Law firm partner compensation is comprised of pay, profit and reinvested capital.  Few law firms distinguish between the three and it may be fair to say few partners even think of their compensation in this way.  However, if the partners took this view they might pay better attention to how each of these elements affects what they take home.  Here are the elements with a brief comment on each.

1.  The fair exchange for one’s labor—partners are very much active workers in the business.  They must be productive in fee generation both as an originator and as a timekeeper.  And they must undertake a host of non-billable activities for a modern law firm to operate well (manage, train, supervise and marketing are among a few on that list).  This is their true pay.

2.  PLUS profits from the labors of others—all other timekeepers should be profitable (generally even non-equity partners).  They are consistently and significantly profitable in the top firms.  This is their true profit.  For an interesting and related IRS view on this see my article on Unreasonable Compensation For PC Shareholders.

3.  LESS investment for growth—new people, offices, practices and markets are often funded out of current cash flow.  Since firms deduct these expenses currently they are the hidden capital invested by owners to grow the business.

4.  LESS investment for capitalized assets—items shown on the asset side of the balance sheet when there is no corresponding third party obligation for funding those assets (debt or capitalized lease obligations).

5.  LESS investment in working capital—higher salaries for associates being a prime example of a limited duration cash gap often funded by initially lower equity partner compensation.

A recent Law.com article, Reed Smith Holds Back Partner Pay for Legacy Firm’s Nonequity Rank, illustrates the use of compensation as a tool to direct behavior and performance.  As indicated in the article there are mixed views as to whether this is the right and proper approach.  Answering that question solely from the context of an article is nearly impossible since we do not know what else the firm is doing to ensure compliance with billing and collection policies.  So our comments here are not directed toward that particular firm referenced in the article.

However, we can say that using compensation as the lead element to direct performance is probably not the best approach.  Rewards and punishments (the carrot and the stick) both may secure temporary compliance but often with resentment at the manipulation.  There is an excellent article by Harvard Business Review by Alfie Kohn, Why Incentive Plans Cannot Work, that broadens our thinking about the role of compensation.

Those who do the job (broadly defined) well should be paid more than those who do not.  In that context compensation is the recognition of differing contribution.  That alignment is very important and was demonstrated as such by David Maister in Practice What You Preach.  Compensation becomes the tangible expression by leadership of what they truly value.  It is vitally important that what they say is valued ends up being what they valued with compensation.  Also, that the pay differential is proportional to the performance differential. 

The recent article in the National Law Journal entitled, Should Law Firm Leaders Get CEO Pay?, raised some interesting points.  One of my first blog entries dealt with the transition of managing partner compensation.  Today lets look at how law firm leaders are generally paid while in the role.

There are three broad approaches to compensating management:

•  Based on inputs.  Discuss and arrive at an appropriate hours budget with the incumbents for each position.  Attribute working lawyer fee credits for the time spent up to budget at the individual’s average effective rate.  Attribute hours in excess of budget only upon approval—the incumbent should justify why the additional time was required.  This may occur in a year of a relocation, significant technology migration, merger exploration or other episodic and important event.
•  Based on results.  Pay a percent of firm fees and/or a percent of the partner income pool—a small percent designed to yield a pay decision that compensates at about what they are making now if the firm performs the same level, more if they advance the firm’s performance or less if they dilute performance.  Alternatively pay a percent of average partner income to position the person again where they are now if the firm performs the same.  It is difficult to get partners to forgo marketing and practicing law and undertake a significant management role if they are to be paid less by doing so.
•  Fixed.  Pay a stipend based on the demands of the job or add a bonus to factor in how well you do that job.

The method used is largely a product of the firm’s size, management sophistication and the partners’ collective sense of the appropriate role of a law firm leader.  At the end of the day, paying for leadership is a “tax” paid by all partners for the centralization of management functions and the benefits of leadership in running a more competitive law firm.  The very large law firms with full-time lawyer leadership positions have come to realize that they need a compensation program that is specifically geared to their leaders; yet aligned with the values and culture that all partners are compensated under.

The Altman Weil 2007 Senior Leadership Survey provides insights into the leadership roles, responsibilities and compensation of managing partners and executive directors.  We have conducted this survey five times over the past 15 years.  The link below opens a table that illustrates for all firms the relative compensation position of the managing partner and executive director relative to other partner compensation benchmarks.

Senior Leadership Relative Pay

The use of a tiered partnership structure is common among larger law firms.  According to the 2006 Altman Weil Compensation Systems Survey 85% of firms over 100 lawyers use this structure.  Although those “partners” are slightly more likely to be treated as W-2 employees for tax purposes.

The range of thinking on this topic runs the gamut from cynic to advocate.  The cynics generally feel that it is one of the tools law firms use to manage earnings (PPEP - Profits Per Equity Partner).  Even though law firms are privately held businesses, their performance is a much discussed topic.  And a key ranking is based on the PPEP.  Just as public corporations dress up their financial statements, so now do law firms.  Another cynic view is that this just avoids making hard people decisions.  “We provide the easy out of a separate box to put people in rather than confront whatever issues are holding this person back.  If we can not say no at least we can say non-equity.”

Advocates espouse the additional time lawyers have to develop the skills a hyper-competitive market is looking for (code for the ability to generate an independent book of business).  They also point to this tier as an appropriate alternative for those lawyers whose career goals do not include equity partnership responsibilities.  By allowing these seasoned lawyers the opportunity to acquire the mantle of ownership (or if you prefer — the pride of partnership) you can retain talented individuals who have no desire to become full owners of the business.  Tier distinction is generally only internally known.  Therefore many clients will see the firm as having more “partners”, and those non-equity will be able to market as a “partner” likely getting work and rates different then when they were senior associates.  And if the commentary about the Millennial generation is true; then praising them with non-equity creates the “everyone is a winner” syndrome that they were raised with.  For more on the Millennial generation in the work force see the 60 Minutes program aired 11/11.

I like the career flexibility non-equity tiers offer, as long as the firm still is disciplined regarding rigorous criteria for admission into these ranks.

The market occupies itself with the compensation contest of the leading law firms.  And although this makes for good reading, it is not the whole story.  The National Association of Law Placement (NALP) collects and publishes a wealth of information regarding compensation and hiring patterns of recent graduates and associates in law firms.

Test your knowledge of the market:

1.  How many law school graduates were there in 2006?

2.  What percentage were hired by law firms?

3.  What size law firms hired the largest number of those graduates and how many did they hire?

4.  What size law firms hired the second largest group of those graduates and how many did they hire?

5.  What was the median starting salary for the 2006 graduates?

6.  What does the starting salary curve for look like (i.e. bell shaped, skewed, etc)?

7.  Since 1992 how much have overall associate salaries increased?

8.  How does that compare with inflation for the same period?

9.  How does that compare with the profession’s change in prevailing billing rates for the same period?

10.  What do the long term starting salaries tell us about the future?

Most of the answers are available from NALP.  Spend some time on this site to gain a better understanding of what the recent graduate market is like.  Also read this article, The War for Talent and Starting Salaries,  from Ward Bower about the supply and demand equation for recent graduates.

Now the rough answers:

1.  44,000
2.  55% (24,000)
3.  Over 100 lawyers (9,700)
4.  2 - 10 lawyer firms (8,400)
5.  $62,000
6.  Bi-modal with the small firms clustered just below the median (around $45,000) and the large firms forming the upper mode around $140,000.
7.  Doubled (100% increase)
8.  1.4 times inflation
9.  Prevailing billing rates increase 1.8 times inflation for the same period.  Consistent with how the fee production of associates tracks with their compensation costs.
10. Large firms compete for top graduates in top firms.  They hold the line on increases during and immediately following a recession, then accelerate the pace of change once the market is solidly underway again.  The larger firms drive more aggressively regarding salaries than do their smaller competitors. We will likely see a slow down in increases when the economy faces its next recession. Then afterwards the competition will heat up once again.

Retirement is a topic generating some buzz in the news.  In October 2007, the U.S. Equal Employment Opportunity Commission settled an age discrimination case against U.S. law firm Sidley Austin LLP on behalf of 32 former partners.  The firm paid $27.5 million dollars and entered into a consent decree.  In August the American Bar Association at its annual meeting recommended that law firms end mandatory retirement policies and urged that law firms evaluate their older partners on the basis of individual performance.  Led by action in April by the New York State Bar Association which separately had adopted a similar position.  A comment to the Welcome post in this blog about the EU retirement perspective further highlights the issue as broader than just our US interests.  More on the EU in a moment.

All of this is quite timely as we are in the midst of data collection for the next iteration of Altman Weil’s Retirement and Withdrawal Survey.  This study has a Spring 2008 publication.  In addition, we felt that a more individual perspective would be both timely and informative.  So in September we conducted a flash survey of Managing Partners in US law firms with more than 50 lawyers.  The Altman Weil Flash Survey on Lawyer Retirement indicated that only 38% of lawyers agreed with the enforcement of mandatory retirement provisions in law firms.  However, fifty percent of respondents reported that their firms currently have mandatory retirement policies.

As the Baby Boom generation nears retirement, many have already had a change in perspective.  Clearly the landscape has changed since these policies were put into place.  The EEOC is willing to extend its reach to law firm partnerships, partners are living longer and healthier lives and are eager to continue the practice of law, and finally law firms are more aggressively seeking well connected lawyers to help grow their firms.  The time has come for further dialog among firm partners to sort out how best to move forward.

Now back to the EU comment mentioned earlier.  I asked our colleague in the UK, Tony Williams of Jomati Consultants, LLP, if he would provide his perspective.  His thoughts follow:

“I think the reason for partners retiring early are various but let me summarize them:

1. UK firms particularly over the last five years have been far more performance orientated. As a result the pressures on partners have continued to be pretty relentless and the possibility of easing off as one approaches ones mid to late 50s is generally not an option. This is exacerbated by the fact that most of the major UK based firms operate on a lockstep remuneration system. Accordingly if you cannot sustain a level of billings which justifies your place on the lockstep then you go. Some firms have introduced some flexibility to their lockstep but this tends to be very limited and very short term.
2. This pressure has caused a number of partners in their mid 50s to reconsider their positions and particularly in view of the high level of earnings over the last few years to decide that they want out. Some retire completely others remain in a consultancy capacity and some may move across to become general counsel etc.
3. Until relatively recently partners were able to make very tax efficient pension contributions and so many are in a sufficiently comfortable financial position to be able to retire. This is particularly the case for those that have significant London properties as property price increases in London have been significant over the last ten years and if on retirement the partner is trading down they are able to release significant amounts of capital tax free.
4. That being said there is some evidence of a more flexible approach being adopted. It is quite clear that firms are wanting to keep and remain motivated the best older partners. This is particularly an issue as the baby boomers are starting to retire because they do have a range of experience and client connections built up over a significant period of time which are increasingly valuable. Furthermore if partners have a young family or a second family there is often a financial imperative to continue working. In addition recent changes to pensions law has limited the tax efficient ability to save in a pension fund.  That combined with lower interest rates and longer life expectancy has reduced the yield on pensions by well over half over the last ten years.
5. A further factor is that this year the UK introduced age discrimination legislation which clearly applies to law firm partnerships. As a result the older partners are no longer seen as the soft option and the issue of partner performance is being addressed across the entire age range of partners. As you may have seen, Freshfields was recently involved in the first high profile age discrimination case which it won. It is interesting however that many of the partners that they have eased out in London over the last year have moved to other firms to continue their careers albeit at significantly lower income levels.The major UK firms have seen it as a pressing need to get their profitability up to a level which is more comparable to the major US firms (partly because they want to grow in New York but mainly to remain competitive as US firms are more aggressively hiring in London). As a result they have been much more ruthless in relation to partner performance and are holding their equity much tighter than ever before. Most firms have now introduced a non equity partner status to effectively defer the granting of equity and to ensure that equity is only given to partners who will grow the business and perform at an appropriate level.”

   Tony further offered a very good related article, The Little Grey Cells Have A Leading Role In The Best Firms, that speaks to the age issues of law firms.

Law.com had a good article (Midsize Firms Go For Big Changes) regarding how law firms work through the difficult issues of associate pay.  Realize that the definition of ”mid-size” is very much market dependent.  Yet many firms are grappling with recruiting and retaining young lawyers in a fiercely competitive market (at least for the better graduates from the better schools).  The market leaders continue to push to find where the market will segment.  $145,000 for first years did not do it, and neither did $160,000 — will $180,000? $200,000?  And that is just salaries — layer on a signing bonus, year-end bonus, fringe benefits and employer mandated benefits to see the entire picture.  These “mid-size” firms are balancing competitive pay, client concerns over value, partner concerns over investment (profits) and associate concerns over lifestyle.  More changes are likely as the market sorts out growing demand against a relatively fixed annual supply of US trained lawyers.

The word on the street is that the year over year increases are staggering and that compression is rampant — or is it?  A quick look at NALP data for April 1st 2007 and 2006, even allowing for sampling error yields a mixed view.  See the table:

 Associate Pay Increases

There is a mixed result.  Inflation for the period was 2.6%.  Some increases clearly resulted in real dollar gains year over year; while others did not.  And the change in spread (a measure of compression) indicated an equally mixed result with smaller firms doing quite nicely in this regard.

The spread is usually described as a ratio of the highest paid partner’s income to the lowest paid partner’s income.  So a firm where the highest paid partner earns $1,000,000 and the lowest paid partner earns $100,000 has a spread of 10:1.  We are often asked about whether a particular firm’s compensation spread is appropriate.  There are two answers to that. 

The first is what most firms are initially asking — are we in line with what other similarly situated firms are doing?  Now the simple solution is to turn to survey data, determine the comparables and compare.  But let’s explore this a bit further.  Are we asking about all partners or just equity partners?  Firms with two tier ownership might be interested in a different number then a single tier structured firm.  Do we exclude the part-time or semi-retired partner?  Do we exclude the outlier partner at the top of the pay list who is an anomaly?  The ratio is going to vary, possibly quite a bit, based on how we address each of these questions.

What we have found in our research is that the acceptance of a greater spread (higher ratio) increases with size.  Also the differences between single tier and multiple tier spreads becomes noticeable in firms with more than 10 lawyers and significant for firms with more than 75 lawyers.  While smaller law firms (20 or fewer lawyers) are generally comfortable with all partner ratios under 3.0; large law firms (over 150 lawyers) are more likely to have all partner ratios of 4.0 to 9.9 to 1.0.  The diversity of views on this is remarkable.  6% of these large law firms have ratios in the 2.0 to 2.9 range while another 6% have ratios in excess of 20 to 1.

The second answer is related to the culture of the firm.  Here the answer depends on the individual firm’s ownership environment.  Some law firms manage the spread and some do not.  When they do manage it, the reason is often a cultural attribute.  It is their collective sense of propriety for the relationship among the owners.  A partner once asked me if I make 10 times one of my partners, is that partner really a partner of mine?  Interesting question that articulates the relationship that exists between pay and culture.  When the ratio is managed it is in a structured compensation/ownership system of points or tiers or similar arrangement.  Other firms take a decidedly different view — one that says this is an unimportant and/or irrelevant factor.  This is more likely in confederation style law firms or law firms that prize individual enterprise as the key differentiating factor.  Note that while one might expect that firms with formulaic compensation systems would have higher ratios, this has not been borne out in our research.  Certainly there might be a greater tendency for this result in a system that is unmanaged by subjective factors, but it appears that the lawyers drawn to law firms with such systems tend to join and stay together because there is not a significant performance difference among them.

Merger discussions generally center around the rationale for and methods of putting two law firms together.  The focus is on the opportunities to access new clients and markets, to qualify for more interesting engagements, and to bring on additional expertise.  There is a long list of issues to consider — strategy, culture, conflicts, financial results and the like.  Then there are structure concerns, redundancies, tax considerations, and more to negotiate prior to bringing the transaction to a successful conclusion.  Yet even with careful planning, every once in a while the pre-merger thinking misses the mark and the post-merger firm is not destined to make it. 
 
Like pre-nuptial agreements, de-merger clauses are often not considered appropriate.  Who wants to plan the breakup at the beginning of the relationship?  And certainly an “out” option may delay and complicate integration of the two firms — such as sharing clients, integrating service teams and combining administrative functions.  A de-merger clause may not be appropriate in all situations, but it can be helpful.  Undoing a failed merger is tricky under the best situations, it becomes much more challenging when one firm has given up its identity as part of the deal.  Having a roadmap can ease the difficult and sometimes contentious task of undoing the deal.
 
Here are some factors where a de-merger clause might be helpful:
 
Protecting client relationships — this can be complicated in two ways:  1) how client relationship responsibility is assigned in the combined firm (expertise, location, succession plan and the like), and; 2) who clients want to continue with as their advisors (the client’s wishes control).  A de-merger clause should think through how to fairly treat the firm who brought the client to the dance.  Then there are the new post merger clients.  Here the complications are how the client came to the new firm and where it ends up after the break up.  Particularly difficult are jointly obtained clients where only one firm will serve the client going forward.
 
People — A law firm’s most precious resources are its people.  Generally one would expect to have people return to their pre-merger firm.  Many times it is not quite so simple.  There may be some unofficial recruiting going on behind the scenes.  Some individuals may prefer to “cross-over” to the other firm.  Then there are the displaced personnel lost during rationalization.  Finally there are the reluctant participants — partners who went along with the deal with reservations and now desperately want to take their practices and leave.  Each of these scenarios can be anticipated and protocols agreed to as part of a de-merger clause. 
 
Infrastructure — It is more an issue when the firms have combined physically.  Someone will need to move or there will be costs to segregate and reconfigure space to accommodate two separate firms.  The same holds for technology, library and other shared administrative services.
 
Partial acquisitions — These are deals where not all partners become equity partners in the new firm.  In these instances the de-equitized partners are often bought out of their equity positions as part of the transaction.  If these buy-outs are relatively minor as a cost of the deal, a de-merger clause might be helpful.
 
When are de-merger clauses possibly not helpful?
 
Succession deals — The purpose of a succession deal is to provide an exit strategy for “sellers” while transferring clients and market presence to the “buyers.”  The acquirer will invest heavily in making the transfer successful and it would not be terribly helpful for the seller to have an out to pursue a more attractive offer that could come along.
 
Integration efforts — Forging a single firm out of the two predecessor firms is challenging and requires three to five years under good conditions.  Having a short term strategy to undo the deal complicates these efforts.  It is just common sense that each party will tend to protect their positions while the option exists.  Thus a discord to the efforts required to go forward as a single firm. 

A recent Wall Street Journal article (9/24/07) “A Stingier Job Market Awaits New Attorneys“* discussed some of the less reported aspects of beginning a career in law — that most new lawyers do not get the top salaries currently being written about ($160,000), many finding employment elusive and law school debt burdens that run $50,000 to $80,000 or more.  Add to that consumer debt and you have a significant fiscal challenge very early on in life.

I read the WSJ article just after reading an excellent article entitled “Personal Financial Ratios:  An Elegant Road Map to Financial Health and Retirement“ in the Journal of Financial Planning authored by Charles J. Farrell.  The Farrell article uses simple ratios to demonstrate how lifestyle (living expenses, debt repayment and savings rates) can be monitored to achieve retirement goals.  He explains the underlying assumptions, provides a realistic budget, and exhorts fiscal discipline.  Be warned, this frank depiction of what it takes to reach retirement debt free and with sufficient savings may shock those who listen to the traditional wisdom of how much debt someone can afford and still accumulate wealth.

Bringing these two articles together suggests that many law students should plan more conservative lifestyles.   Expensive cars and vacations, frequent entertainment (dining out, theater, etc) may need to be deferred until income, savings and debt are brought in line.  Unspoken in Farrell’s article, but certainly a possibility is that social security and Medicare will not provide for recent graduates when they reach retirement in the same manner that those programs do for current retirees.  If those social programs were to materially change for the worse; the more aggressive scenario presented in the article would become much more important a consideration.

* a WSJ online subscription may be needed for this link to work.