Building a Comp Plan That Works

Cotterman: The recent reversal differed in several respects from the one in the early 1990s. Back then, new-hire salaries rose sharply in a wave that started in New York City and moved westward, affecting secondary as well as primary legal markets. This time, the wave of rising salaries had a lesser impact on the secondary markets, and it went the other way: eastward from California's Silicon Valley. Another difference is that last time the layoffs primarily affected staff and associate positions. This time partners of many firms were affected as well.

The profession will likely spend the balance of this decade working out of the pay issues created by the starting salary increases of the late 1990s to early 2000 (much as they did during the 1990s, when the median starting salary for recent graduates in private law firms remained flat until 1998). In fact we are seeing that now: many law firms have held the line since 2000, or have made only modest annual adjustments or even skipped a year or two of adjustments and are just now making one for 2003. The same holds true with bonuses: they have been reduced (although they are still not insignificant sums of money).

A&FP: Historically, have compensation system differences between partnerships, S-corporations, and professional limited liability companies/partnerships (PLLCs/PLLPs) had much impact on how downturns affected law firms?

Cotterman (& Brennan): I'd say no impact on how a firm weathers a downturn, though my evidence would be more anecdotal than statistical.

What can be supported statistically ' Altman Weil's 2003 compensation systems survey will be coming out soon ' is that there aren't a lot of compensation differences between partnerships and professional corporations in terms of how the systems work. The differences that do exist deal primarily with the differing tax treatment that the firm and its owners are subject to under their form of organization. For example, professional corporations must pay out their profits by the end of the year or face a corporate tax on those earnings.

Bear in mind that twenty-plus years ago firm organization was driven by the tax law and pension considerations. If you wanted a good pension plan, you had to be a corporation, because the pension plans for unincorporated businesses were meager. This tax advantage of incorporation was eliminated early in the 1980s, when federal tax law changes roughly equalized the pension benefits available in incorporated and unincorporated businesses.

Despite the liability advantages of incorporation, some firms nevertheless retained their partnership organization, in part because they found it so hard to make profit distribution decisions at year's end. If a partnership at the end of the year says, 'We don't know how to divide the money but we'll get around to it next year,' that's no big deal; nothing happens just because that money is allowed to sit there. But if a professional corporation did that, they'd be writing a check for 36% of it to Uncle Sam and they'd never see that money again.

Note that S-corporations sidestep this end-of-year distribution dilemma, since their profits pass through and are then taxed like a partnership. Organizing as an S-corporation was originally an option mainly for smaller firms, but last more recently the size limit was raised from 35 to 75.

After the business events of the last 18 months or so, law partnerships are also revisiting the incorporation question with renewed concern for its original reason: liability exposure. If a partner I don't even know does some horrible thing on the other side of the country, I don't want to lose my house, my retirement savings and everything else. PLLCs and PLLPs provide improvements over the unlimited liability of a partnership, but each jurisdiction has its own nuances. Some Illinois firms, for example, have inquired about incorporating in Delaware due to its more generous protections. There are complex issues in setting up such arrangements, however.

A&FP: In several chapters you remark that firms often get into trouble through use of outdated 'rule-of-three' formulas for pricing the billable hours of their associates, or through miscalculating the profitability of contributions made by of-counsels or even by partners who perform sales or service work exclusively. Do these errors have a common source?

Cotterman: The problem with the 'rule of three' and similar rules of thumb is that they're not market focused. It'd be nice to think you could say that my practice ought to run on an economic model that says, 'I'm paying my associates X, and that same X will cover the overhead, and then a third X will be my profit. 'But the first two components aren't aligned any longer: the X that's the overhead isn't the X that is the salary, in many cases. And you certainly can't simply add all three together and tell clients that's what they should be paying for this particular individual's knowledge and skill and efficiency and everything else that they bring to the table.

A&FP: In the book you also mentioned a 'disaggregation' trend that was already differentiating compensation by specialty in, for example, the IT staff. You predicted the same pattern would increasingly affect lawyer compensation, first for associates and later for partners. Have you observed any further development of this trend? And speaking of trends, what's happening with billable hours?

Cotterman: A good compensation system is going to recognize that people contribute differently to the organization, and that different areas of the law have different pay markets. This is evident in our surveys of compensation by legal specialty. We're still early on, but the market is getting more attuned to paying people based on merit and market. For example, more firms are leaving the lockstep scale method of paying associates. After one or two years, they start to base pay on how productive you are, how much you've advanced in skills, how much you've developed your sense of being a lawyer and the economics of your area of practice.

That also ties in with the billable hours issue. Firms started to expect 2,200 to 2,400 billable hours a year when new associates started to expect $140,000/year salaries. But working that many hours a year is not the best way to produce a good lawyer. I've been working with firms to help them understand the consequences of their choices. Lawyers can decide to work 1,200 hours a year and have a life, or they can decide make half a million dollars a year. I can help them do either, but they can't do both.

Brennan: A common thread here is that firms commonly look for simple solutions, whether in choosing an organization type or in paying associates. But managing a law firm is complicated, and simple answers to complex problems generally do not work. We encounter the same issue in other areas such as profit distribution, integrating two firms after a merger, and even collecting receivables. For example, firms want a simple way to allocate origination credit, but then multiple lawyers claim credit for the same work.

A&FP: Speaking of origination credit, the book's example of one firm's almost humorously convoluted policy reminded me of a hall of mirrors. I wondered if they needed a consultant to help them interpret their own policy!

Cotterman: Yes, you really can get lost in it. In fact we've recently been helping clients overcome such confusion with a method based on a set of vignettes. We show them a fact situation for attorneys A, B and C and ask, 'How do you allocate compensation?' Then we twist it: same facts except for this one, how does that change your answer? After the partners respond individually to about eight pages of origination scenarios, we tabulate the results to see how close they are. Then we get them together to discuss where they agree and to let them work out their differences. This exercise first of all elicits from the firm a common vocabulary regarding 'origination.' Then it helps them come up with their own priorities and protocols, which they can apply as a decision tree. This gives them consistent guidance even when a scenario arises for which they don't have a ready solution. Often we help firms foster communication and understanding so that they can reach agreement among themselves as to what is 'fair.'

Joe Danowsky is the Editor-in-Chief of this newsletter.

On a recent visit to Altman Weil management consultants in Newtown Square, PA, I met with James D. Cotterman, a longtime contributor to (and just-retiring Editorial Board member of) this newsletter. Jim was the lead author and editor of both the 2nd and 3rd editions of the ABA-published book Compensation Plans for Law Firms. Regrettably I can't share with you Altman Weil's excellent hazelnut coffee, but I hope you'll enjoy the following condensed excerpts from our conversation about Jim's book. With Jim's concurrence, I've also prettied up my sketched notes on some compensation system and profitability interrelationships explained in the book; these flow diagrams appear on pages 2 and 5.

Joining the conversation was William F. Brennan, our newest Editorial Board member. A CPA and Certified Management Accountant (CMA), Bill is a past Vice Chair of Finance of the Law Practice Management Section of the American Bar Association and a past president of the Philadelphia chapter of the Association of Legal Administrators. His 20-plus years of experience with the legal profession began at Pricewaterhouse and have included administrative director and CFO positions at two AmLaw 200 law firms. Now a consultant at Altman Weil, Bill provides consulting services to law firms on merger integration, financial management and cost reduction.

A&FP: In introducing the 3rd edition of Compensation Plans for Law Firms two years ago, you remarked gently that the days of steeply rising starting salaries and spectacular sign-on bonuses for new associates could not last forever. Alas, not long after that law firms started canceling job offers and even laying off many of those associates. As you now plan the 4th edition, what are some of your thoughts on these employment fiascoes?

Cotterman: The recent reversal differed in several respects from the one in the early 1990s. Back then, new-hire salaries rose sharply in a wave that started in New York City and moved westward, affecting secondary as well as primary legal markets. This time, the wave of rising salaries had a lesser impact on the secondary markets, and it went the other way: eastward from California's Silicon Valley. Another difference is that last time the layoffs primarily affected staff and associate positions. This time partners of many firms were affected as well.

The profession will likely spend the balance of this decade working out of the pay issues created by the starting salary increases of the late 1990s to early 2000 (much as they did during the 1990s, when the median starting salary for recent graduates in private law firms remained flat until 1998). In fact we are seeing that now: many law firms have held the line since 2000, or have made only modest annual adjustments or even skipped a year or two of adjustments and are just now making one for 2003. The same holds true with bonuses: they have been reduced (although they are still not insignificant sums of money).

A&FP: Historically, have compensation system differences between partnerships, S-corporations, and professional limited liability companies/partnerships (PLLCs/PLLPs) had much impact on how downturns affected law firms?

Cotterman (& Brennan): I'd say no impact on how a firm weathers a downturn, though my evidence would be more anecdotal than statistical.

What can be supported statistically ' Altman Weil's 2003 compensation systems survey will be coming out soon ' is that there aren't a lot of compensation differences between partnerships and professional corporations in terms of how the systems work. The differences that do exist deal primarily with the differing tax treatment that the firm and its owners are subject to under their form of organization. For example, professional corporations must pay out their profits by the end of the year or face a corporate tax on those earnings.

Bear in mind that twenty-plus years ago firm organization was driven by the tax law and pension considerations. If you wanted a good pension plan, you had to be a corporation, because the pension plans for unincorporated businesses were meager. This tax advantage of incorporation was eliminated early in the 1980s, when federal tax law changes roughly equalized the pension benefits available in incorporated and unincorporated businesses.

Despite the liability advantages of incorporation, some firms nevertheless retained their partnership organization, in part because they found it so hard to make profit distribution decisions at year's end. If a partnership at the end of the year says, 'We don't know how to divide the money but we'll get around to it next year,' that's no big deal; nothing happens just because that money is allowed to sit there. But if a professional corporation did that, they'd be writing a check for 36% of it to Uncle Sam and they'd never see that money again.

Note that S-corporations sidestep this end-of-year distribution dilemma, since their profits pass through and are then taxed like a partnership. Organizing as an S-corporation was originally an option mainly for smaller firms, but last more recently the size limit was raised from 35 to 75.

After the business events of the last 18 months or so, law partnerships are also revisiting the incorporation question with renewed concern for its original reason: liability exposure. If a partner I don't even know does some horrible thing on the other side of the country, I don't want to lose my house, my retirement savings and everything else. PLLCs and PLLPs provide improvements over the unlimited liability of a partnership, but each jurisdiction has its own nuances. Some Illinois firms, for example, have inquired about incorporating in Delaware due to its more generous protections. There are complex issues in setting up such arrangements, however.

A&FP: In several chapters you remark that firms often get into trouble through use of outdated 'rule-of-three' formulas for pricing the billable hours of their associates, or through miscalculating the profitability of contributions made by of-counsels or even by partners who perform sales or service work exclusively. Do these errors have a common source?

Cotterman: The problem with the 'rule of three' and similar rules of thumb is that they're not market focused. It'd be nice to think you could say that my practice ought to run on an economic model that says, 'I'm paying my associates X, and that same X will cover the overhead, and then a third X will be my profit. 'But the first two components aren't aligned any longer: the X that's the overhead isn't the X that is the salary, in many cases. And you certainly can't simply add all three together and tell clients that's what they should be paying for this particular individual's knowledge and skill and efficiency and everything else that they bring to the table.

A&FP: In the book you also mentioned a 'disaggregation' trend that was already differentiating compensation by specialty in, for example, the IT staff. You predicted the same pattern would increasingly affect lawyer compensation, first for associates and later for partners. Have you observed any further development of this trend? And speaking of trends, what's happening with billable hours?

Cotterman: A good compensation system is going to recognize that people contribute differently to the organization, and that different areas of the law have different pay markets. This is evident in our surveys of compensation by legal specialty. We're still early on, but the market is getting more attuned to paying people based on merit and market. For example, more firms are leaving the lockstep scale method of paying associates. After one or two years, they start to base pay on how productive you are, how much you've advanced in skills, how much you've developed your sense of being a lawyer and the economics of your area of practice.

That also ties in with the billable hours issue. Firms started to expect 2,200 to 2,400 billable hours a year when new associates started to expect $140,000/year salaries. But working that many hours a year is not the best way to produce a good lawyer. I've been working with firms to help them understand the consequences of their choices. Lawyers can decide to work 1,200 hours a year and have a life, or they can decide make half a million dollars a year. I can help them do either, but they can't do both.

Brennan: A common thread here is that firms commonly look for simple solutions, whether in choosing an organization type or in paying associates. But managing a law firm is complicated, and simple answers to complex problems generally do not work. We encounter the same issue in other areas such as profit distribution, integrating two firms after a merger, and even collecting receivables. For example, firms want a simple way to allocate origination credit, but then multiple lawyers claim credit for the same work.

A&FP: Speaking of origination credit, the book's example of one firm's almost humorously convoluted policy reminded me of a hall of mirrors. I wondered if they needed a consultant to help them interpret their own policy!

Cotterman: Yes, you really can get lost in it. In fact we've recently been helping clients overcome such confusion with a method based on a set of vignettes. We show them a fact situation for attorneys A, B and C and ask, 'How do you allocate compensation?' Then we twist it: same facts except for this one, how does that change your answer? After the partners respond individually to about eight pages of origination scenarios, we tabulate the results to see how close they are. Then we get them together to discuss where they agree and to let them work out their differences. This exercise first of all elicits from the firm a common vocabulary regarding 'origination.' Then it helps them come up with their own priorities and protocols, which they can apply as a decision tree. This gives them consistent guidance even when a scenario arises for which they don't have a ready solution. Often we help firms foster communication and understanding so that they can reach agreement among themselves as to what is 'fair.'

Joe Danowsky is the Editor-in-Chief of this newsletter.