One of the quickest ways to silence a roomful of lawyers is to raise the question of how to divide law firm partnership income. Many lawyers are reluctant to discuss the subject because they are unfamiliar with the options and uncertain how to select among them. Others are concerned that a conversation with their partners about compensation splits will be too uncomfortable. The good news is that there are there are enough different ways to slice the pie for each viable firm to be able to find a solution that works. Also, as with other partnership agreements, the conversation becomes much easier if it starts with what kind of culture and behavior the partners want to encourage rather than with money. The actual numbers flow more easily once the goals are clear.
The major variations are as follows:
1. It’s Good to Be King. One lawyer is the name behind the firm. He originates many of the clients by virtue of his prowess, reputation or connections. All the others bask in his reflected glory. He gets to look over the books and decide how much the other partners should be making based on subjective or objective criteria. He may not disclose all of what those criteria are. However, most people see the fairness of his decisions. There is enough money coming in to keep most of the people happy most of the time. The incentive is to keep the king happy.
2. The Gang of Four. Instead of having one king, a group of lawyers forms a committee to decide how to split the income for the rest of the partners. At some larger firms, the compensation committee is separate from the executive committee that runs the firm. At others, the compensation committee makes a non-binding recommendation to the executive committee. At still others, it is the same committee. Although the committee likely has to publicize some of the factors on which it makes its decision, the other partners often become supplicants who write up an annual impassioned summary of achievements and predictions for the committee. This structure works if people trust in the process and the people on the committee. The incentive is to shoot for the targets the Gang of Four makes public and to make sure everyone in the Gang likes you.
3. The Black Box. The Black Box is a variation of The Gang of Four, except that the criteria are entirely subjective. It may work if there is enough money to go around, but the problem is that lawyers, like everyone else, often compare themselves to their peers. The subjective element creates a huge potential for perceived unfairness, which can cause rifts in the firm. The incentive is to work hard and play office politics.
4. Eat What You Kill. The EWYK model appeals to the strong strain of individualism in Western culture, and American culture in particular. The theory is that each member of the firm is the captain of her own destiny, can choose how much to work in any given period and should be rewarded for her efforts. It is a very common structure among smaller firms, but tends to go by the wayside as firms grow. The behavior it incentivizes is the sharing of space and administrative resources, individual responsibility, the development of individual practices and a sense of independence. It can also encourage divas. It does not encourage other benefits of being in a firm, such as cross-selling to specialists within the firm, a team-based approach that becomes necessary as matters become more complex and multidisciplinary, the sharing of knowledge, the development of associates coming up through the ranks and, perhaps most importantly, balancing out the strength of individual practices on a year by year basis. A lawyer might have a bad year followed by a good year, while another has a good year then a bad year: the EWYK model does not let them smooth out the cash flow. Finally, the incentive to develop a sense of community within the firm is not emphasized, which means that lawyers feel less incentive to stay. When they leave, they take “their” clients, who have never developed a relationship with others in the firm. Nonetheless, many smaller firms with practices that do not require extensive teamwork find the clarity of the approach appealing.
5. The Formula. The Formula takes the overall firm revenue and plugs in percentage values for factors that may include some or all of
(A) length of service,
(B) client or matter origination,
(C) ongoing relationship management (in case clients get handed over from one lawyer to another),
(D) billing responsibility for a matter (which may be separate from relationship management),
(E) time spent servicing clients,
(F) management and administrative time,
(G) special projects or other incentives,
(H) total hours billed,
(I) prospects for the coming year (especially if there are client payments that will straddle the fiscal year-end, as in corporate matters that get billed at the end of the transaction or contingent fee matters) and
(J) other creative elements.
The advantage is that if everyone knows The Formula, it reduces the chance that people will see distributions for a particular year as being unfair. It sets the incentives. If structured properly, it encourages the kind of internal cooperation that is good for the firm’s longevity, which is why it is common throughout the service sector. The disadvantage is that a mechanical formula removes business flexibility and encourages people to structure their practice in ways the framers may not have intended. For instance, big corporate transactions can be very lucrative, but a formula that focuses entirely on collections may encourage business lawyers to move to firms that give them more steady current income rather than periodic bonuses when transactions close.
6. Solomon’s Baby. Outside of the law firm world, many people who own partnerships expect a fixed percentage of the profits, like dividends from shares of a corporation. Law firms have two variations:
a. Lock-step compensation, in which everyone in the same year of partnership is paid the same, was the gold standard for generations. Not so today. It requires a huge amount of trust that each member will pull his or her own weight, make up for down years with future up years, get paid less in up years than might be possible elsewhere to even things out or out of a sense of community, and stay with the firm. It requires and encourages teamwork and long term planning, and reduces internal conflict over pay.
b. Some smaller firms have fixed distributions that reflect the perceived relative contributions of the partners. Often, they are based on circumstances at the time the firm is formed and may seem imbalanced as time goes on. The imbalance often fractures firms that do not have a mechanism to revisit fixed percentages as practices develop over time.
7. The Reference Standard. In baseball, even the greenest Major League player is entitled to be paid a minimum salary. Law firms sometimes do the same, with each member of the firm being entitled to receive some minimum compensation. For instance, some firms have decided that no partner should receive less than the highest paid associate. Others use a similar method to calculate retirement or buyout distributions.
8. The Bleacher Seats. Since the 1980s, more and more firms have been moving toward a tiered partnership structure. The tiers are divided differently in different firms, but many contain a tier of “non-equity partners.” These partners may hold themselves out as partners to the outside world, but really receive a salary plus bonus based on individual performance and have varying degrees of tenure (some of the many flavors of being “of counsel” overlap with being a “non-equity partner”). The next tier may be paid on a formula that combines a smaller fixed amount plus a percentage of the firm’s net income or divides a set percentage of firm profits among all partners in that class. The top tier is often paid on more of a percentage basis divided using one of the approaches outlined above. The assumption is generally that total compensation – and risk – increases as one climbs the tiers. Firms use a tiered structure to manage expectations and attorney development and to maintain firm financial health. Some firms have a policy of moving non-equity partners out the door if they do not advance within a certain period of time. Other firms use the incentive structure to focus non-equity partners on client origination, which may come at the cost of servicing existing firm clients. Rightly or wrongly, many perceive non-equity partners as being like tenured associates who can only advance if the firm fears they will walk away – meaning that they have developed invaluable expertise or a separate, portable client base. As long as the firm stays on top of how its attorneys are developing, though, this system works well enough that most of the nation’s largest firms have adopted one or another variation of it.
There is no one “best” way to divide law firm income. Indeed, many firms take a creative approach in combining these basic elements to reach a result that their members find fair. For instance, a firm could pay each partner a minimum and then use another method to divide up any balance of cash left at the end of the year. A firm could distribute a third of its net income on a lock-step basis, a third based on total hours and the rest on a formula basis that gives 70% credit to origination and 30% to service. It all depends on what the partnership wants to reward.
Finally, whether partnership terms work well for any firm depends on one big intangible: trust. Do attorneys trust each other to continue developing and maintaining their separate practices? Do they trust each other enough to work together on firm and client projects, to assume joint liability, to share the burdens of administration and not to jump ship at the first opportunity to make a few extra bucks? Do they trust each other enough to set shared goals and rewards? Most importantly, as they develop the partnership compensation structure, do they trust each other enough to have open, good faith conversations about what kind of firm they want? The level of trust drives the partners’ options.