Transferring equity interests is typically more challenging in smaller or first generation firms than those that are larger or more mature. Firms that include their founding members may have even more difficulty with transitioning a law firm. Founding partners often want compensation for the start-up risks they took, along with their reduced income in early years and the the going concern value of the organization they helped to build.
As law firms fully allocate profits to current partners each year, younger partners frequently resist the notion that founding or senior partners should receive compensation for prior risks.
We believe that senior partner goodwill payments that are tied to real residual contributions (book of business) are best compensated as part of a transition plan.
Our experience is that each situation is different and much of the tension relates to the degree of compensation. In practical terms, if the founding members want a payment level that is greater than the cost of starting a new firm, younger partners are then inclined to start a new firm.
Additionally, equity interests based primarily on tenure can leave highly productive partners without a comparable level of influence on firm priorities, which is a risk. Law firms that can balance these realities with their long-term needs can ensure their most productive partners stay and can create advancement opportunities for talented younger partners.
How then can a firm transfer ownership to the right people in an orderly way?
Consider the following recommended objectives for any systems that allocate membership units to members:
- Ensuring that those partners who are consistently contributing profits to the firm have a commensurate influence on firm strategy, policy, and management;
- Ensuring that units are available for new partners without a disproportionate impact on the productive partners;
- To facilitate the transition of firm ownership from one generation to the next; and
- To ensure that the most consistently productive partners have the votes to protect the culture of the firm.
Many firms decouple ownership from compensation to help ensure fair pay. Typically, paying partners is accomplished using a bonus plan or some other formulaic approach. Some firms consider management contributions when adjusting equity, but recommend compensating managerial with income rather instead of ownership.
New model firms view partnership equity from an investment perspective. In many instances, a single owner capitalizes the firm initially and owns all the equity. These firms concentrate on building value in their platforms that new partners, when invited, can purchase at am agreed upon valuation upon entry.
Inevitably, however, a traditional law firm structure requires a process for the orderly transfer of equity. While not the only approach, we believe that the best way to meet our recommended objectives is to transfer ownership based on a 3-year rolling average of contributed profits. Our clients employ other viable methods for managing equity interests, but the most successful firms, regardless of their approach, recognize the relationship between consistent performance and ownership.
Smart senior partners realize that if they do not make room for others in a timely way, they risk partner defections and the eventual extinction of the firm. Ultimately, most partners want a positive legacy and do not want to be known as the person who presided over the demise of the firm.