LAW
FIRM
PROFITS AND THEIR
ALLOCATION—
One Firm’s Experience
E
very law firm wants to improve its prof-
itability in a way that is fair to all partners, and that accounts properly for
both the tangible and intangible contributions of its partners. This article
recounts a conversation about a hypothetical firm that attempted to do just
by Joseph Mais
10
Arizona Attorney u May 2000
that.
T
he law firm of Abel, Baker and Cook recently celebrated its fifth anniversary. After the party, the
founding partners, knowing of my interest in law firm
economics, took me aside to tell me about the financial
history of their firm.
“Our first year together, 1995, was a financial disappointment,” according to Sharon Baker. “Each partner
received $150,000 in compensation that year, an amount
significantly less than we had each made with our former
firms.”
The three name partners decided to improve profitability by raising their billing rates from $230/hour to $250/
hour, and the billing rates of their three associates from
$130/hour to $150/hour. They also agreed to work harder
and manage their accounts receivable more carefully. “We
were not trying to get rich, but we did believe that if we
worked a little harder and managed our business a little
better, we could make a little more money,” Steve Abel
explained. “As it turned out, we did work a little harder
and smarter. But instead of making a little more money,
our profits skyrocketed.”
“You see,” Michael Cook broke in, “the revenue of a
law firm that bills by the hour is basically the product of
four things: (i) the number of timekeepers, (ii) their average billing rate, (iii) their average recorded hours and (iv)
realization, which is the portion of one’s recorded billings that is collected.” Cook removed a chart from the
drawer in his desk and handed it to me. “This chart shows
how we materially increased the firm’s profits by making
small increases or improvements in our rates, hours and
realization, while holding the line on expenses.” (See Chart
A.)
I studied the chart and soon realized that the firm’s
profits had doubled even though the firm’s revenue had
increased by less than 30 percent. This was because every
incremental dollar of revenue resulted in an additional
dollar of profit for the firm. “That is an impressive improvement in just one year,” I agreed. “How did you distribute profits?”
“We adopted a formula that attempted to allocate profits to each partner based on his or her economic contribution to the firm,” Cook replied. “Application of our formula was easy in 1996. Because each of us brought in our
own work and supported one associate, our model was
driven by our own collections, and those of the lawyers
we supervised. In 1996, each lawyer worked 1,800 hours
and each lawyer collected 97 percent of his or her work.
So each partner’s collections were identical and each partner was paid $300,000.
“Unfortunately, our profit allocation formula was
tested in 1997,” Cook continued. “Abel’s best client was
acquired just when my practice was getting hot. When
the firm closed its books at the end of 1997, everything
was exactly the same as in 1996, except that I had billed
2,400 hours, while Abel had billed just 1,200 hours. We
still had $900,000 in profits to distribute, but application
of the firm’s profit allocation formula would have resulted
in the following allocation profits:
Abel
Baker
Cook
$155,000
$300,000
$445,000
“This is because my economic contribution to the firm
(as we measured it) was $145,000 higher in 1997 than it
had been in 1996 (i.e., 600 incremental hours at $250/hour
x 97 percent realization), while Abel’s economic contribution to the firm had decreased from the previous year
by a like amount.”
“All of us were surCHART A
1995
1996
prised that application
Number of Timekeepers 6
6
of a formula we
thought was fair and
Billing Rates
3 partners @ $230/hour
3 partners @ $250/hour
neutral when we
3 associates @ $130/hour 3 associates @ $150/hour
adopted it would result
in Cook being paid
Average Billable Hours 1700
1800
nearly three times as
Realization
90%
97%
much as Abel in 1997,”
Baker said. “Abel noted
Revenue
$1.65 million
$2.10 million
that his practice, like
Expenses
$1.20 million
$1.20 million
Cook’s, had supported
a partner and an assoNet
$450,000
$900,000
($150,000/partner)
($300,000/partner)
(Continued on page 36)
May 2000 u Arizona Attorney
11
Law Firm Profits
(Continued from page 11)
ciate, and felt that a reduction in his
compensation of no more than
$75,000 was appropriate, with Cook
receiving a comparable increase.
Cook noted, however, that if Abel had
made an economic contribution to
the firm in 1997 equal to Cook’s, both
would have received $445,000 in
compensation. We were able to reach
an acceptable compromise, but only
by suspending application of our formula and taking a longer view of relative contributions.
“Pressure on our partnership intensified in 1998,” Baker continued,
“when Karen Abbott, the associate
who had been working for Abel, told
me that she had run out of work and
would probably leave the firm if she
were not reassigned. Because Cook
and I were very busy at the time, we
asked her to work on our matters. Unfortunately, Abel continued to
struggle and, once again, the year
36
Arizona Attorney u May 2000
ended with firm profits and partner
billable hours unchanged from 1997.
The only difference between 1998
and 1997 was that Cook and I now
each supervised and provided work
for all three associates.
“Cook came to our compensation
meeting at the close of 1998 with an
analysis showing that for 1998 and
for each of the two previous years,
each associate’s efforts had contributed about $75,000 to the profits of
the firm. Cook noted that strict application of our ‘economic contribution’ formula (which would allocate
all profits from the associates to him
and to me) would result in the following allocation of the firm’s $900,000
in profits in 1998:
Abel
Baker
Cook
$80,000
$337,500
$482,500
“The arithmetic was indisputable,”
Abel said. “But we each knew that I
could no longer be part of the firm if
we allocated profits in this manner.
Once again, we were able to reach an
agreement, but Cook and Baker told
me that they could not be expected to
subsidize my practice indefinitely. In
fact, I had been working continuously
to rebuild my practice and, fortunately, those efforts paid off in 1999.
Once again, I was able to provide fulltime work for myself and Karen
Abbott. In fact, the firm had to hire
two new associates in 1999.”
I suggested that one could draw
three lessons from their experience.
“First, modest improvements in effort, rates, realization or leverage can
make an enormous impact on the
profitability of the firm. Your firm’s
modest increases in billing rates,
hours recorded and realization resulted in a 100-percent increase in the
firm’s profits in 1996.
“Second, formulaic profit allocation models may be too inflexible to
serve the best interests of the firm,
particularly if they focus only on the
economic contribution of each part-
ner in the just-concluded year. Your
firm’s model, which would have resulted in Cook making three times
more than Abel in 1997 and six times
more than Abel in 1998, was destabilizing, and arguably unfair. Fortunately, you recognized this and made
the necessary accommodations.
“Finally, however, it is also destabilizing (and unfair to the highly productive partners) for a firm to carry a
partner whose economic contribution is consistently disappointing.
Cook was correct in 1997 when he
noted that if Abel had matched Cook’s
economic contribution to the firm,
Cook would have made more money.
A law firm’s compensation system
must be flexible enough to give partners like Abel the opportunity to overcome a bad break, but a firm that routinely requires its most productive
members to subsidize its least productive members is headed for trouble.”
“In fact,” said Baker, “those are the
very lessons we took from our experience. Of course, making as much
money as possible was not the reason
we became lawyers, or decided to practice law together. We believe that if you
consistently hire talented and energetic people who aspire to provide outstanding service to all clients all the
time, it is not difficult to operate profitably. We spend far more energy trying to become better lawyers than focusing on our bottom line.”
Cook offered the last word. “Even
if you focus solely on law firm economics, as we have tonight, most
firms in the real world are vastly more
complicated than ours. Not all partners originate all of their own work,
not all clients or practices are equally
profitable and not all partners make
the same intangible contributions to
the firm and the community. These
factors need to be considered when
assessing how to fairly distribute the
firm’s profits. Fair-minded people can
come to different conclusions about
what is fair, as Abel and I did in 1997.
Be we believe that the basic principles
you identified are correct.”
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For more information or assistance with the deadline, call
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Joseph Mais is an attorney with Brown
& Bain, P.A.
May 2000 u Arizona Attorney
37