Compensation and Remuneration Revisited

Clarifying and Defining What the Firm Expects of its Partners

Before deciding the best method of compensation and profit sharing in law firms, it is important to be clear about what the firm expects of its partners and what roles and responsibilities it needs them to perform. Partners equally need to be clear how they are to discharge their various roles as owners, managers and producers. The current trend away from the more revenue and formulaic systems is no accident. Firms are increasingly responding to the growing realisation that such revenue driven systems reward only a very restrictive set of behaviours and at times actually serve to penalise longer term entrepreneurial activities.

Significant time input is required across the world for partners in all law firms. On top of time spent on client work, we are seeing partners being budgeted to spend marketing and business development time in the range of 300 to 500 hours a year and other non chargeable time depending on factors such as the size of team and type of client. Non chargeable efforts also need to be made on client relationship management, team and human capital management and the partner’s contribution to the firm as an institution. This results in many firms expecting partners to spend (and record) a minimum of 2300 total hours per annum on the business of the partnership. Within this timeframe it should be possible for the non chargeable activities to be carried out even within the context of a large client portfolio.

In general, as the firm continues to grow, partners will need steadily to become managers of others as their main activity; they will need to reduce the time spent on files and matters, and to increase aspects such as delegation and supervision. In addition they will need to build capability and competence in four or five key areas.

Addressing the Right Questions

Whatever system is currently in place, and whatever the size of the firm, there are some consistent issues and themes which if not sensitively and fairly addressed, can have a serious effect on the partnership.

Firm-wide issues

Many problems are encountered by law firms in which underlying levels of profitability are insufficient to reward all their partners satisfactorily. In some firms, a contracting market and reductions in levels of work are resulting in heavy profit erosion. We suspect that there are many experienced partners in smaller firms who are performing an extremely valuable service to their clients but who would give their eye teeth to receive a level of reward which a newly qualified major city attorney or solicitor would reject. In such situations, the focus clearly has to be on the improvement of financial performance, but it is vital to continue to foster a sense of sharing and mutual support in difficult circumstances. The problems can be exacerbated if the firm finds it necessary or expedient to pay premium rates for its high flying lawyers because even less distributable profit will then be left available for the firm’s remaining partners.Other firms are finding it difficult to satisfy their younger partners, who are ambitious to progress quickly. Any system of partnership reward and compensation should recognise that partners often take time to find their feet following entry to partnership. Here, a lockstep system scores highly, as it emphasises the distinction between the personal attributes and earning power of each partner, on the one hand, and the assets and value of a firm as an ongoing institution, on the other. However, the younger partner – after a period of adjustment to life as an equity partner – often builds business very quickly and aggressively and will get frustrated if his or her peers at other firms are progressing faster in their partnerships. Hence, a fixed and rigid formulaic approach, such as lockstep, can rarely take into account the individual merits of each partner on a frequent basis, and frustrations can arise if progression seems too slow. The ambitious younger partner will be attracted to a system which has a worthwhile and chunky performance related element to it.

Equally, it is also difficult to maintain an appropriate balance between the needs of the individual and the firm. Under a discretionary or so-called subjective system, the pendulum can easily swing between the benefits of fostering individual ambition and the dangers of an individual ‘eat what you kill’ mentality. An ad hoc system can assist here by ensuring that the overall package of partner rewards and compensation is nudged and finessed periodically to ensure an overall fair result. The bigger the partnership, the more difficult this becomes, as fairness can only be achieved if a single person or a very small group of senior partners takes the time and trouble to assess every situation on its merits. Conversely, an autocratic and controlling senior partner can cause long term problems by imposing an idiosyncratic and selfish approach.

The needs and demands of different types of partner

Another set of obstacles can be presented by the different types of partner which the firm may encounter.

The first group are any exceptional high flyers in the firm. Fierce competition for the rain-maker or for the partner with a rare skill increases the risk of poaching. At a pragmatic level, the firm may recognise that it needs to pay a premium to one or more partners to ensure retention, but this can cause a sense of division and resentment in the partnership, unless carefully handled. The payment of special premium rewards is also usually unhealthy for the high flying partner, often leading to arrogance, and undermining efforts to encourage a more collegial environment in which partners are encouraged to pursue the firm’s best interests rather than their own.

Further problems can be found with any consistently underperforming partners. It is, or should be, a golden rule of any partner remuneration and compensation system that it should not be used as a tool to punish under-achievement. Equally, partners who are working hard and making real contributions to the development of the business find it difficult if the problems of consistent underperformance are not addressed. This issue has become harder for the older partner. In former times, partners would tend to ease off as they approach retirement, and, with the disappearance of goodwill, a gentle decline towards retirement whilst maintaining a full profit share was often felt to be a fair trade-off for years of hard work and loss of goodwill payments. With shrinking margins and increasing competition, however, most modern law firms realise that they simply cannot afford to carry any passengers, and the older partner finds himself or herself in the position of having to work harder in later years than in earlier in order to justify their profit shares. Sadly, some find this difficult, not least because their client base tends to be made up of individuals and professionals of similar age and can often shrink as their clients reach retirement age and no longer have a need for legal services.

Finally, some firms contain caosters who – even if not underachieving – are drifting along, just doing enough to escape scrutiny. Whilst this can be the case at every level, it can particularly be true of the more mature partner. Some senior partners retain huge amounts of energy, but some also may be in decline, with waning productivity and fading appetites for work. Some partners even appear happy to settle for a lower tier of compensation on the basis that lower tiers of compensation or profit share will expect a lower level of hard work and contribution and hence will put them under less pressure to perform. The problem can be exacerbated by the reward system, if it fails to have mechanisms in place to achieve a fair but sensitive approach. But the contribution of partners with only moderate records of performance or who have a single bad year should be taken in context. Any form of ‘subjective’ or performance related system should recognise long term contributions and not just the current year’s performance.

Choosing a Profit Sharing System

Methods of profit sharing in law firms have traditionally differed greatly between North America and Europe. In Europe, the majority of UK law firms have historically operated against a background of ‘true partnership’ with equal sharing for all partners after a period of progression up the lockstep. In smaller law firms, the progression of an incoming partner towards equality tends to have proceeded by negotiation or as a result of senior partners ‘giving up’ part of their profit sharing entitlement on an ad hoc basis. In larger European firms, the tendency has historically been for the firm to have a formal lockstep arrangement. In contrast, many North American firms have tended to operate on more meritocratic principles based on individual performance of partners as originating and working attorneys, which finds its most extreme model in the ‘eat what you kill’ principle.

What is interesting, however, is the extent to which we see a growing trend on both sides of the Atlantic towards performance related systems based on a wider managerial and business role for partners. There is now broad recognition that partners in successful law firms must – as their firms grow – develop their roles as managers of people, developers of business, leaders of teams, builders of ‘thought-ware’ and nurturers of client relationships. This immediately raises a difficulty in that success in many dimensions of these roles can only be considered qualitatively rather than quantitatively. The identification of winners and losers (and those in between) therefore contains many subjective elements.

The two simplest models of profit sharing lie at each end of a wide extreme. At one end, we find the egalitarian equal sharing model with the seniority progression known as lockstep. At the other extreme is a formulaic version performance based system based on the principle that every partner’s profit share or compensation is inextricably linked with the revenue introduced to the firm by him or her – the eat-what-you-kill system. These two simple but very different systems may continue to work for an ever dwindling number of law firms, but have – in their pure forms – already become less common and I dare say they will become even rarer. As firms make changes to their system to recognise and reward the differing roles and contributions of partners, it is inevitable that some features of the previous system will remain, if only in terms of nomenclature. Traces of the old ways will also remain deeply embedded in the psyche or culture of the firm. As an example, many firms in the United Kingdom continue to refer to their system as ‘modified lockstep’ long after all recognisable elements of a pure lockstep have disappeared. What they mean by this description is that their system is now heavily performance related but that seniority continues to be an element. There is a further example of adjustments at the other extreme of reward system – the heavily formulaic extreme. Here, some firms are fond of saying that they have ‘stopped looking at the numbers’. What they mean is that partners’ compensation or profit shares are no longer entirely driven by the numbers, but that the firm will look behind the financial data to consider total contribution. But as we will see later, financial and economic performance continues to be a critically important area.

The big decision therefore is where firms will choose to lie on the spectrum between the two extremes of pure lockstep and pure eat-what-you-kill. There is no one right answer. History will be an element as it is clearly easier to move along the spectrum by incremental steps than it is to lurch from one extreme to the other. But, as we will see from the next chapter, there are a number of other crucial elements in the decision-making process, not least the support which the system must give to the attainment of the firm’s strategic goals.

For start-up firms, or for firms who want to expand quickly, an eat-what-you-kill system continues to have great attractions, as both the overall need for working capital and the fixed-cost elements of overhead are quite significantly diminished in comparison to firms whose compensation model obliges them to pay market compensation for all its partners. However, significant recruitment constraints also apply as they are in a position to attract only those partners who are prepared to take a business risk in joining or starting a firm in which there are few compensation guarantees. In order to lure the best talent from other firms, it is often necessary to offer a compensation package which is sufficiently high and secure to seduce the partner into leaving his existing –and probably quite comfortable – position at a rival firm. In the face of this, we have over the last decade or so, seen a number of firms which are prepared to take significant financial risk – by incurring debt or inviting external finance – in order to fuel profitable long term growth. For such firms, a performance related system of compensation for its partners is usually essential, but there will also be a reasonably high fixed element to partner packages.

As the legal profession attempts to respond to recessionary pressures, some firms are altering their business model towards a model aimed towards both longer term growth and sustained expansion. A rising tide may well no longer lift all boats. Inevitably, therefore, expansion will have to rely more on a combination of clever strategic thinking and entrepreneurial efforts and contributions. In turn this may redirect law firms more and more towards performance related systems of rewarding partners who contribute well

Lockstep and its variants

In the UK, Europe and Australia, 50% to 70% of partner remuneration² is still largely based to some extent on a lockstep system but the use of pure unadjusted lockstep continues to fall steadily in these jurisdictions. Instead, hybrid forms of lockstep are slowly growing in which performance related adjustments of some kind are made based on qualitative criteria.Few firms in North America have ever used lockstep and most who have used the system have now abandoned it. Partners in North America seem more willing to place their compensation in the judgement of others while UK, European and Australian law firm partners prefer a more predictable and pre-established set of criteria.

Under a Lockstep or seniority based system, an individual Partner, upon admission to the Partnership, is exchanging his own individual earning power and his own intellectual capital, for participation in a ‘mutual fund’ of other Partners. Through this, he is able to share in the joint future incomes of his Partners, some of whom will be his contemporaries and some of whom will offer differing levels of expertise and experience gained through the years.

The main benefits of a Sharing or Lockstep system of Profit Sharing

For a Firm with a large element of firm-specific Intellectual Capital, the sharing or lockstep system of Profit Sharing has some important potential advantages. The main benefit is to provide outstanding diversification and to reinforce a culture in which clients are viewed as firm clients and in which efficient teamwork is encouraged. In the case of many lockstep firms the client is regarded as central to their whole ethos, and for such a firm a culture of ‘firm before self’ is entirely consistent with a sharing, lockstep model of profit sharing. What is also clear is that the presence and level of firm-specific capital is so marked in such firms that they are potentially much more profitable for individual partners than alternatives outside the firm. This in turn reduces the risks of poaching by other firms.

The draw-backs of Lockstep

Lockstep or the sharing system of Profit Sharing does however have the following disadvantages:

• It does not deal explicitly with the issue of underperformers or shirkers.
• It does not deal with the issue of exceptional high flyers.
• It does not reward, sufficiently quickly, superior young Partners.
• It can reward moderate partners to a greater extent than they deserve.
• Even if underperformance is not a problem, nevertheless, in the world of professional services there is a fine line between the good partner and the excellent one.
• It can prove difficult to find the right place on the equity ladder for lateral hires.

In the lockstep firm, the problem of shirkers and underperformers is seen as more of a management and development problem than a problem of reward. Firms with a lockstep or sharing system of profit sharing tend to be less tolerant of poor or mediocre performance than firms which make extensive use of individual performance based rewards. The attitude can be very much one of ‘shape up or ship out’. The problem is that not every issue of underperformance results from laziness or lack of intellect.

The experience of a number of firms is that a reduction in profit share to cope with underperformance can tend to demotivate the partner still further with the result that performance levels drop even more.

How Lockstep Works

Lockstep works by providing for a progression for incoming partners from a starting allocation of a profit share until he or she reaches parity with the other partners; this parity is often known as ‘the plateau’. The most common way of expressing this formula is by a points or units formula, and this generally works in one of two ways. The first and most common method is for the distributable profit to be divided by the aggregate amount of points allocated to partners to arrive at a points value which will of course vary from year to year as profits (and the number of points in play), go up and down in each accounting year. The second method, which is less common, is to attribute a fixed value to each point. This is sometimes useful in order to provide a differential points value when the firm has different offices operating under wholly different market and profitability conditions.

Bands and Spreads

Whatever system of partner assessment is used, the end result will be to place partners into a number of bands, either for the purposes of the total compensation or rewards package or for the performance related elements of it. In the case of managed lockstep systems, the assessment can also inform and affect progress on the lockstep and through gateways. In the case of modified lockstep (primarily based on seniority but modified by performance factors), the assessment helps to place partners on the correct step in the lockstep.

The number of bands, the separation between bands and the overall spread between highest paid partner and the lowest paid partner also has to be considered. For this, a spread or ratio higher than 3:1 appear to be exceptional, at least in the UK and Europe. According to The Lawyer in the UK, DLA Piper is said to have a spread of 5:1, whereas Slaughter and May is at 2:1. Clifford Chance, Linklaters, Freshfields and Allen & Overy all vary between 2.3:1 and 2.5:1³. Our Kerma Partners 2008 Global Compensation survey⁴ showed some interesting differences between the USA and the rest of the world. The USA was notable for its larger than average spreads – roughly half of the US firms surveyed had spreads of 4:1 or 5:1 and around a quarter had larger spreads than that. Elsewhere in the world only a few firms had spreads of more than 3:1 or 4:1. These spread differences can be attributed to the distinction between lockstep firms and those where other methods of compensation are in use. Journalist Nathan Koppel writing in the American Lawyer in July 2005⁵ discovered that the ratio between highest and lowest partner in 2004 at Baker & McKenzie was 35:1 whereas at lockstep firms like Fried Frank and Cleary Gottlieb the range was 4:1 or 3:1.

Greater spreads also tend to lead to larger numbers of bands. Lockstep firms will normally have between five and twelve bands to reflect the number of annual steps to parity. Firms with huge spreads can sometimes have as many as twenty or more bands.

Firms like Baker & McKenzie have traditionally maintained greater flexibility in order to cater for a more diverse partnership and increasingly disparate pay levels, and are therefore likely to have a greater number of bands to reflect their different structure and business recipe. Hence, it is not possible to state dogmatically what might be either the optimal number of bands or a best-practice spread. A number of principles do however emerge:

• The fewer the number of bands, the more egalitarian the firm is likely to be.
• Even for firms with a truly meritocratic culture, the number of bands should be restricted as far as possible – too many can cause envy as small differentials between bands can cause hair-splitting comparisons between broadly similar partners.
• The creation of special bands for the benefit of one or two real high flyers should ideally be avoided if possible, as elite bands can cause both resentment and complexity; in the real world, however, the pragmatic use of elite bands may sometimes be unavoidable.
• There should be ‘blue water’ between the bands both in terms of performance criteria and pay levels. Bands which are too close together can cause a lot of grief and negative emotions about hardly perceptible differences in performance or over small amounts of dollars or pounds.

Points and Units

Whether or not partners are placed into bands or tiers, and however the rating or evaluation is carried out, the decision or judgement in relation to each partner has ultimately to be resolved or converted into a monetary award. The most popular method for allocating distributable profits is to allocate a number of points or units to each partner in accordance with the band to which they have been assigned or in accordance with a table of points. Typically, this will result in a flexible pool or aggregate number of points in circulation in the relevant year of distribution. In practice, most firms with a unit or points pool will accordingly have a floating pool which will rise every time a new partner is admitted or every time existing partners gain more points by climbing to a new band. Firms will limit the number of partnership applicants or the number of units or points offered to incoming partners by deciding periodically whether the firm can afford any new partners, and satisfying the existing partners that the proposals and business case for a new partner would not devalue the profit shares of existing partners. Thus, the imposition of controls on the number of profit-sharing units to be allocated may not be entirely necessary. However, some firms prefer to see some controls in place. One method would be for the growth of the points’ pool to be linked to the growth of the firm’s profits.

Accordingly, it would be possible to provide that no new equity partners can be admitted unless each of the profit units maintain at least an agreed floor value (index-linked perhaps) based on the profits of the preceding year (or perhaps those budgeted for the current year). A more drastic provision (drastic because it could stop partners from gaining additional points except at the expense of retiring and demoted partners) might provide that no new units at all could be issued unless the profit units remain unprejudiced by the new issues. These limitations would not of course apply if the firm’s profits increase faster than the rate at which new units are issued to new equity partners and those rising through the firm’s bands by operation of the lockstep or by graduating to higher tiers though improved contributions to the firm.

Aligning with a Corporate Model

It is becoming fairly common for law firms to try to align with more corporate models of salary and compensation structures, especially as jurisdictions such as Australia and the United Kingdom start to embrace deregulation for the legal profession. However, the world of corporate business has no easy formula for resolving salary and compensation issues for its senior staff. For senior executives at the same level as equity partners in a law firm, the salary package in most corporations will combine a fixed salary with bonuses, some of which will be payable in cash and some in longer term stock options. In contrast, the traditional partnership model on the other hand has historically operated on the basis of the partners allocating to themselves the whole of each years profit; indeed most partnerships are taxed on the whole of their income each year. The main change for law firms who embrace full corporate structures would therefore be the concept of deferred compensation – not all of the firm’s income would be on the table for allocation and distribution each year. Apart from that fundamental change, the main compensation and reward challenges currently facing law firms would continue to apply whether the setting is a corporate one or the firm uses the more traditional partnership model (I think you could return to a few of these issues in your conclusion. They seem to me to be fundamental to the whole compensation debate and the move to more corporate structures may have further ramifications for compensation structures in the future… Comparing to the investment banks for example might work well in concluding chapter)

The investment banks form a sector exemplifying a profession that has for some time abandoned a partnership structure in favour of a corporate model. In the last decade of the twentieth century, investment banks used long-term guaranteed contracts and bonuses to attract and retain staff. This was soon abandoned in favour of more flexible systems with performance related bonuses structured to include a greater proportion of restricted stock which is released over a number of years. These base compensation structures are supplemented by a menu of signing and year-end bonuses, pension provisions and other perks and reimbursements.

The banks also instituted salary targets to align with revenue, in pursuance of strategies to reduce fixed costs and to increase the proportion of variable overheads. Such fixed targets are often around 50% of revenue. Typically, therefore, fixed salaries became capped at a relatively low level ($250,000 or £125,000 being fairly common). The problem however arose that although many of the bonuses remain theoretically discretionary, some bonuses have to be paid in order to retain the best talent even in a downturn.

Further considerations have affected the mergers and acquisitions market. In a consolidating market, acquisition strategies have driven those financing deals to devise compensation plans which provide incentives for the current management to stay and to build up the value of their equity within the consolidated entity. Hence, a substantial part of the purchase price usually gets paid in stock, notes and other forms of paper in the purchasing company. Typically, the deals depend on several years of growth to make the finances work for all parties and many deals are therefore structured to pay one third of the purchase price in each of cash, equity (in the new firm) and loan notes.

The legal profession is still very fragmented and we are likely to see a period of consolidation with mergers & acquisitions increasing in pace and scale. This trend, combined with the emerging trend to convert many law firms into corporations will see partners’ salary and compensation packages become combinations of fixed base salary, performance related flexible elements and some elements of deferred compensation tied to long term growth. The assessment of total contribution over a balanced scorecard or a number of critical areas of performance will therefore be increasingly important.

Setting Base Partner Salaries or Base level Compensation

As has been seen, many firms are staring to introduce for the equity partners and members the concept of a base salary or base level compensation. From the individual partner’s point of view, this gives the security of a fixed level of reward which is not subject to the tides of personal good and bad fortune within the firm. Partners know that this fixed base will allow them to pay their mortgages and living expenses. It is very important to fix these salaries at the appropriate level. If it is fixed too high, the fixed base element may give partners too much security and may also become a disproportionately high focus of attention in the compensation setting round. If fixed too low, it can become somewhat meaningless. The experience of a number of firms is that the aggregate level of such base salaries should be targeted to be around half of the total compensation package, thus leaving a realistic proportion of total compensation subject to both performance related and proprietorship aligned factors.

A number of different models can be employed to arrive at the appropriate amount for these base fixed salaries, although many firms do not have any systematic methodology in place, and some firms will consider combining a number of these methods to arrive at an overall result. Once these base levels have been set, there is a trend not to reconsider them annually but regularly to apply an inflation element to them.

Method One – Conversion of Drawings

The first method in common use is to convert existing monthly drawings levels into a ‘salary’ sometimes grossed up for tax purposes (although only the net sum would of course be paid). This has the advantage of providing only a minimal change but, depending on the firm’s drawings policy, may not necessarily draw fair distinctions between partners. Some firms have a flat drawings policy under which all partners receive an equal monthly sum irrespective of seniority or performance, whilst others adopt a very conservative monthly drawings policy which bears no relation at all to the sort of fixed or flat base sum upon which partners would expect to rely for their basic needs.

Method Two – Converting part of Compensation Package

Another method sometimes used is to convert a part of the overall compensation package from the previous year into a fixed base salary for the current year. This has the advantage of preserving the existing differentials between partners and also forms a small and therefore uncontroversial change.

Method Three – Salaried Partner Plus

Another method is to look at the market salaries and compensation packages currently paid to very senior lawyers and attorneys below equity partner level. New incoming equity partners or members would start at a base salary level around the same as the salary level as a salaried partner, and the base levels would rise proportionately from there for all other equity partners.

Method Four – Market Salaries

This method is not dissimilar to method three in that the firm makes an attempt to fix market salaries for all its equity partners or members, having regard to salary levels in both the private firm market and for in-house lawyers and general counsel. In theory, this sounds sensible and logical, but it can be quite difficult sometimes to obtain meaningful benchmark salary levels and even more difficult to set a level for, say, a generalist partner in his 50s. It is however an attractive way of differentiating between partners in high cost and low cost offices, particularly in a firm with international offices.

Lateral Hires

Base level salary or compensation packages (highlighted in the previous section of this chapter) are brought into stark relief when considering the introduction of lateral hires whether at shareholder or equity level or as a non equity partner. Firms will want to draw an appropriate balance between offering a seductive package (which therefore will often contain a high fixed element) and the creation of flexible compensation which is tied to the performance and success of the laterally hired partner.⁶ The overall package needs to be sufficiently attractive to persuade the partner to leave his or her current firm but the hiring should never be carried out without reference to those who – perhaps as a remuneration or compensation committee – have the responsibility for the firms partner remuneration and compensation setting for the whole of the firm. It is worth noting that the level of fixed or base salary set for the new laterally hired partner will ultimately affect the base salary structure for the rest of the partners – too high an introductory package can destabilize the firm and lead to key existing partners leaving the firm.

Furthermore, the possible introduction of a lateral hire can usefully test the viability and purity of the firm’s compensation system. If the system is quirky, inexplicable, over-complex or thoroughly outdated, it is unlikely to be attractive to a new joiner.

¹ This paper is a summary of a larger study I am writing on Partner Compensation. For further details please visit my website www.jarrett-kerr.com or my blog www.nickjk.wordpress.com
²The Kerma Partners 2008 Global Compensation Survey
³ The Lawyer UK 200 September 2007
⁴ Kerma Partners 2008 Global Compensation Survey of Law Firms
⁵ Nathan Koppel “The High-Priced Spread” American Lawyer July 2005
⁶ For a useful discussion of the issues concerning compensation for lateral hires, see my colleague Ed Wesemann’s article “Managing Expectations – Compensating Unique Lateral Partners” (2007)