Is the Traditional Law Firm Compensation System Hurting Clients, Lawyers, and Law Firms?

Insights Is the Traditional Law Firm Compensation System Hurting Clients, Lawyers, and Law Firms? Michael Moradzadeh · June 1, 2016

The start of a new year is always a time for big changes in a law firm partner’s life. Suddenly, lawyers get to meet all new people. Why? Because the start of the year is when laterals — partners and associates — start jumping firms. This is not due to exciting New Year’s resolutions to meet new people or try out new places. No, it is instead due to law firms’ odd and antiquated compensation structures. Law firms have created a perverse incentive system that hands out large checks at the end of the year and benefits no one — not clients, not associates, not partners and not even the firms themselves. The result is both a rush for exits once the ball drops and, potentially, a dangerous situation for any firm that had a surprisingly great year.

Law firms typically distribute all their profits at the end or beginning of the year, draining the account for the new year, while forcing partners to stay until the big payout before leaving the firm. The result is that the end of the year is crunch time for partners and associates. All their billing must be in by then so the firm can work its magic and hand down either the large checks for partners’ draws or bonuses for associates. And magic is an apt word for it. For associates, there is usually a target hour total that has to be hit. They are pushed to hit that number — or else they may incur a significant financial penalty. The problem is that associates very rarely control their own workflow. The result is tear-your-hair-out pressure and sometimes questionable billing practices that hurt the firm’s reputations with their clients.

For partners, especially junior ones, the end of the year handouts must seem like a pure magic show. At many firms, only a few partners in the firm’s leadership truly understand how the money is divvied up and questions as to how the finances work are not tolerated. The different types of compensation systems vary by firm — from kill-what-you-eat to lock-step. But for many partners, they frequently have the negative aspects of an air of mystery. The mystery engenders bad feelings among partners, some of whom are disappointed at the size of their compensation. They almost certainly compare themselves to other partners and frequently enough will come to the conclusion that they are underpaid for their work. It is human nature to assume you were owed more than you were paid.

The problems are significant. With the information hidden, rumors can start pushing partners and associates to the door. Once people leave, rumors start spreading creating a vicious downcycle for the firm. Witness the case of the late Heller Ehrman. Rumor had it that Heller went under after settling a number of big cases. The firm failed to properly incentivize partners and even worse, failed to inform them of a strategy for going forward. The result was that a number of partners may have felt that their compensation would drop in the next year. Without strong guidance and a clear communications strategy, the partners were acting very rationally in running for the exits.

What makes things more dangerous is that partners have a huge incentive to wait until their payout before leaving. This means the firm may have no idea how many of their partners will leave immediately after they payout, precisely when the firm has taken on large amounts of debt to cover end of year expenses. Firms are left to simply guess how many attorneys will really be there next year, leaving both the partnership and the clients holding the short end of the stick in January.

At the same time, these firms drain their accounts and plan budgets for the coming year without a true picture of the changes in cost and revenue from these unpredictable firm departures. If payouts happened more regularly, departures would be made throughout the year, and not when the firm was most vulnerable with limited cash reserves. The resulting crisis in cash flow has led to the collapse of many firms — large and small.

Draining their accounts is a particularly bad strategy for law firms. Due to the fact that they are structured as partnerships, law firms do not keep a “rainy day” cash fund around. Instead, they borrow heavily from banks in order to cover shortfalls and smooth out their earnings for the year. What happens frequently enough is that the firm simply doesn’t have enough cash on hand, which also pushes partners out the door and starts the “spiral of death” that has proven disastrous for firms.

These points play into the obsession with “profits per partner.” Profitable partners are pressured to leave because it may help increase the PPP numbers. While there is a temporary bump in these numbers for the firm, it means their entire structure is supported by fewer and fewer rainmakers. And once the rainmakers leave, the chance of collapse grows.

There is a better way. Law firms should rely less on debt, should have more consistent payroll, and greater transparency in compensation models. Borrowing from partners and making them wait for their payout leads to firm instability, disgruntled attorneys, and clients who feel pressured and underserved.