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.

Pricing

June 23rd, 2014 by Jim Cotterman

Pricing should reflect a fair value to the client for the product/service/result provided and the market in which they are provided.  Thus hourly rates vary by location, practice specialty, practitioner experience and work/issue sophistication.  They are also sensitive to market factors.  For example, insurance defense rates are less and slower to move for a given practitioner than rates charged for similar work paid by the client directly.

Hourly rates have long been augmented by alternatives such as contingent fees and fixed fees for certain practice/market specialties.  And interest in moving beyond the hourly model is accelerating.  Law firms are investing resources in more sophisticated tools to understand cost of services and in people to analyze and structure pricing options.

The key is finding a means to best address a client’s needs for predictability, cost reduction and risk sharing in its legal spending.  How does the client define value and how can the firm better define the value it provides to the client?  Conversations with clients are critical as needs, issues and priorities vary.

The Trouble with Billing Rates

June 9th, 2014 by Jim Cotterman

The long historic ability of the legal profession to raise rates well in excess of inflation year over year has largely ended.  Two factors combine to raise a practitioner’s hourly rate –

1) an elevator lift of all rates to reflect an overall increase in pricing structure (pre-recession averaging each year 4.5% and higher than inflation’s 3.2% and post-recession from a bit more than one-third to a bit less than one-half of that which was pretty close to inflation), and;

2) the up escalator increase reflecting an additional year of experience (2% to 5% for each additional year depending on where the practitioner is in their career).

Realization, a law firm’s ability to collect those rates and the opposing force against increases, has been on a long steady decline from 95% in 1985 to 82% recently.  With pre-recession increases well in excess of inflation, the minor one-half of one percent annual decline in realization was largely ignored.  However, now that rate increases are modest the decline in realization is more noticed.  Increased price discounting at the front end and more aggressive push back from clients on bills on the back end reflect increased pressure for lower cost and better value. 

Collected hourly rate increases fueled revenue growth on a per timekeeper basis.  Thus making it possible for high year over year compensation increases.  Concurrently, demand, at least as measured by average billable hours, is diminished.  Result:  Modest revenue per timekeeper growth and in some pockets real challenges at holding the status quo.  The consequence is that unless overhead and the service delivery model are radically altered, there will be little room for the historic annual compensation increases.

Financial transparency

May 24th, 2014 by Jim Cotterman

Law firms are somewhat unique in the amount of information that is publicly available regarding their finances.  Most closely held businesses do not operate in such an open manner.  Of course, the accuracy of that publicly available information is a separate matter to consider, particularly when obtained from unofficial sources.  Here each firm must decide what is appropriate for public disclosure and how to best convey that information.

Yet, transparency in the governance and operation of a law firm is a good practice for the owners of the firm.  They are a large group relative to their firm’s total employment and are all active and personally invested in the firm.  But such disclosure is not sufficient to avoid financial distress.  Two additional factors are also important.

First, lawyers are not schooled in accounting or financial analysis.  If transparency is to have meaning, partners must be able to understand and interpret the financial information and metrics.  Firms should Invest in training sessions to acquaint partners with the financial reports and operating information, how to interpret that information, banking covenants and the metrics the bankers rely on, and how to reconcile the tax return, year-end financial statements and internal financial reports. 

Second, and possibly most important, is a culture where 1) firm leaders welcome questions from partners and others about the firm and 2) where integrity and honesty is embedded in the ethos of the firm.  Transparency assists accountability, but it also establishes responsibility.  The responsibility to ask and then act when action is required.

Retirement is not a moment in time

May 1st, 2014 by Jim Cotterman

The evolving role of a senior partner as s/he transitions away from the private practice of law takes many paths. Some are specific and short – “In a year I shall retire to my cabin in the woods.” Others are longer duration – “I would like to slow down and phase out over the next five to seven years.” And still others are indefinite – “I want to maintain a part-time practice with a few of my cherished clients as long as I can.” Obviously, there are many permutations on these. And what works best depends on the specific path taken. It is likely that each firm will have multiple paths in process and thus require flexibility in dealing with these differing situations. Compensating senior partners requires a view that considers that chosen path and recognizes that most partner compensation arrangements are designed not for this transitional role, but rather for the full on partner.

Generally, what a partner leaves behind is the client and referral relationships built up over a career. Those relationships have value if the successors can retain them and maintain/grow the revenues and profits from them. There are variables to consider. For example, founders may have some additional value attributed to the risk and start-up costs that successors do not incur with an established business. The area of the law may also alter what and how value is recognized. For example, an estate practice has value in the will bank and contingent fee practices have significant investment locked up in cases that can span years. It is appropriate to consider if and how to deal with the compensation deferred by virtue of a start-up and/or locked up in unique practice assets.  

Another key financial aspect of retirement is the return of capital. Senior partners carry disproportionate amounts of the total capital invested in the firm. With buy-outs that tend to occur faster than buy-ins, it is easy to foresee the stress retiring boomer partners are likely to have on capital structures. Add to this mix additional stress points such as the increased use of non-equity partner, thus delaying or eliminating potential future sources of capital, as well as the generally increasing capital needs of law firms. Law firm financial leaders need to be conversant with capital planning.

Beyond the valuation and compensation aspects of retirement, thought should be given to how to transfer the intangible value of senior partners – their wealth of legal, business and life knowledge; their leader, manager, mentor and steward roles; as well as their client, referral and market relationships. This requires some internal discussion as well as discussion with the clients/referrals. Professional service firm relationships are often trust-based, thus they are harder to transfer than skill-based relationships. It takes a number of touch points (face-to-face interactions) to effect a transition of trust. And the changing nature of practice delivery has and will continue to decrease the opportunity for face-to-face interaction.  This is the succession planning that firms refer to — working in a coordinated and thoughtful way towards retirement and well in advance of that retirement.

Ideally one would like the retiring partner to have worked him/herself out of a job on their last day at the firm. Good concept, but devilishly tricky to accomplish.

Should performance evaluations be linked to pay decisions?

April 22nd, 2014 by Jim Cotterman

There are a variety of views on this topic of linking pay and performance evaluations.  My general response is to link the two because pay proportional to performance(r) is a critical element of best practices in lawyer compensation.  They are both part of the ongoing cycle of plan, train, do, coach, assess, reward.  The plan and assess elements often occur concurrently — assessing prior performance and planning for future (including career development).  And it is important that the feedback from the performance evaluation and the compensation decision be consistent and understood by all, including the individual’s team leader.  

 

But to decide, first assess a number of factors.  Ask:

1. To what extent are the compensation decisions based on performance evaluations?  For example, if the associate compensation system is entirely an automatic lock-step and bonuses are tied exclusively to a billable hour formula — then there is little reason to connect the two.  The subtleties of a proper performance evaluation are not connected to changes in pay in this example.  

2. Are there other dimensions to the pay decision outside of the individual’s performance (team, practice group, department, office, firm performance) and how important are each in the overall compensation philosophy?  In this situation, the performance evaluation and the pay decision should both assess and discuss the same dimensions, how they interrelate and the relative importance of each in the overall compensation decision.

3. Is there sufficient flexibility in the compensation program for material differences in pay between high and low performers?  Even if pay decisions are heavily influenced by the performance evaluation, if there is an immaterial pay differential opportunity between those judged high performers and those judged low performers, there is little reason and high risk to connect the two.

4. Is the performance evaluation process properly designed, implemented and supported so as to be effective?  Are both performance and career development properly balanced?  Is the review cycle the proper interval?  Is there a need for a mid-period formal check-in and/or are there opportunities for informal review available?  Are the metrics sufficiently descriptive to mitigate against differing views of performance (this generally rules out the simplistic “Does Not Meet, Meets and Exceeds Expectations” systems).  Is the evaluation thorough, yet focused (remember that the partners have many, many of these to complete)?  Are the reviewers trained in completing the evaluations?  Are the individuals who aggregate the individual evaluations into a comprehensive assessment trained?  Are the individuals providing feedback trained?  Are prior year evaluations available to note progress and to provide continuity? 

5. Have the stresses that highly integrated performance evaluation and pay programs create (tendency for less open communication, more conservative setting of performance goals, heightened focus on short-term performance rather than career development, grade inflation to achieve a desired compensation result — protection of ones key team members) been considered and mitigated to the extent possible?

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 client 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 — i.e. 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.