, ABA’s Compensation Plans for Law Firms.

Realization

March 14th, 2014 by Jim Cotterman

The profit metric that tells how efficiently work done at standard rates is converted into cash.  It does not tell you how fast this happens, just the amount of slippage that occurs from end to end.  There are key intermediate steps that are measured such as billing realization (converting time value into bills) and collection realization (converting bills into cash) and a number of variances (see below) critical to isolating and confronting slippage. 

But first a bit of history and why it is now getting so much attention.  Realization has been dropping since the mid 1980s — a long, gradual and persistent deterioration.  But until the recent recession, rates were going up much faster; yielding a collected rate increase well in excess of inflation.  Strip away the historic ability to increase rates and the realization slippage is uncovered for all to see.  To confront this problem, examine realization where the slippage occurs.  There are four general areas where losses occur that must be understood and managed.

1.  Timesheet discounts — those adjustments individuals make to the time they record when they believe something took longer than it should.  This is one area that does not show in the financial system realization numbers because it is not captured.  It prevents firms from identifying budgeting issues and training needs.

2.  Pricing discounts — the difference between standard and actual rates.  Both the frequency of use and level of discount have been increasing and accordingly realization suffers.

3.  Efficiency adjustments — those adjustments to the value of time recorded at actual rates before billing.  These are done by the billing partner.  They may be targeted or prorated across the timekeepers on the matter in proportion to their recorded time value.

4.  Value adjustments — those adjustments made by clients when they perceive that the bill does not reflect fair value for the agreed to budget for services, the services rendered, and/or the outcomes achieved.

Each of these areas require separate tactics to tackle the associated realization decline.  Terms like pricing variances, efficiency variances, value variances should accompany any discussion around realization.  The realization journey begins with client acceptance and continues on to matter engagement, work planning, staffing, project management, billing and collections.  Thus, firms should examine their policies about client selection, engagement letters, pricing/retainers, staffing, practice management, billing adjustments, AR write-offs and collection efforts.  Those policies should be administered through the practice leaders who should hold individual partners accountable.

Also consider how the firm strategically positions itself with respect to pricing.  Does it set high standard rates with an expectation of using discounts to satisfy financial and/or procurement departments in client organizations.  Just look at the medical and accounting professions where these models have been in place for many years.  Historically the legal profession did not adopt this pricing model, thus it has strived for high realization and little, if any, discounting.  Clients are now more aggressive at pursuing pricing discounts, without the law firms having a pricing model with sufficient margin to easily accommodate them.

Realization issues also tend to concentrate among individuals, practices, offices and clients that are struggling — underperforming.  It is important to look for outliers across these segments.  Firms should manage their way through these issues by identifying the problem and taking corrective action.  In the current market where there remains an imbalance between supply and demand for legal services, that corrective action is more likely going to be to shed the problem.  It is not fixable by changing status or compensation, which unfortunately, is what is attempted all too often.

So, if you are going to the Managing Partner or Executive Committee to talk about low realization; be prepared to talk about what kind(s) of variance(s) exist, where and who is the problem, and the targeted options to correct or shed it.

Searching for better associate bonuses

March 4th, 2014 by Jim Cotterman

Recent questions regarding changing associate bonus programs prompted me to note a few thoughts for all to consider.

 

1.  Associates generally like an objective effort driven bonus that they can control (at least to some extent) that reflects their production.  The objective measure of their effort is the billable hour.  The problem is that hours only recognize effort.  Other production-based approaches that could be used, such as time value recorded, billed time value or collected time value are also possible, but involve attributes that the associates cannot control – assigned billing rates and partner pricing decisions, partner billing adjustments and client value adjustments and payment practices.  Better programs recognize that production effort really requires a multi-faceted look.

2.  When firms better align compensation practices with client interests they look to factors such as work quality, competencies, efficiency and effectiveness rather than production.  This requires greater effort and judgment, but certainly improves on the process.  Yet, firms still need to differentiate based on quantity.  Two otherwise excellent associates (equal on all other factors), one with 1,700 hours is unlikely to be paid the same as the counterpart who has 2,200 hours.  And the higher hour associate is unlikely to perceive that the pay program rewards proportional performance if they are paid the same.  It is hard to eliminate this from the pay program.

 

3.  The professional services model remains premised on highly utilized timekeepers to generate high profits.   Lower effort is quite likely going to result in lower profit and lower compensation.  Changing a bonus program from production to other factors should be accompanied by efforts  reinforcing production expectations consistent with the firm’s business needs and desired work environment.

 

4.  It is important to recognize that a bonus should represent performance above and beyond what has already been compensated for in the base pay of salary and benefits.  To the extent that some portion of a bonus is for quantity, that portion should not kick in until a threshold is surpassed.

 

5.  Moving the associate bonus programs beyond a math exercise provides opportunities to recognize and reward the associate for growth and development that is critical for career success.  Associates should benefit from a more thoughtful overall approach to their development and pay — ie. Going beyond hours to include a focus on quality, efficiency and other intangibles is much better aligned with a longer view on development that also benefits the firm and clients.

Working Capital Requirements Likely to Rise

April 17th, 2013 by Jim Cotterman

The Wall Street Journal had an interesting and sobering article today about companies stretching payments to suppliers.  What caught my interest is the discipline and aggressiveness of these policies in a post recession environment.  Such tactics increase working capital requirements for suppliers.  Working capital is the amount of money a business needs to pay its bills while it waits to be paid for its goods and services. While this article focused on the portion of working capital attributable to the gap between invoicing and payment, there is also an equally important portion attributable to the gap from produced/worked to invoice.

Combined, the work to invoice and invoice to payment cycles can represent three to eight months of cash flow for a law firm.  The median length of time is four months.  Some specialty firms can be much longer.  Law firm have over the past several years increased capital requirements and reduced their dependence on debt for financing.  This latest move by clients could add to capital needs even more.

The article also mentions how the companies are approaching this problem by bringing banks into the mix.  Essentially the bank buys the suppliers invoices at a discount and collects from the manufacturer.  There is a great graphic depicting this approach in the article.  While this may work well now, in measured amounts and with historically low interest rates; how it plays out when rates increase and the investment in these receivables grows is yet unknown.

A Different Use for Your Malpractice Insurance Application

September 25th, 2012 by Jim Cotterman

I suspect that for many professional firms the malpractice insurance renewal application is not something to look forward to.  That was not the case for a member of the AICPA’s professional liability insurance committee.  That intrigued me, so I read more of the article.

Law firms can benefit from this insight.  I regularly request the application as part of merger due diligence to understand the firm’s practice as well as its known and anticipated claims.  As an overall picture of a firm’s business, is quite comprehensive.  Using that snapshot to evaluate and manage the associated risks (as the article suggests) is a tremendous opportunity. 

Compensation season coming to an end

February 17th, 2012 by Jim Cotterman

About now most firms should have finished their compensation deliberations and possibly their communication efforts.  Assuming no Spring surprises, there should be a lull before the next round kicks off.  But before you set your compensation committee free, we recommend one more request on their time.  Take a few moments to reflect on this year’s process.  What went well?  What challenges did you have?  Think over the entire process – economic data review, partner written input, partner interviews, input from administrative leaders, personal study, committee deliberations, feedback to/from partners and the like.

It is all fresh in your minds, so capture that knowledge now.  This does not need to be laborious.  Just a quick memo to the committee chair with bullet points and short narratives.  Capture both positive and negative aspects of this year’s efforts.  The Chair can organize this and determine how best to proceed.  The conclusion might be to continue as is, but I suggest there is always room to improve and ongoing incremental improvement should be integral to your operations.

Retirement update

July 25th, 2011 by Jim Cotterman

The common wisdom is that defined benefit (DB) plans have largely been replaced by defined contribution (DC) plans such as the 401(k).  While generally true, DB plans are still being adopted.  According to the GAO’s March 2011 Private Pensions report, “most new DB plans were started by highly paid, middle-aged professionals who run small businesses and were looking for ways to put as much tax-deferred income aside for retirement as possible.”  The top three business classifications sponsoring new DB plans have been doctors, dentists and lawyers.  Doctor and dentist offices are uniquely well suited because of their advantageous business model.  Law firms are a bit less well suited, but there are still reasons to consider a DB plan in the right circumstances.  The report’s data is for years 2003 - 2007 where 14,150 small DB plans (those with fewer than 100 members) were newly formed representing 8% of the total number of all plans created.  Of those, approximately 1,000 were for law firms.

The GAO goes further to point out that these new DB plans are sometimes sponsored to supplement an existing DC plan that has reached its statutory contribution limits.  Using a combination of plans can greatly enhance the ability to save for retirement.  The attractiveness of securing retirement savings on a tax deferred basis is significant with a GAO estimate of 18% improvement in after tax retirement income after 10 years and 40% after 20 years.

Unfortunately, even with significant tax advantages, the private plan participation remains stalled at roughly half of the private sector workforce.  Plan formation just barely surpassed plan terminations.  And this was prior to the recession.  Now un- and under-employment remain stubbornly high, with particular note to the growing problem of the long-term unemployed.  The consequences of all this on participation rates and asset accumulation are still largely unknown.

The eternal search for cost advantage

July 7th, 2011 by Jim Cotterman

Much has been written pro and con regarding cost reduction strategies.  One of the more contested approaches is outsourcing, particularly the more aggressive off-shoring.  This is the movement of tasks and often jobs from internal positions to somewhere else.   That somewhere else can be a lower cost rural area or another country.  Successful strategies have been built around both, understanding that there is no single correct answer to these challenges.

This article, Outsourcing Pioneer Brings Work Back To The U.S., in Law Technology News reminds us that not only is there no single correct answer, but that yesterday’s best approach may be replaced by a new, or even old, alternative tomorrow.   Some say first movers capture the bulk of any temporary advantage while late entrants capture very little.  This identifies an important trait of leadership — the ability to move quickly enough to seize on opportunity (even to change direction), yet simultaneously slow enough to be thoughtful and build consensus. 

Some thoughts on lateral hires

May 9th, 2011 by Jim Cotterman

I was asked recently about lateral hires and compensation practices.  My response, which goes beyond compensation, follows.  If the firms don’t do these other things well it matters very little about the compensation.  And even if the compensation is well done, the other things here are critically important for the hire to be successful.

1. Lateral candidates tend to promise more then they can deliver in terms of how much and how quickly their practice will move.  This is not an intentional overstatement as their firm is equally off at the other end on how much lost business will occur.  The clients have the final word on this matter and their response may not be what either the candidate or the firm anticipated.  Another factor (hopefully) is that candidates are inexperienced at picking up a practice and moving it.  If the partner is experienced at moving their practice that should tell you something as well!

2. Candidates may be making the change for reasons they do not fully understand (which could lead to post change remorse once it is all sorted out).

3. Firm’s due diligence is often lacking with little or no credentialing, insufficient analysis of candidate’s practice (see number 1 above) and insufficient evaluation of how good a fit this person is with group, office and firm overall (see partially number 2 above).

4. Each firm needs to have a really good handle on what it is paying its equivalently performing partners.  It is very bad for morale if current partners are paid less than the incoming laterals.  But how many times do we hear partners lament about this very situation?  And if this situation is a symptom of some problems with a current program, they are exacerbated when laterals are kept whole.

5. My personal observation is that firms will often pay very high in the market range, even above range, to seal the deal with a lateral partner.  But it is important to note that there is always someone who can and will outbid you.  Further, money does not buy loyalty — it can only arrange a short term rental.  Finally, once you set the initial compensation so high, where do you go from there and how do you recreate internal equity when the time comes to fully integrate the lateral into the firm’s program?

6. Smart candidates avoid having a target painted on their backs with a high signing bonus, high draw, high guarantee — they will look for assurance of “X” if they deliver “Y”, which is reasonable because they don’t have relationships in the firm or experience with the new firm’s particular politics.  They will be willing to share in risk and reward with the the rest of the partners to some extent and will look for a fair draw.  There is a real need to strike the right balance between comfort for the new person and full integration into the firm’s program.  Some may consider this next comment a bit unusual, but I recommend laterals have an active mentor — maybe the partner who sponsored their candidacy — to improve the integration and to catch/head off the difficulties that will invariably arise.

7. The above comment leads me to this next thought that there is really very little effort to integrate partners into the group, office or firm overall once they arrive (or at least after the initial honeymoon period).  Moreover, since they are not well plugged in they find themselves having to market internally nearly as hard as they have to externally.

Sampling

April 6th, 2011 by Jim Cotterman

Understanding how to use sampling as an efficient technique to draw conclusions about a large population of data is an important research tool.  It also has application to e-discovery as discussed in three blog posts by Doug Austin.  The first, sets out a framework for a defensible search process.  The second, discusses how to determine an appropriate sample size, and links to a easy-to-use tool to accomplish the math portion.  The third discusses how to obtain a random selection for the sample and again provides another link to a simple tool to accomplish the task.

Calculating internal hourly rates

March 22nd, 2011 by Jim Cotterman

Law firms have an increased interest in understanding internal rates as AFAs (alternative fee arrangements) take hold with clients.  Understanding costs at a firm level is easy once you sort through the differences between cash and accrual accounting.  The hard part is allocating costs to various sub-groups within the firm — such as individuals, classes or groups of individuals, matters, clients, offices and practice groups. 

For those of you who are precision minded it is possible to devise a cost accounting system so detailed as to take any activity and assign it to multiple cost centers — each of the aforementioned sub-groups.  The account numbering schematic for such a system would be quite complex as would the coding and verification tasks.  We will forgo the obvious political challenges involved in selling such a system.  So while such precision is a possibility, it is largely not a practical approach.

Simplification is preferable, although not altogether without its potential political challenges.  And there are some, probably acceptable, higher risks for analysis error.  But let’s use simplification at its best for this posting and reserve a more in-depth discussion for an upcoming article.  We will use the following assumptions:

1.  A single office law firm partnership with a collection of practices that are reasonably similar in their economic models.

2.  Partners and associates use/share resources (offices, secretaries, technology and the like) without any significant distinction from group to group.  This means that office sizes are very similar, secretarial sharing is equal across groups and that all timekeepers use a similar technology package.

3.  Paralegal use/sharing of resources is about one-half that of lawyers.  Thus each lawyer will be counted as one fee-earner and each paralegal will be counted as a one-half fee-earner.  This convention is commonly found in most economic surveys of the profession.

4.  Expenses include the net affect of cost advances and recoveries on the behalf of clients.

5.  Compensation deductions from total expenses for determining firm overhead define compensation as salary, bonus, benefits and associated payroll taxes.

Accordingly we can take the total expenses of the law firm and subtract the compensation costs of the associates and paralegals.  The remaining expenses represent the overhead of the firm. .Divide this remainder by the total full-time-equivalent (FTE) fee-earners to determine the overhead per fee-earner.

Once overhead is sorted out, we can turn to compensation.  Here there are three assumptions for our posting.

1.  We are looking for internal hourly rates for each group of individuals — partners, associates and paralegals — so average compensation for each group is used.

2.  Compensation for development of internal hourly rates includes only salary, benefits and the associated payroll taxes.  Including bonuses (with their associated benefit and payroll tax costs) is an option depending on your firm’s particular philosophy on bonuses.

3.  A partner’s compensation consists of a fair exchange for his/her labor (the portion we need) and the profits earned on the work done by others.  There may also be a return on capital component depending on whether interest is paid on partner capital or not.  Again, for simplification, we will use the partners’ draw as a proxy for the fair exchange portion we are interested in for our purposes. There are other proxies that could be substituted, such as extending the lock-step associate pay scale into the partner ranks or using an outside reference point such as a senior in-house lawyer.

So we now have the total average cost of the group to include allocated overhead and compensation before bonuses.  Divide the total average cost by the expected billable hours to obtain a preliminary internal hourly rate.  Divide that rate by the expected realization factor for the group to obtain a required internal hourly rate.  Attached is a sample calculation.