Tag Archives: small firms

Profit-Sharing in Smaller Partnerships

In my most recent article, I looked at some alternative options for profit-sharing among law-firm partners. All of the options I described can be found in mid-sized and large firms. They can all be made to succeed and they can all be made to fail; there is no ‘best option’.

What about small partnerships (where the majority of practising lawyers are to be found)? All of the issues around performance and sharing that pop up in large firms also exist in small firms. Furthermore they often exist in environments of greater complexity, not lesser; layers of complexity – like familial involvement; long term, perhaps even multi-generational, friendships; longer-term career progression (articled clerk to equity partner is not an unusual journey within a small law firm); equity purchase involving ‘goodwill’; and self-funding for day-to-day cash-flow needs – are but a few added complications. To date, equal sharing and suppressed (if not silent) dissatisfaction have been the default ‘easy options’.

In the past, partners currently in their 50s and 60s were, by and large, comfortable with (or at least tolerant of) equal sharing. This was basic portfolio theory in action: ‘I’ll be busy when you are not and visa-versa. If we share equally, all will be better off over time’. Theirs has been a career journey that coincided with the big shift in law firms from ‘cottage artisans’ to managed commercial businesses that occurred throughout the 1980s and continues still. During this period, hierarchies became less important and specialisation more important. Still more significant, measurement and ‘accountability’ became central to ‘good business’. ‘Performance’ emerged as a construct that applied more to the individual than the collective. Not coincidentally, theirs was also a career journey that has seen a significant increase in the financial success of law firms. Many of these partners commenced with modest income expectations, expectations that have been ratcheted up over time.

Simultaneously (in Australasia for sure and likely elsewhere), as business cycles lengthened and corporate memory shortened, portfolio theory as a risk-management tool became less significant. ‘The next downturn’ used to be five years away. Now, any lawyer in Australia under 50 years of age hasn’t practised through an economic recession. Of course, ups and downs, busy times and quiet times still happen, but younger partners seem significantly less fearful of the prospect. These partners seem to be attracted to a more immediate ‘this year’s reward for this year’s performance’ approach. Many of these younger partners started with relatively high income expectations.

There is a lot to like about equal sharing, but increasingly small partnerships are asking me about alternatives. They like the upside of equality but want the capacity to reward outlier performance. They are particularly interested in acknowledging sustained higher performance – and, increasingly, sustained higher performance among relatively young partners (highly mobile talent).

In these circumstances I usually suggest that firms set aside a proportion of the net profit (before principals’ salaries) to be used as a bonus pool. The purpose of the pool is recognition and reward. (A side note: Theoretically the prospect of reward should provide an incentive to improve, but invariably it doesn’t. My advice? If you introduce a bonus pool as a behavioural change strategy you can avoid disappointment by lowering your expectations now!)

Firms usually allocate 5 to 15 percent of total profit (collected fees less expenses) before tax to the bonus pool.

Bonus pools usually work retrospectively and annually.

I have seen a number of approaches to allocating the bonus pool:

  • In firms with less than ten partners a voting method is sometimes used. All partners vote on how the bonus should be allocated. Votes are tallied and profits allocated according to the ‘score’. Firms often publish criteria to be assessed but, in my experience most partners and directors concentrate on fees controlled. Interestingly, managing partners usually finish in the middle of the pack, never at the top.
  • In firms where the data is available, the bonus pool may be allocated on the basis of profit contributed. A partner’s contributed profit is determined by totalling their fees personally billed with those billed by their direct reports and those introduced or referred to other groups, less the direct salary cost. In the case of referred fees this requires determining an hourly direct cost of each billable hour. This produces an index that will always be greater than the firm’s actual profit because there is a necessary double count of referred work, with both referrer and referee receiving credit. The partner with the most contributed gross profit is allocated 100 points and the remaining partners are pro rated according to their contributed profit. The total points are summed and a value determined for each point. The bonus is then distributed on the basis of points multiplied by the per point value. For example (see Table, below), assuming we set aside a bonus pool of $150,000, and we have five partners with contributed annual profit. Pro-rata contribution points total 369, therefore each point is worth $406.50.
  • Because the calculation of contributed profit is often cumbersome and frequently negotiable, some firms use total fees controlled to allocate bonuses. Some use data only from the current year, others use a three-year weighted average. In the case of a weighted average, the most immediate year is weighted by a factor of 3, last year by a factor of 2 and the year before last by a factor of 1. This has the effect of rewarding partners with a growing practice relative to those with a declining practice. This method also uses the above weighting methodology and is usually less controversial than the ‘profit contributed’ method, although often misleading. A partner with a number of highly paid senior staff will most likely do well under a fees-controlled methodology. To do well under a profit-contribution model, partners need lower cost leverage.
  • I have seen bonus pools allocated using a ‘balanced performance’ approach. Partners are assessed for financial contribution, citizenship (basically, not being toxic), and practice-building efforts. Although theoretically ideal, this requires an assessment process much of which is subjective. Partner-performance-management programmes don’t always work well in small firms (it can be a bit like uprooting a pot plant to check on the health of the root system; sometimes it’s best to leave them be, especially if you are all good friends or family).
  • In some firms the managing partner recommends allocations. These recommendations are usually accepted. This method requires trust and transparency. Gen X partners and the few millennial partners I’ve met hate it.

Of course, any of the systems that I outlined in my last article could also be made to work in small firms. I do however want to wave one warning flag: differential profit-sharing (i.e., anything other than equality) consumes valuable partner time and in extreme cases gives rise to bureaucracy. Small firms can afford neither.

If unequal sharing is to work in a small partnership, in my experience the methodology needs to be transparent, understood by all partners, meaningful (not token) and, above all, trusted.

Dr. Neil Oakes has served the Australasian legal profession since 1989. Neil lives on the mid-north coast of NSW near the small coastal town of Scott’s Head and enjoys all of the pleasures of coastal life. He has a large garden in which he tries to grow vegetables organically, battling every bug in Christendom. His interests include art, cooking, eating and the odd glass of wine.

Eight Reasons for Optimism

2 squareThere has been no shortage of pessimistic predictions for the future of legal practice. Issues such as graduate oversupply and underemployment, digital disruption and increasing disintermediation, increasing price competition coupled with increased cost of delivery, greater client empowerment and price sensitivity seem to dominate the legal media.

In addition to these now perennial issues, firms are now living through significant changing generational demographics among the partner / director base. Some firms now have three generations within their partnership, and the Millennials are on their way! The Baby Boomers, Gen X, Gen Y and potential millennials all have differing views around collective endeavour and entitlement.

Although all of these issues and challenges are real and here, there remains cause for optimism, certainly in Australasia.

FMRC data indicate that many firms are growing, increasing revenue and profit, retaining excellent clients and enthusiastic, capable talent. Having served the profession since 1989, I have seen significant change – but change rarely manifests in the degrees of profundity championed by many ‘black hat’ commentators. Change in the legal services market has been a constant, sedimentary process, never a cathartic baby – bathwater – footpath scenario.

1. The ‘disrupters’ don’t seem to be disrupting

There has always been space in the Australasian market for firms of all shapes and sizes. In recent years we’ve seen a number of alternative models emerge. What we have not seen is a rush of clients away from existing firms to the providers of ‘new law’. Nor have we seen market incursion by non-lawyer providers or new entrants in significant numbers. The profession is, in fact, remarkably stable. Lawyers may be practising inside alternative structures or under international brands, but the number of practising certificates relative to total legal market has been remarkably constant for many years.

2. An increase in shareholder class actions should prompt a swing in the insourcing / outsourcing cycle

When I started working with lawyers, two percent of practising certificates in NSW were held by in house lawyers; it’s now about 32%. This has been a significant structural change.

The insourcing of legal work was thought to be a cyclical phenomenon, and perhaps it still is. I suspect that company directors (and their insurers) may become increasingly risk averse as class action litigation increases. This may see significant work returning to the private profession as a matter of good governance and risk minimisation.

3. Price has stabilised (but watch the discounting)

I recently read an article reporting on a large survey of corporate lawyers that concluded that 70% of respondents felt that they received ‘fair value’ from their current providers. This is good news.

All of the segments surveyed by FMRC in Australasia show modest annual increases in price, and have done for the last three years. That said, all you have to do to get a discount is ask for it.

I am seeing more firms investing significantly in improving the client experience, explaining and delivering value and building their brands through trust-based relationships, all the while maintaining pricing levels and providing clients with choice of pricing methodology.

4. ‘Big law’ has left the GFC behind; they are by and large succeeding, employing and innovating

Far from facing a predicted death, large Australasian firms are doing well. Some are dealing with on going challenges, but most are increasing graduate intake, salaries and profit. In the main, partner and lawyer productivity is up and expenses are being contained: a good recipe for on going business success.

5. ‘Mid-tier’ firms are stable as a market segment, although competing for talent and clients

I have studied this market segment for a long time. We’ve listened to advisers predicting the demise of the mid-sized firm for decades. The remarkable truth is how stable this segment has been, for decades. The size of the market, productivity measures, profitability measures, and graduate intake are all remarkably stable.

Within the segment, there is significant competition for both clients and senior talent, but this is actually beneficial to the market as a whole. These firms are having to provide greater value, innovative solutions, better employment conditions and opportunities, and more innovative profit-sharing approaches.

6. Small firms continue to do well, particularly those that collaborate

I’ve watched and measured groups like Law Australia and Law Link in New Zealand as they have developed over the years. I am utterly convinced of the merit in small firms collaborating to achieve success. Sharing resources, pooled buying of expertise, advice and services delivers an economy of scale that many small firms could only dream of.

Outside such groups many smaller firms are doing well. Commoditisation remains a constant challenge but technology and international process outsourcing are returning profit margin to offerings that stopped being profitable some time ago

7. The quality of the next generation of leaders and lawyers

WOW, interviewed any graduates recently? I don’t know whether to be excited or terrified, but for my money the future of the profession is in good hands. These people are very impressive.

8. Economists and futurists seldom hit the bull’s eye

We’ve seen some bold predictions in the legal media in recent times, some predicting the end of days for lawyers. Who knows? One day we might all be digitised out of work, but I doubt it.

Predicting booms and busts relies on a set of considered assumptions. Many get it wrong because they assume that markets behave ‘perfectly’, informed consumers making rational purchasing decisions. The thing is, they don’t. In fact, the very essence of consumer marketing is to get ill-informed purchasers to make irrational purchasing decisions. How can a $7000 handbag exist when it does exactly the same thing as a supermarket shopping bag?

Markets don’t behave perfectly and consumers don’t usually buy the quickest, cheapest alternative, even if it’s better.

There is little doubt that commoditised, repetitive tasks are being digitized out of the hands of lawyers. Its also likely that some people in some market segments will choose to purchase from those with whom they have developed relationships over many years. What ever happens, it’s highly unlikely to be all or nothing.

Change has been and will continue to be sedimentary, layer upon layer. Change can be and should be managed, indeed it is being managed right now. Good firms will continue to be good firms. The emerging digital economy presents opportunities that will enable many firms to thrive. I remain extremely optimistic.