I know the components of their P&Ls and within a certain range what proportion each component of income and expense should account for. For the record, professional services firms’ financials are just not that hard or mysterious, especially when compared to corporations (which actually aren’t all that hard, either; there are just more moving parts).
How could it be that law firms were so much more profitable than other professional services firms? For example, the average pre-tax profit margin for CPAs is 17.1% and for the big communication agency holding companies, 12.0%.
Standing back, I realized that the primary reason law firms look so much more profitable is that profits are reported before equity partners are paid. The rationale is that equity partners are entitled to everything that’s left over after other expenses are paid, since they own the firm.
| As an aside, law firm profitability as it’s currently reported most likely annoys the stuffing out of your clients. When they compare their (real) profitability against the (inflated) profitability at law firms, it simply exacerbates mistrust and their feeling of being ripped off due to the perception that law firms are generating outsized profits on the backs of their clients. They don’t say to themselves, “Oh this makes sense because….” They just see the eye-popping numbers. Maybe that alone is a good reason to re-think this. |
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Here’s what’s wrong with that. Equity partners wear two and sometimes three hats at a firm. Yes, they are the owners. Some have management responsibilities of varying degrees. But first and foremost they are workers (or, as an irreverent friend of ours likes to say, “day laborers”): The vast majority of their hours are spent servicing, advising, litigating for clients.
What this means is that law firms are reporting profits before taking into account a huge proportion of their labor costs. Were their work done by equally competent lawyers who were not equity partners, the labor costs would fall into the expense bucket.
If we go back to Corporate Land, it would be as if a wide swath of middle to senior management’s labor were not counted as costs. Et voila´! Profitability would balloon. But not really.
So: Here’s my question to our gentle readers. On average, what proportion of equity partners’ comp is really and truly labor costs and should be counted as an expense? And, for extra credit: What impact would this have on firm profitability?
I eagerly await your inputs and observations.
—Janet Stanton, Partner, Adam Smith, Esq.
We could view partner compensation in three buckets: salary, profit, and commission. Salary pays for the legal advice. Profit covers the ownership interest. Commission rewards sales.
Yes, I understand that thinking about commission for rain making is an anathema to lawyers and firms. But I’ve long wondered if we called that element of compensation what it really is – sales commissions – whether that might not help us think more clearly about partner profit.
Given your corporate experience, any thoughts if this idea makes sense?
Hi Ron –
Interesting observation. Question for you; do you include partners’ management responsibilities under salary?
In Corporate Land, commissions are generally limited to those directly responsible for sales – and even not in every case at all. For general or even senior management (including those in sales) the only sort-of equivalent is often stock options. The idea behind them is to incentivize individuals to perform in a way that contributes to the greater glory of the company.
Another way to think about commissions in Law Land (and, yes, that word would drive many lawyers/firms nuts) is origination credits which are recognized in comp and often (hopefully!) “sunset” as some commission agreements call for.
Cheers!
Well, we have 80 partners and profit per partner is $550,000.
$100 million in revenue.
That’s $44 million.
Our average fees per partner are $500,000. This is for work performed.
I get about 1.5% of the profit for $750,000 of fees collected and $2 million of client fees originated.
Let’s say our overhead and COGS is 44%.
44% of $750,000 is $330,000. That means I get $330,000 for “sales” and my profit share. Supposedly, my sales reward is 20%.
Obviously, at $2 million, I am getting more like 16.5%.
You can look at this many different ways, but eventually you come to the conclusion that actual profit is much lower than 20%. More like single digits.
Why?
Admin time.
Bloated comp for equity partners who I could replace in 30 days at 60% of their cost.
Overpaid associates at various levels.
In the space of 2 years, I could shed 25 partners, 25 associates, add 20 paralegals, add skilled legal secretaries/ practice managers, pay the non- lawyer staff more and link their bonus to firm profit, pay maybe 20 existing associates a lot more because they are stars, and I would likely increase my comp by 15% while gaining a happier, better compensated and productive client service team.
My partners feel I am crazy. Treat no lawyers like serfs and indulge the mailing it in lawyer gentry.
A sick organization and none of them see what is coming.
Hi Tim –
I think you’re exactly right about the single digits. We’re also big fans of highly skilled business professionals for whom a JD is completely irrelevant (except to make the practicing lawyers somehow more comfortable – but kinda – so what?). Law firms are both allergic to change – yet they are incredibly fragile organizations that can unravel in a matter of weeks.
Thanks!
How would you assess ‘actual’ profit margin in a partnership structure – allocate a deemed salary for each partner (say, picking a random figure, $400,000 pa) and deduct that from the reported profit, then see what is left?
There are a small number of listed law firms around, Slater and Gordon in Australia/UK for example (although they do not operate in the same markets as ‘big law’). Its reported EBITDA margin is 24-25%.
I have often wondered why law firms dont allocate to their partners a base salary, plus ‘equity points’ (shares) on top of that for performance and the chance to give salaried employees some shares as well. Even if the secretary only gets $500 pa in ‘dividends’, it has to create a better corporate spirit than the current structure. Where is the incentive to save money, to be more efficient, to take on more?
I would agree with Chris. However, of course such a salary is hard to find – since there are usually no “bigshots” which are salary partners.
The only way to really calculate profitability would be if you assumed that all owners=partners in a law firm would not work anymore but the work is done by hired attorneys. Their salaries have to be deducted from the profit – and if there is anything left over, that is the real profitability. And from what I would assume, 10% would then be a real good number….
Thanks Chris and Herbert –
You both make interesting points.
Currently US firms are not allowed to share equity more broadly (which I have to believe puts them at a competitive advantage vs. other industries in attracting top-notch business professionals – but that is a topic for another article.)
Herbert – I believe you have it right – both in terms of how to figure “real” profitability and what the likely true profit % would be.
What are the chances any firms would attempt that exercise?
Cheers,
Janet
I’d like to suggest that for law firms, and for other professional service firms where all or almost all of the owners are professionals who work at the firm (i.e., not the big public ad agencies), a better metric is to not count any of the attorney labor cost when ranking firms against each other. Imagine a three-lawyer practice that grosses $900,000/year and has non-lawyer expenses of $300,000/year, leaving $600,000 to pay the three lawyers. If all three lawyers are partners, then the partner income is $200,000/lawyer. If one is an associate who is paid $100,000/year, then the partner income is $250,000/partner. If two are associates who are paid $100,000/year, then the owner income is $400,000. Yet these are all, from the outside, the same practice: three lawyers grossing $900,000 and netting collectively $600,000.
Hi MidRange –
Thanks for your comment. What you suggest is interesting, but would further inflate law firm “profitability.” I believe true labor costs should be reflected in the expense bucket. Also, the scenarios you describe are simply different staffing models – all equally valid.
Cheers,
Janet
Janet, you and I may be saying the same thing but in different ways: either count all of the attorney labor as a cost, or count none of it, but don’t count just some of it as a cost. In a manufacturing or retailing firm, and in your model of a law firm for measuring profitability, all of the labor is counted as an expense. In my model, none of the attorney labor is counted as an expense (or put another way, the distinction between partners and associates is disregarded). In the prevailing measurement of law firm profitability (PPP or total reported profit for partners, either way), the problem is that some of the attorney labor is counted as an expense and the rest of the attorney labor isn’t.
Sorta kinda building on Ron Friedmann’s comment (the first in this thread), we could arbitrarily say that the labor and sales cost of a partner is 50% of what the firm collects for the partner’s work and 20% of what the firm collects for the partner’s origination. Thus, a lawyer who originates $1 million and collects for $400,000 of work would have an imputed labor cost of $400,000 ($200,000 as 20% of the origination and another $200,000 as 50% of the working revenue). If the lawyer makes $500,000 then the lawyer is getting $100,000 of profit for being part of the firm. If the lawyer makes $300,000 then the lawyer is losing $100,000 for being part of the firm.
Hi Midrange Guy –
My apologies for not responding sooner; we’ve been traveling on business. Last week in the UK – this week in Dublin for a client.
Based on what I’ve heard from readers, law firm real profitablity is closer to single or very low double digits – which is very close to other professional services firms.
Really love the dialogue.
Cheers,
Janet
These assumptions seem flawed. The fact that top law firms can pay their partners more (often significantly so) than most professional services firms would appear to me to be de facto evidence their gross margins are higher. I like the concept here, but the execution and assumptions in these comments aren’t there yet.
Your point is much appreciated; thanks. With respect, the thrust of our article is to recognize that what the legal industry refers to in common parlance as law firms’ “profits” is calculated before the partners are paid a nickel. I’m sure every CEO in corporate America would love to be able to state their company’s profits without accounting for what management is paid–their margins would look quite high, indeed. The level of partner pay, good-bad-or-indifferent, wasn’t really our topic in this piece.
Janet and Bruce,
I think you are perhaps asking the wrong question. It shouldn’t be profit margin on revenue; what businesses ask is what is the return on invested capital. It seems to me that the issue here is allocation between return on capital and return for labor. Perhaps the right models to look at would be the conversion of Goldman Sachs and/or Accenture from professional partnerships to publicly traded companies. My recollection is that both of those companies took a fairly mechanical and simple solution of taking 50% of each partner’s compensation and converting it into “profit” and then calculating how much equity capital would be supported by that amount of profit. (That calculation is then a question of what an acceptable minimum equity ROI threshhold would be – let’s say 20% return on next year’s projected profit). The question then for law firms is calculating what is the maximum percentage of partner compensation that could be converted to “profits” so that there is sufficient equity capital at an attractive enough return to (a) sell to new investors to raise the capital needed by a law firm, (b) have enough capital iretained by the existing partners to compensate them for the “loss” of income (being a fairly complex calculus of trading multiples and the fact that capital gains are taxed at a lower rate, and (c) retain enough capital to hire new partners (and to promote existing partners to senior ranks). [Again a complex guess that involves figuring out how much additional growth gets generated if a law firm has additional capital). It also probably means entirely revamping retirement plans and considering whether the retirement plans are compensation expense or earned capital. If you use this model, I think you will see that high growth law firms are likely to have a higher amount of “profit” (because high growth results in higher equity multiples) and thus, boutiques like Wachtell, who have less growth and less need for capital would have lower equity multiples and thus could convert less of their compensation to the profit line and still treat its partners economically neutral in the long run. A fascinating topic, but profit margin or operating margin is only relevent for comparisions within the same industry; thus even a comparison to other professional services industries, such as accounting, is not relevent (for one reason because of the much higher leverage that accounting firms have).
Ray:
Delightful to hear from you! I’m responding for Janet–we’ve discussed your very astute observations.
First, return on capital/ROI is obviously a powerful metric. We’ve always been reluctant to talk about it in Law Land because law firms are not, as you well know, capital intensive in the least.
That said, what you propose–by analogy to Goldman Sachs and Accenture–is fairly compelling. Janet had a scarring experience in her years in advertising and communications/marketing when many of the great names in the business were sold out by their founders and taken over (“rolled up”) into behemoths that proceeded to destroy the firms’ brands.
There’s also, of course, a strong school of thought (which you’re well aware of) that the “original sin” of investment banking (GS, Lehman, Bear, potentially others) was to do an IPO. But that’s a different conversation.
Janet & I have often wondered whether investors–under the UK’s Legal Services Act–would have any interest in acquiring an interest in existing law firms, and we’ve always thought, “Not a chance,” since it’s unclear how a significant capital infusion would be able to add to growth. Then again,we may just be displaying a lack of imagination!
In any event, wonderful to hear from you and thanks for the terrific contribution.
One big difference between the investment banks and law firms is that an investment bank needs two sources of capital: one to support its day-to-day operations (cash in the bank, A/R, expense advances, rent deposits, etc.) and another to play with (sorry, to trade securities with and underwrite new offerings) — its inventory. The investment banks need much more capital per employee.
The large accounting firms are a better comparison, because capital isn’t a big income-producing factor for them. They do have one advantage over the large law firms; SEC rules and the nature of the industry make it very hard to start another large accounting firm. Could a lawyer for, say, Ford change firms and take a big piece of work with him/her? Probably yes. Could an outside accountant for Ford change firms and take Ford’s audit work? Not so easily.
It depends on the size of the law firm too. I recently started a boutique firm. We focus on a small niche area instead of being a full-service firm with several unprofitable areas. We make use of contract legal work and referrals so we are close to full service, but without the overhead associated with underused staff, extra office space, etc. Our profit before paying the partners is 45%.