The Money You Take Depends on the Money Your Firm Makes

Reprinted from:
Published 8/08

The compensation model employed by your firm directly affects your bottom line. Ed Poll shares how a team approach can help you and your firm earn more.

There is an implicit and presumed interrelationship between law firm billings, profits and partner compensation. That interrelationship is expressed in various ratios and weightings, with wild cards like origination credits tossed in for good measure. One might suggest that it's not important what formula is used so long as all involved perceive that the process of determining that number is fair – recognizing that people respond to what they're rewarded for.

Despite the seeming emphasis on the profits-per-partner measure at the largest firms, in general people will accept a great deal less than the top compensation as long as they like the colleagues with whom they work. This has a greater impact than money. While money must be competitive (it need not be on the high end), "firm culture" is first and foremost. People must like the work they do and those with whom they do it. Lawyers who are together physically in an office environment should share a camaraderie that shapes the development of a firm culture. Many factors come into play: the exchange of ideas and the education of one lawyer by another. These are vital to a successful law firm, and to successful lawyers. But the monetary impacts of firm profitability and partner compensation remain substantial, so understanding the dynamic between them within the context of firm culture is essential.

The Two Models

Typically there are considered to be two general compensation models: lockstep, in which the firm's overall success each year is averaged out to determine a standard rate of compensation increase for most lawyers, and “eat what you kill (EWYK),” in which all attorneys are rewarded on how much business they personally bring in. Each has advantages and disadvantages:

• Lockstep is good at building collaboration, client service teams, and institutionalizing clients
• Lockstep is bad at rewarding exceptional and penalizing subpar performers
• EWYK is good at developing new business and new markets, and spurring entrepreneurship
• EWYK is bad at cross-selling services and promoting firm harmony.

Any firm that encourages lawyers to maximize their individual compensation may have fast near-term growth. Approaching compensation as an institution makes for greater firm harmony and longevity. Either way, however, both lockstep and EWYK systems generally depend upon the same metrics: hours worked per year, origination credit, supervision credit, and other formulaic measures based on the billable hour.

The Realization Rate

Whether the lockstep or EWYK compensation model is the norm, it emphasizes the traditional billable hour measure. For the largest law firms and for solo practitioners alike, collecting the money that lawyers are owed – their realization rate – is far more important than the number of hours they bill. Most lawyers want to see their billable hours go up month by month. Yet the fundamental economic basis of their compensation, namely the financial health of the firm, depends not on billable hours but on the cash collection that those hours represent.

The level of collections determines firm profitability, and profitability determines how much is available for compensation. The firm can either look at revenue and figure out what its cost structure should be so it can turn a profit, or it can look at costs and determine how much revenue is needed to cover them and make a profit. These two models define what's available for the total compensation pool, but they fill that pool in different ways.

Cutting Costs to Match Revenue

In economic model number one, which matches cost to revenue, consider a law firm where the revenues from a given client are 10% less than the costs to service that client in lawyer and staff compensation. This is an obvious warning sign in which the law practice is like an athlete who is exercising in hot weather. Maintaining hydration with adequate body fluids is critical to an athlete's performance and health, but unfortunately, the body's ability to detect dehydration is slow. There is a lag between the time the body becomes dehydrated and when it sends the thirst signal to head to the nearest water supply to do something about it. Law firms often react in the same way. Lawyers often see only the intake – the cash “hydration” of revenue – and do not realize the dehydration that dissipates cash faster than the money comes in.

In this critical situation a decision must be made. The choices are hard, but each one must be considered in turn. Here is a suggested order of assessment.

• Terminate the client relationship and the revenue it represents. This is the most difficult, because it raises not only cash flow problems but ethical ones (lawyers cannot suddenly cease representation when the client's interests will be compromised, such as right before a court date, and otherwise must give reasonable notice of withdrawal).
• Consider whether a technology purchase can reduce the amount of time being dedicated to the client. Paradoxically, when a firm makes an investment in technology, its immediate cost of operation increases due not just to the equipment cost but also the value of the time needed for training. If this is not approached carefully, more technology will create client and staff dissatisfaction rather than greater efficiency.
• Assess whether fewer people can handle the same client workload. But be aware that additional work assignments can cause attorney burnout and decrease the level of service. The only feasible way to do this may be to take some services now being performed out of the mix of what the client receives.
• Adjust staffing and leverage ratios after considering whether lower compensated associates and paralegals can handle, with appropriate supervision, tasks that might otherwise be carried out by higher compensated senior partners. At that point it must be determined whether the senior partners are superfluous, and thus candidates for de-equitization.

Raising Revenue to Cover Costs

It's apparent that there is no easy way to adjust costs to revenue. Certainly it can be done, but the strategies for doing it each have drawbacks that are hard to overcome. That brings us to the second economic model: determining how much revenue is needed to cover costs. In a law firm, revenue is a highly personalized commodity because it is the product of each person's individual effort. The measure of that effort generally the product of time and billing rates. Increasing revenue puts the focus on whether to raise rates and how to increase billed hours. Because billing rates greatly impact a partner's compensation, the greater revenue generated from higher rates is inseparable from how that compensation is determined.

Raising rates is always a tricky thing to do, and the general ability to do it hinges on two factors. First is the ethical consideration of whether the higher rate is reasonable in proportion to the value of the services performed. And second is the business context of whether the higher rate is supported by economic and competitive conditions. It's important to determine the higher fee in the context of all the labor being devoted to client service, including paralegal and staff time as well as lawyer time. There is no perfect time to raise fees. Those clients who do not want to pay the higher fee will seek other counsel. Those who believe that the service they receive is of value will accept the higher fees and remain with the firm.

Once rates are set, partner compensation from hours billed will be governed by metrics that define how the firm views itself and how work is done for clients. Such metrics may emphasize:

• Origination (percent of new business that the partner brings in)
• Total hours worked
• Hours assigned to other lawyers in the firm (a traditional hallmark of rainmakers)
• A base compensation figure for all partners with a bonus decided from various other factors, such as contribution to firm governance, profitability of work brought in, and realization rate.

Note that some firms are moving away from time invested for the client as an element of pricing and toward the value of the service. This latter approach tends to emphasize team effort of lawyers for the benefit of clients.

The Team Concept

Some of these metrics will do more than others to increase, not only the partner’s compensation, but the firm’s revenue stream – which is, or should be, the ultimate goal. That is the best argument for making explicit the tie between individual compensation and the firm’s overall revenue. Firms that service major clients with teams (not just a single rainmaker) can identify and provide needed practice specialties that reflect a full range of client concerns. A billing attorney coordinates the service provision according to a strategic plan, and can give clients a complete and virtually seamless service package. The client receives “one-stop shopping” from a group of lawyers who are chosen to address specific needs, both in terms of practice specialties as well as billing rates.

The team approach allows for blended high and low rates on client work, which maximizes profitability and collections. This is the corporate model, which says that compensation is paid based on what is generated for the organization – not for any one individual. The best compensation approach gets away from a star system that rewards only the individuals who stand out from the crowd, by also rewarding those individuals who help the crowd perform better – by providing better client service. In the long run, neither lockstep nor eat-what-you-kill systems are healthy. Team-based systems are the best solution because they incentivize everyone to work for the financial health of the firm.