The Question of Partner Compensation Guarantees
Partner compensation guarantees can be an appropriate tool in lateral hiring situations, both for the benefit of the firm and the individual partner. However, the number of guarantees, their duration, and the situations in which they are triggered can quickly run out of control and threaten the firm culturally and financially. Understanding how that can happen is important for every partner in the firm.
(Reprinted with permission of The International Review, copyright 2014)
the QuestiOn OF Partner cOmPensatiOn guarantees
Guarantees don’t destroy law firms. It is easy to point to guarantees
as a cause of Dewey’s demise, but it is probably more accurate to
look at them as a symptom, because there were so many things that
went awry at Dewey.
Are compensation guarantees inherently ‘bad’ in law firm opera-
tions? Definitely not. But just as a kitchen knife is not inherently a
bad thing, there is no question that when used improperly, irrespec-
tive of good intentions, bad things can and will happen with both
knives and guarantees.
Your first area of caution with any partner compensation / distribu-
tion guarantee is whether, and to what extent, it may pay a partner
more than they have earned under your firm’s compensation
model, as the model is supposed to be applied to all partners.
A second area of caution with a partner compensation / distribu-
tion guarantee is how long the guarantee stays in effect before your
partner is fully absorbed into the law firm’s compensation model.
As a transition device for integrating a lateral partner, compensation
guarantees are viewed by many firms as a legitimate tool. When
you bring on a lateral partner you should be able to forecast, with
some accuracy, where that partner, with a certain level of business,
will fit into your compensation system and what they should earn.
“If you do ‘X’ then you should receive ‘Y’ has to be part of every
lateral hire conversation. Done properly, the guarantee is both a
protection against the firm underperforming for the lateral and
against a lateral over-representing how he /she will perform.
As we all know, the world is an uncertain place, and disappoint-
ments with lateral hires who underperform are pretty high. But
by Edwin B. Reeser and Patrick J. McKenna
The Question of Partner
F A L L 2 0 1 4
cooperate and your firm doesn’t succeeded in meeting its net in-
come goals. Then you have to reset the partner to a lower level,
which could trigger his / her departure and a financial loss for the
firm (especially if a recruiter fee was paid for the deal).
2. When it assures a level of income based on different operating ratios.
Another area where a compensation guarantee becomes problem-
atic is when a lateral comes from a firm that has a significantly
higher operating margin. All things being equal (they never are, but
let’s do this for illustration) a law firm with a 40% operating margin
can afford to pay its partners more for the identical book of busi-
ness than a firm with a 20% operating margin. Like twice as much!
Let’s say George has a $10 million practice with a strong 40% operat-
ing margin in a law firm with that same margin. George will often
be diluted by laterally moving his practice into a different firm with
a 20% operating margin. Why? Because
relatively few law firms compensate based
on contribution to profits. Instead firms
historically compensate based on gross
revenues. Rather than reconfigure their
entire internal compensation system to
one based on individual partner profit
contribution (and possibly resulting in a
significant pay reduction for high volume
/ low margin practice partners) the partner
candidate receives a guarantee so that he
/ she can receive a comparable income to
what they were earning in a firm that could afford to pay it. In some
cases, the pay package has to be even more than that to get them to
come. Thus it must be recognized that the challenge in this situation
isn’t with the newcomer, but rather it is a struggle to maintain what is
an inequitable allocation of income already existing in the new firm.
If the new partner’s practice is profitable enough to generate a net distribut-
able income sufficient to carry his / her compensation and allocated costs,
even if the guarantee kicks in, it is still a ‘win’ for the law firm. But what
happens if notwithstanding strong performance of the new addition, there
is a requirement for the law firm to step up and make a guarantee pay-
ment to the partner, and the impact to the firm is ‘out of pocket’?
If the acquiring firm is large enough, the ‘tithe’ from other partners to
subsidize guaranteed payments is spread widely and individually bear-
able. But that will hold true only to a tipping point where the partners
it works both ways. It is your task is to place the incoming lateral
into the hierarchy of your compensation model and forecast what
the income will be. But, what happens when the compensation
being offered isn’t enough to get that lateral candidate to come to
the firm? Here are a number of areas in which that compensation
guarantee can become a real problem:
1. When it assures a partner a level of income that is not achievable.
A guarantee that serves as a backstop against underperformance by
the law firm, for a short time such as one year or two, and is measured
against delivery by the partner of his or her hours / billings / collections
goals, is not an unreasonable feature of any transitional compensation
arrangement. Eventually, however, every partner should fit within the
same system, and be fit into the hierarchy of compensation fairly with
all other partners who perform similarly. To pay two people differently
for comparable contribution to profitability can be controversial, and
if it is a significant difference it can
A guarantee that is problematic is
the one that assures a partner a level
of income that the firm knows or
should know is above that achiev-
able. This is a decision by leader-
ship, usually without wide disclo-
sure, in a closed compensation
system, to subsidize the compensa-
tion of the new partner addition
with a reallocation of income from the other partners – who don’t
themselves have guarantees. This is a zero-sum game. The money
has to come out of somebody’s pocket, and the pockets it usually
comes from are the other partners. Naturally how much and from
whom depends on how and when the guarantees are triggered and
become operative, and that can quickly become very complex.
How does this happen?
One instance is when a firm assumes or represents it is on an up-
ward trajectory for partner income. The firm aspirationally justifies
the guarantee as expiring at a point in time where the firm will be
performing at a level which meets or exceeds the guaranteed level
of compensation. The firm expects to underwrite the ‘excess com-
pensation,’ in the first couple of years, because it has a strong desire
for the new partner’s business and / or practice type. Of course that
then becomes a future problem when the rest of the world doesn’t
guarantee that is prob-
lematic is the one that assures a
partner a level of income that the
firm knows or should know is above
the QuestiOn OF Partner cOmPensatiOn guarantees International Review
F A L L 2 0 1 4
paying that tithe themselves begin to reach a position where they would
be better off leaving the firm to join another, where their business will be
better paid for. This occurs as the impact of shifting the income alloca-
tion means that the operating margin of the firm is further reduced
relative to their compensation as to this class of partners bearing the
‘subsidy tax’ to enhance compensation for others.
The result can be that your higher margin practices, the ones you
should want to keep are precisely the ones most motivated to leave,
if they themselves do not have a guarantee. To protect against that,
guarantees may beget more guarantees, which further leverages up
the income allocation pressure.
It should not go overlooked that operational
superiority, which involves not only ‘efficiency’
but ‘effectiveness’, is a huge competitive ad-
vantage, and firms that do not possess it are at
a serious handicap in being able to attract, as
well as retain, talented lawyers with strong cli-
ent books of business. (It is also very hard to
achieve, so law firms have resorted to all man-
ner of internal gymnastics with their structures
and procedures to compensate).
3. When it brings pressure on the firm’s need to
report higher incomes.
A true compensation guarantee, one that
guarantees a partner a minimum distribution
irrespective of how the firm performs as a
whole, is contrary to any traditional partnership ethos of ‘we are all in
this together’. While partnerships may have different levels of participa-
tion, the fundamental principle is that everybody rises and falls pro-
portionately together. Guarantees break that relationship and disrupt
the culture. They provide the guaranteed partner with an unrealistic
safety net that . . .” if we do well we rise together, but if we don’t then
no matter, I get mine and my partners can pay for it.”
Apart from the cultural schism this creates, there is an operational
problem as well. Actual financial performance of the firm is not ca-
pable of being forecast with any real assurance two or more years into
the future when the guarantees may be called. One can forecast to
within a percentage point or so around October 1st of most calendar
years ending December 31st. By mid year, with some ability to make
midcourse corrections that will impact year end results, you really
shouldn’t see outcomes that are more than 10% off . . . again assum-
ing something unexpected doesn’t happen, like having a sequence
of major litigation matters resolve unexpectedly, your largest client
changes firms, or merges out of existence and the work goes to the ac-
quiring firm’s counsel, etc. But forecasting with any kind of certainty
two years out, let alone four years out is problematic.
Accordingly, the precise impact of all guarantees outstanding for a term
of more than one year cannot be forecast as to the financial impact they
may really have on your firm. The tougher it gets on the firm’s overall
profitability, the harsher the impact may be on the partnership to step
up and pay on those guarantees – at a time when they are already feeling
the pain of their proportional share of the reduced profits.
The most devastating effect on
your firm’s morale and institu-
tional glue happens when two
years out your firm is down ten
percent on distributable prof-
its, and your partner see guaran-
tees going out to six of the top
ten most highly compensated
partners – amounts likely to be
robust and going to those part-
ners perceived to be best able to
weather any financial adversity.
The guaranteed compensation tool,
when it gets too prevalent, too great
in magnitude, or used for purposes beyond a short transition period
for the partner(s) coming aboard, especially if it triggers guarantees to
persons already partners in your firm who demand that if Ms. Newbie
gets one then they deserve to have a guarantee too, becomes dangerous.
It’s akin to holding that kitchen knife at the wrong end.
guarantee, one that guarantees a
partner a minimum distribution ir-
respective of how the firm performs
as a whole, is contrary to any tra-
ditional partnership ethos of ‘we are
all in this together’”
EdwIN B. REESER is a business lawyer in Pasadena special-
izing in structuring, negotiating and documenting complex
real estate and business transactions for international and
domestic corporations and individuals. He has served on the
executive committees and as an office managing partner of
firms ranging from 25 to over 800 lawyers in size.
by Edwin B. Reeser and Patrick J. McKenna
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