Data Driven Compensation

law-firm-compensation-small-mid-sized-firmsThere are a lot of small and mid-sized law firms that rely on relatively few clients.  These client relationships are typically consolidated among an even smaller subset of top performing lawyers. It is not unusual for us to  encounter a firm of twenty lawyers serving less than 20 or 30 clients that are managed by three or four partners. We have also worked with firms of more than 50 lawyers working for 6 or 7 groups of clients controlled by as many partners. In these instances, the loss of a client or a partner is potentially a destabilizing event.

Compensation Challenges

Compensation in these environments can present real challenges. Many of these firms, despite their longevity and history, are one or two client losses away from instability. This insecurity can permeate the thinking of law firm partners, causing them to have a short-term approach to organizational development and compensation.

Dominant Instincts

The dominant instincts present in many of the top performers in these firms include the following:

  • Business development is a priority;
  • Business development carries the highest reward;
  • Personal billable contributions are important but secondary to attracting new work;
  • Attorneys must maximize compensation while they have the clients;
  • Disruptions in client relationships can cause more stress than the legal work;
  • Others don’t appreciate the effort it takes to develop, keep and grow a client base;
  • As attorneys, we feel threatened all the time; and
  • With so many incomes reliant on relatively few books of business, it is difficult to relax.

Top Performer Power

As a means of survival, a firm’s culture often bends around the immediate needs of a small but powerful group. As a result, unintended consequences can occur. For example, top performers may appreciate that another partner is succeeding, and even might take less short-term compensation to support their growth, but also might not like the potential shift in the future balance of power.

Small entrepreneurial firms that were created by a few high energy producers can pay better than market compensation for many years. By staying lean and making only long-term investments that support the practices of the top performers, these firms can generate high profits. Managed properly, the partners in these firms can amass a nice retirement, and some even become wealthy. In many ways, partners in these firms accomplished what they set out to do when they took the risk of starting the firm.

Law Firm Transition Process

At some point, however, small firm partners reach retirement age or their practice starts to diminish and many begin to focus on transitioning the firm or creating a more viable institution. Because of their immediate profit generation focus, these firms generally do not have the infrastructure or the necessary junior partners who are capable of perpetuating the firm.  And when there is a transition path, splitting the origination portion of the compensation pool becomes a challenge. If the compensations issues are not addressed, any attempt to transition or transform a firm may be derailed.

Forward-thinking partners start the transition or transformation processes well in advance of retirement or foreseeable client losses. A transformation process starts when the current partners who make up the power structure of the firm desire to change or transform the firm’s strategic vision and operating model. Since most clients buy first from lawyers and then from firms, it is easy to understand why most  firms find it difficult to transform from a collection of individuals to a branded offering . Most successful small and mid-sized firms focus compensation on keeping originators happy first, followed by high producing lawyers and those with unique skills sets, with everyone else falling to the third tier.

Stability Factors

Organizational development that includes advanced compensation concepts comes from stability.  This requires time and means that high producers must embrace the transformation. A firm can find itself in between what is good for current profits and what is best for the long term. Highly productive partners (enabling partners) are called on to invest more income into a strategic initiative than under-performing or new partners. As the new partners or previously under-performing partners become more successful and demand more in the compensation formula, the enabling partners’ incomes can decline, and their prior strategic investments of current income are potentially lost forever.

Analysis and Tools

One way to deal with this is to use a rolling average of results in the compensation formula. For example, a firm that uses a 3-year rolling average of results can allow productive partners to participate in the future uptick in earnings resulting from a successful strategic plan implementation. Some of our clients refer to this as a “slow up/slow down” approach. The slow up/slow down approach is not without issues. Declining partners can “hide” in the formula for a couple of years. While these declining partners deferred income in previous years, it often creates tension when nonperforming partners draw a disproportionate share of current year earnings.

Recognition of where a firm is in their life cycle is also essential. A compensation plan for a young firm that has not fully passed through their start-up phase is likely to differ from a firm that is approaching the transition stage. In our experience, there are several best practices that support stability at all stages, but variations of the application of these best practices is often required. For example, moving from a one-year results approach to a rolling two or three-year results approach.  Another example includes the level of profits apportioned to objective, equity, and subjective pools.

Putting It All Together

Properly designing and administering small and mid-sized law firm compensation systems requires a process-oriented approach, experience, analysis and tools, and an understanding of the factors that contribute to stability. A sense of the firm’s economic, political, and market factors contributes to the development of an effective compensation plan. The capability, capacity and commitment of the firm’s revenue-generating staff to achieve strategic goals and produce a market competitive profit are equally important.

Read more about developing a more effective compensation system at your law firm.

 

CLICK HERE

 

law firm compensation plan, bonus, subjective, objectiveIn determining attorney compensation,  bonus considerations can be either subjective or objective in nature.

 

Subjective bonuses should be considered when intangible value is created or the achievement is not economically measurable. Typical areas of work that fall under this bonus category are:

  • Quality of professional work
  • Work ethic
  • Client relations and service
  • Personal development
  • Business development competence
  • Professional recognition
  • Training contributions
  • Adding to the reputation of the firm

Such awards are not tied to a specific economic contribution but encourage continuous development among lawyers. The value is seen in increased capability and value to clients as well as personal growth. For this bonus category, it is important to adjust expectations towards long-term rather than short-term benefits.

Objective bonuses are defined as rewards for meeting or exceeding levels of billable hours, billings, collections or profitability. Unlike subjective awards this bonus type requires consistency in its methodology to incent attorneys. Certain measurements like profitability bonuses with rather long-term benefits are harder to calculate and therefore require a thorough explanation to the team members.

The use of profitability models requires a certain level of transparency and information sharing concerning cost structures. The benefits of sharing profitability information include:

  • Helps manage expectations;
  • Can pressure firm management to operate efficiently;
  • Helps ensure that compensation is competitive;
  • Incents improved billing and collection realization, cost management and revenue maximization (rates and other billing approaches);
  • Improved business acumen and maturity at all levels;
  • Supports building a profitable practice;
  • Better prepare lawyers for eventual partnership; and
  • Mitigates the tendency to focus on billable hours to the exclusion of all else.

Through comprehensive guidelines and accountable management, a firm can ensure that lawyers do not feel unfairly treated based on available profitability information.

In some situations, firms may prefer alternative compensation plans that differ from typical salary and bonus approach. Typically, these plans include fee sharing, profit sharing, hourly compensation and completion/task- based compensation. In any case, compensation policies and pay plans should be based on a comprehensive approach that includes written guidelines, rules, context and philosophy, and transparency, while anticipating strategic needs of firm.


READ OTHER RECENT ARTICLES ABOUT COMPENSATION SYSTEMS THAT WORK ON OUR “BEST PRACTICES” BLOG: 

Bonus_win_law_firm_Communication.jpg Determining Attorney Bonuses: Subjective and Objective Considerations
Roadmap_Compensation_Pay_lawyers.jpg Well Developed Compensation Policies and Pay Plans for Lawyers
Set_Salary_Bonus.jpg Setting and Adjusting Base Salaries

 

Data Driven Compensation Law FirmCompensation issues are a main reason that clients and prospective clients contact us. Our clients view business generation as a means of survival and want to reward heavily for it.  The partners who make up our client law firms understand the transient nature of client relationships and want to realize a high return for their efforts during periods of success. Many partners took considerable risks to create new opportunities and expect fair compensation to parallel their success.

Understanding these dynamics,  the most successful law firms focus on creating an environment where driven attorneys can thrive and see a direct benefit from their efforts. Compensation is a significant determinant in holding a successful firm together. Employing a system that encourages profitable behaviors and pays based on those contributions is essential. It is not that hard, but many just can’t get this part right.

We base our preference for a contributed profit approach to compensation on the following factors:

  • Heavily incents the right behaviors;
  • Enables transparency;
  • Promotes accountability and empowerment; and
  • Is field tested; our most successful firms have thrived and grown using these systems.

Data driven systems help our clients resist unconsciously falling victim to all of the weak arguments that enable unprofitable behaviors. We also understand that it is hard to address partner performance issues.  But pretending they do not exist, hiding them with a non-existent or inadequate measurement systems, or simply hoping things will improve only leads to larger failures.

Measuring legal client profitability for the last 15 years has taught us many valuable lessons that could take up several pages, but here is an example of the power of a single report set.

Practice Profitability With matter Level Detail

 

This example includes a practice profitability report with matter level detail. Initially, we can review profitability at the timekeeper level. Starting with actual hours billed (not billable hours in WIP) and the amount charged to the client for these hours (revenue credit) we can quickly determine an average rate for each timekeeper.

Nothing new here, but averages can be misleading.  We recommend looking to the matter profitability to ensure that the average rate is a good measure of a timekeeper’s performance. For example, reviewing Client 1’s result indicates that P2’s average rate is below the mean of all client matters for all clients.

Further, Client 1 accounts for only 20% of P2’s total revenue, which makes a review of additional clients and matters necessary. In this instance, assume that we are trying to determine if P2’s average rate has any predictive value or is it the result of a unique client or file result that is not likely to repeat. This same process can provide the same information for all timekeepers supporting P2’s practice.

Moving past the revenue metrics, we move to timekeeper payroll cost, which is a constant throughout all clients and matters. Peer comparisons of payroll costs and benefits can provide insight into timekeeper pay levels and production efficiency. In the same way, peer comparisons of overhead costs can provide insights into cost efficiency.   Collectively, these data form a basis for analyzing pricing and staffing mix appropriateness.

Quickly reviewing staffing and overhead costs, staffing mix, rate realization, and billing rates are all possible with these data. Presenting AR Write off information at the matter level can reveal collection inconsistencies among timekeepers and matters. Enabling partners to quickly understand the impact of production, billing rate, write-downs, staffing mix cost and overhead costs will result in a more financially competent firm.

Unprofitable or struggling partners who have some business can use these data to understand and improve results. As most lawyers are afraid of upsetting a client relationship, the resist making necessary changes to improve profitability. Without compensation consequences, they have no real incentive to improve their results. I use the work consequences deliberately because struggling partners likely need better results just to stay at their existing compensation levels.

High integrity data-driven systems make all information available to all partners, which fosters transparency. Trained partners using quality data allow firms to work with truths rather than debilitating perceptions.

For example, partners often believe differently about the effect of cost on large books of business. We are also frequently asked if the partners with the most business should always receive the most compensation. Profit driven systems are not concerned with regulating how a particular partner or group ethically creates their profits. All profit dollars are valued the same in these systems.

A good origination sharing policy also facilitates collaboration. A system that allows for sharing at the matter level is ideal for partners who collaborate on a file by file basis. See the following report sample and please refer to our law firm best practice blog for more information regarding origination sharing.

Data Driven Law Firm Compensation
Notice the Originating attorney percentage in the top right of the report and also see the allocations of origination profits in the four columns to the right of Client Net Income column. In this example, the originating partner has decided to share 10% of the profit on this client and matter with another attorney.

Compensation systems built on profitability raise the level of partner consciousness in the following areas:

  • Production
  • Billing Rates and Pricing
  • Realization
  • Payroll Costs
  • Overhead Costs
  • Staffing mix
  • Write-Offs

When every partner has a working knowledge of the impact of each of these elements on profitability, a high-performance culture can result.

For more information on implementing Data Driven Compensation Systems, please see our law firm best practice blog (CLICK HERE) and see our resources page (CLICK HERE) for client profitability seminar materials. See also our post on rewarding for training and leveraging (CLICK HERE).

law firm, base salary, lawyer, compensation

Setting and adjusting base salaries requires law firms to consider many factors. While initial base salaries for lawyers are often driven by external market factors, we encourage law firms to consider qualitative factors such as work quality, work ethic, and client service when determining the capability and progression of their lawyers.

To ensure that a law firm develops a market-competitive and fair compensation system that rewards the firm’s valued behaviors, we recommend a balanced approach. Within this approach, we advise firms to evaluate base salaries separate from objective rewards for economic performance. Economic contributions would be considered as one criterion among a range of qualitative criteria that are based on the firm’s culture, experience, strategic needs, client needs and financial model.

Each lawyer receives a score on a factor-based rating table. Since the importance of each factor will vary from firm to firm, it is important for each firm to clearly communicate performance expectation guidelines. In addition to setting base salary, firms can also use this rating assessment, to determine bonuses for economic and other specific qualitative contributions.

When setting compensation for more senior lawyers (8+ years), law firms should also apply profitability methods.

While there is no magic formula for setting and adjusting base salary, effective systems will encourage and reward the behaviors that ultimately contribute to the long-term success of a law firm.


READ OUR DETAILED POST “Setting and Adjusting Base Salaries“, which includes helpful tables and graphics, on our Law Firm Best Practices blog.

 

Market_Sensitive_CompensationIn addition to promoting profitable behaviors, a market sensitive compensation plan can produce a very competitive firm, ready to support a transition process for their most successful attorneys.

Maintaining Competitiveness

Preserving the competitiveness of a law practice over an extended period requires a consistent focus on several fundamentals including:

  • Marketing effectiveness;
  • Origination sharing;
  • Rates and realization;
  • Billing and collection habits;
  • Legal staffing and capacity;
  • Training and leveraging contributions;
  • Recruiting contributions;
  • Attorney development;
  • Client service metrics; and
  • Client relationship fundamentals.

It is tough for busy lawyers to pay attention to these factors and also to manage client legal challenges. A good support system that can help order priorities can make the job much easier.

Self-Interest versus Firm Interest

Many experienced partners indicate that it becomes more difficult to keep their practices fundamentally sound with time and success.  At some point in a partner’s career, he or she faces a choice between

  • continuing to invest in their practice for the likely benefit of others or
  • focusing on short-term profit maximization to correspond with their retirement horizon

Choice one helps the firm, but choice two does not.

Ceding client control is an individual decision

It is equally important to recognize that ceding client control happens on an individual lawyer basis and can often lead to adverse income implications. Further, many lawyers believe that they have not received ample compensation for their years of hard work and personal sacrifice.  Together, these factors make the transition process exceedingly difficult.

Beyond transition issues

A well-managed firm is better able to manage the transition process. Often factors not directly related to transitioning partners or their staffs can affect a firm’s ability to focus on the necessary longer-term strategic factors.

For example, savvy younger partners may come to the realize that their firm has no transition plan and decide to find a better opportunity.  Often the primary motivation for leaving is the reality that their earnings will erode as a result of an inevitable loss of business from aging senior partners.

Consider another example. Other partners may believe that their current good fortune may not last forever and want to maximize their income during success periods. A compensation plan that is not responsive to the market makes the firm vulnerable to either losing these partners or worse create an atmosphere of declension.

Alternatively, competitively paid partners who desire to grow their practices can offset losses at the senior partner level. Market sensitive compensation can also make it easier to attract good fit laterals who can also offset losses in other areas.

Data-driven compensation

A data-driven compensation plan that pays at competitive market levels can reconcile the perceived and actual value of a lawyer’s economic contributions – there is no better gauge of value than what a competent competitor will pay. Accomplishing this level of acceptance will remove a large obstacle inherent in the practice transition process.

The primary tool for compensating at the market is a contributed profit analysis by originator with client and file level detail. The main elements of this system include:

  • Origination sharing policies;
  • Profitability by originator with client, file, and timekeeper detail;
  • Maximum empowerment over directly allocated costs;
  • Maximum empowerment over case staffing;
  • Maximum empowerment over directly assigned marketing costs; and Minimum of 80% of total income based on contributed profit; and
  • Two year rolling average contributed profit for income allocation.

Admittedly, these systems take time and effort to build, but experienced professional help is available. The resulting impact on profitability, firm competitiveness and attractiveness in the market can transform a struggling firm and elevate the   success of high performing firms.  Combining a market- based compensation system, with a transition compensation feature and a process for the orderly transition of ownership interests will significantly increase a firm’s ability to pass from one generation to the next.

Law Firm Best Practices Read more about data-driven compensation systems on our Law Firm Best Practice Blog.

For many firms, especially first-generation firms, admitting new partners at the right level can be a challenge. Whether it is a new partner from their current ranks or a lateral partner from another firm, placing a new partner at the right level is much easier if compensation does not depend on equity share and the firm has a process for routinely adjusting ownership.

Recall from our previous posts on our Best Practices Blog that we discussed systems for compensating partners based on contributed profit and changing equity based on a rolling average of that added profit. If you missed those posts or you would like to review, we have provided links here.

The considerations for admitting a new partner often depend on the firm’s compensation system and the proposed partner’s ability to thrive in at the partner level. One initial hurdle for most newly admitted partners is the transition to owner from employee, which often includes a change in payroll status and a continuing guarantee of firm debt.

Compensation independent of equity

When compensation and equity are not dependent, we recommend a nominal equity percentage (1%) initially that is adjusted after a period. We recommend the first adjustment period span three years and then annually after that using a prior three-year rolling average of contributed profits.

We like this approach for new partners for following reasons:

  • Making new partners is much easier and typically does not by itself create a material shift in equity interests among current partners;
  • New equity partners often rely on origination sharing with current partners, which may change post admission;
  • Increased equity comes with a greater financial commitment, and new partners frequently need time to afford the applicable capital contribution; and
  • It allows time for the firm to implement any strategic initiatives such as transitioning senior partners and the process of reshuffling clients.

Although less preferable, some firms may have a solid three-year track record with an attorney and may choose to include those results into the ownership alignment process immediately. As a result, no three-year adjustment process is necessary, and equity continues to adjust annually.

While we are not discussing laterals until our next post, it is also possible to use this same approach toward lateral equity considerations.

Compensation dependent on equity

Firms that base a material part of compensation on ownership can implement other alternatives to immediately offering a high-value initial equity position. Slotting new partners based on a factor of their pre-partner compensation effectively equates compensation and equity. For example, assume a firm’s policy for new partners is to ensure that partnership does not result in a pay cut. In this instance, a person currently making $215,000 annually (salary and benefits) would rate a 10.75% share a firm that generates an annual profit of $2,000,000.

It becomes even more complicated if the firm’s policy is to ensure that equity partnership results in a raise in income after considering any benefit differentials. Regardless of these complexities, we do encounter these situations and typically evaluate the feasibility of following options:

  • Creating tiers for timekeeping and origination contributions;
  • Creating a transitional compensation plan for new partners that includes a partial guaranteed payment;
  • Including the previous three-year’s results when calculating the new partner’s initial equity;
  • Creating an income reserve in new admit years as a safeguard against an over or under slot; and
  • If necessary, amending the operating agreement to include a process for regularly adjusting equity.

Tying equity to compensation is more complicated and requires consistent and thoughtful consideration of partner contributions to ensure that partners are fairly compensated, and the ownership structure of the firm is supportive of a highly productive culture.

Sum up

As mentioned throughout, our default recommendation is to adjust new partners to an appropriate level after a three-year period, which is only possible if compensation is independent of ownership. We do encounter very successful firms that do not formally have a process for adjusting, but typically these firms are highly profitable and can pay above market. Our next post will consider admitting new Lateral partners.

For more on these topics and great resources, please visit our best practices blog and resources pages at performlaw.com.