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Equity Discussion in a Law Firm

Equity Discussion in a Law Firm

Introduction

This paper is presented to stimulate thinking about alternative capital structures for a law firm in the world we now live.

The points raised are what has been described to me as ideas worth thinking about. These ideas come from:

  • Academics
  • Chairmen of law firms
  • External board members of law firms
  • CEO’s of law firms
  • Partners in law firms

Many firms have, are or planning to go down variations of the paths described below. Some of the ideas presented are revolutionary – which, given the state of the market, are worthy of debate.

What's wrong with law firms today?

  • Lawyers complain of being treated like “leverage tools” and given inadequate opportunities for mentoring, training, client contact, and career advancement
  • Clients feel overcharged and underserved, and are constantly searching for a better deal from a different firm
  • Partners have grown tired of a “what-have-you-done-for-me-lately” culture in which they have to bill and earn as much as possible during their productive working years and who, like clients, are all too willing to chase a better deal at another firm

Who is to blame for this discontent?

Many academics and other observers of the legal industry and profession suggest that the cause of these issues is law firm short-termism:

  • Law firms place too much emphasis on current revenue generation—the annual “profitsper-partner” numbers— and not enough emphasis on building long-term value
  • At core, it is this short-term outlook that leads law firms to squander valuable opportunities to build long-term loyalty among their clients and lawyers
  • There is an argument that the most promising solution to law firm short-termism is a simple one: change the law firm’s capital structure

In the space of 20 years, we have seen dramatic change in the legal profession:

  • Lawyers no longer spend their entire careers at the one law firm. Just recently a senior partner changed firms for the 8th time
  • There is unprecedented volatility in retaining talent in major law firms all over the world
  • Lock-step compensation systems have gradually been replaced by systems that reward the best performers in response to this volatility – this has changed the culture in many firms – and not for the beUer many people argue
  • Over the same time period, clients have shifted from relying on a single law firm as their long-term trusted advisor to instead relying on in-house legal departments and shopping their outside work among a number of different law firms
  • Lawyers and clients alike increasingly view the law firm as a loose association of economically motivated free agents who happen to practice law under the same roof
  • Law firms focus exclusively on the short term because the people in charge of law firms are compensated based solely on short-term performance
  • These people do not hold permanent equity interests that would compensate them for creating long-term value
  • Law firm partners share in a firm’s profits only for so long as they are employed and generate revenues
  • Upon retirement, a small number of partners may receive a declining draw that resembles an employee pension, but their equity interest vanishes
  • Law firms are structured to be nothing more than transitory associations of individuals who happen to practice law under the same roof for a particular period of time
  • This paper explores how an alternative capital structure—one with conventional permanent equity—would change lawyer incentives and improve both the economics of law practice and the cultural experience of all of a law firm’s constituencies
  • The proposed thoughts offer the promise of marked improvements for law firm partners, lawyers, and clients

Permanent equity model

In a permanent equity model:

  • Partners would be rewarded for building lasting businesses, not just for current billings, and their equity interests could grow to be worth many times their annual compensation, thus providing a significant nest egg for retirement
  • Junior lawyers would no longer be merely a source of leverage in a harsh, up-or-out culture, but rather would be embraced as the future of the firm and the key to its equity value
  • Finally, clients would benefit because the value of the firm would depend more on the sustainability of future earnings then on billings in any single period, and law firms would have every incentive to win and retain their clients’ continuing loyalty, even if that means accepting alternative billing arrangements and lower current billings

You can only create long term shareholder value by creating customer value. So the introduction of a permanent equity model fits perfectly with many firms current strategy to focus the business on the market.

There are many variations possible in an equity model:

  • Who gets it?
  • Just partners, or some senior lawyers
  • Do retired partners keep it for a period
  • Is it an inside model – or an outside model – or a mix of both?
  • Do partners have to buy the equity – or is it granted in reflection of value already created?
  • How do you decide who gets what to begin with?
  • How do you revamp the compensation system to fit with an equity model?
  • Base pay
  • Bonus based on performance – 30% paid as shares – or some other number
  • Dividends or capital growth model, or both
  • And many other factors

Appendix

You can see from the next set of slides that there is significant growth in market value for those professional services firms that have gone down the equity path.

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Author(s)

John Colvin

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