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El Rincón de Hildebrandt

1 de Febrero de 2008

Follow the Money, Blane R. Prescott

Blane R. Prescott


Hay pocos temas en los despachos de abogados que generan interés o debate, que forman la cultura de la empresa y su éxito a largo plazo y que influyen en el comportamiento de los socios, como Compensación. Y si muchos socios argumentarían que el sistema de compensación no es más que un pequeño componente de su empresa, a menudo es cierto que uno simplemente tiene que "seguir el dinero" para entender mejor las raíces del éxito o del fracaso en un bufete de abogados. El siguiente artículo analiza algunas de las cuestiones más fundamentales de la Compensación y se describen los cuatro sistemas más comunes a medida que se han desarrollado entre las empresas en los últimos cincuenta años.

(This article utilizes the terms “partner” and “partnership,” yet the underlying concepts are equally applicable to lawyers operating as shareholders in professional corporations.)

Before describing any systems and their virtues, it is first helpful to explore some of the fundamentals of partner compensation. This will help the reader to understand and evaluate their own compensation process, and any potential problems, before seeking a solution or a new system.

SEARCHING FOR THE PERFECT COMPENSATION PLAN
While the setting of partner compensation is often thought of in mechanical terms, and the process and mathematical results are given tremendous scrutiny, the real test of a compensation system is what happens after the process and results are announced. Because those results directly impact and involve human beings, a wild card element is introduced that is hard to predict. As so often happens when some measure of value is assigned to a human being and his/her performance, the results expose and test an individual’s feelings of self worth, their perceptions of acknowledged appreciation from others, and other highly sensitive human emotions such as ego, motivation, and greed. So no matter how well a compensation setting process may work once, and regardless of the effort to duplicate the process in later years, there is no assurance that the results will be as successful over time because of this human component. It is not surprising, therefore, that so many firms struggle with partner compensation. Almost all systems produce disappointing results at some time, so most firms are always on the lookout for ways to improve the process, to discover another system that is better or easier, or one which prompts fewer negative reactions among partners. The desire for a better system is therefore both natural and understandable, yet many firms would be well served to understand this simple rule of thumb: There is no such thing as a perfect partner compensation system, and just because the one being used occasionally fails, it may be closer to perfect than one might realize.

Another reason there is no such thing as the perfect compensation system is that the process (at least in any Subjective System) relies on strong leadership skills to implement. A system that is seemingly perfect in one firm can be a disaster in another firm of virtually identical size, practice, and composition, only because the leadership talent resident in the first firm is lacking in the second. While Subjective Systems are now the most common form of compensation in law firms today, they are not necessarily easy to implement. They require strong leaders who have the ability to communicate both constructive criticism and praise, who understand how to motivate and encourage a wide variety of partners, and who can resist the temporary pressures of peers in favor of the long term interests of the firm and its clients.

No Matter How Good The Plan, It Can’t Make Up for a Lack of Money. It has been said for a thousand years, in many different ways: You can’t get blood from a turnip. You can’t turn a sow’s ear into a silk purse. You can’t turn lead into gold. The modern equivalent among law firms is that if your firm isn’t earning enough money to carry its weight, no compensation system in the world will be able to divide those insufficient profits in a way that makes everyone happy (or alternatively, “equally unhappy,” which is the occasional result of even well functioning plans).

It’s the Results, Not the Process, Which Counts. Probably the most common misunderstanding about good compensation systems is that they are simply a mechanism for dividing the money, as opposed to being a management tool that motivates, incentives, rewards, and disciplines. If the only goal of a compensation system was to divide the money, then just about any competent accountant could devise a rough justice formula to recognize and reward the major factors that contribute to a firm’s success. But since the goal is not just to divide the money, but to manage the reactions afterwards, to elicit reactions which reward or change behaviors, a whole other realm of efforts are required beyond just the mechanics of division.

The Money Itself Never Sends the Intended Message By Itself—You Have To Explain It. One of the most difficult aspects of compensation is explaining decisions that will ultimately disappoint a partner. Ironically, this is a skill that few lawyers have when dealing with someone who is a peer, colleague, and friend. Yet, without those specific, honest, face-to-face conversations, the long-term goal of setting compensation is lost. As a result, some firms make the mistake of thinking that they can just announce numbers, and that a message will be correctly interpreted from the numbers. While such firms are correct that some kind of message will be perceived, it is rarely the message intended.

For example:
Intent:
A compensation committee is unhappy with the slowdown in a particular partner’s billable hours for the year, so they decide to reduce his compensation by $25,000 to send that intended message. They assume the money will send the message for them.

Result:
Without a specific explanation, the recipient is much more likely to receive a message along the following lines: “We, the greedy $%^*#’s on the Compensation Committee, don’t have a clue as to your true immense value, we don’t appreciate the depth and breadth of your contributions to the firm, and have therefore decided to keep the money for ourselves and/or reward other, less productive, partners.”

TEST OF A GOOD COMPENSATION PLAN
While there may be no such thing as the perfect compensation system, there are certain traits that most successful compensation systems share. Leaders can test their compensation system by answering the following questions:

  • Does the system reward all of the elements necessary to operate and maintain a healthy firm, or does it just reward a few, leaving holes in the fabric of the firm?
  • Does the system promote the most profitable work for the firm, or do individual partners have the latitude to act on their own, eroding the firm’s profits at the expense of others?
  • Does the system promote teamwork?
  • While there are undoubtedly examples of firms that operate best as sole practitioners, the overwhelming evidence indicates that most firms, regardless of practice, are more stable, more profitable, and enjoy a more satisfying practice when groups of people work closely together, using their collective strengths to offset any weaknesses.
  • Does the system offer a sense of predictability in total, year-end compensation?
  • Experience has shown that systems which offer no predictability, or in which compensation levels vary widely from year-to-year, create anxiety and internal competition in most firms, and ultimately erode the health of the firm.
  • Does the system provide for meaningful differences in compensation among partners?
  • One of the quickest and easiest ways to upset partners is to attempt to use small, inconsequential differences in compensation among partners to send messages, or to teach someone a lesson.
  • Does the system have the flexibility to account for and handle unexpected personal situations, which may impact an individual’s productivity?
  • Does the system encourage behavior that serves the best interests of the client?

Again, no system is perfect, and it would not be surprising if a good system were to fail on one or two of these points in any given year. It would not even be surprising if a system were to occasionally produce disappointing results for a highly valuable partner. But the real test of a great compensation system comes after looking at the results of the system over a two or three year period: Do the partners have a sense that they have been treated fairly? One of the most frequent comments from partners operating under a well functioning compensation system is that some years they feel overpaid, some years they feel underpaid, but that over time, they feel as though they are treated fairly.

THE EVOLUTION OF PARTNER COMPENSATION SYSTEMS
The four most common partner compensation systems generally reflect the experiences of law firms as they grow, evolving from sole practitioner operations into mid size or large operations, utilizing a compensation system that is ultimately reflective of their size and past compensation problems and experiences.

Hypothetical Situation:

Abe graduated from law school and decided to go into practice for himself. Practicing on his own, he enjoyed the fruits of his labor, even when those fruits were occasionally a little thinner than he had hoped. Abe did everything in his one-person law firm: He developed the clients, practiced law, prepared the bills, and divided the profits (admittedly an easy task as a sole practitioner, but a system whose clarity of purpose and process he would long for as his firm grew). And then Byron showed up. Byron was an old friend from law school; they had similar practices, they trusted one another, they were the same age, and so they decided to form a firm. Instead of dividing the profits of the firm by one, Abe would now simply divide by two.

PARITY FOR ONE AND FOR ALL
Not surprisingly, the simplicity of Abe’s sole practitioner approach to compensation is the basis for the first type of true, partner compensation to be discussed here: Parity Systems. Parity Systems are typically an outgrowth of two individuals choosing to practice together, and either out of a desire to avoid the issue of comparing performance and relative value, or on the naive assumption that an equal split will always be a fair division of profits, it is decided that the two partners will share and share alike.

While common in firms that are just starting out, Parity Systems are rarely seen in firms of more than a few lawyers, or in firms that are more than a few years old. The principal reason is that the system assumes everyone’s contribution is equal. And while such an assumption most often seems to be easily embraced by the lesser performing partner(s) of the firm, most other partners readily recognize differences in performance and contribution within a short period of time. Beyond the assumption that everyone’s contribution is equal, such systems have a more intrinsic flaw: They provide no real basis for individual merit, or an incentive to work harder. Yet, there are some basic advantages to such systems, in that among the right (or rare) group of people, they can foster tremendous loyalty, teamwork, and team spirit. But overall, Parity Systems generally work best in firms of less than two lawyers, and their success and effectiveness tends to decline rapidly with growth beyond that point.

Despite the lack of incentives and the obvious weaknesses, there are a few firms that embrace Parity Systems. Parity Systems tend to work well in firms with (i) extraordinarily high profits, (ii) firm that enjoy unusually high levels of trust among the partners and (iii) a common, and consistently achieved, work ethic.

LOCK STEP SYSTEMS: WHERE PARTNERS ARE ASSUMED TO AGE LIKE A FINE WINE

The birth of lockstep compensation systems coincided with the growth in law firms. For example:

Hypothetical Situation Part II:

Abe and Byron formed their partnership, and shared their profits equally. Because they made similar contributions to the firm, neither partner felt he was treated unfairly relative to the other. After three years of practice and a growing sense of success, Abe and Byron decided they need some help, and so they hired Carla. Carla had been practicing on her own for one year, and had a small practice. Abe and Byron hoped that by joining their firm, Carla would eventually develop and grow her practice. Since Abe and Byron had always shared the profits equally, they decide to continue that plan and share the profits equally with Carla. At the end of the first year, it was apparent that Abe and Byron were continuing to make an equal contribution. But Carla, while a valuable part of the firm, just didn’t have the same level of practice or clients. Both Abe and Byron noticed that, despite working just as hard as ever, and having more clients than in past years, they were earning less money than when they were on their own. So Abe began thinking, and ultimately decided that they needed a system that would be reflective of the seniority that both he and Byron brought to the firm’s operations.

As shown in the hypothetical situation, Lockstep Systems typically evolve from parity (or other) arrangements, in which it is decided to reward partners for their seniority, presumably to enable more senior, productive lawyers to earn more than the junior, less productive lawyers. True Lockstep Systems rely on a preset level of increasing compensation, usually annual adjustments upward of either a fixed dollar amount or other relative measure of the profit pool, until retirement. True Lockstep Systems do not allow for any other adjustments up or down, other than on the predefined path according to years of seniority. In some rare examples of Lockstep Systems, the structure actually anticipates lower productivity as one nears retirement, and reduces compensation accordingly in predefined steps.

Lockstep Systems, while not as rare as Parity Systems, are nonetheless increasingly scarce. There are some geographic regions in which they still have a foothold; London, New York, and San Francisco are three cities in which Lockstep Systems are still found. The reason for the gradual disappearance of Lockstep Systems is simple. In a true Lockstep System, there is no real individual merit incentive. One of the most common observations about Lockstep Systems is that such an arrangement can actually encourage a partner to retire but not notify the firm. After all, if the system continues to reward the individual no matter how long and how hard they work, or don’t work, then why retire?

Despite the decline in usage, there are some firms in which Lockstep Systems still flourish. Lockstep Systems tend to work best in:

  • Firms with a small number of partners, because as the number of partners grows, it is more likely that one or more partners will not work as hard as might be indicated by their seniority and compensation.
  • Small firms composed of partners who are roughly of the same age, because small groups of peers increase the likelihood of similar work ethic, cultural outlook, shared values, etc.
  • Firms with extraordinarily high profits, because as partner profits grow to high levels, partners can become much more tolerant of one another’s weaknesses or minor inequities in contribution.
  • Firms with a common work ethic, or,
  • Firms with an unusually strong, commonly held philosophy about compensation.

It is important to note that there are some firms using what they call a Lockstep System, but which allow management the discretion to move partners both up and down within the lockstep framework according to individual merit and performance. Such systems tend to be extremely successful, but are not true Lockstep Systems, and are described below under Subjective Systems.

Hypothetical Situation Part III:

Five more years went by, and the partnership of Abe, Byron, and Carla continued to grow. Their new lockstep system had cured the inequity between the junior partner and the more senior partners, at least temporarily. For the first two years, Abe and Byron earned a little more than Carla due to their seniority, which was appropriate given their greater contribution to the firm and its profits. At the end of year three, however, Carla noticed for the first time that she had brought in as much revenue as Byron. And by the end of year five, she had double the revenues of Byron, as did Abe. “Abe, this isn’t fair, we do all of the work, and Byron gets the benefits by virtue of his seniority. We need a new compensation system that takes into account our individual contributions, not just our seniority!” So Abe set to work once again, this time doodling with numbers, formulas, ratios. . .

OBJECTIVE/FORMULA SYSTEMS:

A FORMULA FOR FAIRNESS IS ELUSIVE
Objective or Formula Systems are often the result when firms are transitioning away from a Lockstep System, or some other system that is perceived to be unfair. Formula Systems are relatively simple: Purely objective data is gathered, and a mathematical formula is used to assess contributions and thereby determine partner compensation. There are hundreds of examples of such systems in use today. Two of the most common formulas are shown in the following examples. It is important to note that in each of the following examples, the formula produces a number for each partner, and each partner then receives a relative share of the firm’s profits according to how his number relates to the sum total.

Example One:
15% of the billings he/she originates but gives to others in the firm, plus 30% of his/her personal collections.

Example Two:
5% of the “value” of hours spent on firm approved or nonbillable projects, plus 10% of the annual collections resulting from clients he/she originates, plus 30% of the collections on work he/she personally performs.

The appeal of pure formula systems is relatively simple: By vesting compensation decisions in a formula, the biased human or arbitrary element is supposedly removed, and the results will thereby be totally “fair.” A secondary benefit is that a good formula is often sold on the basis of minimizing the management time “wasted” in making compensation decisions.

Yet, despite all of their attributes, pure formula systems are not gaining in popularity. On the contrary, firms have been turning away from pure formulas in droves for the last ten years. Why? Firms relying on formula compensation systems generally find that there are at least three significant challenges:

Challenge One: A formula must recognize and reward all of the factors necessary to maintain and successfully operate a firm, i.e., cross selling, training, personal productivity, collections, firm management, etc. Simple formulas tend to ignore or overlook the variety of such factors, often with the result that important and necessary elements (most often management and cross selling) are not rewarded, often with harmful results to the firm. More complex formulas often tend to overcompensate factors, which, while helpful to the firm, may not be as important as represented by the results.

Challenge Two: The formula must be flexible enough to take into consideration special circumstances. Common examples of special circumstances include health problems that temporarily remove partners from practice, or family problems that distract partners or reduce their productivity. If a formula is too strict, it can encourage an otherwise productive partner to look for a more secure work environment that won’t inflict a severe penalty for temporary reductions in productivity.

Challenge Three: Despite the perception that a formula is objective, many firms discover that over time partners modify their contributions to maximize their return from the formula, and in essence, manipulate the result.

Challenge Four: The use of a strict formula in setting partner compensation deprives the firm’s leadership of the most fundamental and important management tool – the ability to use compensation as both a carrot and a stick in altering behaviors.

Despite the challenges noted, some firms successfully use and prosper with formula systems. How do they do it?

First, some of the most famous formula systems are actually only guides to setting compensation, rather than true formulas. In these systems, a formula is used to create a beginning set of numbers, which are then massaged, manipulated, and sometimes mangled, to come up with more workable, acceptable, motivating figures. Second, true objective systems are often characterized by constant, frequently annual, adjustments to the formula itself. Because firms and people change, and the economy fluctuates, formulas must often be adjusted to reflect the changing needs and priorities of the firm. But the need for minor changes in a system is not a weakness in and of itself. Many of the best compensation systems periodically undergo minor improvements. Third, true objective systems tend to increasingly utilize subjective factors over time, often to the point that 50% or more of an individual’s compensation is determined on a purely subjective basis. Such a change is generally positive, and often creates one of the more successful forms of compensation, yet at the same time turns a formula system into a subjective one.

Where do formula systems work best?

  • In small firms. Most firms rarely grow beyond 15 lawyers using true formula systems. While there are a few, well known large firms that continue to formulas in some respect, such firms are the exceptions rather than the rule.
  • In profit centered operations, or space sharing arrangements, or in firms experiencing a lack of trust among the partners, or firms which are made up primarily of lateral hires with little or no history with one another.
  • In insurance defense practices, or firms that are primarily oriented to plaintiffs’ litigation.
  • In firms with highly diverse practices with little or no desire to cross sell.
  • In firms that are transitioning away from parity, lock step, or dictator systems.

SUBJECTIVE SYSTEMS
While this is a broad category covering numerous approaches, the common defining element is that systems in this category rely upon a subjective assessment of partner performance, without reference to a specific weighting of criteria or a formula. Subjective Systems are now the most commonly used approach to setting partner compensation. At the same time, Subjective Systems tend to be the most difficult and time consuming processes to implement.

Hypothetical Situation Part IV:

Abe was at wit’s end. His firm had continued to grow, and the process for setting compensation was becoming more time consuming. After abandoning the firm’s old lockstep system, Abe had developed a formula for fairly determining each partner’s compensation, yet the results were less than satisfying. The formula didn’t always make a majority of the partners happy. It occasionally produced the wrong incentives. And worst of all, the formula occasionally produced results that simply defied common sense. Each year he had responded by modifying the formula, adding new factors, or re-weighing old factors. Things finally got so bad that for the last two years he secretly “re-adjusted” the formula results, and oddly enough, virtually everyone was happy.

As noted above, Subjective Systems cover a broad spectrum of compensation approaches. Many firms that are searching for a new compensation system often overlook Subjective Systems on the incorrect assumption that such systems lack structure or predictability, or that they don’t consider objective financial data when setting individual partner compensation. On the contrary, virtually all successful Subjective Systems include these elements and more. Because the variations in such systems are so extensive, it isn’t possible to fully describe the most common systems. However, the following list discusses some of the most common elements which make up a subjective compensation system:

Prospective Versus Retrospective Systems. Subjective Systems can either set compensation at the beginning of the year (by assigning relative shares of the profits and applying the allocation as profits are earned), or await the end of year results before making major decisions and allocations of profits. Prospective approaches are more common than retrospective, although as described below, even most prospective approaches reserve some funds for final year-end allocation.

Who Sets Compensation? Since one of the defining elements of a Subjective System is that it does not rely on a formula, someone or some group must be charged with responsibility for determining allocation of profits. In the most successful systems, the function is generally performed by management, or a group composed of management plus others elected specifically for the purpose of setting compensation. Most firms that separate compensation authority from management authority ultimately find that they have two groups of management, one of which (that without compensation setting authority) exercises relatively little leadership or authority.

What Do We Reward? Most Subjective Systems have defined, in some form, the traits and characteristics which the system is designed to reward. While some firms write out elaborate criteria, the same function can be accomplished verbally by communication from the body setting compensation, either prior to their annual exercise, or through a broad discussion of goals after compensation levels are set. However, this should not include any group discussion of individual results, as this is one of the most divisive and destructive discussions in which a law firm can engage.

Reviews Objective Financial Data And Subjective Assessments. Healthy Subjective Systems always review financial performance data for the individual partners, and solicit/consider performance reviews of the partners in some capacity.

The System May Track Origination of Clients. The question as to whether a firm should track origination of clients or not is one of the most hotly debated and controversial topics in law firms. While the majority of firms do track origination data in some form, most experienced Compensation Committees readily acknowledge that such data is highly susceptible to manipulation, error, and abuse, and as a result, is often viewed as nothing more than a beginning point to investigate an individual partner’s rainmaking and retention abilities. Interestingly, firms that do not track any origination data tend to report far fewer problems with client hoarding, tend to be more teamwork oriented, and in general, have fewer problems in accurately rewarding their rainmakers. Upon hearing this latter option, firms/partners which track origination data often consider such a finding blasphemy. Yet the truth is, firms that don’t track origination data still consider the origination of clients as one of the most important factors in setting compensation, yet they just skip the troublesome process of tracking the data in a so called “fair and objective” form. Frankly, neither method is more right than the other, and the prospect for a firm to abandon the tracking of origination data is hardly worth the debate, as long as the compensation setting authority understands the weaknesses and errors which infect the data.

Use of a Compensation Structure. Probably the most critical factor in any successful subjective compensation system is the use of a predefined structure, within which partners are moved up and down to reflect their contribution and performance. Such structures vary widely in name, but are remarkably similar in implementation. One common example is a structure that ranges from 100 points to 500 points, in fifty point increments. Partners are assigned a given point level, and regardless of how many partners are at the same level, each receives the full number of points. Profits of the firm are then divided among the total number of points assigned to the partners, and distributed accordingly. Compensation decisions then focus on moving partners up, and down, within the point structure, often with maximum annual limitations as to the number of levels that can be moved in any one year.

Retrospective Bonus Pool. Most firms that utilize a prospective compensation system also reserve some portion of their profits for year-end allocation in a bonus fund. Such bonus funds typically have minimum awards, to help ensure that all such awards are meaningful, and to avoid the temptation of giving everyone a piece, which then becomes expected compensation over time.

Despite their popularity and success, Subjective Systems are not the answer for all firms. The critical element in making a Subjective System work is strong, trusted leadership, and without that one element, the system will generally fail. Hybrid systems that are a cross between an Objective and Subjective approach continue to be quite popular, and depending on the magnitude of the subjective element, such systems tend to have more of the traits of Subjective System.

SO WHAT’S A FIRM TO DO?
As noted at the beginning of this article, compensation systems have a profound influence on law firms, and are frequently one of the principal causes of a firm’s success or failure. Finding a compensation process that is right for a particular firm requires more than just an assessment of what works for other firms, it requires an assessment of the philosophies, resources, and capabilities of the partnership.



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