By H. Edward Wesemann Click here
The use of non-equity partnerships has increased to the point where it is now estimated that 70% of U.S. law firms with more than 75 attorneys have more than one level of partnership. Although the use of multi-tiered partnerships has become common in law firms, the structure of the firms and their motivation for creating more than one type of partnership varies tremendously.
In considering whether to use or discontinue the use of a non-equity partnership level, a firm needs to:Ø Understand traditional law firm structure based on equity partnerships.
Traditional Law Firm Structures
Historically, law firms have been comprised of partners who own the firm and associates who are salaried employees.  The classic definition of a partner has three characteristics:
1. Shared Liability. Partners have a shared liability for the debts of the firm. This means that, in the normal course of business, if the firm fails to pay a debt, the creditor can look to the individual partners personally to pay the debt. While this liability is most often noted with large debts, such as leases or bank loans, shared liability among the partners is technically present in every transaction, including salaries and purchases. With the adoption of limited liability partnerships (LLPs) in many states, individual partners may be protected from certain forms of liability. Additionally, it is possible for creditors to agree in a contract to a non-recourse provision that absolves or limits the personal liability of a partner for a specific debt.
2. Division of Profits. Partners are not employees and have no salary — they are paid from the profits of the firm. In larger firms, partners are often paid a regular draw that may appear like a salary, but technically is simply an advance on profits. In the event that profits are insufficient to cover the amount paid out in draws, the partner could be asked to repay the deficiency. Should the firm dissolve, the partners would divide the proceeds or share any insolvency.
3. Voting Rights. State partnership law dictates certain rights and responsibilities of partners, including a voice in the management of partnership business, a vote in the election or expulsion of partners, access to the financial records of the partnership, and the right to dissolve the partnership. The basics of partnership law can be strongly controlled by the partnership agreement. Essentially, partners can agree to structure and operate their partnership any way they wish.
Reasons for Multi-Tiered Partnerships
The traditional law firm structure envisions attorneys starting with firms as associates, becoming partners and continuing with the same firm as partners for their entire career. Many firms had “up or out” policies, which meant that associates who failed to be elected partner were expected to leave the firm.
Starting in the late 1970s and early 1980s, these two traditions were challenged for the reasons explained below:
1. Lateral Partners. As law firms grew, some firms became more willing to consider the addition of lawyers with significant amounts of business who were willing to leave one firm and join another. The structure of many firms, however, made it difficult for a “lateral-entry attorney” to join a firm at the partner level. At the same time, many firms’ partnership agreements made it so difficult to expel a partner that they effectively gave partners life-long tenure. Appropriately, firms were reluctant to grant this tenure to an unproven lateral-entry attorney. This was especially true as some of the more aggressive firms found that not all lateral-entry attorneys lived up to the expectations on which their acceptance was based.
2. Up or Out. At the same time, firms discovered that, from a business perspective, the “up or out” policy was ineffective. Indeed, senior associates and young partners were among the most profitable attorneys in firms. When combined with the hefty training and development costs of associates, the potential loss if those associates failed to become elected partners became an adverse financial event for law firms.
3. Partner Transition. Finally, the leap from associate to partner is a significant change both financially and in terms of performance expectations. As associates, attorneys are expected to contribute to the firm through their individual production. The measure of their success is the quality of their work and how much work they perform. While individual work performance continues to play an important role as partner, new expectations are added, including the generation and management of client relationships, the supervision of work, the training of associates, and the performance of firm management functions. These competitive pressures in many firms make it difficult for new partners to transition smoothly.
These three issues, either separately or in concert, brought about the creation of non-equity partnership tiers. Non-equity partnerships, which permitted less stringent terms for the removal of partners and provided more flexible means of tying their compensation to performance, provided for the addition of lateral partners. Non-equity partnerships also granted firms the opportunity to provide highly productive associates a niche in the firm that fulfilled their ego need to be called a partner without diluting the allocation of firm profits or seceding governance authority by adding an equity partner. At the same time, it provided a transition (though some refer to it as a “limbo”) where associates can learn to become equity partners.
Forms of Non-equity Partnership
Four principal areas differentiate equity and non-equity partners:
1. Election of new partners. Most partnership agreements require an affirmative vote by a majority of the equity partners to accept a new equity partner. Often a “super-majority” is required, either in terms of the percentage of affirmative votes required or by requiring a majority of all equity partners, rather than just those attending a meeting. This requirement is typically lessened for the acceptance of a new non-equity partner, and frequently firm management (the managing partner or the executive committee) is given authority to approve non-equity partners without partnership approval.
When dealing with lateral attorneys, some firms consider a less restrictive admission procedure advantageous because it allows firms to act more quickly and decisively when competing for lateral opportunities. Another justification is that in normal “associate-to-partner” votes, the partners have had time to know and make judgments about the attorney being considered. It is considered unwieldy to expect a large partnership to get to know a lateral at this level.
Law firms typically require the same vote for removal as is required for approval of partners. In some cases, however, the required vote for removal is even more stringent than for election. The vote for removal of a non-equity partner is usually less stringent than for an equity partner and, in some firms, the firm’s management has the right to remove a non-equity partnership without a vote of the partners.
The streamlined means of terminating a non-equity partner are designed to reinforce the probationary period. If non-equity partnership is meant to provide lateral partners an opportunity to prove themselves, both in their ability to adapt to the firm’s culture and their ability to generate business, then there must be an effective course to remove unsuccessful laterals.
2. Compensation. Equity partner compensation is usually based on a share of the total profits of the firm. Actual compensation for equity partners is based on the amount of the firm’s total profits and the proportion of those profits received by the individual partner.
Non-equity partners, on the other hand, are generally paid based on a variety of factors unrelated to profits of the firm. This compensation may range from a fixed, salary-like compensation to a formula based on the partners performance. Indeed, one of the advantages for many firms of non-equity partners is the flexibility the firm may enjoy in determining the means of their compensation.
3. Voting Rights. Equity partners enjoy the right to vote on certain business affairs of the firm. In larger law firms, the day-to-day functionality of this right may be decreased by the sheer size of the firm and the number of partners involved. Often, in larger firms, certain authority is delegated to partners who are elected to management positions. Generally, however, equity partners have the right to vote for members of management, changes to the partnership agreement and the dissolution of the firm. They also typically have the right to review the financial records of the firm.
The range of voting rights for non-equity partners ranges greatly among firms, and differing voting rights may serve as the basis for several different tiers of non-equity partners. Typically, non-equity partners cannot vote in partnership affairs. Though they may have no voting rights, non-equity partners are often permitted to attend partnership meetings and receive financial statements. In other firms, non-equity partners may have the ability to vote on certain issues, e.g. all issues other than the election or removal of equity partners. Frequently, the ability to serve in an elective office of the partnership is limited to equity partners.
4. Capital Contributions. One of the features of equity partnership is having capital at risk. This means that the partner has made an investment in the business that could theoretically be lost. The actual contribution could be cash made to the firm in exchange for the partner’s share of ownership. It could also be in the guarantee of loans made to the firm by a financial institution. Capital also could be contributed through retained earning, i.e. by the partner foregoing his/her due profits during a fiscal year.
Typically, non-equity partners do not have capital at risk. Increasingly, however, creditors are seeking to recover debts from non-equity partners on the grounds that the firm held them out to be partners without distinguishing them as being non-equity partners. Certainly the use of LLPs in many states offers some protection to non-equity partners, but no more than is offered to equity partners.
New Uses For Non-equity Partnerships
Law firm structures and their use of non-equity partnerships are generally based on the two motivations cited earlier — the acceptance of lateral partners and as a transition for associates into partnership ranks. Recently, firms are seeing two comparatively new uses for non-equity partnership.
Some firms are experiencing a new phenomenon — associates turning down offers of equity partnership. Having become comfortable in their practices, some associates look to the prospect of becoming a partner and, instead of a brass ring, now see only pressure to generate new business for the firm and to sign on for a big capital account loan just when they’ve paid off their law school bills. That is in addition to paying their own employee benefit costs, paying a larger Social Security contribution, and waiting for large chunks of their compensation until year-end.
Although desire to achieve elite “partner” status is still strong, the relative security of associateship has a certain appeal to it. For both the firm and the associate, therefore, non-equity partnership may be seen as an attractive alternative to traditional equity partner status.
At the other end of the spectrum is the problem law firms face in dealing with equity partners who either never raised themselves to the level of partnership expectations or who have partially retired without telling anyone. This problem only began about 20 years ago, because previously firms were “big tents” that could accommodate a wide variety of work levels through compensation systems that reflected differing levels of effort and financial performance.
In the early 1980s, however, The American Lawyer magazine popularized a new statistic as the measure of law firm economic success — profits per equity partner (PPP). With public availability of law firms’ comparative financial information, PPP developed into a competitive issue. Lateral prospects used PPP as a means of differentiating among firms; it became the first cut for judging the suitability of law firms as merger partners. Even within law firms, average PPP statistics became as important to individual partners as their own actual compensation in evaluating their firm’s performance.
It did not take long for firms to realize that the denominator in this calculation (the number of partners) is as important as the level of profits themselves. Indeed, by adjusting the partnership ranks and converting equity partners to some other status, a firm could see a double-digit increase in its average profits without bringing in one more dime of revenue or cutting a single expense.
Disadvantages and Risks of Multi-tiered Partnerships
The biggest problem with the use of non-equity partnerships is that it can simplify a firm’s personnel decisions to the point that tough, necessary decisions are prolonged or never made. Advising likable associates that they have been elected to non-equity partnership is certainly a less onerous task than telling them they have been rejected for equity partnership, forcing them to either remain as associates or leave the firm. Unfortunately, some firms are finding that what is relatively painless in the short term can have devastating long-term ramifications.
Those associates promoted to non-equity partner simply to keep them onboard without sharing profits may be strung along by the hope of eventual full equity partnership, when in actuality they have already been deemed lacking in the essential qualities for equity partnership. Caught in this amorphous system, they may even be reconsidered for equity partnership year after year, particularly if they have a protector within the partnership. Some candidates, due to sheer longevity of their appearance on consideration reports, might actually be elected to equity partnership in a year when the recommending committee is feeling particularly soft-hearted. As firms now attempt to deal with unproductive partners, they often realize that it is just such “lapses” in their partnership admission process that caused that problem in the first place.
Similarly, using de-equitization to deal with underproductive partners is certainly easier than firing those persons. But from a practical point of view, this step rarely resolves the underlying issues for either the firm or the newly demoted partner. In fact, the more likely outcome is that, rather than sending a “wake-up call” to the partner, his or her reaction will be a declining sense of urgency. This often surfaces in a lack of responsiveness and a deteriorating client-service ethic. It doesn’t take long for partners assigning work to recognize this decline. As a result, given the alternative of using senior associates with a comparable skill level and a more responsive attitude, demoted partners’ hours soon dry up. All these factors combine to sabotage hopes of returning to being a fully productive member of the firm, or ever regaining full-equity status.
Worse, because non-equity partners fall between senior associates and equity partners in their level of practice sophistication, if a non-equity partner attracts work that would be valued by up-and-coming senior associates, an important associate development opportunity is missed. Good associates are able to see handwriting on the wall very quickly and, rather than risk being passed over for partnership themselves, will seek better learning opportunities at competing firms.
Perhaps most importantly, law firms rarely want to be judged based on people they reject for, or remove from, equity partnership. But the outside world — and often, even associates and employees within the firm — cannot distinguish between equity partners and non-equity partners. If an individual does not meet the firm’s standards for equity partnership, then including him or her as a partner devalues the designation for those who do meet the standard.
A non-equity partnership track can offer a firm valuable flexibility in dealing with both associates and lateral entry partners. However, there are opportunities for abuse by firms using the concept as a convenient way to deal with difficult personnel decisions. In creating or maintaining a tier, firms must constantly re-evaluate their motivation for the use of non-equity partnership. Firms should clearly and reasonably define the length of time new non-equity partners are expected to remain at that tier. Most importantly, the firm should establish procedures that assure non-equity partners undergo an annual evaluation to determine whether they should remain as a non-equity partner, be converted to an equity partner or be removed from the firm.
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Qualters, Sheri. “In Tough Times, Two-tier Law Partnerships Gain Footing.” MA: Boston Business Journal. March 22, 2002.
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Wesemann, H. Edward. “Taking the Easy Way Out: Non-Equity Partnerships.” NY: Legal Times. February 20, 2003.
ALA Research Study. “Tiered Partnerships: Equity/Non-equity Partner Classifications in Law Firms.” IL: Association of Legal Administrators. This Research Study is included in the ALA Management EncyclopediaSM.
Clay, Thomas S. “What Are the Obligations of Partners?” Click here PA: Altman Weil Inc. 2002. www.altmanweil.com
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“Partnership Track Survey.” Click here PA: Legal Network Ltd. Legal Network. December 2002. www.specialcounsel.com/home.asp
Rose, Joel A. “Admitting New Partners.” Click here NJ: Joel A. Rose & Associates, Inc. Articles. 2002. www.joelarose.com/articles/admitting.html
Greene, Arthur G. Getting Started: Basics for a Successful Law Firm (A Law Firm Partnership Guide Click here. IL: ABA Law Practice Management Section. 1996. www.abanet.org/webapp/wcs/stores/servlet/ProductDisplay?storeId=10251&productId=-10040&categoryId=-3716
Greene, Arthur G. Strengthening Your Firm: Basics for a Successful Law Firm (A Law Firm Partnership Guide) Click here. IL: ABA Law Practice Management Section. 1997. www.abanet.org/webapp/wcs/stores/servlet/ProductDisplay?storeId=10251&productId=-10042&categoryId=-3716
 For a detailed discussion of partners’ obligations to their firm, see Clay, Thomas S. “What Are the Obligations of Partners?” Click here PA: Altman Weil Inc. 2002. www.altmanweil.com Joel A. Rose discusses the process most firms use to admit new partners. See Rose, Joel A. “Admitting New Partners.” Click here NJ: Joel A. Rose & Associates, Inc. Articles. 2002. www.joelarose.com/articles/admitting.html