Profit distribution creates tensions and bad behaviour

by Jaap Bosman

Commentators outside the legal industry often criticize the way in which law firms operate and organize their business. Although certain aspects of law firms might come across as archaic or strange from a ‘normal’ business consulting perspective, the business of law is still one of the most profitable business models in existence. In what other industry can you make so much money, while investing so little. Partners at the elite law firms make more money than most captains of industry and more than any elected head of state. From a business perspective it is hard to beat the business of law.

Oddly enough also as it comes to the level of obsession over the profitability, the legal industry is a bit of an outlier. One will be hard pressed to point out any other type of privately-owned business, where there is so much ‘transparency’ and comparison on profitability. There is a thriving publishing industry that lives of reporting on law firms’ profit numbers. Not only the famous AML-100/200 in the US, but also for example The Lawyer in the UK and JUVE in Germany publish overviews and rankings based on profit levels. I am not aware of any other industry where non-listed companies voluntarily disclose and compare their figures. One could argue that the legal industry is in a way obsessed with profit.

The legal industry seems overly obsessed with profit numbers

To a certain extent for any company it is healthy to be focused on profitability. For us at TGO Consulting it is the core of what we do: we focus on helping law firms to be more profitable and have better clients and mandates. At the same time in our practice we are often witness to the destructive power of unhealthy focus on profitability. In many partnerships there are tensions on how the profits are distributed among the partners. So here we have a kind of a contradiction: on the one hand law firms as a firm need to be as profitable as possible, while on the other hand individual partners focus on how the profit is distributed may have averse effects on the profitability of the firm as a whole.

One of the advantages of a global practice and working with many different law firms across the world, is that we in detail come across more different profit distribution systems than any law firm leader will ever see or be aware of. The two main categories are ‘collective’ and ‘individual’. The lockstep and equal sharing profit distribution systems are well known examples of the collective system. The individual system is also known as ‘eat-what-you-kill’. On both categories there are numerous variations and also hybrid systems do exist. However, in the ‘collective’ system each partner gets rewarded based on the performance of the firm as a whole, as where in the ‘individual’ system a partner’s remuneration boils down to personal performance.

At first sight, one might be inclined to think that the individual system is the most fair system and will be a system that does not create tensions between partners. That might be one of the reasons why this system has been so widely adopted across all parts of the world. Partners who work hard and are successful are rewarded and some others that do not perform do not drag them down. Whereas in theory the individual system might seem ideal, in practice this system creates all sorts of issues. Based on our experience partners in firms which follow an individual based profit distribution system have more discussions on profit distribution than those who employ a collective system.

Partners often complain that their compensation is not fair

The reason behind this is that in an individual profit distribution system there typically are all sorts of internal compensation systems such as origination credits, or rewards for management positions. In the individual system, there is a clear disadvantage for a partner who cooperates with another partner on a large matter. The cooperating partner will have to ‘pay’ origination credits and while helping out on the other partner’s big mandate will have no opportunity to get out and work on their own book of business. We have come across situations where this type of ‘slave partners’ are only employed to make the strong and originating partner even more rich. The question ‘who owns the client’ is of particular interest to any partner working in an individual profit distribution firm. On top of that comes that in some firms each partner must ‘pay’ a certain percentage of his/her profit to the founder(s) of the firm. Another issue with the individual system is that partners don’t want newly appointed partners to cannibalize on their practice, so each new partner has to find a new niche and a new clientele to build a practice. An individual profit-based system also runs a risk of poor utilization of associates.

So, if an individual profit distribution system can create all sorts of fights and tensions, is a collective system any better? The short answer for that is: no. Under any collective profit-sharing system, partners can become hypersensitive to under-performers. The mere thought that while they are working their ass off and have built a great practice, some others are leading a laid-back life, go home at five and still make the same amount of money is unbearable. We experience that in collective systems the firm leadership is under permanent pressure to identify and deal with under-performers. Sharing a collective profit requires an enormous amount of trust. Maybe more than most lawyers are able/prepared to give.

In order to prevent partners from under-performing, collective distribution-based firms invariably monitor individual partners. Every partner has to produce a minimum amount of revenue under their own name and has to meet a threshold in billable hours. The surprising thing is that this effectively will create similar tensions as in an individual based system. If I have to produce revenue, I will want the file and the client put in my name. If I have to produce billable hours, I will make sure I meet my threshold, before handing out work to my associates. Like in an individual system, in a collective system it is not a good career move to be a ‘slave partner’ (or a lawyer’s lawyer), as the rainmaker will always feel more important and entitled to more money.

A collective system with a black-box might be the best solution

Many consultants today are preaching the end of the ‘lock-step’ system, which is one of the collective sharing systems. We are not one of them. Our data clearly shows that firms where partners cooperate and trust each other, have a higher PEP that those who only focus on individual gains. So if cooperation is the most profitable business model, and we do not believe that the lock-step model has become a relic of the past, what would be the best profit sharing system. After having seen and analyzed literally dozens of different profit distribution systems, I have pivoted towards a black-box profit distribution system, based on collective sharing. It might be the only way to stop discussions on who gets what, and the only way to put a halt to individualistic behavior that favors the individual, while it harms the firm. I am aware that I need to elaborate on this point of view, and I will do so in a separate article in the coming weeks.

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