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By conventional measures, Big Law firms are some of the most profitable businesses on earth.

The average profit margin for the Global 100 is a lofty 39 percent, according to data published this month by The American Lawyer. The highest profit margin in the group, which goes to Quinn Emanuel Urquhart & Sullivan, is almost 68 percent. That’s more than three-and-a-half times the net margin of tech giant Apple Inc., and over nine times that of Warren Buffett’s Berkshire Hathaway, based on each company’s returns in the last quarter.

How can that be possible?

It’s true that law firms have little in the way of fixed costs, beyond staffing and office rent, and that fee rates remain high despite growing pressure from clients. But it’s still a massive difference.

It’s also completely false.

What if I were to tell you that most Big Law firms actually have profit margins of less than 15 percent? Some generate virtually no true profit at all.

The crux of this issue is the way that equity partners are compensated. Traditional law firm partnership structures are effectively unable to retain any earnings at the end of each fiscal year. Except for any planned investments, all remaining profit—what the Am Law 100 and Global 100 surveys refer to as “net income”—is distributed among the equity partners in full.

Compared to companies in other industries, this gives law firms an artificially high profit margin, since from an accounting perspective, equity partners receive no above-the-line salary and therefore represent no cost to the business. It also means that the most popular metrics used to assess law firm profitability—profit margin and average profit per equity partner (PEP)—are susceptible to distortion by leverage.

Take two 100-lawyer firms that generate identical revenue. Firm A has 90 equity partners and 10 associates, while Firm B has 10 equity partners and 90 associates. Assuming its associate salaries and other costs are the same, Firm A will appear significantly more profitable than Firm B, as its bottom line will only be affected by the cost of 10 associates, rather than 90. (This can also cause tension between a law firm’s various teams and practices, where differences in leverage can create the illusion of profit disparity.)

Even average profit per lawyer, which I personally consider a much better way to assess a firm’s relative profitability than PEP, is not fully immune to this problem.

The solution is relatively simple—in principle, at least: You just assign equity partners with a notional salary and deduct this cost from net income, leaving “true” profits. Actually setting an appropriate salary for each individual firm isn’t quite so straightforward, however, and doing so risks introducing a degree of subjectivity to financial analysis that is designed to be as objective and accurate as possible.

I’ve experimented with notional equity partner salaries before. It formed part of a formula I created back in 2012 to value law firms as businesses as part of an article in The American Lawyer. I used a market-wide equity partner salary cost set at 50 percent of each firm’s net income, which left a cash flow that was then subject to a multiple that varied depending on the firm’s size, its historic growth rates in revenue and profits, and its brand strength.

It was an imperfect and somewhat broad-stroke approach that was more designed to shed light on the issues an investor would face when analyzing a law firm target, rather than to provide precise valuations. (For those interested in the results, Kirkland & Ellis narrowly edged out Latham & Watkins as the world’s most valuable law firm, with a business worth just shy of $4 billion. Quinn Emanuel was the clear leader by value per equity partner, with the effective stakes held by its owners worth more than $17 million on average.)

I recently broached this subject again with Alan Hodgart, a law firm consultant in London. Hodgart shares my frustrations with the way that law firm profits are reported, and has come up with a far neater method of calculating notional equity partner salary costs than my previous one-size-fits-all approach.

He suggests either adding a 25-30 percent premium to each firm’s highest-paid salaried fee-earner, or matching the compensation packages offered to general counsel at the firm’s core clients. This equates to a notional equity partner salary of around $1 million at an elite firm, $650,000 at a midmarket firm and around $400,000 at firms focused on lower-margin, commoditized work.

Applying these figures to The American Lawyer’s latest law firm financial survey data has dramatic results.

Assigning a salary cost of $1 million per equity partner sees Latham & Watkins’ profit margin fall from 50 percent to 34 percent; Linklaters’ drop from 46 percent to 24 percent; and Jones Day’s crash from 49 percent to just 2 percent. (Impressively, Quinn Emanuel and Wachtell, Lipton, Rosen & Katz’s profit margins both remain above 50 percent, even after such deductions.)

Among the midmarket firms, a notional salary of $650,000 per equity partner sees Baker McKenzie’s profit margin halve from 34 percent to 17 percent, and DLA Piper’s drop from 26 percent to 16 percent. The same figure wipes out Norton Rose Fulbright’s profit entirely, with its margin plummeting from 31 percent to 0.003 percent.

It is easy to dismiss this as the kind of self-reflective navel-gazing of which firms are so often guilty. As much as partners like to obsess over and endlessly debate these issues, the truth is that a law firm’s inner workings are of little interest to anyone outside the industry. Clients couldn’t care less about financial metrics and partner compensation systems, so long as the service they’re receiving is good, right?

Well, not entirely. Hodgart said that law firms are actually “shooting themselves in the foot” by publishing artificially high profit margins that don’t account for the cost of equity partners. “Clients see these results, compare them to those of their own business, which are usually much lower, and wonder why they are paying such high fees,” he said.

One might also consider the potential impact on a partnership’s attitude towards costs and efficiency. I go back to Norton Rose as an example. It’s not a big deal if clients ask for discounts when your firm’s profit margin is 31 percent. But at a margin of 0.003 percent, even the smallest discount would mean that work had effectively been carried out at a loss.

I’m very keen to hear readers’ thoughts on this issue. Does the way that the industry measures law firm profitability need to be addressed? What changes, if any, would you like to see? Feel free to get in touch.

Global Firms in Focus is a weekly column about international law firm business by chief global correspondent Chris Johnson. Reach him at cjohnson@alm.com. On Twitter: @chris_t_johnson.