Occasionally firms are presented with a unique opportunity to attract a senior in-house lawyer or governmental official as a lateral partner. If such a person becomes successful, the rewards to the firm can be staggering. But the failure rate of lawyers who intend to build a practice from scratch, regardless of their credentials, is high. It is precisely this potential high risk return that often causes firms to make compensation offers to these laterals — based as much on emotion as any rational thought process.

Normally, setting compensation for lateral partners is a fairly easy function. Since the motivating factor for bringing in most laterals is obtaining their client base, deciding how much to compensate them typically involves determining how much of the billings of the lateral are portable; figuring out how much that is worth in your firm’s compensation system; and deciding how much above that amount you are willing to stretch to attract the person. There is a lot of subjectivity in such decisions but it is always based on an identifiable expectation of what the lateral brings to the firm. With lateral candidates who are not currently in the private practice of law, the process becomes even more subjective and, unfortunately, often requires a firm to involve themselves in some level of a bidding war.

A Case Study

Recently a client asked us to help them think about the compensation of a specific lateral candidate they were considering. I have altered the facts to maintain confidentiality and the client has approved our writing about the situation with the altered facts. The lateral is a lawyer coming out of a Federal regulatory agency. The candidate’s entire career has been spent in government and the last 14 years have been spent in this agency, during which he developed a very high profile among legislators, members of the industries the agency regulates and the news media. Without a doubt, this guy knows everybody in these very specific industries and appears to be held in very high regard for his knowledge and skill in building working coalitions. He has prepared a very aggressive business plan that he believes will develop into a $3 to $4 million practice within a couple of years. The firm’s strategic plan is strongly based on a focus on two of the industries this lateral is involved in and it is the belief of some of the partners that bringing this candidate in could solidify their practice and allow them to effectively compete with the Washington firms that dominate client representations before the agency.

Apparently, several of these Washington firms also have an interest in this candidate and are supposedly talking compensation approaching $1 million. While it seems logical that all of the “players” in this practice would be interested in this person, there is no way to verify the information the candidate is supplying about what competitors are offering.

A Thought Process

When an actual lateral opportunity like the one described above presents itself to a firm, typically there are time constraints involved and the opportunity is usually championed by a proponent from within the law firm who tends to focus on the best case scenario and equally ignores the risks.

Scenario Planning. When dealing with laterals, especially those without a clear client base and track record, it makes sense to consider a number of objective factors including the client originations the lateral will produce, originations that will accrue to other attorneys in the firm as a direct or in-direct result of the lateral, and the value of the billed work of the lateral as an attorney, regardless of whether it is for his or her client or someone else’s. We suggest this be viewed from at least four different scenarios:

• Minimum First Year Success – the level of performance that would meet the minimum expectations of the firm, and below which would cause the lateral to be considered a failure.
• Mature Year Mendoza Line* – the on-going level of performance once the lateral has settled in, and below which he or she would be considered a failure.
• Mature Year Likely Scenario – the level of performance that is viewed as being the most likely end result and, typically, the level on which a given deal’s economics are built.
• Home Run – not necessarily the maximum but the level of mature year performance at which the firm would clearly describe the lateral as a “home run.”

The following matrix is an example of possible responses for the lateral in the case study:

Return on Investment. The purpose of the analysis above is simply to consider and come to internal agreement on what the reasonable expectations are for the lateral. The baseline issue, however, is the maximum compensation the firm is prepared to pay to accomplish the various levels. Since most law firms in the U.S. operate on a cash basis, this really requires a cash flow analysis to calculate how much money is at risk at any given time for the various scenarios that have been identified. Using this analysis, one can project the maximum cash flow at risk based on the scenarios and project a reasonable required return on that amount to justify the investment. A common standard for return on investment is, by the third year, 15 percent of the annual revenues originated as the return to the partnership after the lateral’s compensation, plus a cumulative return of 25 percent on the maximum negative cash flow incurred over the three years. That, of course, is tempered by the subjective benefits of the lateral.

What the Market Will Bear. But, when all is said and done, sometimes it makes sense to take a deep breath and look at the issue on the basis of what is realistic – not only realistic for your firm, but also for the firms that are competing for the lateral candidate. It is rare — and culturally difficult — for a law firm to bring in a lateral whose earnings will be substantially higher than the current highest paid partner, regardless of how outstanding the opportunity may be. The pressure intensifies when time constraints imposed by the lateral’s situation require a firm to make decisions in a compressed time period. For these reasons, as part of their strategic planning discussions and implementation, firms often engage in discussions about the introduction of possible laterals, and the potential positive and negative ramifications they will have on the partnership and compensation structures. While these discussions are hard to have in the abstract, they do permit firms to abbreviate the discussion time required when an actual lateral is available. Furthermore, it gives the firms leaders an idea of the level of acceptance for any “above bracket” compensation.

At the same time, the firm needs to be looking with skepticism at information presented by the candidate as to what competing firms are offering. As skilled as lawyers are in negotiating on behalf of their clients, they often become passive and accepting when negotiating with laterals. If the firm across the street is offering $200,000 more than you are, one of you has drastically misjudged the potential risk and reward of the candidate or the candidate is embellishing the offer.

Structure of the Compensation Package. For some firms a pivotal issue is whether the lateral joins the firm as an equity or non-equity partner, or shareholder. Sometimes firms are concerned that it will be difficult to attract a candidate unless equity partnership is offered. In fact, it would be rare for a firm to invite a lateral without an established and verifiable book of business to join a firm as an equity partner or shareholder. The firm needs the means of reversing its decision quickly and without great difficulty if the lateral is unable to produce the intended result or, at least a way of “stopping the bleeding.” Typically, non-equity status permits a firm to create flexible compensation that ties to the success of the candidate.

A common means of compensation is to set up a basic draw with trigger points for increases or decreases. For example, for the candidate in the case study, a compensation agreement might include:

• Basic draw (salary) of $35,000 per month for a one year contract.
• Review after six months with the right to cancel if there is substantial failure against expectations. Draw may also be increased at six month point in recognition of success.
• Bonus compensation of 20 percent of originations in excess of $1.2 million in originations.
• Consideration for equity partnership or shareholdership at the end of the first full year with the firm.

Another option that firms use is an “earn-out” that establishes a projected cash flow for the originations of the lateral, including compensation, and provides the shareholder increased salary draws based upon the fulfillment of the projects. The key for most firm structuring of non-equity compensation deals with laterals (particularly those coming from corporate or government positions) is to limit the firm’s downside while providing the lateral with a meaningful incentive. Clearly, the greater the downside risk avoidance for the firm, the larger the incentive required for the lateral.

Due Diligence and Risks. In fairness, I have to advise you that our experience has not been good in seeing corporate general counsel and government officials succeed as practicing lawyers. With lawyers coming out of corporations, the likelihood of success seems to decline with the size of the corporation the candidate is leaving, particularly if the individual is leaving with a “package” that removes most of their financial incentive to build a practice. Inside corporate counsel entering the private practice of law seem to either work out beautifully because they really understand what clients want and buy, and have great regulatory relationships and provide access to potential clients as a result of their previous position, or they work out miserably because they have been away from the “real” practice of law for too long, are technically not up to speed and have become lazy.

Bottom Line

Of course, all of this analysis goes out the window if the lawyer is a long-serving elected official or a former presidential candidate. On balance, our observation is that about one-third of lawyers coming out of government or corporate legal departments succeed in private practice and maybe 10 percent approach the level of business development that their hiring was based upon.

Bringing in a lateral lawyer who is currently not in private practice is a gamble and can result in a huge win — but more often does not. Make sure you understand the odds as you consider the decision.

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*The Mendoza Line refers to Mario Mendoza who, in 1979 with the Pirates, had a batting average of .198. The line refers to how bad you can be and still play major league baseball.

I frequently hear Managing Partners comment that associates are different today than they used to be. “Different” is, of course, often code for “not as good.” We talk about Gen X and Gen Next in our efforts to understand what motivates young lawyers. But, at the same time, it is worth noting that the structure and economics of legal practice is changing at least as quickly as the lawyers. Occasionally it is valuable to step back and do a cold read on our business principles.

When someone becomes an equity partner in a law firm they become an owner of an institution that has a substantial value – certainly greater value than is demonstrated on a cash basis balance sheet. Yet the majority of U.S. law firms admit partners with little or no requirement that they make a purchase of the firm’s capital assets. Apparently, the theory is that associates labored in the vineyards for a period of years and have earned their right to participate in the fruits of their labors. That may have made sense when the current law firm model evolved in the 1970’s and associates worked for comparatively low wages in exchange for a shot at the brass ring of partnership. But with New York starting salaries topping $145,000 and, by trickle down, the salaries of associates all over the country on the rise, one has to ask – is it rational to give away something that the existing partners have invested so much in, for such a small price?

Certainly there are law firms that require an up-front capital requirement from new partners, often helping finance that contribution with guaranteed bank loans. But this is simply a cash contribution to bring new partners equal to the current cash capital account value for existing partners. The vast majority of firms, however, take pride in telling new partners, “You enter naked and you leave naked” meaning, you don’t pay anything to become a partner and you don’t get anything when you leave the firm.

But let’s rethink this whole process. What is the true value of the law firm that we are giving away so freely? If an appraiser were given the assignment of determining the value of a partnership in a law firm, the consultant would have to consider a whole variety of assets that make up the value of a law firm. These would include, at a minimum, the firm’s know-how (Intellectual Capital), the fee earners that the firm assembled and maintains (Human Capital), the firm’s contacts and influence (Relationship Capital), and the firm’s reputation or brand (Reputational Capital). These are, of course, in addition to the standard Economic and Structural Capital that shows up on a balance sheet.

The immediate reaction may be “those things are too subjective to be valued” or “even if they could be valued, that value would be diminimous.” But anyone who has been involved in evaluations and appraisals knows that a value can be assigned to anything and usually with surprising accuracy. Consider the value of each area of capital independently:

Intellectual Capital

Among the greatest values that a law firm brings to the client marketplace is its collective expertise and experience. Intellectual capital takes on different forms and appropriately greater value depending on the sophistication of the legal matter. The intellectual capital provided for a routine commoditized matter involves perfected documentation and procedures. With greater sophistication comes the ability to organize complex projects and drive results.

The firm’s investment in its intellectual capital involves the aggregate of non-billable training and development time, and a value equal to creating that knowledge were it not available. A new partner in a law firm has access to the intellectual capital to both, as a source of enhancing their skills and to make them more attractive and valuable to potential clients. Suppose that we assume that every partner learns something every year that they practice law which makes them a better lawyer or increases their knowledge of their practice or an industry beyond the knowledge that lawyers routinely have. To keep the math simple, let’s say that the time required to achieve this knowledge or skill is just 15 minutes per week (that’s an hour a month or 12 hours per year). Assuming that the average member has been a partner for 15 years, even at the most discounted billing rate, that makes the value of acquired knowledge per partner something north of $50,000.

Human Capital

Law firms are assemblages of people who were trained and developed or laterally recruited. The firm invested in the training and development of the attorney, or paid headhunter fees to acquire the individual. In a business where its greatest assets ride up and down the elevator every morning, having people and a sustainable culture is a hugely valuable asset. An average headhunter fee is 25% of compensation and, typically, hiring through law school recruiting and summer associate programs costs at least that much. If we only consider the value of partners, we’re looking at an average investment of around $75,000 per partner.

Relationship Capital

Relationship Capital is the law firm’s collective network. This involves both relationships that refer business to the firm (accounting firms, banks, smaller law firms, trade associations) and relationships that assist in serving clients (government officials, court clerks, money sources). The ability to tap into those relationships provides partners with a competitive advantage in attracting and serving clients. It has been my experience that, in most law firms, about 10% of their average revenues each year comes from new clients, and that at least 10% of their new business comes in as the result of a referral from someone outside the firm. So, given that the average revenue per equity partner among the AmLaw 200 last year was $1.8 million, the value of new client work in any given year that was the result of referrals is around $18,000 per partner per year. Our research seems to indicate that the average life of a client (balancing out long-term relationships with one time litigation matters and transactions) averages 3 ½ years. The average margin for the AmLaw 200 is 36% which produces a per partner value of the current referral base of $22,000 ($1.8 million x 10% x 10% x 3.5 x 36%).

Reputational Capital

This is the firm’s brand, or what accountants call “Goodwill.” It is the value of the firm’s name recognition and reputation that accrues to members of that firm. A partner with a well-regarded law firm never has to go through the rituals of proving quality, and recognition of the firm’s name easily opens door that would otherwise be impenetrable. The value, however, depends on the reputation of the firm. Certainly, the value to a new partner of the reputation of a Wall Street firm is vastly greater than that of joining a mid-sized firm in a small mid-western city. To make this easy, let’s assume that the only way a firm creates reputation and name recognition is advertising, public relations and sponsorships. Let’s further assume that what the PR firms tell us is true and branding requires a sustained effort over a period of time, and say that the period of time necessary to gain a reputation is, optimistically, three years. According to surveys, the average spent on reputation building aspects of marketing is about ½% of revenues. Then, again using the $1.8 million revenue per partner figure, the value of investment in reputation is $27,000 per partner ($1.8 million x .005 x 3).

Economic Capital

Perhaps the largest assets of a law firm are its work in progress and accounts receivable. These are assets that have literally been bought and paid for by the existing partners. Let’s conservatively say that a firm has 45 days of work in progress (work that has been performed but not billed) and 45 days of accounts receivable (work billed but not collected). Again using the average of $1.8 million revenue per partner, the value of WIP and AR (knocking off 10% for write-downs and delinquent accounts) equals more than $400,000 average per partner.

Structural Capital

It used to be that the fixed assets of a law firm were limited to a bunch of old furniture, some typewriters and, perhaps, a law library. But the required investment in technology and the value of hardware and custom software which, after accelerated depreciation, rarely reflects the investment made by existing partners. Operational leases and other forms of off balance sheet financing make the value of structural capital even more obscure.

But this pales in comparison in some firms to the value of under-market office leases and unamortized tenant improvements. During the late 1990s many law firms found that they had overestimated their office space needs, and renegotiated leases to dispose of excess space. In most cases, this meant an extended lease term, sometimes as much as 15 or 20 years in exchange for giving back chunks of space. Today it is not uncommon to see firms with five or ten years to go on a lease that may be 30% below market rates. Even if a firm doesn’t cash in on the asset, the value translates in increased profits through lower operating costs for firms’ second largest expenditure category after salaries. By the same token, the tax code requires a 40 ½ year amortization of tenant improvements. It is rare for a law firm to stay in the same offices for 40 years, which means that the unamortized value of office build-outs in excess of tenant improvement allowances is recoverable in a lump sum deduction when a law firm moves.

Clearly there is value in fixed assets in every law firm but it is highly dependent upon where firms are in their depreciation cycles. So we’ll ignore it.

The Value of Partnership

The sum of the values expressed above comes to more than $570,000. Of course, there may be debts that count against the value of partnership – long-term debt, off balance sheet equipment leases, guarantees and unfunded non-qualified partner pension plans. But the largest portion of debt is typically devoted to fixed assets which are, hopefully, depreciating at a level approximately equal to debt service.

The point in all of this is that there is a definite value to becoming a partner in a law firm. Beyond the status, virtual lifetime tenure and six-figure income it provides, a new partner becomes an owner in a going concern. Whether the existing owners ask new partners to buy into the business or generously gives a part of their business away is, of course, up to those owners. But, at a minimum, new partners ought to recognize the value of what they are receiving.

When I’m playing golf, and a putt is meaningless, I can sink them backhanded all day long. But when you get to the end of a golf match and are standing over a three footer you need to sink to keep from losing a $5 bet, the hole suddenly seems to get smaller. I’ve heard partners argue that making a new partner has no economic impact on the firm. If partners understand that they are collectively betting on a new equity partner and the amount of the bet is approaching $500,000, the partnership decision might justify a little more selectivity. Sometimes a smaller hole is a good thing.

After years of anticipation, true global consolidation on a significant scale is finally occurring in the legal industry. The driving influence appears to be the availability of a structural vehicle that helps firms deal with the legal and functional hurdles of international mergers. That vehicle is the Swiss Verein.

The twin recessions of the past decade have left many large law firms seriously misaligned in the quality of the work performed by their lawyers. Some firms’ lawyers are in over their heads, but many others are wading around in the shallow end. Edge International has developed a Capability Alignment tool that can help firms better match the right work to the right attorney.

Law firms rise and fall on their reputation, both among clients and competitors. But what do we really mean by “reputation,” and how is it measured? Edge International’s exclusive Reputational Index points the way towards the answers, and warns that the world’s leading law firms are raising the reputational stakes for everyone.

It seems that increasingly large portions of law firm marketing resources are devoted toward branding. In fact, it often appears that the first priority for every newly appointed Chief Marketing Officer is a “rebranding” project. When pressed, the reason given invariably is that a firm’s brand reflects the way the firm is seen by the marketplace.

Conventional wisdom says that a firm needs at least 100 lawyers to be taken seriously in the marketplace. But is that really true, and does it apply to all types of firms in all locations? Viewed in five dimensions (capability, clients, reputation, collegiality and profitability), here is an analysis of whether, and to what degree, size matters.

Lawyers and the legal media frequently talk about the size of law firms. But unlike how most businesses address size (annual revenue), law firms seem to define size as the number of lawyers practicing at a firm. Managing partners who talk about growth typically mean adding enough lawyers to reach “critical mass.” When lawyers are laid off, it’s termed “right-sizing.” So with all this focus on lawyer head count, shouldn’t there be some benchmark as to the optimum size for a law firm?

When a firm starts talking about size in the abstract, it is usually signal- ing concern about being big enough to compete for the most sophisticated and challenging work while remaining small enough to maintain a strong client focus — large enough to attract the big fish and small enough to not scare away the small fish. At the same time, firms want the prestige of being a large firm while enjoying the culture and collegiality of a smaller firm. And oh yes, this should all occur while maximizing profitability.