5/21/14

Pricing, Profitability and Compensation - Part Two

In Part One of this series, we talked about how pricing is pulling towards the compensation challenge for law firms, based on how pricing is interwoven with profitability. In this next section we put forth a “Straw Man” for how compensation might change to better motivate profitable behavior by law firm partners.


Part Two

A Modest (and High-level) Compensation Proposal

What follows is a possible approach to developing a next-generation comp system for a law firm. This approach breaks down comp into a base, plus three different reward or bonus buckets, allowing a firm to reward all types of profit enhancing behavior from partners. The challenge for this system, and any system like it, will be striking the right balance between the three reward options. As previously noted, the balance will need to protect current revenue along with encouraging new revenue. And it will need to properly reward key partners, to retain them within the firm.

Baseline Worker Comp Reward

First - law firm partners need to continue to function as workers. Clients hire them because of their expertise. So any comp system will have to first account for that worker aspect. This proposed model sets a base level of billable effort (a.k.a. work), that all partners should reach. The exceptions (there are always exceptions) might be partners with leadership and administrative responsibilities.

Further refining this concept, we might divide the base level of compensation into two or three levels, where partners are rewarded as workers. This reflects the value of partners as workers and should likely reflect their experience levels. For argument’s sake, let’s set this threshold at 1000 hours. And for their 1000 hours, a firm would set base comp of at three levels (recognizing junior, mid-level and senior partner experience), so if all the partner does is bill (and collect) on the 1000 hours, they will be paid the base amount relative to their assigned level. This base level might be treated as a “labor cost” in a firm’s profitability model.

Of course, firms will set expectations that the base is not enough. Any partner functioning only at this level will likely be let go in short order since they would be only be a worker performing at a substandard level of effort.

Above the Base

Our theoretical firm has three options for a partner to increase their income (and keep their jobs).

Reward Option #1 - Be a better worker.

In this option, the partner would increase their billed and collected hours well above the 1000 hour mark. Our future firm might set a per hour ‘bonus’ for each partner level. Partners who fit solely into this category for comp might be high-level subject experts, such as first-chair trial lawyers, high-value niche regulatory experts, or others with higher effective billing rates.

There will be long-term challenges with partners who only function in this role, as they are truly serving in just a worker role. They may be highly specialized, high-demand workers, but they are not actively expanding the business. Consider a star player on a NFL Team. They will be paid very handsomely, but they don’t make decisions about the business.

Reward Option #2 - Maintain an existing, valuable client relationship

Many partners at firms inherit institutional clients of the firm. Keeping these clients happy has tremendous value. Although in a new model, keeping this client work profitable will be equally, if not more important. A client that brings in $2mm in fees might sound appealing, but if it cost the firm $3mm to serve that client, there is an obvious problem. So the compensation rewards for this option will be tied to maintaining revenue levels and improving the profitability of the revenue.

Here the comp reward can be tied to revenue and profit levels for existing clients. A partner pursuing this comp option will want a happy client and well-managed work. They will be concerned about practice management resources such as project management and practice innovation, and will be pushing for greater efficiencies and new value propositions in service offerings.

Reward Option #3 - Bring in new work

New work will come from both existing and new clients. From existing clients, this might be cross-selling new types of work or significantly expanding work in a given practice. In both circumstances, the revenue will need to be profitable or have the potential for profit. New work may initially be profit-challenged, but ultimately must fall within a firm’s acceptable level of profit. Of course, adding new, profitable revenue to a firm will have the highest value and be reflected in the comp systems as such.

Partners pursuing this option for comp will demand business development resources and differentiated service offerings. They will want to see efficiency enhancing efforts implemented to keep the services cost competitive, although they may not be the ones personally driving those innovations.

Combinations

Depending on the type of practice, a partner might enhance their comp through a combination of the three options. For instance, they may choose to bill a lot and bring in new work. In any event, partners who work hard across any of our options can be properly rewarded. But those that expand the business and enhance profit will be rewarded at the highest levels.

Note: For those partners still living in the old world (e.g. Tax lawyers), this new model will still be able to properly reward their efforts. Those in the old world can still be getting rate increases and still be getting work by being high-level subject matter experts. They would see rewards from all three options and thus be properly compensated.

This reward schema is different from many current law firm comp systems, as they tend to place first emphasis on a partner’s “worker” behavior at the highest value. “Hard work” is primarily perceived as having many billable hours. As billable hours is only one driver of law firm profit, the new models, like the one proposed here, will need to move away from that narrow thinking. Hard work comes in many other ways than just billing time. This new approach recognizes and rewards all of those efforts.

The Leap of Faith?

Regardless of the changes firms make to their comp systems, they will need to find some way to balance out how they reward various profit enhancing behaviors by their partners. They may choose to place greater emphasis on one option or another, but to have an effective comp system, they will want to include all three. Leaving one out and assuming or hoping their partners will still engage in that type of behavior is ill advised. Current comp systems reward “worker” behavior at a high level and as a consequence, partners will focus on that effort to the exclusion of most of the others.

As a former Knowledge Management (KM) professional, from personal experience I can tell you that partners (and lawyers in general) will not engage in efforts that do not impact their comp. One example is CRM. Law firms installed expensive enterprise software systems expecting lawyers to take the time to utilize them, adding valuable client data and leveraging that to bring in more work. Lawyers, for the most part, did not participate. The moral of this story is firms should not expect changes in behavior from lawyers unless they create a clear economic incentive for that change.

Where does that leave us? First - the traditional law firm compensation systems reward behavior that is outdated. They focus on rewards for hours and revenue. They tend to reward partners who bill a lot of hours, along with partners who bring in revenue, regardless of how profitable that revenue is. In today’s market, those rewards are not sufficient to drive profitable partner behavior. Innovative firms will start altering their compensation systems to reward partner behavior that drives a profitable practice in this changing, competitive market.

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1 comments:

Dmitry Minyaylov said...

Thanks for the insightful post Toby.

In regards to your comment about lawyers being reluctant to adopt new comp systems, I can say that that sentiment is very common to new systems in general.

I have worked for a number of software companies that specialized in productivity software (Project Management, CRM, Knowledge Base/KM). The major push back to these applications was that they were difficult to adopt.

Cheers,

Dmitry

 

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