Over the next few weeks, as the Firm Spy reveals the results of our Firm Spy Remuneration Survey, we expect that many non-partner lawyers across the nation will be demanding answers from their superiors.
With this in mind, we thought it was a fantastic time to look at the various ways that the very partners who decided your salary this year once became partners themselves. This will lead into another post we’re currently compiling (and will publish soon) on the ways we believe contemporary corporate partnerships are changing and what it means for junior lawyers.
We have extracted the following summary of the various partnership models from an old ALB (issue 7.10) which was informed by Mark Pistilli, a partner at Chang Pistilli & Simmons:
1) No goodwill, net assets model: The incoming partner pays a set amount to existing partners for his or her share of the net assets of the firm, excluding any value of goodwill. The partner is then paid out his or her share of the net assets, excluding goodwill, of the firm on retirement.
2) Goodwill model: the incoming partner pays a set amount to existing partners for his or her share of the goodwill and other net assets of the firm. The partner is then paid out his or her share of the goodwill and other net assets of the firm on retirement.
3) No buy in/buy out (non funded) model: the incoming partner does not have to pay for his or her share of the firm’s assets – but they are not entitled to be paid out of for his or her share of assets upon retirement.
4) No buy in/buy out (funded) model: same as above but this model involves contribution to funding of the firm by the incoming partner, often organised by the firm’s bankers.
5) Change in net assets model: partners only pay for net asset deficiencies or are paid by the firm for net asset growth, when they leave the firm, based on changes in net assets for the time they were partners.
6) Bespoke variations of the above, some involving “sweat equity” (credit for work done in the firm as a non-partner).
We think the following edited article, penned by management consultant Joel A. Rose, also gives a good insight into the workings of a modern law firm and helps explain why most major firms opt for the “change in net assets model” or a variation of it:
Although there may be many definitions of firm capital, it is usually viewed as being two separate, yet related, elements: (1) working capital and (2) long-term capital.
In its most basic form, working capital is the money necessary for the daily operation of the firm. In most financially successful firms, working capital is the capital that the firm requires to be contributed by the partners.
Long-term capital is the money that is necessary to pay for the “hard assets,” i.e., furniture, automated equipment, etc. Long-term capital is usually funded through bank borrowings or leases. This allows a firm to spread the cost of these assets over their working life and thereby spread the burden for payment of that debt among the current and future partners who will benefit from that asset.
… A few techniques have been developed for determining the amount of working capital that a firm may require. One is to periodically calculate three months’ expenses for the firm, excluding partners’ draws. This three month time average will vary depending upon cash flow. Some firms having a very liquid cash flow – clients pay bills promptly – may calculate two months’ expenses. Those firms that have experienced slower client payments are encouraged to consider extending their cushion of firm capital to three and a half or four months. Many firms utilize their bank credit lines in lieu of partners’ capital contributions as their cushion to pay firm operations and partner draws during “cash flow droughts”… A second technique is to set working capital equal to a fixed percentage of gross fee collections. Oftentimes this may range between five and eight percent.
Most firms [that use the "net assets" or "goodwill" models] determine capital contributions based proportionately on partner earnings. The partner who earns seven percent of the firm’s income usually contributes seven percent of the firm’s working capital, and so on.
Typically, these firms determine the value of the firm, including partners’ interests as hard assets plus the value of work-in-process and accounts receivable less outstanding debts. When a lawyer is admitted as a partner utilizing this system, the firm determines its value and the incoming partner buys his or her capital interest or fractional interest from an existing partner. This system does not usually work well for a larger or mid-size firm as the cost to new partners to buy into the firm becomes exorbitant, since they are expected to purchase a portion of the growth in work-in-process and accounts receivable that they were responsible for creating. A second reason for not utilizing this method of capitalization is that, should a partner leave the firm to join with another existing or new firm, the remaining partners wind up paying money to a withdrawing partner who may join with a competitor law firm, especially if that partner takes with him or her, their clients.
We said yesterday that firms have made a habit of attempting to sell the reasonableness of remuneration decisions by reference to the state of the market and “what the market is doing”. But we think that the firm’s partnership structure is also likely to influence the salaries that junior lawyers can expect. For example, older partners in a firm with a “no goodwill, net assets model” or a “goodwill model” would naturally be less likely to tinker with the firm’s capital to prop-up non-partner salaries in circumstances where revenue is down. Those partners will suffer a reduction in their cash-out share upon their (potentially imminent) retirement. They wont see the upside that might come in 2011 or 2012 from retaining talent in 2010 with better salaries. So, if you’re wondering why your pay is comparatively low this year, perhaps it is because all of your firm’s partners are the decrepit remnants of an anachronistic partnership model.
Or maybe they’re just tightarses.
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