Protecting assets: Tips for managing your law firm's equity

With the Legal Services Act now fully implemented and alternative business structures (ABSs) going live regularly, we have entered a new and uncertain world for the UK legal services market. However, it is also one in which some lawyers in £10m-plus turnover law firms are apparently declining the offer of equity partnership.

While the full effects of the changes taking place now won't be known for 10 to 20 years, it's still a good time to be in the legal services market. There are countless opportunities and, unless you 'bet the firm' (which isn't advisable), it's unlikely that anyone's equity will really be at risk.

But, what is equity these days and who should have it? I've witnessed a broad range of approaches to firm remuneration strategies and to the granting and taking away of equity. This article provides some practical solutions to those questions, building on more than 20 years of experience in working in the legal industry.

Defining equity

The equity (profit) in a law firm is a ?function of growing and improving the following factors:

• people;

• reputation;

• brand;

• client relationships;

• business processes; and

• knowledge.

The objective is to grow these factors over time and to benefit from the multiplier effect of improving all of them together.

Historically, UK law firms have tended to distribute profit on a lockstep basis. Even where the system has been modified to include merit elements, gateways and so on, lockstep still underpins the majority of firms' approaches to distributing profit. This is not surprising - changing profit-sharing arrangements in partnership agreements requires a high majority vote in favour. Where any change includes winners and, more importantly, losers, those who are likely to lose or are on the borderline aren't going to rush to vote in favour of change.

Types of remuneration

Changes to profit-sharing arrangements are however slowly happening. In this context, there are five key components to remuneration in a modern law firm:

1. interest on capital;

2. a notional or fixed share;

3. responsibility (or role) payments;

4. bonuses (or merit awards); and

5. residual profit - 'real' equity.

 

1. Interest on capital

Should interest be calculated on the basis of a risk-related return or just a base rate plus a reasonable margin? The answer to that question hinges on whether capital really is at risk.

In a well-managed firm, there should be very little risk to partners' capital as the cost of fixed asset investments reduces, ?IT services are increasingly sourced from the 'cloud', and premises expenditure gradually decline, with offices becoming more open and flexible approaches to working being adopted.

2. Notional or fixed share

This should represent a partner's fixed share for undertaking that role and should also be guaranteed (this much easier in an LLP than in an unlimited partnership). So, if profits aren't enough in one year to pay for this (hopefully that won't be the case), the unpaid balance is carried forward and paid the following year.

Partners' drawings should be based on this element of profit sharing. This fixed share should be set high enough to differentiate the role of an equity partner from the role of a more junior fixed-share partner.

3. Responsibility (or role) payments 

The big accountancy firms put a lot of store in responsibility payments and it is a key element of a partner's remuneration. It should be the same in law firms.

Success in the new legal market isn't so assured for key roles in law firms to be undertaken by 'gifted amateurs'. It is now essential that firms are led by partners (including non-lawyer partners) who are best placed to provide the leadership ?that firms and the practice groups within them need.

A proportion of profits should be set aside for those who undertake these roles. I don't advocate very high rewards for those in very senior leadership roles (nor do I think that those in leadership roles should do no client-facing work either). The most that should be allocated to this part of a partner's remuneration is 50 per cent of the notional or fixed share - and that should only be for the most senior leadership roles.

4. Bonuses (or merit awards)

I have yet to come across a system of rewarding partners through a bonus system that has produced a satisfactory outcome. This is particularly the case where the criteria tend to be narrowly focused on financials when, at partner level, excessively high individual financial achievements are probably counterproductive to the effective running of the business of the firm in the medium to long term.

Having said that, in any year, some partners are going to go the extra mile, so it's worth setting aside a small proportion of profits to recognise this. It shouldn't be so large that it is itself a motivator for excessive performance year in year out. ?No more than five per cent of total profits is reasonable.

All of the partners should vote on ?this anonymously, perhaps using an internet facility such as Survey Monkey. Not only is it a powerful indication of ?the partners' views of who and what merits an award, but it is also a good indicator of the strength of your current partnership culture.

As you will appreciate, there are lots of ways in which such surveys can be undertaken, but I'd limit partners' votes ?to a manageable number and then split the pool according to the proportion of the total votes that a partner gets - clearly, partners shouldn't be allowed to vote for themselves.

5. Residual profit - 'real' equity

After all of the above is taken into account, the remaining balance represents the residual profit of the ?firm. This should be distributed in ?capital ratios.

It is up to your firm to then determine whether capital should be contributed equally or on another basis. Having experienced a number of variations in this area, I've found that near-equal capital contributions (and, generally, near-equal profit sharing) is a powerful driver of positive partnership behaviour. However, it does mean that, for senior partners, there is no quasi-goodwill related return reflecting their contribution to building up the firm's reputation and so on.

The sum total of applying these five criteria to partners' remuneration is that there should be a high degree of appreciation as to how any partner's remuneration is determined, a degree of certainty in day-to-day 'pay' to facilitate planning and a fair degree of consistency in the remuneration of all partners.

Creating new equity

Traditionally, UK law firms have operated on the "now't in, now't out" policy. However, this is changing as new entrants set out their stalls and are increasingly doing so on the basis of offering partners shares that are tradable and, importantly, remain the partners' property even after they have retired.

The new equity is the value of a future dividend stream from improving profitability. The expectation is that there will be an increasing dividend stream, so increasing the value of the underlying shares that exist in firms can increase the scale of their activities through replication, efficient business processes and diversification.

It is in firms that are predominantly consumer focused where this new equity exists, as Russell, Jones & Walker (Slater & Gordon), Paribas Group and Irwin Mitchell are showing. All of these are substantial businesses operating in large-scale personal injury and other claims markets.

Does new equity exist in other firms? It does if you are willing to think about your business in a different way. The Co-op is proposing to do so in a number of areas. Firms with traditional but reasonably substantial high street practices can also benefit, but the rewards will be smaller and will take five to ten years to come through.

This can be illustrated by considering a firm's wills bank. It is very probable that a large high street firm that has been established a number of years will have a wills bank extending to thousands of wills, and may well be adding another 500 a year. It's likely that the firm is only converting about 20 per cent of its current annual wills into probates.

Assuming the average probate is worth £5,000 on average, that's an annual fee income of £500,000 and a profit at a 20 per cent margin of £100,000. By increasing the retention rate for probates to 50 per cent, it will generate a fee income of £1,250,000 and a profit of perhaps £400,000 (assuming some economies of scale are achieved). It is the £300,000 of additional profit that is new equity.

The means by which the retention rate is enhanced will come from a number of business case and investment dynamics criteria. It's interesting, in this context, to reflect on what Duke Street Capital has said about why it has invested in Paribas Group (the parent company of insurance litigation firms Plexus Law and Cogent Law):

Business case

• Acts for large number of blue chip insurers

• Litigates 200,000 cases per annum

• Diversified into claims management outsourcing, rehabilitation, loss adjusting and H&S assessment and auditing

• USPs - demonstrable and material cost savings for clients (sustainable client relationships)

• Innovation abroad (South Africa)

• Revenue growth of 25 per cent per annum

Investment dynamics

• Leader in fragmented market, with strong growth potential through outsourcing (of claims management)

• Strong management team

• Track record of revenue and profit growth of 25 per cent and 50 per cent over three years

• Barrier to entry is that scale is difficult to replicate

• Growth through pursuit of new channels, sectors and claim segments (employers and public liability)

• Acquisitions at low multiples, driven by recent legislative and regulatory change

James Caan, who has invested in Knights, mentioned paying up to seven times earnings for recruitment agencies and he believes law firms exhibit similar characteristics, so one presumes similar multiples are available to savvy law firms.

Managing the equity

What should you be considering in relation to bringing people into the equity partnership and retiring partners out of it?

This has also been changing over the past 20 years. Some common characteristics include:

• the time it takes to achieve partnership (not necessarily equity partnership), which is around about seven years?post-qualification;

• a lengthening of the period from being appointed a fixed-share partner to achieving equity, which is now more commonly three to five years; and

• a period in the equity of between 30 and 35 years.

Appointing people to the equity remains a sensitive subject and, despite some very sophisticated systems, it can still be a very opaque process. There is a lot of debate about who deserves the equity, which is fuelled by:

• a loss of cohesion in partnerships as they have grown and diversified;

• access to better information about performance;

• changes in the skills required of partners; and

• partners' ability to adapt to these changes.

Often, the debate has centred on slicing and dicing the current cake, not about increasing the size of the cake!

Exiting partners remains difficult, time consuming and quite unsatisfactory. It is invariably driven by performance challenges that had existed for many years prior to the partner entering a formal performance management process.

Inviting people into the equity

When should you invite someone into the equity? Over the past 20 years, there has been an explosion in fee income in law firms, but the numbers of associates appointed to equity partnership has grown at a much lower rate. To maintain profitability, it's clear that this trend will continue and that firms will be very sparing about who gets a share of the equity.

Thus, the key issue is to only offer equity to those who really want it and who demonstrate consistent performance and potential to add to the value of the existing equity. Such candidates need to demonstrate that they have developed all of the skills needed of partners. They need to be performing like equity partners before they become them.

In this context, fixed-share partners need to be able to demonstrate that they have a credible business case that shows how they will be able to earn fees that are equivalent to at least the current average fees per equity partner, and how they will earn a profit from those fees equal to the current average profit per equity partner. Nothing less is sufficient if the partnership is not to suffer dilution in the equity (clearly there will be cases where the promise of such a return is sufficient justification for appointing a high flyer to the equity ranks and suffering a temporary dilution).

Taking the equity away

When should you take the equity away? Firstly, make sure you can take it away and:

• check the partnership agreement for the relevant enabling provisions;

• ensure there is no discrimination and that you have a fair process (or are prepared to pay for an unfair process); and

• check who the other weak partners are and that they are a long way off, or the prospect of a domino effect will put other partners on their guard that they will be next.

Secondly, make it easier by offering alternatives such as:

• an ambassador role, i.e. a largely non-fee earning role to promote the firm in the marketplace;

• an administrative role that frees ?up other partner resources to ?grow the firm;

• a fixed-share role (including, where appropriate, a part-time role) that enables a partner to wind down ?in a dignified way; and

• a fixed pension for, say, five years for an underperforming partner.

Introducing these latter options makes for a much easier conversation, as it's not then a cliff edge discussion. Indeed, knowledge of these alternatives may well encourage partners to take the initiative.

Addressing underperformance

In determining when a partner's position needs to be reviewed, the tool of choice is the partner performance measurement framework; history suggests that this process should be kept as simple as possible. I also favour simple performance hurdles that all partners accept must ?be achieved to facilitate the smooth running of the partnership.

Once it is clear that someone is ?falling behind, get it out into the open quickly - don't delay, as that doesn't ?help you or the partner concerned. In ?fact, if you get it out into the open early enough, you are more likely to find that the partner can turn around his performance. If it's left unaddressed, that prospect diminishes rapidly.

One firm I worked at had a yellow and red card system, where a yellow card was issued if a partner failed to achieve the hurdle in any year, a second yellow card was given if the same thing happened the following year, and a red card was issued if the failure was repeated for a third year in succession. A partner would be rehabilitated one level if he exceeded the hurdle the following year.

Individual firms can decide how many criteria a partner needs to fail before a yellow card is issued and what the sanction is when a red card is issued. This particular firm voted to remove the partner from the equity and demote him to the fixed-share partnership. While this may seem brutal, it has a number of helpful features. It is:

• open and honest;

• governed by clear performance criteria;

• less time consuming;

• potentially motivating;

• reversible; and

• collegiate.

Myriad options

As the legal market changes, firms will have to adapt the ways in which they remunerate partners and manage their equity. The systems that firms can apply are very wide ranging, but the above ?sets out a number of options that have suited the firms at which I have worked. ?They may be relevant to your firm as you endeavour to secure the future commitment of lawyers to equity partnership in your firm.

Karl Wingfield is the chief executive at UK law firm BP Collins (www.bpcollins.co.uk)