Thursday, September 20, 2012

Making a Lateral Partner "Whole" for Deferred Comp

Parsley Sage Rosemary & Ginsburg llp
“Always a reasonable result for a reasonable fee, always”
MEMORANDUM

To:
Management Committee
From:
Mike Marget
Date:
September 20, 2012
Re:
Making a Lateral Partner “Whole” – Year-end Distributions

Partners leave “money on the table” when they move from one firm to another. The money in question is deferred compensation – their share of profits for the year over-and-above monthly draws received – which is forfeited when they change firms before the year-end distributions are paid to partners by their Old Law Firm (“OLF”).  No worries though.  When this happens, lateral partners invariably look to New Law Firm (“NLF”) to “make them whole” with respect to the compensation left behind.

The term “year-end distributions” references payments to partners in Year 2 relating to their respective share of the firm’s net income earned in Year 1.  These payments are typically made several weeks or even months after year-end.[i] 

If your law firm intends to hire lateral partners, the earlier in the year you can accomplish this, the better.  “Earlier” means less expense in terms of NLF “make-whole” payments to lateral partners.

If your firm is going to lose partners to lateral hiring, “later” is better.  The longer OLF can hold onto them means (a) more billable hours generating more profits in the current year and (b) departing partners will forfeit more deferred comp which can be used to additionally compensate those who remain at OLF.  Although this incremental money is inconsequential in the long run, short-term it is better than a poke-in-the-eye.  Plus, if the departures can be delayed from say February 28 to April 30, OLF enjoys the knowledge that the poaching firm (NLF) is on the hook for larger make-whole payments, as explained below.

Fact Pattern
1)     “Partner” expects to earn $300,000 from the profits of OLF.
2)     The $300,000 will be paid in the form of 12 monthly draws of $15,000 each ($180,000) and $120,000 in the form of a year-end distribution.
3)     Accordingly, each month Partner is working and “earning” $25,000, of which $15,000 is paid currently and $10,000 is deferred.
4)     The deferred comp earned at OLF does not vest until actually paid, meaning Partner will be reluctant to make a lateral move unless indemnified for all the deferred comp.
5)     OLF (like most firms) pays the year-end distributions days/weeks/months after December 31 and has a partnership agreement provision requiring 30-days notice of withdrawal.

Most law firm’s take their time before paying year-end distributions.  Some time is needed to “close the books” and calculate net income for the year.  Additional time may be required at those firms where the amount of each partner’s year-end distribution must be decided by a compensation review process.  Year-end compensation decisions are time intensive.

Such delays are inevitable, but there also are practical benefits to those law firms who engineer a significant gap between December 31 (year-end) and the later payment date of the year-end distributions.  One such benefit is reduced interest expense.  During the gap period, the firm can utilize the accumulated cash for working capital purposes, postponing the inevitable borrowing from bank lines-of-credit once the year-end distributions are funded. 

Another collateral benefit accrues to those law firms who defer paying the year-end distributions the longest.  Each month of delay means:
A.     For OLF – more money left on the table which will be used to increase compensation for everyone else; and
B.     For NLF – more money must be allocated from its budget to make-whole the lateral partner with respect to the deferred comp left behind at OLF.

A Tale of Two Laterals
There are two law firms.  Let’s call them G&J and JLY.[ii]
·        G&J pays its year-end distributions by January 31. 
·        JLY delays the year-end distributions until the end of March.

As a result, at G&J partners who plan to leave make their intentions known during the first week of February – as soon as the year-end distribution checks clear the bank.  That “whooshing” noise you hear at midnight on February 28th – after the standard 30-day notice period expires – is the revolving door as partners move out of firms like G&J who pay their year-end distributions in January.

The timing is different at JLY.  New partners tend to join JLY laterally earlier in the year, but because JLY delays these distributions until the end of March, JLY partner defections typically commence on April 30.

Assume NLF makes offers to two lateral partners – one from G&J; the other from JLY.  Both earned $300,000 for 2012 (pursuant to the terms set forth in the Fact Pattern box) and agree to accept the same terms from NLF for 2013.  Keeping these lateral partners pari passu with their 2012 compensation package obligates NLF to pay each of them the entire deferred comp amount for the year.  Without this deferred comp indemnity, partners would require some significant other motivation to change firms.

The former G&J partner is able to join NLF on February 28, 2013, after collecting $30,000 from 2 monthly draws from G&J and forfeiting 2 month’s deferred comp ($20,000).  In order to “annualize” the former G&J’s 2013 compensation at $300,000, NLF will pay $270,000 for 10-months’ work – 10 monthly draws of $15,000; plus $120,000 in deferred comp for the year.  ($100,000 of the deferred comp amount accrued while the former G&J partner worked at NLF; $20,000 represents a “make whole” payment for the deferred comp earned but forfeited at G&J.)  In essence, the former G&J partner is costing NLF $27,000 a month for the 10-months’ work in 2013.

lateral from G&J
 monthly
2013
 paid by G&J
 paid by NLF
 # months worked
1
12
2
10
monthly draws
 $      15,000
 $   180,000
 $      30,000
 $   150,000
deferred comp
         10,000
       120,000
                  -  
       100,000
"make whole" pymt
                  -  
                  -  
                  -  
         20,000
Total
 $      25,000
 $   300,000
 $      30,000
 $   270,000
 compensation per month
 $      25,000
 $      15,000
 $      27,000

Meanwhile, the former JLY partner is not available to join NLF until May 1, 2013.  The former JLY partner collected 4 monthly draws totaling $60,000 at JLY and forfeited 4 months’ deferred compensation upon joining NLF.  As a result, to annualize the former JLY partner at $300,000 for 2013, NLF will pay this lateral partner $240,000 for 8-months’ work – 8 monthly draws of $15,000 and the entire $120,000 deferred comp for the year. 

lateral from JLY
 monthly
2013
paid by JLY
paid by NLF
 # months worked
1
12
4
8
monthly draws
 $      15,000
 $   180,000
 $      60,000
 $   120,000
deferred comp
         10,000
       120,000
                  -  
         80,000
"make whole" pymt
                  -  
                  -  
                  -  
         40,000
total
 $      25,000
 $   300,000
 $      60,000
 $   240,000
 compensation per month
 $      25,000
 $      15,000
 $      30,000

Because G&J pays its year-end distributions at the end of January, the make-whole payment by NLF to the former G&J lateral partner is $20,000 and the average monthly compensation for this lateral is $27,000 per month over 10 months. [iii] 
 
The former JLY requires a make-whole payment of $40,000 simply due to how JLY manipulates its year-end distribution funding which delays lateral movement 2 months longer than firms like G&J.  As a result, NLF pays the former JLY lateral partner $30,000 a month over the 8 months of the transition year.

[i] Granted there are firms who pay year-end distribution on or about December 31 each year.  Law firms taxed as corporations pay their bonuses before year-end to avoid double taxation on profits.  There are a few partnerships who similarly like to make these payments between Christmas and New Year’s.  Nevertheless, even in these situations partners rarely announce their intentions to depart until after these payments are made.  So, considering partnership “notice” provisions, delays due to notifying clients and simple good manners, there is usually a 30-day transition period (if not more) between year-end and a lateral move.  That 30-day period represents one month of deferred compensation for the current year which will be “left on the table” when the partner leaves.
[ii] These are real firms and the year-end distribution dates are factual.
[iii] This is $2,000 more monthly than what it cost G&J (see, in the Fact Pattern narrative).  Assuming the former G&L partner receives no increase the following year, the monthly cost to NLF in 2014 reverts back to $25,000 a month.  (Aren’t numbers fun?)

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