This article first appeared in Managing Partner Magazine in May 2013 and is reproduced with their permission.
It always used to be the case that partner profit sharing discussions were considered to be a matter of entirely internal focus. In recent years, partner remuneration has become less idiosyncratic and has tended to take at least passing notice of best practice in the law firm arena, as firms have become increasingly aware both of the advantages of taking account of lessons and practices in play outside the law firm arena and also of the need to provide a coherent structure to firms and lateral hires with whom they wish to have discussions.
The well documented movement in recent years towards more meritocratic performance related systems and away from the many different and individualised lockstep arrangements and, indeed, the more formulaic methods of profit sharing, forms part of this harmonisation trend.
In this movement, I have noticed six externally driven issues with which firms need to contend. The first is that, as firms move away from assessing partners just on their revenue performance, law firms have joined every business sector in finding the evaluation of an overall contribution to be extremely difficult particularly in areas of soft management skills. There are some who argue that financial results will reflect business development as well as team building successes and that accordingly revenue evaluation should remain the predominant criteria. Other firms are carefully building Balanced Scorecard (BSC) methodologies and are striving to supplement these by measures and metrics which will help a fair assessment.
The second issue for all business sectors is that for several years now the financial climate has resulted in decreasing net profit margins and cash flow issues that put pressure on the amount of distributable profit which can be allocated by way of bonus or performance related payment. It is less easy to give bonuses when profits are low.
The third issue concerns the outliers in any group of partners at both ends of the performance spectrum. Firms increasingly recognise the need to reward high-flyers and exceptional performers whilst at the same time there is less tolerance for those who are performing least well. High performers can usually assess their performance and reward against perceived external benchmarks. The problem with underperformance is that the problem is usually judged internally relative to other partners, rather than by reference to external benchmarks. Hence, the worst performing partners can become isolated and unloved even if – objectively speaking – their performance is at an acceptable level. As firms remove more and more underperformers, partners who were previously at the low end of the middle group of performers then begin to form a new bottom group. This may not be an issue in over-partnered firms but may affect the firm’s overall performance in firms where partner numbers are about right.
The fourth trend is towards an increasing alignment of the partnership model with the corporate governance and shareholding structure used by the majority of business-to-business firms. Law firms have traditionally been accustomed to think very short-term and to allocate all profit in one year to their partners, whilst the culture and practice of holding back or reserving profit is the norm in the corporate world. As the professional service model moves towards the corporate one, the practice is gradually emerging of reserving some element of profit for long term funding needs as well as for deferred partner and staff rewards. Similarly, in firms with a corporate alignment the profit calculation can be divided into three elements of notional salary, the expected ‘dividend’ (even sometimes on a deferred basis) to give an appropriate equity or proprietorship return, and bonus for good performance.
The corporate alignment issue also gives rise to a fifth issue particular in jurisdictions like the UK where stakes in law firms can be bought by external investors. The first valuation calculation that has to be carried out by law firms is to define the firm’s earnings before interest, tax, depreciation and amortisation (known as EBITDA). In order to do so, the firm’s net profit must be reduced by the market salaries to which partners would be entitled if they were not owners. The resulting profit after the deduction of notional salaries then becomes one of the key elements in the various methods of calculating the firm’s valuation. Many firms find, unfortunately for them, that their EBITDA is tiny or non-existent and that consequently their firm is worth little or nothing. From a profit-sharing point of view, however, the EBITDA calculation does help to separate the ownership and risk aspects of being an equity partner from client-facing and worker-manager aspects.
The final and sixth issue is of concern to all professional service firms operating either internationally or in regions with widely different economic environments. Variations in profitability in different markets can put great pressure on integrated remuneration models. Many international law firms, operating with a Swiss verein structure will allow member firms to continue in alliance mode, retaining their local profits. Some integrated models with a global profit pool allow an element of subsidy which id often capped. Another method is to apply a purchasing power index to the unadjusted profit share. This approach seeks to preserve the concept of equity but does so in terms of purchasing power rather than contribution to profitability.
The clear message is that any profit sharing system in a law firm needs to stand up to external benchmarks and standards as well as being tailored for the specific context and needs of each law firm.