On September 21, 2006, Juris played host to its managing partner forum, a roundtable discussion between managing partners. What was on their minds?
Talent (attorney) retention
Motivating attorneys to do right
Problem attorneys
Collection speed
While not on the list, the subject that dominated discussions regardless of the topic was compensation. Compensation seems to be both the root of the problem and the suggested solution to virtually every management issue in the law firm.
One of the attendees said it better than I could have. I have to paraphrase since I did not make an exact recording of his comment. Prior to joining the law firm, he had worked in the corporate world. He said that everywhere else the focus was outward, on opportunities; in the law firm everything always turns internally—to compensation.
Compensation is a motivating force, but it is also the destructive force that ends the lives of many midsized firms.
The day before the forum, I attended a symposium on benchmarking. A speaker from Austria showed the attendees a chart of the aging Austrian attorney population. It illustrated the same time bomb about to explode in our country. Our existing midsized firm partners are nearing retirement. Many of those are looking to post-retirement payments from “their” law firm to partially finance their retirement. The young guys are looking forward to the compensation benefits the old guys have been enjoying. They aren’t so enthusiastic about sharing the rewards of their labors with retired partners.
The developing demographic crisis may force a new model among law firms that finally separates the issues of ownership and compensation much like what is taking place in the U.K.—the UK no longer even limits ownership to attorneys.
Under the prevailing U.S. law firm model, partner compensation is that which is left over in a law firm after paying all expenses other than partner distributions. In the rest of the business world, it doesn’t work that way. In other types of businesses, an owner who also works in the business receives compensation for his or her effort, and that compensation, like salary payments to non-owners, is treated as a business expense. What is then left over after all expenses, including their own compensation, belongs to the owners—the shareholders. However, it represents risk income rather than payment for effort. That risk income (profit) can be distributed in proportion to ownership or accumulated to finance growth in the business.
Moving to such a model could solve a lot of issues. It means that new owners (partners) are investors with an investment expectation and retirees (selling investors) can expect to benefit from the increase in the value of the business during their tenure.
Deciding on the salary portion of payments to partners and the business valuation isn’t easy, but the owners of closely held businesses and the key employee owners of those businesses agree to acceptable numbers all the time.
First, let's deal with the salary side.
Start with the notion that every job has value. The newcomer to that position will earn about 80 percent of the incumbent that is fully experienced in the position. The compensation of the long-timer who continues to increase their effectiveness in the position can continue to increase up to 120 percent of the value. The range could just easily be 70 percent and 150 percent. The point is that there is a minimum and a maximum job value level.
If competent associates in your area earn $100,000 annually, your newest associate will earn about $80,000 and your seniors $120,000. From time to time, the 100 percent value has to change for inflation and competitive reasons. This is a simplified example. In real life, tax associates might have a different job value than an associate without a specialty; or, you might have one job value for associates with 1 to 3 years of experience and another for those with 4 to 8 years of experience.
Staying with our $100,000 associate value example, what should the salary value for a partner be (excluding any distribution as an owner or required capital contribution to fund growth and/or to recover losses)? The recent Juris® Law Firm Economic Survey indicated that the average partner compensation is around $250,000. That, I might add, is also the compensation level earned by law firms in the second quartile. In other words, that is the partner compensation level for firms that are neither the best nor the worst. We have to pick something, so let’s set the job value of a competent partner at 2.5 times the value of a fully competent associate.
The job values in our example for fully competent and experienced incumbents would be as follows:
Associates: $100,000, ranging from $80,000 to $120,000
Partners: $250,000, ranging from $200,000 to $300,000
Now we have to deal with equity. Associates moving to partners would have to buy in. That means that while their salary may jump significantly upon making the move to partner, a portion of that higher compensation will go toward the buy-in over 3 to 5 years. Who does that buy-in go to? It goes to existing owners giving up some ownership share to the newcomer, or it funds additional growth of the firm, increasing the value of the business for all of the owners.
How do you value the ownership? If the firm was selling (merging), the value would be determined through negotiation. For the purpose of passing the firm from generation to generation, we need to just pick a method that all the parties can accept. Generally, the value used for passing on minority interest is a discounted value—it is likely to be 75 percent to 50 percent of what the business value might be if 100 percent of the business was being sold. For the purpose of determining value, you could use any of several following methods, including the following:
- Book value (Assets less liabilities) computed on an accrual basis so that the collectable value of work in process and accounts receivable is included
- Some percentage or multiple of “fee” revenue
- Some percentage of the pretax profit after all salaries, including the “salary” portion of partner compensation
Each of the above methods has its negative and positive aspects depending in part on whether you are a buyer or seller. Rather than pick any one, I suggest you use all three methods and average them. I will leave it to you to apply this approach to your firm, but here is a formula that you can refine for your particular case:
- Book value (assets less liabilities) computed on a cash basis plus 90 percent of billed but uncollected fees and expenses less than 120 days old and 70 percent of unbilled fees and expenses less than 90 days old.
Plus
- Annualized “fee” revenue for the current year plus the fee for the prior two years divided by three for an average of the three years. That average is multiplied by a factor. I suggest a multiplier of 1 for most cases. If the firm depends on a small number of clients, the percent should be lower, .75 for example. If no one client accounts for 10 percent of the business, it could be higher, 1.25 for example.
Plus
- Income before taxes and interest (after all expenses including the salary portion of partner compensation) times a multiple of 5. Reduce this value by any interest-bearing debt. In computing this number, use the higher income of the most recent year ended or the average of the annualized current year plus the two immediate prior years. For this purpose, partner salaries can be imputed using 2.5 times the average associate’s salary.
- In the final step, average the above three values by dividing by three.
Right, wrong, or approximate, you now have a value for admitting new partners and buying out the retiring partners consistent with the rest of the business world. Ideally, you will have an option to make the buyout payments over a three- to five-year period.
PS: The above replaces origination credits to retiring partners. The two concepts are not compatible. You can’t do both. Post retirement origination payments are substituted for equity buyout payments that are based on the “going concern value” of the law firm.
Morepartnerincome.com is sponsored by Juris, Inc. For information about Juris® products and services for increasing law firm performance and partner income, go to www.Juris.com.
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