[00:00:00] Welcome to the Founding Partner Podcast. Join your host, Jonathan Hawkins, as we explore the fascinating stories of successful law firm founders. We’ll uncover their beginnings, triumph over challenges, and practice growth. Whether you aspire to launch your own firm, have an entrepreneurial spirit, or are just curious about the legal business, you’re in the right place.

Let’s dive in.

Jonathan Hawkins: Welcome to Founding Partner Podcast. I’m your host, Jonathan Hawkins. Usually, I interview founding attorneys but this week I’m gonna do another solo episode. And today I’m gonna talk about equity partner compensation and how to design it, or at least how to think about it when you design it. I’m not gonna talk about income partner, non-equity partner comp, or associate compensation, just about compensation for equity owners.

Now, over the years, I’ve [00:01:00] seen all types of compensation systems. They’re really all over the map, but generally speaking, on one end of the spectrum, you have what I call eat-what-you-kill systems, and then on the other side, you have comp that’s just based on ownership in the firm. And I’ve like I said, I’ve seen infinite variations in between.

And there are upsides and downsides to every system. To quote Charlie Munger, ” Show me the incentive, and I’ll show you the outcome.” So let’s talk about strictly eat-what-you-kill systems. And those pretty much the lawyers get paid if you produce. Generally speaking, it’s what you bring in and how much you collect, so what clients you originate and what sort of production you’re responsible for this kind of system certainly is gonna encourage the equity owners to work and work hard, hopefully.

Because if they don’t, they’re not gonna get paid or they’re not gonna get paid much. But there are downsides, like I said. In these types of systems, at least the [00:02:00] way I’ve seen them, you tend to get these siloing effects. Most partners are gonna focus on their clients, their work, their stuff, and what’s good for them under the formula rather than what might be good for the whole firm or the firm as a whole.

Things like training, mentoring, all the stuff that doesn’t show up in the formulas probably are gonna get neglected and not really done. So you end up, I’ve seen when you have these type of systems that are heavy eat what you kill, you end up with what become almost like office sharing arrangements where the partners come together, share overhead expenses, give the appearance of this big firm, but really you’ve got these mini firms throughout and these partners with their little fiefdoms that are really focused on themselves.

Now, let’s talk about the other side of the spectrum where you have just you know, the partners get paid based on how much they own in the firm, [00:03:00] regardless of production. That can work if the partners have similar size books of business, similar, work ethic and that if they’re in this similar time in their life.

I’ve seen it work. I know firms that are very successful that take that approach. But it could cause trouble. It introduces at least the possibility of sort of the freeloader problem, where somebody just decides for whatever reason they’re not gonna work as hard because everybody else is bringing it in and everybody else is working.

I see this a lot with firms that might have older partners and younger partners. The older folks feel like maybe they’ve earned it, maybe they’re tired, whatever their reasons, they’re slowing down and they’re not doing as much, but they are getting a big cut, while the younger partners who are on the up are really busting it and they feel like they are just giving it away.

So it can cause some problems. You know, again, it can work really well [00:04:00] for a time if everybody’s on the same page but, you know, it runs into problem. Now, another system I’ve seen, and I think it’s less common, but, you know, it used to be a lot of firms would pay based on seniority, how long you’ve been there and you just sort of step up along the way.

I have not seen much of that in a long time, maybe ever, but that’s sort of baked in a little bit on the pure ownership type model particularly where you’ve got older partners that still own a big chunk of the firm. So, those are the two ends of the spectrum. Pros and cons to both. So, what should you do?

How should you design your system? So the first thing I need to say is that equity partner comp is an art, not a science. There’s no system that is just works for everybody all the time forever. So don’t try to find that. I’ve been trying to find that for a long time. I haven’t figured it out yet.

And the second thing to keep in mind is what works for one [00:05:00] firm may not work for another firm. So if your friends down the street say, “Hey, this is how we do it. It works great for us.” Maybe it works for you, but maybe it doesn’t. So just because someone else it doesn’t mean you should just take it and use it.

But, you know, obviously all the input you can get and all the ideas you can get can help. The other thing to keep in mind is that what works now for a firm may not work five or 10 years from now. Facts on the ground are gonna change. And so I always tell people, you know, your comp system is not a static thing.

At some point, you are probably gonna need to change it. Now there are some caveats there. You should never change it in the middle of a comp cycle. You cannot change the rules of the road or the rules of the game in the middle of the game. So I suggest at a minimum, no more than once a year, but really I think once a year is probably too much as well.

I think you need to give any [00:06:00] system you design some time to sort of play out, see how it really works. And so it’s something you might revisit every, you know, two to five years maybe max and just see. Again, it may keep working, so keep where it is but it may be you need to change it. Another key element I think of any equity partner comp system is it has to be fair, or at least everyone needs to perceive it as fair.

If people feel like they’re getting screwed, it is gonna cause dissent. And sure, there are gonna be years where somebody makes more money than somebody else. That is always gonna happen. But that’s probably fair, and as long as people say, “Yeah, I get it. That makes sense,” people will stay in it and it should work.

Real quick, if you haven’t gotten a copy yet, please check out my book, the Law Firm Lifecycle. It’s written for law firm owners and those who plan to be owners. In the book, I discuss various issues that come up as a law firm progresses through the stages of its growth from just before [00:07:00] starting a firm to when it comes to an end.

The law firm lifecycle is available on Amazon. Now, back to the show.

Jonathan Hawkins: So let me talk about my current thinking on design of comp systems, and this is gonna be pretty high level, but this is my current thinking. Again, subject to change, but I think something like this generally work. So the way I like to think of it is you take some elements of the system that’s based on ownership, and then you have some elements that’s based on production.

So you combine both of those because you minimize the freeloader problem, but you also give people incentive to work and let them know that if they work harder and do better and perform better, that they should do better in any given year. Now the other thing I should say too is I am a big believer that equity should be purchased, not given.

I know there are people out there that disagree with me on this. That’s a topic for another podcast, but that is a hill I will die on. [00:08:00] So using that as a basis if you have to buy equity, then to me, it makes sense that at least some of the compensation you get for owning the equity should be based on you owning it.

So to give, you know, if I buy a share of Amazon I expect to get some sort of return for owning that piece of Amazon. It should be the same way in a firm. If you own some piece of the firm, you should get a return just by virtue of owning it. So, again, I think that’s one of the sort of the underlying reasons I think that equity should be or equity comp should be based in part on ownership.

Now another part is sort of the rising tide element and the element that if it’s purely formula, no one who is logically looking at the comp system is gonna spend any time doing the things that will help the firm if it doesn’t feed into that comp system. Because if they’re taking time away [00:09:00] from the formula, their comp’s gonna get reduced and they’re gonna get no payment or no benefit directly, at least, for all this other time they’re spending for the firm.

So let’s go back to the formula. Generally speaking I think you know, 40% to 60% of an equity partner’s compensation should be based on how much they own. It could be as low as 30. I’ve seen 70/30 type arrangements, but it needs to be a sizable chunk. And then the rest, you know, another 40% to 60% should be based on production metrics formula, in other words.

And in that formula, it can be, you know, the historical elements are what’d you originate and what did you work? Those are sort of the two elements, and you can weight them different ways. I’ve seen so many different weightings and different formulas. I’ve seen other firms introduce other categories like managing a file.

So it could be somebody originates it and hands it to somebody else and they manage [00:10:00] it. It could be training. It could be a number of things. The key is I think whatever you choose, it has to be measurable and it should not be too complicated. If the formulas are too complicated and nobody understands it, then it’s not gonna create any incentive for anybody to do anything ’cause they’re not gonna know what to do, and they’re not gonna know if I pull this lever, turn this knob, I should get more under this part of the formula.

So, those are some of the costs. I’m not gonna get details here, but let me give you an example of what this might look like in practice. So here’s an idea. So every partner gets a draw, base draw, let’s just call it like 150,000, 180,000. Then at the end of the year, you have profits. Let’s just say it’s a million bucks I think you should take a piece of that and make sure you keep some reserves.

I know a lot of firms that will just take the million bucks and just flush it all out and give it to all the partners, and they just take it, so they start the next year with zero in the bank account. I don’t like that approach. I really think [00:11:00] you should have some amount of reserves that stay in the firm at all times.

You know, I don’t like operating on a line of credit. I know many firms that do. I just think it’s risky. So, but again, topic for another, another podcast. So anyway, you get your million bucks. Let’s say you take out 200,000 for reserves and you’ve got 800,000 left, and that’s the total amount to distribute.

So you put, let’s just say it’s a 50/50, 50% of that or 400 goes into the pot to be distributed based on ownership. And let’s say you’ve got four partners, 25% each, so they each get 100 out of that pot. Then you take the other 400 and put it in the 50% pot that’s based on production, and that’s where you run your formula, whatever it is.

And after you run the formula, there’ll be comparative percentages that are formulated depending on how people did relative to each other. And whatever those numbers come out to be, that’s how you split up that second [00:12:00] pot. So if somebody has a really good year, they originate a ton, they work their ass off, they do a lot, they’re gonna get paid more out of that bucket than somebody who doesn’t.

So, you know, high level again, that sort of lays out a general framework. What’s works for your firm is gonna be different than what works for somebody else. And again, you’re not gonna be perfect when you start. It’s the art of the comp system. It’s not a science But you gotta start somewhere. So you gotta put something out there and just see how it plays out, and then, you know, if you need to tweak it the next year or the year after that, you can.

And so let me end with this. I am not a compensation design expert. There are people out there that do this. I am not an expert but I’ve seen a lot of them, and I do have strong opinions about it, about what? What I think will not work for sure. So if you’re listening to this and you want, just wanna run something by me about comp systems or partnership issues or anything like that please reach out.

I love this stuff. This [00:13:00] is really fun for me. So, encourage you, reach out. We’ll get on a call. We’ll talk. And the last thing before I let you go if you found this podcast, this episode, or just the podcast in general useful and entertaining I’d love it if you hit the subscribe button and maybe give a good review.

That’d be great. And please share this with other attorneys that you think might get some value out of it, and I greatly appreciate that. So next week, probably be back with an interview. Again, please reach out. Love to hear from you. Thanks.

OutroUpdatedWebsite-1: Thanks for listening to this episode of the founding partner podcast. Be sure to subscribe on Apple podcasts, Spotify, or wherever you get your podcasts to stay up to date on the latest episodes. You can also connect with Jonathan on LinkedIn and check out the show notes. With links to resources mentioned throughout our discussion by visiting www.lawfirmgc.com. We’ll see you next time for more origin stories and [00:14:00] insights from successful law firm founders.