Wisconsin Lawyer
Vol. 85, No. 3, March 2012

• WebXtra Video: More from the author... Untying the Gordian Knot: Law Firm Compensation

In Greek legend, the Gordian knot was the name given to an intricate knot used by Gordius to secure his oxcart. Gordius, a poor peasant, was made king because an oracle informed the people that their future king would come to them in a wagon. In gratitude, Gordius dedicated his oxcart to Zeus, tying it up with a complicated knot. The oracle also foretold that he who untied the knot would rule all of Asia. In 333 BC, Alexander the Great arrived in Macedonia and confronted the legendary Gordian knot. After much struggling with the knot, Alexander became frustrated and called out, “What does it matter how I loose it?” With that, he drew his sword and in one powerful stroke, cut the knot. For many lawyers and law firms, such a bold decision to cut, rather than untie, their own Gordian knot of compensation issues may be appealing, but it would be short sighted. Effective compensation solutions require a more thoughtful approach.

How Compensation is Handled Affects a Firm’s Culture and Values

Compensation often is one of the most controversial topics in law firm management. This article reviews the most common compensation systems, how each of them rewards specific behavior patterns, and why effective compensation systems must be aligned with a law firm’s culture and values. Whether lawyers are forming a new firm or dealing with existing systems, they should be cautious with compensation decisions because simply improving short-term personal rewards may create negative and long-term damage to their law firm’s culture and values.

Understanding Effective Compensation Planning

There is no magical compensation system that will satisfy all partners, meet all strategic goals, and last forever. One easy approach is to increase the compensation of the most productive lawyers and decrease it for the least productive. This approach, however, requires agreement on the law firm’s definition of productive. Lawyers must believe they are compensated fairly for their contributions to the firm; however, this requires agreement on the firm’s definition of fairness. Compensation planning also requires that partners develop an understanding of the respective value of rainmakers, client minders, and hourly grinders. The most effective compensation systems reward different contributions to the firm’s overall success. If handled incorrectly, a law firm’s compensation system also can become a strategic liability, because inadequate compensation will have a negative effect on the firm’s ability to recruit and retain successful lawyers. In compensation planning, one size definitely does not fit all.

The Starting Point

When creating an effective compensation system, a firm must make certain basic decisions. Among these are the following:

1. Who, or what body, will make the compensation decisions?
2. Will compensation be set prospectively (that is, determined in advance of the year) or retrospectively (that is, determined when year-end results are known)?
3. If part of compensation is profit distribution, will the profit be what is left after overhead is paid or will the profit be what is left after salaries and draws are paid to partners in addition to their overhead contribution?
4. Will there be a class of nonequity partners that is not entitled to share in the final distribution of profits?

A firm also must measure and track certain data, such as personal productivity (hours billed multiplied by hourly rate), origination (how much business a specific lawyer brings in the door), and client management (the client relationships a lawyer is specifically accountable for). Also consider other intangibles like pro bono hours and involvement in firm management, mentor programs, and committee service.

Different Ways to Split a Dollar

Law firm compensation systems generally fall into five basic categories.¹

Equal partnership. Smaller firms often use this system. Because all partners basically share in profits equally, the paramount financial concern is firm profitability. Individual performance is much less important than how well the firm does as a whole. This approach allows for individuals to have positive years and down years, as long as overall the firm does well. Usually, performance is averaged over three to five years, as opposed to limiting compensation measurement to a single year’s results.

The major problem with equal-partnership systems is a lack of incentives. There is no financial reason or reward for an individual partner to push beyond “normal” partner performance levels. There usually is little individual financial difference between the partner who works 12-hour days and the partner who plays golf twice a week. There is no perceived or real value in working harder. Therefore, partners who are more profitable, put in more hours, bring in more clients, or make valuable nonbillable efforts often leave to join firms that better appreciate and financially reward their efforts. In an equal-partnership firm, eventually only the low-performing partners remain, profitability declines, and the law firm dissolves.

Modified Hale and Dorr (incentive system). In the 1940s, the Boston law firm Hale and Dorr created one of the first incentive-based compensation systems. The firm created three categories in which a partner could earn income: “Finder” (originator of the client), “Minder” (responsible for the client), and “Grinder” (the partner actually doing the work). As an example, 10 percent of receipts go to the Finder, 20 percent to the Minders, and 60 percent to the Grinders. The remaining 10 percent of receipts go to a discretionary bonus pool, which is allocated year end to the partners who have shown exceptional performance.

The allocation percentages can be adjusted annually to address issues that the firm determines are the most important for the coming year. For example, a firm may choose to lower the Finders’ percentage if plenty of work is coming in, and increase the Minders’ and Grinders’ percentages so people will focus on getting the work done. If the focus needs to shift the following year, the percentages can be adjusted to influence performance in those areas. The fundamental assumption is that if everyone is individually motivated by the compensation system, the firm as a whole will do fine. Partners know exactly what they have to do if they wish to increase their income. Many partners prefer such a system because it allows them to become the masters of their own financial destiny.

A problem with this system is that no rewards are built in for nonbillable time. If all the partners would equally share all the nonbillable activities required in a professional service firm, then there would be no problem. However, the reality is that firm management, training or mentoring of newer lawyers, practice-group leadership, and recruiting or committee work are not shared equally. There is little motivation to use time for these important aspects of running a profitable firm.

Simple credit/unit system. The simple credit/unit formula rewards all activities (including individual production, client generation, and nonbillable activities) and seniority by using a totally objective calculation. For example, a typical formula might award each partner one credit for each year of service to the firm, one credit for certain levels of individual production (fees billed or fees received), and one credit for each client generated. The total available amount of nonbillable credits is three times the number of partners. The available nonbillable credits are allocated pro rata for nonbillable time recorded. When all credits have been allocated, they are converted to percentages and applied to the firm’s profit for the fiscal year to create each partner’s individual income. Because production is at the heart of this system, partners who may under-produce will have lower rewards. Partners know exactly what they have to do to earn the income that they desire and they know how all factors are weighted.

50/50 subjective-objective. The 50/50 subjective-objective system recognizes that both types of criteria are valuable to the firm as a whole. On the objective side of this system, 40 percent of a partner’s income is based on actual billings and 10 percent is based on client generation. On the subjective side, 10 percent of partner income is based on a partner’s client-development abilities and 40 percent is based on nonbillable activities (such as firm management, training, mentoring, and firm marketing). The subjective reward is based on the collective perception of all the partners at the firm. Therefore, a low subjective reward can send a message to partners who are not perceived as positive contributors to the firm (even though they may have very good objective numbers) to improve their subjective contribution in order to improve their compensation.

Eat what you kill. This system solely rewards individual efforts, with no recognition for anything beyond personal production. This type of system may charge each partner a share of firm overhead, but each partner also will pay the salary of his or her assistant. Marketing, continuing education, personal technology, and membership costs are the financial responsibility of the individual partner. Junior partner and associate time is purchased from the firm at set rates, but charged out to clients at whatever billing rate the partner thinks is appropriate. After having paid all his or her costs, the partner gets to keep 100 percent of the remaining receipts. Every partner has total responsibility for his or her income and clients. Partners know exactly what they must do to achieve the income levels they desire. The system creates an incentive for hiring and retaining only profitable, hard-working junior lawyers. It also creates a strong motivation for partners to collect their receivables, because it is their own money. The firm itself will maintain tight controls on spending, because partners will not tolerate a large overhead allocation.

Unfortunately, under this system no one gets recognition for nonbillable time spent, which often creates a void when it comes to firm management, training, marketing, and human resources activities. It also does not foster collegiality or team building – other than as methods to market other partners to work for one’s clients. When uber competitiveness spreads throughout the firm, it creates a very difficult environment for most staff, including newer lawyers and even some partners. In addition, some firms using this system have problems with lawyers hoarding files and clients – sometimes even to the detriment of clients.

The Importance of Alignment

Jay Lorsch and Tom Tierney reviewed the compensation systems of professional service firms, including top-performing law firms, in their book “Aligning the Stars.”² They found that the most significant component of a positive (as compared to negative) compensation system is alignment of rewards with the firm’s goals. In other words, the behaviors and performance that the compensation system encourages, and therefore rewards, should represent the type of behaviors the firm wants. In addition, the dynamics of a competitive marketplace and the firm’s evolving goals will generate new demands and priorities for the compensation system. A law firm’s short-term response to any of these factors can easily throw the compensation system out of alignment with long-term goals and send conflicting messages about what the firm values.

Lorsch and Tierney found that effective compensation systems among the most successful firms shared the following common factors:

1. Partners trust both the process and the decision makers within the process. This trust is most often accomplished by having a great deal of transparency to whatever system is used.
2. Effective compensation systems encourage and reward a long view and focus on the firm’s strategic goals. Whether lawyers are partners or equity owners, their shared focus is to maintain the sustainability of the firm.
3. Successful firms are both explicit and inventive about the methods they use to evaluate and reward both performance and compensation. The leadership at these firms understands that measuring only a partner’s economic contribution may not measure a partner’s real value to the firm. Although it is easy to measure objective hard data (such as billable hours and receipts), it is hard to measure subjective soft data (such as client development and firm management). The most effective compensation systems track both.

The Importance of Culture

In his landmark work, “Managing the Professional Service Firm,” David Maister outlines the fundamentals of success for successful professional service firms, including law firms. Maister refers to this model of success as being a “one-firm firm.”³ The one-firm firm approach centers around management practices consciously chosen to maximize the trust and loyalty that members of the firm feel both to the firm and to each other. These become a set of reciprocal, value-based expectations. Everyone knows the values they must live by and the code of behavior they must follow. Compensation systems encourage intra-firm cooperation.

The most successful firms set compensation through a judgmental process, assessing the individual’s total contribution to the firm. The compensation system reflects and supports a culture of shared beliefs about the goals and values that are important to the firm and the behaviors necessary to attain those goals. This is especially important in law firms, because lawyers value personal autonomy and personal discretion. A law firm’s dominant cultural values will have more influence on the behavior of the firm’s partners than any policy or mandate from management. Therefore, the key to the successful functioning of this kind of system is agreement on values. This is because a successful compensation system requires trust: the members must believe that the compensation decisions are made by colleagues who have the firm’s best interest as their only agenda.

The Importance of Values

Effective compensation systems will reward behaviors that support the values of the law firm. Every law firm should define the values that illustrate its culture. As a starting point, ask “What does it mean to be a member of our firm?” “What activities demonstrate our values?” One answer might be, “Every lawyer is expected to devote full time to the business of the firm, full time being defined as billing X hours.” Another answer might recognize the value of nonbillable hours: “Activities such as client development, firm management, and training and mentoring will be valued within our compensation system.” Such a statement, however, does not mean every lawyer can do whatever he or she wants. Rewarding public service as a value does not mean the firm can allow lawyers to spend a majority of their time lobbying for a nonprofit public interest group. Rewarding service to the profession does not mean partners spending half their time in bar association committee meetings. Any compensation system that values nonbillable activities will require some level of management approval for these activities. This means that time spent effectively on managerial tasks also must be recognized and rewarded.

Understand What is Broken Before Trying to Fix It

Lawyers should always be aware of the need to modify compensation systems to reflect changing circumstances within and outside their law firm. Before exploring change, law firms should try to understand what partners do and do not want in a compensation system. 

• Does the current compensation system address current needs and priorities?
• Have partners accepted the firm’s compensation system, and is the system accomplishing its objectives?
• Has the firm set reasonable objectives, targets, and quotas of acceptable performance for partners?
• Are partners being compensated directly for fee-generating activities, in terms of dollars and hours produced? That is, are partners paid the fees they generate (“eat what you kill”) and not as part of a firm-wide compensation system?
• Are nonfee-generating activities such as firm management, marketing, training and supervision of associates, and development of management or practice areas being considered as well?
• Does the law firm have an effective policy to deal with partners whose performance is below par?
• Does the compensation system provide adequate incentives and rewards for associates who originate business from existing and new clients?
• Does the compensation system reward lawyers who take on managerial duties, participate in executive or administrative committees, or lead a practice team?

 A Need for Action

Current economic conditions require adjustments to compensation systems at many law firms. Successful law firms begin the process of updating and modifying their compensation plans by defining their values and creating a strategic plan of the goals each lawyer expects to achieve. While a simple objective compensation system based on a partner’s personal productivity may be easier to manage, it may not necessarily reward the desired behaviors or help the firm achieve its strategic goals. On the other hand, a subjective system requiring personal judgments may be perceived by some as being too unpredictable and even unfair. Often, the compensation planning process begins with an objective foundation but adds subjective factors that measure more intangible activities. The balance between objective and subjective factors depends on the unique culture, values, and behaviors the specific firm wants to reward.

Untie Your Gordian Knot

Creating effective compensation systems requires lawyers and law firms to assess many variables and align these with desired values and behavior patterns. When specific circumstances require corrective action to compensation systems, thoughtful analysis and planning is better than bold quick decisions.

Endnotes

¹Michael J. Anderson, Partner Compensation: Systems Used in Professional Service Firms (Edge International, 2001).

²Jay W. Lorsch & Thomas J. Tierney, Aligning the Stars: How to Succeed When Professionals Drive Results (Harvard Business School Press, 2002).

³David H. Maister, Managing the Professional Service Firm (Free Press Paperbacks, 1993).

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