It's Compensation Time Again

If your firm is like most, much of the month of December seems to focus on compensation. If your firm's compensation system is a retrospective one, partners may be jockeying for their “fair” share of the pie for the current year. If the system is a prospective one, as is the case in my firm, all eyes are looking forward.

Whatever compensation system a firm uses, everyone should agree that the purpose of the system is to allocate the firm's profits equitably among the partners who have contributed to the generation of those profits. Whether that is achieved, of course, may be in the eye of the beholder. In any event, absent a system in which a single person or committee has absolute discretion as to how profits are to be allocated, a compensation system cannot be successful unless it has the confidence of all partners.

In the following article, I describe the system that my own firm uses to set compensation each year. We have used the system for more than 20 years, and, while it may have some shortcomings, it has survived the test of time.

General Structure

There are a few elements that make our compensation system different from those used by most firms. First, like some others, our compensation system is prospective, so that the decisions we make each December will dictate how profits for the next year will be shared. Partners who have joined us from firms using a retrospective system applaud this approach. They say it reduces the tensions they witnessed in their former firms as partners jockeyed for higher stakes in a pool of dollars awaiting distribution.

Second, we express each partner's share for the compensation process as a stated dollar amount rather than as a percentage or units. We do this by projecting bottom-line profits for the coming year and then allocating that total amount among the partners. To determine a partner's share of any amounts distributed during the year, the partner's dollar amount is simply divided by the total dollar amounts of all partners. Thus, if actual performance exceeds budgeted profits for the year, each partner receives distributions proportionally greater than his or her stated dollar amount. If actual performance falls short of budgeted profits, each receives proportionally less.

Why do we use the dollar amount method for determining a partner's share rather than a percentage? The answer has a historical basis. As the firm has grown and added new partners, some longer-term partners seemed to feel that their performance was not being rewarded as before, because their percentage interests decreased from year to year as a result of the addition of new partners. The bottom line was increasing at the same time, so the total distributions received by these partners increased as well, but they focused on percentages. By expressing partner shares in dollar amounts instead, the firm was able to increase the dollar amount allocated to a partner from one year to the next (so the partner could see that he or she was earning more), while at the same time reducing the partner's actual percentage interest in a larger pie.

Developing the Compensation Schedule

Each November we distribute a package of financial and other information to all of the partners concerning individual partner performance for the current year and for the preceding two years. (We include three years of data to focus on longer-term performance.) We then invite written memoranda from the partners commenting on their own performance and ask that they comment as well on any positive (no negatives allowed) contributions made to the firm by other partners with whom they have worked during the year. Most importantly, we ask (we formerly required) that each partner prepare a full compensation schedule for all partners in the firm, including the preparer. In other words, we ask each partner to be a “mini-compensation committee,” with the responsibility to allocate the firm's projected profits for the next year among all of the partners.

This information is then submitted to the Chief Financial Officer of the firm, who prepares a spreadsheet reflecting each partner's schedule of allocations, the average of all of the allocations made to each partner, the median of the same, and so on. That spreadsheet is then given to the Management Committee (which sits as the Compensation Committee). In order to protect the confidentiality of individual partners, the members of the Management Committee are not allowed to see individual allocations made to each of the members of the Committee. Instead, the spreadsheet reflects only the average amount allocated to each of the members by all of the partners.

Referring to this information, as well as all of the financial and other information previously distributed to the partners and the partners' written memoranda, the Management Committee proposes a schedule of compensation for the next year.

Reaching Consensus

The final step in the process is to submit the completed schedule of compensation to all of the partners for their consideration. The schedule does not become effective unless it is approved (and signed) by at least 75% of the members of the firm holding at least 75% of the then current partnership interests in the firm. This approval is sought in individual, one-on-one meetings at which two members of the Management Committee meet with each partner to discuss why the partner was allocated a particular dollar amount and to answer any questions the partner may have. I am pleased to report that, after using this approval system (which is built into our Partnership Agreement) for more than 25 years, there has not been a single year during which the compensation schedule did not receive the requisite approval.

Merit Fund

I should mention one other feature of our compensation system. Because a completely prospective system would leave no leeway to reward exceptional performance in a year, all of the profits for the year having been allocated at the beginning of the year, our compensation schedule (and the schedules submitted by the partners) includes a separate line item for something called the Merit Fund. The Merit Fund is a discretionary pool of money set aside for retrospective award at the end of the year. Like amounts allocated to individual partners, the amount allocated for the year to the Merit Fund is stated as a dollar amount on the compensation schedule. During the year, the Merit Fund therefore receives distributions just as though it was a separate partner, with its share of distributions set aside in a separate account to assure that the amount directed to the Merit Fund will be available at the end of the year for distribution to those partners who are awarded Merit Fund dollars by the Compensation Committee. Not all of the money in the Merit Fund must be awarded in any year, and if individual partner performance does not result in an award of the entire Fund, any excess is distributed to all of the partners in proportion to their dollar amounts.

Some Observations

We try to achieve as much transparency as possible in the compensation process, in that all partners participate at the beginning and at the end, thereby giving each one a greater sense of control over the process. This diminishes the feeling of helplessness some partners tell me they have experienced when working with other systems.

It astounds me each year in reviewing the full spreadsheet of allocations prepared by the partners how close the dollar amount allocations are for each partner. Sometimes, a partner underestimates his or her own contribution to the firm compared with how others view that performance. In other cases, a partner may overshoot the mark compared with how others see him or her, but the difference is rarely significant.

Finally, we have found over the years that providing each partner with an opportunity not to sign the compensation schedule (in obtaining the 75% approval to make the schedule effective) affords each partner an avenue to express in a formal way his or her “objection” to the compensation schedule without disrupting the system or taking more draconian steps.

Conclusion

Compensation is one of the most important (and sensitive) subjects partners have to deal with. Whatever compensation system a firm selects, it will work in the long run only if it has the confidence of all of the firm's partners. Based upon my own firm's experience, that confidence can best be won by providing a role in the process for all partners.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the Managing Partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations, and divestitures. He can be reached at [email protected].

If your firm is like most, much of the month of December seems to focus on compensation. If your firm's compensation system is a retrospective one, partners may be jockeying for their “fair” share of the pie for the current year. If the system is a prospective one, as is the case in my firm, all eyes are looking forward.

Whatever compensation system a firm uses, everyone should agree that the purpose of the system is to allocate the firm's profits equitably among the partners who have contributed to the generation of those profits. Whether that is achieved, of course, may be in the eye of the beholder. In any event, absent a system in which a single person or committee has absolute discretion as to how profits are to be allocated, a compensation system cannot be successful unless it has the confidence of all partners.

In the following article, I describe the system that my own firm uses to set compensation each year. We have used the system for more than 20 years, and, while it may have some shortcomings, it has survived the test of time.

General Structure

There are a few elements that make our compensation system different from those used by most firms. First, like some others, our compensation system is prospective, so that the decisions we make each December will dictate how profits for the next year will be shared. Partners who have joined us from firms using a retrospective system applaud this approach. They say it reduces the tensions they witnessed in their former firms as partners jockeyed for higher stakes in a pool of dollars awaiting distribution.

Second, we express each partner's share for the compensation process as a stated dollar amount rather than as a percentage or units. We do this by projecting bottom-line profits for the coming year and then allocating that total amount among the partners. To determine a partner's share of any amounts distributed during the year, the partner's dollar amount is simply divided by the total dollar amounts of all partners. Thus, if actual performance exceeds budgeted profits for the year, each partner receives distributions proportionally greater than his or her stated dollar amount. If actual performance falls short of budgeted profits, each receives proportionally less.

Why do we use the dollar amount method for determining a partner's share rather than a percentage? The answer has a historical basis. As the firm has grown and added new partners, some longer-term partners seemed to feel that their performance was not being rewarded as before, because their percentage interests decreased from year to year as a result of the addition of new partners. The bottom line was increasing at the same time, so the total distributions received by these partners increased as well, but they focused on percentages. By expressing partner shares in dollar amounts instead, the firm was able to increase the dollar amount allocated to a partner from one year to the next (so the partner could see that he or she was earning more), while at the same time reducing the partner's actual percentage interest in a larger pie.

Developing the Compensation Schedule

Each November we distribute a package of financial and other information to all of the partners concerning individual partner performance for the current year and for the preceding two years. (We include three years of data to focus on longer-term performance.) We then invite written memoranda from the partners commenting on their own performance and ask that they comment as well on any positive (no negatives allowed) contributions made to the firm by other partners with whom they have worked during the year. Most importantly, we ask (we formerly required) that each partner prepare a full compensation schedule for all partners in the firm, including the preparer. In other words, we ask each partner to be a “mini-compensation committee,” with the responsibility to allocate the firm's projected profits for the next year among all of the partners.

This information is then submitted to the Chief Financial Officer of the firm, who prepares a spreadsheet reflecting each partner's schedule of allocations, the average of all of the allocations made to each partner, the median of the same, and so on. That spreadsheet is then given to the Management Committee (which sits as the Compensation Committee). In order to protect the confidentiality of individual partners, the members of the Management Committee are not allowed to see individual allocations made to each of the members of the Committee. Instead, the spreadsheet reflects only the average amount allocated to each of the members by all of the partners.

Referring to this information, as well as all of the financial and other information previously distributed to the partners and the partners' written memoranda, the Management Committee proposes a schedule of compensation for the next year.

Reaching Consensus

The final step in the process is to submit the completed schedule of compensation to all of the partners for their consideration. The schedule does not become effective unless it is approved (and signed) by at least 75% of the members of the firm holding at least 75% of the then current partnership interests in the firm. This approval is sought in individual, one-on-one meetings at which two members of the Management Committee meet with each partner to discuss why the partner was allocated a particular dollar amount and to answer any questions the partner may have. I am pleased to report that, after using this approval system (which is built into our Partnership Agreement) for more than 25 years, there has not been a single year during which the compensation schedule did not receive the requisite approval.

Merit Fund

I should mention one other feature of our compensation system. Because a completely prospective system would leave no leeway to reward exceptional performance in a year, all of the profits for the year having been allocated at the beginning of the year, our compensation schedule (and the schedules submitted by the partners) includes a separate line item for something called the Merit Fund. The Merit Fund is a discretionary pool of money set aside for retrospective award at the end of the year. Like amounts allocated to individual partners, the amount allocated for the year to the Merit Fund is stated as a dollar amount on the compensation schedule. During the year, the Merit Fund therefore receives distributions just as though it was a separate partner, with its share of distributions set aside in a separate account to assure that the amount directed to the Merit Fund will be available at the end of the year for distribution to those partners who are awarded Merit Fund dollars by the Compensation Committee. Not all of the money in the Merit Fund must be awarded in any year, and if individual partner performance does not result in an award of the entire Fund, any excess is distributed to all of the partners in proportion to their dollar amounts.

Some Observations

We try to achieve as much transparency as possible in the compensation process, in that all partners participate at the beginning and at the end, thereby giving each one a greater sense of control over the process. This diminishes the feeling of helplessness some partners tell me they have experienced when working with other systems.

It astounds me each year in reviewing the full spreadsheet of allocations prepared by the partners how close the dollar amount allocations are for each partner. Sometimes, a partner underestimates his or her own contribution to the firm compared with how others view that performance. In other cases, a partner may overshoot the mark compared with how others see him or her, but the difference is rarely significant.

Finally, we have found over the years that providing each partner with an opportunity not to sign the compensation schedule (in obtaining the 75% approval to make the schedule effective) affords each partner an avenue to express in a formal way his or her “objection” to the compensation schedule without disrupting the system or taking more draconian steps.

Conclusion

Compensation is one of the most important (and sensitive) subjects partners have to deal with. Whatever compensation system a firm selects, it will work in the long run only if it has the confidence of all of the firm's partners. Based upon my own firm's experience, that confidence can best be won by providing a role in the process for all partners.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the Managing Partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations, and divestitures. He can be reached at [email protected].