Here on "Adam Smith, Esq." I’ve been writing about the possibility of outside investors in law firms—and even IPO’s of firms—starting in December 2004. For the full roster, see that piece, plus:
- How to Change Everything/December 2004
- Shearman & Sterling’s IPO/May 2005
- Non-Lawyer Partners Post-Clementi/June 2005
- Publicly Traded Law Firms: The Starter’s Pistol Has Fired/June 2005
- Clementi Reforms Progress/October 2005
- "The Innovator’s Dilemma" Strikes Again/April 2006
- Who? Me Innovate?/January 2007
- It’s Happening Sooner Than You Think/January 2007, and
- Publicly Traded Law Firms in the US? Georgetown Law Symposium/April 2007
Now it’s time to stop talking about it hypothetically and starting talking about what a firm might actually need to do in preparation for opening itself to the capital markets.
I’d like to start by stepping back and asking whether most law firms, on the current model, are prepared to actually take rational advantage of a sudden influx of capital. My answer is that most are not—and not for intellectual or analytic reasons, but for cultural ones.
For as long as anyone has conceived of the profession as being simultaneously a business, lawyers’ remuneration has come in only one form: Ordinary income. There has been no such thing as equity accumulation in a firm, stock options, etc. (Indeed, this is one often-overlooked financial incentive for associates to look longingly at investment banking, private equity, management consulting, and in-house positions: All those firms can offer not just nice incomes but the possibility of true wealth creation as well.)
Today of course the measuring rod for law firm financial performance is seen as Profits Per Partner. (I believe this is a superficial, manipulable, and readily misleading metric, but that’s a discussion for another day; the reality is that today it’s what everyone looks at.) As the ever-escalating race to achieve higher and higher PPP plays itself out—justified, if one chooses to be charitable, by the war for talent—lawyers have become even more addicted to high annual incomes. I fear that altogether too few think in terms of an alternative to eye-popping income, namely capital accumulation.
The problem is deeply rooted.
At least in part, it stems from partners’ wearing three hats simultaneously, and scarcely ever imagining there’s an economic distinction among the three. Partners are at once:
- Workers, billing hours and producing legal "output," whose value as such is what the firm would have to pay a non-equity partner to perform the equivalent work.
- Managers, performing all the socially desirable and civic-spirited duties required to keep an enormously complex enterprise functioning smoothly, from recruiting and mentoring associates to serving on practice management teams, writing and speaking, and cultivating new business. Their value in this role requires a somewhat more impressionistic and softer calculus, but it is at the very least what you’d have to pay non-lawyer executives to accomplish the same tasks. And lastly:
- Owners/investors, meaning the residual claimants on the firm’s economic value once all expenses attributable to operations, investment, and financing activities have been paid.
The problem is rooted not only in the minds of partners, but in the very way almost every firm that I’m familiar with does its cost accounting, whether it’s to determine the profitability of a single matter or to produce the annual ur-number, Annual Profit. The cost accounting convention I’m referring to is the one which treats the work equity partners perform throughout the year as essentially free—on the premise that their only "cost" is what they will have taken home by the end of the year in terms of their share of profit. But this, of course, merely repeats the fallacy of conflating the three hats into one.
I believe a more conceptually correct system would price the contribution of equity partners as above, with explicit costs for their role as workers and as managers. The result would be to produce a more realistic view (more comparable to firms in all other sectors of the economy, at least) of a law firm’s profits from the perspective of a potential non-equity partner investor.
Why do I dwell on what seems a green-eye-shade quibble?
Because if firms are to understand and prepare for the implications of having significant outside capital available, they need to let go of the income-is-God mindset. Partners will have to accept—nay, embrace—lower incomes (and horrors, lower reported PPP) in the expectation that the earnings the firm retains for current and future investment will reward them handsomely, through their ownership stake, in the long run. Today partners simply have no expectation of a capital return on their years of service to the firm, as one has never existed. But the possibility of investments that grow the future value of the firm as a firm must change that expectation.
This is not actually an economic problem, but it could be a cultural doozy.
Let me introduce another twist.
Historically, law firms have been anything but capital intensive. Certainly if one’s mental model is the closely-knit, single-city/single-office firm, most capital demands could almost be satisfied from the petty cash account, or certainly from very low-tech forms of financing, mostly through that exotic vehicle called a lease.
Today, although not all firms recognize it equally, the world is a very different place. IT was the first area to conspicuously start absorbing capital, and there are no signs that it’s done. Indeed, to sophisticated clients a sophisticated IT infrastructure is simply a given. Building practice areas, and establishing the right global geographic footprint, are also not for the capital-challenged. One hears so many estimates that I’m tempted to throw darts, but the treasure that has been spent by US firms setting themselves up in London, and UK firms setting themselves up here, is immense, even for the largest firms on both sides of the pond. (One published report has it that a Magic Circle firm lost £70-million over five years in establishing its New York practice.)
Such is today’s economic reality, however.
Now let’s add back the cultural dimension: We have the intergenerational issue. Senior partners, who may be expected to have disproportionate voting control, are neither used to an environment requiring extensive long-term investment nor do they expect to be around long enough to see it bear fruit. Moreover, the ranks of the senior partners—certainly these days—know the answer to the famous question, "Are you better off today than you were four years ago?" Which leads directly to "Tell me again what’s wrong with this?"
Meanwhile, junior partners expect the global business environment will demand committed, long-term investments to meet the competition, and are largely of the reasonable view that firms forswearing those investments will be the ones who will not be around forever. (I put aside junior partners who anticipate leaving the firm laterally before the investment might bear fruit, but their ranks, however small, certainly do not rank long-run considerations foremost.)
So we have in many firms a sort of gridlock.
I hasten to add that if your economic world revolves around this year’s ordinary income and nothing but this year’s ordinary income, this is understandable if not excusable. But: If we add in the prospect of an additional component of capital appreciation from now until retirement and beyond, the incentives change, and they change in a way that should encourage dedicated long-term investment. To be sure, the risk preferences of junior and senior partners may still diverge somewhat, but the threshold issue of whether the firm qua firm deserves a sustained capital commitment should be taken off the table.
This brings us to the nasty question of whether firms’ managements are actually equipped to handle long-term investments. Ask yourself whether you and your colleagues have all the skills you need to feel comfortable shepherding investments through their life-cycles:
- Imagining;
- Rank-evaluating;
- Launching;
- Monitoring;
- Fine-tuning; and
- Harvesting
By and large, the management challenges for law firms to date have centered on issues such as talent, recruitment, professional excellence, and optimal utilization of resources—not on hands-on management of long-term investments designed to change the way the firm does business. How often have you heard about—or witnessed—projects launched with great fervor and fanfare only to die on the vine, neglected, in the face of pressure from clients for service and from colleagues for billable output?
When imagining a world wherein law firms have access to the capital markets pari passu with corporations, the first objection is usually that they have no need for capital in their businesses and, if one gets to a second objection, it’s that lawyers are earning handsome incomes, thank you very much, so what would an equity "kicker" add?
Both are nonsense. Today’s global firms require far more capital than can be raised by docking the partners’ draw periodically or negotiating a line of credit with the Citigroup Private Bank—and even if the latter could suffice, can’t we all be a tad more imaginative here? As for the need for an equity kicker on the compensation platter, the key point is not that lawyers "need" more money, it’s that an equity component would fundamentally change the incentive set.
The bigger concern, I predict, is that if law firms open the door to capital infusions, be it through public or private offerings, they will find themselves ill-equipped on day one to manage the largesse.
