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Essential elements of an effective partner compensation system

Not All Partners Are Created Equal

Partner compensation is an art form. I think Thomas Jefferson intuited that when he said, "There is nothing more unequal than the equal treatment of unequal people"--even though when he made this statement it was in connection with designing an educational system, one of his many passions. Though Jefferson was proposing to recognize the variation in student's learning needs and capabilities, little did he know that he was laying the groundwork for one of the most powerful and basic tenets of effective partner compensation systems!

Only through a quirk of fate do all partners contribute equally to a firm's success. Yet, many firms install a pay-everyone-equal system under the mistaken belief it prevents arguments and promotes teamwork. The reality is partners are not equal, and sooner or later, an equal system will cause as much unhappiness as any system that is poorly conceived.

Partners in firms are human. They need to be "carrot-and-sticked" like everyone else. If a partner gets paid the same for extraordinary performance as for ordinary or sub-par performances, common sense says performance will not be maximized.

So, to recognize the varying degrees of capabilities among partners and to provide motivation for partners to excel, performance-based partner compensation systems have been developed. But development of these systems is very difficult because there is nothing more sensitive to a partner than how much he or she earns vs. the other partners. One way to deal with these sensitivities is to adopt sound concepts to begin with.

I have consulted with over 200 firms and nearly 1,000 partners. The following represents my strongest beliefs about partner compensation, based on these experiences and observing what has worked for these partners.

1) The best systems are performance-based. There should be a direct link between pay and performance. That's how most of the world works, and it applies equally well to professional service firms. It's fair and sensible for people who produce more to be paid more, and vice versa.

This, by no means, requires systems to be 100% based on performance. Even the best systems have part of the compensation based on a fixed draw, commensurate with the partners' street value. But, the variable portion of the compensation system should be significant enough to cause a change in partner behavior.

2) The system should motivate the partners to do what the firm needs them to do. Here's where strategic planning comes into play. To position themselves for success, it is helpful for firms to go through the process of deciding what kind of a firm they want to be in 5 to 10 years and creating goals to achieve their vision. But unless there is a mechanism for ensuring the partners pursue activities consistent with those goals the firm's vision will not be achieved. An excellent mechanism is a performance-based compensation system that contains a meaningful component for rewarding partners who help achieve their firm's goals.

Several years ago I made a presentation to a 12-partner law firm to assist them in developing a strategic plan. The presentation went great--I saw lots of heads nodding agreement with me and asking great questions to which I had equally great answers. Just when I had visions of cashing the check, one partner stood up and asked his fellow partners, "OK, let's say we hire Marc to develop a strategic plan. What's going to make us do it?"

The conversation proceeded to move into partner compensation and how their system, which they had no intention of changing, made no provision for rewarding those who achieved their goals in a strategic plan. This firm had no means of motivating the partners to do what the firm needed them to do. They also had no motivation to hire me as their consultant.

3) The system should reward the values the partners feel are most important. Billable hours, practice development, management, training, billing and collection, technical proficiency, teamwork, quality client service--these are some of the more important values that partners may embrace. How important is one vs. the other? This is what the partner group needs to decide. For example, if the system pays handsomely for
billable hours, but the consensus is that practice development is more important, then the system may not be credible.

4) Most or all the partners must perceive the system as fair. Probably the biggest turnoff for personnel partners or associates, in any organization, is the sense a policy or practice is inherently unfair. Partner compensation is no exception. In a small firm--say, six or fewer partners--all partners should feel the system is fair. In a larger firm that may not be possible, but most partners should feel the system is equitable.

I once worked with a firm that had an extremely complicated system that essentially locked out certain partners from ever achieving significant increases in their income, regardless of their performance. This was unfair and caused a group of partners to become disenchanted with the firm. Keep in mind, a partner can still feel a system is fair, even though its implementation may result in less compensation than if another system was selected.

5) Partners should be able to see rewards for getting results and accomplishing more. The system should be motivating, especially to younger partners. They must see a near-term reward for posting outstanding results. All partners who are prepared to work hard and make sacrifices to achieve extra results must see the work is worth the effort before they begin. There is nothing more de-motivating than putting forth this extra effort, only to see your fellow partners slack off and still receive the same pay.

One of my newer clients illustrates this. The original firm had five partners: two founding partners and three younger, newer partners. The two founding partners had little interest in growing the firm and were set in their ways. The younger partners gradually saw there was little they could do to achieve their goals within the framework the founding partners established. So, they did what countless groups of partners today do regularly. They left to start their own firm.

6) The system should be flexible. Good systems change as the firm's needs change and the environment around the firm changes. Earlier, I emphasized the importance of rewarding partners who achieve goals that support the firm's strategy and vision. These goals may change from year to year. Goals established last year may no longer make sense. Try to avoid systems that remain the same year after year despite substantial changes in the nature of the firm's practice.

I'm reminded of a client that experienced a gradual deterioration of its collections. It wasn't that they were experiencing bad debts. The problem was partners weren't making an effort to collect receivables--the partners had become lax in asking their clients to pay. This firm got so desperate, they changed their compensation system one year to give extraordinary rewards to those partners who were successful in making significant reductions in their receivables. It worked! The next year, they decided marketing needed to be emphasized, so they lowered the weight given to collections in their system and gave more recognition to marketing. They were flexible.

7) Multitier systems make sense. Instead of putting all partner income in one pool and allocating a single pool of income, a multitier system establishes several pools. The most common tiers are return on partner capital (as shareholders, partners should be entitled to a return on their investment), salary (which usually equates to street value or what they would be paid if they left the firm and got a job with another firm), and an incentive element (the variable portion of the compensation system that pays out based on achievement of goals, extraordinary accomplishments, or other performance-related factors).

As stated earlier, the incentive element must be significant enough to make an impact. One client I worked with had a one percent bonus pool, which equated to barely $1,000--hardly enough to cause a change in behavior. The incentive element should be at least 10 percent and can be as high as 15 to 25 percent in a firm that knows how to work with goals and incentive plans.

8) Marketing should play a meaningful role. More than any other aspect of performance, the ability to bring in new business in a professional services firm translates to bottom line success. But marketing often does not come easy to many professionals. If time and effort are put into marketing, particularly at the partner level, results often appear.

I personally do not subscribe to the myth you have to be a natural-born salesperson to market effectively. Like anything else, marketing can be learned. If you are offered training, make time for it and pursue it with a passion because only then will you develop a proficiency for practice development. But my work with firm partners has shown unless there is a meaningful reward for making the time to market, then marketing usually won't get done. A partner compensation system must contain a meaningful component for rewarding business brought in. Partners should feel the monetary consequences of not marketing, just as any business owner would.

9) Compensation systems should be integrated with goal setting and performance evaluation of partners. A strange phenomenon takes place in most firms once a person is made a partner--evaluations stop. This has never made sense to me. In fact, a stronger case can be made for partners needing performance evaluations than for nonpartners, because partner performance impacts the firm's success much more.

Goals are the steps that need to be taken to achieve the firm's vision. Performance evaluations are designed to improve an individual's performance. Combining the power of goal setting with performance evaluations, if done effectively, is a great way to maximize partner performance.

But one more technique is needed--linking these programs to partner compensation. By putting monetary rewards in the system for excellent performance, it lends more credibility to the goal
setting and performance evaluation

10) The system shouldn't cause allocations to vary wildly from year to year. In any given year, some partners will have better years than they normally do and some will have worse years than normal. Usually, these variations are the result of major changes with clients. One year a partner may land a big, new account. Another partner may lose a big client to a merger. Over many years, these peaks and valleys tend to even out.

In looking at criteria on which to determine the current year's allocations, firms should look at each partner's performance over a two or three-year period, not just the most recent year. This eliminates sharp, temporary swings in pay, which can be disruptive and demoralizing to partners when it's their year to take a cut. Partners need some semblance of
stability in their paychecks so they can plan their lives.

11) The managing partner should be able to impact the compensation system more than the other partners. One of the hardest parts of the managing partner's job is to manage the other partners. Partners don't like to be managed and often resist efforts on the part of any partner, managing partner included,
who suggests changes in the way they conduct themselves.

One technique MPs find helpful is the authority to impact a partner's income allocation. If a partner is receptive to the MP's efforts to suggest changes, and better yet, experiences positive results because of it, the MP should be able to reward that partner for the positive behavior, just as the president of any other business might reward a vice president for excellence. Conversely, if a partner rejects the MP's suggestions, and, as a result, that partner's performance falls or remains below expectations, the MP should be able to impact that partner's paycheck accordingly.

This authority is particularly useful when the MP tries to get a partner to do something that is clearly good for the firm, but which the partner, for whatever reasons, resists. For example, a partner is making no attempt to achieve his or her goals, or a partner is neglecting billing and is months behind, or a partner is treating employees abusively which results in higher turnover.

Here is one important caveat: If the MP job is more administrative and there is no expectation that part of the MP's job is to hold partners accountable, then it probably isn't essential the MP have this special authority.

12) Formula systems don't work! There are as many formula systems as mosquitoes in a swamp, but they all share these basic features:

* A formula is established that assigns a particular weight to tangible performance measures such as billable hours, realization, business originated, etc.

* The formula is 100 percent objective.

Subjectivity is intentionally removed from the system. The system appeals to numbers and logic-oriented people. But here's the problem with formulas: Partners, being the clever people they are, find loopholes. In no time at all, they will figure out how to make adjustments to maximize their payout. They tend to do things that boost their own paycheck at the expense of what is best for the firm.

Here's an example I recently experienced: The firm has four partners and operates strictly on a formula system--the partners "eat what they kill" and "bear the expenses of the hunt." A year ago, one partner suggested the firm develop the capability to provide personal financial planning services to increase revenue growth. That same partner suggested she develop this expertise. The other partners gave their approval immediately and enthusiastically to the entire plan. But a week later, when that same partner submitted bills for payment for PEP software and fees for taking a series of courses designed to culminate with the CFP designation, the other partners insisted these costs be borne personally by the PFP partner-to-be. The rigidity of the compensation formula prevented the firm from making an investment that in the short-term, would add expenses, but in the long term, would increase profits.

Other examples include partners hoarding billable hours instead of delegating them to lower level personnel; partners working on clients outside of their expertise and failing to get other partners involved who have the expertise; and partners failing to step forward to become involved in management because, as an intangible, management is not included
in the formula and hence, is not

Many firms embrace formula systems thinking this is a fair way to allocate income that also eliminates arguing and in-fighting. These results very well may be realized, but the cost is huge. Formulas encourage partners to do what is best for themselves and not the firm--a heavy cost indeed.

13) Compensation for ownership and compensation for performance should be dealt with separately. Many firms provide for payments to retired partners. These payments typically are not guaranteed, and they remunerate partners for a number of things, chief among them being ownership in the firm and the value and size of the client base they originated. The mistake many firms make is mixing together ownership and performance in determining annual income allocations. For example, many firms determine a percentage ownership each partner is assigned, and these percentages are used to allocate income. If partners A, B, and C own 50%, 30%, and 20%, respectively, they would split income in this ratio. In some cases, the percentages are determined strictly on how much ownership the partners actually purchase. In other cases, the partner group negotiates the percentages or a powerful partner or group of partners mandates the percentages.

Here's where problems arise. Frequently, partners in their 30s and 40s amass a large portion of the firm's ownership, and their high percentages of ownership remain high even as younger partners get admitted to the firm. But when the larger owners are in their 50s and 60s, for reasons that have little to do with aging, other partners begin making greater contributions to the firm's growth and profitability. Yet, because the firm's compensation system is heavily weighted toward firm ownership, the older partners are overcompensated. This results in the older partners essentially getting paid twice for retirement: once during their last 10 to 15 years as a partner as a result of being overcompensated and again after they retire.

The above scenario is obviously one to avoid. Eventually the younger partners will get fed up with the system and bolt. It is essential for partners to understand the importance of separating ownership from performance. The amount paid to a partner each year should be based primarily on what he or she contributes to the firm that year. Ownership can and should play a role, but it should be relatively minor. Remember, younger partners must be rewarded for their performance. If there is little or no money left to pay these rewards because allocations-based-on-ownership use these funds up, there will be dissension in the ranks.

14) The system should differentiate between management and administration. Management is getting things done through other people. It's delegating--each hour of time spent managing should create multiple hours of work for others. Management ensures the firm creates a vision for itself, develops strategies for achieving the vision, and implements action steps to achieve the goals. Management holds people accountable for their role in achieving the firm's goals.

Administration is more operationally oriented. It includes scorekeeping, systems development, and policy creation and interpretation. It is administration's job to support the firm's producers and to provide controls to ensure the firm's policies and procedures are adhered to. Administration is very important to the success of a firm, but it is not worth nearly as much as good management. The CEO of an organization is often the highest paid employee in the firm, but excellent firm administrators typically earn a small fraction of what a managing partner earns.

Many firms build in factors to compensate partners for administration. This is a mistake. Administration should be done by trained, professional administrators so partners are freed up to do what partners are supposed to do. According to a cowboy-turned-consultant I once heard, partners should do two things and nothing else: "Mess with the clients and mess with the staff." If firms build factors into their compensation system to pay for administration, they are encouraging their partners to engage in activities an outside person can do at a fraction of the cost, and probably twice as effectively. I've never understood why firms are willing to pay a partner $100,000+ a year for reconciling the firm's bank statements.

As the Partners Go,
So Goes the Firm

The saying, "as the partners go, so goes the firm," is true for all sizes of firms. Partners are in a much better position to impact the bottom line than their professional staff. It's the partners who bring in most, if not all, the business. It's usually the partners who manage the client relationships that are so essential to client retention. It's usually the partners who create new markets and services that are so essential to fueling revenue growth. It's the partners who mentor and nurture the staff that results in a longer-term, motivated employee group. So the key is: How can you create an environment where partners are happy, motivated, and content? A fair and motivating partner compensation system isn't the only important thing, but it goes a long way. Motivated, productive partners can have a huge impact on firm profitability, perhaps even doubling it from the industry norm.

As with many multiple-prong approaches to managing an activity, few firms will be able to adopt all 14 concepts into their system. But every one of these concepts works and produces results. The more of these concepts you can build into your firm's system, the happier your partners will be--and happy partners make more money. *

Adapted with permission from Insight, May 1997, the magazine of the Illinois CPA Society.

Marc L. Rosenberg, CPA is a management and marketing consultant to CPA and law firms, nationwide. His firm is based in Northfield, Ill.

By Marc L. RosenbergIn Brief

Pay Me What I'm Worth

What makes a partner compensation system effective? The author discusses 14 partner compensation strategies that should be considered when developing a system that will be effective and motivate partners to do the best job possible. He not only covers what makes good sense, but also some of the things that are being done that don't work, e.g., compensation schemes that may actually operate only to the benefit of individual partners, but to the detriment of the firm.

Also included is a practical exercise in pay equality that can be used in your firm to determine how your partners feel about what's important.

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