Improving Compensation Decisions in a Mixed Economy

This year's annual ritual of dividing income is over now for most law firms. This round of decisions affects 2009 income and 2010 base or positioning in a prospective program. A year ago, the profession was quite anxious about the economy (legal and otherwise) and their personal financial futures. It was analogous to being boxed in with pressure being asserted on all six sides simultaneously ' a severely depressed economy, ultra tight credit markets, skittish partners reluctant or unable to contribute capital, price-sensitive clients under their own cost reduction imperatives, intractable landlords and facility leases, and competitive approaches by firms less severely affected by the downturn. The profession responded with serial layoffs, furloughs, reduced hours, wage freezes and reductions. Non-wage expenditures were scrutinized like never before. The medicine, while bitter, largely worked, although aided by an economy that finally found its bottom. Yet the recovery is not complete as the effective unemployment rate remains frustratingly high.

However, again like the economy, not all is right in the legal profession. Law firms struggle with competing interests of survival versus preservation of long-held values. One long-held value beginning to fall is the lock-step compensation arrangement for associates. Rightly or wrongly, it is giving way to “merit” based approaches where pay is tied to skills, competencies, and contributions. Another mainstay at risk is the role of recent law school graduates in law firms. Client push back on paying for first and second year associates has brought about renewed interest in apprenticeships. This is a worthy, albeit expensive, proposition for firms and associates alike. Firms continue their evaluation of partners ' equity and non-equity alike ' striving to maintain the key players for what they expect (some might say hope) to be the dominant post-recession practices.

Through all of this, partner compensation decisions have become even more challenging. When dollars were plentiful, it was easy to be generous to all and to satisfy the high producers; but when dollars tighten and practice fortunes vary dramatically, internal equity and external competitiveness become increasingly difficult to achieve. If key business generators perceive their compensation to be inadequate, they may defect along with their clients. Other highly skilled lawyers with sought-after expertise may also be recruited with offers of higher compensation or more stable environments. Many firms understand the risks, but few have the ability to assess them in a systematic way.

Understanding Compensation Decisions

How should a law firm approach compensation decisions in the current economy? The fundamentals still apply: a focus on the quality of the compensation decisions and the interrelationship of those decisions with culture and strategy. The various types of systems and processes are simply tools to achieve good. The characteristics that should be demonstrated in a law firm's compensation decisions include:

1. Decisions allocate pay proportionately to contribution (merit);
2. Decisions are competitive with comparable market decisions (external equity);
3. Decisions are determined consistently from person-to-person and year-to-year;
4. Decisions reflect the firm's culture and operating philosophy;
5. Decisions demonstrate that what leaders say is important is really what is rewarded (credibility and trust); and
6. Decisions recognize and reward those activities that implement the firm's strategy.

In my consulting work, I use a series of tests to see how well the firm's compensation decisions reflect these characteristics.

Correlation Studies

One set of tests is correlation studies. The purpose of a correlation study is to gain an understanding of what factors the compensation decision-makers took into account in making their decisions. Each dot on the scatter graph in Figure 1, below, represents an individual partner.

[IMGCAP(1)]

A scatter graph visually assists in identifying what, if any, patterns exist between two variables. The more scatter or randomness that exists in the “picture,” the lower the correlation is between the variables. The trend line is another visual tool to help identify a pattern in the data. The more highly correlated the data, the tighter the fit between trend line and dots. Positively correlated data move in unison and in the same direction. Negatively correlated data move in unison, but in opposite directions.

In the upper right corner of the graph is the R2 value. This statistic quantifies the strength of the relationship between the variables. A value of zero means that there is no observable relationship between the variables. A value of 1 means the variables are highly correlated. The example in Figure 1 looks at the correlation between compensation and responsible lawyer revenue. You can see that there is some pattern in the array of dots, some relationship between responsible lawyer revenue and compensation. However, there is a fair amount of randomness as well. The R2 value of .2211 is somewhat consistent with the strength of relationship we find in the profession between personal productivity and compensation. This scatter graph tells us that we can explain about 22% of the variability in pay by the variability in responsible lawyer revenue at this firm. It also tells us that 78% of the variability in pay is explained by some other factors. Additional variables would be studied until a more complete picture emerged of what the firm did and did not take into account to make its decisions.

Multiple variables should be examined to aid understanding of how much influence one variable has over another or the extent to which the decision-makers used a particular variable in a systemic way. It does not explain the process or rationale used to reach the decisions or the decision for any individual partner ' but it may point to areas of systemic inconsistency and highlight questions to pursue further.

It's important to note that Individual R2 values (which are a shorthand for the strength of the relationship between compensation and various decision factors) cannot be added together to determine the combined effect that two variables have on another. There can be significant overlap between variables. For example, good business generators are almost always strong personal producers. Business generation tends to be highly correlated with partner compensation; let us use an R2 of .84 for example. The R2 of personal productivity to compensation is generally around .23. However, the strength of the relationship (R2) of both personal production (.23) and business generation (.84) is not 1.07. In reality, the combined R2 will more likely be .85 or .86 because the two variables overlap each other.

Identifying these patterns aids in understanding what is behind the decisions in order to determine if those decisions are consistent with the firm's stated desires for its partner pay program.

Partner Productivity Analysis

A second set of tests is analyses of partner productivity (personal and business generation). Distribution tables that depict the proportion of partners performing at varying levels of personal productivity and business generation illustrate the nature and spread of economic performance. They aid in assessing a firm's vulnerability to weak market conditions. They also aid in understanding the economic contribution breadth that the pay program must consider.

An array of the combination (personal productivity and business generation) of the two variables compares data to determine in stark terms the percentage of partners who generate work in excess of their personal production (“exporters”), those who “break even,” and those who require support (“importers”). (See Figure 2, below.) It is also helpful to segment importers and exporters each into two tranches and to display it for the current year, sustained over several years and trend over several years (a multi-year, weighted average).

[IMGCAP(2)]

The firm's partners in the example in Figure 2 have improved their ability to cover their personal production with more partners generating work in excess of what they themselves do (“exporters”). This is evident from the most recent year's data indicating 55% are net exporters compared with the multi-year average of 52%. However, 38% of the partners still are not self-sufficient, a decided weakness and particularly so in these times.

Identifying individual exporters, those who only break even, and those who import work from their partners is critical to making rational compensation decisions. It is a first step in understanding the economic rationality of the decisions.

Market Ranges and Risk

A third set of tests analyzes whether compensation decisions are within or outside of a predicted range for each lawyer's economic performance. They also aid understanding the compensation decision in the context of the individual's ability to generate business. This is a very powerful tool, as it not only identifies the risks in incorrectly rewarding different levels of business generation, but it also places that in the external context of the compensation decisions relative to market. An example of that analysis follows.

Partners in a sample law firm have been categorized as Entrepreneurial Leader, Business Generating Partner, Self-Sufficient Partner, Service Partner, Below Service Partner, and Technical Specialist Partner. These terms were set forth and defined in the author's article, Making the Grade: What Should Law Firm Ownership Really Mean? (available at http://www.altmanweil.com/). They categorize a partner's ability to create revenue-producing business opportunities for the firm without for the moment focusing on the absolute size of the client following.

In Figure 3, the first row shows the actual number of partners in each category, while the second row shows the same values as percentages. The third and fourth rows indicate those partners who are compensated below the market range (row 3) and above the range (row 4). This table provides us with a prioritized summary of where in-depth conversations regarding performance and pay decisions should begin. In row three, we question decisions where partners who can provide work to others are undercompensated to their predicted range. And in row four we question decisions where partners are overcompensated to their predicted range. In each situation we engage in a conversation about the particular facts giving rise to those decisions, how well those decisions comport with the compensation program goals, and what might be done over time to improve decisions where the underlying facts do not support the decision.

[IMGCAP(3)]

Forty-six, or 34%, of this firm's partners have not demonstrated a sustained ability to generate revenue-producing business opportunities at a level sufficient to meet expectations of a service partner (those partners classified in the “Below Service Partner” column).

Compounding this problem for the sample firm is an additional 21% of the partnership who are rated as “Service Partners.” When combined, these two categories represent a full 55% of the partnership who are not self-sufficient revenue generators. These individuals require the support of others to keep busy. Having more then half of your owners in this situation is a sufficient challenge in good markets. To face this in a deteriorated market is a bit of a nightmare.

We can also see that 19 of the firm's 60 partners who are paid below their expected range (row 3) fall into the categories of Entrepreneurial Leader and Business Generating Partner, i.e., those partners who can drive business into the firm in a meaningful way. This represents a heightened risk of losing important contributors in a firm where that skill set is not well dispersed among the ownership group.

There are also 26 individuals who are paid above their predicted range (row 4). Only two of them are significant business generators, and 21 are not self-sufficient. Both of these scenarios are red flags for this law firm, indicating significant risk.

A word of caution. This tool highlights risk factors. It does not indicate that any particular decision was bad. It does allow the consultant and the firm to engage in a frank discussion of each specific case to determine its individual appropriateness and what, if any, action should be taken. It also facilitates a discussion of the underlying causes of these decisions, which can lead to systemic corrective measures.

Armed with information like this, there can be an informed discussion about how a law firm's compensation committee is carrying out its charge. The adviser can consider an array of changes that will improve decisions, as well as other changes to inoculate the firm against disruptive departures. Such changes are often quite complex to implement. As one partner so eloquently stated, “You can't get turkeys to vote for Thanksgiving.” Change will result in some people getting less, while others take more. The compensation changes could also coincide with changes in partner status or even, ultimately, separation. Instituting safeguards such as a compensation floor, collars to the amount of change in the first year or two, and transition assistance can protect individual lawyers from undue economic hardship.

If you are unsure what to do next, consider the four steps below:

1. Evaluate partner and associate pay programs to determine if the compensation decisions reflect what is important in your firm (performance, culture, work/life balance, strategy and the like).
2. Examine the profit profiles of your timekeepers (partners, associates, paralegals, etc.) by status and by experience for lawyers to see if the compensation decisions are economically rational and if the margins are appropriate.
3. Use the compensation process to engage people and seek out opportunities to discuss pay and performance as it relates to strategy and culture.
4. Review your expectations of owners with the owners and consider how your ownership structure affects the vitality of the firm and interacts with your compensation programs and decisions.

James D. Cotterman is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia. He can be contacted at 407-381-2426 or e-mail [email protected]. Copyright ' 2010, Altman Weil, Inc., Newtown Square, PA, USA.

This year's annual ritual of dividing income is over now for most law firms. This round of decisions affects 2009 income and 2010 base or positioning in a prospective program. A year ago, the profession was quite anxious about the economy (legal and otherwise) and their personal financial futures. It was analogous to being boxed in with pressure being asserted on all six sides simultaneously ' a severely depressed economy, ultra tight credit markets, skittish partners reluctant or unable to contribute capital, price-sensitive clients under their own cost reduction imperatives, intractable landlords and facility leases, and competitive approaches by firms less severely affected by the downturn. The profession responded with serial layoffs, furloughs, reduced hours, wage freezes and reductions. Non-wage expenditures were scrutinized like never before. The medicine, while bitter, largely worked, although aided by an economy that finally found its bottom. Yet the recovery is not complete as the effective unemployment rate remains frustratingly high.

However, again like the economy, not all is right in the legal profession. Law firms struggle with competing interests of survival versus preservation of long-held values. One long-held value beginning to fall is the lock-step compensation arrangement for associates. Rightly or wrongly, it is giving way to “merit” based approaches where pay is tied to skills, competencies, and contributions. Another mainstay at risk is the role of recent law school graduates in law firms. Client push back on paying for first and second year associates has brought about renewed interest in apprenticeships. This is a worthy, albeit expensive, proposition for firms and associates alike. Firms continue their evaluation of partners ' equity and non-equity alike ' striving to maintain the key players for what they expect (some might say hope) to be the dominant post-recession practices.

Through all of this, partner compensation decisions have become even more challenging. When dollars were plentiful, it was easy to be generous to all and to satisfy the high producers; but when dollars tighten and practice fortunes vary dramatically, internal equity and external competitiveness become increasingly difficult to achieve. If key business generators perceive their compensation to be inadequate, they may defect along with their clients. Other highly skilled lawyers with sought-after expertise may also be recruited with offers of higher compensation or more stable environments. Many firms understand the risks, but few have the ability to assess them in a systematic way.

Understanding Compensation Decisions

How should a law firm approach compensation decisions in the current economy? The fundamentals still apply: a focus on the quality of the compensation decisions and the interrelationship of those decisions with culture and strategy. The various types of systems and processes are simply tools to achieve good. The characteristics that should be demonstrated in a law firm's compensation decisions include:

1. Decisions allocate pay proportionately to contribution (merit);
2. Decisions are competitive with comparable market decisions (external equity);
3. Decisions are determined consistently from person-to-person and year-to-year;
4. Decisions reflect the firm's culture and operating philosophy;
5. Decisions demonstrate that what leaders say is important is really what is rewarded (credibility and trust); and
6. Decisions recognize and reward those activities that implement the firm's strategy.

In my consulting work, I use a series of tests to see how well the firm's compensation decisions reflect these characteristics.

Correlation Studies

One set of tests is correlation studies. The purpose of a correlation study is to gain an understanding of what factors the compensation decision-makers took into account in making their decisions. Each dot on the scatter graph in Figure 1, below, represents an individual partner.

[IMGCAP(1)]

A scatter graph visually assists in identifying what, if any, patterns exist between two variables. The more scatter or randomness that exists in the “picture,” the lower the correlation is between the variables. The trend line is another visual tool to help identify a pattern in the data. The more highly correlated the data, the tighter the fit between trend line and dots. Positively correlated data move in unison and in the same direction. Negatively correlated data move in unison, but in opposite directions.

In the upper right corner of the graph is the R2 value. This statistic quantifies the strength of the relationship between the variables. A value of zero means that there is no observable relationship between the variables. A value of 1 means the variables are highly correlated. The example in Figure 1 looks at the correlation between compensation and responsible lawyer revenue. You can see that there is some pattern in the array of dots, some relationship between responsible lawyer revenue and compensation. However, there is a fair amount of randomness as well. The R2 value of .2211 is somewhat consistent with the strength of relationship we find in the profession between personal productivity and compensation. This scatter graph tells us that we can explain about 22% of the variability in pay by the variability in responsible lawyer revenue at this firm. It also tells us that 78% of the variability in pay is explained by some other factors. Additional variables would be studied until a more complete picture emerged of what the firm did and did not take into account to make its decisions.

Multiple variables should be examined to aid understanding of how much influence one variable has over another or the extent to which the decision-makers used a particular variable in a systemic way. It does not explain the process or rationale used to reach the decisions or the decision for any individual partner ' but it may point to areas of systemic inconsistency and highlight questions to pursue further.

It's important to note that Individual R2 values (which are a shorthand for the strength of the relationship between compensation and various decision factors) cannot be added together to determine the combined effect that two variables have on another. There can be significant overlap between variables. For example, good business generators are almost always strong personal producers. Business generation tends to be highly correlated with partner compensation; let us use an R2 of .84 for example. The R2 of personal productivity to compensation is generally around .23. However, the strength of the relationship (R2) of both personal production (.23) and business generation (.84) is not 1.07. In reality, the combined R2 will more likely be .85 or .86 because the two variables overlap each other.

Identifying these patterns aids in understanding what is behind the decisions in order to determine if those decisions are consistent with the firm's stated desires for its partner pay program.

Partner Productivity Analysis

A second set of tests is analyses of partner productivity (personal and business generation). Distribution tables that depict the proportion of partners performing at varying levels of personal productivity and business generation illustrate the nature and spread of economic performance. They aid in assessing a firm's vulnerability to weak market conditions. They also aid in understanding the economic contribution breadth that the pay program must consider.

An array of the combination (personal productivity and business generation) of the two variables compares data to determine in stark terms the percentage of partners who generate work in excess of their personal production (“exporters”), those who “break even,” and those who require support (“importers”). (See Figure 2, below.) It is also helpful to segment importers and exporters each into two tranches and to display it for the current year, sustained over several years and trend over several years (a multi-year, weighted average).

[IMGCAP(2)]

The firm's partners in the example in Figure 2 have improved their ability to cover their personal production with more partners generating work in excess of what they themselves do (“exporters”). This is evident from the most recent year's data indicating 55% are net exporters compared with the multi-year average of 52%. However, 38% of the partners still are not self-sufficient, a decided weakness and particularly so in these times.

Identifying individual exporters, those who only break even, and those who import work from their partners is critical to making rational compensation decisions. It is a first step in understanding the economic rationality of the decisions.

Market Ranges and Risk

A third set of tests analyzes whether compensation decisions are within or outside of a predicted range for each lawyer's economic performance. They also aid understanding the compensation decision in the context of the individual's ability to generate business. This is a very powerful tool, as it not only identifies the risks in incorrectly rewarding different levels of business generation, but it also places that in the external context of the compensation decisions relative to market. An example of that analysis follows.

Partners in a sample law firm have been categorized as Entrepreneurial Leader, Business Generating Partner, Self-Sufficient Partner, Service Partner, Below Service Partner, and Technical Specialist Partner. These terms were set forth and defined in the author's article, Making the Grade: What Should Law Firm Ownership Really Mean? (available at http://www.altmanweil.com/). They categorize a partner's ability to create revenue-producing business opportunities for the firm without for the moment focusing on the absolute size of the client following.

In Figure 3, the first row shows the actual number of partners in each category, while the second row shows the same values as percentages. The third and fourth rows indicate those partners who are compensated below the market range (row 3) and above the range (row 4). This table provides us with a prioritized summary of where in-depth conversations regarding performance and pay decisions should begin. In row three, we question decisions where partners who can provide work to others are undercompensated to their predicted range. And in row four we question decisions where partners are overcompensated to their predicted range. In each situation we engage in a conversation about the particular facts giving rise to those decisions, how well those decisions comport with the compensation program goals, and what might be done over time to improve decisions where the underlying facts do not support the decision.

[IMGCAP(3)]

Forty-six, or 34%, of this firm's partners have not demonstrated a sustained ability to generate revenue-producing business opportunities at a level sufficient to meet expectations of a service partner (those partners classified in the “Below Service Partner” column).

Compounding this problem for the sample firm is an additional 21% of the partnership who are rated as “Service Partners.” When combined, these two categories represent a full 55% of the partnership who are not self-sufficient revenue generators. These individuals require the support of others to keep busy. Having more then half of your owners in this situation is a sufficient challenge in good markets. To face this in a deteriorated market is a bit of a nightmare.

We can also see that 19 of the firm's 60 partners who are paid below their expected range (row 3) fall into the categories of Entrepreneurial Leader and Business Generating Partner, i.e., those partners who can drive business into the firm in a meaningful way. This represents a heightened risk of losing important contributors in a firm where that skill set is not well dispersed among the ownership group.

There are also 26 individuals who are paid above their predicted range (row 4). Only two of them are significant business generators, and 21 are not self-sufficient. Both of these scenarios are red flags for this law firm, indicating significant risk.

A word of caution. This tool highlights risk factors. It does not indicate that any particular decision was bad. It does allow the consultant and the firm to engage in a frank discussion of each specific case to determine its individual appropriateness and what, if any, action should be taken. It also facilitates a discussion of the underlying causes of these decisions, which can lead to systemic corrective measures.

Armed with information like this, there can be an informed discussion about how a law firm's compensation committee is carrying out its charge. The adviser can consider an array of changes that will improve decisions, as well as other changes to inoculate the firm against disruptive departures. Such changes are often quite complex to implement. As one partner so eloquently stated, “You can't get turkeys to vote for Thanksgiving.” Change will result in some people getting less, while others take more. The compensation changes could also coincide with changes in partner status or even, ultimately, separation. Instituting safeguards such as a compensation floor, collars to the amount of change in the first year or two, and transition assistance can protect individual lawyers from undue economic hardship.

If you are unsure what to do next, consider the four steps below:

1. Evaluate partner and associate pay programs to determine if the compensation decisions reflect what is important in your firm (performance, culture, work/life balance, strategy and the like).
2. Examine the profit profiles of your timekeepers (partners, associates, paralegals, etc.) by status and by experience for lawyers to see if the compensation decisions are economically rational and if the margins are appropriate.
3. Use the compensation process to engage people and seek out opportunities to discuss pay and performance as it relates to strategy and culture.
4. Review your expectations of owners with the owners and consider how your ownership structure affects the vitality of the firm and interacts with your compensation programs and decisions.

James D. Cotterman is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia. He can be contacted at 407-381-2426 or e-mail [email protected]. Copyright ' 2010, Altman Weil, Inc., Newtown Square, PA, USA.