Compensation Division: More Than Simple Math

Published on: 
06/01/2014
Compensation, or how to divide what is left over, is one of the most difficult challenges facing any law firm management committee, whether a two-person firm or a 2,000-person firm. The committee must consider two main objectives when making the ultimate decision of division. First, the system must be fair — and, more than that, staff must perceive it as fair. Second, the system must be productive; in other words, the system must encourage the attainment of the goals the firm sets, whether it be hours worked, dollars collected or new clients attracted to the firm.

In thinking about this subject, we must consider essentially three levels. First, consider the staff. Second, consider associates and nonequity partners. Third — and what should be the last in order of importance —consider equity partners, who receive distributions from what is left over.

Staff

As in the case of most employment, there are several factors that both sides — employers and employees — will consider.

Obviously, the actual cash compensation must be competitive with the marketplace in the profession and specific geographic community. In many cases in the last few years, the availability of benefits such as health care have also played a major role in employees' thought processes. In larger firms, where health care is now mandated by the government, this factor will likely diminish in importance in terms of employees comparing one large firm to another. Smaller firms (or at least those with 50 or more full-time employees) that did not previously offer health care now must do so due to the Affordable Health Care Act. Those firms must now figure out how to make this new requirement fit into the overall scheme of meeting the bottom line and making a profit.

Noncash factors oftentimes rise to the top of the list of reasons for selecting employment. Such factors include — but are not limited to — reputation of the firm, camaraderie of colleagues within the firm, education and learning experiences and opportunities, and freedom to engage in professional association activities such as the American Bar Association, state bar associations, and the National Association of Legal Assistants. These factors all bear different weight depending on the circumstances.

Succeeding in attracting qualified personnel is only the first step. The next step is retaining these employees, and that is of paramount importance in achieving the second main objective of compensation: a productive system. To retain employees, employers must constantly pay attention to their needs. In listening to one firm manager in just the last few days, I was struck by his comment that he treats everyone in his employ as family, meaning that he knows about their families, he knows when they get into trouble, and he knows when and how to offer assistance. This truly is a family — one that will stay together for a long time. While this may sound sweet and cozy, it is also based in economics. Turnover of personnel is one of the highest-cost items in any business operation. This is equally true in a law firm. Many law firms, especially larger ones, could significantly increase their bottom line profit by paying more attention to their personnel issues.

Associates and Non-equity Partners

In the boom of the 1990s, many associates developed an entitlement mentality: They believed that a solid education, graduation from a good law school in the top of their class, and a passing score on the jurisdiction's bar examination entitled them to a job at a major law firm with a high compensation package. Considering the impact of recent economic events on law firms' finances, this mentality may be changing. Law firms, even large ones, must provide value to their clients. And they must be profitable in order to open their doors the following day.

While the new, high-priced associates may not earn more than they cost the firm in the very beginning, at some point within the first three-to-five years, on average, these lawyers must be profitable. The issue for law firm managers in these cases is how quickly they can educate their new lawyers about the culture of the law firm, the expectations of the firm's clients, and the technical skills of lawyering that they did not receive in law school. In fact, it is these kinds of issues that often persuade a lawyer to join this firm as opposed to that firm. Firms that position education among their top goals will ensure their long-term future and success.

When I was a new associate with a law firm, having come from the business world, I knew and believed in the philosophy that every employee must be a profit center for the employer in order to keep his job. And I wanted to keep my job. I liked the people, and I was eager to learn as much as I could about the practice of law. This was a good firm, and it was a good opportunity for me. That's why I kept track of my own profit and loss to be assured that, assuming a rational employer and no personality conflicts, this law firm would want to keep me. When the management realized that I was concerned about the firm's well-being first and my advancement in the firm second, I was invited to become a partner — a dream come true.

To create your own profit-and-loss statement, you need to know certain information and use the right numbers. You need to know your total billable hours and how many hours you recorded for the month. This is clearly known to every associate. However, you may have to ask someone in the firm's management how many hours the firm actually billed — in other words, how many hours the firm wrote off. In some firms, you may need to guess at this by number by inquiring about the percentage, on average, of associates' work product that the firm includes in its bills. In addition, associates may be more specific by asking if there is a difference in the write-down percentage based on the class of the associate (first year, second year, etc.). Then, based on seniority with the firm, associates can use that percentage for estimating purposes.

The more difficult part of this process is to determine the expenses attributable to the associate. For example, what is the cost of the associate's compensation package (gross salary, profit sharing / pension plan contributions, car allowance, etc.); the cost of the associate's secretary, or secretarial allowance if the associate is in a pool environment; the cost of the physical space occupied by the associate and the assigned secretary; and the cost of other expenses that could be called direct expenses? In addition to the foregoing, the firm should also estimate other expenses that include the amount of office overhead — by percentage —that each associate accounts for. Overhead includes rent, insurance, utilities, entertainment and education. In the past, a one-third ratio would suffice; however, in today's world, overhead has increased considerably, and this percentage may be higher for your particular situation.

Armed with this information, and inquiring minds can obtain it without great difficulty, you and your associates can now come up with a personal financial formula that would look like this:

Billings – (Associate's Total Compensation (Direct and Indirect Expenses)) = Net Profit

The net is the profit available resulting from an associate's effort. This is the bottom line in determining a newer lawyer's value to the firm.

When analyzing the value of a partner to a firm, management will frequently talk about realization. Realization focuses on collected billings, not just billings. In the discussion about the value of associates, I have said nothing about collections. Normally, an associate will not have any power to deal with a client directly to collect billings. The firm generally selects the client, so it should be the firm's responsibility to collect the fees, not the associate's responsibility.

Equity Partners

Equity partners in the Am Law top 50 law firms recorded average profits per partner of $1.6 million in 2012. The contrast to the typical solo lawyer's experience could not be more dramatic. According to the Bureau of Labor Statistics, the median annual wage for lawyers was $113,530. The lowest 10 percent earned less than $54,310, and the top 10 percent earned more than $187,200. The disparity is startling. However, in California, where I live, the numbers are even more startling. One quarter of all lawyers earn $50,000. In Florida, half of the solo attorneys earn $80,000 or less. The earnings are comparable elsewhere in the United States.

There are, of course, various formulae for determining compensation among partners. As suggested earlier, it's not important what formula the firm uses as long as everyone involved perceives that the process of determining that number is fair. Above all, firms must recognize that people respond to what they consider to be fair compensation, and they tend to live up to what the firm will reward them for.

Conclusion

In general, people will accept a great deal less than the top compensation to which they might be entitled as long as they like the colleagues with whom they work, they think the work that they do is interesting, and they enjoy the clients for whom they work. In some circles, this is called a "firm culture" or "life balance" law firm.

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