Law Firm Articles

Compensation for the New Partner

The variables for setting compensation of a newly promoted partner can be a challenge to get right for all concerned. Let’s look at an example.

Last year as an associate Sally’s total compensation consisted of a $250,000 salary, a $50,000 year-end bonus, $28,000 for a package of health/dental, life, disability and LTC insurance, $37,000 in employer pension contributions, $12,800 in employer paid payroll taxes and $2,200 in miscellaneous reimbursements of business-related clubs/dues. Total compensation was $380,000. Sally must make three annual $25,000 payments to have a seat at the partnership table — her buy-in requirement.

Let’s assume that Sally generated a 28% profit to the partners as an associate and that per timekeeper overhead was $185,000. This means that her working lawyer fee receipts were $785,000. Let’s also assume that Sally has worked hard at positioning herself in the marketplace and has built a $500,000 portfolio of client relationships mostly from existing clients plus a few of her own new clients. The new clients, while small in number, are right in the sweet spot of the firm’s strategic intent.

What is a fair compensation for Sally assuming this year’s performance is as good as her last year as an associate? We will also assume for ease of discussion that everyone else repeated their prior year performance and the firm’s overhead remained steady.

1. As a partner, Sally drops below the line.

The $380,000 compensation package ceases being a firm expense. Good for the firm. Sally is now “self-employed” so she must plan for making quarterly estimated tax payments as the firm no longer “withholds” taxes or remits the employer’s share of social security and Medicare taxes. The firm will continue to pay the insurance premiums and remit the dues on her behalf, but the tax reporting and treatment of those items will change. So, to stay even Sally needs a draw, distribution and payments in kind totaling $380,000. For the moment we will ignore any individual income tax effects.

2. What about a cost of living adjustment?

Inflation for 2018 was 1.9%. Wouldn’t we all like to be immunized against economic forces? Yet the firm wants Sally to be excited about her first year as a partner and is concerned about the message no adjustment sends. Associates would be getting increases and should the firm maintain some separation between the young partner and its senior associates?

3. Let’s not forget that Sally also has that buy-in requirement of $25,000 for each of the next three years.

Possibly more after that. To keep Sally “whole” her compensation package needs to be $405,000. But any increase over the $380,000 dilutes the profits for the remaining owners. Should they make less so she takes home the same? And should the firm pay new partners’ capital for them (which is essentially what this suggests)?

4. What would a lateral be worth with Sally’s metrics?

The firm would like to be competitive with what the market is paying. The market might pay anywhere from $415,000 to $570,000 with a significantly greater likelihood for the lower third of that range IF the portfolio of client relationships is truly portable. That might be a big assumption since her portfolio is largely based on long time clients of her current firm. Again, if all else remains the same then the remaining partners’ earnings are diluted when paying Sally at “market.”

5. Are newly minted partners still profitable?

Sally produced a 28% profit margin in her last year as an associate. What is typical when one becomes a partner? Partners share in profits, correct? Yes, technically they do share in profits; but as a practical matter young partners slowly recapture that profit margin over a period of years, not immediately.

6. What about locking Sally in and saying that growth in her earnings is dependent on growth in firm earnings?

She will earn more than her $380,000 as the firm earns more. There is a degree of logic here, particularly if the sharing of earnings growth is generous. In this situation the partners are saying we built the firm to “x” and your $380,000 is fair for that.

These are typical considerations for firms making first-year partner compensation decisions.