The Economics of Partnership for New and Aspiring Partners Moderated by Kendyl T. Hanks November 2010 Industry veterans discuss the strategies driving partner compensation while highlighting the need for associates and partners alike to understand what is expected of them to increase earning potential and status in their firms. How a law firm compensates its partners can dramatically impact the firm s culture and its lawyers individual practices. And yet law firm economics are often a mystery to young lawyers, even as they approach partnership. Understanding the economics of law-firm partnership is crucial to a new or aspiring partner s ability to successfully navigate his or her new role in the firm, particularly in light of recent economic turmoil. Indeed, in an effort to adapt to changing market and client pressures, many law firms are reassessing their economic models and partnership structures in ways that indelibly impact opportunities for young attorneys to be elevated to partner, and affect their ability to succeed should they be selected to join the firm s partnership ranks. In a preview of a panel discussion on the Economics of Partnership to be presented on February 25, 2011, at the ABA Young Lawyers Division, New Partner and In-House Counsel Conference in Philadelphia, first-year partner Kendyl Hanks of Haynes and Boone, LLP in New York explores the economics of partnership with her own firm s managing partner, Terry Conner. Ms. Hanks and Mr. Conner are joined by ABA leaders Linda Klein, Managing Shareholder of Baker Donelson s Georgia offices and member of the firm s Board of Directors, and Jack Young of Sandler Reiff & Young, who has held numerous senior positions in firms of different sizes. These panelists are also joined by Lisa Smith, who is the head of the Law Firm Strategy & Structure Practice Group with the consulting group Hildebrandt Baker Robbins. The panelists offer young lawyers a peek behind the curtain of law firm economics, and share their views on the pros and cons of different compensation models. Q. Some publications rank law firms by profits per partner (PPP). Is this an accurate indicator of a law firm s success, and how important should this be to a new partner? Terry Conner: Profits per partner may be the most widely reported, and mis-reported, law firm financial statistic. There are two variations of this statistic: PPP, which divides the firm s net income by all partners, and profits per equity partner (PPEP), which divides net income by the number of equity partners. Although PPP is gaining currency, PPEP is more often reported, and is viewed by many as a proxy for how well a firm is doing financially. Another common law firm financial metric is revenue per lawyer (RPL), which reflects the interplay of a firm s productivity, billing rates, and ability to collect billable time, and therefore provides insight into the practice and financial vibrancy of a firm. But like most other law firm financial metrics, RPL, taken alone, ignores the effects of other key factors, such as a firm s expense burden. Even very healthy law firms can see their RPL reduced as a result of high (and in many cases profit-improving)
associate-to-partner leverage, and the effect of lower billing rates in certain legal markets, which are not necessarily detrimental to the revenues or income of partners in higher-rate markets. Linda Klein: I define success by the quality of the service provided to the client, not by the profit derived from that service. Of course, law firms are inherently for-profit organizations. As long as a partner enjoys his or her work and feels fairly compensated, PPP should not matter. Lawyers should also keep in mind that PPP is not necessarily an accurate indicator of a law firm s performance the numbers can be adjusted when firms de-equitize partners or make achieving the rank of partner more difficult. It is often a tradeoff lawyers considering partnership should think about whether they would rather wait longer at a firm with very high PPP or make partner sooner at a firm with lower PPP. Lisa Smith: Like any metric PPEP has its value and limitations. On the value side it can provide some insight into the overall profitability of the firm, and if you look at PPEP over a period of years it will give you a sense of performance over time. On the flip side PPEP is an easy measure to manipulate. So it is important to also consider the mix of equity and income partners the fewer equity partners, the higher PPEP is likely to be. Jack Young: PPP is not a particularly useful comparison because the term means different things to different firms. A better measure would be the return on the investment for the firm and the client. Profits, however, do measure lawyer satisfaction and quality of life issues. Q: What are the principal variations among popular partner compensation systems, and what are the modern trends in partner compensation (and what is the impetus for those trends)? Jack Young: The lockstep approach is soon to be a relic. The traditional partner scheme in law firms rewarded seniority, while today, most law firms reward client generation. The old finders versus grinders debate has been won by the finders -- the modern approach is based on client billings or value to the firm through specialized expertise needed to service institutional clients or a law firm specialty. This phenomenon is not surprising. Lawyers no longer feel a general sense of loyalty to a particular firm, with some notable exceptions, and thus having loyal clients is the best form of selfpreservation and billing worth (also know to lateral recruiters as portable billings ). Terry Conner: Traditionally, most law firms employed lockstep or seniority-based compensation systems, which provide a predictable, and easy-to-administer, income progression based upon a partner s tenure with the firm. Today, however, most large firms compensate their partners based upon the individual partner s performance. Among performance (sometimes called merit-based) systems, the two most common categories are objective, or formula-based, systems, and subjective systems. Increasingly, large law firms compensate their partners based on a subjective evaluation of the partner s performance, although the subjective evaluation typically will be based upon review and analysis of both objective data (e.g., personal collections, productivity, realization rates, and client revenues) and more subjective factors, such as contributions in practice and firm leadership, mentoring of associates, community activities and bar activities. One of the most important performance factors business development efforts and results is also among the most difficult to assess, because the firm s revenues
from a particular client often are based on the efforts, over time, of several lawyers. Therefore, a major variable among firm compensation systems, whether objective or subjective, is the nature of the clientrevenue information recorded for each partner and the degree of reliance on that information in setting compensation. Compensation systems also vary as to whether the system is open (i.e., all partners know what all other partners make) or closed, whether partnership compensation is set annual or biannually, whether the system includes a bonus component based on the most recent year s performance, the number of different compensation levels, the range between highest-paid and lowest-paid partners, the time period over which a partner s performance is evaluated, and how much of an increase or decrease in a partner s compensation is permitted in a single year. Lisa Smith: In most large firms partner compensation is based on a qualitative and quantitative assessment of a partner s contribution to the firm. The key differentiators in many firms are originations and contributions to business development and client management, and personal productivity, as measured by dollars collected on one s own time. It is also important to note that most partners do not get a salary they are sharing in the firm s profits. So while you may have a sense of what you will earn based on the firm s budgeted income, there can be upside if the firm does better than expected, or downside if the firm does not meet budget. Lockstep compensation, where partners advance based on seniority, works very well in the small number of firms still using this approach (a few of the top NY and London firms). The common characteristics of lockstep firms is a very high bar for equity partner admissions, consistent performance among the partners, and advancement of skills and value as partners progress through the levels. Most lockstep firms also happen to be among the most profitable firms. Most firms are not able to maintain these characteristics and would find that a lockstep approach would be nearly impossible to maintain. In addition, as we move away from lockstep compensation for associates, it is unlikely that we will see firms adopting it for partners. Q: How does the way in which partners are compensated affect a law firm s culture? Linda Klein: Lock-step compensation systems can disproportionately reward senior attorneys who no longer generate the bulk of the firm s revenue, which can understandably cause highly-productive younger partners to be dissatisfied. On the other hand, compensation plans focused exclusively on billable and collected hours can create a culture that lacks long-term vision, in which billable hours come before business generation. In the same vein, a system that focuses exclusively on original client intake by compensating based largely on origination credits can devalue other contributions partners make to the firm, such as ongoing client service, and non-billable activities that brand the firm and bolster its reputation. Each of these systems has its benefits and drawbacks. In the end, a compensation system that balances all of the diverse contributions partners make will have a positive impact on the firm s culture. Jack Young: Partner competition is now the engine of any firm and depends on a lawyer s ability to bring in, and service clients.
Terry Conner: A firm s compensation system both affects and reflects the firm s culture. Partners naturally will behave in ways that are rewarded by the firm s compensation system. For example, if a firm s system strongly rewards a partner s individual productivity, or a partner s being recognized as the billing partner or supervising partner for a particular client, then the partners typically will strive to increase personal billable productivity and client-revenue credits. Whether this is constructive or problematic depends upon how the system is actually administered, and whether the system adequately values other good behavior, such as 1) pushing work to other lawyers who are most qualified to perform the work, or whose lower billing rates may be more cost-effective for the client, and 2) teamoriented business development. Many compensation systems struggle to balance the drive for individual business generation and billing performance, and other valuable contributions. Q: Many firms have or are moving toward tiered partner systems that increase ranks of income partners and reduce the number of equity partners what are the causes and effects of this trend, and what does it mean for young partners? Terry Conner: Law industry statistics show that a majority of large law firms now have at least two tiers of partners (e.g., equity and income), and that the number of income partners is increasing. A primary cause for these trends is the increasing competition for good legal business among large law firms, and the related fact that it is increasingly difficult for younger partners to establish a strong business base of their own. In this more competitive environment, a firm may believe that the benefits of sharing in a firm s net income, which depends heavily upon the business generation of key partners, should be reserved for those equity partners. Also, the income expectations of income partners may be more easily managed through salary-based compensation as opposed to being in the equity-partner, performance-based system. Some firms manage their compensation systems and the ranks of equity partners in order to increase their reported PPEP. This may be managed in a way that increases the overall competitiveness and strength of a firm, but can be counterproductive when it leads firms to make partner-classification decisions that do not otherwise reflect partner contributions and the overall value of the firms. Linda Klein: While many firms are experiencing a drop in revenue, they are still under pressure to keep their PPP on an upward trend. By moving to a tiered partnership structure and reducing the number of equity partners, firms are able to report higher PPP numbers, which influences their rankings in certain media reports, their perceived prestige, and their ability to recruit top talent. By restricting the number of equity partners, however, young partners will be asked to wait longer to achieve equity status. Although some young partners see value in income partnership such as avoiding the costs associated with buying in to the partnership and sharing in the firm s losses if productive young partners do not feel fairly recognized or rewarded for their contributions to the firm s profitability, they will seek that recognition elsewhere. Jack Young: It means that the partners who have the client make the rules.
About the Author Kendyl T. Hanks is a Partner at Haynes and Boone, LLP, in New York, specializing in constitutional and business litigation trials and appeals. Kendyl serves on the ABA Board of Governors and House of Delegates, and is active in the ABA Young Lawyers Division, the ABA Section of Business Law, and the New York State Bar Association. Kendyl received her undergraduate degree from Princeton, and her J.D. from the University of Texas at Austin School of Law.