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.

• 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.

• 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.

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• Partner Cost and Client Profitability (Part II)
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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.

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).

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

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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?

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

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People who sell are usually at the top of the food chain in every organization. Why? Because nothing happens until you have a customer or client. They are the force. They are the only source of revenue. They are the only thing that gives an organization the opportunity to succeed. Everything else is cost!

If it all begins with sales, it makes sense that origination credit, the equivalent of sales commissions in the business world, would be an important component in the compensation system of law firms. Having said that, there are good compensation plans and there are bad ones. Bad origination credit arrangements impede business development and get in the way of cross-selling, and team selling.

Think of the law firm as a triangular vessel that accumulates revenue-producing clients and matters.

The problem in most midrange law firms is that work doesn’t get delegated. Partners tend to hoard work. As their capacity is used up doing the work, new business development diminishes. It is a process that limits the firm’s performance and growth. What is the fix? The reward for “bringing in business” needs to be temporary. The politics need to be driven out of the system. You should get credit for making the sale if you make it, regardless of who will supervise or do the work. You should not get credit for the sale if you didn’t make the sale. Thus, new business occurring naturally from established relationships, referrals, and branded sales should not result in origination credit. The most important change needed to continually drive new business is that origination credit should expire with the case or matter, or for a continuing portfolio sale, it should expire after 12 or 24 months. Origination credit should be viewed more as a “bonus” than a way to build a compensation annuity. The emphasis should be on “what have you done lately?" Providing a handsome bonus for bringing in new business, say 20 percent off the top, requires that not all revenue be burdened with an origination cost.

Law firm partners are revenue producers, but if their individual production is all they contribute, the firm’s capacity is fixed and limited. One can break through that capacity barrier only if partners recruit, mentor, delegate and supervise. The role of a midrange law firm partner is to bring in business and get as much of the work done by others as practical. Thus, a sound compensation plan will not only have a “commission” component designed to reward for current “sales” (rainmaking) success, it should also compensate for supervision of the cases and matters regardless of who does the actual work. In midrange firms, this is typically the billing attorney role.

When it comes to individual production, the plan should not reward partners for neglecting rainmaking and delegation. One way to do that is to provide the partner with a billable target for personal production, one that leaves room for business development and the duties associated with delegation and supervision duties. Those hours are job requirements, and for that target the partner would receive a base compensation. The variability in compensation should come from three sources:

1. Collections for matters and cases under the partner’s supervision regardless of who did the work. That will include collections related to the attorney’s personal production as well as that attributed to others.

2. Origination credit earned only on new business where the partner actually closed the business. The credit is limited to the case, or for new portfolio business, it is limited to the revenue produced only for a temporary period such as 12 to 24 months.

3. A subjective element based on performance that considers assigned individual goals, teamwork, and support of firm strategies and policies.

Of course, it is always easier said than done. Fitting the pieces together is never easy. What is important is to understand that a compensation plan that is weighted heavily toward individual productivity limits partner income and firm capacity. Without rainmaking, delegation, and supervision, the triangle that represents the firm’s capacity is significantly smaller.

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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Technology-related investments are on the rise in law firms. It not just for replacement purposes, although Y2K-related purchases are now solidly in the obsolete camp. A host of new technologies in hardware and software provide law firms with new ways to increase income and cash flow. They include both new products and services as well as remarkable new capabilities in the current generation of mainstay law firm systems. Microsoft’s Vista, wireless technology, .NET technology, PDAs like the BlackBerry™, dashboard technology, peer group benchmarking, workflow improvements, automated event and exception tracking, automatic client engagement rules compliance, revolutionary changes in how information is reported and used in law firms—these and other technologies are driving new IT investments in law firms.

They are investments that usually more than pay for themselves, but the payback takes time. My friend John Dondey, at Baytree Leasing, reminded me that there are better ways to use cash than tying it up in depreciating assets such as IT equipment and software. With leasing, law firms have an easy way to finance IT investments without it taking money out of partners’ pockets. With leasing, law firms can avoid upfront payments all together, and monthly leasing payments should be offset by the higher income-producing benefits of the new investments.

With outright purchase, the law firm has to choose between making investments that they know are needed or using their cash for partner distributions. Leasing lets the firm do both. The firm can keep pace with peers and competitors without reducing partner distributions. Leasing provides the law firm with fixed, scheduled payments to simplify expense budgets and provides a hedge against rising interest rates. Cash requirements, including partner compensation, can be forecast and managed with greater accuracy.

Leases will cover the full cost—hardware, software, training, implementation and other related services. Companies like Baytree offer lease facilities that not only cover initial cost but also accommodate subsequent upgrades, add-ons, and technology refreshment during the term of the lease. And the process is super easy. Baytree, for one, has reduced the process to an art form—fast credit approval and simple applications make the process quick and efficient.

There are a number of leasing companies targeting law firms, but when I think of law firm leasing, I think of John Dondey and his team at Baytree Leasing Company. If you are interested in pursuing leasing for your IT investments, you can e-mail John Dondey at jdondey@baytreeleasing.com or call 877-229-4888, extension 224. You can also visit their web site. You can find other quality leasing vendors listed on the Ancillary Products and Services page within the Alliance Section of www.juris.com.

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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Earlier this year, Hildebrandt’s Susan Longo and Susan Lambreth set out the differences between BigLaw firms and the majority of midsized firms in an article appearing in Law Practice Today. The authors note that those midsized firms that have addressed these same issues have reaped positive benefits. What are the areas of difference? They identified five.

Culture

Partner Compensation and Authority

Bench Strength and Talent Pool

Professional Management

A Traditional View of the Business of Law

From the culture standpoint larger firms tend to have a branded or institutional culture—it is all about the firm not the individual. They have put structure and processes in place for effectively managing the firm and for projecting an image and style for the firm. If we look at most midsized firms, partner autonomy remains a core value. In such an environment, self interest obstructs the developing and institutional image or culture. The notion of “my” clients is superior to “our” and “we” and thus the continuity of the firm is always in jeopardy. In the end “my” type firms are less successful.

The exalted level given partner autonomy in the majority of midsized firms limits the authority of its managers. In addition, midsized firms tend to undervalue the management component of its managing partners and practice leaders. Limited authority coupled with misguided compensation plans produces the result you would expect. Inadequate management is the reason 75% of midsized firms have no strategic plan. It explains why they fail to set clear goals, measure performance and hold people accountable. Their performance is in stark contrast to the top performing 25% of midsized law firms whose partners earn two to seven times the partner income level of those law firms with a “my” culture and inadequate management.

When it comes to bench strength and talent pool, the large firm has an advantage that is beyond the reach of midsized law firms. However, as I noted in a prior post, even if one looks at the legal services needs of major corporations, a large talent pool is only important in about 10% of their cases. Rather than compete with Biglaw on Biglaw's terms, the more successful midsized firms look elsewhere for competitive advantage—price, industry knowledge, narrowly defined markets they can dominate. Less successful firms tend not to have defined the competitive advantage or value proposition for their firm. They pursue a “me too” strategy. The problem with “me too” is that rather than differentiating the firm, its message is “we are no different.” If you are no different then why should a client do business with you rather than some other firm?

Regarding professional or non-lawyer management, studies rather consistently show that firms who have invested in non-lawyer C level management produce higher levels of per-partner income. A minority of midsized law firms is beginning to add full time management but it is still the exception. The lack of non-lawyer managers (managers who do are not conflicted by two apposing responsibilities, the billable hour vs. their management duties) leads to wide differences among midsized firms when it comes to their financial performance. Because management is more consistent among Am Law 200 firms the variation in financial performance is less. All Am Law partners are doing well financially; the same can not be said for all midsized law firm partners. Midsized law firms can improve performance and consistency by adding non-lawyer professional managers or by at least increasing the value they place on the contribution of their part-time lawyer managers.

When you come down to it, the fifth point difference trumps all the others. BigLaw is in the Legal Services Business. Most midsized law firms have not made the transition from the practice of law to the business of legal services. In their article, Longo and Lambreth write “Years ago, most law firms were small and managed by partners who had full-time practices and spent only as much time as they had to on business strategy and operations. In fact, there were those who resisted a business-like approach to running their law firms for fear that it would have a negative impact on productivity (too much bureaucracy, administrivia), collegiality (fosters unhealthy competition) and entrepreneurial spirit (too much accountability). Today, that business philosophy translates into inefficiencies, compromised profitability, uneven client service and lack of direction, just to name a few drawbacks of operating under such a business model. For many mid-sized firms, recognition of the need for change in their management approach has evolved slowly because they haven’t fully embraced the benefits of a more centralized management structure and the hard decisions required to remain competitive.”

I couldn’t have said it better. At the same time I should point out that at least a quarter of midsized firms appear to have made it into the business camp and are doing well with partners earning two to seven times that of the rest of the pack.

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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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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