remember the “one firm” concept is at the core of this discussion.
by tommye barie
the succession insitute
previously we reviewed the goal-setting process, including which person or group should orchestrate which parts of it. now we will conclude the discussion by walking through the financial side of assessing goal accomplishment and how it works when considering actual firm profits.
more: the partner comp battleground | if you don’t eat what you kill, what do you eat? | 3 ways to emphasize the one-firm concept | 8 steps for a successful change process | building competency on every level | change happens: how to master it.
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let’s start with some statistics from our latest succession planning survey, which we did in partnership with the aicpa’s pcps. the following tables show information regarding compensation systems, broken down by size of firm (by full-time equivalent [ftes] which includes everyone, from administrative to staff to partner):
looking at the three graphics above, you can conclude the following:
- most compensation systems are open (meaning all partners know what all partners are paid) but the larger the firm, the more likely it uses a closed compensation system. open compensation systems generate more partner-to-partner comparison discussions, while closed compensations do not, because there is no data to discuss. comparison can make some sense when everyone is familiar with the work, efforts and contributions of the other partners. but the more partners a firm has, and the less each partner knows about all of the others, the more dysfunctional and disruptive the comparison conversation becomes.
- the second table above shows that the most common model used for partner compensation is a guaranteed portion of partner salary (or base pay), together with an additional incentive component based on both subjective/qualitative criteria and objective/quantitative formulas in the compensation plan. while the breakdown was not included in this graphic, it shouldn’t be a surprise that the larger the firm, the more likely this model is used. for example, this model is used about 60 percent of the time for firms with 50 ftes or more. the smaller the firm, the higher the likelihood that partner pay is determined by objective metrics only, and the larger the firm, the higher the likelihood that partner pay is based on both objective and subjective, or quantitative and qualitative, metrics.
- when it comes to the managing partner’s role in compensation, as you know from our prior columns, we believe that he or she should be able to set individualized goals for each partner based on the strategic plan and have a discretionary compensation stick to hold partners accountable for achieving their goals. the third table above shows that the percentage of firms using this approach is far too low. for example, 6 percent of firms with less than 16 ftes use it. even at firms with 100 or more ftes, only 41 percent to 42 percent are using it. based on this table, it is easy to see why “lack of partner accountability or unity” has shown up consistently in the “pcps top issues” survey. most firms don’t give anyone the ability to hold the partners accountable to a plan or to clear expectations identified in advance.
now that we have considered these compensation system statistics, let’s back up a little and start from the beginning. the first concept to discuss is base pay. then we will discuss incentive pay. and then within incentive pay, we will cover two common variations. for simplicity of this potentially complicated discussion, we will start drilling down from the number we call budgeted expected pay (bep).
bep is pretty straightforward. it is that amount the firm budgets in the planning process that is what it thinks each partner will earn, assuming normal expected performance.
while this sounds simple, for many firms, this concept is unsettling. why? just looking at the table above, 43 percent of firms believe all pay to partners is just a draw against final profits. because of this they take the idea that “owners don’t get paid until there are profits to share” to an extreme.
we believe that all partners should make more than the people below them in the organizational hierarchy. and we totally understand, being entrepreneurs ourselves, that if there is not enough money to go around at the end of the day, then the owners are the ones who get to eat the shortfall. but i can also tell you that any going concern that doesn’t pay its partners as well or more than the highest-paid employees doesn’t have much of a future either. why not be an employee if you can make more, and have less responsibility and less liability than an owner? while this is a conversation for another time, the point here is that there should be a total pay expectation that is budgeted for every partner that is in excess of that paid to principal or managers. we will share later how to reconcile a budget shortfall, as well as reconciling profits in excess of expectations.
to begin with, you need to set the right expectation. so, whether your firm utilizes a compensation system based on all objective (quantitative) measures, a combination of objective and subjective (qualitative) measures or some hybrid, the reality is that if the firm makes about the same in profits and a partner performs similarly this year to last year, he or she will make about the same amount of money this year as last year. so the idea of starting the budgetary process with an identified bep per partner is a logical way for a firm to create a realistic plan, as well as to identify potential hurdles that need to be overcome if partners want to improve their earnings in the coming year.
with that in mind, consider the following table:
in this case, we set up a budget based on past typical earnings. if we earn the expected profits, and everyone performs at an expected normal, then each partner will make his/her bep. if we don’t meet budget, and partners perform at various levels over and under expectation (which is normal), then we will simply adjust partner pay based on performance to the amount we have actually earned (more on how that works later). the key to consider in our example is that bep is comprised of a base salary (often called guaranteed salary) and incentive pay.
in our case study for this article, we used an 80/20 ratio, but firms use every imaginable variation to this, based on what they think is best for them. this could just as easily be 70/30 or any other ratio a firm decides upon. what is important to understand for this case study is that some portion of pay is guaranteed (meaning you have earned that by coming to work every day and doing what you do) and the rest is earned based on what you actually accomplish during the year.
a point of confusion that usually arises here is “we don’t have the money to pay out that level of pay every month of the year” or “we are very risk-averse and we don’t want to borrow to fund operations so we don’t want the obligation to pay out our partners at a guaranteed level until the end of the year.” it doesn’t matter what the specific objection or comment is because our response is the same. don’t confuse bep with cash flow. and don’t confuse guaranteed pay with a guaranteed monthly draw. what we agree to pay a partner by the end of the year, versus how we manage our cash flow, is rarely the same. we see a wide range of payout percentages. for example, one of our firms pays out at a rate of 100 percent (spread out monthly) of expected bep during the year, and on the other extreme, we have a firm that pays out expected bep at a rate of 35 percent (spread out monthly). managing your cash and managing overall partner pay expectations are two different issues and should be dealt with independently.
now, back to the numbers above. once you’ve established what a reasonable bep is per partner (usually based on past earnings, average earnings, earnings expected based on the partner compensation model, or whatever makes sense at that firm), and once you have established the compensation framework variables as to the base and incentive portions, the rest is simple math. in the case above, if you look at the pay for the partner with the name of alpha, he/she has a bep of $175,000. incidentally, it is often common for a new partner to make somewhere between $175,000 and $200,000 annually. in that sense, it might represent the floor for partner pay at the firm (obviously, this varies between firm size and the economy of the area the firm practices). eighty percent of $175,000 is $140,000 for the guaranteed pay, with 20 percent ($35,000) expected as incentive pay.
as we have covered in our previous columns on this topic, the incentive pay we are introducing here (the $35,000 in this example) represents 100 percent of expectation, with 100 percent being what every partner should achieve, with a range of actual achievement pertaining to incentive pay typically being from 50 percent at a low (technically it could be zero but we have never seen that level of poor performance) to 200 percent (we have seen goals achievement in excess of 200 percent, but 200 percent normally is at the high end of the range).
next, we’d like to recommend that you consider reviewing, if necessary, the previous installments in this series that cover how we set up partner goals. once those partner goals are established, and they are monitored with clear communications from the managing partner to the partner throughout the year, at year-end a final determination is made. for simplicity for our case study, let’s assume that alpha had four goals that made up his/her at-risk or incentive pay. see the table below:
as you can see, it was determined that alpha overachieved goal 1 by 25 percent, underachieved goal 2 by 10 percent, overachieved goal 3 by 50 percent and hit goal 4. this kind of pattern is common as some goals are easier for different partners to overachieve and vice versa. the key here is to understand that normal performance, not excellent performance, should meet the 100 percent mark, so paying the 20 percent at-risk portion of a partner’s pay is expected to occur if they just have an average performance year. if a partner underperforms, then they don’t earn their expected pay. similarly, they can earn more than expected when they have a better than average performance year. it is also common for your top partners to overperform in every category.
now let’s take a summary view of all of the partners, assuming each had a number of goals, and their incentive pay was finalized according to the table below.
in the scenario above, the partners earned, according to their at-risk performance, $50,575 more than expected ($335,575 less $285,000 = $50,575). so, let’s consider several scenarios on how we move forward from here.
be smart about how you view overall variances in bep and actual
the first mistake typically made when assessing goal performance, especially when actual profits are in line with budget or a little less than budget, is that no incentives will be earned by any partner. in other words, given the lack of excess funds, it is assumed that everyone will just earn their bep.
this is a terrible conclusion because, when actual profits are hovering in this less-than-stellar range, the assumption that everyone equally pulled their weight is rarely true. so, the conclusion that because there is no extra money, no one should earn incentive pay is not only demotivating, but actually unfair. in this situation, the odds are that a partner or two performed well, maybe even exceptionally so, and just because that performance was not enough to make up for the other partners’ shortfall in expectations doesn’t mean that it is okay to simply write off the efforts of the performing partners. therefore, we recommend that you always assess goal accomplishment and incentive pay as if there are ample resources and then adjust accordingly as a subsequent step.
so now that we know to evaluate individual performance first regardless of the firm’s budget-to-actual performance, next we have to adjust the calculated performance pay to actual available profits. this adjustment is almost always up or down as rarely does the performance evaluation independently line up exactly with profits on their own.
actual profits in excess of bep
let’s first take a look at a positive variance on profits – when profits are in excess of bep. there are many common approaches to this adjustment. the first, with which we disagree, is to adjust pay proportionally upward based on total pay. we also don’t think firms should simply allocate the remaining profits based on ownership either. typically, ownership is reflected in pay in the first place as we tend to find the owners with the largest equity stakes earning the highest salaries anyway, so allocating excess profits based on total pay often isn’t much different than allocating the excess profits on ownership. additionally, ownership often has an impact on retirement pay, so when this is the case, owners get the benefit of running a profitable firm there too.
what we recommend is that additional profits be allocated based on the incentive pay earned. this naturally favors the higher paid owners (because in raw dollars, their earnings at risk are greater and therefore still have a significant weight when it comes to the denominator for total earned incentive pay), but it also recognizes that any partner at any pay level may have contributed exceptionally and should be rewarded appropriately in that year for their accomplishments.
let’s take a look at the table below to see these methods at work. assume actual profits were $125,000 more than bep, totaling $1,550,000 instead of the budgeted number of $1,425,000. the first step is to reduce the assessed extra incentive pay of $50,575 from extra profits of $125,000, because the incentive pay calculation already has accounted for this part of those excess earnings. this leaves a difference that is not already reflected in the numbers below of $74,425 ($1,550,000 – $1,425,000 – $50,575 = $74,425). that amount is then typically handled one of two different ways. the second column to the right distributes the excess of $74,425 by total pay, and the last column to the right distributes the excess based on incentive pay.
as you can see, the numbers are not significantly different. however, allocating the excess profits based on the incentive pay, when incentive pay is intended to recognize efforts and accomplishments of the current year, is in our opinion a fairer way to reward those partners who had the greatest impact on this year’s total profitability. to help with the math, here are the formulas for the last two columns (see the letters assigned to each column):
- allocating excess profits based on total pay: $74,425 * (c1-5/g) + c1-5
- allocating excess profits based on incentive pay: $74,425 * (b1-5/f) + c1-5
bep in excess of actual profits
now for the more difficult question: what happens when there are less profits than budgeted? the reason why this discussion is difficult is because when there are excess profits, everyone gets more than expected, so while they might have wanted even more than allocated, they are still happy given that they got more. however, when a firm makes less than expected, most people will be taking home less than they expected, which creates much more frustration, hostility and a desire to micromanage the process to attempt to influence the final outcome.
when profits are less than bep, we recommend that you still start by evaluating everyone’s performance as if there are ample resources. then, with those numbers, allocate downward to the available profits. we recommend just the opposite approach for the allocation downward as we did for the upward allocation. we believe that firms should allocate downward based on total pay (base plus evaluated incentive) rather than just evaluated incentive pay. the reason is that because base pay reflects 80 percent of the bep, allocating on incentive pay alone could be overly punitive in isolated cases when the firm is allocating a shortfall.
review the table below assuming a shortfall from bep of $150,000 from the budgeted $1,425,000 to $1,275,000. the numbers we are using would rarely ever occur because we are showing an evaluated additional incentive of $50,575 at the same time when the firm fell far short of its budgeted profits (so in real life, while there would likely be partners who earned excess incentive pay, most would earn normal pay or less). because this is a case study, we are continuing with the same numbers for base and earned incentive for consistency to more clearly show how the process works with adjustments either up or down.
in this case, not only do we need to adjust downward overall for the $150,000 shortfall, but we also need to adjust downward the excess $50,575 incentive pay, for a total adjustment of $200,575.
once again, the numbers are not a lot different, but allocating down by total (guaranteed pay plus evaluated incentive pay) makes more sense when you look at who performed and how the numbers above came out. to help with the math, here are the formulas for the last two columns (see the letters assigned to each column):
- allocating shortfalls from bep: $150,000 shortfall, plus $50,575 excess evaluated incentive proportionally down based on total pay: (h/g) * (c1-5)
- allocating shortfalls from bep: $150,000 shortfall, plus $50,575 excess evaluated incentive proportionally down based on incentive pay: (($200.575 * (b1-5/f)) – c1-5)*-1
i mentioned earlier that we would discuss two common variations of incentive pay. guaranteed pay plus incentive pay based on goals is the most common. but some firms create two types of incentive pay. one part or type is based on a very objective group of expectations, and the other group being more related to strategy and goal accomplishment tailored to the specific responsibilities of the individual partners. we have been discussing the latter. but some firms create objective metrics assigned equally to all partners in order to make sure partners meet some basic minimum partner roles and responsibilities. those metrics might be a minimum and a maximum number of charge hours, maintaining a minimum leverage ratio, managing a minimum size of book, turning in timesheets timely, billing timely, collections levels, etc.
as we have discussed before, these incentives are usually all objective and commonly “check-the-box” types of metrics (did he/she do it or not). they are also often meant to provide the compensation committee with an additional tool to utilize when assessing next year’s raises. so, if we go back to our 80/20 (base/incentive) example above, utilizing this additional incentive option, the compensation framework might shift to 70/10/20 (base/objective minimums/incentive). the compensation committee would be involved in assessing the base each year and the earned 10 percent incentive because it would be determined based on easily reportable and trackable performance. the 20 percent incentive grounded in the firm’s strategic plan would still fall to the managing partner to oversee, with goals identified in advance, and performance monitored and evaluated throughout the year.
in the end, one approach or another will seem the fairest to the partners in your firm and that is the approach you should choose. as we have said above, with a one-part incentive system, the key to the incentive process is for the managing partner to evaluate the goal accomplishments of each partner, assess a percentage earned for each goal and let the chips fall where they may as to the first calculation. the same is true for the two-part incentive system, except that the compensation committee, if there is one, needs to get involved, add the managing partner’s assessment to the mix and then let the chips fall where they may. whether the firm earned more or less than bep, it is time to then do the appropriate calculations to adjust upward or downward. and just because actual profits come in at or below bep, that doesn’t mean you do away with the goal evaluation process, but rather, you need to complete it normally and make the appropriate adjustments afterward.
we hope this case study review on partner compensation “common points of confusion” has helped you clear up the roles and responsibilities of those who should be involved in your process, and provided you with some insight as to how to approach the final assessment and calculations to create a transparent and fair process for all of the partners.