5 Compensation Issues to Review at Reopening

Partner compensation cuts. Furloughs. Layoffs. High receivables. Clients in crisis. Despite all these dismal legal media headlines, there will be a reopening of the economy. Demand for legal services will return, perhaps more slowly in some sectors.

Meantime, your firm’s compensation cuts and adjustments are the pain still felt and talked about by all your partners and employees. They’re asking: “Will compensation return to normal?” As leaders, you’ll have to answer and consider tweaks to your pre-pandemic system.

To begin with, leaders should consider a self-assessment of how they handled partner and associate compensation issues during the pandemic. Warren Buffet famously said: “It’s only when the tide goes out that you discover who’s been swimming naked.” While self-assessment can be uncomfortable, it can also pinpoint surprising positives as well as criticisms of past actions. We’ve worked with firms who use surveys, interviews with partners and upward reviews to get honest feedback on their leadership or culture*. An assessment from within or with outside support applies equally to your handling of compensation in the Covid-19 crisis. While every firm will discover different strengths and weaknesses, we predict that these 5 issues will surface in most.

1. Transparency and Trust

In our conversations with partners, we frequently hear that transparency about how compensation decisions are made and what factors influence those decisions is a highly valued feature of a compensation system. In making decisions about recent cuts for partners and employees, leaders should have been transparent about who was affected and why. Ideally, leaders will have consulted those affected in advance. In the recent cuts, some of the best practices did not involve “across the board” or “equal treatment”. They affected partners first, and more significantly. Firms protected lower-salaried employees from any cuts.

How does your recent transparency record match what you normally do with annual partner compensation? To the extent that you were as transparent, or more so, your leadership credibility will be intact. If your self-assessment reveals lower appraisals of transparency, trust in leadership will be eroded.

Transparency builds trust. We hear time and again from younger generation partners that compensation decisions should not be made in a “black box” environment. They do not need to know every detail of each decision or even each partner’s compensation. But they want to know the criteria, have some idea of the weighting and have input about their past and future performance. Do you need to tweak transparency to rebuild trust?

2. Overweighting Originations

When the tide is out, we may find that originations from high performing partners are down, and that average performers had even weaker originations. If firms place high weight on originations, especially over only the past year, the quantitative compensation rankings may be very scrambled at 2020 year-end. There may be pressure to penalize or exit partners at the bottom of the rankings. Those same partners may have proven their worth in more qualitative measures but get little credit. The tweaks to consider will be:

• down-weighting originations, even in more flexible, non-formula systems;
• placing a specific weight on originations and other quantitative factors; and
• averaging originations over two years back, plus the current year.

3. Increased Weighting for Qualitative Factors

We often help firms articulate and measure qualitative performance that will be given weight in partner compensation systems. We think that, this year, some of these factors were very critical to the future of the firm, though we won’t recognize that importance until late this year. Looking at partner performance over 2020, review the partners who excelled at:

• Client relations. Keeping stressed clients informed and supported. Cross-referring those clients to other firm services, such as real estate partners who could help re-negotiate a lease.
• Mentoring, training and counseling. Even the best associates will be concerned about getting enough hours or getting feedback. In a remote working environment, effective partners replicated the office “drop-in” or coffee break discussion by making individual video calls or doing small-group check-ins.
• Innovation. What did partners do to pivot the firm’s business, attract clients to new services or create legal project management innovations? A crisis can be an opportunity for innovators. Does the compensation system recognize innovation efforts, even though some may fail?

If these factors do help offset weak originations and keep associates busy and onboard, should they not be upweighted in the future?

4. Your Benefits Package

When associates and staff reflect on their pandemic experience, the benefits of some meals and the gym membership may not seem as important as some other benefits. First among these, though not listed in the benefits package, is job security. Every associate and staff member will be thinking about this as we move toward reopening. Firm leaders and partners will have to take specific actions, mostly through communications, to “keep the keepers”. Reassure your best people. Talk them through their next level of development.

Health care, sick leave and disability benefits will be under a new spotlight. Firms may need tweaks or new plans to meet new employee and partner needs. For example, will some need leave to care for sick or disabled parents? Do you have such a benefit?

5. The Level of Monthly Draws

In most firms a core amount of partner compensation is really paid in advance of collected profits. These are monthly draws that are viewed by many partners as “guaranteed minimums” (but of course, they are contingent on actual collected profits). On reflection, do you need to re-balance the amount that is pledged to monthly draws compared to year-end distributions? Another common category is a bonus pool amount that is held for year-end, both for associates and partners. That category will certainly be downsized at year end. All the pieces of compensation distribution may need review, and if you are making those adjustments for 2021, the internal consultations have to start now.

We all hope the tide will come back shortly after reopening. A candid review of your crisis response and tweaks to your compensation will demonstrate leadership and stability. Above all, you won’t be swimming naked in 2021.

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*In addition to compensation reviews, Edge performs Cultural Assessments in law firms, to test the reality of the culture the firm believes it has. Contact [email protected] to learn more.

Entrepreneurship is at the Heart of Good Governance

In the last couple of years I have been honoured to advise nearly a dozen clients on complex governance projects in at least six different jurisdictions. Some of these projects have been driven by tax or regulatory considerations, but most have had effective management and leadership at their core. One of these projects was to help a mid-sized limited liability partnership to modernise its decision-making processes. Another was to create a structure to combine the best features of partnership into what is essentially a corporate structure. Several projects wrestled with complex partner compensation problems whilst other projects related to merger or, in a couple of cases, the firm’s growth which had rendered the historic structures obsolete or no longer fit for purpose. The context of this work has varied from traditional partnerships through to LLPs and LLCs, civil companies, corporations and multi-disciplinary structures.

What I have found is that the increasingly complex world of professional firm governance always raises the question of the qualification for ownership status. Until about ten years ago, professionals seemed to get promoted to partnership by little more than rites of passage and without questioning very deeply their fitness to be an owner. As a one-time managing partner, I have to put my hand up and admit to being at fault in failing sufficiently or rigorously to assess such promotions. More recently, however, equity in professional firms has become more tightly held, and this trend has been accompanied by a growth in professional competency and assessment frameworks, balanced scorecards, promotion criteria and partner job descriptions. Our recent Edge International Global Compensation Survey confirmed this trend, and particularly the growth in importance of business development skills as an essential partner competency.

Even so, firms nowadays are rightly reluctant to elevate professionals to partnership unless they seem to meet some hard-to-define extra qualities – some spark that lights them up. The negatives are easy to establish – no jerks, no journeymen partners, nobody who will impede progress, and nobody who lacks rainmaking skills.

Hardly anybody mentions entrepreneurship – maybe because it seems so difficult to describe in terms that lead to easy partner identification. Here then is a start. Entrepreneurship has been defined as “the identification and exploitation of previously unexploited opportunities.” It is clear from this description that the ability both to innovate and to drive is at the heart of entrepreneurship. In professional firms, this ability can be demonstrated in at least three areas – services, clients, and processes – and prospective partners should be required to show entrepreneurship in at least one of these areas. The ability to spot opportunities in new and emerging services or to exploit twists in existing services may be one such quality. Another might be the ability to re-energise or renew the way the firm interacts with its clients or delivers its services. Less obvious – but of equal importance – is the ability and drive to improve processes, capture knowledge, and create systems and unique ways of doing things.

In their business plans, prospective partners should be required to set out some of the unexploited opportunities that they could create, and how they would see themselves as exploiting and managing those opportunities for the benefit of the firm. I have lost count of the times that I have been told that firms contain partners who should never have been promoted. A more rigorous approach in promoting partners would in my view inexorably lead to more entrepreneurship, faster decision-making and better profitability.

Moving Upstream: Practice Migration Strategies to Improve Law Firm Profitability

Most law firms have a limited number of options to improve their profitability. They can ask their lawyers to work harder —which in many firms is a function of having the work to do, as well as a culture that inspires and rewards hard work.

Another alternative is to cut costs but, for most law offices to truly make a dent in profitability problems, the level of frugality required will affect lawyer work styles in an unacceptable manner. That leaves the options of increasing rates or increasing leverage. Law firms quickly observe that these two options provide the greatest opportunities for profitability improvement. But, most often, making significant changes in pricing and leverage requires a major up-grade to the firm’s practice.

Accordingly, a common law firm strategy is to attempt to move the firm’s practice “upstream.” Simply stated, this means improving the mix of disciplines and areas in which the firm practices to provide more sophisticated work which generates higher fees. At the same time, more sophisticated practices typically permit greater leverage.

Implementing upstream migration strategy, however, can be difficult and somewhat risky. It requires that the firm accurately assess which of its practices are suitable upstream migration targets. The firm must also objectively determine its own capability to perform those practices at an appropriately competitive level. Unfortunately, to perform this analysis well, a law firm must have an incredibly acute understanding of the marketplace for the services it would like to provide and the ability to make honest judgments about itself.

Downstream flow

It is difficult to argue against the concept of a law firm seeking to upgrade its practice. Firms naturally become stagnant in their mix of practice areas and the level of the work they do. Legal work constantly flows down a value curve in which it is considered less sophisticated by the lawyers doing the work and is less valued by the clients benefiting from the lawyers services. The obvious examples of this are commodity work, such as insurance defense or loan documentation, where both clients and law firms recognize that value is created through the routinization of the process and the volume of the workload. But all legal work is subject to this process, no matter where it is on the demand curve.

For example, only a couple of years ago, private equity deals were among the most valued aspects of any law firm’s corporate practice. The deals were complex and chaotic and premium legal fees were routinely paid as “deal dust” in large transactions. But as hedge funds grew, and both the hiring of in-house lawyers and fee sensitivity increased, often clients’ views of the lawyers involved began to shift from being “valued members” of the deal team to “a necessary evil.” At the same time, for the lawyers, the adrenalin surge of working all night to meet a closing deadline transitioned to the routine and mundane work of meeting unnecessarily tight and arbitrary timetables. From the clients’ perspective, after watching a magician perform the same act several times, the audience begins to understand how the trick is done and a lot of the magic goes away. From the perspective of the lawyers, having performed the trick dozens of times it starts to get boring even if the audience is wildly appreciative.

Identifying upstream practices

By definition, upstream represents practices that are superior to a firm’s current practice mix. Downstream represents those that are inferior. Of course, where a firm is poised on the stream is a function of the law firm’s practice in relation to the possible practice alternatives. For example, product liability defense is decidedly upstream to firms doing consumer insurance defense but downstream for firms with sophisticated patent infringement cases.

If identifying upstream practices were as simple as comparing hourly billing rates, the strategic targeting of desirable practices could be accomplished with mathematical precision. However, practices also have strategic value to a law firm beyond the maximum generation of revenue. Certain practices speak to the institutional foundation of a law firm, either because of client relationships or the generation of significant amounts of other work. For instance, in the case of a corporate transactional firm, listed company governance work may have become commoditized but being the general counsel of a public corporation is a defining feature of the firm and creates work for all of the firms’ practices. For intellectual property practices, patent prosecution may have become highly commoditized but provide access to eventual patent litigation and licensing work.

Unfortunately, the institutional value of practices can be seductive to the point where a firm can justify the institutional value of any practice, regardless of how low its billing rates. In fact, we can identify four positions a practice can take in the comparison of revenue value and institutional value.

The Bread & Butter practice is an ingrained part of a firm as an institution to the extent that it personifies the firm and its reputation. Baker & McKenzie, for example, was created as and long maintained a reputation as a tax firm. Even after the competition from accounting firms made stand-alone tax practices lower revenue producers than many other areas, Baker & McKenzie continued to purposefully maintain its reputation as a tax firm, even though they had become one of the largest full service firms in the world.

The Rocket practice is an area that provides extraordinary billing rates during what is often a short-term life span and, typically, has no real bind to the firm’s institutional values or reputation. These are practices that are presented with entrepreneurial opportunities, and tend to not have a tie to the core strategy of the firm. A current example is the Corporate Investigations practice that a number of firms are entering. The growth of CEO misconduct, insider trading and fraud and abuse issues have created opportunities for law firms to act as independent internal prosecutors on behalf of shareholders. Although highly lucrative, such practices do not provide ties to a law firm’s institutional reputation. Clients hire investigative firms because of their objectivity and lack of practice ties to the company. In such situations, practices are unlikely to spin off significant work in other practice areas.

Upstream Practices are those areas that provide a significant revenue increase while supporting the firm’s institutional character. For instance, for a firm with a strong corporate transactional practice, a move to white collar crime defense in high-profile cases could produce strong revenue increases but might potentially be deleterious to the firm’s institutional reputation. On the other hand, a firm that has a strong health care practice could logically add white collar criminal defense involving fraud and abuse as a natural part of its institutional reputation.

Targeting Upstream Practices

There appears to be two ways in which law firms engage in practice upstream migration. The first is strategic, in which the firm makes a conscious decision to move into a practice area that provides an upstream benefit and then goes about implementing that strategy. The second is opportunistic — for instance, a lateral candidate provides a serendipitous entrée to the upstream practice area. While the focus of upstream practice migration is strategy, it must be noted that a considerable number of law firms’ attempts to upgrade their practices are the result of unplanned luck.

The issue of evaluating potential practices remains the same, regardless of whether it is the target for a strategic practice shift or considering a lateral opportunity. This evaluation involves five questions:

1. How far upstream is the targeted practice?

Developing a new practice or dramatically expanding an existing practice requires a large amount of management focus and an element of risk. The first logical question, therefore, is whether the practice is sufficiently upstream to justify the effort. When firms are dominated by lower rate practices, the focus on rates tends to limit horizons of the level of rates possible, even for new practices. What rates are being charged by competing law firms for this practice and how do those rates compare with existing rates in your firm are pivotal questions

2. How strong is the institutional tie for the upstream practice?

It is possible to add a practice as a free-standing economic unit but that eliminates the institutional value of the practice. The question, then, is how well does the upstream practice area fit with the firm’s existing practice? This involves two issues — how likely is it that the practice will be of value to existing clients of the firm, and will clients of the upstream practice be prone to purchase other legal services from the firm? The answer to these questions largely involves determining whether there are spin-off opportunities for the practice and if they are likely to benefit the firm’s existing clients.

3. What is the anticipated life of the practice?

Legal practices go through a life cycle just like businesses. As they become more mature, they become more mainstream; eventually they move downstream with lower billing rates. The time it takes for firms to mature differs among practices, and a practice that is just reaching maturity is more likely to produce high rates for a longer time than a practice that is moving toward saturation. Practices tend to move through the life cycle stages rather uniformly, so a practice area that reaches maturity rapidly is likely to move downstream equally rapidly. By the same token, a firm that stayed in a growth stage for an extended period is likely to slowly move through maturity and provide an upstream opportunity for a longtime.

4. What is our level of capability and how are we positioned in the marketplace?

For the migration to an upstream practice area to have a significant impact on the profitability of a law firm, the firm must be able to demonstrate a level of sophistication that moves it toward a position of dominance. For example, for a firm to add one or two specialty lawyers in a highly valued corporate transactional practice may generate some additional revenue but, in order to make an impact, the firm must have a reasonable depth in comparison to competitors or a path to achieving that depth.

5. Is the firm willing to accommodate the cultural impact of a practice migration?

There are identifiable cultural differences between firms with differing practices. The strategy of moving practices upstream will almost certainly have an impact on a firm’s culture, the way partners relate to each other and the values that the firm espouses. Clearly the addition of laterals and practice groups have an impact on culture but the expectations of clients from upstream cultures may have a profound effect on issues such as teamwork, urgency, work ethic and independence.

Implementing a Practice Migration Strategy

Like so much with strategy, selecting practices into which the firm wants to migrate is the comparatively easy part. The heavy lifting comes with attempting to implement the strategy.

For most firms, the default means of migration is by buying a practice (through the hiring of laterals with both the capability of doing the work and a ready base of clients seeking the services).When firms are using practice migration primarily to jump start profitability increases, there are some factors that must be in play if the primary implementation driver is going to be lateral entry partners.

In observing firms that have successfully moved their practice upstream (and there are some stunning examples of what can be accomplished) three features seem ever present. First, the firm always has a clear vision of what it is trying to accomplish — and often the goal is bodacious. Firms that say “let’s get a couple of lawyers in that practice area and see what happens” rarely accomplish much.

Second, they have a clear idea of what the ties are to their existing practice and how the institutional synergies will occur. In fact, one of the problems is that sometimes their lawyers are out talking to clients about the practice before the migration has effectively occurred.

Finally, and most importantly, building the upstream practice always involves requiring that incumbent lawyers with the firm migrate with the practice by building their capabilities and knowledge. They don’t allow the lawyers to “keep working in their old practice and work in the new area when they have time.” That assures they will never have time, sends a message to the firm about the importance of the migration and guarantees its failure.

Other Benefits of Practice Migration

The focus of the foregoing has been on Upstream Practice Migration as a strategy for increasing profitability. But a more important aspect of the strategy may be as a means of increasing lawyer job satisfaction. By virtue of the law school admission screening process and law firm hiring standards, the large firms to which this article is directed are populated by some of the brightest, most able and most creative minds our society has to offer. And, according to ABA surveys, the overwhelming motivation for most lawyers to enter the private practice of law is intellectual challenge. Yet, many large firms promulgate compensation systems that reward their lawyers for performing routine cases over and over rather than passing the work to less qualified lawyers for whom it would represent a challenging learning experience.

Upstream Practice Migration provides a means for lawyers to again find their work to be challenging – and, in the process, improves profitability by pushing the current work to younger, less qualified lawyers to create leverage and justifying higher billing rates for everyone involved in the migration.

Five Unintended Consequences of Economic Recovery

As the global economy moves toward an eventual recovery, there will be some huge opportunities for law firms, as well as some minefields.  How firms deal with these issues may determine their short and long term success.  There are all sorts of possible scenarios but the five issues discussed below certainly appear to be the most significant extensions from where we are today.

1.  Expanded Role of the Federal Government. It probably comes as no surprise to anyone who has read a newspaper in the past six months that the involvement of the U.S. Government in the operation of the private sector has rapidly expanded.  While this raises all sorts of political and philosophical debates, law firm leaders should note that the areas involved in the greatest government activism are also the industries that many law firms have targeted as their fastest growing sources of future revenues — Financial Services, Health Care, Pharmaceuticals, Telecom and IT, Energy, Housing, Insurance, and Automobiles.  This level of Federal influence is likely to continue at least until there is sufficient economic recovery for businesses to relax their dependence on government support.

While the nature of this new working relationship is still evolving we can anticipate several likely consequences.  First, regardless of the political party in control, the Federal government has always enjoyed using the power of the purse strings to support social agendas.  This will almost certainly mean that the level of reporting, disclosure and approvals required by law firm clients  will increase, thereby providing opportunities for a broad array of regulatory work.  At the same time, this will likely result in the expansion of auditing and a retrospective review required when firms are performing legal work on client engagements that involve public funds.  We know from experience in prior recessions that government audits can be pervasive and, when performed several years after the fact, can be a gargantuan test of law firms’ document retention policies.  So the structure and overhead cost of government compliance may grow as a part of law firm management.

But the more significant change may be the Federal government as a client.  To the extent that the government moves from the role of a regulator to being an operator, the need for specialized council is likely to expand.  As most firms have experienced at some level, working for a government agency brings into play a host of procurement, billing and payment issues that could have a permanent influence over these issues in law firms’ relationships with private sector clients.

Finally, the true winners from all this may be the firms with large government relations practices.  Working with the government requires major lobbying efforts which provide attractive opportunities for law firms with government agency experience.

2.  The Loss of the Brightest and Best. It is a business necessity and completely appropriate for law firms to adjust their level of capability to reflect the client demand for legal work.   Indeed, the number of lawyers laid-off as a result of the economy by the AmLaw 200 is now approaching 5,000 and this does not include the new law school graduates for whom offers of employment have been cancelled or deferred.  In most firms these lawyers are associates and non-equity partners whose redundancy is primarily based on their performance statistics rather than their legal capability.  That is, the lawyers most likely left at law firms after the culling are those who have traditionally generated the most business and worked the most hours.  Cynics at some firms characterize this as keeping the brawn and laying off the brains.

What is being lost in this process is the transfer of know-how, particularly in the transactional practices, to new classes of lawyers.  We have really only seen this once before in 2001 and 2002 when the tech boom ended — and that was on a much smaller scale.  But, even then, law firms lost what seemed like a whole generation of lawyers who could handle certain aspects of engagements and, as a result, in the middle of this decade, headhunters’ hottest properties were third year associates with corporate experience.

It is likely, especially if this is the “U shaped” recovery some economists describe, that there will be a lost generation of lawyers — especially in the corporate and real estate transactional practices.  When demand increases for mid-level associates the existing pool of trained lawyers may have lost their skills and will be too senior to work at the lower associate levels.  The challenge for law firms is to create the knowledge management systems that will permit a rapid recovery of a full transactional capacity when the need recovers.

Of course, the other shake out of all this is the availability of an extraordinary number of incredibly bright and well credentialed lawyers at bargain basement prices.  It is a target rich environment for firms willing to invest in a buy, develop and hold opportunity.

3.  Deflation and the Liquidity Trap. While the news pundits opine on the risks of the stimulus packages creating high inflation, the greater risk may in fact be a deflationary spiral.  This occurs when the economy slows to the extent that uncertain buyers stop buying and, to stimulate sales, sellers decrease prices.  This causes buyers to further defer purchases in anticipation of lower prices to come and the spiral begins.

At the same time, there is little incentive to borrow because of the increasing purchasing power of cash.  For example, if prices decline by 10 percent (as was the annual deflation rate during the Great Depression) borrowing $1,000 to buy 100 widgets would need to be paid back with $1,000 that is capable of buying 110 widgets.  Therefore, even if the borrower’s interest rate was zero, the effective cost of the loan is at 10 percent interest.  So, with all the incentives being in favor of those who are conserving cash and not borrowing, capital investment comes to a crashing halt.  Unfortunately, capital investment and borrowing is what fuels law firm transactional practices.

The trick for law firms (other than rooting for a bit of inflation) is understanding the effect of Keynesian economics on their specific client bases and practices, avoiding debt and maintaining a strong level of contributed capital.

4.  Globalization. Economic downturns drive isolationism.  When there is large scale unemployment and a lack of demand for goods and services worldwide, it is politically difficult for any government to advocate active international trade and foreign investment.  During the Great Depression, restraints on international trade and economic cooperation are frequently cited as one of the primary factors exacerbating the severity and length of the problem.

Currently we are seeing large scale concern about any portion of economic stimulus programs benefiting non-U.S. workers and companies.   Major manufacturing facilities and distribution networks in other countries, particularly developing nations, will likely continue to operate but the general decline in the availability of investment capital should slow new development.

The result is likely to be the culling of the herd of law firms seeking to become international players.  As the availability of legal work, particularly in Europe and China, declines for law firms that do not have an active client base and/or a strong local practice, about half of U.S. law firms’ overseas offices will be bleeding cash at a time when it is much needed for internal purposes.  It would be a good idea for law firm leaders to do some fast soul searching as to the motivation for each foreign office and consider several different scenarios based on their best guess as to the severity and length of the depression.

5.  Renewed Focus on IT. Law firms have, for most of this decade, enjoyed a holiday from significant IT expenditures.  Overwhelmingly, law firms’ use of technology centers on document creation and management.  Since the big switch, about ten years ago, that brought the last stragglers over to Microsoft Word from Word Perfect, we have seen only minor changes in the MS operating system and their core MS Office products.  As a result, users have had the time to become more familiar with the software causing them to demand less training and make fewer calls to the help desk.  Accordingly, the number of desktops supported per IT employee in law firms has more than doubled in recent years, while the cost of hardware has fallen by so much that some firms are spending more per lawyer to purchase smart phones than they are for desktop computers.  Oh, we’ve managed to find places for our IT dollars but most of them have gone to niceties like contact management systems and data warehousing software.  But we are due for those IT dollars to increase — by a lot.

As law firms attempt to maintain and grow profitability in a tough economy, there are really only a few strategies they can pursue.  Having fiddled with most of the options it is likely that some firms will figure out that the fastest growing businesses, as we move toward recovery, are those that are able to fundamentally change the basis on which they compete.  And, for most businesses, that means making giant strides in productivity, largely through the use of technology.  For most large law firms, nothing has changed with the introduction of technology except the ability to create more attractive documents.  Take away the bells and whistles of word processing and, in large measure, the manner in which lawyers practice, particularly in large law firms, has changed little since the 19th century.  Sure we went from handwritten documents to manual typewriters to self-correcting “Selectrics” to word processing — but in the process the only real increase in productivity has come from a comparatively small decrease in the number of secretaries.

But the current lack of sophisticated legal work is causing some major firms to take a hard look at legal work from large corporations that they previously deemed unprofitable commodity work.  And in the process, some of these firms are reevaluating the realities of legal practice.  These realities include the level of timekeepers necessary to handle certain types of work and the real potential for technology beyond making and managing documents.  The firms that enjoy first mover advantage on the changing productivity standards of law firms will have a highly sustainable competitive advantage with major corporate clients.

Like so many other issues, law firm leaders may view these circumstances as problems or opportunities.  Either way, while most firms have surplus capacity in their partner ranks, this would be a good time to devote some attention to the business of practicing law in a recovering economy.

Why Aren’t Associates More Profitable?

I had occasion to be on a panel with several other consultants and some managing partners recently.  One of the consultants said, “As you all know, every law firm loses money on associates during their first three years of practice.”   The panel (me included) smiled and nodded acknowledgment of this commonly accepted belief: all young associates cost more than they produce in revenue.

But it got me thinking…could this be true?  What is the strategic logic of hiring associates who don’t produce profit?  One of the first rules of business states that the easiest way to make money is to stop losing it.  So, if all law firms really lose money on associates during their first three years of practice, why don’t they just fire the lot of them and enjoy a nice increase in profits?

Do We Really Lose Money on Associates?
Unfortunately, this is the point where theoretical accounting and functional accounting collide, producing quite a wacky result.  It makes sense to spread the costs of operating a law firm over the entire staff of attorneys and paralegals and then derive a cost-per-timekeeper (fee earner outside the U.S.).  But if a firm fires an associate, the firm saves the associate’s salary (lets say $100,000 per year for round figures), benefits, taxes (say another $25,000), plus half the cost of a secretary (maybe another $30,000).  Suppose this firm even maintains a magic lease that allows it to add or shed office space at will, precisely matching its lawyer count. That equals another $10,000 in savings.  The sum of this savings adds up to well less than $200,000 total.  Yet, most firms should receive at least $300,000 for the associate’s time, thus producing a negative cash flow of $100,000 if the firm fires the associate.  So, why do firms think they regularly lose money on associates?

As law firms attempt to become more “business-like,” they also attempt to apply industrial cost accounting techniques to the practice of law.  The difference is that law firms are structured with owner operators, which produces a distinctly different result than does an investment owner model.  Cost accounting for law firms simply cannot be figured in the same way as it is for a Buick plant.

The Economics of Ownership
In truth, the overhead costs of running a law firm are the responsibility of the owners.  They make the decisions of what costs are incurred and accept the business risks of maintaining unused office space, obsolete computer systems, etc.  Owners accept this risk because it is justified by the reward of profit sharing.

Unfortunately, many law firms have lost their ownership mindset and gone overboard with leverage models.  Conventional wisdom holds that the reason New York law firms are so profitable is because they have three or four associates for every partner.  In point of fact, the reason New York law firms are so profitable is not simply because they have more associates; they are profitable because their partners are capable of generating so much work that the partners can’t do it all themselves. Therefore, they must hire associates to accomplish all the work to be done.

This is a concrete point.  It is fundamental to a law firm’s profitability.  Suppose that attorneys Moe and Larry leave the practice of law and decide to open a hot dog stand.  They don’t worry about the allocation of overhead because they know the cash they generate by working at the hot dog stand must exceed their costs in order to produce a profit.  When sales increase to such a degree that they cannot handle a single additional customer or sell one more hot dog, they hire an employee.  In hiring the employee (who is, of course, called Curly), Moe and Larry’s hope and expectation is that there will be sufficient demand for hot dogs that the new revenues created by having Curly will exceed Curly’s cost, thus generating additional profits (the law firm leverage model).  At some point, Moe and Larry look each other in the eye and agree they will come up with enough business to keep the new guy busy.

Using Accounting that Makes Sense
The reason I bring this up is that as law firms become more sophisticated in their use of practice groups, they are increasingly tracking revenues and expenses to those groups and making management and compensation decisions based on each group’s profitability.  Managing profitability of a law firm at the practice group level makes complete sense, but only if the means of tracking both revenues and expenditures is completely appropriate for a professional service firm, and not more applicable to a manufacturing company.

Unfortunately, I see many firms that simply divide the total non-timekeeper compensation expenses of the firm by the number of timekeepers, or worse, by the total number of billable hours.  The result is that partners are able to push their overhead costs to the non-owner timekeepers, thereby making themselves look more profitable.

The truth is, a firm must base its system for measuring the success of segments of its organization on more than simplicity of calculation.  This means that, if a law firm is going to measure profitability at any level other than firm-wide, the firm must first consider three basic concepts:

Overhead belongs to the owners.  The costs assigned to the worker bees are costs related to their presence.  The test is, if the attorney leaves the firm, do the costs go away?  If they don’t, it’s overhead.

Everything paid to partners cannot be calculated as a compensation cost in measuring profitability.  Partner compensation is based on three factors: how hard they work, i.e., how much money they bring in as a working attorney; how much business they generate for others to do; and their capital at risk.  The only one of these factors related to the cost of work performed is the portion of compensation based on how hard they work.

This is important because partners, as owners, are paid from profits.  It is a zero sum game — if firms count total compensation as an expense, there will be no profits.  In this case, the measurement would be based not on the profitability of the practice group, but the accuracy of the firm’s compensation system.

Revenues must take into consideration originations by the group, not just work performed.  One of the key roles of a practice group is business generation for themselves and other practice groups.  Basing profitability solely on revenues generated for work performed will inevitably result in the balkanization of the firm into the practice area silos most firms are working to eliminate.

Granted, I appreciate that the above may sound theoretical, but I consistently see firms making strategic decisions on which practice groups to grow and spend money on based on very questionable cost accounting.  Bottom line, look at the numbers – look at them hard – but don’t let them get in the way of common sense and business judgment.