The Distribution of Law Firm Profits

by Joel A. Rose
 

Distribution of profits is frequently one of the most potentially disruptive experiences that partners or shareholders have to face.  It is axiomatic that no single compensation plan will be universally accepted and agreed to by partners in firms no matter how closely these legal organizations may resemble each other in size and type.  The “best” compensation plan for any law firm is the one that creates the least amount of discontent, and has the highest “grade” of fairness among and between the partners.

Philosophically, every law firm has a method for compensating its lawyers.  Many compensation plans are purely subjective in nature, while others are highly structured.  Most plans are a combination of the two.  A compensation plan that is well-conceived and skillfully implemented should: (1) enhance the ability of the lawyers to provide a high quality of legal work; (2) reward extraordinary performance in terms of business developers, over-achievers (production and collection) rising “young stars” and lawyer managers (legal and administrative); (3) promote an atmosphere conducive to client service; (4) attract and retain qualified lawyers; (5) encourage efficiency through division of skills and utilization of the expertise within the firm; and (6) improve the economics of the practice.

The rules of the compensation plan should be understood by the lawyers before the beginning of a new year.  The compensation plan should be supported with reliable records that are comprehensible and can be made readily available.  The plan should be fairly administered and its rules and results should be evaluated appropriately.  Any compensation plan is only as good as its implementation.  A good plan can be badly handled, and a bad plan can be handled reasonably well by fair-minded attorneys.

Over the years, a number of plans have evolved for the distribution of income to the partners or shareholders of law firms.  It is advantageous to examine certain principles of selected plans that have stood the test of time and worked well for the firms which have used them.

Decisions To Be Made

For most firms, certain basic decisions have to be made for the current operation of their plan.  As the firm matures, the nature of the plan and its elements may change.  Among these basic decisions are:

  1. Who or what body will make the decision on allocation of income?
  2. Will the allocation be based on percentages or units or participation?
  3. Will the distribution be prospective (distribution percentages or units of participation determined in advance of the year) or retrospective (distribution percentages or units of participation determined when year-end results are known)?  Or will an initial percentage be prospective and a specified amount of dollars or percentage be withheld for end-of-year distribution based on retrospective considerations?
  4. Will the firm determine that the profits to be distributed will consist of all that is left over after overhead is paid, or will profits be considered everything after a predetermined draw (or salary equivalent) is paid to partners or shareholders in addition to overhead?
  5. Will the firm have a class of non-capital partners whose salary and bonus will be exempt from the final distribution of income to general partners or shareholders?  Or will there be a gross percentage to be divided among general partners and other pools to be divided among other partners?  (The term “partnership” is used to represent either a partnership or a corporate form.  The term “partner” is used for a partner or shareholder).
  6. Will hourly rates be periodically established or reaffirmed by or for each partner, associate, or other direct producers of income - law clerks, legal assistants (non-lawyer professionals or paralegals) and sometimes secretaries - so that an equitable base for billing to clients and the resultant gross billings allocation for all partners will be equitably established?

Partners’ Functions

Virtually all plans consider that partners perform the functions that create and maintain a continuing, vital entity.  In simplistic terminology, one firm designates those persons who perform these functions as: finders (or rainmakers), who originate the business from a clients source; minders (who maintain the business originated by others; grinders, who do the work on client matters; and binders who provide for the management functions, engage in community or bar activity, attend and comment on continuing legal education, and enhance the firm’s ability to obtain business through its acquired reputation.

In addition, past earnings records, the competitive legal market for younger partners or outstanding specialists, and unusual retirement, death, or capital provisions may have a bearing on the judgment applied in income distribution.

The following are examples of selected plans:

Straight Percentages or Unit Systems:

(1)       Percentages or units of participation without formula, prospectively determined (a smaller number handle this retrospectively with predetermined draw) is the most commonly-used system, backed by statistics, with a committee making the decision.  The committee may or may not submit this for partnership approval or rejection for further review.  These committees have recently broadened the age range of membership.  They are now more often selected by the partnership, often with preselected nominations.  The committee generally uses a sounding-out process.  Some have all partners participate initially in the decision making, and many interview all partners before the decision in made.  A few use a secret vote by all partners that is submitted to the committee.

(2)       Using a percentage with float is the same as (1) above, except that a float or reserve ranging generally from five percent to ten percent is used, based on the year’s performance.

(3)       A third alternative is similar, except that one “owner” (or more) or a continuing senior partners’ committee makes the decision.

(4)       Many highly-institutionalized firms have moved from one person’s or senior partners’ domination of allocation to a committee of broadened age membership.

There is now a heavy use of computerized or well-organized manual systems of statistics.  Business origination may not be a statistic, but the firm must be award of who brings in business or controls business.  Heavy attention is given to client responsibility and outstanding lawyers.  The firm may or may not give attention to firm or department management.                                                                                                                                   

Statistics are developed to show what major client business results from which fields of law, and seasoned judgment is applied to allocation information and past records of compensation.  There is careful planning of income and expense budgets; attention is given to the outside activities of lawyers, firm-wide management of recruiting, appraisal of gaps in legal organization at all levels, assessment of progression needs stemming from the aging process; a watchful eye is kept on new trends and legislation and what other major firms are doing.

Formula Systems

Statistical plans are frequently calculated according to mathematical formulae based upon the allocation of credit.  Weights may be assigned for various elements as follows: three for business origination (permanent); six for work done; and one for profitability.  Management time and consequential time may be weighted.  Interest is provided on capital accounts.

More than one year’s figures are used.  Business origination is transferred by assent, or on death, disability, or retirement, or the best interests of the firm.  The system places a heavy emphasis on the continuity of management, particularly with regard to the business origination weighting and the interpretations of the rules of the system.

There may be variations of the formula.  For example, business origination may be reduced in weight from three to one and a half, while work done is increased to eight and a half, for a total of ten. Some  variations split business origination by agreement or decisions into subfactors, such as for maintaining clients or for case responsibility.  Management time may be weighted.  There may be a modification in percentages based on hard cases, handed-down large estates, or bar association activity in the interests of the firm and its reputation.

A third alternative is an equal sharing plus formula or statistical information plan.  Under this formula, x percent of the net income is shared equally among all partners, and the remainder is distributed as determined by a judgment on statistics and subjective factors.

Combination Plan

Another alternative is a combination plan, which might operate according to this formula:

A.        Work incentive - 50 percent of distribution: To keep every partner a working partner, a proportion of each paid bill is based on the time-dollar contribution.

B.        Group incentive - 20 percent of distribution: To provide each partner with an interest in the performance of all others, the seniority in terms of years as a partner, up to a given limit, is multiplied by average compensation for past x years.

C.        Business development incentive: 20 percent of distribution: To make every partner business conscious as well as work conscious, actual data on business produced by the individual or the judgment of the committee may be used.

D.        Incentive to use associates: five percent of distribution: Stimulates partners to delegate work, based on data on work delegated and on supervision of associates.

E.        Contingency fund: five percent of distribution: Sparingly used to compensate for extended illness, public service, hard cases, firm business, and outstanding achievement that reflects credit on the firm.  The unappropriated portion is allocated in proportion to distribution under the first four items of the formula.

Profit Centered - Highly Departmentalized

In rare cases, a firm may be able to have a judgment by one partner or a committee on economic results from each department head.  Department heads recommend lawyers within their departments.  Subjective judgments may be made as deemed pertinent.  Gross receipts, overhead, and profitability are allocated to each department.

Multiples of Lowest Partner’s Percentage

A cap is placed on the highest percentage at four or five or other multiple times the points of the partner receiving the lowest percentage.  Statistics and other pertinent factors are considered.  Each partner is slotted to a relative ranking position.

“Owners” or Dominant Partners

“Owners” or dominant partners set their own distribution; the rest is allocated to other partners.  Usually this may occur with a highly profitable practice derived almost entirely from the practice of one, two or three partners.

Heavy capital accounts are usually contributed by the owners.

Individual Achievement

With a highly-developed system, each partner buys the time of other partners, associates, and paralegals who are direct producers of income.  Each partner is credited with his share of the gross receipts.  The overhead of partners, associates, and paralegals is directly apportioned, and the general overhead is allocated or directly applied.  The managing partner may be provided with a specific supplement.

Profit Pools for Senior Associates and Non-lawyers

Professional corporations automatically may provide a profit-sharing situation for all personnel by the establishment of a profit-sharing trust or pension plan.  Private practice firms in some cases have established an incentive for associates in the form of a percentage of profit or pool to be divided among this group in accordance with established criteria.  Some firms have established a pool for non-lawyer participation.
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