February 19, 2009

Merit Based Systems?

4:37 pm

The recent NYT article, “Chill of Salary Freezes Reaches Top Law Firms”, once again highlights that the recession is causing many firms to rethink their compensation structure. In the short term that means freezing salaries. “There is this sense that firms didn’t act prudently during the boom and now they are getting religion, and that it’s better late than never…Many associates we have spoken to think the freeze probably saved jobs.” In addition, many firms are also taking the long term approach of moving to a more merit-based compensation and advancement system. David Lat, founding editor of AboveTheLaw.com, suggests “I think some breakdown in the lock-step mentality might actual stick. Firms are recognizing that on a certain level, it makes sense to pay people in a way that reflects their performance”

But can merit based systems become a reality in a profession steeped with tradition and typically averse to change? For Henry Bunsow, a partner at Howrey, the answer is yes. Bunsow states, “I would say the leaders of Howrey are very concerned about client perception and the cost of legal services and justifying the cost of legal services… And the idea that the compensation levels are arbitrarily set, when those compensation levels in turn result in hourly billing rates, makes no sense from a business standpoint – no business in this country would run themselves that way.” Howrey introduced a merit-based system in 2007.

Still, many will argue that a move towards a system without billable hour requirements or mathematical formulas will result in fewer billable hours. There are two answers to this argument. First, for many law firms, culture dictates lawyers work long hours, so a minimum billable hour requirement is unnecessary. Second, focusing on the quality of hours and not the quantity can have a greater impact to firm profitability than any negligible impact on hours. The key is to make the hours count. As Bunsow also notes, “Our goal is to attract and keep the best people, to compensate them for what they’re worth and to justify their cost to the clients, because we think clients are willing to pay for high quality legal services.”

To implement such a system, law firm managers should begin with full disclosure for the reasons for changing to a new system. Next, evaluation criteria should be discussed. If the goal is improving quality of work, special consideration should be given client satisfaction. Recently, the Association of Corporate Counsel began working on a “Value Challenge Index”. Criteria for the value proposition can be easily applied to a merit based evaluation and includes:

1. Understands goals and expectations

2. Legal expertise

3. Efficiency/process management

4. Responsiveness

5. Innovation/Flexibility

6. Results delivered

7. Values: Pro Bono/diversity/green/professionalism

The merit based decisions and budgets for salary increases should be put in the hands of practice group leaders. “In this fashion, the firm can control its budget and the percent of associate salary expense relative to revenue and total expenses. Also, since these partners are most knowledgeable about associate performance, they are the most appropriate persons to award merit increases.” Lastly, increased monitoring and management of individual margins and rate spreads is essential to improving profitability in a merit based system. But you were doing that already, right?

–Rick Rawls

Rick Rawls is a Senior Business of Law Consultant for Redwood Analytics/Lexis Nexis

September 4, 2008

Associate Salary Increases & Firm Margins

10:20 am

It should come as no surprise to anyone that the most recent wave of associate salary increases have helped to erode law firm profit margins. Whether the wave begins in west coast technology firms, or east coast financial capital firms, its effects are felt beyond big law in the mid-size and regional firms headquartered in the mid-west and southeast. And, with 80% of law firm expense tied up in compensation and occupancy, the impact can be devastating. What is more surprising is the response of law firm leaders in this new economic environment. Reactions run the gamut from slash and burn tactics to taking it on the chin and silently watching margins erode. Formulating a balanced strategy and resisting the urge for an emotional response is critical. Consider the following.

First, is increasing associate salaries is an appropriate response to increased competition for the best talent in your market or just a follow the leader reaction? Associate salary increases typically begin in markets where competition is fierce for not only attracting the best talent, but also keeping that talent as the reality of billable hours requirements hits home. Increasingly, associates are not willing to trade work life balance for a big paycheck. This attitude is not pigeonholed in the bottom half of the law school classes, but pervades throughout. Are there other work life benefits your firm can offer to entice top talent?

Secondly, recent surveys suggest the demand for legal services have declined in the first two quarters of 2008, and making sure your lawyers are properly utilized is essential to maintaining profitability. As margins become slimmer, there is no room for unproductive associates taking up space. But are associates really the problem? Most associates have little control over the projects they are assigned and virtually no ability to generate new business. They, like everyone else in the firm, rely on the rainmakers to generate enough billable hours to support the business. Before taking a defensive posture and eliminating positions, look for ways to improve your business development efforts. Are you effectively cross-selling your services to existing clients? Do you place enough emphasis on developing new business and in the right sectors?

Lastly, in today’s competitive marketplace, passing increased costs on to your clients is rarely an option. Even in big law, where clients were thought to be less price sensitive, general counsels are scoffing at increased rates as a result of higher associate salaries. Can you blame them? That doesn’t mean you have lost the ability to control your average rates. The next time someone asks you for an alternative billing arrangement, consider the request an opportunity to control your own destiny. Look for ways to strengthen the value proposition, improve practice management at the matter level, and increase leverage.

Can you avoid the impact of associate salary increases? Not likely. But focusing on the positive economic aspects of your business, rather than going on the defensive, may help you roll through the downturn and leave you prepared for the eventual upswing.

- Rick Rawls

June 3, 2008

Partner Cost and Client Profitability (Part VI)

12:00 am

This is the last in a 6-part series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis. The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability. The second article, titled Partner Cost And Client Profitability, (Part II), is focused on pitfalls of some firms' methodology in allocating costs to partners. The third article, titled Partner Cost And Client Profitability, (Part III), is focused on basing a partner's direct cost on a "minimum margin percentage". The fourth article, titled Partner Cost and Client Profitability (Part IV), is focused on basing a partner's direct cost on a "minimum margin dollar amount". The fifth article, titled Partner Cost and Client Profitability (Part V), is focused on allocating a partner's direct cost using a variation of both the "minimum margin percentage" and "minimum margin dollar amount" based on different partner "ranks" using a sliding scale. This final article compares the different methodologies to help a firm decide which one to utilize in their environment.

Over the past several weeks, I have explored a number of methodologies for determining the appropriate amount of partner compensation to consider direct cost and allocate to clients for purposes of evaluating client and matter profitability. Since a partner is compensated for a multitude of contributions to the firm (billable hours, originations, matter & client management, attorney management & development, and for firm ownership), the issue is complex. Through my last five postings, I have evaluated half a dozen methodologies, all of which are used by at least one firm Redwood has worked with, but not all are recommended.

The first step Redwood took as we set out to answer this question was to determine what we were trying to accomplish with an allocation methodology. From there, we developed a list of five criteria to evaluate each methodology against. As I wrote about in the prior blog entries, the advantages and weaknesses are all based on this list:

Simplicity. If the methodology is not easy to understand with a minimal number of decisions, it will prove difficult to build partner buy-in.
Positive margin. There is value associated with every hour of partner time at standard rates. While discounting may be a planned strategy to acquire a client or matter, at full rates, every hour should have some margin.
Rate based. Compensation can be affected by a large number of factors including discretionary bonuses and overall firm performance in a year (cash received from a litigation case). As a result, it is possible for compensation to decrease from one year to the next. Since we are trying to assign costs to the client for the billable time only, it is important to ignore these effects. Instead, direct costs should be based on partner’s standard rate,
Leverage. While not the only measure, leverage is extremely to increasing firm profitability. Any methodology should (through the resulting margins) encourage the use of lower cost timekeepers over higher cost (and highly compensated) partners.
Closed Compensation system. If this is a concern for your firm, it can generally be accomplished by using a rate-based methodology and leaving out any actual compensation figures.

In our journey through this process, we gathered various approaches from our clients and from industry experts. The list of criteria above is a solid place to begin evaluation to determine if the resulting model is providing the desired outcome. In the figure below, you will see the six methodologies that we evaluated and the degree to which they meet the criteria above (solid circle indicating criteria met, half circle indication partial, and blank indicating criteria not met). As you can see, the three methodologies that we recommend to our clients, Minimum Margin %, Minimum Margin $ and Sliding Scale, meet almost all six of the criteria we have laid out here.

If you use or know of another methodology, we would be interested to hear about it and may be able to provide some guidance on its performance against the list of criteria. Please send an email to rpaquette@redwoodanalytics.com with any suggestions, questions, or additional methodologies that we have not yet seen.

May 27, 2008

Partner Cost and Client Profitability (Part V)

12:00 am

This is the fifth in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis. The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability. The second article, titled Partner Cost And Client Profitability, (Part II), is focused on pitfalls of some firms' methodology in allocating costs to partners. The third article, titled Partner Cost And Client Profitability, (Part III), is focused on basing a partner's direct cost on a "minimum margin percentage". The fourth article, titled Partner Cost and Client Profitability (Part IV), is focused on basing a partner's direct cost on a "minimum margin dollar amount". This article is focused on allocating a partner's direct cost using a variation of both the "minimum margin percentage" and "minimum margin dollar amount" based on different partner "ranks" using a sliding scale.

Over the last 4 weeks, we have been discussing in some detail the topic of partner compensation as a direct cost in profit modeling. Specifically we are answering the question: “How much of a partner’s compensation should the firm consider when calculating the cost rate allocated to each billable hour he/she works?” We have evaluated several methodologies that create unfavorable results and 2 that Redwood Analytics recommends. While we will discuss another methodology today (or variations of previous strategies), it is important to remember that there is not one right answer that will work for all firms. Instead, it depends on the current state of affairs of the firm, the long and short term goals of the firm, the relative level of partner compensation, and maybe most importantly, how the firm thinks about client profitability.

Sliding Scale (for minimum margin % or $):

The final methodology we will explore in this series is a variation on the previously recommended approaches. In this variation, firms have the flexibility to use different minimum margins for different partner “ranks”. We do not suggest moving to complete customization (where each partner has a different threshold) but we do recognize that the minimum margin for a senior partner may differ from that of a mid-level partner and a junior partner. In other words, it has been argued by several partners we know that the relative portion of compensation paid to a partner for performing billable work decreases with seniority. Since most firms have some form of partner ‘shares’ , ‘points’ or other credits, we recommend using this as the basis (see fig 1 below), but standard rate or tenure could work as well. In this example, we have split the partnership into 3 buckets to determine the minimum margin %, the firm is free to choose any number of buckets. It should be kept in mind that too many can unnecessarily increase complexity and open the door for disagreement for both start/end points for the ranges and the minimum thresholds

Minimum Shares	Maximum Shares	Minimum Margin %
1	50	40%
51	100	30%
101	150	20%

Figure 1

Alternatively, instead of using a handful, a firm could create a continuum to represent the changing minimum that would eliminate the abrupt change in partner profit that would be experienced as they progressed from one bucket to the next (see fig 2 below). In this example, a partner with 150 shares would have a 20% minimum margin while a partner with 100 shares would have a 30% minimum.

Figure 2

In the examples below, we see the three familiar partners from our previous blog entries with the minimum % applied from the table shown in figure one. Once again, the Jr. Partner is not affected by the minimum because his fully loaded margin exceeds the threshold. Unlike the minimum margin % methodology though, this approach differentiates the Rainmaker and the Dept. Manager (instead of both having 40%). Keep in mind that while we have illustrated this methodology using the minimum margin % approach, we can also apply this to the minimum margin $ approach.

Role	Comp	Std Rate	Shares	Minimum Margin %	Cost Rate*	Actual Margin
Rainmaker	$1MM	$250	125	20%	($200)	20%
Dept. Manager	$500M	$200	75	30%	($140)	30%
Jr. Partner	$150M	$150	25	40%	($83)	44%

* Assumes 1800 standard billable hours expectation

Advantages of the methodology:

It ensures that every partner has a positive margin associated with his/her hours when valued at standard rate. While one may purposely choose to lose money on specific matters through discounting, there should be margin on every hour of time when valued at published rate.
It is based on the partner’s published rate. While total compensation can rise and fall with firm profits, this relative cost will not fluctuate and this method is in line with thinking about compensation for a partner’s work effort.
If executed properly, a leverage model will be supported by forcing the highly compensated partners to a lower margin % than lower compensated partners.
It supports a firm with a closed compensation system since actual compensation will not be revealed through profit model.

We have to address the weaknesses of this approach as well:

Higher complexity. With either bucketing (fig. 1) or the margin curve (fig. 2) the firm will still have more decisions in this methodology than in either minimum margin approach. More decisions open the door to more disagreements and dissenters.

Like the other Redwood recommendations, the weaknesses are overshadowed by the strengths in the model. And, if the firm can build agreement around the (semi-arbitrary) decisions necessary for this methodology, Redwood believes this creates the most robust model of all those explored, allowing the firm to assess relative client profitability without having to exclude a client due to high/low partner costs. In the last entry of this series, we will detail the list of criteria we have developed to better understand the strengths and weaknesses of a new methodology that we may encounter.

While this series documents every methodology (some with slight variations) that we have come across in our years of working with firms, we do realize that it is not necessarily exhaustive. Have you used, seen, or thought about a methodology that we have missed? Do you have any other feedback? I’d love to hear from you: rpaquette@redwoodanalytics.com

May 20, 2008

Partner Cost And Client Profitability, (Part IV)

12:00 am

This is the fourth in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis. The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability. The second article, titled Partner Cost And Client Profitability, (Part II), is focused on pitfalls of some firms' methodology in allocating costs to partners. The third article, titled Partner Cost And Client Profitability, (Part III) , is focused on basing a partner's direct cost on a "minimum margin percentage". This article is focused on a related methodology: using a "minimum margin dollar amount" to allocate partner direct cost.

Thus far, we have evaluated a number of methods of allocating partner direct costs (compensation) to a client. Since firms have differing long and short term goals, levels of partner compensation, and thought processes about client profitability, we have concluded that there is not one perfect solution for this question, but instead a handful of recommended options.

Minimum Margin $ (or fixed margin $ for firms with closed compensation):

Very similar to the Minimum Margin %, this methodology differs only in that the threshold is set as a dollar value instead of a % of standard rate. Some firms we interviewed think about partner profitability in dollars, stating as an example that each partner should have an annual margin (standard revenue less direct costs) of $100M on their bRate MinimumMargin Minimumillable time (hourly margin is an option as well).

In the example, again we have the same partners but now each is given a minimum annual margin of $100M (or $56 per hour based on 1800 std hours). Since the Rainmaker and the Dept. Manager have fully loaded margins much less than this amount, they are set to the minimum while the Jr. Partner remains at his full compensation level. Notice that with this methodology, while both the Rainmaker and the Dept. Manager are at the minimum threshold, they have different Direct Margin %. While the dollar margin is the same, the higher rate timekeeper has a lower margin %, thus encouraging a billing attorney to use the more junior (or lower cost lawyers) on their matters.

Role	Comp	Std Rate	Minimum Yearly Margin	Minimum Hourly Margin*	Cost Rate*	Direct Margin
Rainmaker	$1MM	$250	$100M	$56	($194)	22%
Dept. Manager	$500M	$200	$100M	$56	($144)	28%
Jr. Partner	$150M	$150	$100M	$56	($83)	44%

*Assumes 1800 standard billable hours expectation

Advantages of the methodology:

It ensures that every partner has a positive margin associated with his/her hours when valued at standard rate. While one may purposely choose to lose money on specific matters through discounting, there should be margin on every hour of time when valued at published rate.
It is simple. Firm leaders need only to decide on one variable that can be based on firm analytics and margins for other titles (e.g. income partners or senior associates).
It is based on the partner’s published rate. While total compensation can rise and fall with firm profits, this relative cost will not fluctuate and this method is in line with thinking about compensation for a partner’s work effort.
The most highly compensated partners will be forced to the minimum margin ensuring they appear less profitable than junior partners, therefore supporting a leverage model.
Multiple partners hitting the minimum margin level will have different margin % if they have different standard rates, further promoting a positive leverage model.

We have to address the weaknesses of this approach as well:

A firm will need to decide on the minimum margin. While strong arguments can be made for a certain threshold, there may still be dissenters.
Each partner who is affected by the minimum threshold will have the same margin (in dollars), leaving discounting as the only differentiator of profit on billable time

Like the Minimum Margin %, the strengths of this methodology prevail over the weaknesses and many firms have found this option easy to implement and easy to gain support for (due to minimal arbitrary decisions). In the final two entries, we will discuss some variations on the two minimum margin methodologies (% and $) and discuss a set of criteria to help a firm determine the pros and cons of each.

May 16, 2008

Managing Partner Forum Attendees: Business Development Most Effective Way To Improve Profitability

12:00 am

This past week, The Remsen Group held the Southeast Managing Partner Forum in Atlanta. Fifty-eight participants attended representing thirty-nine firms in the Southeastern region. According to 23% the participants, marketing and business development was the most effective way to improve long-term profitability. This eclipsed raising rates, which was rated as the most effective way to improve long-term profitability by 21% of respondents.

According to the 2007 Law Firm Economic Survey from LexisNexis, marketing and business development was second only to rates as the most effective way to improve profitability. Yet only 3% linked compensation to marketing and business development activity. It is apparent that firms consider marketing and business development as important keys to improving profitability.

In our 2008 Survey (currently accepting submissions - please click here if you would like to participate), we dedicate 19 questions on business development. We hope to be able to flesh out what works for firms and what isn't working to improve profitability.

In a year where the majority of economic news points to an economic downturn, how a firm invests now will determine what opportunities open for it after the economy recovers. It's worth reviewing some past posts that help firm's manage down cycles and prepare for the eventual upswing:

Another interesting statistic that follows earlier surveys is that over 2/3rds of the attendees of the Managing Partner Forum in Atlanta did not follow a firm-wide strategic plan. John Remsen, along with John Smock and Thomas Grella, Esq., have teamed up to provide a web seminar on Law Firm Strategic Planning. John Remsen is the owner of The Remsen Group, a marketing consulting firm that is focused on the law firm market. John Smock is a management consultant and partner with Smock Sterling strategic management consultants. Mr .Grella is the Managing Partner of McGuire Wood & Bissette, PA and co-authored the book The Lawyer's Guide to Strategic Planning published by the American Bar Association. The webinar is scheduled for June 10th at noon eastern. To register, click here.

May 13, 2008

Partner Cost And Client Profitability, (Part III)

12:00 am

This is the third in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis. The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability. The second article, titled Partner Cost And Client Profitability, (Part II), is focused on pitfalls of some firms' methodology in allocating costs to partners. This article is focused on basing a partner's direct cost on a "minimum margin percentage".

When it comes to allocating partner direct costs (compensation) to a client the answer, unfortunately, is not a simple one. After exploring options with various law firm leaders at a number of firms, we heard consensus on one key point — that “it depends.” “Depends on what?” you might ask. Well, it depends on the current state of affairs of the firm, the long and short term goals of the firm, the relative level of partner compensation, and maybe most importantly, how the firm thinks about client profitability. As a result, we have developed a handful of options to address the analytic needs while considering firm goals and philosophy. In my next several entries, I’ll explain some of those options, and their pros and cons. Today’s option is basing a partner’s direct cost on a minimum margin percentage for each partner.

Minimum Margin % (or fixed margin % for firms with closed compensation):

In this methodology, margins (Std Rate less Direct Cost Rate as a % of Std Rate) are kept at or above a minimum threshold (or equal to the threshold for firms with closed compensation cultures). In the example below, we have the same three timekeepers from previous examples, with the Rainmaker and Dept. Manager having compensation that exceeds their billable hours revenue. With the minimum margin % methodology, these two timekeepers’ direct costs are set so that the margin % is 40% (this variable is set by the firm) while the Jr. Partner maintains the 44% margin occurring ‘naturally.’

Role

Compensation

Std

Rate*

Cost

Rate*

Direct

Margin

%

Rainmaker

$1MM

$250

($150)

40%

Dept. Manager

$500M

$200

($120)

40%

Jr. Partner

$150M

$150

($83)

44%

*Assumes 1800 standard billable hours expectation

Advantages of this methodology:

It ensures that every partner has a positive margin associated with his/her hours when valued at standard rate. While one may purposely choose to lose money on specific matters through discounting, there should be margin on every hour of time when valued at published rate.
It is simple. Firm leaders need only to decide on one variable that can be based on firm analytics and margins for other titles (e.g. income partners or senior associates).
It is based on the partner’s published rate. While total compensation can rise and fall with firm profits, this relative cost will not fluctuate and this method is in line with thinking about compensation for a partner’s work effort.
The most highly compensated partners will be forced to the minimum margin ensuring they appear less profitable than junior partners, therefore supporting a leverage model.

There are some weaknesses to this approach:

A firm will need to decide on the minimum margin percentage. While strong arguments can be made for a certain threshold, there still may be dissenters.
For those who have the minimum margin %, the only profitability differentiator relative to how they affect client profitability is the realization on the hours worked. If too many partners are at the minimum, there is virtually no difference in leverage within the partner ranks.

Overall, the strengths of this methodology far outweigh its drawbacks. With this method, client profitability can be evaluated objectively with minimal explanation about the handling of partner compensation. In subsequent entries we will be evaluating additional methodologies vetted by Redwood Analytics and providing a checklist of criteria that your firm can use to select a methodology.

May 6, 2008

Partner Cost and Client Profitability (Part II)

12:00 am

This is the second in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis. The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability. This article is focused on pitfalls of some firms' methodology in allocating costs to partners.

Some firms have chosen to exclude costs all together from billable hours worked by partners. Generally it has been requested for one of two reasons: the firm would like to keep actual partner compensation out of the profitability model (a closed compensation system), or the firm is thinking about a P&L model where partner compensation is simply a distribution of firm profits. While this methodology does accomplish those goals, from a client profitability perspective, it introduces its own set of issues.

What results is a model where client profitability is maximized by only using partners to perform the billable time. In the example below, there is a timekeeper with a 66% profit margin and two partners, both with 100% margins. Any hour that the Associate performs for a client will in essence drag down that client’s profitability and a matter manager might be tempted to use a Partner where an Associate would suffice in an effort to ‘game’ his clients profitability. This is contrary to the proper use of leverage and economic theory which would have the partners working on tasks for which lower level timekeepers are not qualified such as originations and the management of matters and attorneys. For this reason alone, there needs to be some cost associated with each billable hour of a Partner’s time, if not for any other purpose than to represent the opportunity cost of them not performing these other tasks. Besides, every firm that we have encountered expects their partners to perform a certain quantity of billable hours for their clients which would imply that some of their compensation should in fact be allocated to the client.

Role	Compensation	Std Rate	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$0	100%
Dept. Manager	$500M	$200	$0	100%
Associate	$80M	$100	($44)	66%

Another methodology that has been requested in an effort to support a closed compensation is what we call a fixed (or capped) partner cost. In this scenario, every partner is given the same direct costs. Aside from the privacy of actual compensation, firms make their case by stating that above a certain point, all partner compensation is for contributions besides the billable hour. However, since billable rates vary significantly even in the upper echelons of partners, it is hard to justify those hours having the same cost rate. Regardless, like the methodologies we have already examined, this too creates some unfortunate outcomes.

The biggest concern with this methodology is the reversed leverage that it creates (similar to having no costs at all). In the example illustrated below, we see a firm that has chosen $270,000 as the partner direct costs. Any partner whose compensation exceeds this threshold has their compensation limited and as a result, all have a $150 cost rate for their time. The result is that the highest rate timekeepers have the highest profit margin, 40% in the case of the Rainmaker, while those with lower compensation, like the Jr. Partner, have minimal (or zero) profit margin for their work. Certainly, the cost to the firm for these 3 timekeepers is not the same.

The alternate version (and preferable to the former) is to use the dollar amount as a limit to partner compensation and not a flat amount for every partner. In the example below, we see the Jr. Partner whose actual compensation is below the $270,000 mark. In the fixed methodology his profit margin is 0% but if it were capped, his direct costs would be his actual compensation and therefore would have a more favorable profit margin of 44%. This still does not relieve the cost similarity between the Dept. Manager and the Rainmaker but it is a slight improvement over having all partners at one cost rate. Of course this methodology does not meet the requirements of a closed compensation system (unless the firm is primarily interested in the privacy of Sr. Partner compensation).

Role	Compensation	Std Rate	Fixed Cost	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$270M	($150)	40%
Dept. Manager	$500M	$200	$270M	($150)	25%
Jr. Partner (Fixed)	$150M	$150	$270M	($150)	0%
Jr. Partner (Capped)	$150M	$150	$270M	($83)	44%

The next installment will focus on better ways to calculate partner cost in measuring client profitability.

April 29, 2008

Client Profitability: What Is The Cost Of Partner Time?

12:00 am

The following is the first in a series of posts on compensation written by Ron Paquette, an analyst with Redwood Analytics, now part of LexisNexis. Ron is a new contributor to the blog who we hope will write regularly.

Most law firms want to evaluate client and matter profitability. When deploying profitability models, one of the most common questions Redwood receives has to do with determining the cost of partner time on billable work. Since most matters in the legal industry today are billed on an hourly rate, the most effective means of allocating costs is on an hourly cost basis. There are two components to costs, direct and indirect (overhead) – the focus of this discussion is on the direct component, e.g. partner compensation. And since most firms set billable hours expectations for their partners, the question becomes: How much of a partner’s compensation should the firm consider when calculating this “hourly cost rate” allocated to each billable hour he/she works?

Partners are compensated for a number of contributions to their firm. Some include:

Billable hours;
Originations;
Matter & client management;
Attorney management & development; and
Their status as a co-owner of the firm.

Since no firm (that we have encountered) determines a partner’s compensation by measuring each contribution and summing them, our goal with every firm is to come up with a proxy that is reasonable and creates a means of evaluating client/matter profitability that is truly usable.

You might be wondering why this is such a big deal. After all, you know how much a partner is compensated – why not allocate all of that compensation across his/her clients? It’s important to distinguish between a partner’s profitability and his/her clients’ profitability to the firm. Should a client or matter look less profitable solely because a highly compensated partner performed some of the work? What if most of his/her compensation was a reflection of his value to the firm as a rainmaker? What if there were two partners with similar legal skills and similar billing rates, but Partner A is a heavy originator while Partner B is primarily a service partner? Should the client appear less profitable simply because Partner A was staffed to the matter instead of Partner B?

If, as we’ve seen some firms do, you choose to include all partner compensation in this hourly cost rate, clients could end up being allocated costs like in the figure below.

Role	Compensation	Std Rate	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	($556)	-122%
Dept. Manager	$500M	$200	($278)	-39%
Jr. Partner	$150M	$150	($83)	44%

In this example, the Rainmaker and the Dept. Manager are both compensated more than their billable hours alone would bring in as revenue (calculations assume 1800 standard or budgeted hours). For every one hour the Rainmaker works on a matter, it would take 4.5 hours of Jr. Partner time for the client to have a 0% profit margin (and all this without considering overhead). Therefore, EVERY HOUR for which the Rainmaker or Dept. Manager billed time would appear unprofitable. Granted, it may be desirable that the firm should be leveraging a more junior person to the matter, and the Rainmaker and Dept. Manager should have a relatively lower profit margin for their work, it makes no sense that their contribution to a matter is unprofitable.

We’ve discussed the concept of the cost of partner time with many leaders of law firms over the years. What we know for sure is that there is not a one size fits all solution. What has become clearer, however, is that there are key criteria that every solution should strive to meet. Over the course of a series of entries, we’ll be exploring the pros and cons of various options. We welcome your feedback and reactions.

April 15, 2008

How To Compensate A Rainmaking/Investor "Muted" Partner?

12:00 am

A reader emailed me with a question related to the compensation of a non-practicing equity partner whose responsibilities include only the investment of capital in the firm and bringing in new clients. The firm has a niche practice and is looking to expand. Their plans require more capital than the existing partnership can manage. They are in a position to bring in another partner who will be responsible for infusing additional capital in the firm. The partner will also do some rainmaking. The new partner will not be responsible for any management or production and will not be expected to manage any of the clients in which he brings.

Because of the rainmaking responsibilities, I wouldn't classify the partner as a "silent partner". However, since the partner won't participate in the day to day management of the firm nor will be responsible for any production, it may be better to classify him as "muted".

I asked several attorneys I knew and didn't get very good answers. Thus I am taking the question to More Partner Income readers. What ways would you suggest this firm compensate an equity partner whose responsibilities are only investment in the firm and rainmaking?

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Role	Compensation	Std Rate*	Cost Rate*	Direct Margin %
Rainmaker	$1MM	$250	($150)	40%
Dept. Manager	$500M	$200	($120)	40%
Jr. Partner	$150M	$150	($83)	44%