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.

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.

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