US firms have raised the bar for promotion and more frequently ask the hard question, “Is there really a need for more owners in this practice?”.  The recent Law.com article, London Law Firm Leaders Taking a Hard Line on Partner Promotions, demonstrates that UK firms are facing similar economic and promotion challenges.  And many of them are making tiered ownership distinctions, which further complicates the task.

Generally law firms are best situated if they promote to ownership only those who can maintain, refresh and expand the business opportunities of the firm.  Without this one attribute, no firm can remain competitive or viable for very long.

Unfortunately, this is easier to preach then to practice.  Getting a good answer to the question and a fair understanding of one’s ability to attract business is easy in some situations.  But in large law firms where the relationships with clients are quite complex — often spread across time zones, client business divisions, and law firm practice groups, law firm leadership is handed a very difficult and subjective assignment.  This is particularly so since the candidates are mostly younger partners who are just beginning to establish their market presence and some of the decision is a bet on the future.

The hard liners will say, “Candidates make it when we can no longer afford to ignore them.”  Often this means waiting until the candidate and a string of clients are about to leave.  Strongly Darwinian, this model does little, in my view, to create a collaborative organization.  More likely it will reinforce individualism as the dominant cultural element.  It will however, substantially lower the likelihood of bad promotion decisions.  On the other hand it raises the possibility of two opposite problems.  First, such firms are more likely to miss opportunities to collaboratively grow business.  Second, one may wait too long and the solid candidate bolts.

Others will preach generosity in recognizing the efforts of others to grow the firm.  This is key to firms that desire a strong institutional culture.  Many law firms we work with, and in particular larger law firms, work hard at establishing and maintaining this perspective.  Unfortunately, this approach does increase the likelihood that promotion decision, particularly in good times, will create challenges when the market turns and only the most skillful of the partners will be able to further the workflow of the firm.  It is during these times that the firm’s culture is truly tested.  Will it move towards the Darwinian model as a consequence of economic pressures?  Or will it pull together with increased efforts to maintain work intake to ride out the downturn.

This is one of several fact scenarios a six-member panel of experts discussed at a recent New York City Bar event.  The moderator was Dean Joan Wexler and the event was co-sponsored by the Committee on Senior Lawyers and the Public Service Committee of the Federal Bar Counsel.  The event is part of the ongoing awareness efforts stemming from the NYSBA report on mandatory retirement and the NYCB report on the use of lawyers of retirement age in pro bono practices.

The Committee debated the effects of an ad hoc approach to waivers; the potential consequences of a waiver precedent on other senior partners approaching and in the decompression program; the possible adverse reaction of younger partners who enthusiastically support the policy; the likelihood that no waiver might force the withdrawal of that senior partner along with the key clients and associated revenues; client reaction either way; the ABA position on mandatory retirement and the potential legal issues that might arise out of the Sidley Austin case coupled with the announcements of several law firms regarding changes to their own provisions.

Clearly this topic requires further discussion within firms as an aging, but largely active, lawyer population approaches the traditional retirement years.  There are competing interests involved.  However, I agree with the NYSBA report’s consensus view that “…mandatory age-based retirement is inconsistent with accepted employment practices in this country…” and that “such practices are against the best interests of law firms, clients and the professions…”

Now is a good time for law firms to engage in a dialogue about their own provisions and what is in the long term best interests of their firm, partners and clients.  More information can be found at the NYSABA Special Committee on Age Discrimination in the Profession web site.

As Professor William Henderson at the Indiana School of Law writes in his May 2006 paper titled An Empirical Study of Single-tier Vs. Two-tier Partnerships in the AmLaw 200, “…this study documents that average PPP are significantly higher in single tier firms, even after controlling for geographic market segment and firm leverage.  The higher profitability of single-tier firms appears to be a function of higher levels of prestige, which enable single-tier firms to (a) attract and retain a more lucrative client base, and (b) run a more rigorous promotion-to-partnership tournament in which associates work longer hours and are less secure in their futures with the firm…”

So should anyone consider a second tier?  Perhaps.  There are still some benefits to a second tier including  establishing a career option for critically important senior advisors and the very best technical specialists who do not want the responsibility of full ownership — the “pride of partnership”; or, as a proving ground for those who have yet to demonstrate sustained business generation in acceptable quantity and quality but who you consider are more likely than not to do so.  Undertaking tiers still requires carefully stated objectives (including how this structure relates to the firm’s strategic intent; clearly articulated rigorous admission standards for both tiers; that the firm design the tier to be a desirable career path; and, that the equity partners reach consensus that this is a good thing to do.

Why does this happen?  Law firm owners must be able to create market presence, build trust based relationships, be alert to business opportunities and bring in work for their firms.  In good times it is easier to do this.  When the marketplace contracts, those who are least skilled, least experienced and least well positioned to get business will be hurt the most.  Add to that what might, upon reflection, have been an excessively generous promotion or pay increase.

Obviously, a firm would prefer not to have the problem.  But that takes discipline during good times to appraise an individual’s ability to sustain performance in a variety of circumstances.  Therefore compensation committees must look beyond the numbers, engage in realistic appraisals of sustainable performance and potential, make compensation decisions and promotions much more carefully and to discuss their conclusions with each individual.  Frank, candid and constructive dialog consistent with the firm’s values and strategy are the most effective means to manage expectations and to build credibility as a leader.  These steps will not eliminate the problem, but will go a long way to reduce the severity of the issues later on.

However, if a law firm is in the midst of the problem there are hard decisions to make.  Some firms will turn to “non-equity” ownership structures as an answer.  This is not a good reason to create a tiered ownership structure, but if you already have one it had better have clearly articulated and enforced performance standards for admission and retention into each ownership tier.   Secondly, you have maybe a two to three year window of opportunity to improve contributions from those who are in a tier not warranted by the individual’s sustained performance or immediate potential.  After that, leadership’s credibility is damaged.

But the problem is now - and the heavy hitters are getting restless.  Now is not the time to fully reverse course and to overreact in the opposite direction.  Leaders must move with deliberate speed to address the situation.

First, assess the situation with brutal honesty.  How bad is the market change?  How long is it likely to last?  What shape will the recovery likely take?  What might not come back at all?  What resources does the firm have to ride out the cycle?

Second, take the pulse of the firm.  To what extent are the heavy hitters willing to ride it out?  How well informed are the partners regarding the firm’s fiscal health, market forces and their own ability to contribute?  Get assessments and projections for each major practice.

Third, craft a plan consistent with your analysis of the current situation and likely future.  Balance the response to the facts and circumstances.  Look at a range of fiscal and operational opportunities, yet do not forgo all investment for the future.  Develop a time-line for each corrective action.  When to begin the corrective action, how long it will take to be fully implemented as well as the time-line for how it will affect the firm’s finances. 

Fourth, communicate, communicate, communicate.  Engage in constructive discussions regarding the most promising corrective actions.  Keep people informed, invite feedback and dialog.  Remain open, candid and upbeat in all of your interactions and communications. 

Lastly,  treat people with respect and compassion.  This is important to each leader for how they are perceived by others, to each affected person for their legacy perception of their firm, and to everyone else as the clearest possible indication about how they could be treated in the future.  How you treat people in difficult times defines the true values of your firm.

Using the 2007 AmLaw 200 and NLJ 250 (both based on 2006 results) we see that Latham & Watkins and Skadden Arps were both approaching the $2 billion annual revenue threshold.  But they were neither the largest by number of lawyers or the most profitable by profits per equity partner.  The largest was Baker & McKenzie and the consistently most profitable firm is Wachtel Lipton (although they came in at # 2 in 2006). 

View the Comparison Table to see these four firms and their rankings in revenue, revenue per lawyer, profits per equity partner and total number of lawyers.  

View the Correlation Graph to see how the AmLaw 200 look when you graph the relationship between profits per equity partner and the total number of lawyers.

1. Total debt (including capitalized leases) should be no more than 100% of the net book value of the fixed assets; 90% is okay, but 80% or less is much better.

2. Lines of credit should have a zero balance at year-end and for most of the year.  The credit line should not be used to pay partners or be used as the first source of working capital.  It should be there to augment working capital, covering unusual economic conditions (i.e., negative economic performance beyond one standard deviation of norm).  An available line of credit equal to the funds required to cover one month of payroll (including owners) is one rule of thumb.

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.

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.

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?

The question I get most when talking about capitalization is how much and in what form? I have two precepts. Owners should contribute meaningfully at buy-in and provide the majority of capital needs to their firms. Clearly law firms should expect meaningful financial investment from each owner. Having a seat at the table is serious business. Taking cash out of your pocket and putting it into the law firm’s is also serious business. Making a financial committment is one of the attributes of fully contributing owners.

Second, the firm should have significant liquidity. My test is probably much more severe than most. For most firms there should be sufficient cash at year end to pay out earnings, fund the retirement obligation and all payables plus two weeks of cash flow. As you might imagine, there is a fair amount of push back on these items. But a look at the profession suggests that law firms are closer than they believe to doing this. The attached chart, Balance Sheet Metrics, provides some key metrics for all firms and for the 25% most profitable firms. There are some clear differences in how the most profitable firms manage their balance sheet.