Remuneration conundrums for law firms taking investment

One of the more taxing conundrums to address for firms wanting to avail themselves of outside investment (and particularly those who are adopting a corporate structure in order to do so), is the issue of how to manage remuneration.  Traditionally partnerships have stripped out all or the vast majority of their income each year, and distributed it to the partners.  Partners therefore enjoy very high levels of annual income, but often have little or no capital or deferred remuneration elements in their package.  The partnership income distribution model, of course, starts to unravel when outside investment is taken and is totally unsuited to businesses which may be looking to achieve a market flotation, as the value of a business is calculated by reference to its net profits, and these can only be readily ascertained by agreeing a base remuneration package which leaves a healthy net profit for shareholders.  

Typically, the changes needed to align law firm remuneration with a more corporate model will mean that for the first time lawyers will have both short term (salary and annual cash bonus) elements of their remuneration, and a much longer term component in the form of capital appreciation and/or long term incentive plans.  In theory, there is nothing wrong with this, and as long as they can get themselves comfortable with the idea of leaving profits within the business in order to achieve long term capital growth, then all should be well.  In my experience, however, the reality can be very different.  It can be extremely hard for people who have been used to high levels of regular income to adjust to much lower salaries (particularly when the inevitable – if erroneous - comparisons are made with the widely reported Profit-Per-Equity-Partner statistics from those firms which continue with the income-stripping model), and there seems to be a natural tendency for people to value the equity component of their remuneration far less highly than the short term cash element, because of fears over the long-term robustness of share valuations and the inherent uncertainties over achieving longer term targets.  The recent market volatility that has been experienced will have done nothing to allay such fears.

Another issue is the knotty problem of how to set base salaries.  This is not a simple thing to do in an industry which has not typically been salaried in the past, and therefore independent data are scarce. Private practice lawyers generally do not readily accept comparisons with in-house lawyer remuneration, as they see the roles as fundamentally different, and so although it is relatively easy to benchmark salaries with in-house roles, this is likely to prove somewhat contentious.  However, getting the base salary right is critically important.   If it is fixed too high, the net profit of the business (and therefore the share value) will be depressed and external investors will be unhappy.  A high base salary may also give lawyers too little incentive to perform and achieve the salary related elements of the job, and can encourage an “employee” as opposed to an “owner” mentality.  If fixed too low, it can make recruitment very difficult, and encourage an aggressive dog-eat-dog culture.  It can also lead to a situation where although bonuses may theoretically be discretionary, in practice they have to be paid in order to retain the best talent even in a downturn.   This dynamic was experienced by many of the investment banks which began using corporate as opposed to partnership remuneration models.  

These issues are not insoluble, but law firms who are seeking to take external investment need to have a very transparent debate about how remuneration will be structured, and to set expectations accordingly.   If they do not, then they are storing up inevitable problems for the future

For further information please contact me at np@mp-csl.com .