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Robert R. Fafinski, Jr., Esq.
Fafinski Mark & Johnson - Eden Prairie, Minnesota

Compensation

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Rethinking Partner Compensation Criteria 

Howard L. Mudrick

 

“You get what you pay for” may be one of the oldest truisms in the annals of compensation management. With good reason. It seems that no matter what system firms devise for setting compensation, those who are subject to it will figure out the "rules" and adjust behavior so as to maximize the value received. If the rules are poorly set, the organization ends up with inefficient and often problematic allocations of its human resources. This problem is particularly acute when applied to law firm partner (or shareholder) compensation systems. For many firms, the idea of “managing” the partners themselves seems foreign -- they are, after all, "partners." However, with limited management ability to affect behavior, and compensation systems which reward the ineffective allocation of resources, it is little wonder that many firms find themselves struggling for economic stability.

This issue does not just relate to the structure of the system, i.e. “objective” formula systems versus “subjective” systems, although the latter do give management at least some control over compensation setting and thus behavior. Many discussions of the relative merits of these two compensation approaches are available. Rather, the issue is one of what should be rewarded. This article will focus on the criteria used to set partner compensation, and the challenges and limitations of some of those criteria.

Historical Context

There are at least as many partner compensation systems in existence as there are law firms. And, it seems as though every system emphasizes different criteria, or similar criteria to differing degrees. However, historically, most firms emphasized one or more of three primary factors in setting compensation:

Seniority

Many firms once used a lock-step or modified lock-step approach to partner compensation. As partners became more senior, they automatically moved up the compensation ladder. Few complained, because everyone took their turn at higher compensation levels. Because partners rarely, if ever changed firms, there was little risk of partners defecting for more money. Circumstances, of course, have changed, and lock-step compensation systems have become a problem for many firms.

Lock-step systems today work well only under certain limited conditions. The firm must have a strong and usually institutional client base. It must have strong economic performance relative to the market in which it competes. It must strictly control partnership admissions. And, the firm must be willing to deal with unproductive or under-productive partners quickly and effectively. It is no surprise that such systems rarely work today. Few firms now claim they have a seniority based or lock-step approach to compensation.

However, many of the compensation system problems firms face result from the residual effects of seniority based systems. While a firm may claim to reward other things, in reality it clings to a system which rewards partners for longevity. Partners assume their incomes will increase and few partners ever take cuts. This results, over time, in a default seniority system. Often, it takes a radical change in the firm culture before a true break with the past can be achieved. Without such a break, the firm will often languish, unable to compete effectively because it fails to reward real contributions.

“Origination”

Nearly all firms, except those that base compensation solely on seniority, reward business generation in some manner. This is and will remain appropriate, as long as it is handled properly. After all, any business organization must have sales to survive, and most companies have learned that rewarding top sales persons is well worth the expenditure. However, in law firms, sales data -- called “origination” -- is the single most difficult statistic to judge accurately. In fact, almost any quantification of origination in a law firm is “wrong” in that it will not reflect accurately the relative contributions of partners to the development of the firm’s business. As a result, almost any formula system which includes origination without some subjective adjustment will produce skewed results.

The problems are many. First, origination is often extremely difficult to assess.   Therefore, most firms use some proxy, typically billing responsibility, which is often a very poor proxy for origination. Usually, only one lawyer will be responsible for billing, but many partners contribute to bringing in and maintaining a client. In the case of some institutional clients, very little origination value can be attributed to the billing lawyer. The partner is one of a number of partners responsible for servicing the client, which was actually "originated" by some now retired (or dead) partner. Unless the firm adjusts numbers for the various contributions partners make, compensation will inevitably be unfair.

Second, origination tends to have a lifetime value in many firms. No matter how long a client remains with a firm, the lawyer originally responsible continues to get the credit. This can result in perverse behavior. For example, partners in some firms register every public company somewhere in the firm’s accounting system, just in case the firm ever does business with the company. Third, specific assignment of credit may reduce partner willingness to team-market. In some firms, partners are not even willing to work on other partners’ projects unless they receive some of the credit. Of course, this leads to accounting nightmares and worse. The end result of many compensation systems which consider origination mechanically, is a firm which is little more than a collection of solo practitioners. While business generation is critical, it is important to judge each partner’s total contribution to the firm’s business base.

Finally, the firm should consider the profitability of the work. If a firm values only the volume of work, it will inevitably end up with a substantial amount of unprofitable business. Many firms today find that the clients of the firm’s biggest rainmakers are unprofitable or marginally profitable. Like the tailor who “loses $10 on every suit but makes it up in volume,” the law firm actually sees its profitability erode as its revenues grow. Although few firms today directly consider the profitability of the work in setting partner compensation, the number that do is growing.

Be careful not to overpay for business development. This is not to say that those who bring in substantial business shouldn’t be rewarded. They should, and very well. However, it is easy to overestimate the value of sales. Most successful rainmakers are also hard working lawyers. As a result, their compensation packages reward both their rainmaking success and their hard work, among other things. Lawyers at the top of the firm’s compensation scales are generally strong in both areas.   Many firms have experimented with the “pure rainmaker” -- the lawyer who does not bill hours but is paid a substantial amount to make rain. In most cases, often involving former political figures, the firm ends up frustrated and overpays for whatever business the lawyer brings in. In this situation, other lawyers, including partners, must be compensated for performing and managing the work. Often a reasonable “cost of sales”, which should cover both the rainmaker’s compensation (“commission”) and the overhead it takes to support him or her, will not justify what is actually paid to these lawyers. Law firms can take an important lesson from corporate America in evaluating these situations.

Personal Productivity

Firms compensate partners for the work they do personally. This is clearly appropriate, and the goal is to reward and encourage hard work. In practice, this has often focused on the partner’s billable hours. There are a number of problems with such a focus.

First, focusing on billable hours alone fosters a variety of problems, including work hoarding which results in poor delegation, write-offs, and sub-optimal leverage, and over-recording of hours which has obvious implications for the firm and for clients. Second, focusing on hours alone tends to ignore the economic value of the partners' practices. Billing rates in some practices are far lower than in others. Should a partner be penalized just because he or she practices in an area with lower rates? Many firms struggle with just this question, which leads to internal conflict between the strong and weak practices. Unless resolved, the firm faces loss of its strongest practices, not its weakest. 

Economic necessity requires that firms consider practice value when setting partner compensation. Thus, while hours are still considered, many firms now consider the amount realized from the partner’s personal work. This, of course tends to give more value to work done at a higher rate. 

A third problem with too heavy an emphasis on hours is a sub-optimal allocation of time to marketing, management and other firm building activities. In effect, the firm rewards short-term performance at the expense of the long-term.

Business development and personal productivity remain the two most important elements of most partner compensation plans. This is unlikely to change quickly and, as long as the factors are considered in light of the issues discussed above, this is appropriate. But to compete successfully in the future, a number of other factors should be considered.

New Performance Criteria

Other than seniority, the criteria discussed above are relatively short-term in nature. Perhaps even more than other American businesses, law firms have been guilty of managing for the short-term. Even the accounting systems in place emphasize only short-term performance -- hence the end-of-year push for collections in most U.S. law firms. If firms are to remain competitive in the long-term, they must reward performance that contributes to long-term success. Business origination and personal productivity will not, and should not, go away. However, a variety of additional factors must begin to play a greater role in law firm compensation systems. In most cases, firms have paid lip service to these factors for some time, but until recently, little more has been done.

Client Service

Perhaps nothing is more important to the future success of a law firm than its level of client service, and each client defines service differently in light of his or her own expectations and desires. Successful partners find out what their clients' expectations are and exceed them. Partners who provide such service should be rewarded, because it leads to a continued relationship with the client.

The only way to really know what clients think about the service delivered by partners is to ask them. Some firms -- still far too few -- are beginning to factor client comments about partners into their compensation decisions. These firms generally have well established client assessment programs which regularly gather information on client satisfaction on a variety of issues. Eventually, most successful firms will base partner compensation decisions at least partially on client feedback.

Quality of Work

Surprisingly, many law firms have long ignored technical quality in setting compensation, as long as the quality, or lack thereof, did not adversely impact short-term economic performance. Some firms have even been careless in screening poor quality lawyers prior to promotion to partner. As a result, many firms find themselves with at least a few quality problems among their partners. To the extent that these are not so strong as to warrant termination, firms are beginning to take quality into account when setting partner compensation. The best lawyers are paid more, all other things being equal. Assessment of quality places a premium on input from clients, department and practice group heads, and other partners.

Intellectual Contributions

Law firms add value for clients by using knowledge and intellectual creativity to solve the clients' problems. In general, firms at the cutting edge of practice earn greater fees and enjoy higher levels of prestige. Partners who contribute to keeping the firm at the cutting edge intellectually should be rewarded for their contributions.

For example, a partner might devise a solution to a particular type of tax problem. That solution has far more value to the client than the ten minutes in the shower it took to create. The firm should bill, and compensate, accordingly. Another partner may devise a deal structure which can then be applied for other clients. Such contributions, while not easy to measure, are vital to the firm's long-term success. 

Project Management

Some lawyers, while not rainmakers, can nevertheless manage substantial client projects or multiple client projects and assure their successful completion. Historically, this contribution was often undervalued, unless present in the same lawyers responsible for originating the clients. Because it is vital to the success of the client relationship and to institutionalizing the client base, firms can no longer afford to ignore project management.   And, as alternative billing arrangements such as fixed fees become more common, profitable project management will be more crucial.   Measurement tools, including write-off analysis, inventory analysis and matter profitability analysis will all play a part in determining who are the strongest project managers.

Leadership 

Given the number of firms that have gotten in trouble in recent years due to lack of direction, it has become clear that true leadership in a law firm is both a scarce and valuable commodity. Without partners capable of setting a true direction for the firm and leading others toward it, most firms flounder. The importance of leadership will become more apparent as the legal marketplace becomes ever more competitive. Rewarding those who contribute leadership will help assure continued strength.

Firm and Practice Management

Many firms have long paid lip service to management in setting compensation. However, except for a few individuals, often only the managing partner, the only real effect management has had on compensation has been to serve as a “credit” against the partner’s billable hours requirement. The importance of management and practice management at various levels is becoming clearer as firms face ever greater market challenges. Enlightened firms will begin to view management as more than just a necessary evil, and reward partners based on how they perform in management roles. The success or failure of their efforts, rather than just holding the position, will become a crucial factor in setting compensation.

There are, of course, a variety of individual criteria which might be important in setting partner compensation. Firms should look at what an individual partner brings to the table and make decisions accordingly. However, it is clear that enlightened firms, in addition to valuing some of the same criteria long considered important, will begin to expand criteria to consider those which contribute to long-term success. Only in this way can a firm remain competitive.