Innovative Law Firms Use Thoughtful Compensation Strategies
Part I
Equitable, transparent and intelligible compensation plans strengthen the stability of a firm. Partners in a law firm are compensated in accordance with the terms of their partnership agreement. These agreements vary from firm to firm and are limited only by the partners’ imagination. Often partner compensation is based on a distribution of net profits among the partners.
In recent years, law firms have seen a general uptick in revenues, yet costs have risen even faster, resulting in a decline in annual profits among many mid-sized and larger U.S. firms. This has had a significant impact on partner compensation, as firms are often tied to revenue-based pay structures. This begs the question: how should partner compensation be impacted by a decline in profits and is impact based compensation the best option?
COMPENSATION BASED ON CONTRIBUTION
One potential solution is to tie partner compensation to their individual contribution toward the firm’s net profit. This allows firms to reward partners for their contributions to firm profitability, rather than simply relying on a revenue-based system where partners equally split the profit.
Compensation as a pro-rata share of net profit is more equitable since partners are rewarded for their individual efforts. This curbs the ability of one partner to ride another’s coat-tails to financial gain with minimal effort. This person is called a “free rider” which is a term that originated in economics and refers to an individual who takes advantage of the work of others when that work creates benefits shared by an entire group.
Pro-rata compensation encourages individual action since the effort put forth by each partner is rewarded based on his or her input.
COMPENSATION BASED ON HIERARCHY
Another version of compensation based on (perceived) contribution is compensation structured as an equal split of net profits among the partners. For example, if the firm’s net profit at year-end is $100k and there are 10 partners, each partner receives $10k in profit sharing. This is based on a presumption that only the partners add value to the bottom line.
Throughout the year, a firm might agree to pay partners a monthly minimum profit distribution, regardless of the firm’s current profitability. These payments are advances on future net profits. At the end of the year, the advances are subtracted from the total net profit owed to each partner, and an adjustment is made to (hopefully) pay out the remaining net profit. This causes problems if the annual net profit remaining for distribution is less than what was advanced. Additionally, if there isn’t enough profit in a given month to distribute the guaranteed minimum, the firm may have to take on debt to make good on the guarantee.
It’s wise to strategically consider this method of compensation and whether or not it’s beneficial for your firm.
IN CONCLUSION
An equitable, transparent, and intelligible compensation plan strengthens the stability of a firm. Thoughtful compensation strategies contribute to a healthy bottom line. However, this suggestion is often met with the following response: “No! Forget thoughtful approaches to compensation. I am the founding partner. I hired the lawyers who are now my partners. I know their relative contributions to the firm and I set their compensation accordingly.”
This method of determining compensation is an example of first order thinking, a short sighted way of making decisions. You can read more about it here – Mindset – The Building Block of a Resilient Law Firm.
In this scenario, the partners have no idea how the decisions are made, but if they perceive fairness, everything is fine. However, time passes, the firm grows and changes. The need will arise for a predictable and transparent system for setting compensation. Law firm breakups and partner departures are often due to perceived inequities in compensation arising from not being satisfied yourself, or relative to your peers, or both.
In the next part of this series, we’ll talk about why individualized performance based compensation can result in employees becoming competitive with one another, regardless of where they fall on the firm’s organizational chart. This is especially true when there’s a fixed amount of incentive based compensation available and employees and partners are competing for limited bonus money.
How does your firm handle compensation? Comment below and share this post with someone who needs to read it!
