Lateral movement of partners is a fact of life in the profession of law. We understand some moves succeed for the hiring firm, and others fail. On balance, fewer than half work satisfactorily for the hiring firm.
Let’s look at basic economics of lateral hiring and draw basic conclusions about its wisdom. We will limit ourselves to three types of lateral hire.
Type I is the “worker bee” associate, income partner or junior equity partner, where the decision is to acquire a labor unit of production for salary, perhaps with a performance bonus. The easiest hire to make, these are predicated on existing work, the ability to match salary with reasonably predictable revenue streams, and ensure a profit margin with each hire.
Type II is the “business book” hire of a partner, where the firm acquires a worker plus a gross revenue addition from which a profit may be contributed to the partnership. This is a more difficult hire to make, as a component depends on the fulfillment of the expectation the hire will deliver a certain level of business.
Type III is the hire of a star equity partner, to acquire a substantial gross revenue addition. The labor of the star partner is a consideration, but not the driving one. This decision almost always includes additional supporting attorneys. This is the most difficult of hires to make, in part because of market competition and accurately assessing the level of business delivered.
The economics of these three types of lateral additions are different in their short-to-intermediate-term impact to the law firm. Let’s look at what you give, and what you get, as a firm.
The Type I Lateral Addition
By definition, the firm already has business to substantially engage the new attorney almost immediately.
The Type I hire has two cost components: the recruiter fee and the “pipeline” cost. For a $400,000 salary attorney, a recruiter fee of 25 percent ($100,000) is expected. “Pipeline” cost carries the attorney until he or she generates cash flow. Assume the attorney records billable time starting Jan. 1. The firm processes invoices for January time by Feb. 15 (that is perhaps optimistic). Clients receive those bills by Feb. 28, and pay by March 31 for this example.
A 45-day turnover cycle on A/R from the billing date is good. During this three-month period the “pipeline” is filled with receivables and the firm pays $100,000 of partner salary. Thus, before receiving cash flow from the new attorney, the firm has expended $200,000, plus the allocable fixed overhead for generating the work. This is $50,000 or more for three months for an attorney in a typical large firm. The “margin” of profit to be expected from this attorney with expected production of 1950 billables, at $550 hourly, is $1.072 million recorded, less 8 percent for prebill adjustments, less 7 percent for realization rates on billings, for net collected $917,000. Quarterly that equates to $229,000. Take $917,000, subtract annual per attorney overhead of $200,000, salary of $400,000, benefits and employer costs of approximately $60,000, and projected gross margin is $257,000.
Fifteen months pass before the firm reaches breakeven, recovery on the costs of the addition, and receives net benefit to cash flow and profits of $257,000 annually. The first year the impact is a net loss of $64,250. Starting with the 16th month the firm receives cash flow and profits gains of $257,000 per year.
What is the impact of a delayed start? For an April 1 start date the recruiter fees and pipeline are unchanged, but cash flow is three months less. At $64,250 per quarter, cash flow and profit for the year are now negative by $128,500. If starting July 1, losses increase to $192,750. Starting Oct. 1, no collections arrive and the bottom line is negative $250,000. For one salaried attorney working fully the day they start. No wonder the job market is difficult for lateral mobility of talented Type I attorneys, especially late in the fiscal year, even though they contribute significantly to profits relatively quickly.
This example illustrates the easiest type of lateral hire. Done properly, payback on hiring cost is relatively short and returns are good. If the firm requires a “capital” contribution from income partners of $20,000-$50,000, or goes to a “one tier” form of structure and converts income partners to equity with a $150,000 junior equity status (turning away from the PPP “derby”), the firm gets more flexibility as to timing hires, and the previous cash burden is actually converted to a significant cash boon to the law firm. The new lateral effectively pays all recruiter fees and fixed overhead for the pipeline period with his or her capital contribution. Only the salary/draw is covered by the law firm. If the partner is in a junior equity class with a 60 percent draw program, this cash flow from undistributed profits is even lower. This arrangement strengthens the firm’s financial condition with a larger profit pool and lower salary costs, unless the benefit is used for current year distributions to the upper levels of the equity partner class — an unwise policy.
The question then is: Does it make sense to make a lateral hire at this level? The answer depends on whether the hire can be put to full utilization immediately, and for a term of more than a year. If the answer is “yes,” the hire becomes a contributor of $257,000 of distributable partner profit annually. Assuming a 600-lawyer firm, with 150 equity and 150 income partners, and 300 associates, the income partners contribute $37.5 million to partner profits and increase profits per equity partner (PPP) by $250,000. That makes for a resounding “yes.” The contribution to the profit pool is 28 percent of their collections, after fully paying their own salary and overhead.
The Type II Lateral Addition
Let’s hire a partner with a $2 million business book. The partner’s hourly rate is $700 with 1,900 billable hours recorded. The partner records $1.33 million of work time, bills $1.22 million and collects $1.138 million. She bills time for lawyers working on her matters, collecting $862,000. She is allocated $600,000 of profits for that performance. Capital contribution is 40 percent of annual projected profit, or $240,000. Recruiter fee is 25 percent of draw (not projected total annual income). At 60 percent draw level, that is 25 percent of $360,000, or $90,000. Per capita overhead is $50,000 each for her and her associate, the recruiter fee on the associate is $50,000, so we have $240,000 cash costs. Pipeline cost of another $50,000 for the associate and for the partner, at a 60 percent draw rate on projected income of $600,000, (150 x .25 x .60) another distribution of $90,000, for a total of $140,000. Bottom line: The firm is out of pocket $380,000. Net contribution to profit is projected at 32 percent of collections, or $640,000 for a full year of contribution from this hire.
The partner is a net contributor to the profit pool of the partnership. She is putting “in” $640,000 and “taking out” $600,000. But the firm paid $380,000, or nine-and-a-half times the $40,000 margin, upfront. Who invests that much for that small a return?
The answer is nobody. The lateral partner contributed $240,000 in capital, used as the cash to facilitate the transaction. The firm used the capital contribution for recruiter and overhead costs. That leaves “pipeline” costs of $140,000. The firm has “only” advanced about three times the annual margin of $40,000. But wait, it isn’t all expense. $90,000 of the distribution is actually coming from the “profit pool,” and $50,000 is her associate overhead expense. Potentially problematic at a three-to-four-year payback since half of such hires fail in three to four years, but not a “no.”
If the firm “capitalizes” rather than expenses currently the recruiter fees of $140,000 for the two hires, cash flow is not improved, but “profit” is increased by $140,000 less first year amortization on that asset — which with five-year useful life assigned to it is $28,000. On the books the firm paid $28,000 for the recruiter fee in the first year. By capitalizing pipeline costs, along with the $240,000 overhead cost for the 90 days, less the $90,000 that is advances of profit share to the equity partner, $150,000 of otherwise reported expense is converted to an asset, amortized over five years, and the first-year cost is $30,000. Voila, the recognized cost is $58,000 in year one, and what appeared a sketchy decision given transactional costs and lengthy payback period is rationalized with “adjustments” to the balance sheet, impacting the income statement. Partner capital is received without being characterized as income (which is correct), fees are paid with cash from partner capital contributions, and the expense impact reducing earnings from recruiter fees and pipeline costs are recognized as to 20 percent because they were capitalized. The cash is gone, but the partnership “net profit” is not materially diminished by the hire. The expense remainder will be spread over the following four years. Impact on the income statement is close to neutral, but the firm has added $2 million in gross revenue “growth.” Apply this to Type I hires and they look really good!
Pause from the above, and examine this partner and her contribution from another perspective. She is producing $1.138 million of revenue on her own time. Her overhead allocation is $200,000 per year. That means she is netting out to the firm from her labor about $938,000. But she is being paid $600,000, thus she personally contributes net $338,000 to the profit pool from her own work for others to receive — plus profits from her client work done by others. What is really happening?
Fundamentally, from higher margins on higher billing and realization rates for partners, she delivers higher than average revenue per lawyer (RPL). Much higher. (If in our hypothetical firm average RPL is $800,000, at $1.138 million she is way above average RPL). The Type II partner is a ferocious contributor to the profit pool, generating distributable income to other partners from both her labor and profits earned from the associates working on her client matters. Her net contribution from her labor of $338,000, plus 32 percent margin ($275,000) on the work done by others, delivers $613,000 for others in the partnership to share. That is more than she is getting paid. The contribution to the pool is 30.6 percent of gross collections, after paying herself and her overhead. That is an attractive figure.
The question then is: Does it make sense to make a lateral hire at this level? If the book of business is there and the partners can deliver the working hours for themselves, the answer is a resounding “yes.” This class of partner is a substantial contributor to profits to the enterprise, sustaining themselves and delivering significant distributable cash to the equity partner profit pool. This raises some interesting questions, including who among the partners are receiving that surplus she creates.
For comparison, an associate at $350 per hour and 2,000 billable hours is producing $700,000 recorded time, but after firmwide average adjustments to prebills and realizations would generate about $600,000 in collections, well below the $800,000 RPL average. Subtract $200,000 for overhead, another $230,000 for their own salary and benefits, and the total is a contribution to profit of $170,000. But note that is the average — it doesn’t work that way for the firm.
The writeoffs for associate time in the first couple of years are more likely to be in the range of 20 percent or more. Some clients won’t pay for first- or second-year associate time at all. Heavier loads of pro bono work are pushed down on junior ranks but credited as “billable.” For a junior associate at $250 per hour, a solid 1,600 billed hours is probably pretty good. Adjust for realization and collections are closer to $375,000. Per capita overhead is the same, and thus with a net of $175,000, less salary and benefits, the firm is “investing” roughly $25,000 to $50,000 per year on each. That doesn’t include training programs, summer clerkships, etc. The tipping point is partially through the third year. Breakeven is a couple of years after that. The number of associates in years 4-8 is far fewer than the number in years 1-3. Margins climb sharply with seniority, and returns on associates at higher levels, strong rates, strong hours and good realizations percentages makes them strongly profitable. A more senior associate with billing rate of $400 per hour and 2,000 billable hours generates perhaps $220,000 profit for the firm. But there aren’t many of them. Given the flogging associates receive to bill hours, it may seem incredible that they don’t generate more profit, but with 20 percent annual attrition, too many never last long enough to overcome the sunk cost.
The Type II lateral is also more challenging the later in the year they arrive.
The Type III Lateral Addition
Let’s hire a “star” partner with a $10 million business book, $850 hourly rate and 1,700 billable hours. Assume lesser prebill adjustments of 5 percent on personal time, and realization on hours of 95 percent for 1,534 collected hours ($1.3 million). Profits allocation is $2.75 million, guaranteed. As a working partner she contributes $1.3 million from her labor, and with $220,000 overhead costs $2.95 million. She cannot pay her profit allocation from personal productivity. The firm must reallocate enterprise profit of $1.65 million collected from other lawyers. It derives from collective “surplus” contributions to profits over what they took out as workers, and in some cases from their client book. It takes several of them to do it. The aggregate profit from associates will not be enough to do it, so it must come from other partners.
The business book should contribute to profits a 32 percent margin ($3.2 million). Net of the lateral star’s share, one perspective is that the book of business brought by the star has paid for herself, and $450,000 is contributed to the pool. We have already seen, however, that may not be the correct way to view it.
Recruiter fees are $687,500 (there is no contingent profit return over the draw with a guarantee, so the $2.75 million is subject to the 25 percent fee. If the partner were on the 60 percent draw program then the fee could be reduced to $412,500). Her capital contribution is $1.1 million. The pipeline cost is roughly $1.7 million.
There are likely to be support partners. They may have business of their own. If they don’t, the recruitment fee could be discounted. If they have business, then the fee may be higher. It really depends on the firm, and the negotiated arrangement with the recruiter. Fees for these larger arrangements are flexible. Some firms pay a straight 25 percent on base salary for every lawyer in the group. Other firms request sliding scales, gradually diminishing to as little as 10 percent. Since the 2008 Great Recession, most recruiters on larger group transfers relocate associates for no fee. Assume one junior equity partner at $800,000 non-guaranteed with 60 percent program draw at $480,000 ($120,000 fees), two income partners each with $500,000 salary ($250,000 fees), and seven associates at no cost in fees (but definitely pipeline costs), and the rest of the work absorbed into the new firm’s capacity. That is total fees to the recruiter from the additional partners of $370,000, and with the star lateral a total of $1,057,500. The junior equity partner contributes $320,000 in capital, and to the extent income partners going to the firm are required to contribute capital from that class, there could be, at the rate of $50,000 for such partners, another $100,000 of capital contributed, for a total of $1.62 million.
The “package” is now $1.62 million cash “in,” recruiter fee of $1,057,500 “out,” and another $1.7 million pipeline ($893,000 is expense and $807,000 is equity partner “profit”), for cash outflow of $1.137 million. Capitalizing recruiter fees and pipeline costs of roughly $2 million with a five-year amortization period, the recognized cost is about $400,000, excluding equity partner draws against profits.
Now the “look” is not so bad. The capital contributions almost cover the expense cash flow, and only $400,000 or one-fifth of the $2 million in expense hits the income statement. The star lateral’s package is delivering $450,000 annualized to the profit pool after pipeline (about $337,000 if the start date is Jan. 1), so earnings reduction is only $113,000 the first year and $50,000 each of the ensuing four years, and the firm reports “growth” in gross revenues of $10 million. The amortization of the recruitment “asset” will shadow five years and consume most of the projected margin brought by the star lateral. Assuming they delivered all that was expected.
Cross check the above with seven associates at an average of $170,000 profit contribution and two income partners at $250,000 contribution each for $1.69 million. So, the only net contribution to the partnership profit pool arguably comes from the midlevel equity partner. This is a fragile construct to build such a shallow profit from.
The question then is: Does it make sense to make a lateral hire at this level? The firm is not going to net additional money for five years on the hire — if things work as planned. A shortfall in meeting expectations can cause deep shortfalls that must be taken from other partners in the firm. The star is bringing an already leveraged package, and paying herself from it. The “enterprise profit” from the new work is already being consumed. There is little to nothing left to share with the new firm. If there is a guarantee, little risk to her if she underperforms, but real risk to the firm, depending on the guarantee terms. The financial burden of a star that promises $10 million and delivers $7 million is very substantial, about a $1 million drop in profit. Flow that through the above example, and the firm underwrites $5 million of partner profits generated by others to plug the hole. And is taking $400,000 in book losses for five years on the amortization of the acquisition cost. Even if what is expected is delivered, after five years of no net contribution, the contribution to the partner pool is only 4.5 percent of gross collections from the star lateral partner’s group.
What does the addition do for the firm? One thing it potentially does is boost the PPP of the firm, as with two equity partners the average they bring is $1.775 million. But really that is misleading because of the wide spread in compensation of the two partners.
Are there “intangibles” of why the decision makes sense beyond the numbers? Not if what we are talking about are numbers. Besides, the “intangibles” are in fact calculated in the arrival at the numbers, so they cannot be used to argue distinctions. The fact is that every group that has bargaining power to extract every penny of what they bring, brings little or nothing for their new partners. Those that extract more than what they bring are a burden. With the heavy price of failure to fully meet expectations, half a dozen successful star lateral additions are easily undone by one or two modest failures.
A problem with larger star lateral groups, if they maintain their potential mobility, is when they leave there is a meaningful infrastructure that has continuing cost for a period of time. They basically park themselves within a partnership, pay a modest amount for the privilege of using firm space while keeping the income from their practice, and that is the best case. The tougher case is they actually take from the partner pool more than they give, and diminish distributable income earned by and contributed to the pool by others. Which others? All lateral and legacy partners in Type II. And that is a weakening thing for the firm.
So the answer is “maybe, sometimes, but a lot less often than one might think.”
Given a choice, you might want to think about having five of the Type II additions, and no “stars.” And everybody makes more money. Or pay less for Type III talent. •
Edwin B. Reeser is a business lawyer in Pasadena, Calif., specializing in structuring, negotiating and documenting complex real estate and business transactions for international and domestic corporations and individuals. He has served on the executive committees and as an office managing partner of firms ranging from 25 to over 800 lawyers in size. An archive of articles on law practice management is available for free download from www.jdsupra.com.