The Evolution of Law Firm Compensation

IntersectionLaw firm compensation plans are by and large unsophisticated, hard to administer, too subjective, opaque, and reward the wrong behaviors. As someone wise once said, "If your compensation plan is in conflict with your strategy, your compensation plan is your strategy." To generate maximum financial performance in a law firm, and achieve the highest level of client satisfaction, we need to re-align the incentives. I've said a great deal about the deficiencies of law firm compensation plans (here and here and here). A good plan should further the firm's strategy, be easy to administer, and both drive and reward the desired behaviors. Many miss the mark on one or more of these dimensions. Here are the typical challenges I observe:

No alignment with strategy. Our strategy establishes one set of goals; the compensation plan rewards other, often entirely opposing, activities. We're a full-service law firm for our clients, but we don't track or reward cross-selling. In fact, we create internal competition and ill-will by forcing partners to take a pay cut when they bring others into their relationships. We wish to expand into new practice areas and geographies, but we punish the partners brave enough to lead an expansion because their short-term economic contribution suffers. We want everyone to get out of the office and become a rainmaker, but we pay partners primarily to stay in the office and bill time. We promise clients seamless transitions when partners retire or depart, but we punish partners who introduce younger colleagues into key relationships by requiring them to split credit. We promote our client focus, but we pay for hours, not efficiency.

Limited transparency. Some firms share compensation amounts among all equity partners. Others share nothing. Some firms have lengthy compensation plan documents. Others make all decisions in a closed-door session involving a select few. Some offer helpful scenarios to guide partner behavior in matters such as fee-splitting. Others trust partners to figure it out. What most miss is that transparency is not the same as having an open or closed system (sharing, respectively, all or no compensation details). Transparency is about establishing clear direction as to which behaviors we reward, and in what proportion, and doing so well in advance of the desired behavior. More than one managing partner has been shocked to discover that many, if not most, partners are unclear on the firm's primary compensation drivers. This is management shortcoming, not a result of dim bulb partners.

Poor or insufficient metrics. Some financial metrics are easy to come by, such as billed hours or collected receipts. Others are more elusive, such as timekeeper or client profitability. Still other metrics are more directional in nature, such as cross-selling (we may know the client worked with another practice group, but we don't necessarily know whether the relationship partner drove that). Some behaviors have only subjective metrics: serving as a good mentor? community involvement? acting in the best interests of the firm? A solid plan has specific metrics tied to the desired behaviors, and a clear and sustainable methodology for measuring performance in more subjective areas.

Inconsistent or incomplete reporting. When the compensation drivers are established, they should be published and then periodically the metrics tracking performance should also be published. Why not monthly? It serves little purpose to provide no metrics until year end, or provide vague or incomplete metrics at uncertain intervals during the year. It's hard make a course correction if we have neither a map of our destination nor our current coordinates.

Failure to acknowledge self-interest. We all want to earn a healthy living. But just as partners are loath to discuss budgets with clients, many avoid compensation discussions until required to do so by executive or compensation committee fiat. There's nothing wrong with wanting to know what specifically I can do to increase my compensation -- especially if the management committee has aligned the comp plan to strategy, so maximizing compensation furthers the strategy! Also, far too often top rainmakers or management or comp committee members prevent meaningful discussions of compensation plan changes because they fear losing income. While a revised plan may indeed result in changes to some partners' compensation, if the outcome is improved financial performance for all (and improved client satisfaction), then it's bad form and quite possibly a breach of fiduciary duty for those at the top of the pay scale to refuse to review alternatives.

Pursuing a disruptive implementation. If we identify a better compensation approach that serves the partners' and the clients' interests, it's statistically improbable that everyone will make the same. The change may be good. Some partners who are more comfortable billing time might be quite pleased with a plan that offers more certainty but less potential. Rainmakers may enjoy growing their books of business without being tethered to the billable hour. But some change may be troubling: some may see a compensation decrease commensurate with a declining trend in economic contribution. But we don't have to make these changes all at once. We can establish the end-state and then migrate to it over several years, providing training or transition support to those who might be significantly disrupted by a new plan.

Incomplete modeling. By nature, any forecast is speculative. To change a compensation plan means applying numerous "what if" scenarios to current performance, with no guarantee that we will sustain our current level of performance. We also don't know if, or how quickly, an adjustment to, say, origination credit will grow the pie. We don't know for sure how many partners will defect if their compensation will decrease, because the market dictates whether their economic contribution is more valuable elsewhere than here. They may already have the greenest grass they'll ever see. So we must model numerous factors, using realistic variables, and then create a few versions of the future. Failure to do this may result in significant disruption and unrest, and risk-averse lawyers tend to become flight risks during times of uncertainty.

Big dog accommodations. Every firm has one, if not many, partners who are the top of the food chain and who are somewhat blasé or even outright hostile to firm policies. Nothing creates organizational turmoil than when senior leaders or big dogs are allowed to break rules that little people must follow. When a top rainmaker threatens to leave, sometimes the best response is to say goodbye. When new compensation policies are put in place, it may be reasonable to make certain accommodations for those who feed others. But there's a limit. The behavior we desire should be incorporated into the compensation plan, and there's no room for unwritten rules.

A compensation assessment or redesign can be an extraordinarily effective tool to improve financial performance, foster a client-focused and collaborative culture, reduce unnecessary distractions, and provide a roadmap for career success. Expecting smart people to somehow "figure it out" is lazy management. Build the future you want in your law firm. Start today.

 

Timothy B. Corcoran was the 2014 President of the Legal Marketing Association and is an elected Fellow of the College of Law Practice Management. He delivers keynote presentations, conducts workshops, and advises leaders of law firms, in-house legal departments and legal service providers on how to profit in a time of great change. For more information, contact him at +1.609.557.7311 or at tim@corcoranconsultinggroup.com.

 

The Perils of Income Smoothing

Illustration by Chloe Cushman, h/t Financial PostPerhaps you've been following the criminal trial of former leaders of disbanded law firm Dewey LeBoeuf LLP. The prosecution contends that these leaders purposely misled other stakeholders, including equity partners, bondholders, and the general public as to the firm's fiscal health. Law360 reporter Andrew Strickler recently asked me whether such shenanigans are standard practice. After all, if everyone does it, and if there's no standard for financial reporting, is it wrong? You can read "BigLaw Fee Antics Persist Despite Dewey's Cautionary Tale" and many other articles related to the Dewey trial here. I'll offer some brief elaboration on my comments.

First, it may be helpful to have the fastest lesson ever in law firm accounting. Most law firms operate on a cash accounting basis -- simply put, when a client sends a check, it's counted as revenue. When the law firm spends money or a lawyer records time, it's counted as an expense. A lawyer doing work for a client today, and incurring expenses on behalf of that client tomorrow, might not get paid until many months after. At fiscal year end, the firm's total expenses recorded for the year are subtracted from all the revenues collected, and what remains is the firm's annual profit. So revenues associated with a specific matter might fall into next year even though much of the expense was counted this year.

Most companies, however, operate on an accrual accounting basis -- for reporting purposes, revenues and expenses are recorded according to certain trigger events. So the company might sell a product with 12-month payment terms. The entire revenue is "booked" at the time of sale even though the actual cash flows in over a much longer period. This approach allows business leaders to gain insights into financial performance without worrying about timing issues. Of course, in the example above some buyers default so there is a process to reconcile what we booked with what we actually received.

It may also be helpful to understand that good "fiscal health" is often loosely defined as a track record of generating increasing revenues and profits every year, generally without huge peaks or valleys. Many investors like certainty. Of course, business is unpredictable. Higher returns tend to require higher risks. So when investors, or market analysts whose job it is to advise investors, demand consistent performance year in and year out, they often mute the performance of companies that are inclined to gamble less. Many business leaders act conservatively, seeking a predictable annual growth rate rather than making bold bets and possibly generating leaps in income. Investors with a high tolerance for risk expect much bigger bets and much larger returns, and are willing to accept bigger misses. In a law firm setting there are no external institutional investors, but there are partners (who are equity shareholders), staff, potential recruits, clients, and competitors who all serve as stakeholders. Show weakness or fiscal instability and competitors will pounce, clients may hedge their bets by shifting work elsewhere, and lateral recruits with sizable books of business will get cold feet and seek stability elsewhere. So law firm leaders tend to want to project an aura of fiscal stability, of endless, solid, stable growth through good times and bad, regardless of economic or competitive conditions.

Whether a company relies on accrual accounting or a law firm relies on cash accounting, its leaders can be tempted to play with the timing of events to smooth out peaks and valleys. While these leaders may have good intentions, "income smoothing" is, by and large, unethical, and most likely illegal when it reflects a purposeful intent to use creative accounting to present a false picture of financial performance. Studies have also demonstrated that, in the long run, income smoothing negatively impacts performance. I have no particular insight into Dewey's financial performance or accounting practices during the period immediately before its demise, but there are numerous techniques I've observed by other organizations elsewhere that suggest purposeful income smoothing.

Perhaps the law firm has already met its financial targets for its January to December fiscal year and a few more checks arrive in the mail in the final days. If it sits on the checks for a little while before depositing, the revenue is recorded in the following year, giving the firm a headstart. Or perhaps a friendly client will send a check in December with a January date, allowing the firm to record the revenue in one fiscal year but actually cash the check in the following fiscal year. The reverse also happens, a client sends a back-dated check -- it arrives in January with a December date, allowing the firm to pretend the check arrived in time to count in the earlier period. The same can happen with expenses -- making a lease payment early, say paying the December rent on December 1st and the January rent on December 30th, in order to reduce the coming year's expenses.

"But wait," you might say, "If we have extra income and we want to pay the rent early, isn't that a sign of good fiscal health?" Sure, it could be. But when the intent is to specifically disguise actual financial performance and it results in stakeholders making poorly-informed decisions, then it's more nefarious than prudent. Imagine if firm leaders delayed recording fee receipts for a specific partner by ensuring that all expenses are recorded, and accelerates some expenses from January into December, with the net effect negatively impacting the partner's performance metrics so that his colleagues demote him to a lower equity tier and he earns significantly lower compensation. Or imagine that firm leaders offered several compensation guarantees to new lateral recruits but hid this from other partners, disguising these contractual payments as travel expense reimbursements.

You can see that a lack of financial controls can create a slippery slope where even an honest and good-intentioned leader might tweak some figures to address some short-term issue, with the expectation that everything will work out over time and no one will be the wiser. And sometimes it does. But, just as with gambling addicts, sometimes a tweak here or there that doesn't pan out leads to even bigger bets "to get caught up and then I'll stop." That same lack of controls can tempt bad actors into specifically defrauding shareholders and other stakeholders.

Sadly, too many law firm partners aren't given access to detailed firm financial information, or they are too disinterested to request access, or are given access but don't have a clue how to interpret the results. Some have argued that forcing law firms to use the accrual accounting method will help improve transparency -- but this move is not without consequences. Others have argued that law firms, despite being private enterprises, should release periodic public financial reports. One way or another, demystifying law firm finance and perhaps adopting more transparent approaches will serve the profession well. There may not be readily available statistics on how prevalent income smoothing is in law firms. But perhaps all we need is a smell test: Do you know how your firm accounts for revenues and expenses? Do you know if and when and by whom these practices are audited? Do you have absolute faith in your leaders' integrity? Does the position description for firm leadership require finance or accounting training? Are there sufficient fiscal controls in place to prevent one bad actor from wreaking havoc? If you don't know these answers, it doesn't mean there's a problem. It just means you'll be the last to know when there is.

Timothy B. Corcoran is the immediate past President of the Legal Marketing Association and an elected Fellow of the College of Law Practice Management. He delivers keynote presentations, conducts workshops, and advises leaders of law firms, in-house legal departments, and legal service providers on how to profit in a time of great change.  To inquire about his services, contact him at +1.609.557.7311 or at tim@corcoranconsultinggroup.com.

The Predictability and Perils of Over-Monetization

"There is no such thing as over-monetization!" Until the client catches on. And then you're screwed. I don't know when I first learned that money could become a verb and monetize and monetization were a thing. But as a young corporate guy moving up the ladder, these words were ideal additions to my vocabulary. If there was one thing I was good at, it was making money for my organization. But in my perpetual quest to close sales, develop new products, defeat the competition, and win awards, I never lost sight of the client's needs. In fact, it was this laser focus on long-term client satisfaction that formed the basis for my success year after year.

It sounds simple in practice, but when faced with the choice to make a few more dollars today while potentially putting the long-term client relationship at risk, many businesspeople are awfully short-sighted. And so it is with lawyers, whose compensation plans often reward billing hours, collecting cash receipts, and generating sizable short-term profits. Maximizing matter profitability often conflicts with a client's desire to lower legal spending. So we might win the battle but lose the war when the client selects a different law firm for future matters of this type. In the end, did we really profit from this transaction?

In this endless quest to make money and make sales, why are we surprised when clients react negatively to high prices? priceincreasesIn simple terms, in a price elastic (or price sensitive) market clients buy less when the price goes up and they buy more when the price goes down. In an inelastic market, the price doesn't have the same direct influence on buying behavior. Many law firm partners came of age at a time when clients were less price sensitive, or had sufficient legal budget so they could overcome their annoyance at rising prices. A simple google search will reveal in-house counsel complaining of rising rates for decades, but most did little about it until the "Great Reset" when shrinking legal budgets drove new behaviors. In addition to seeking lower prices -- by extracting price concessions from incumbent law firms and/or by shifting work to smaller firms with lower rates -- clients also began to seek alternatives and substitutes, e.g., more in-house staff, or LPOs, or non-traditional legal providers, to meet their legal demands. This behavior is as predictable as the sun rising in the East.

The concept of over-monetization is simple: when clients can obtain similar services at lower prices elsewhere, or when clients can obtain reasonable alternatives and substitutes at lower prices, and they act on this, your prices are too high. If your offerings are over-monetized, the clock is ticking. You can try, but you will never find enough new clients with pockets so deep they don't mind over-spending, or with management so inept that they don't recognize over-spending, to make up for the rush of clients out the door.

It is not hard to identify over-monetization. In the legal space, there are some excellent providers, e.g., Wolters Kluwer ELM Solutions (formerly TyMetrix), SkyAnalyticsBTICounselLink on the buyer side; Peer Monitor, PWC, Citibank, ALMBTI, and more on the seller side, to provide such benchmarking. Remember, it's not just how your published rates compare to other firms' published rates; it's what clients are actually paying that matters. However, numerous law firm leaders persist in believing their offerings are unique, not subject to price elasticity, or tied to a premium brand that is immune from the price pressures facing weaker competitors. For a few law firms, this is true. Odds are, this isn't you. (I'm being gentle. All legal services are eventually subject to price pressure.) If you're observing some leading indicators of price pressure, including decreased realization, decreased client retention, decreases in new matters, a declining competition win rate, increased discounts, increased demand to contain firm overhead, and so on, then you're in the thick of it.

Recognizing price sensitivity is half the battle. Business leaders have a bias for optimism, but when that optimism turns to blind stupidity the organization is in trouble. Some years ago my parent company's brand new CEO insisted that warnings of price pressure and declining market demand were merely the bleats of frightened sheep, so he outlawed the term "over-monetization" in all business discussions. He then insisted that all product lines must adopt a hefty price increase in the coming year, irrespective of past price increases, client demand, competitive forces, or any other factor. Every. Single. One. My team had spent a year developing a new pricing methodology for our core product offering because a long history of excessive price increases had eroded the goodwill of even our most loyal clients. The widespread adoption of substitutes and alternatives was rapidly eroding our revenues and profits as well, so we not only resisted raising our prices, we planned to lower our prices. And we were overruled. Even more onerous price increases took effect, and a few years later, long after most of us had moved on in frustration, the entire business unit disappeared. Completely. There was nothing left. The CEO, however, was handsomely rewarded when the price increases led to a one-time boost in revenues. Market analysts loved him. Until the following year when clients resisted that tactic. So he then conducted layoffs to boost profits. And he was rewarded again. Consistently boosting prices beyond what the market will bear works if your goal is to make a lot of money and run. But it's no way to build, or lead, a sustainable, successful business based on repeat clients.

The lesson is that ever-rising prices will not only eventually intersect with the clients' desire to spend less, it will often cause the clients' desire to spend less. But it doesn't have to be this way. Any business school teaches the concept of a business cycle in which products and services evolve from shiny new ideas adopted by a brave few, to commonplace tools in use by many, to outdated anachronistic offerings relied on only by slow movers. Typically prices are low for early stage offerings, and prices increase during the lifecycle until they reach their apex, at which point no one buys any longer. If your current offerings are over-monetized, you need to find new early-stage offerings that better meet market needs. Or start to downsize your business, because declining revenues and profits will not support the infrastructure you've built.

For law firms, this means finding new ways to price and package existing legal services so they better meet clients' desire to spend less. This can be a good thing. We can capture more market share from competitors who won't change their approach. We can lower our prices and win more. Of course, savvy business leaders recognize that we can't merely lower our prices to find long-term success; doing so would be tantamount to suicide. But we can embrace project management and process improvement in order to profit from efficiencies even as revenues for some product lines are flat or declining.

Your law firm is a business, so get over your angst about the use of words like price, and product, and sales. It's not a matter of if, but when your services will be over-monetized. So get there before your clients and you can reinvent your product offerings, and your business, before the disruptive new entrants and your fast-moving competitors dictate your future.

 

Timothy B. Corcoran is the immediate past President of the Legal Marketing Association and an elected Fellow of the College of Law Practice Management. He delivers keynote presentations, conducts workshops, and advises leaders of law firms, in-house legal departments, and legal service providers on how to profit in a time of great change.  To inquire about his services, contact him at +1.609.557.7311 or at tim@corcoranconsultinggroup.com.