This article provides a holistic overview of the key terms, structures, and moving pieces impacting lateral partner compensation in law firms.
At the outset, there is one main rule of lateral partner and compensation: there is no one-size-fits-all approach. I’ve seen many offers over the years and they are all different.
Partnership: Generally speaking, there are two tiers of partners: (1) equity partner, and (2) non-equity (or “income”) partner. For firms that are structured as corporations, they may use the terms “Member” or “Shareholder” or “Director” but I will use the more widely-used partner terms in this article.
Understanding the various tiers of partnership, and key terms of assessing firm performance, is necessary to have a full and comprehensive view of the various moving pieces that impact compensation.
Equity Partners: Partners who have an ownership interest in the firm entitling them to share in the profits. Equity partners receive shares (or points) to reflect the amount of their ownership. In the American Lawyer’s AmLaw 100 survey, equity partners are defined as “those who file a Schedule K-1 tax form and receive no more than half their compensation on a fixed-income basis.” (American Lawyer, 2021) Equity partners have the most to gain and the most to lose because their compensation is derived primarily from the firm’s profitability.
- Capital Contribution: A portion of an equity partner’s projected earnings is contributed to fund the operational expenses of the firm (also a way for you to have “skin in the game”). There are many ways that firms structure capital contributions. Some firms withhold a portion of an equity partner’s earnings from each paycheck and spread the contribution out over several years. Others, however, require the partner to contribute the full amount immediately and, if necessary, to independently borrow money from a bank with personal recourse for the loan. If a partner leaves a firm, the capital contributed is returned to the partner as the partnership agreement dictates, which can range from sixty days to multiple years. Note: Many firms have moved to increase the overall percentage of capital contribution required in order to reduce a firm’s reliance on lines of credit or other third-party loans. While capital contribution may not seem important during the courting phase, it can also be a proxy as one factor for assessing the financial health of the firm.
Non-Equity (or “Income”) Partners: Partners who have some voice on issues and limited voting rights, but do not share in the firm’s profits. In the American Lawyer’s AmLaw 100/200 survey, non-equity partners are defined as “those who receive more than half their compensation on a fixed-income basis.” (American Lawyer, 2021)
Hybrid Equity: Some (and a growing) number of firms have a hybrid equity/non-equity structure. This means that a portion of the compensation is guaranteed/fixed while a portion is tied directly to the value of the equity/shares. Some firms have a one-tier partnership but the more junior partners are predominantly guaranteed/fixed, and as time goes on, the amount of the equity increases and the guaranteed/fixed amount decreases. Once you are over 50% equity, you are considered an equity partner for purposes of the American Lawyer rankings.
Here’s a chart to understand the two tiers of partnership.
|TITLE||VOTING RIGHTS||CAPITAL CONTRIBUTION||SHARE OF PROFITS||FIXED COMP.||PROS||CONS||EQUITY PARTNER||Yes||Yes||Yes||No, but lateral partners often have a guarantee for a fixed period of time after joining.||Highest internal prestige; share in upside of profits||Capital contribution; potential liability; risk of decreased comp if the firm has a bad year|
|NON-EQUITY / INCOME PARTNER||Sometimes; if you do have voting rights, they are limited||No, but see "hybrid-equity" below||Yes, but see "hybrid-equity" below||Yes, but see "hybrid-equity" below||Predictable income/cash flow; usually eligible for bonuses; reduced liability since capital contribution is limited, if any.||Less internally prestigious than equity partnership; less economic upside potential.|
Key Metrics that Can Help Understand Compensation
Profits-Per-Partner (PPP): A staple of the American Lawyer’s annual AmLaw 100/200 rankings, this is the most widely recognized measurement of a law firm’s profitability. This is the figure on which firms and lateral partner candidates are most focused. According to the American Lawyer, PPP is calculated by “dividing the firm’s net operating income by the number of equity partners.” (American Lawyer, 2021) Explanation: Take the firm’s revenue from a one-year period. Subtract all overhead and operating expenses (rent, salaries, etc.). What’s left (before deducting income taxes and interest) is the net operating income. Divide this figure by the number of equity partners and you have the PPP. Despite its widespread visibility, critics claim that some firms are tempted to “game” the numbers they report.
Why is PPP relevant to you? Generally, the higher a firm’s PPP, the more you can expect to make as an equity partner. However, there are exceptions to this.
For example, let’s take Firm A and Firm B, both of whom have PPP of $2.5M.
- Firm A’s equity structure starts at $800,000 (equivalent point value) and goes up to $4.5M.
- Firm B’s equity structure, on the other hand, starts at $1.5M and also goes up to $4.5M.
- Firm A may have a much higher proportion of partners at the lower end and higher end, and the average number is $2.5. The distribution of partner compensation would be more in the “U” shape.
- Firm B may have more of a traditional bell-shape curve, where a majority of the partners are in the middle, with fewer outliers.
Additionally, some firms have a much wider spread of partner compensation. For example, some firms have a 1:4 ratio of the lowest to highest earning partners, while other firms have a 1:20 ratio, which provides much more distribution on the lower and higher ends.
Some people have used the phrase “Profits for Me”, which is a more apt way of understanding that there’s much more to your particular earning than the reported PPP.
With that said, there is one important benefit of a firm with higher PPP: If you are a high earner, you are not seen as an “outlier” if you make several million dollars. Some partners feel discomfort at being on the high end of a compensation structure because of an imagined (or perhaps real) target on their back. With a firm where earning more is still “in the middle” you do not face the potential pressure of being an outlier. This is a gross and sweeping generalization, but it’s worth mentioning.
Revenue Per Lawyer (RPL): In the AmLaw 100/200 survey, RPL is calculated by dividing the gross revenue by the number of full-time lawyers. This is often viewed as a proxy for overall firm performance and a measure of productivity. If you want to compare firms, RPL is perhaps the most accurate indicator.
Profitability Index: This is a term/calculation used by the American Lawyer to see how profitable a firm is. It’s a snapshot to the firm’s efficiency as it pertains to profits. It is defined as operating income divided by revenue. The higher the number, the more profitable the firm is. Firms range in the teens to low-60s at the very top. Most AmLaw 100 firms range in the 30% range.
Gross Revenue: The fees a firm generates from legal work only (does not include disbursements or reimbursements, or non-legal ancillary businesses) (American Lawyer 2021). A firm can have high gross revenue but still have lower profitability, which is why the American Lawyer has different rankings (e.g., gross revenue rankings, profits-per-partner rankings).
While gross revenue is a term that is often used to rank which firms are at the top of the AmLaw (from a general perspective), the AmLaw has various types of rankings (for example, which firms have the most gross revenue, which have the highest profits-per-partner). Just because a firm is at the top of the AmLaw for gross revenue does not mean that the partner compensation is at the top of the market. There is no correlation between gross revenue and profits-per-partner.
How Compensation is Paid
Guarantee: For incoming lateral partners, the amount of compensation guaranteed for a certain amount of time. After the guarantee period is up, the compensation is reset when the partner falls under the firm’s existing compensation formula. If you are non-equity, your level will be set at a guaranteed level. If you are equity, you will slot into the appropriate equity level.
For non-equity partners, the payment is usually twice a month, with a possible bonus on the end.
For equity partners, you are usually given a certain level of shares that equals the amount of your guarantee. If the value of your shares end up lower than the guarantee, the firm would true you up at the end of the year. You would also get draws/distributions as an equity partner, but sometimes firms will provide alternative payment schedules, especially if their draws are lower and you need a higher level of cash to ease the transition (before your first few distributions).
Firms are tending to minimize the length of guarantees to protect themselves against partners who do not perform as well as expected. The norm tends to be the remainder of the current fiscal year and the following full fiscal year. Longer than that is the exception.
Draw: The monthly, quarterly, or annual amount firms distribute to equity partners as an “advance” against the fiscal year-end calculation and distribution of profits. This is typically a fixed amount per period and is determined by the partner’s anticipated annual compensation. The lower the draw as a percentage of forecasted profitability, the more conservative the firm is being managed.
Periodic Distribution: A portion of the profit that is distributed throughout the year, often on a quarterly basis. This is paid in addition to the base draw. Most firms tend to have their highest distributions towards the end of the year (in December or earlier in the following calendar year).
Hold-Back: A portion of compensation (usually equity partner compensation) that is held by the firm and paid at a later date. The holdback is usually paid during the first month or quarter of the following year.
- Beware: Some firms will hold their “holdback” until 4-6 months into the following year, which is a way to hold captive partners. Why? If partners move earlier in the year, they could forfeit their final holdback (depending on how the partnership agreement addresses this). But if they wait until Spring, they will have already earned credit that would be lost if they go to another firm.
Bonuses: There are so many ways firms bonus their partners. While not all firms offer bonuses, most do. Bonuses are a topic for a separate and dedicated post, but the most common bonuses are tied to factors that the firm deems important and wants to incentivize. There are two types of bonuses: back end and/or signing.
- Back-End Bonuses: Most firms look at a variety of factors (firm citizenship, cross-selling with others, your own billable time) but at the end of the day, your origination of new business tends to be the driving variable.
- For many firms, lateral partners receive a threshold bonus when you hit certain tiers. For example, if you originate and collect over $___, you will receive a bonus of $____. And this can have multiple tiers/levels. Some firms also include bonuses if you collect a certain amount on your own billed time.
- Signing Bonuses: Law firms often give lateral partners signing bonuses for two reasons: (1) to sweeten the allure of making the move; and/or (2) to help offset a financial hit the partner would experience by leaving the prior before all of the distributions and/or bonuses are paid out. It’s a way to “make whole” and perhaps more. Some firms will pay the signing bonus all up front, while some might pay, for example, half up front and half at the end of your first full calendar year (or some variety thereof). Keep in mind that the time of the year in which you move can greatly impact how much money you are leaving on the table, and it’s important to understand the impact of this as it pertains to bonuses and how much a firm may (or may not) be willing to spend to make you whole.
“Eat What You Kill” Compensation Model: A term used to describe law firm compensation models that reward partners largely for the work that they bring in and handle (or supervise) themselves. The upside is that this type of structure rewards the generation of work and client relationship over the “doing” of the work. Some may regard this system, however, as creating a more competitive culture where a partner’s billable credit may prevail over more efficient staffing or cross-collaboration.
On the other hand, while “eat what you kill” conjures up a more negative association just based on the parlance, many think of it as positive and justly rewarding those partners who generate the most business. Here, lateral partners with higher origination credit can earn much more, as the firm wants to primarily incentivize business development. I know a number of partners who could not be happier in this type of environment because their business development efforts are rewarded at the top of the market.
Hybrid Compensation Model: Most firms have a hybrid, where multiple factors are taken into account (your origination of new clients, your origination of new matters from existing clients, your cross-selling of work to other partners, your firm citizenship, etc.) Most of these firms have a bonus element to reward those whose performance merits it.
Formulaic Compensation Model: This is a sub-set of the “eat what you kill” model. Some firms will pay partners on a formula. In short, if you generate X or bill Y, you receive __% of the figures. The benefit to some: it’s predictable and objective, does not allow factors such as politics to get into the mix, and as one partner joyfully explained, “my compensation can often be determined in 10 minutes on an Excel spreadsheet. ”
Lockstep Compensation Model: Partners tend to increase in “lockstep” based on their tenure with the firm, even if they are not particularly high business generators. (Note: lateral partners get slotted in at a particular level and do not start at the bottom just because they are new.)
Just for staying with the partnership, your compensation increases in lockstep with the others. However, some lock-step firms have “gates” at certain levels that serve as a way to ensure that the partner is meeting expectations before they automatically move to the next level(s).
Lockstep compensation was traditionally the norm for magic circle/U.K.-based and certain Wall Street firms. However, magic circle and Wall Street firms that historically subscribed to the lockstep compensation model are modifying their compensation models in order to most effectively compete for the partners with very large practices and to retain the partners with very large practices (who could be susceptible to being lured away to firms that would pay much more for the same size of practice).
It’s a very delicate balance between retaining the cultural glue that has made the firm a special place for many years and staying competitive in the battle for lateral partner talent (and retention).
Transparency of Compensation
Open Compensation System: Compensation data is distributed to the entire partnership (or at least equity partners). This provides more transparency, but at the same time can lead to more in-fighting among partners who may feel they should be “making as much as ____” down the hall.
Additionally, from a recruiting standpoint, it can limit a firm’s ability to pay a premium to recruit (or retain) in-demand lateral partners. There’s always a fear of paying an incoming partner too aggressively. While it may be justified or necessary in order to “land” the in-demand partner, there is a very constant fear of upsetting other partners who may not be earning as much, even though their finances are similarly situated. This can lead to a whole host of problems on multiple levels.
Closed Compensation System: Compensation data is confidential and usually determined by the compensation committee. Although transparency is reduced, this provides a firm more flexibility to reward the highest performers without having to justify compensation decisions more widely within the partnership. Some firms have an “ask first” compensation system, where the compensation is not automatically shared with the partnership, but if a partner requests to “see the books” he/she is granted access to compensation information for all partners.
Credit and Billing
There is not a consistent way that firms use terminology for credit and billing. However, if you are working on a lateral partner questionnaire, it’s important to understand how your firm defines each of the key terms and whether they are consistent with the new firm’s definition.
The below are some terms that help firms determine lateral partner compensation by viewing your current financial profile.
Originations: A term that describes the work a particular attorney is responsible for developing (i.e., originating) from his/her own clients.
Billing Attorney: The attorney responsible for supervising the work of other attorneys on a matter and rendering the bill. In some firms, Billing Attorney can refer to the attorney performing the work (see also, Working Attorney definition below).
Working Attorney: The attorney(s) performing the work.
Relationship (or “Originating”) Attorney: If numerous attorneys are working for one client, the relationship attorney is usually the one who oversees and supervises the work from a higher level and enjoys a close relationship with the client. The relationship attorney also may be the billing attorney, but sometimes the relationship attorney serves simply as a liaison between the client and the billing attorneys.
Standard Billing Rate: The billing rate (non-discounted) the firm represents to clients for a particular attorney. Sometimes referred to as the “rack rate.”
Effective Rate: The actual rate that clients were billed by an attorney. This figure is derived by dividing the total amount billed in a year by the total hours billed. The effective billing rate is usually less than the standard billing rate because it takes into account discounts, write-offs, etc.
Realization Rates: There are two types, and it’s helpful to understand the differences:
Collections Realization Rate: The percentage of fees billed to clients that are actually collected. Example: An attorney bills $2,000,000 but after the bills are sent throughout the year, the attorney provides additional discounts to generate goodwill with clients. The amount collected for the year is $1,900,000. The annual collections realization rate is 95%.
Billing Realization Rate: How much of the time worked/recorded actually gets billed to a client. If an attorney spends 100 hours on a matter but feels only 80 hours is justified and subsequently bills those 80 hours (and writes-off the 20 hours), the billing realization rate is 80%. To get the annual billing realization rate, perform this same analysis for the entire year (the amount of time worked/recorded divided by the amount actually billed to the client).
For both types, the higher the realization rate the better.
This covers the key components and I will be writing more in-depth articles on specific aspects of lateral partner compensation.