Our firm is an insurance defense firm based in Denver, Colorado. The firm was founded in 2015 by two founding partners and we have grown to a firm of twelve attorneys – two founding equity partners, three non-equity partners and seven associates. Non-equity partners are included in firm management and the non-equity partners serve as members on the management committee. Non-equity members are compensated in the same manner as are equity partners – salary and bonuses determined by three year moving average ratios of weighted working attorney and originating attorney collections. Partner ownership interest does not factor into equity partner compensation. The firm does not have a partnership agreement. The firm is currently considering admitting qualified non-equity partners as equity partners. We are considering having a requirement that new equity partners purchase their shares via a buy-in tied to a firm valuation that includes a goodwill value. Our initial discussion with the equity partner candidates that we are considering has not been positive. They feel there should be no buy-in and they don’t see any benefit to being an equity partner. We would like you thoughts and opinions on this matter.
I can see where there is little distinction in your firm between equity and non-equity partners. I encourage firms when creating a non-equity tier to resist the temptation of giving away the farm and not retaining some incentives for non-equity partners to want to become equity partners. Typically, I suggest that there be a different compensation structure for equity partners than non-equity partners so that there is a compensation component for bearing the risk of ownership for equity partners. Often I suggest that non-equity partners come under a different compensation structure than associates, be given a few additional perks, and be included in partner meetings to a degree but not having a vote.
Approaches to buy-ins and buy-outs are all over the place in law firms. Here are a few of the common approaches:
The spectrum of law firm valuation and withdrawal entitlement theory can be characterized by two polar positions. The first considers the firm as a means to generate income (i.e., compensation), with modest, if any, value beyond the cash basis capital account. This is the dominant view currently in the profession and has resulted in the vast majority of firms valuing only the cash basis balance sheet for internal withdrawal rights. The second considers the firm as an investment, much like most other commercial endeavors.
I have many firm clients that are in their firm generation with original founders that have been in practice for twenty years and these firms have substantial institutional goodwill. Some of these firms sell shares to equity partner candidates based upon a firm valuation including a goodwill value. Other such firms take one of the other approaches. Often the problem with this approach is affordability.
Personally, I believe there should be some skin in the game for a non-equity partner to become an equity partner or shareholder. In your situation you are a young firm and acquiring and retaining lawyer talent should be your primary objective. Therefore, rather than selling shares I believe that you might want to consider approach number two – naked in – naked out with a cash-based capital contribution that is affordable. If cash is a problem for the candidate have them pay what they can with the remainder payable on a capital (promissory) note paid over a one to three year period. Then have the partnership agreement provide for a founder benefit for the two founders as discussed above (say 1.5 multiple) upon retirement.
Do all that you can to fund partner retirements through 401k plans and other vehicles.
John W. Olmstead, MBA, Ph.D, CMC