Six external trends and issues affecting partner profit sharing

It always used to be the case that partner profit-sharing discussions were a matter of entirely internal focus. In recent years, however, partner remuneration has become less idiosyncratic, moving towards meritocratic performance-related systems and away from the many different and individualised lockstep arrangements. In this movement, I have noticed six externally-driven issues with which firms need to contend.

1. Measures and metrics

As law firms have moved away from assessing partners just on their revenue performance, they have joined every business sector in finding the evaluation of an overall contribution to be extremely difficult, particularly in areas of soft management skills.

There are some who argue that financial results will reflect business development as well as team-building successes and that, accordingly, revenue evaluation should remain the predominant criteria. Other firms are carefully building balanced scorecard methodologies and are striving to supplement these by measures and metrics which will help to provide a fair assessment.

2. Distributable profit

For several years now, the financial climate has resulted in decreasing net profit margins and cashflow issues. These have put pressure on the amount of distributable profit which can be allocated by way of bonuses or performance-related payments. It is less easy to give bonuses when profits are low.

3. Performance outliers

Firms increasingly recognise the need to reward high flyers and exceptional performers; at the same time, there is less tolerance for those who are performing least well.

High performers can usually assess their performance and rewards against perceived external benchmarks. The problem with underperformance is that the problem is usually judged internally relative to other partners, rather than by reference to external benchmarks. Hence, the worst-performing partners can become isolated and unloved even if - objectively speaking - their performance is at an acceptable level.

As firms remove more and more underperformers, partners who were previously at the low end of the middle group of performers will then begin to form a new bottom group. This may not be an issue in over-partnered firms, but it may affect the firm's overall performance if partner numbers are about right.

4. Cash reserves

Law firms have traditionally been accustomed to think very short term and to allocate all profits in the year to their partners, while the culture and practice of holding back or reserving profits is the norm in the corporate world.

As the professional service model moves towards the corporate one, the practice is gradually emerging of reserving some element of profit for long-term funding needs, as well as for deferred partner and staff rewards.

Similarly, in firms with a corporate alignment, the profit calculation can be divided into three elements of: notional salary; the expected 'dividend' (even sometimes on a deferred basis) to give an appropriate equity or proprietorship return; and bonus for good performance.

5. Firm valuation

In jurisdictions like the UK, stakes in law firms can be bought by external investors. The first valuation calculation that has to be carried out by law firms is their earnings before interest, tax, depreciation and amortisation (EBITDA).

In order to do so, the firm's net profit must be reduced by the market salaries to which partners would be entitled if they were not owners. The resulting profit after the deduction of notional salaries then becomes one of the key elements in the various methods of calculating the firm's valuation.

Many firms find that their EBITDA is tiny or non-existent and that, consequently, their firm is worth little or nothing. From a profit-sharing point of view, however, the EBITDA calculation does help to separate the ownership and risk aspects of being an equity partner from client-facing and worker-manager aspects.

6. Intra-office profits

Variations in profitability in different markets can put great pressure on integrated remuneration models. Many international law firms operating with a Swiss verein structure will allow member firms to continue in alliance mode, retaining their local profits.

Some integrated models with a global profit pool allow an element of subsidy, which is often capped. Another method is to apply a purchasing power index to the unadjusted profit share. This approach seeks to preserve the concept of equity but does so in terms of purchasing power rather than contribution to profitability.

The clear message is that any profit-sharing system in a law firm needs to stand up to external benchmarks and standards, as well as being tailored for the specific context and needs of the firm.

Nick Jarrett-Kerr advises law firms worldwide on strategy, governance and leadership development (www.jarrett-kerr.com)