The compensation systems in use in law firms fall into three basic categories:
A combination of subjective and objective systems is preferred by the respondents to our Compensation Systems in Private Law Firms survey. Lock-step/equal sharing, as a pure system, was least preferred. There are considerable differences based on practice specialty and size of firm. A discussion of the various types of systems follows. Subjective Compensation Systems Subjective compensation systems embody the concept of "rough justice" -- that level of relative compensation where you intuitively know that the system is in balance. Individual compensation decisions and overall compensation alignment are "right." It is a sense from one's "gut" and one's sense of "fair dealing." Because lawyers in small firms have more intimate and immediate knowledge of their partners' work and abilities than do partners in large firms, it would seem that small law firms would be more subjectively oriented, and larger firms more formulaic in their approach to compensation systems. The study referred to above does not bear this out, however.[a] Percentages and Points Traditionally when lawyers have established new law partnerships, interests have been distributed as percentages. The total of all interests must always total 100 percent. Percentages suffer from a psychological impairment where one can advance only at the expense of someone else (a "zero-sum game"). For example, let's say that Trout, Bass and Blue start a law partnership with each sharing equally of the profits and losses and each contributing generally to the capital. After a few years, they add a fourth partner, Fish, to the firm. Fish is to share in 15 percent of the profits or losses and contributes 15 percent of the capital. This leaves each of the three founders with a 28.33 percent interest in the firm. Each capital account must be adjusted to bring the entire system into balance. As the three founders reach the peak of their careers, they are proud of the firm's growth, which they attribute primarily to their skills. However, they are concerned that their ownership and profit sharing interests continue to dilute with the advancement of each new partner. In addition, many of their younger partners annually grouse at their percentage level. The eventual result is that no one is willing to give up percentages. This is a common scenario. It makes little difference to the participants that each year they have made more and more money. This is because they have increased the value of their interests faster than the dilution impact of growth. Then a recession hits. Incomes fall as costs continue to rise. The founders push to maintain their positions and younger partners push to regain lost income. Their only tool is to reallocate the partnership interests, which must still total 100 percent. This is extremely difficult without a pool of retiring or withdrawing partners from whom to recapture percentages. Many firms in this situation change to a point system. Rather than artificially remaining at 100 points irrespective of the size of the firm, and reallocating points as new partners are admitted or as younger partners advance, the firm now assigns points on the basis of criteria they develop in order to facilitate a rational compensation relationship among all of the partners. Total points are not limited to 100. Frequently, this alleviates the anxiety surrounding any individual giving and receiving of points. A very critical consideration in partner/shareholder compensation is the relation of compensation of one owner to another, in addition to the income of the firm as a whole. The first question is: "What is the desired pay relationship between a newly admitted partner and the most highly paid partner in the firm?" The multiple from lowest to highest can be as little as 1.0 to 1.5 and is frequently 5.0 or higher, depending on the size of the firm, the age distribution within the firm, the amount of profits, the relative control of the firm's book of business, the type of practice, and the aggressiveness of the partners. Larger firms tend towards higher ratios than smaller firms, and insurance defense firms tend to have lower ratios than those firms with a corporate practice according to data from our annual Survey of Law Firm Economics. If a low to high ratio of, for example, 1.0 to 4.0 is desired, one could initiate a point system in which the most highly paid partner receives a maximum of 100 points, and the most junior partner receives a minimum of 25 points. To ascertain the value of each point, it is only necessary to divide the total number of points issued into the sum available for distribution. The points used should have a significant meaning that differentiates between one number and the next. For individuals who earn large sums of money, a distinction of a few hundred or even a few thousand dollars in compensation per year may be important psychologically to the higher paid partner, but it is meaningless in economic terms. To the lower paid partner there is the continuing question, "How can the compensation system be so precise that it can differentiate by so small a sum?" Law firms have lost productive individuals over such matters, leading to significant morale problems. In determining the number of points to be used, a firm should consider what significant differentiations it wants to utilize. One can achieve a four-to-one ratio by using a maximum of 20 points and a minimum of five points, just as well as by using a maximum of 100 or 1,000 points. For the individuals between the maximum and the minimum, an additional point should provide a significant amount of earnings. Point systems are easier to administer than percentages, but they are a version of the same method of compensation. Lock-step or equal sharing systems can also use percentages or points in quantifying the allocation of profits. The capital accounts of partners under a point system are determined in the same way as those whose firms use percentages. The firm's accountant generally calculates from earned profits to determine a percentage of that total and credits capital accounts with retained earnings in proportion. Additional capital contributions required can also be computed by applying points/percentages to the required total. If a firm wants a different capital account system, it must specify this in its partnership agreement.[b] How "Rough Justice" Systems Work How do "rough justice" or subjective compensation systems work? Some firms approach them in a democratic manner. For example, each partner is asked to participate in the process. The participation may be in the form of a questionnaire or simply narrative comments made during the income distribution meeting. Partners may be interviewed by one or more members of a compensation committee. Ballots or "score cards" may be used where partners provide judgments on other partners' performance in specific areas. The smaller law firms can effectively handle these deliberations in a single meeting. Larger firms may need several months to gather the information and to allow the participation process to work. Some firms use a committee to perform the evaluation (absent formal participation of each partner). In practice, these committees typically test the waters to ensure that their general thinking is in keeping with that of the firm generally. Compensation committee reports that contain surprises require significantly more selling to be approved.
[c] Applying Compensation Criteria Apportioning profit is a complex and difficult task. There are no right or wrong answers. As we often tell law firms, partner compensation-setting is more art than science. Rough justice requires evaluation of the individual, comparing the evaluation against those of all other partners and relating the determinations to available funds. In this part of the process of compensation-setting, the concepts of risk sharing, permitted disparity and peer group are very important. Each firm will have a different sense of what should be done in these areas.
The different positions of partners within a firm are often very difficult to reconcile. To start, one must first develop an understanding of each partner's expectations with respect to compensation. One then must find or create some common ground from which a workable system can be fashioned. Often, the assistance of an impartial individual is required, one who can hear all sides, summarize the issues and direct the partners toward common ground.
Read full excerpt from How to Manage Your Law Office: Basic Approaches to Compensation.