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Do you have a bloated middle?

Posted by Jack Bostelman on Jun 09, 2014 | 0 Comments

A law firm leader thinks about non-equity partners

Keith Mayfield, chairman of an AmLaw 100 firm, reads the recently published Altman Weil annual survey[1] of law firms in transition. Leaders of more than half the firms with over 250 lawyers believe they have too many non-equity partners. Yet only 2.2% of surveyed firms have an up-or-out policy for this partner category. “Law firms need to manage the non-equity tier with much more attention and discipline, including standards for entry and exit,” advises Altman Weil.

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“That's us,” Keith sighs. At his firm 60% of the partners are non-equity partners. More than half the non-equity partners are “career” non-equity partners – in other words, are not on a path to become equity partners. There can be many reasons for this. All have good legal skills and many have niche specialties. But some are not good at bringing in business; others are not willing to work hard enough.

Keith realizes his firm is far from alone. At two-thirds of the AmLaw 200 firms, non-equity partners outnumber equity partners, based on raw data in the recently published AmLaw 100 and Second Hundred lists based on 2013 financial results.

How Keith's firm got to this dilemma

Keith's firm originally started down the non-equity partner path to provide an intermediate career step for partners who were still developing, and to create a short waiting stage even for those who were ready in order to improve the profits per equity partner calculation that's so widely followed.

In time, retaining a lawyer indefinitely as a non-equity partner became a way to dodge difficult up-or-out decisions. And in good times the leverage effect of having a high proportion of non-equity partners improves profits per equity partner. The average compensation of non-equity partners in the AmLaw 200 is half that of equity partners, yet they are billed at nearly the same rates.

Time for action

Keith realizes it's time to take action. He recognizes both the financial and social risks of his firm's “bloated middle.”

Financial risks of too many non-equity partners

Leverage effect

Because their compensation is fixed, the non-equity partner layer is a form of leverage on the firm's income. At Keith's firm, the career non-equity partners receive fixed salaries, but at significantly higher levels than those of associates. When non-equity partners bring in more profits than they are paid, those net profits improve profits per equity partner. Conversely, when they bring in less than they are paid, which is a very real possibility during an economic downturn, they reduce profits per partner.

Viewed another way, non-equity partners are part of the expense side when computing the firm's profit margin (revenues less expenses, divided by revenues). Firms with a bloated middle tend to have lower profit margins. This is another way of saying their profits are more vulnerable to revenue declines than firms with higher profit margins.

Lower profit margins correlate with a high proportion of non-equity partners. One quarter of AmLaw 200 firms have profit margins of 30% or less. In three quarters of those firms, more than half the partners are non-equity partners. Virtually all firms with profit margins of 25% or less have more than half their partners as non-equity partners.

Because of their longer tenure at the firm and their seniority, it is more difficult to terminate career non-equity partners than associates. Thus, during a downturn, a firm with a high percentage of non-equity partners has fewer financial alternatives to cut costs than a firm with a higher proportion of equity partners. Associates can be more readily exited, either through express lay-offs or quicker weeding through tougher performance reviews. Income of equity partners automatically adjusts to reflect lower (and higher) profits. While a prolonged income reduction could cause equity partners to leave, in the short run it's self-regulating.

In contrast, not only does the compensation of non-equity partners continue to be a drag on firm profits, but also when non-equity partners bring in less profit than they are paid the income of equity partners is reduced even further than the decline attributable purely to the downturn. This is a negative example of the magnifying effect of leverage on profit swings.

Fee effect

A second adverse financial effect of non-equity partners arises when there is not enough work for the firm. To the extent non-equity partners (or equity partners) hoard work that can be done by associates billed at lower rates, client fees are higher. It may be a better outcome for the firm and its clients if non-equity partners are incentivized to push work to the most junior lawyer who can handle it and instead to spend their free time developing new work. Lower fees will avoid write-downs and write-offs and make the firm more competitive.

Of course, many of a firm's career non-equity partners have that status because they are not good at bringing in business. This is a second example of how the presence of many career non-equity partners can have an adverse financial effect during a financial downturn.

Social risks of too many non-equity partners

Another consequence of non-equity partners hoarding work that could be delegated is that associates don't have enough work, which creates morale and training problems. When associates aren't working, they're not learning. They also are understandably unhappy.

When work picks up, the associates are operating below the level of their class because of their more limited experience. That reduces opportunities for delegation to them, forcing partners (including non-equity partners) to perform more associate work. This prolongs the inefficiencies of higher client fees noted above, with the added adverse financial effect that partners are less available to take on new work for the firm.

Career non-equity partners are the concern

The problems described above do not arise to the same extent when non-equity partner status is a transition path for associates or laterals to become equity partners. The way to clarify for everyone the intermediate nature of non-equity partners is to apply an up-or-out policy, such as a five-year limit on the time a lawyer may be a non-equity partner.

One reason fewer problems arise in this scenario during a downturn is that the compensation levels of transition non-equity partners are generally lower than those of career non-equity partners. As a result, the leverage effect is reduced. Second, these non-equity partners may have the skills to bring in new business. To the extent some do not, moving them out of the firm during difficult times is more manageable than for career non-equity partners.

Next steps

Change policy prospectively

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Keith decides to pursue a two-stage approach. First, he plans to propose to his Executive Committee that going forward, the firm use the non-equity partner category only as an intermediate stop for lawyers believed to have the potential to become equity partners. Coupled with that would be a five-year up-or-out policy.

Only associates and laterals would be eligible for non-equity partner status. Underperforming equity partners would be counseled and, if they could not turn around their performance, be transitioned out of the firm. They would not be eligible for non-equity partner status.

Existing non-equity partners who have held that status for under five years would be told they have five years to qualify as equity partners. Otherwise they must leave. The performance they must achieve to qualify as equity partners would also be individually explained.

Keith emphasizes to the Executive Committee that the new policy will force the firm to make some tough decisions when evaluating senior associates and non-equity partners. They make plans for a firmwide partners' meeting to discuss the new policy.

Address existing career non-equity partners

For the second stage, Keith intends to engage an outside consultant to help formulate a plan for reducing the number of current non-equity partners who are beyond the five-year limit. He expects that some will be allowed to remain, but that most will be given individual goals they must satisfy to qualify for equity partner, or else be asked to leave the firm.

Expected effects of the new policies

Keith recognizes that in the short run the effect of the new policies will likely be a reduction in profits per equity partner, because there will be fewer non-equity partners from which the firm will profit and more equity partners who will share in profits.

Over time, though, Keith believes profits per equity partner may improve, while continuing to avoid the financial and social risks of a bloated middle. This is because the increased size of the strong equity partner tier may result in more and higher quality work for the firm. Also, lower client fees from staffing senior associates rather than non-equity partners on matters may reduce write-offs and write-downs, the benefit of which flows directly to the bottom line.

Conclusion

Keith recognizes that pulling back on the non-equity partner tier will be hard work, but believes it will strengthen the firm, both financially and culturally.


[1] The Altman Weil survey, conducted in March and April 2014, polled managing partners and chairs at 803 US law firms with 50 or more lawyers. Completed surveys were received from 38%, including 42% of the 350 largest US law firms.

[Photo credits: © Can Stock Photo Inc. / Elnur]

About the Author

Jack Bostelman

Jack Bostelman is the president and principal consultant of KM/JD Consulting LLC. Before founding KM/JD Consulting, Jack practiced law in New York for 30 years as a partner of pre-eminent AmLaw 20 firm Sullivan & Cromwell.

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Before founding KM/JD Consulting LLC, Jack practiced law in New York for 30 years as a partner of pre-eminent AmLaw 20 firm Sullivan & Cromwell.

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