Law firms can be incredibly short-term oriented. In the U.S. we can, in part, blame the tax code which causes firms to view everything on a cash in / cash out basis. But that can’t be the whole problem, because law firms in Canada and Europe tend to be just as short sighted and they’re taxed on the accrual basis. In part, a short-term viewpoint may be a function of the revolving partnership door at many firms. The people participating in this year’s profits may be a different group than will participate in next year’s, so current year profits are the primary focus of everyone’s attention. Perhaps it is systemic to businesses in general brought on by the way that corporate shareholders seem to focus on current dividends and stock prices rather than long term positioning. Whatever the motivation, short-term viewpoints make it tough for law firm managing partners who are charged with delivering profitable performance in the immediate term but are also expected to have a vision that builds the firm in the long run.
So how does a law firm’s partnership judge the firm’s financial performance? Let me suggest a statistic for law firms to look at in judging their long term success: Jaws. Jaws is the cumulative percentage increase in revenues compared to the cumulative percentage increase in expenses over a three to five year period. If the jaws are opening (the growth of revenues is greater than the growth of expenses), the firm is growing successfully in a manner that enhances profitability. On the other hand, if the jaws are closing (expenditure growth exceeds revenue growth), you’ve got a problem.
It’s important that this be looked at in nothing less than a three year basis. An investment that causes an abnormal growth in expenditures in one year may not show up on the revenue side in the current year.
Nothing exemplifies this shortsightedness more than the driving statistic of law firm management: profits per partner. Profits per partner is a natural extension of earnings per share in public companies. But just as corporate CFO’s have found ways to monkey around with the number of shares outstanding, law firm managers have figured out how to boost profits per partner – reduce the number of partners.
If in reducing the number of equity partners law firms were legitimately reducing the number of places at the table, this would be a valid exercise. But, frequently, firms simply convert equity partners to non-equity partners or, worse, blatantly leave out whole tiers of partners from the denominator of the profit per partner equation. The result is a better looking statistic, but it doesn’t give the remaining partners any more take home cash (i.e., the money paid to de-equitized partners is just shifted from profits to expenses).
Let’s look at a hypothetical. A law firm has 10 partners, three of whom are earning $500,000 per year, three of whom are earning $400,000 per year and the remaining four are making $300,000. The total profits of the firm, therefore, are $3.9 million for a profit per partner of $390,000. Suppose the firm makes the four bottom partners non-equity at their current compensation. Their compensation would become an expense to the firm reducing profits by $1.2 million, but the remaining $2.7 million that is distributed to the six equity partners produces a profit per partner of $450,000. Profitability went up by $60,000 per partner but nobody made any more money.
Here is the key. In order for a firm to increase real profitability (the amount of money partners actually receive) by reducing the number of equity partners, the de-equitized partners must become part of the leverage that pays the equity partners compensation. That is, partners are paid for the work they perform and for the value of the business they bring in. This means that to enable a partner at the high end of the compensation scale to make more money than just the profit on the work he or she performs, someone at the bottom end of the scale must make less than the value of the work they perform. This is the definition of leverage. Obviously, the more people you have making less than the value of their work (the contributors to leverage), the more money there is to pay the people at the top of the scale (the beneficiaries of leverage).
This means that if a firm de-equitizes a partner, the compensation of the remaining partners will go up only if the firm adjusts that partner’s compensation to reflect the actual value of his or her working attorney contribution. Yet, we constantly see law firms demoting equity partners to non-equity partner without changing their compensation and wondering why no one’s K-1 has increased.
While boarding a flight on a 757 one day I chatted with the pilot. If you have ever seen the flight deck of an airliner, every square inch is covered with switches and gauges. I asked the pilot how he kept track of all of the dials and he said he never looks at them. He said he focuses on just three things: the air speed indicator, the altimeter and the artificial horizon. If anything goes wrong with any aspect of the plane, it is set up to sound an alarm and then he goes to the appropriate gauges to diagnose the problem.
This is a great analogy for law firm financial management. The new financial software programs have given law firms access to so much financial information that one large firm (I am not making this up) gives each member of its management committee almost a full banker box of computer printouts every month. They have minute detail on every timekeeper broken down by office, practice group and, probably, birth weight. You know what happens; a member of the committee asks for a specific report and it becomes a part of the regular monthly report output.
In considering the financial information required to manage a law firm, less is often more. That’s why I like the concept of dashboarding – establishing a few important measurements of financial activity that you have to monitor and only worrying about other issues when an alarm goes off because something is not proceeding as expected. To set up a financial dashboard a law firm’s management committee should sit down with the chief financial officer and figure out what the factors are that affect profitability. Typically, they are things like billable hours recorded, average hourly rate, write-downs during billing, expenses, number of timekeepers and the aging of accounts receivable. Then have the CFO prepare a spreadsheet showing, on a monthly basis, the anticipated amount for each of the important statistics. If the outcome for a month is off by an unacceptable amount, maybe 10%, the CFO reports that fact and gives the primary reasons why the deviation occurred.
The result is that financial reports are now a page or two long, can be produced within a day or two of month-end and financial accountability has actually increased. Members of management are now free to take the time they spent pouring through pages of reports and spending it on implementing the firm’s strategic plan—an activity that can actually create new revenues. I think it makes great sense.