Why the economics of free agency should worry partners

So the question then becomes…why do law firms in the US do it? The very partners at the top receiving the high incomes should be the ones most averse to the idea.

The answer is….because in fact the ‘players’ are not ‘owners’ in the modern law firm model.

As the partner screams of ‘heresy’, ‘blasphemy’ and perhaps ‘fool’ subside, let us see why it is clearly the case.

Equity partners in US law firms, beginning more than 40 years ago began subscribing to partnership agreements in which they waived any claim to any of the assets of the firm, and disclaimed ‘goodwill’. Rather, they converted their very flexible partnership agreements to a commitment to make a capital contribution to the firm, which was the ONLY sum they would ever receive upon their death, disability, retirement, or withdrawal (“DDRW”) from the firm. In most instances that base capital earns no interest or accrual in value.

Why did law firms do this?

Several reasons, but two of the more important were:
1) every time a partner would join or leave the partnership, or internally there was an adjustment of earnings shares, there would be a matching ‘buy-sell’ associated with the transfer that could impact EVERY equity holder in the firm. There would be taxable gains/losses and typically no income to distribute on these capital transactions for partners, as the firm grew, creating a nightmare both for record keeping and the method for determining valuation, and
2) trustees for the estates of deceased partners, conservators for disabled partners, angry spouses of divorcing partners would sue the firm for premium valuation over book value of the assets, going concern multiples, goodwill, etc. In a large law firm it would be reasonable to expect that every partner in the firm would personally be a named party in at least half a dozen lawsuits throughout their entire careers! (Remember, they are general partners at that time, and technically even in an LLP still are). The managing partner and CFO would likely spend half their time in depositions and on the stand, or dealing with these cases, and all it would take is one instance of an adverse decision to severely damage the firm and every partner’s interest.

So the answer was for everyone to waive off any direct ownership interest in the assets of the firm, and that is what was done by the vast majority.

If you step back and think about this for more than ten seconds, you see that a number of business outcomes are inevitable from this type of ‘adjustment’ to the growth impact upon a professional service partnership.

The first consequence is that your only compensation is what you take out currently…so there becomes a big motivation in taking everything possible out of the firm on a current basis, and there is no interest in the viability of the entity as a sustainable going concern once you have left. Argue all you want against that…but that is what happens and it is more than apparent in the marketplace even if it is not widely discussed. This puts the partners in power and who make the decision in a serious conflict. They have the power to make the decisions as to who gets paid how much, and they have a shorter period of time to participate in distributions. The overwhelming pressure and self-interest is to favor themselves over the remainder of the partnership. You have seen it at work in many law firms, even though it is usually only exposed publicly in the ones that fail.

The second consequence is that the ‘capital’ contribution has the label of equity and is reported on the lower right side of the balance sheet as equity…but it doesn’t operate as equity. It is DEBT, a non-interest bearing loan by a shareholder/member/partner to the firm, which is an obligation of the firm to repay on DDRW. It should be on the liabilities section at the top of the right side of the balance sheet.

The third consequence is the number for partner capital you see on the balance sheet is ‘hooey’. The money is not in some account securely stashed away. It is ‘gone’, converted into paying the cost of creating accounts receivable, buying equipment, paying expenses, and in some cases actually funding distributions back to the partners.

Thus…….THERE IS NO OWNER to counter the free agent player negotiation power. Instead, the firm is simply eviscerated financially.

A lot of wonderment has been expressed about how can it be in the face of such pressures for change to improve client service and the ‘value proposition’ and to work many other logical business changes that law firms have not done it. How could they ‘not get it’?

The answer is that those asking that question don’t ‘get it’. They are assuming attributes of the business model exist when they do not.

Reset the assumptions to the above, and the behavior is entirely logical. Why work to effect difficult change, and take current pay cuts for future returns…when there will be no future returns? Instead, concentrate on perpetuating the struggling model and resorting to internal income re-allocations through the vast array of accounting and structural techniques over which the inner circle has absolute control, and the ability to do it quietly.

This is not cynical. It is just to be expected and completely rational from the perspective of those that make the decision.

There is a lot more to this than the above observation, of course. But for now, start with this.

Cheers,
Ed

My reply

Published first in September 2014 and updated here with thanks to Ed Reeser