Retirement Benefits – Does your Firm Provide a Nest Egg?

For many years, a generation of law firm partners has become accustomed to funding their own retirements through personal savings and schemes. They know that their naked-in-naked-out style of partnership means they will never be able to extract value from their years of effort. However, partners in highly profitable first-generation law firms – those they have founded in the last thirty years or so – are waking up to the realization that the legacy they have built up has some value that does not necessarily need to be given away. They are therefore becoming increasingly reluctant to envisage free entry (other than fixed-capital contribution) to the firm by new partners with no benefit to those who built the firm. After all, new partners come into a firm which enjoys the benefits of an established brand, a sustainable client base, and a successful business recipe – all painstakingly developed by the hard work and skill of the founding partners.

Historically, goodwill started to be excluded from accounts of law firm partnerships in the 1960s and 1970s. Existing partners were often at that time compensated for goodwill write-out by being given an annuity – sometimes for life – to reflect the fact that they had not had an opportunity to build up a pension. According to one report for example, after 15 years of partnership> at Clifford Chance, retiring partners were allowed to receive an annuity of 17% of their final profit share for five years, rising to 23% for partners with more than twenty years of service. The annuity solution has remained in place for a few law firms and accountancy firms, with different arrangements in place for valuing the annuity by reference to the average of the last five years compensation or on an agreed multiple of the firm’s underlying profitability, and payable over a five- or ten-year period.

As a possible alternative, some firms are considering asking new partners to buy their partnership share on an agreed valuation methodology. Valuations of any law firm as a going concern is notoriously difficult, particularly in jurisdictions such as the USA and Canada where law firms are not freely marketable outside the established legal profession. Some firms – especially those burdened with debt – are worth little or nothing, but at the other extreme we often see firms that are so profitable and valuable that any market valuation of an incoming partner’s share becomes an unaffordable proposition.

The annuity option is therefore possibly more viable. However, to take this forward, founding partners who want to reserve retirement benefits for themselves need to answer three questions:

1. Is their firm worth anything now or likely to be worth anything when they leave?
2. More specifically, is their firm sufficiently attractive to new partners if the entry deal was to include retirement provisions for the founding partners?
3. If satisfied about their answers to the first two questions, what provisions are likely to provide fair protection for the retiring founder partners whilst remaining affordable for the continuing partnership?

Whilst the founding partners will presumably continue to derive income benefits from their shares of an increasingly profitable business, a balance needs to be struck between – on the one hand –encouraging and rewarding talented new lawyers, and – on the other hand – compensating the founding partners for their heavy investments over time.

Succession Doesn’t Just Happen

“We need a succession plan. My partners and I formed this firm thirty years ago. We started with clients aplenty, and spent the early and middle years – in fact, up until a few years ago – tasking younger partners to service the business we already had through the impressive rainmaking skills of the founding partners; we did not task them with developing their own client base because we wanted to make sure our (founding leadership) clients were serviced by the most seasoned and technically proficient lawyers. The truth is that we’ve always brought in most of the business, but now we’re concerned about ‘legacy’ and the health of the firm after we begin winding down and retire. At the very least, we’ve got a significant leadership gap and client development skills gap among the non-founding partners, and thinking more pessimistically our firm may not survive our retirement. Can you help us?”

I’ve been presented with this fact pattern pretty chronically over the past few years. On further inspection it usually becomes clear that the founders’ definition of the firm’s “problem” is a bit too limited. Lawyers in the associate ranks lack confidence about where their firm is going and the longer-term opportunity afforded them. They know precious little about how the firm is managed and what kind of compensation the firm generates for equity partners in the longer term; as a result, younger lawyers become very short-term focused and find lots of reasons to become disaffected. Layered on top of all this is the perceptible tentativeness of the “next generation of leadership” – they would like to inspire ambition within the junior ranks, but they don’t feel very confident themselves. What’s a firm to do?

It goes without saying that each law firm situation along these lines is fact-specific. However, I’ve found that there are a number of reliable recommendations from which most firms could benefit that fit this profile, namely:

Transparency – leadership needs to trust that non-founding partners and associates will benefit from having more information rather than less information. Let the rest of the firm know how you lead the firm and how you do your job. Help others understand and let them appreciate how effectively the firm is being managed in this regard.

Earn the Right to Teach Patience – if your firm generates above-market compensation for equity partners but achieves it in part because of a very tightly managed associate compensation grid, then let associates know what could be in store for them as they climb the ranks. Associates and non-equity partners have a hard time deferring near-term compensation gratification if they don’t know how that model could redound to their benefit down the road.

Define and Communicate Partnership Criteria – associates and non-equity partners crave a GPS system. Let them know in meaningful parameters what kind of “points they’ll need to put on the board” over time to become a shareholder.

Define and Communicate Partner Compensation Criteria – founding partners tend to not be very formulaic about how they split up the profits among themselves because it’s an intimate group that has worked side by side for so many years. As more non-founding “arm’s length” partners are made, first generation firms would benefit from defining their compensation criteria more explicitly. New partners and leaders want to understand how their activities are being valued, and they want to be put to their highest and best use; a law firm’s set of objective equity partner compensation criteria can supply direction and reinforce managerial credibility.

The “Vision Thing” – founding leadership ought to have in mind a longer term destination for the firm, and it ought to be documented. Whether the firm has landed on the right longer-term view of what place it will occupy in the marketplace is less important for these purposes then just having a destination in mind – a destination that can be articulated and supported intellectually.

Partner Readiness: Client Development Skills Training – lawyers do not passively bump into the skills they’ll need to begin sourcing clients on their own; rather, first-generation firms should take an active role in outfitting partners and leaders-in-waiting with the necessary consultative selling skills so they can build up their practices, and be ready to lead the firm’s revenue efforts over time.

Founding Partner Wind-Down Compensation – first generation firms often allow founding partners to retire gradually so that there is a wind down period during which partners are not active at the same historical levels. At wind down, founding partners typically become non-equity partners of the firm. As non-equity partners they’ll get a salary and bonus, but their bonus plan can and should be very tailored to the particular non-equity founding partner, and should answer loud and clear the question “What is my highest and best use to the firm?”

Client Transition – founding partners are well advised to put in place a 12- to 36-month plan for involving one or two other partners in the management of key clients, so that at wind down and full retirement there is at least one equity partner ready to slide into the full relationship management role. The non-equity bonus plan of a wind down partner should motivate and reward that partner to accomplish the client transition seamlessly over time, and interim client-transition milestones should be defined along the way before full retirement.

Generational transitions are not easy, particularly when it is the founding generation that is cycling out. Let the next generation of leadership appreciate how and why the firm has been so successful, and put some scaffolding in place so new leadership can leverage what you have built.