COMPENSATION 101: A Primer on Choosing a Compensation System

by Joel A. Rose
 

What are legal partners entitled to, compensation wise?  A plan that is well-conceived and skillfully implemented?  A plan that takes many aspects into account?  A plan that enhances the lawyer’s ability to provide high-quality legal work and reward extraordinary performers – the business developers, overachievers, rising young stars and lawyer managers?  A plan that promotes an atmosphere conducive to client service?  Attracts and retains qualified lawyers?  Encourages efficiency?

No matter how closely legal organizations may resemble one another, there is no single compensation plan that can be utilized by all firms or gain universal acceptance by all partners.  Ideally, the best compensation plan is the one that creates the lowest level of discontent and the highest degree of equanimity among the lawyers.

Sound impossible?     
Perhaps.
Read on.

The Big Picture:

A realistic package should be widely perceived within the firm as being fair, supported with reliable, comprehensible and readily available records. It should be based on each partner’s objective and subjective contributions.  The compensation system must meet the needs of the firm as it exists today, and should encourage, by incentive, activities that the firm wants to encourage.  The compensation system should take the following into account:

  • Income
  • Draw
  • Distribution of profit
  • Retirement considerations
  • Expenses
  • Deferred payment plans such as pension and profit sharing
  • Insurance premiums
  • Club dues
  • Other allowances or capital requirements
  • Security, motivation and diversity of the partners’ work and activity
  • An equitable and competitive fee structure.

A partner compensation system may be based on several scenarios:

  • Lock step/seniority
  • Performance/contribution (subjective or objective)
  • A combination of the above.

Most law firms establish some form of draw for each partner at the onset of the coming year.  Some firms calculate this amount as a percentage of the current draw and bonus received for the previous year.  Some look at the variable average of the current draw only.  Some review the draw and bonus received over the past two or three years.

Some draws follow a standard progression based on years admitted to practice, such as years a partner has been with the firm.  Draws may reach parity over a predetermined period of time so that all partners practicing for 15 years or more receive the same draw.  Partners who join the firm as lateral hires receive credit for all or part of their experience.  The draw schedule may be revised annually or every two years.

More firms are recognizing the contributions of individual partners by establishing variable draws equivalent to 70 or 80 percent of the standard draw progression.

Virtually all compensation plans involve regard and consideration for the lawyers’ collective performance.  This includes creation and maintenance of the vital entity that is known as the firm.  In turn, the firm maintains records and rewards the partners who originate business and produce the work.  It recognizes the partners, who perform the management functions, engage in community or bar activity, attend and participate in continuing legal education forums, and enhance the firm’s ability to obtain business through its acquired reputation.  The method of reward varies from firm-to-firm, and is ultimately determined on a firm-by-firm basis.

Selecting the Right Method:

Straight percentage:  The simplest method of allocating profits is a straight percentage basis, determined annually at the beginning of each year.  For example, a firm of three partners determines that each will share in the net profit by allocating 45, 30, and 25 percent, respectively.

Say that the gross fees collected total $450,000 and with overhead at 42 percent, the net profit to be distributed is $261,000.  At the end of the first year, the first partner, with 45 percent, receives $117,450; the second partner, with 30 percent, receives $78,300; and the third, with 25 percent, receives $65,250.

Units of participation:  An alternative to the straight percentage is a unit system.  This method circumvents political and ego problems that may arise when one partner is unwilling to reduce his or her percentage interest in the firm.  If three lawyers invite a fourth lawyer to join them, and one of the partners is reluctant to reduce his or her interest, the firm may opt to allocate profits on the basis of units of participation.  In this system, the three lawyers retain their numerical units and the fourth lawyer is given a share of units:  The first partner receives 45 units, the second 30 units, the third 25 units and the fourth 20 units.  At the end of the year, the gross legal fees collected total $585,000.  After subtracting the overhead of 42 percent, the net profit to be distributed is $339,300.  Based on the units of participation, in this case 120, the first partner’s share is 45 units (37.5%) is $127,238; the second receives 30 units (25.0%) or $84,825; the third receives 25 units (20.8%) or $70,574; and the fourth receives 20 unites (16.7%) or $56,663.

Final percentage or unit determinations are made by a senior partner or compensation committee.  Compensation committee generally use a “sounding out” process and may encourage all partners to participate in the initial decision and conduct interviews before a final decision is made.  A few firms take a ballot of all partners before submitting final results to the committee.

Float:  Using a percentage with “float” is essentially the same method as a unit of participation.  Based on the year’s performance, a float or reserve – generally ranging from 5 to 10 percent of net profit – is set aside.  The float is allocated to the partners who have performed extraordinarily during the year.  This determination is frequently made by one or more partners or by the compensation committee.

Seniority:  Some firms find it useful to establish a variable or percentages or units based on seniority, reputation, and past and anticipated performance, with the balance of profits divided equally.  They create standard draws among all or classes of partners, with variable bonuses paid according to the contribution of each individual partner.

A Formula Approach:

Many firms are successful with relatively simple formula compensation plans.  Some firms establish the basis for sharing of fees collected as one-third for originating the work and one-third for producing the work, with one-third set aside for overhead.  This simple formula uses a one-to-one ratio for the origination and production of work.  As a firm grows larger, it is increasingly more difficult to evaluate the contribution of one partner in relation to the total contribution of other partners.  It quickly becomes obvious that lawyers who spend time on management and administrative activities must be recognized for performing those functions.  Most formula systems therefore include a method for prorating origination and production of work, and providing credit for managing the firm and performing other firm-approved, consequential non-fee producing activities.

Credits may be weighted as follows:  three credits for business origination; six for production; and one for profitability.  (Business origination credit may be permanent as long as the client remains with the firm, or it may be phased out over a five- to seven-year period.)  Management time and firm-approved activities may be weighted in the same proportion as production credit.  The weights assigned to particular criteria depend on the firm’s needs.  For example, business origination may be reduced in weight, while work done is increased.  Other variations include splitting credit for business origination into subfactors, such as credit for maintaining clients or case responsibility.  There may also be a modification in weights based on difficulty of case, transfer of responsibility for large estates or bar association activity.

An alternative to the strict incentive system is to establish an equal or variable draw that includes an allocation based on formula information.  Under this method, some percent of the net income is shared equally, or variably among all partners and the remainder is distributed as determined on the basis of weights for statistical and subjective factors.

Credit for origination of business can either be continued for the life of the lawyer, or it can be given to the “firm” after a period of time.  Typically, this time period can be five to seven years.  It can also be shared or transferred to a lawyer who is, or becomes, responsible for maintaining the client.  Much business will come to the firm without any clear indication of who should receive credit for origination.  The firm will then have to decide whether to exclude this data from its figures, assign them to the lawyer handling the work or distribute the credit.  Some firms allocate credit among lawyers who originate the business and those who maintain the client.  Other firms allocate this credit to the “firm.”  The firm receives credit in the same manner as a partner.  However, the total amount of credits allocated to the firm may subsequently be reallocated to individual partners and reflected in their total credit calculation as consideration for business origination, work production and profitability.  As an alternative to this method, the firm total may be allocated to all partners equally.

Defining Profit:

The weight and use of the profitability factor depends on the firm’s concept of profit.  For compensation purposes, profit may be calculated as a figure above the partners’ draw, associate salaries and overhead.  Profit may also be based on a figure related to the time-dollar value of services on particular matters.  The manner in which profitability is calculated by the law firm, and the personal effort expended by the lawyer who benefits from the credit, should determine the weight accorded to this factor.

The statistic for work production may consist of such records as fee producing or total hours; the time-dollar value of these hours; prorating the hours worked by each lawyer against the final fee; the time-dollar value of the assisting lawyer without regard to the total fee; or simply a guess of the value of effort contributed by each lawyer to the matter.

It is recommended that the basis for any formula be actual fees received.  Until the money is received, the business origination or work performed credit has no economic value and only contributes to overhead.  In many compensation plans, uncollectible advances to clients may be charged to the responsible lawyer.

As the firm continues to evolve, time will make changes in personnel, values and goals of the partners.  Consequently, what pleased the founding partners may not necessarily be welcomed by the new order.  This development should be approached as a natural and inevitable course of events.  The firm that succeeds in establishing a sound compensation plan is one where partners view  the decision-making process as dynamic and understand that it is not etched in stone.

©1999-2015 Joel A. Rose & Associates