Compensation Models for Small Law Firms

The way a small law firm shares its income among the people who earn it is among the most sensitive matters in the business of law. It affects whom the firm attracts and keeps, how fee earners behave on a daily basis, whether work is shared or hoarded, and whether partners remain friends after the third difficult year. Law firm compensation models are not merely a matter of arithmetic. Each model embeds a view about what the firm values, whether that is originating clients, doing excellent work, supervising others, building the firm's assets or simply being present, and each produces behaviour that follows the incentives, for good or ill.

This article describes the principal compensation models used in small firms, the strengths and weaknesses of each, and the practical design questions that must be answered whichever model is chosen. It addresses partners and equity holders first, then salaried associates and non-equity roles, and then the legal, tax and governance matters that determine whether a chosen model will function. It is written for firms of between two and perhaps twenty fee earners, in which the people deciding on the model are also the people affected by it.

No figure or ratio in this article is offered as a norm of any market. The worked example is illustrative arithmetic only, designed to show how models behave and not to suggest what any attorney-at-law should earn. The rules of the profession, the law of partnership and employment, and the tax regime of each jurisdiction vary, and each firm should take local advice before adopting or changing a scheme.

What a compensation model must achieve

Before comparing models, the principals should agree the objectives. A compensation model that tries to achieve everything achieves nothing, and it is better to rank the objectives and accept the trade-offs.

• Fairness, as perceived by those affected. A model that is mathematically elegant but regarded as unfair will fail. Perceived fairness depends on transparency and on the connection between reward and contribution.

• Sustainability. The firm must be able to pay what it promises in a lean year. Fixed commitments should be set at a level the firm can bear in poor conditions.

• Retention. The firm should be able to keep the people whose departure would damage it, particularly those who hold client relationships or scarce skills.

• Collaboration. The model should not encourage individuals to protect clients or to refuse to share work that would be better done by a colleague.

• Investment. The firm needs to retain enough to invest in technology, premises, training and marketing, and the model should not distribute every unit of profit as it arises.

• Simplicity. A scheme that no one can explain is a source of suspicion. A small firm should favour a model that can be set out on one page.

Equal sharing and lockstep models

Equal profit share

In an equal sharing model, each equity partner receives the same share of the firm's profit regardless of individual billing, origination or seniority. Its attraction is simplicity and the absence of any incentive to compete for credit. It encourages partners to refer work to whichever colleague is best placed to handle it, to invest time in the firm's collective affairs, and to support one another in difficult periods. Its weakness is that it can breed resentment where contributions are unequal and persistent. A partner who consistently generates most of the firm's revenue may eventually conclude that the arrangement subsidises others, and may leave, taking clients with them.

Lockstep

Lockstep ties each partner's share to seniority or years in the partnership. Partners progress up a scale at fixed intervals, irrespective of the work each does in a given year. The model rewards loyalty and reduces internal competition, and it makes the path to full participation clear to junior partners. It is, however, best suited to firms whose partners are broadly comparable in productivity, and it is vulnerable when one partner contributes markedly more or less than the scale assumes. A firm adopting it should provide a mechanism for dealing with persistent underperformance, since the formula itself offers none.

Performance-based models

Origination-based compensation

Under an origination model, a partner's reward depends significantly on the clients they bring in. The model emphasises business development and gives strong reward to those who generate work. In small firms it can be effective in the early years, when winning clients is the firm's chief challenge. It has well-known defects. It encourages partners to hold on to client relationships and to resist introducing colleagues to those clients, because sharing the client may dilute the credit. It undervalues the partners who do the work, as distinct from those who find it. It also raises difficult questions of attribution: when a client comes through a referral, through the firm's reputation, through a former partner or through marketing, who has originated the instruction? Firms that adopt origination credit must define the term precisely, decide how long credit lasts, and provide for the sharing of credit where several people contributed.

Eat what you kill

In its pure form, each partner is paid on the basis of the fees they personally bring in and collect, less a share of the firm's overheads. The firm functions as a collection of independent practices sharing infrastructure. The model is simple and strongly rewards productivity, and it is common in chambers-style and cost-sharing arrangements. It provides little incentive to invest in the firm as an enterprise, to train juniors, to share work or to build a transferable client base, since every unit of time spent on the common good is a unit of lost personal income. Firms that adopt it should recognise that they are not building a single firm in the full sense, and should draft their agreements accordingly, in particular on the treatment of clients on departure.

Merit-based or discretionary models

A merit model leaves each year's distribution to a decision by a compensation committee or by the partners collectively, taking into account factors such as revenue, collections, origination, quality of work, supervision, management contributions and collegiality. Its virtue is flexibility. It can recognise contributions that formulas miss, such as mentoring a junior, leading the firm's technology project or handling a difficult client. Its drawback is subjectivity: without a documented framework, decisions can look arbitrary, and the process can become political. Where it is used, the criteria should be written down, the weighting given to each should be stated, and each partner should receive an explanation of their result.

Hybrid and modified models

Most functioning small firms use a hybrid. A common structure begins with a fixed base for each equity partner, which reflects seniority and the partner's role, and then divides the balance of profit by a formula that rewards chosen contributions. A reasoned hybrid has the following components.

1. A base share distributed equally or by seniority, which provides stability and a sense of shared enterprise.

2. A performance share allocated by reference to personal collections, originated fees or both, with a cap or a diminishing rate so that a single exceptional year does not distort the whole.

3. A contribution share distributed on the basis of defined non-fee contributions: management, training, supervision, marketing, and the development of precedents and systems.

4. A retained share held back by the firm as working capital and investment before any distribution.

The proportions should be chosen to reflect the firm's priorities, and they should be reviewed at stated intervals. The firm should resist the temptation to adjust them every year in response to particular grievances, since constant change erodes confidence.

Worked illustration of three models

The following is illustrative arithmetic only. It is not market data, and the units and ratios are assumptions chosen to show how models behave, not recommendations.

Suppose a firm with three equity partners has distributable profit of 600 units for the year, after all expenses and after the retention for investment. The partners' collected fees personally billed are as follows: Partner A, 500 units; Partner B, 300 units; Partner C, 200 units, a total of 1,000 units. Suppose that Partner C also carried the firm's management work, which reduced the time available for billing.

Model	Partner A	Partner B	Partner C
Equal share (one third each)	200	200	200
Proportional to personal collected fees (50, 30, 20 per cent)	300	180	120
Hybrid: 40 per cent base equally, 50 per cent by collected fees, 10 per cent for management contribution (assumed to be allocated wholly to Partner C)	230	170	200

In the hybrid row, the base is 240 units (40 per cent of 600), divided equally at 80 each. The fee-based portion is 300 units (50 per cent), divided in the proportions 50, 30 and 20 per cent, giving 150, 90 and 60. The management portion is 60 units (10 per cent), allocated wholly to Partner C. The totals are therefore 230 for Partner A (80 plus 150), 170 for Partner B (80 plus 90) and 200 for Partner C (80 plus 60 plus 60), which sum to 600.

The lesson of the illustration lies in the comparison. Under the equal share, Partner A, who produced half the fees, receives the same as Partner C, who produced a fifth. Under the pure fee-based model, Partner C, who carried the management burden, receives the least, and has no incentive to continue doing it. The hybrid recognises both contributions, though it requires the partners to agree that management has value and to agree how much. Each firm must supply its own numbers and its own judgement of what to reward.

Compensation for associates and non-equity fee earners

Salaried associates are usually paid a fixed salary with a possible bonus, and the structure should be simple, predictable and affordable. Several design points deserve attention.

Salary and progression

The salary scale should reflect experience and responsibility, with clear criteria for progression. If progression is tied to years of qualification alone, the firm loses the ability to recognise exceptional performance; if it is wholly discretionary, associates may feel that advancement is arbitrary. A short written set of competencies for each level, covering technical quality, client handling, supervision, business development and management, gives structure without rigidity.

Bonus schemes

A bonus should be linked to factors the associate can influence and that the firm values: collected fees against a reasonable target, quality as shown by review, client feedback, and contribution to the firm's development. A bonus based solely on billable hours encourages the accumulation of hours without regard to realisation, and may promote over-servicing of files. A bonus based solely on firm profit is too remote from the associate's behaviour to motivate. A combination, with a modest weighting on firm performance to encourage shared interest, is common.

Origination credit for associates

Where an associate brings in work, the firm should decide in advance how it will be recognised. Options include a defined percentage of fees collected from the new client for a limited period, a bonus on instruction, or recognition in the progression criteria. If the firm says nothing, the associate will assume the reward is greater than the firm intends, and the dispute that follows is avoidable.

Path to equity

If the firm intends to admit associates to equity, the criteria, the process, the price (if any) and the nature of the interest should be written down, and no expectation should be created that the firm does not intend to fulfil. Non-equity or salaried partner roles, which carry the title without the capital interest, should be described accurately, since an individual held out as a partner may acquire liabilities to third parties under the law of partnership regardless of the internal arrangement.

Legal, regulatory and tax considerations

Compensation arrangements must be lawful, and the professional rules in many jurisdictions restrict how a law firm may share fees. The following matters should be checked against local law and the rules of the regulator.

• Fee sharing with non-attorneys. Many jurisdictions prohibit or restrict the sharing of legal fees with persons who are not attorneys, and some prohibit non-attorney ownership of a law practice. A bonus to a paralegal or practice manager measured by a percentage of fees may raise questions. Check the rules before designing any scheme that pays non-attorneys by reference to fees.

• Referral fees. Payment for the referral of clients may be restricted or require disclosure to the client. A compensation scheme that rewards origination through referral from outside the firm should be examined in that light.

• Employment law. Salary, bonus, notice, deductions from pay and the clawback of previously paid sums are governed by employment legislation. A bonus described as discretionary may become contractual if it is paid consistently and described in a way that creates an expectation. Draft the terms carefully.

• Partnership law. In the absence of a written agreement, default rules on the sharing of profits, the right to participate in management and the consequences of a partner's departure will apply. These may differ from what the partners intended.

• Tax and statutory contributions. Partners and employees are generally taxed differently, and partners' distributions may need to be reconciled with tax liabilities, including advance payments. Take professional accounting advice before finalising the structure, and ensure the firm holds sufficient cash to meet tax obligations falling due.

Governance and documentation

A compensation model that is not documented will be remembered differently by each participant. The written agreement, whether a partnership deed, an operating agreement or a compensation policy, should address the following.

1. The definition of the profit to be distributed, including the treatment of accruals, work in progress, bad debts, drawings and the retention for working capital.

2. The method of calculation, with a worked example attached.

3. The timing of drawings and of the final annual distribution, and the rules for repaying overdrawn amounts.

4. The definitions used: collected fees, originated fees, personal billings, management contribution.

5. The decision-making process for the annual allocation, including who decides, on what information, and how disagreements are resolved.

6. The treatment of leaves, illness, parental absence, and part-time work.

7. The consequences of departure: payment for work in progress, recovery of unbilled time, client choice and any restrictive provisions to the extent they are lawful and reasonable.

8. The process for amending the compensation model, including the required majority.

Transparency is a design choice. Some firms share every partner's figures with all partners, which supports trust but may expose differences that cause friction. Others disclose the formula and each person's own result only. Whatever approach is chosen, each partner must have enough information to confirm that the model has been applied as agreed.

Common failures and how to avoid them

Small firms tend to encounter the same difficulties. Compensation is decided informally in the early years, when the partners are friends and the sums are small, and then becomes contentious as the firm grows and the figures matter. The remedy is to document the model before it is needed.

A second failure is rewarding the wrong behaviour. A firm that pays only for hours will receive hours; a firm that pays only for origination will receive client hoarding. The test of any model is to ask what behaviour a rational, self-interested fee earner would adopt under it, and whether the firm would welcome that behaviour.

A third is ignoring the invisible work. Training juniors, reviewing files, maintaining precedents, handling compliance and managing the office are essential but unbilled, and if they are not recognised they will be neglected or resented. The firm should identify them, assign them and reward them.

A fourth is rigidity. A firm's circumstances change as it grows, takes on new practice areas, or admits new partners, and a model suited to a three-person firm may be unsuited to a ten-person firm. A scheduled review every two or three years, with a willingness to adjust, prevents the model from becoming a source of grievance.

Practical next steps

1. Hold a principals' meeting to agree and rank the objectives the model must serve: fairness, retention, collaboration, investment and simplicity.

2. Gather the firm's data for the previous two or three years: fees billed and collected by fee earner, originated fees, write-offs, time spent on management and training, and overhead allocation.

3. Model at least three alternatives on the firm's own figures, as in the illustration above, including a stress test for a year in which profit falls significantly.

4. Check the professional rules on fee sharing, referral fees and ownership, and take advice on tax and employment consequences.

5. Write the model into the partnership or operating agreement, with a worked example, definitions and a decision process.

6. Prepare a written compensation structure for associates, with progression criteria, bonus rules and any origination credit.

7. Communicate the model to everyone affected, and arrange a review date.

How practice management software supports compensation decisions

A compensation model is only as reliable as the data behind it. Practice management software such as Legalytech records time, billing, collections and matter ownership against each fee earner, and produces reports on work in progress, realisation and receivables by person and by matter, so that the principals can apply an agreed formula to consistent figures and explain the result.

This article is provided for general information only and does not constitute legal advice. Practitioners should consult the rules of their own jurisdiction and regulator.