How much and how attorneys are paid are probably the most controversial topics in law firm management. These issues also have the potential for the most constructive (or destructive) response to management and productivity problems and other priorities that affect law firms. Why then, do so many firms have difficulty in reaching agreement about partner compensation? The answer may best be found in the personalities of the firm, the availability of distributable dollars and the egos of attorneys, most frequently demonstrated in the willingness of partners to make the compensation system work. Every law firm has a method for compensating its partners. Some compensation plans are highly structured, but many others include subjective elements.
The primary objective of every distribution plan should be fairness. Partners must believe they are compensated adequately for their contribution to the success of the firm. An inherent problem with the concept of fairness, however, involves differences of opinion regarding what is fair. Lock-step compensation plans based entirely on seniority are less popular today than in the past. Many of the better established firms have introduced incentives to recognize lawyers’ contributions. Incentives may be provided to attorneys who generate business from new clients. Obtain work from current clients, maintain business, produce work, record and collect a predetermined number of billable hours, manage the firm or its practice areas, train attorneys or participate in bar association or community activities that enhance the firm’s reputation.
Each firm needs to decide on the relative importance of each of the factors to be rewarded. If a formula is used, specific criteria must be constructed to provide for the desired results.
The partners should understand the rules of the compensation plan before a new year begins. The compensation plan should be supported with records that are comprehensible, reliable and readily available.
Any compensation plan is only as good as its implementation. Plans should be fairly administered and their rules and results evaluated appropriately. A good plan can be badly handled; conversely, even a bad plan can be handled reasonably well by fair-minded attorneys.
Basic Decisions
For most firms, certain basic decisions have to be made for the plan to operate. As the firm matures, the nature of the plan and its elements may change. Among these decisions are:
(1) Who, or what body, will make the decision on allocation of income?
(2) Will the allocation be based on percentages or units of participation?
(3) Will the distribution be prospective, with distribution percentages or units of participation determined in advance of the year – or retrospective, with distribution percentages or units of participation determined when year-end results are known? Alternatively, will an initial percentage be prospective and a specified percentage or amount of money be withheld for end-of-year distribution based on retrospective considerations?
(4) Will the profits to be distributed consist of all that is left over after overhead is paid – or will profits be considered everything after a predetermined draw, or salary equivalent, is paid to partner or shareholders in addition to overhead?
(5) Will there be a class of non-capital partners or principals whose salaries and bonuses are exempt from the final distribution of income to capital partners or shareholders? Or will there be a gross percentage divided among capital partners, and other pools divided among other partners?
In addition, records of past earnings, the competitive legal market for younger partners or outstanding specialists, and unusual provisions involving capital, retirement or death may have a bearing on the judgments applied in income distribution.
Plan Examples
The following is a digest of selected partnership distribution plans.
Percentages: The most frequently used system involved percentages determined at the beginning of each year, backed by statistics that show, for each attorney, billable and consequential non-billable time, billings, collections, aging of accounts receivable, amounts of write-offs and write-downs of unbilled time, disbursements and write-ups of bills.
Partners are assigned percentages of net profit by a compensation committee. For example, a firm of three partners may determine that each will share in the net profit by allocating 45 percent, 30 percent and 25 percent, respectively. The gross fees collected total $650,000; with overhead at 42 percent, the net profit to be distributed is $377,000. At the end of the year, the first partner, with a 45 percent allocation, receives $169,650; the second, with 30 percent, received $113,100; and the third, with 25 percent, receives $94,250.
The percentages the committee recommends may be final or subject to approval by the firm’s management.
Committees charged with administering compensation are increasingly expanding the age range of their members; more mid-level and younger partners are being elected to serve. In many firms, nominees are preselected. The decision-making process may involve some or all of the partners on the committee. A few firms use a secret ballot, completed by all of the partners and submitted to the committee for implementation.
Although many large firms use a percentage system, as a firm increases in size, problems frequently arise. First, it may become burdensome to calculate each partner’s percentage share. Second, a difficulty inherent in using a percentage system is that the total of percentage points must equal 100. If a partner is desirous of receiving a greater percentage, one or more other partners must relinquish a corresponding share.
Units of Participation: A units of participation distribution plan allows the partners to achieve the same allocation results as a percentage plan without having to contend with the 100 percent ceiling. Under a units plan, partners are assigned units in accordance with their contributions and other factors. There is no limit to the total number of units that may be assigned to any partner.
For instance, in the firm of A,B & C, A may have 40 units, B may have 35 units and C may have 25 units. A will receive 40/100ths of net profit. B will receive 35/100ths and C will receive 25/100ths. The following year, the allocations of B and C are increased: A receives 40 units, B 40 units and C 30 units. A and B each receive 40/110ths of the firm’s net profit; C receives 30/110ths of net profit. Although A’s proportionate share of income decreases in the second year in relation to B and C, he or she has not had to “give up” any units.
If a three attorney firm invites a fourth to join, and one of the partners is reluctant to reduce his or her interest, the firm may opt to allocate profits on the basis of units of participation. The three attorneys retain their numerical units and the fourth attorney is given a share of units. The problem, common to percentages schemes, under which partners may not want to relinquish any of their points, is avoided, and the compensation plan can more easily accommodate the needs of a growing firm.
Percentages or units of participation with a reserve: Many firms use plans that include a reserve ranging from 5 to 10 percent of net profit, based on the year’s performance. The reserve is allocated to individual partners based upon their perceived contribution to the firm, determined either under a formula or subjectively. The following will illustrate how the reserve is allocated.
Suppose a firm has a net profit of $377,000 and a 10 percent reserve. The distributable profit to be allocated, according to straight percentage, would be $339,300 – that is, $377,000 minus $37,700. The reserve, $37,700 is allocated to deserving partners subjectively, based on their contribution to the previous year’s performance. Factors that a committee may consider in determining how to allocate the reserve may include hours worked, fees collected, consequential non-billable hours devoted, business origination, profitability as the result of billings and collections, administrative skills and the like.
After analyzing the partners’ respective contributions, the committee may determine that one partner should receive 50 percent of the reserve, or $18,850, for having originated substantial fees. A second partner receives 35 percent of the reserve, or $13,195, for having managed a large case and collecting substantial fees. A third partner receives 15 percent, or $5,655, for having developed an in-house specialty and managing the associates’ career development program.
Variable of percentages or units: Another way to allocate profits is to establish a variable of percentages or units based upon seniority, reputation, past performance and anticipated performance, with the balance of profits divided equally.
Each partner receives a variable draw – for example, A receives $120,000; B, $105,000; and C, $95,000 – determined according to the above factors. At the end of the year, the balance of the net profit to be distributed amounts to $57,000. This is divided equally so that each partner receives a bonus of $19,000.
Some firms establish standard draws among all partners or among classes of partners, paying variable bonuses according to each partner’s contribution. For example, at the beginning of the year, all partners or classes of partners may receive a standard draw of $95,000. At year end, the committee allocates variable bonuses based upon partners’ contributions to the firm.
Statistical Plans
Statistical plans are frequently calculated according to mathematical formulas. The following is a description of various examples of formula plans.
Simple Formula: Many firms are successful in using compensation plans based on relatively simple formulas. Some firms establish the basis as 30 percent for originating the work, 30 percent for producing the work and 40 percent set aside for overhead. This simple formula uses a one-to-one ratio for the origination and production of work.
As a firm grows larger, however, it is increasingly difficult to evaluate the contribution of one partner in relation to the total contribution of other partners. Most formula systems include a method of pro-rating origination of work and production of work, and provide credit for managing the firm and performing other firm-approved, non-fee-producing activities.
Weighted Credit Formula: Under a credit formula, weights are assigned to key elements – for example, business origination, work production, profitability and attorney responsibility. The weighting process is usually a function of a firm’s needs and priorities.
For example, a firm with a substantial volume of institutional client business may allocate one a half credits to business origination in a given matter, six and a half credits to work production and two credits for managing the matter, for a total of 10. Another firm that has an ever-changing transactional client base and constantly needs to generate business may allocate three credits to business origination, one or two credits for procuring additional work form current clients – if the additional work results from the efforts of an attorney other than the originating lawyer – six credits to work production and one credit to profitability.
Other variations involve splitting credit for business origination into subfactors, such as credit for maintaining clients or case responsibility. A firm also may modify weights based on difficulty of case, transfer of responsibility for large estates or base association activity.
Much business comes to most firms without any clear indication of who should receive credit for origination. The firm will then have to decide whether to exclude these totals from its figures, allocate them to the lawyer handling the work or distribute the credit. Some firms allocate credit to the firm, which receives credit in the same manner as a partner. In such a case, however, the total of credits allocated to the firm may subsequently be reallocated to individual partners and reflected in their total credit calculation.
Credit for Profitability
The weight and use of the profitability factor depends on the firm’s concept of profit. For compensation purposes, profit may be calculated as a figure exceeding the partners’ draws, associate salaries and overhead. Profit may also be based on a figure related to the time-dollar value of services on particular matters. The manner in which the law firm calculates profitability and the personal effort expended by the lawyer who benefits from the credit should determine the weight accorded to this factor.
The statistics for work production may consist of such records as fees produced or total hours; the hours worked by each lawyer, pro-rated against the final fee; the time-dollar value of the assisting lawyer without regard to the total fee; or an estimate of the value of the effort contributed by each lawyer to the matter.
It is strongly recommended that the basis for any formula be actual fees received. Until the money is received, the business origination or work performed credit has no economic value and contributes only to overhead.
The following system illustrates a formula that is based on time records and hourly rates. A firm receives a fee of $2,000 for a matter for which two attorneys were required to perform the work. The first attorney recorded four hours at an hourly rate of $190, for a total time-dollar value of 760, and the second attorney spent seven hours at an hourly rate of $175, for a total time-dollar value of $1,225.
The firm’s final percentage distribution is based on the total time-dollar value of the matter. When the actual fee of $2,000 is collected, the first attorney is credited with 38.3 percent, or $766; the second attorney receives 61.7 percent, or $1,234.
Another method of calculating how to distribute the profits of the firm among partners is a formula system, in which the firm allocates fee credits for origination and production of work. Under this plan, business origination equals a multiplier or one, and work production equals a multiplier or two. The partners decide to use these two factors as a partial basis for determining compensation. They also subjectively consider such other factors as profitability, management, bar activities and community work.
In the system for allocation of fee credits for origination and production, the data collected are based on fees received and set up in three columns headed “Fees Received,” “Origination Attorney” and “Production Attorney.” Total fees collected are posted in the “Fees Received” column. The fees attributable to individual or shared effort, by attorney, are posted under the “Origination Attorney” and “Production Attorney” headings.
An alternative is an equal-sharing-plus formula, or statistical information plan. Under this formula, 90 percent of 95 percent of the net income is shared equally among all partners and the remainder is distributed according to a judgment based on statistics and subjective factors. This alternative recognizes the contributions that all partners make in many firms in aiding those who originate and those who maintain the business of their firms.
Combination Plan
Still another alternative is a combination plan, which might operate according to this formula:
Work Incentive: To keep every partner a working partner, a proportion of each paid bill is based on the amount of time invested in the matter. The percentage of distribution in this example is 50 percent.
Group Incentive: To provide each partner with an interest in the performance of the others, seniority – based on number of years as a partner, up to a given limit – is multiplied by the average compensation for the past three or four years. The percentage of distribution in this example is 20 percent.
Business Development Incentive: To make every partner business-conscious, as well as work-conscious, data on business produced by the individual is considered, along with the judgment of the committee. The percentage of this distribution – in this example, 20 percent – is usually determined by the compensation committee after reviewing computer-produced financial data and management information and consulting with the chair of the firm’s business development committee. Credit may be given for business generated from new clients and the development of additional business from current clients. This credit is usually shared if two or more attorneys have been instrumental in attracting the business.
Incentive to Use Associates: This is based on information regarding work delegated and on supervision of associates. The objective is to stimulate partners to delegate work. The percentage of this distribution to a given partner – in this example, 5 percent – is usually determined by the billing attorney or the chair of the department to which the matter is assigned.
Contingency Fund: This is sparingly used to compensate for extended illness, public service, difficult cases, consequential non-billable work, firm business and outstanding achievement. The percentage of distribution in this example is 5 percent.
When considering various types of compensation plans, partners are cautioned that the lawyer compensation practices of other firms may not be satisfactory for their own offices. The fact the certain plans are in use does not indicate that they may be suitable elsewhere or even that they work well for the offices that use them.
As any firm evolves, time will bring changes in its personnel and in the values and goals of the partners. What pleased the founding partners may not necessarily be welcomed by the new order. This is a natural and inevitable course of events. The firm that succeeds in establishing a sound compensation plan is one in which partners view decision-making as a dynamic process and understand that the plan is not etched in stone.