The variables for setting compensation of a newly promoted partner can be a challenge to get right for all concerned.  Let’s look at an example.

Last year as an associate Sally’s total compensation consisted of a $200,000 salary, a $50,000 year-end bonus, $24,000 for a top shelf package of health/dental, life, disability and LTC insurance, $29,500 in employer pension contributions, $9,900 in employer paid payroll taxes and $1,600 in misc. reimbursements of business related clubs/dues.  Total compensation was $315,000.  Sally must make three annual $25,000 payments to have a seat at the partnership table - her buy-in requirement.

Let’s assume that Sally generated a healthy and typical 30% profit to the partners as an associate and that per timekeeper overhead was $150,000.  This means that her working lawyer fee receipts were $665,000.  Let’s also assume that Sally has worked hard at positioning herself in the marketplace and has built a $400,000 portfolio of client relationships mostly from existing clients plus a few of her own new clients.  The new clients, while small in number, are right in the sweet spot of the firm’s strategic intent.

What is a fair compensation for Sally assuming this year’s performance is as good as her last year as an associate?  We will also assume for ease of discussion that everyone else repeated their prior year performance and the firm’s overhead remained steady.

1.  As a partner, Sally drops below the line.  The $315,000 compensation package ceases being a firm expense.  Good for the firm.  Sally is now “self-employed” so she must plan for making quarterly estimated tax payments as the firm no longer “withholds” for taxes or remits the employer’s share of social security and medicare taxes.  The firm will continue to pay the insurance premiums and remit the dues on her behalf, but the tax reporting and treatment of those items will change.  So to stay even Sally needs a draw, distribution and payments in kind totaling $315,000.  For the moment we will ignore any individual income tax affects.

2.  What about a cost of living adjustment?  Inflation for 2007 was 4.1%.  Wouldn’t we all like to be immunized against economic forces?  Yet the firm wants Sally to be excited about her first year as a partner and is concerned about the message no adjustment sends.  Associates would be getting increases and should the firm maintain some separation between the young partner and its senior associates?

3.  Let’s not forget that Sally also has that buy-in requirement of $25,000 for each of the next three years.  Possibly more after that.  To keep Sally “whole” her compensation package needs to be $340,000.  But any increase over the $315,000 dilutes the profits for the remaining owners.  Should they make less so she takes home the same?  And should the firm pay the new partner’s capital for them (Which is essentially what this suggests)?

4.  What would a lateral be worth with Sally’s metrics?  The firm would like to be competitive with what the market is paying.  The market might pay anywhere from $390,000 to $520,000 with a significantly greater likelihood for the lower third of that range IF the portfolio of client relationships is truly portable.  That might be a big assumption since her portfolio is largely based on long time clients of her current firm.  Again if all else remains the same then the remaining partners’ earnings are diluted when paying Sally at “market.”

5.  Are newly minted partners still profitable?  Sally produced a 30% profit margin in her last year as an associate.  What is typical when one becomes a partner?  Partners share in profits, correct?  Yes, technically they do share in profits; but as a practical matter young partners slowly recapture that profit margin over a period of years, not immediately.  See Partner Profitability for a chart that shows profession wide data.  The bright maroon line is break-even; so above the line are profit contributors and below the line are the true profit sharers.

6.  What about locking Sally in and say that growth in her earnings is dependent on growth in firm earnings.  She will earn more than her $315,000 as the firm earns more.  There is a degree of logic here, particularly if the sharing of earnings growth is generous.  In this situation the partners are saying we built the firm to “x” and your $315,000 is fair for that.

These are typical considerations for firms making first year partner compensation decisions.

Some firms consider a bonus any payment in addition to base pay.  So a distribution beyond draw/salary made in accordance with a defined allocation is a bonus.  No attempt is made to distinguish performance from individual to individual; or for any one individual, from actual to expected contribution.  Such payments commonly arise out of point, percentage, tier and lockstep systems that align the distribution with the underlying pre-existing allocation for base pay. 

A slight variation of the above occurs when there is a pre-determined distribution allocation that differs from base pay allocation.  Sometimes there may be more than one such distribution tier.  For example, the first $1,000,000 is distributed on base pay, the next $1,000,000 is distributed equally, the next $1,000,000 on some other basis.  A variation of this for admitting new owners is properly examined in an upcoming post.

Sometimes firms use a bonus to reward extraordinary contribution.  When best done, extraordinary contribution is narrowly defined.  Recipients are few and the size of each bonus large.  Under this definition only about 2.5% to 5% of contributors would qualify for a bonus.  A large bonus exceeds 20% to 25% of base pay.

Other firms will award a bonus when an individual’s performance exceeds that expected for his/her base pay.  Usually the exceptional performance must warrant a bonus of at least 10% of base pay.  Under this definition many more individuals might qualify for a bonus.

Then there are the firms where a bonus may be awarded an individual who measurably outperforms his/her peer group.  This is generally more common in point, tier and lockstep systems that have a bonus modifier.  Here one must not only excel but excel beyond that of his/her peers.  Again the differentiable performance should probably warrant a bonus of at least 10% of base pay.

These are the most common bonus types.  If you have experienced a different approach, please join in with a comment.

The next question may very well be which method is best?  That largely depends on the underlying base pay program, the desired values and behaviors as well as the strategic intent of the organization.  There is one type of bonus system that the author has little regard for — small differentiated payments to nearly everyone.  That approach is likely to create more trouble than it is worth.  One might be better off running an extra payroll.  You are likely to accomplish much the same result with significantly less effort and less downside risk.

Another question typically asked is why minimum bonuses of 10% or 25%?  By setting a minimum bonus as a percentage of base pay the threshold automatically adjusts as pay increases.  For example, a $10,000 bonus for someone making $100,000 or less conveys something very different from that same amount for an individual with $1,000,000 in base pay.  Another reason is to recognize the lack of precision possible in pay decisions.

The success or failure of any compensation system is not simply inherent within the structure of the program.  Compensation is just one element of how law firms operate.  What we tend to forget is the purpose of a compensation program is to make good compensation decisions.  It is a tool.  Certain tools are better than others depending on the circumstances.

For example, a pure lock-step program largely requires the firm to assess a senior associate’s ability to progress as a partner over the remainder of his/her career.  Essentially you are making some thirty or more years of future compensation decisions at one time.  Such an assessment requires much more careful attention to the qualities of being a partner.  And such attention is rare.

Before we dismiss any particular compensation program or quickly accept the “conventional” wisdom of a current favorite approach; we should think about how well the program will fit the firm and how well it will facilitate good compensation decisions.

Let’s start off the year with a look at a law firm partner compensation approach that many consider an antiquity, yet 8% of firms still use.  Lockstep compensation for partners has vocal proponents and detractors.

What are some of the key positive attributes of such a system?

1. It supports a single firm philosophy.
2. There is little internal competition.
3. Leadership has more time to lead without the annual compensation ritual.
4. Non-traditional roles and new postings are more easily undertaken.

What are the main arguments against lockstep?

1. There is no accountability.
2. Stars are not specifically recognized monetarily (at least not instantly).

For a more extensive review of this approach read my article, Lockstep Compensation - Does it Still Merit Consideration?