It’s Time to Pay: Revenue Versus Profit-Based Compensation
Robert Rifkin, CPA, MBA
Every law firm uses a formula to compute a partner’s compensation. The two formulas used by most law firms is either based on a partner’s billable revenues or the profits that each partner contributes to the firm’s bottom line. To achieve your firm’s long-term goals, this article focuses on why a profit-based system may be a better and more effective option for you.
Why Not Revenue?
Focusing on revenue can present a distorted picture of a partner’s contributions. For example, Partner A generates $700,000 in billable revenues, performing all the work himself, while Partner B generates only $550,000 in revenues at the same hourly rate, but also supervises four associates who each bill 2,050 hours. Partner B clearly brings more profits to the firm, even though they personally generate less revenue. In this scenario, a revenue-based compensation scheme would reward Partner A more.
In addition, focusing on revenue fails to account for the impact of overhead and collections. The partner who generates staggering billable hours, but incurs a significant chunk of overhead, may be less profitable than one who bills fewer hours. Billed hours have no value to the firm if they are not collected — all they have done is increase overhead.
Finally, revenue-based compensation can encourage a partner to focus on billables to the exclusion of other activities that support the firm’s strategic goals. For example, if the firm wants to build from within, partners must spend time training and mentoring associates. However, partners might be unwilling to do so if it eats into their billable time and compensation. If compensation instead recognizes contributions to profitability, then partners are more likely to sacrifice their own billable hours for the purposes of supervising a team of associates.
How Can You Incorporate Profits?
You have decided to choose a profitability model for partner pay. Now what? Generally, profit-based measures can be incorporated into the most common compensation systems. For example:
A firm’s compensation plan may distribute net profits based on a simple or weighted formula. A simple formula might account for originating work and producing work on a 1-1 ratio, while a weighted formula assigns increased weight to the most important elements, ideally according to the firm’s strategic goals. Firms with these types of formulas can increase the weight for elements associated with profitability.
In order to incorporate profitability under the lockstep approach, require partners to first satisfy specific profit-based metrics, rather than advancing them to the next level based on the number of years they have been partner (the lockstep approach is an older system that is based on a partner’s seniority, not ability).
- Percentages or Units of Participation
Many firms pay partners a share of the net profits by assigning each a percentage or units of participation. The primary difference is that the total percentage must equal 100, while the total units of participation can exceed 100. Consider more than just ownership interests, seniority and billables when assigning a percentage or units of participation to each partner. Profit-based metrics can play a role in the assignment by taking into account consequential non-billable time, accounts receivable aging and write-offs.
- Reserve Systems
Some firms use percentage or units of participation plans that include a reserve portion of net profit (usually 5% to 10%) based on the firm’s performance that year. Such firms can take a profit-based approach by allocating the reserve based on realizations versus collections, work in progress, and business from new and existing clients.
But Wait, There’s More
While profits may seem like the most important factor to many law firms, do not forget that management, administration and planning keep the lights on. It is important to remember to include these contributions when deciding on your firm’s compensation plan.
Four Financial Threats to Your Firm’s Long-Term Success
Thomas F. Vance, JD, LLM
With the economy on the upswing, many firms are feeling flush, but current success may mask hidden financial danger. Do not let the economic upswing mask hidden threats to your firm’s longevity. Four financial threats in particular could jeopardize your firm’s financial future:
- Excessive Long-Term Debt
It is not unusual for firms to make investments in areas like technology and expanding office space. However, if the investment leads to excessive borrowing, the financing leads to higher fixed costs. If debt undermines the bottom line, it may be a challenge for the firm to cover expenses or reward talent. Furthermore, if your firm’s long-term debt exceeds its assets and cash on hand, then you have borrowed against future partner earnings. This can lead to long-term financial constraints that limit the firm’s ability to bring in new talent and may even prompt valued partners to start looking to the exits.
- strong>Unfunded Retirement Obligations
Established firms are often plagued by unfunded retirement obligations dating back years. These plans divert profits away from current partners. If more than 1% or 2% of your current revenues are flowing to inactive partners, these payments are likely causing undue cash flow constraints. Well-structured retirement payments can play a key role in succession planning. However, unless they are thoughtfully constructed, these obligations can negatively impact partner retention.
- Unwarranted Compensation Guarantees
Many firms offer large, guaranteed salaries to lateral hires, typically to those regarded as rainmakers. However, the urge to expand should not overshadow the need for every attorney to meet performance metrics. Firms painstakingly develop the incentive structure in their compensation schemes—guarantees can undermine this effort. A firm is often rewarded for discovering talent and providing space for that talent to grow. However, the guarantees cannot undermine the expected return on investment. The firm and the lateral hire should have a clear understanding of how the firm will get a return on its investment. Guaranteed salaries eat into profitability and can potentially breed resentment among colleagues. This can push existing talent to seek a similar deal somewhere else.
- Injudicious Expansion
For law firms, growth is frequently seen as the ultimate hallmark of success. In fact, some firms seem to expand only for expansion’s sake. However, not all expansion is healthy and expansion without a strategy has financial repercussions. New offices may seem great, but they must generate enough additional revenue to justify its cost. Additionally, acquisitions and mergers require investments to integrate separate firm systems and cultures. It is unknown if the combined firm can produce enough synergy to justify the expense. Expansion will always require additional investment in the short term. It is essential that the expansion is underwritten by a reasonable plan to realize a return on investment. Otherwise, expansion only reduces profits and may increase debts. This may leave your firm without the financial agility it may need to capitalize on unexpected opportunities.
Knowledge is Half the Battle
Threat awareness is the first step in securing your firm’s future. Once the threats to your firm are identified, your financial advisors can help you develop a strategy to avoid or overcome them.