Professional partnerships: Profit sharing fundamentals
Updated: May 20, 2020
What reward species is your partnership, and why does it matter?
Most professional partnerships share profits in one of seven ways. This article explains each reward species and what this means to your firm.
Why typology is important
The reward species in a professional partnership matters for two reasons.
First, how partners share profits is a core foundational element holding any professional services partnership together.
Secondly, the reward species colors the lens through which partners view what “partnership” means for them. This in turn affects what partners deem fair reward decisions by management or the Remuneration Committee, and it affects what contributions count toward reward outcomes.
For example, a cost-sharing partnership will be less concerned with the revenues attributed to an individual partner than with the timeliness of his/her contribution payment to base costs. And which partner raises which invoice to which client matters less in a partnership where partners share profits equally than in a formula-based, “eat-what-you-kill” partnership.
Many partnerships aren’t clear about what reward species they are. For example, I have encountered firms that have insisted they are a collectivist, seniority-based lock-step where partners broadly share equally, while under the hood they operated a hard-core financial meritocracy where individual contribution very much mattered to a partner’s position on the lock-step. I’ve also encountered the opposite: firms thinking they are meritocracies but with so much lag built into how a partner moves up or down the points ladder that even significant year-on-year swings in contribution almost had little or no impact on reward outcomes.
If your partnership isn’t clear about what type of profit-sharing system it is running, firm leaders are likely to struggle with at least three things. First, they will struggle leading partners so they can contribute at their best. Second, they will struggle expressing clear evaluation criteria for reward decisions, which in turn will lead to bitter, political annual reward exercises. Third, they will struggle creating a culture that supports collaborative behaviors among partners to grow the business.
Clarity about what profit sharing system a partnership runs is critical. The typology below will help you identify what species of partnership you are operating and to align your approach to partner contribution and reward decision-making accordingly.
Introducing the 7 types of financial reward species in professional partnerships
Figure 1 identifies the 7 basic financial reward structure types.
Moving from the outside to center, I briefly review each reward species:
First, the individualistic three species on the left
Second, the three collectivist species on the right
Last, the balanced meritocracy as the model of choice
The three individualistic species
Each partner contributes a fixed amount to the firm’s central costs regardless of a partner’s revenues.
Highly individualistic, this model is essentially an office-sharing model.
Discussions around the table revolve mostly around keeping costs low. Often there is no common purpose other than that the person “fits in” around the office; discussions about partner contribution are neither desired nor necessary.
This model is often found in English Chambers and in micro-partnerships.
Profit sharing is based on a partner’s revenues or, when firm’s systems allow, a partner’s gross profit.
Also highly individualistic, this model often has a high top-to-bottom spread (10:1 or more). Since profits are shared, a minimum revenue or gross profit threshold often applies.
Contribution revolves around the size of a partner’s book of business; if there is a common partnership purpose, it is dominated around the clients of partners with the largest book of business. Almost anything goes in terms of behaviors, except for malpractice and other matters that affect the reputation of the firm.
Financial Meritocracy with Non-financial Elements
Substantial parts of a partner’s profit share remain tied to individual revenues or gross profit, yet a material part also relates to other quantitative and qualitative factors.
Often this structure is expressed in the form of a ladder of tiers or bands. A partner’s initial tier position is determined by financial outcomes, and the exact position is nuanced up or down by other factors that matter.
As contribution relates not only to the size of a partner’s book, constructive discussions of partnership purpose and expected partner behaviors become possible.
The three collectivist species
Fixed share / per capita
This species is at the complete opposite end of the spectrum of a cost-sharing model: it’s not every partner for him/herself, it’s all-for-one and one-for-all.
Partners are equal co-owners in the business, either per capita or pursuant to a fixed ratio that does not change over time based on a partner’s contribution to the business. A change to the fixed ratio often requires an amendment to the partnership agreement.
Some larger firms operate an internal market for shares, allowing partners to buy and sell partnership interests within certain parameters. I’ve also seen firms where the purchase-and-sale is mandatory based on certain contribution and results criteria, yet this is quite unusual.
This likely is the most cohesive of structures, because initially there is no internal competition: the only thing that matters to growing a partner’s income is top line growth and making profitable rational investments, not re-allocating profit shares from other partners.
The key drawback is that there’s no inherent valve to reflect big differences in partners’ contributions. As the partnership grows, “underperformance” – what the economists call “free-riding” – becomes a concern. For that reason, most firms I know modify this species by operating in parallel a bonus pool that is allocated based on balanced meritocratic factors.
A tenure-based lock-step essentially provides for a one-way ladder. Once admitted, partners start at the bottom of the ladder (say, at 50 points) and move up each year until they reach the agreed plateau (say, 100 points). Once they reach the plateau, they share equally with the other partners who have reached the plateau.
Again, individual contribution discussions are held around avoiding underperformance rather than positivist results the firm expects from its partners.
Proponents of fixed-share and tenure-based lock-step systems often advocate that this system does away with discussions around individual partner contribution. I take a different view: a sound partner contribution process is even more important in systems where financial reward isn’t an automatic valve for the practical reality that different partners contribute to the firm in different ways.
This is also because of the sharp edge to all lock-steps and fixed share systems: leaving the equity often is the only route for a partner who does not contribute at a similar level to his/her peers over time. Some firms are more patient than others how much time they give partners to recover from bad years.
Fixed share and tenure-based systems also struggle with overperformers: individuals whose contributions are heads-and-shoulders above the rest can grow frustrated that other partners don’t contribute at similar levels and thus “dilute” that partner’s share to which s/he might be otherwise entitled if all partners contributed at similar levels. While these partners always will be a higher flight risk than the others, often outlier partners enjoy the political power and related independence that outlier performance tends to bring with it.
Modified / Managed Lockstep
This partner reward species tries to remedy the free-rider problem inherent in fixed-share and tenure-based locksteps. Here, the ladder either has gateways or allow for partners to move in two directions.
A gateway requires certain conditions to be met before a partner can move to the next step on the ladder. Ideally these conditions are expressed through a balanced merit assessment; often they are based primarily around financial outcomes a partner has historically produced or around a partner’s future potential to contribute more. A partner who doesn’t meet these conditions is “held” at a position on the ladder until a new result is negotiated or until the partner leaves the firm.
A bi-directional ladder means that a partner can come down the ladder when certain conditions are met. In bi-directional ladders, it is even more important that a downward move is based on a balance of meritocratic factors that are clear and transparent, because in most partnerships moving down the ladder quickly becomes the first step to a partner exit.
I’m often asked what the difference is between a bi-directional ladder and a more individualist merit band system that I describe in “Financial Meritocracy with Non-financial Elements” above. The difference is in the “lag”: in a bi-directional ladder, partners are expected to move down in maximum increments, yet in a merit band system, a partner’s position can – at least in theory - vary significantly year-on-year.
I say “in theory” because in my experience partners operating in meritocracies tend to contribute relatively consistently year-on-year. Big swings in personal performance are often feared by other partners yet are unusual in practice. More common factors that cause a sudden swing in contribution are usually one-offs (contingent fee cases settling, success fees, and personal factors such as a divorce or other traumatic events at home).
Trending towards the center: my case for the multi-factor meritocracy
In a multi-factor meritocracy, a partner’s contribution to multiple categories of performance, viewed more or less equally in importance, determine a partner’s profit share over time. This species’ degree of individualism or collectivism depends on what the firm values in practice versus what it values on paper. In my view, a balanced approach to contribution is best. My usual starting point is a model inspired around Intellectual Capital – which I will discuss elsewhere.
Particularly in law firms, partners’ toenails curl up when they hear terms such as “balanced scorecard” or “multi-criteria framework”. Yet in the end, to achieve any purpose, the firm must consider a myriad of contributions that each partner must make to the business – there is no other way.
Clients often ask me which is my preferred species. It is this multi-factor meritocracy, simply because it allows for the most constructive discussion with partners and is the only model that is truly scalable – most other reward types on my list eventually become inhibitors to growth in partner numbers. As firms grow, on a a balanced meritocratic model enables execution around a common purpose and required behaviors to get there.
There are other benefits. A balanced meritocracy allows some partners to take on different roles in the firm that aren’t 100% client-producing. This is important as the firm grows.
All other models also tend to struggle with part-time and other flexible arrangements, which are often needed to retain and attract the best partners, especially in specialist practices.
Important: many firms claim to have a balanced meritocratic approach on paper, yet in practice financial outcomes substantially overshadow all other areas. This dissonance breeds partner cynicism and is the genesis of many strategic and culture problems within partnerships.
I recognize that the fewest of partner reward structures exist perfectly according to the above model around seven reward species. Each firm has evolved its system over time, containing several elements of the above species. Yes, there are at least as many partner reward systems as there are partnerships.
How do you want to evolve your firm’s reward species? Contact me to schedule a free initial consultation.
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