This column is by Janet Stanton, Partner, Adam Smith, Esq.
Let’s get something straight from the get-go: “Equity” as it is known in Law Land is a chimera. Unlike in the other 98% of the economy, equity in Law Land is an illusion. It has no intrinsic or market value – you can’t sell it, trade it, borrow against it or bequeath it your grandkids in your will. If you don’t believe us, just check with your accountant.
Further, the notion that equity partners are paid purely out of a firm’s profits is also a sham. Equity partners are first and foremost workers and their compensation is primarily based on their financial contributions to the firm (billing, business generation, collecting, etc.) and only de minimis as “owners.” (That law firms report their profitability without accounting for a huge proportion of their labor costs is merely another Alice-in-Wonderland aberration found only in Law Land.)
In fact, equity partners are the primary financial engine at firms. In addition to churning out billable hours, they’re the group most responsible for business generation; charged with bringing in new clients and additional assignments. Hardly the role of passive coupon-clipping owners.
And, then there are the downsides…
There are distinct tax disadvantages for individuals of K-1 compensation versus W-2; mostly related to FICA and health coverage which are not covered by firms under a K-1. There are other consequences since K-1 folks are considered to be self-employed by the IRS – such as the quarterly estimated tax requirement under K-1. Please note, we are in no way accounting experts, who should be consulted to spell out all the implications.
Moreover, most firms require capital contributions from their equity tier; we’ve heard as much as 50% of partner comp annually (though 25%, or so, is more common). And, unlike what one would expect from investing such hefty sums, partners’ capital contributions earn little if any interest.
Of much greater consequence is the reality that equity partners can face significant financial and reputational liabilities if the firm finds itself in trouble – as for example, the firm goes belly up with an underwater balance sheet. Creditors and bankruptcy courts are not at all shy about clawing back compensation recharacterized as a fraudulent conveyance – and equity partners are often the first to be targeted (as they’re the highest paid folks at a firm).
In fact, we know of several big-name rainmakers at prestigious firms who have affirmatively eschewed an equity position just to avoid these headaches.
Despite all of this, we well recognize that the myth and allure of equity are deeply entrenched in the psyche and lore of the industry; becoming an equity partner continues to be viewed as the crowning achievement in Law Land.
What do we suggest?
Firms and lawyers should wipe the pixie dust from their eyes.
Let us stipulate, law firm partners are a highly advantaged lot – whether equity or not. First off, they are very well compensated; the “average” AmLaw equity partner reportedly earns about $1.4 million a year. And, since compensation is primarily based on financial performance, this would not change without equity status. Many lawyers operate with a great deal of autonomy in how they run their practice; with much less management involvement (meddling?) than would be the lived experience of senior managers at any corporation. Moreover, they are often well-respected “pillars” of their communities.
For firms, a non-equity partnership offers clear advantages, especially in terms of decision-making and innovation.
Going forward, firms and individual lawyers will be in a better position to negotiate truly mutually beneficial agreements once all acknowledge reality.
Surely, there are a few more nuances to think through, such as the governance role of partner agreements, which some may choose to overblow.
But, let’s not kid ourselves.
“The worst of all deceptions is self-deception.”
– Plato
Image Courtesy Ravit Sages, Unsplash
It was obvious to me 35 years ago in a big midwestern firm with a one-tier partnership that there was a line that separated partners who were net takers from those who were net givers. In other words some equity partners leverage other equity partners the same way they leverage associates.
Excellent point – we’ve seen that as well.
There is an old English court case, Helmore v Smith (1886), in which the judge held as follows:
“If fiduciary relation means anything I cannot conceive a stronger case of fiduciary relation than that which exists between the partners. Their mutual confidence is the life blood of the concern. It is because they trust one another that they are partners in the first instance; it is because they continue to trust each other that the business goes on.”
There are still many law firm partnerships out there that share this bond of trust, whether they are incorporated or LLPs. And being an “equity” partner is nothing more, or less, than living the bond of trust day in, day out. If law firms fail, it is often because they strayed too far from the original model (Exhibit A: Dewey LeBoeuf with excessive leverage and too many partners with guaranteed pay).
So as far as this commentator is concerned, there is no pixie dust to be wiped from their eyes.
Dear Daniel:
As always, you contribution to the dialogue is learned, sensitive, and nuanced. Many thanks! The extract you cite from the 150-year-old English case (previously unknown to me) describes with great economy of words the highest embodiment of the partnership ideal, and to my way of thinking explains why today even those firms (Dewey in your well-targeted example) which contravene its ideals in every meaningful respect still pay it homage.
We–and in this case specifically Janet–were trying to make the point that, with noble exceptions, there is an awful lot of pixie dust out there in the market.
Thanks again, faithfully,
Janet, you wrote “Equity partners are first and foremost workers and their compensation is primarily based on their financial contributions to the firm (billing, business generation, collecting, etc.) and only de minimis as ‘owners.'”
A firm could separate those two roles, however awkwardly, in its compensation system, and provide one compensation system to reward partners for collecting fees from work that the partners do as workers, and a separate compensation system that recognizes partners who contribute to the well-being of the business by bringing in clients, by publicizing the firm, and by serving in management. I’ve made that separation in my MicroLaw firm by forming it as an S corporation. The lawyers’ salaries generally reflect their contributions as workers; their ownership of shares generally reflects their contributions as owners. I don’t mean the financial contributions, which are not large (the one-time capital contributions total about 10% of the owners’ annual income), but the less tangible contributions that owners who trust one another on the level of Helmore v. Smith will make to their common enterprise.
Hi Midrange –
Thanks for your (always) thoughtful comments…and I have a few reactions.
I worry that compensating for the well being of the business begins to feel transactional. Moreover, I strongly feel that senior leaders in any organization (whether partner, or not) have an obligation that goes beyond bringing in the business; contributing to the intangibles that define the essence of each organization. (As one example, I initiated a formal mentoring program at the two companies I worked at before I tumbled into Law Land.)
Also, some firms kinda do what you suggest by including both quantitative and qualitative criteria in their partner comp systems – though, as you note, implementation is, indeed, often awkward.
Finally, and sadly, we just don’t see an abundance of trust at most law firms. Since I’m relatively new to Law Land, I don’t know if this is a recent change.
Thank you, again.