The Trend towards Performance Related Profit Sharing in law firms

The Trend towards Performance Related Profit Sharing in law firms

In recent years there has been a marked shift in law firms toward performance related partner remuneration.  There seem to be at least four factors at play.  First, It has been broadly felt that a performance related system helps to incentivise partners or that secondly it perhaps in some way helps the firm gain better star quality.   Third, firms have also been trying to align how they value partners and how they pay them.  Finally, I have discerned that law firms have been more and more looking at other sectors of the corporate world and have tried to modify their partnership reward model into something which looks and feels a bit more corporate

1. Incentivising partners

One fundamental assumption which many law firms (rightly or wrongly) make is that it is important to have financial incentives in order to influence partner behaviours and thereby drive law firm performance.  The philosophy of many law firms assumes first and foremost a belief that partners – particularly partners operating in a comfort zone – can be motivated to work harder by being offered the chance of higher rewards.  As can be imagined, there have been many studies on the topic, many of the more recent of which[1] have found that remuneration on the whole does not motivate people all that much, but that dissatisfaction about remuneration (or the perceived unfairness over the way in which remuneration is fixed) can often have a severe demotivating effect.  Hence, if a partner feels that other partners are consistently contributing less than him or her, but are receiving greater rewards, then in the long term the over-performer will vote with his or her feet.  Equally, partners who feel that prima donna partners are pampered and spoilt creatures who are favoured with excessive financial rewards, may become disillusioned with the perception that their honest toil has been overlooked or undervalued.

The introduction of a performance related bonus element is often brought about in circumstances of mixed or confused motives.  Within even the same firm, I have found some partners who have felt that the bonus is primarily designed to reward exceptional performers, whilst other partners have felt that the main purpose is to persuade moderately performing partners to think hard about their overall contribution to the firm and to find ways of improving their contribution.

This confusion therefore highlights the distinction which must be drawn between incentives and bonuses.  Incentives are designed to fix a reward against a future target, whereas bonuses reward past outcomes.   Hence, firms who hold strongly to this incentive assumption will often be attracted to performance based rewards being allocated prospectively rather than retroactively, or to a formulaic element dependant on future performance.

2. Improving firm-wide ‘star quality’

A second underlying assumption is that somehow, a performance related system can operate as a kind of forced ranking system in order to improve the star quality of the firm.  The forced ranking approach requires firms to compare partner contributions and to place partners in order  of performance. The belief is that a performance related system will attract and reward winners and at the same time will repulse and penalise losers.  Indeed, under the ‘pure’ forced ranking systems, corporations will weed out and expel the bottom layer of their performers each year, thereby theoretically raising the performance and quality bar incrementally.  The idea further is that motivated lawyers who are driven to outdo their peers will choose firms where their superior performance will translate into extra financial rewards.   Less able lawyers will at the same time seek out more comfortable firms where their lower level of performance will be tolerated.  This thought process is part of a trend towards higher standards and greater rigour.  We see firms trying valiantly to ‘raise the bar’ on an ongoing basis, and to develop their people.  There, is, however a danger here.  Recent research[2] has shown that forced ranking approaches can result in lower productivity, scepticism, reduced collaboration, damaged morale and mistrust in leadership.  This does not mean that an approach which contains elements of forced ranking is in any way invalid.  Nor does it mean that all partners have to be equally treated.  There should be status tiers in every firm where it is clear who deserves to be at the top and the bottom of the pecking order.  But, in any approach where partners are comparatively graded, great care has to be taken to ensure that the perception does not grow in the firm that there are a very few stars at the top and everyone else is somehow inferior.  Some firms use a forced ranking approach – or variants of it – in their compensation assessment approach.

3. Living up to Values

A further underlying assumption is more values-based, and can be summed up by a number of glib phrases such as ‘practice what you preach’, and ‘reward what you value’.  Pretty well all modern law firms realise how critically important it is to maintain and develop their people resources – what in this guide I will refer to as Human Capital.  Furthermore, it has now become evident to most firms that lawyers, both at partner and employed level, will tend to look at the pay and reward system to figure out what really matters in their place of work.  For many years, there has been a mismatch between the words and the music.  Law firms almost universally assert that they value and encourage positive behaviours in areas such as collegiality, teamwork, collaboration, and empowerment, but often in practice reward their partners for selfish work-hogging, individualistic billings, and personal empire building. There unfortunately seem to me to be many firms where the unwritten rules do not match the fine words of the firm’s leaders. Quite apart from the wholly detrimental effect of a set of completely hypocritical set of values, there is no excuse for shallow and superficial thinking here, or the adopting of template solutions and values which the firm is really incapable of living up to.  This is why I express my firm conviction that a system which carefully and methodically identifies key areas where partners are expected to perform, based on the concepts of Intellectual Capital[3] and the Balanced Scorecard[4] methodology is the best way I have found of aligning a firm’s every day operations to its long-term strategy, and thence into its reward systems.

4. 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.

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.

[1] For examples of such research, see for instance Pfeffer and Sutton “Hard Facts, Dangerous Half Truths and Total Nonsense”  (2006) HBS Press,  Thomas Davenport, “Human Capital” (1999) Jossey Bass) and Andrew Mayo “the Human Value of the Enterprise”  (2001) Nicholas Brealey Publishing)

[2] Novations Group “Uncovering the Growing Disenchantment with Forced Ranking Performance Management Systems” white paper (Boston, MA:Novations Group, August 2004) quoted in Hard Facts

[3] Leif Edvinsson and Michael Malone “Intellectual Capital” (1997) Harper Business.

[4] Robert S. Kaplan and David P. NortonBalanced Scorecard” (1996) HBS Press