During recent consulting assignments, managing partners of several law firms of all sizes have expressed their frustration with the fact that every year the total cash compensation paid to non-equity partners — those longer-tenured attorneys on track to become equity partners and those attorneys the firm is desirous of retaining but who do not satisfy all of the objective and subjective criteria to become equity partners at the present time — continues to increase, yet the latter’s productivity and contributions to revenue remain about the same.
To quote one managing partner, “At what point should the salaries paid to the more highly paid non-equity partners ‘cap out’ and reach a ceiling above which significant raises will not be awarded each year, except for perhaps modest cost-of-living increments?”
Cash compensation package
The cash compensation package offered to non-equity partners is usually comprised of four components:
1. A base salary that generally follows a standard progression or, more usually, is based on merit. Those non-equity partners who continue on to equity partner receive the expected benefits of growing income of those with full equity status. Those who stay as permanent non-equity partners will have their income limited by the actual economics of the contributions they make to the firm.
2. A bonus that is generally awarded because the firm has enjoyed an average or better-than-average year or because of outstanding performance based upon legal merit, contributions to firm revenue, firm economics and the origination of new business.
3. A profit-sharing plan based upon the firm’s success.
4. A reasonably comprehensive benefits program.
The above four components are also influenced by external competitive factors that are beyond the control of the firm, i.e., what other local firms within the city where the office is located pay; what out-of-state firms with local offices pay; what is required to be competitive for non-equity partners at various levels by premier “national” firms, second-tier national firms and premier regional firms, second-tier regional firms and premier local firms, and standard local firms.
It has been my experience that managing partners in law firms of all sizes are reassessing their current methodologies for compensating non-equity partners in an effort to develop creative strategies that make sense to the firm and the latter.
The objectives of their assessment are to compensate the non-equity partners for their daily efforts and reward their significant contributions to the firm’s revenue, profitability and environment in a way that is perceived as being fair to the firm and the non-equity partners; to compensate non-equity partners in a manner that is competitive within the firm’s market; to encourage non-equity partners, by incentives, to share in their added value to the firm as they become more experienced; and use such experience productively and to satisfy the needs of the firm as it exists today and looking forward to tomorrow.
Non-equity partners’ salaries are generally based on a baseline of a predetermined billable hours multiplied by their general billing rates, plus an estimated overhead factor and incentives. The bonus threshold is generally based upon their billings and collections.
Below is a list of the criteria considered by partners in most firms when allocating salary increases and bonuses to the non-equity partners:
• Contributions to firm profitability (their own billing, leverage, rates, collections, origination, synergies);
• Billable hours;
• Generation of new business;
• Generation of business from existing clients;
• Enhancing the image of the firm and themselves;
• Contributions toward a positive and collegial firm culture;
• Leadership and mentoring development;
• Community and pro bono activities; and
• Professional development and accomplishments.
One managing partner said her firm pays a separate 20 percent “commission” on the work non-equity partners originate and asked whether the firm is entitled to earn a profit off the work the latter does.
Applying a Profit Factor
The above criteria for determining salaries and bonuses for non-equity partners may appear to be sound. Also, it is not unusual for firms to pay to non-equity partners a commission for work they generate. However, in my opinion, what is missing from this list of criteria is a bottom-line philosophy that the equity partners are entitled to earn a profit for the work performed by others and the risks inherent in owning and managing a law firm.
I believe it is reasonable for the equity partners to expect to earn 25 to 30 percent or more profit margin on work provided to the non-equity partners.
So, however the salary and bonus structures are created, it is important to make sure that a profit-margin opportunity is not totally given away by virtue of the salary and bonus calculations that overemphasize billable hours and billings rather than collections.
Setting the non-equity partner’s base salary is key to making this system work. Certainly, a part of base salary is market-driven. But consideration should also be given to firm overhead and profit margins.
One way to test this is to assume a baseline of 1,850 hours at current billing rates. Add to that amount benefits and payroll tax. Finally, add a share of firm overhead. Compare that cost to the anticipated revenue at 1,850 hours. If there is not a 25 to 30 percent or more profit margin, there are issues that must be considered.
Is the 1,850 expectation too low? Are rates set too low? Is overhead too high? Or is base compensation and benefits simply too rich given the current circumstances?
If the work performed by the non-equity partner was originated by that attorney, it is reasonable that some portion of the fee generated be paid as a commission for originating that work. Originating the work and doing the work yourself is a common scenario. It is not unusual to see firms pay a 10 to 15 percent commission for that work.
If the work is originated by the non-equity partner but handled by someone else, the commission is often equal to the 10 to 15 percent, or slightly lower.
If the work is originated by the non-equity partner but billed and handled by someone else, the commission should be lower (approximately half the normal commission or less).
All of these origination commissions should be built upon the expectation that the work is billed and collected at reasonable rates. There is little justification for paying for origination for work that is not profitable.
I was not as concerned as the managing partner about paying a commission to the non-equity partners for generating work, even though that percentage is higher than I would have recommended. If the work is profitable, paying such commissions is simply a way to share the profits generated by this work. The key will be to determine that the firm is in fact receiving a profit on the non-equity partners’ production in the first instance in a range of 25 to 30 percent.
A managing partner should first determine the amount of overhead to be allocated to the non-equity partner and then compare fees billed for each non-equity partner versus their direct cost (salary, benefits and payroll taxes), plus overhead. Fees billed should be approximately 25 to 30 percent greater than the allocable cost for each non-equity partner. If not, possible adjustments should be discussed and changes considered.
The managing partner should use a bonus system to reward production and to reward business origination, along the lines discussed above.
The result after applying both calculations should be a sharing of profit generated in Step 1. I recommend basing the origination bonus on actual fees collected and not fees billed, because it is difficult to rationalize a commission system based on amounts other than what actually gets collected.
By incorporating the recommended profit factor into the mix when determining the salaries and bonuses of non-equity partners, the equity partners are able to relate the compensation of the non-equity partners to their contributions to productivity and firm revenue.
Joel A. Rose is a certified management consultant and president of Joel A. Rose & Associates in Cherry Hill, N.J., which consults to the legal profession.