Trends in Partner Compensation Systems in Law Firms

An increasingly competitive legal environment is resulting in changes in how law firms pay their partners.

In my experience there are three main types of partner compensation systems:

1)      Equality/lockstep – Compensation is determined mainly by seniority. I’ve seen this system used by many small firms and some large US and UK firms.  The advantage is it encourages partners to work as a team, while the disadvantage partners may not feel it’s fair if other partners don’t pull their weight yet are paid the same as high performers.  This can lead to a lack of incentive for high performers, and creates a risk they may leave.

2)     “Eat what you kill” – Compensation is determined mainly by personal production. This system is used by small and midsize firms.  Objective systems like this usually focus on just the numbers, which makes it clear to all partners the expectations, and is fairly simple to determine compensation.  The downside is these objective systems also encourage partners to “game” the numbers to their own advantage.  This can lead to breakdowns in team-building, where partners act as “lone wolves” and talk about “my clients”, not firm clients.

3)     Subjective Merit – Compensation is determined by subjective analysis supported by objective factors. It usually involves a compensation committee of 3 or 4 partners, and is used mainly by midsize and large firms.  This system has the advantage of encouraging partners to operate at a higher level and get compensated accordingly.  The subjective merit system may have an objective component as a starting point, but subjective analysis reduces the potential for “gaming” the system in a purely objective formula system.

Depending on the culture of the firm, any of the above systems may work effectively.  However, my experience and research indicates the most effective system for increasing profits is the subjective merit compensation system.

Compensation System Trends

One of the major trends I see is towards more “pay for performance” in law firms, with an emphasis on rainmaking results.  Rainmakers are paid big bucks to switch firms, especially commercial lawyers able to command and move a large client base.

Compensation compression ratios (the $’s paid to the highest paid partners compared to the lowest paid partners) are increasing, as firms accommodate rainmakers at the top end of the pay scale.

Law firms are requiring an increasing minimum practice size to remain as an equity partner.

Non-equity partnerships are growing in popularity as firms attempt to maximize their leverage and equity partner compensation.

Large firm compensation systems are becoming more “corporate” in nature, as firms grow in size and scope internationally.  The larger the firm, the more corporate the model.  Managing partners and executive committees are wielding more power, and are providing more input to the compensation of individual partners, who are becoming more like employees in large firms.

Managing partners and practice group managers are being compensated more for their management accomplishments.  Some firms are compensating their managing partners using balanced scorecard techniques, for example.  Law firms are trying to run like real businesses, and are delegating more and more of the firm’s business functions to their management partners.

Many firms are requiring pre-retirement phase-downs in compensation and have established retirement policies at a set age eg. 65.  There is some controversy here, however, given challenges to the legality of forced retirement. Firms are continuing to try to enforce these retirement policies to maintain increasing equity partnership leverage and profitability objectives.

There is a trend for senior partners with portable practices to move from firms where they have spent their entire careers, after being forced out by the imposition of set retirement age policies.

Most firms have fairly “open” compensation systems, where partners know what other partners are being paid.  The trend is towards less compensation transparency in larger firms, however, with power and information centralized within a few management partners.  Compensation discussions can be too much of a time distraction for large firms.

More non-equity compensation arrangements are being used for hiring lateral partners and retaining good “up and comers” with long-term potential for building a practice.

Buy-in requirements are growing as firms grow and partner leverage increases.

More flexibility for balanced lifestyles and part-time partner arrangements are being demanded and received by the new generation of partners.

Compensation Criteria Trends

There is more emphasis on teamwork, and less emphasis on personal billable hours. This also ties in with growing recognition for the need to lever work, and the growth of alternative billing practices.

More firms are doing strategic plans in response to increasing competition, and this is leading to a need to recognize partners’ non-billable efforts in implementing strategic plans at the firm, practice group and individual partner levels. This also means more recognition of training, supervision, quality control, and various other non-billable tasks performed by partners.

More firms are recognizing client origination results, and firms are tracking client and matter origination more diligently.  Sales skills are being taught to partners and associates.

More peer evaluation is happening, especially in larger firms. There is also more emphasis on client feedback, realization and profitability of partners’ practices. More emphasis on cash in, and less on billings.

Compatibility with firm culture is becoming more important. Non-conformists with firm culture are punished, leaders are rewarded.

Summary

The key trend is toward more “corporate” compensation models, driven by competition and the corporate style of growth of large national and international firms.  Compensation is driven more by the strategic goals of the firm, and partners who contribute to firm goals are compensated at higher levels.  There is more emphasis on pay for performance as well.

Compensation compression ratios are widening, as firms attempt to accommodate and retain the rainmakers in their firms.  This has resulted in major dollars being spent to lure new rainmakers to the large firms.  Business development is more and more highly prized, and rainmakers’ compensation is increasing significantly.

The danger of a high compensation compression ratio is you could end up like Finley Kumble a few years ago.  They hired many rainmakers and paid them exorbitant dollars for their client originations without a sunset clause, and the whole firm came crashing down. Several factors were involved, but the extremely high compensation compression ratio was pointed to as a major factor in their demise.

Firms are also trying to encourage partners to lever more to others, and in the process institutionalize clients so it is more difficult to move clients when partners are offered more money by other firms to lure them away.  Buy-in requirements are rising as firms lever more and reduce the % of equity partners relative to non-equity partners and associates.

Large firms favor subjective merit systems, while smaller firms favor more objective systems. Large firms are increasingly profitable, and the gap is widening, so there may be some correlation/cause/effect with subjective merit systems which leads to increased profitability.

The Search for Value – Focus on Client Profitability First

The idea for this post was inspired by Ron Baker of Verasage Institute.  After checking out some of his writings in recent months, I stumbled across one of his key concepts in the search for value.  The definition of value is contained in this formula:

Value = Customer Profit – Price

I modified Ron’s formula slightly to illustrate the point of this post.  What this formula means is that the value you provide to your client equals the increase in customer profit resulting from your legal work and value added services minus the price you’re charging for your legal work.

With all the fuss over alternative billing lately, many have been talking about the need to cut costs and run lean operations to make money in the face of decreasing prices for legal work.

However, the drive to cut costs to match dropping prices for your work is in the end a losing game.  There will always be someone who will undercut you on price, and there is no upside in this game.

Instead, you want to be the value leader, not the low-cost leader in today’s competitive legal environment. If you can achieve that, you will increase profits dramatically for both your client and your firm.

However, as the formula above indicates, the key is to focus on increasing your client’s profits first when adding value.  If you do, and you can demonstrate the impact this value has on your client’s bottom line, you will remove the pressure on price, thereby increasing your own profitability.

This is a complete rethink of the normal law firm approach to focus on their own profits first.  But if you think it through, you’ll realize your efforts are best spent on increasing client profits first, as your profits will follow in due course, and dramatically so if you do it right.

How can you increase value?

First, talk to your clients to see what issues are keeping them up at night.  Ask them to explain their strategic vision and how you can help them achieve it.  There’s six key areas to focus on, as listed in the Law Firm Value Committee’s “51 Practical Ways For Law Firms to Add Value” list on the ACC Value Challenge website, which is an excellent place to start in the search for value.

Some of the highlights for adding value include:

– Assign professional project managers to manage large-scale engagements and teams.

– Institute a discipline such as “Lean” Six Sigma to monitor efficiencies in all areas of work.

– Create partner roles focused on driving change and enhancing the value and efficiency of client service.

– Publish your network of “known” counsel  in other jurisdictions and share it with top clients.

– Ask clients to share their own strategic visions, so the firm can properly plan, invest, staff, etc. to meet the future needs of its clients.

– Connect clients to other clients and entities in the firm’s network (at no charge).

– Engage a third-party consultant to conduct in-depth client satisfaction surveys.

– Assign a mid-level associate to work part-time at the client’s office for no charge.

– Request periodic access to meetings with the client’s business people to better understand the client’s business.

– Assign each of the firm’s summer clerks to work in the client’s law department for a week or two at no charge to the client.

– Create client service teams of lawyers and staff who serve that client and meet quarterly or monthly to discuss the client’s business, current and potential matters, changes at the client, trends in the client’s industry, etc.

– Commit to clear and transparent fee structures by showing the client what tasks are required at each step in the process of the matter, the timekeeper who will perform those tasks and the allotted time for each.

– Engage clients in the training process and invite them to make presentations and have dialogue with associates about the in-house/outside counsel relationship.

– Create a training program where associates work at the client’s facility to learn the in-house perspective.

– Develop a client dashboard that includes metrics, in addition to a 360-degree view of all matters.

– Use e-billing systems to track performance against metrics.

–  Set up an extranet for on-line training available to both the firm and the firm’s clients.

Admittedly, this is a big firm perspective on in-house counsel’s perception of value, as the Law Firm Value Committee comprises mainly large US law firm lawyers.  However, there are many good ideas here for small and midsize firms as well.

From the small and midsize law firm perspective, there is much you can do to add value.  One of the most effective ways to add value is to refer your contacts and their business to your clients to add to their top line.  Some of the most successful lawyers do that regularly, and their clients rarely question them on the price of their legal services.  As the value you provide to the client increases, the less important price becomes.  The only thing that matters is the net benefit of your value minus the cost of your legal services.  This value will translate into client profits at some point, and that’s what the client really wants from your relationship.

It doesn’t have to be a short-term profit add, either.  The client is as interested in a long-term, strategic partnership as you are.  The more you are around on a flat fee or portfolio billing basis, the more comfortable the client will be in calling you and getting your advice on their next big litigation file or acquisition.  You want to be available when the client calls you, before he or she calls your competitor.  So the closer you can get to the client and provide value added services like those listed above, the more likely your share of the client’s legal business will grow over time.  And that’s the ultimate goal for most law firms, as your profits will ultimately grow with your clients.

Trends In Restructuring Law Firm Business Functions To Increase Profitability

I’ve often wondered why so many law firms insist on keeping business functions run inhouse by lawyers, when they’d be much better off delegating or outsourcing (levering) these functions to someone who knows more about business management than they do.  This behavior can range from the Managing Partner who insists on doing the financial statements himself to the numerous lawyer-run Committees you see operating in many firms.   Many firms would get much better and faster results by having an experienced Executive Director or Administrator perform these functions for them.

Some will say that lawyers won’t listen to someone who isn’t a lawyer regarding management issues.  However, many lawyers are now realizing that they need to streamline their operations further as clients push them on the rates side and squeeze their profit margins further.  I would suggest that more lawyers need to become aware of the option to outsource these functions as well,  given the increasing demands from clients to keep costs down and provide better and faster service.  It also recognizes the need for law firms to focus on their core competency of providing legal services.

One of the main reasons to consider levering business functions is to increase profitability.  This requires that you focus on how leverage of business functions can operate in your firm to release your fee earners from administrative tasks.  Your opportunity costs can be great if you have several partners involved in management and administration functions, when they could instead be doing more productive things with their time.  Things such as getting new, highly profitable work, working on high-end files or performing high level R & D to add value to the firm’s knowledge banks and improve firm profitability.  At $400 to $1,000 per hour opportunity cost, you’d be far better off levering those admin tasks to an experienced COO or Executive Director who could do the job more effectively and efficiently.  Your “real” bottom line will grow substantially after allowing for these recovered opportunity costs .

In a recent survey I conducted with COO’s and Executive Directors of midsize and large US and Canadian law firms, I found that more firms are also looking seriously at outsourcing facilities management, document production,  systems, human resources and marketing functions.  Whole administrative departments are not only being outsourced, but are also being shared with other midsize firms.  This tactic allows midsize firms to compete for much larger files than they’d normally have  a chance at and both firms can benefit from the arrangement.  It’s just another way for firms to extend their reach to be competitive without having to merge or add extra offices, and avoid all the costs and potential heartaches that an ill-thought out merger can entail.

Orrick is an example of a firm that successfully “outsourced” all of their administrative support functions such as HR, marketing, systems, facilities management and document production to a single support center office in West Virginia.  Their global network of offices can access the admin services they need from this Global Operations Center on a 24/7/365 basis.  Through this change, Orrick has reduced administrative costs while improving the quality of these support services.

CMS Cameron McKenna in the UK is the first major law firm to outsource its entire business support function to an outside party, including IT, HR, finance, business development, communications, knowledge management, facilities management and administration services.  This is a major development/experiment and is being watched with great interest by many other firms.

Another administrative service to consider for outsourcing is the search function, such as due diligence, title search, etc.  Why firms have their paralegals do these functions is curious to me.  Paralegals should be focused on higher end legal file functions, and searches should ideally be delegated to clerical staff or outsourced to a dedicated search firm.

Another option for small and midsize firms is to outsource all of their administrative functions to companies like MCG Management Counsel Group in Toronto or Cameron Management Services Group in Calgary (no relation).  These companies can handle all of your administrative and business functions so you can focus on practising law.  I’ve heard this option works very well for some small and midsize firms.

The latest option for outsourcing administrative functions is Face2Face Solicitors in the UK, which provides franchisee solicitor firms with centralized back-office systems – including accounts, IT and regulatory compliance – and central marketing and business development, to enable lawyers to focus on the legal work.  See here for more info.

Outsourcing can done at many levels in law firms and is being experimented with in different ways by forward-thinking firms.  You can theoretically outsource any business function.  One partner I knew once jokingly suggested that he’d like to see his firm’s entire Management Committee outsourced.  Okay, that’s pushing the outsourcing concept a bit, but considering the minutiae that many Management Committees get involved with, perhaps it’s not such a farfetched idea!