Financial Considerations That Involve Your Partnership Agreement

The lesson is that lawyers who work in multi-partner firms owe it to themselves periodically to review their partnership agreement. Of course, far too many law firms do not have a written partnership agreement. The best firms will have a mechanism for periodic review and possible modification to maintain fairness to all partners over time. Absent such a mechanism, every partner should take personal initiative to assess the financial aspects of that agreement. There are three particularly important milestones for doing so: joining the partnership, making a lateral move to a new firm, and retiring (voluntarily or through de-equitization) from the firm.

Joining the Partnership

The decision to accept partnership in the first place is at the foundation of many financial concerns. Consider for a moment whether you would advise a client to move forward with a decision if questions like these were on the table? Is becoming a partner wise '

• When you may have little or no say in a large firm over its direction or policies?
• When the “buy in” to the partnership is at a value asserted by that partnership rather than by an independent study?
• When the sale of your interest could be only under very restricted terms and at a value determined by a formula different than the formula used for the “buy in” and only back to the partnership, not to a third party (even if a lawyer)?
• When your income percentage will be determined by a “compensation committee” to which your only input is submitting a year-end report that is subjectively evaluated and that can thus be colored by committee member perceptions of the information included?
• When, if you participate in firm governance, you will likely receive no additional direct or bonus compensation and instead must continue your full practice to maintain your income?
• When, if the firm enters financial difficulties sufficient to declare bankruptcy, you will be jointly and severally liable for the debts of the law firm in the event of the firm's collapse?

These questions do not mean that joining the partnership is foolish. They do mean that it should be done with eyes wide open. Or said another way, new partners should realize that the practice of law is a business, just as is every other service profession and economic sector, and, the line between partner and employee is becoming narrower each day. The fundamental truth is that partners must contribute to the well-being of their firm. If they don't, they will be terminated irrespective of their partnership status or equity interest. In other words, they must adhere to the basic formula of The Business of Law': P = R ' E, profits for any firm equal revenues minus expenses. New partners should make sure they understand the financial criteria for remaining in the partnership, and continually assess their own performance against them.

Making a Lateral Move

Firms increasingly rely on hiring lateral partners with an existing book of business in order to leverage billings, decrease investment and improve profit. There are plenty of positives as well for lawyers who have decided to leave one firm for another, provided that the financial aspect of the decision is made realistically. Will the financial rewards at the new firm make a move worthwhile? Does the new firm take a shared approach to compensation and clients, or is it every lawyer for him- or herself? The answers will define if a move makes sense.

In particular, the lateral's new partnership agreement should specify the nature of the ready-made book business that firms expect will come with the lawyer to his or her new firm. Anecdotal evidence suggests that firms which used to expect a $1 million book now virtually double that expectation for new partner hires. Certainly, this may involve some posturing. The firm making a lateral hiring decision may not believe it will actually get all of such an amount, but reason that if the bar is set high enough, the revenue might get close to such an expectation. But many pitfalls can keep the business from materializing, and if the business does not materialize as expected, the lateral hire may face financial penalties.

An even more difficult scenario is when the departing lateral hire and the former law firm compete for the business of past clients. The former firm may well press its advantage and keep the business, despite the departing lateral's assurances to the new firm that the business is coming. Moreover, consider what happens if a lateral has “escaped” from a firm nearing bankruptcy with the understanding of bringing over clients from the old firm as well as any “unfinished business.” Law firms that go into bankruptcy must collect funds to pay their creditors, and can argue that the receivables of a departed lawyer belong to the originating firm (“claw back”) that provided the resources to help earn the billing. The only protection for the lateral lawyer is to ensure that the details of “who gets what” are specified in the partnership agreement.

Retiring from the Firm

We now appear to be past the peak of the de-equitization tsunami, but the phase-out of older partners at large firms continues. All lawyers nearing retirement age should ask hard personal finance questions about how to cope with a potential dismissal. Will they be able to get any equity at all out of their firms, and if so how fair will be the price set by their former partners? Are there only certain times of the year (for example, an anniversary date, or the last day of the fiscal year) when they can leave and get their full investment back? Their partnership agreements should have the answers.

Older partners may feel that, even if they are de-equitized, they can count on a pension. But in a 2012 analysis of pension plans of large U.S. law firms, it appeared that a number of the country's largest law firms have pension plans that are underfunded or even not funded at all. See, “Unfunded Pensions Are Big-Law 'Elephant in the Room,'” ABA Journal, (March 1, 2012). What is increasingly likely is that law firms will reflect the Social Security dilemma of too many entitlements and not enough active workers to pay for them. There may be situations where younger lawyers will find it to their economic advantage to leave the existing law firm and its pension obligations to create a new firm with no pension obligations. Partners nearing retirement age, even if not facing de-equitization, should review the status of their pension plans and use their partnership status to demand answers on what the plans funding and future payment prospects are.

At least one large Wall Street firm reportedly has put into place a retirement buy-out program that is quite generous, encouraging senior partners, or those who are on the downside of their careers to retire from the firm voluntarily, with the understanding that they would receive half of the compensation that they had received on the average of the final three years before they retire. This payout is reputed to be seven years. Such an incentive to retire is the same strategy the automakers have used to reduce pension liabilities for years. The early retirement payout reduces the long-term financial burden. The price is steep: in effect the firm is “buying” the retiring lawyers' law practices at a cost of 50% of existing compensation. The orderly transfer of client relationships, during a period of seven years in which the retiring partners cannot compete with the firm, is the advantage that the firm receives.

Afterward

As law firms become more subject to the competitive dynamics of corporate America, they must reflect those dynamics in their own operation. Partnership is no longer a tenured position, and every partner should know what their partnership agreement says about when and how that tenure could end. Those who do not are in the position of the cobbler's children who lack shoes. Before you read through one more client's contract, read your own ' with your own firm.

Ed Poll, J.D., M.B.A., CMC, principal of LawBiz' Management, is a preeminent coach, law firm management consultant, and author. A member of this newsletter's Board of Editors, he is a thought leader in strategic planning, profitability analysis, and practice development, coaching and consulting with lawyers. He released two books in 2012: The Profitable Law Office Handbook: Attorney's Guide to Successful Business Planning, 16th Anniversary Edition, and Secrets of the Business of Law, 2nd ed. His latest book, Life After Law: What Will You Do for the Next 6,000 Days?'deals with pre-retirement planning issues. Poll can be reached at 800-837-5880 or [email protected]. Edward Poll – All rights reserved ' 2013

Becoming a firm partner has long been the unquestioned goal of most lawyers. But in today's large law firms, with many hundreds of partners, is this still a desirable goal when a given partner's voice may have little influence over the direction of the firm, and when a partner's income is determined by a “compensation committee” that lacks transparency? Partners often feel entitled to be rewarded by virtue of their partnership status alone, similar to the rewards given their fellow partners. Is this still a realistic expectation in most large firms?

Recognizing Two-Tier Realities

A new report by Georgetown Law School's Center for the Study of the Legal Profession shows that it is not. See, “2013 Report on the State of the Legal Market.” The report says that as firms have struggled with sluggish demand growth and low productivity, they have increasingly raised the bar for equity partnership while increasing non-equity partnership positions. Of the country's 200 largest law firms:

• 169 of them have two-tier equity/non-equity partnerships.
• The percentage of lawyers who are equity partners in these firms dropped to 25% in 2011, down from 34% in 2005 and 36% in 2000.
• Spreads in compensation between the highest and lowest paid partners (even within equity partner ranks) have widened from the 4:1 or 5:1 range to 6:1 or 7:1 or even higher.

Such corporate law firms increasingly mirror the pay gap between top corporate executives and the rest of their workforce. Yet “employee” non-equity partners own the firm and thus are responsible for its debts. When partners have unequal rewards but share equal risk it leads to a situation that, according to many accounts, produced the Dewey & LeBoeuf bankruptcy. The firm had hired many lawyers with very high guaranteed compensation, often by agreements structured without informing the general partnership. When the fortunes of the firm sagged, the high-rollers bailed, the firm died ' and the rest of the partners were left holding the bag.

The lesson is that lawyers who work in multi-partner firms owe it to themselves periodically to review their partnership agreement. Of course, far too many law firms do not have a written partnership agreement. The best firms will have a mechanism for periodic review and possible modification to maintain fairness to all partners over time. Absent such a mechanism, every partner should take personal initiative to assess the financial aspects of that agreement. There are three particularly important milestones for doing so: joining the partnership, making a lateral move to a new firm, and retiring (voluntarily or through de-equitization) from the firm.

Joining the Partnership

The decision to accept partnership in the first place is at the foundation of many financial concerns. Consider for a moment whether you would advise a client to move forward with a decision if questions like these were on the table? Is becoming a partner wise '

• When you may have little or no say in a large firm over its direction or policies?
• When the “buy in” to the partnership is at a value asserted by that partnership rather than by an independent study?
• When the sale of your interest could be only under very restricted terms and at a value determined by a formula different than the formula used for the “buy in” and only back to the partnership, not to a third party (even if a lawyer)?
• When your income percentage will be determined by a “compensation committee” to which your only input is submitting a year-end report that is subjectively evaluated and that can thus be colored by committee member perceptions of the information included?
• When, if you participate in firm governance, you will likely receive no additional direct or bonus compensation and instead must continue your full practice to maintain your income?
• When, if the firm enters financial difficulties sufficient to declare bankruptcy, you will be jointly and severally liable for the debts of the law firm in the event of the firm's collapse?

These questions do not mean that joining the partnership is foolish. They do mean that it should be done with eyes wide open. Or said another way, new partners should realize that the practice of law is a business, just as is every other service profession and economic sector, and, the line between partner and employee is becoming narrower each day. The fundamental truth is that partners must contribute to the well-being of their firm. If they don't, they will be terminated irrespective of their partnership status or equity interest. In other words, they must adhere to the basic formula of The Business of Law': P = R ' E, profits for any firm equal revenues minus expenses. New partners should make sure they understand the financial criteria for remaining in the partnership, and continually assess their own performance against them.

Making a Lateral Move

Firms increasingly rely on hiring lateral partners with an existing book of business in order to leverage billings, decrease investment and improve profit. There are plenty of positives as well for lawyers who have decided to leave one firm for another, provided that the financial aspect of the decision is made realistically. Will the financial rewards at the new firm make a move worthwhile? Does the new firm take a shared approach to compensation and clients, or is it every lawyer for him- or herself? The answers will define if a move makes sense.

In particular, the lateral's new partnership agreement should specify the nature of the ready-made book business that firms expect will come with the lawyer to his or her new firm. Anecdotal evidence suggests that firms which used to expect a $1 million book now virtually double that expectation for new partner hires. Certainly, this may involve some posturing. The firm making a lateral hiring decision may not believe it will actually get all of such an amount, but reason that if the bar is set high enough, the revenue might get close to such an expectation. But many pitfalls can keep the business from materializing, and if the business does not materialize as expected, the lateral hire may face financial penalties.

An even more difficult scenario is when the departing lateral hire and the former law firm compete for the business of past clients. The former firm may well press its advantage and keep the business, despite the departing lateral's assurances to the new firm that the business is coming. Moreover, consider what happens if a lateral has “escaped” from a firm nearing bankruptcy with the understanding of bringing over clients from the old firm as well as any “unfinished business.” Law firms that go into bankruptcy must collect funds to pay their creditors, and can argue that the receivables of a departed lawyer belong to the originating firm (“claw back”) that provided the resources to help earn the billing. The only protection for the lateral lawyer is to ensure that the details of “who gets what” are specified in the partnership agreement.

Retiring from the Firm

We now appear to be past the peak of the de-equitization tsunami, but the phase-out of older partners at large firms continues. All lawyers nearing retirement age should ask hard personal finance questions about how to cope with a potential dismissal. Will they be able to get any equity at all out of their firms, and if so how fair will be the price set by their former partners? Are there only certain times of the year (for example, an anniversary date, or the last day of the fiscal year) when they can leave and get their full investment back? Their partnership agreements should have the answers.

Older partners may feel that, even if they are de-equitized, they can count on a pension. But in a 2012 analysis of pension plans of large U.S. law firms, it appeared that a number of the country's largest law firms have pension plans that are underfunded or even not funded at all. See, “Unfunded Pensions Are Big-Law 'Elephant in the Room,'” ABA Journal, (March 1, 2012). What is increasingly likely is that law firms will reflect the Social Security dilemma of too many entitlements and not enough active workers to pay for them. There may be situations where younger lawyers will find it to their economic advantage to leave the existing law firm and its pension obligations to create a new firm with no pension obligations. Partners nearing retirement age, even if not facing de-equitization, should review the status of their pension plans and use their partnership status to demand answers on what the plans funding and future payment prospects are.

At least one large Wall Street firm reportedly has put into place a retirement buy-out program that is quite generous, encouraging senior partners, or those who are on the downside of their careers to retire from the firm voluntarily, with the understanding that they would receive half of the compensation that they had received on the average of the final three years before they retire. This payout is reputed to be seven years. Such an incentive to retire is the same strategy the automakers have used to reduce pension liabilities for years. The early retirement payout reduces the long-term financial burden. The price is steep: in effect the firm is “buying” the retiring lawyers' law practices at a cost of 50% of existing compensation. The orderly transfer of client relationships, during a period of seven years in which the retiring partners cannot compete with the firm, is the advantage that the firm receives.

Afterward

As law firms become more subject to the competitive dynamics of corporate America, they must reflect those dynamics in their own operation. Partnership is no longer a tenured position, and every partner should know what their partnership agreement says about when and how that tenure could end. Those who do not are in the position of the cobbler's children who lack shoes. Before you read through one more client's contract, read your own ' with your own firm.

Ed Poll, J.D., M.B.A., CMC, principal of LawBiz' Management, is a preeminent coach, law firm management consultant, and author. A member of this newsletter's Board of Editors, he is a thought leader in strategic planning, profitability analysis, and practice development, coaching and consulting with lawyers. He released two books in 2012: The Profitable Law Office Handbook: Attorney's Guide to Successful Business Planning, 16th Anniversary Edition, and Secrets of the Business of Law, 2nd ed. His latest book, Life After Law: What Will You Do for the Next 6,000 Days?'deals with pre-retirement planning issues. Poll can be reached at 800-837-5880 or [email protected]. Edward Poll – All rights reserved ' 2013