Corner Office: Uses and Abuses of the Two-Tier Partnership

Once upon a time, becoming a partner in a law firm meant you became an owner of the business and shared in the profits with the other equity partners. The typical career path for associates joining a firm out of law school was to work hard for about seven years, at which time you would either be admitted to the partnership or be asked to leave the firm.

This so-called up-or-out practice became increasingly difficult for firms to continue due to the explosive growth in demand for legal services. Throwing out seven-year associates, who the firm was not entirely sure were ready to be partners, but who had developed valuable practice skills and experience serving clients, no longer seemed like a good idea.

So by the late 1990s, many law firms adopted a practice that significantly changed the original partnership paradigm. They created a new position, called nonequity, income, or contract partner, into which associates who were not admitted as equity partners could be placed. In effect, they created a two-tier partnership. This permitted them to retain associates longer, with the prospect that equity partnership might still be in their futures. But it was seldom made clear just how far into their futures.

What Is a Two-Tier Partnership?

Simply, it's a partnership composed of two classes of partners. The equity partners have an equity interest in the firm and its assets, they contribute capital, are responsible for its liabilities, share in its profits and are responsible for its losses.

Nonequity partners are classified and held out to the public as partners. But they have no interest in the firm's assets, put in no capital, are not responsible for its liabilities, and do not share in its losses. Their compensation is fixed annually, they can earn bonuses, and when profits are particularly good, some firms permit them to share in excess profits.

According to the 2006 The American Lawyer's AmLaw 100 survey, 80 of the 100 firms were two-tier partnerships.

Converging Forces

Many forces converged to give rise to the use of the two-tier partnership. Client demands forced firms to increase their capacity to deliver services. At the same time, increased competition among firms, together with clients becoming smarter buyers, forced firms to focus on improving their efficiency and productivity. Since associates became most productive between their fifth and seventh years, it no longer made sense to have them leave the firm in their seventh year, just because they were not clear candidates for partnership ' not to mention that the firm was earning significant profits on their efforts.

Firms began to find it increasingly difficult to determine in so short a time-frame whether a candidate had all the qualities to function as an equity partner in what had become a much more challenging and competitive legal marketplace. So firms stretched the normal partnership track from seven years to nine, ten and more.

Firms also started to reexamine the role and functions of an equity partner, and came to realize that some of their existing equity partners, examined in the more critical light of a more competitive marketplace, did not have the entrepreneurial qualities that had been taken for granted at the time they were admitted. They were good lawyers, but had not developed the entrepreneurial skills required of the owners of today's professional services firms.

At the same time, new associates coming out of law school began to exude an attitude that becoming a partner may not be all it was cracked-up-to-be. Based upon their own observation of the intensive pressure on partners, and extensive hours they saw them working, they began to doubt their willingness to put in the effort to be a partner. Yet they wished to practice law at a high level ' but at a pace that provided a different lifestyle.

In addition, as firms struggled to increase their core skills and expand their practices to become full-service firms in an effort to meet what they perceived to be client needs, they also became enamored with the idea of expanding into regional and international firms. To accomplish this, many sought lateral acquisitions of senior associates from other firms, as well as lateral partners and groups from other firms.

Flexibility of the New Paradigm

The nonequity partner category of the two-tier partnership provided a new position that could accommodate all of these situations, and more. In this capacity, associates could spend the time to develop marketing and entrepreneurship skills. Good lawyers who would never become equity partners could settle in to a new career path. Existing non-entrepreneurial partners could become a resource and be relieved of the pressure to bring in new business. Lifestyle associates could fill the need for additional resources. Senior associates brought in laterally could be evaluated to see if they had the qualities for equity partner. Lateral partners and groups could be observed from within the firm to determine whether they could mesh into the firm's culture. And it could also be used to accommodate senior partners who wanted to continue working beyond retirement. So, many firms rethought the old partnership paradigm, and concluded that the two-tier partnership was the new paradigm for today's world.

The Relevance of Profitability

Like it or not, today, profitability is the yardstick by which law firms are measured. While the internal operations and finances of law partnerships were once well-kept secrets, Steven Brill, when he ran The American Lawyer, poked his head under the tent and managed to lift the veil of secrecy. He created a transparency in reporting the operations of law firms, which today has made profitability a key factor in the perception of a law firm's success.

Just as free agency has inexorably changed professional baseball ' where players once spent the better part of their careers with one team ' today, players with no team-allegiance move from team to team in pursuit of the best compensation package. So too, equity partners in law firms have become subject to equivalent pressures. The arrival of merit-based compensation has made maintaining high profitability a major responsibility of managing partners. They must ensure that partners feel that their earnings are comparable to those of their peers at peer firms.

Because many equity partners would have little difficulty boosting their compensation by moving to another firm, managing partners must focus on retaining their talented partners. This requires that they:

• Keep profits high enough so that partners do not feel they are making a financial sacrifice to spend their careers with the firm;
• Position the firm for steady growth and keep it in a leadership position,
• Provide the resources for partners to fulfill their professional potential; and
• Maintain an atmosphere of collegiality that makes staying with the firm more attractive than seeking more money in an environment that may not be as nurturing and cordial.

Maintaining profitability is also necessary to make the firm attractive to laterals, and to project success for recruiting purposes on campus.

Managing the Denominator

Usually, any increase in profits attributable to a new partner's efforts may not materialize for some time. So, admitting a new equity partner will decrease the profits shared by the others. Obviously, the easiest way to keep the profit pool up is by managing the denominator, or limiting the number of equity partners. That's where making nonequity partners makes good economic sense. In effect, it costs little to make an associate a nonequity partner.

Some Have Abused the Concept

Unfortunately, some firms have created two-tier partnerships solely to retain associates longer, without developing a sound long-term strategy that responds positively to the needs of both classes of partners, and associates too. All too often, it has functioned as a crutch for managements that were not able to make the hard decisions on admitting equity partners. It provided a convenient excuse for deferring action, instead of biting the bullet and being honest with associates about their prospects for partnership. Some firms have also used it to de-equitize underperforming partners and partners who never developed into entrepreneurs. Using nonequity partner status as a repository for underperformers and management's inability to deal effectively with difficult situations demeans the viability of the concept.

Making It Work

The two-tier partnership can be a very positive strategy and effective structure that can facilitate a firm's ability to grow and expand. But to be implemented effectively, the firm, and all its equity partners, must subscribe to the following principles:

• Firm profits must be maintained at a high-enough level to dissuade equity partners from leaving and to attract needed laterals;
• Adequate depth of core skills must be maintained in all practice areas;
• Not all good lawyers can, or want to, be equity partners; and
• Nonequity partnership is an alternate long-term career path

Successfully implementing a two-tier partnership should start with clearly defining and distinguishing the roles and characteristics of the two classes of partners, and the criteria for admission to each. And these should be communicated to all equity partners, current and potential nonequity partners, and senior associates.

Evaluating Partnership Candidates

While six or seven years may well be enough time to determine whether an associate has the technical skills to be a partner, associates usually spend all their time working on client matters and precious little time developing marketing and entrepreneurial skills. Promotion to nonequity partner status enhances their stature and should provide them with the opportunity and time to develop these skills.

Within three years, the firm should decide whether the candidate has developed the skills to be admitted as an equity partner. If not, then the firm is faced with a different, and perhaps more difficult decision. Because if the firm decides to continue the nonequity partner status, the candidate should be forthrightly encouraged to make a career choice to either leave the firm, or stay on permanently as a nonequity partner. Unless the firm is committed to nonequity status being a long-term career path, the candidate would be ill-served by being encouraged to stay. Keeping people in the firm too long ultimately prices them out of the market and increases the difficulty of them making a lateral move to another firm in the future.

Downside Risks

The creation of the nonequity partner category can have downside risks. It can shield associates from direct contact with and access to equity partners. It can de-motivate associates, if all the good work is directed to nonequity partners who act as a buffer between them and the equity partners. It can be abused by equity partners who use nonequity partners as senior associates to get their client work done with less personal effort and supervision. Partners can also distance themselves from and become complacent about mentoring young associates.

It is important to recognize too, that unless nonequity partners continue to grow and develop as lawyers, a firm can build an inventory of mediocre performers. This is why it is imperative that performance criteria be established and communicated. Guidelines should also be adopted that would provide an exit strategy for nonequity partners who become underperformers.

Under the Sidley Microscope

There is yet another risk that a firm runs in creating nonequity partners. With no equity interest in the partnership could they really be considered partners for age discrimination purposes? In the Sidley Austin case, the EEOC is challenging the status of partners who had been equity partners, on the basis of their having lacked involvement in the management of the firm. How might partners be viewed who have no equity interest in the firm at all? If they were deemed to be employees subject to the Federal age discrimination rules, they could be entitled to lifetime careers. Now that's a sobering thought.

Dealing with the Emotional Aspects

Converting to a two-tier partnership, or redefining an existing one, can be a traumatic experience. It requires reconciling the views of all the partners, which in some cases are driven more by emotion than logic. That's where bringing in an outsider who understands lawyers and law firms, who can present an objective viewpoint in addressing the needs of both the partners and the firm, can be invaluable in facilitating the process.

Melchior S. Morrione, Managing Director of MSM Consulting (www. msm-consulting.com), provides management consulting services in governance, strategic planning and marketing to law firms. Previously an international tax partner at Arthur Andersen serving a Fortune 500 practice, he balanced the demands of clients with the need to develop new and innovative client services for the firm. A member of this newsletter's Board of Editors, he can be reached at 201-307-1650 or [email protected]. '2007 Melchior S. Morrione.

Once upon a time, becoming a partner in a law firm meant you became an owner of the business and shared in the profits with the other equity partners. The typical career path for associates joining a firm out of law school was to work hard for about seven years, at which time you would either be admitted to the partnership or be asked to leave the firm.

This so-called up-or-out practice became increasingly difficult for firms to continue due to the explosive growth in demand for legal services. Throwing out seven-year associates, who the firm was not entirely sure were ready to be partners, but who had developed valuable practice skills and experience serving clients, no longer seemed like a good idea.

So by the late 1990s, many law firms adopted a practice that significantly changed the original partnership paradigm. They created a new position, called nonequity, income, or contract partner, into which associates who were not admitted as equity partners could be placed. In effect, they created a two-tier partnership. This permitted them to retain associates longer, with the prospect that equity partnership might still be in their futures. But it was seldom made clear just how far into their futures.

What Is a Two-Tier Partnership?

Simply, it's a partnership composed of two classes of partners. The equity partners have an equity interest in the firm and its assets, they contribute capital, are responsible for its liabilities, share in its profits and are responsible for its losses.

Nonequity partners are classified and held out to the public as partners. But they have no interest in the firm's assets, put in no capital, are not responsible for its liabilities, and do not share in its losses. Their compensation is fixed annually, they can earn bonuses, and when profits are particularly good, some firms permit them to share in excess profits.

According to the 2006 The American Lawyer's AmLaw 100 survey, 80 of the 100 firms were two-tier partnerships.

Converging Forces

Many forces converged to give rise to the use of the two-tier partnership. Client demands forced firms to increase their capacity to deliver services. At the same time, increased competition among firms, together with clients becoming smarter buyers, forced firms to focus on improving their efficiency and productivity. Since associates became most productive between their fifth and seventh years, it no longer made sense to have them leave the firm in their seventh year, just because they were not clear candidates for partnership ' not to mention that the firm was earning significant profits on their efforts.

Firms began to find it increasingly difficult to determine in so short a time-frame whether a candidate had all the qualities to function as an equity partner in what had become a much more challenging and competitive legal marketplace. So firms stretched the normal partnership track from seven years to nine, ten and more.

Firms also started to reexamine the role and functions of an equity partner, and came to realize that some of their existing equity partners, examined in the more critical light of a more competitive marketplace, did not have the entrepreneurial qualities that had been taken for granted at the time they were admitted. They were good lawyers, but had not developed the entrepreneurial skills required of the owners of today's professional services firms.

At the same time, new associates coming out of law school began to exude an attitude that becoming a partner may not be all it was cracked-up-to-be. Based upon their own observation of the intensive pressure on partners, and extensive hours they saw them working, they began to doubt their willingness to put in the effort to be a partner. Yet they wished to practice law at a high level ' but at a pace that provided a different lifestyle.

In addition, as firms struggled to increase their core skills and expand their practices to become full-service firms in an effort to meet what they perceived to be client needs, they also became enamored with the idea of expanding into regional and international firms. To accomplish this, many sought lateral acquisitions of senior associates from other firms, as well as lateral partners and groups from other firms.

Flexibility of the New Paradigm

The nonequity partner category of the two-tier partnership provided a new position that could accommodate all of these situations, and more. In this capacity, associates could spend the time to develop marketing and entrepreneurship skills. Good lawyers who would never become equity partners could settle in to a new career path. Existing non-entrepreneurial partners could become a resource and be relieved of the pressure to bring in new business. Lifestyle associates could fill the need for additional resources. Senior associates brought in laterally could be evaluated to see if they had the qualities for equity partner. Lateral partners and groups could be observed from within the firm to determine whether they could mesh into the firm's culture. And it could also be used to accommodate senior partners who wanted to continue working beyond retirement. So, many firms rethought the old partnership paradigm, and concluded that the two-tier partnership was the new paradigm for today's world.

The Relevance of Profitability

Like it or not, today, profitability is the yardstick by which law firms are measured. While the internal operations and finances of law partnerships were once well-kept secrets, Steven Brill, when he ran The American Lawyer, poked his head under the tent and managed to lift the veil of secrecy. He created a transparency in reporting the operations of law firms, which today has made profitability a key factor in the perception of a law firm's success.

Just as free agency has inexorably changed professional baseball ' where players once spent the better part of their careers with one team ' today, players with no team-allegiance move from team to team in pursuit of the best compensation package. So too, equity partners in law firms have become subject to equivalent pressures. The arrival of merit-based compensation has made maintaining high profitability a major responsibility of managing partners. They must ensure that partners feel that their earnings are comparable to those of their peers at peer firms.

Because many equity partners would have little difficulty boosting their compensation by moving to another firm, managing partners must focus on retaining their talented partners. This requires that they:

• Keep profits high enough so that partners do not feel they are making a financial sacrifice to spend their careers with the firm;
• Position the firm for steady growth and keep it in a leadership position,
• Provide the resources for partners to fulfill their professional potential; and
• Maintain an atmosphere of collegiality that makes staying with the firm more attractive than seeking more money in an environment that may not be as nurturing and cordial.

Maintaining profitability is also necessary to make the firm attractive to laterals, and to project success for recruiting purposes on campus.

Managing the Denominator

Usually, any increase in profits attributable to a new partner's efforts may not materialize for some time. So, admitting a new equity partner will decrease the profits shared by the others. Obviously, the easiest way to keep the profit pool up is by managing the denominator, or limiting the number of equity partners. That's where making nonequity partners makes good economic sense. In effect, it costs little to make an associate a nonequity partner.

Some Have Abused the Concept

Unfortunately, some firms have created two-tier partnerships solely to retain associates longer, without developing a sound long-term strategy that responds positively to the needs of both classes of partners, and associates too. All too often, it has functioned as a crutch for managements that were not able to make the hard decisions on admitting equity partners. It provided a convenient excuse for deferring action, instead of biting the bullet and being honest with associates about their prospects for partnership. Some firms have also used it to de-equitize underperforming partners and partners who never developed into entrepreneurs. Using nonequity partner status as a repository for underperformers and management's inability to deal effectively with difficult situations demeans the viability of the concept.

Making It Work

The two-tier partnership can be a very positive strategy and effective structure that can facilitate a firm's ability to grow and expand. But to be implemented effectively, the firm, and all its equity partners, must subscribe to the following principles:

• Firm profits must be maintained at a high-enough level to dissuade equity partners from leaving and to attract needed laterals;
• Adequate depth of core skills must be maintained in all practice areas;
• Not all good lawyers can, or want to, be equity partners; and
• Nonequity partnership is an alternate long-term career path

Successfully implementing a two-tier partnership should start with clearly defining and distinguishing the roles and characteristics of the two classes of partners, and the criteria for admission to each. And these should be communicated to all equity partners, current and potential nonequity partners, and senior associates.

Evaluating Partnership Candidates

While six or seven years may well be enough time to determine whether an associate has the technical skills to be a partner, associates usually spend all their time working on client matters and precious little time developing marketing and entrepreneurial skills. Promotion to nonequity partner status enhances their stature and should provide them with the opportunity and time to develop these skills.

Within three years, the firm should decide whether the candidate has developed the skills to be admitted as an equity partner. If not, then the firm is faced with a different, and perhaps more difficult decision. Because if the firm decides to continue the nonequity partner status, the candidate should be forthrightly encouraged to make a career choice to either leave the firm, or stay on permanently as a nonequity partner. Unless the firm is committed to nonequity status being a long-term career path, the candidate would be ill-served by being encouraged to stay. Keeping people in the firm too long ultimately prices them out of the market and increases the difficulty of them making a lateral move to another firm in the future.

Downside Risks

The creation of the nonequity partner category can have downside risks. It can shield associates from direct contact with and access to equity partners. It can de-motivate associates, if all the good work is directed to nonequity partners who act as a buffer between them and the equity partners. It can be abused by equity partners who use nonequity partners as senior associates to get their client work done with less personal effort and supervision. Partners can also distance themselves from and become complacent about mentoring young associates.

It is important to recognize too, that unless nonequity partners continue to grow and develop as lawyers, a firm can build an inventory of mediocre performers. This is why it is imperative that performance criteria be established and communicated. Guidelines should also be adopted that would provide an exit strategy for nonequity partners who become underperformers.

Under the Sidley Microscope

There is yet another risk that a firm runs in creating nonequity partners. With no equity interest in the partnership could they really be considered partners for age discrimination purposes? In the Sidley Austin case, the EEOC is challenging the status of partners who had been equity partners, on the basis of their having lacked involvement in the management of the firm. How might partners be viewed who have no equity interest in the firm at all? If they were deemed to be employees subject to the Federal age discrimination rules, they could be entitled to lifetime careers. Now that's a sobering thought.

Dealing with the Emotional Aspects

Converting to a two-tier partnership, or redefining an existing one, can be a traumatic experience. It requires reconciling the views of all the partners, which in some cases are driven more by emotion than logic. That's where bringing in an outsider who understands lawyers and law firms, who can present an objective viewpoint in addressing the needs of both the partners and the firm, can be invaluable in facilitating the process.

Melchior S. Morrione, Managing Director of MSM Consulting (www. msm-consulting.com), provides management consulting services in governance, strategic planning and marketing to law firms. Previously an international tax partner at Arthur Andersen serving a Fortune 500 practice, he balanced the demands of clients with the need to develop new and innovative client services for the firm. A member of this newsletter's Board of Editors, he can be reached at 201-307-1650 or [email protected]. '2007 Melchior S. Morrione.