CHAPTER 7
CURRENT COMPENSATION METHODS
“Money was never a big motivation for me, except as a way to keep score. The real excitement is playing the game.”
—Donald Trump
“The Donald” perhaps understood the nature and culture of public accounting firms when he wrote the above. While money isn’t the be all and end all, it certainly influences owner behavior.
In the beginning of time, two CPAs came together, decided to share profits, and began the never-ending evolution of owner compensation systems.
It goes without saying that many of the compensation systems we discuss in this chapter have served firms well over the years and have served as a catalyst for accomplishing firm goals. At the same time, however, they may have inadvertently served as roadblocks that prevent firms from reaching their full potential.
In our 2006 Compensation Survey, we identified 10 often-used compensation systems and asked respondents to identify their plan if it was not listed. Of the 423 respondents, 55 selected the “other” category, which demonstrates the great variety of compensation systems. The “other” category was the third most selected.
The following chart shows responses to our 2006 Compensation Survey, ranked from highest to lowest, to the question, “What type of owner compensation system does the firm currently use?”
| Method | Response Percent | Response Total |
| Formula (firm uses algebraic formula to determine compensation) | 17.7% | 75 |
| Equal pay | 15.8% | 67 |
| Other (combinations of the other methods) | 13% | 55 |
| Managing owner decides | 12.5% | 53 |
| All owners decide | 10.9% | 46 |
| Ownership percentage | 6.6% | 28 |
| Pay for performance | 5.4% | 23 |
| Eat what you kill | 5.4% | 23 |
| Compensation committee | 5.2% | 22 |
| Executive committee | 5% | 21 |
| Paper and pencil | 2.4% | 10 |
Source: 2006 Compensation Survey
The chart below illustrates the compensation method used according to firm size.
| Compensation Method | 2–4 owners | 5–9 owners | 10–23 owners | >24 owners | Total responses |
| Equal pay | 49 | 3 | 0 | 0 | 52 |
| Formula method | 43 | 17 | 6 | 0 | 66 |
| Managing owner | 26 | 6 | 1 | 0 | 33 |
| Compensation committee | 5 | 5 | 8 | 3 | 21 |
| Executive committee | 3 | 6 | 5 | 2 | 16 |
| All owners | 26 | 10 | 0 | 0 | 36 |
| Pay for performance | 9 | 4 | 4 | 3 | 20 |
| Paper and pencil | 5 | 2 | 1 | 0 | 8 |
| Ownership % method | 18 | 4 | 0 | 0 | 22 |
| Eat what you kill | 14 | 3 | 1 | 0 | 18 |
| Other | 24 | 10 | 4 | 2 | 40 |
| Totals | 222 | 70 | 30 | 10 | 332 |
Source: 2006 Compensation Survey
In this chapter, we discuss the strengths and weaknesses of each method and the type of firm most likely to use a specific compensation system, plus a method not covered in the survey, the lockstep method. We should note that, in each of these methods, there is probability that subjective factors enter into the process and that some firms use a combination of these methods.
FORMULA METHOD
According to our survey, the formula method is used by 75 of the 423 responding firms. It appears, therefore, this is the most popular method among accounting firms today. This is echoed by the 2005 Rosenberg Survey presented in Exhibit 7–1, “Compensation Systems by Firm Size— Rosenberg,” and a Gary Boomer study presented in Exhibit 7–2, “Compensation Systems by Firm Size—Boomer.” According to these surveys, the formula method is most popular with firms with more than two owners.
The formula method may also be the most popular with accountants because it relates best to the typical accountant personality. Accountants like numbers, and how can anyone argue with a formula? We learned in high school algebra how to solve and prove formulae.
The formula system is the most popular today, but when we asked survey participants to indicate which new system they would select, 36 percent (140 of the 387 respondents) did not select the formula method. Rather, they prefer the pay for performance method by a margin of 2 to 1. The formula method was the second highest preferred response with 18 percent (71 respondents). While the formula method has been the method of choice in the past, there is a definite trend toward the pay for performance method.
Those who favor a formula system generally argue it is relatively simple to implement and saves management time when it comes to making compensation decisions. Gather the information (for example, billable hours, new business generation, collections, and book of business), enter it into the formula, and then, voilá, the compensation distribution issue is over. Or is it? These are definitely pluses.
Although the formula system can be easy to apply and may decrease compensation-related discussions, there are, however, inherent problems in this system. First, we have seen many formulas that do not recognize or reward all the criteria necessary for the firm’s long-term success and growth. Many simple formula plans tend to ignore intangible criteria (for example, training, mentoring, and developing new service areas) and merely focus on the tangible criteria (for example, collections, billable hours, and new business).
A good formula system should recognize tangible and intangible (long-term, capacity-building) factors in a balanced fashion.
Second, while formulas are easy to administer, they are also easy to manipulate. Formulas that reward charge time (not billable time) are perhaps the easiest to manipulate. Look at a common flaw based on the experiences of one firm.
ABC firm was using a formula that rewards chargeable hours. One of the owners, who worked the system, annually charged 1,800 hours but billed only half of them. Another owner in the firm charged 1,400 hours and billed 95 percent of them. The second owner contributed more to the bottom line of the firm than the first, but, per the formula, the first was paid more based on the chargeable hour factor.
Another owner in the same firm, the so-called rainmaking owner, also realized he could manipulate another of the factors. Because the formula was heavily weighted toward new business brought into the firm, this owner developed significant new business, but it was not profitable business. Because client profitability was not a key measure, this owner, like the one above, was arguably overpaid.
There is one thing you can be sure about: owners are smart, and if there is a way to work the system, some will be tempted to do so. That is why, no matter what compensation system you ultimately use, it should measure and reward the right activities for your firm.
Third, while firms like formulas for their simplicity, a good formula system needs to have some flexibility. It cannot be as simple as 1 + 2 = 3. What does the firm do when there are special circumstances, such as a short-term illness or a personal issue? And how does the firm treat an owner who turns a money-losing niche into a success when it is not part of the formula?
Fourth, if you use a strict formula in determining owner compensation, you may limit management’s ability to manage the firm, that is, to reward or to discipline. A good formula system should be a guide to setting compensation, not a policy. It needs subjective elements so management can reward exceptional behavior or send a message for sub-standard behavior. Many of the formula systems we have seen contain subjective elements that can make up as much as 50 percent of the total compensation package or bonus element.
According to L. Gary Boomer, a well-known consultant to the accounting profession, a formula approach tends to work best in firms with 10 owners or fewer. This concept is outlined in Exhibit 7–2, “Compensation Systems by Firm Size—Boomer.” This does not mean larger firms do not, or cannot successfully use this method. It is not necessarily the size of the firm that determines whether this method is used; it is the culture. Firms that previously operated as silos will often use a formula system. They have generally sustained independent practices with little desire to bring other owners’ talents to individual client bases. We will discuss this further when we look at the eat what you kill method.
We also often see a formula approach in firms that are moving from an equal pay system or are transitioning from the first generation of owners to the second, and especially when the firm’s first managing owner behaved somewhat dictatorially and made most compensation decisions. In many cases, this is a logical next step in the firm’s compensation evolution. These firms usually set up a formula that rewards finders (those who bring in business), minders (those who supervise accounts and grow them), and grinders (those who sit behind their desks and produce). Profits are allocated to these three types of contributors, and the firm needs to weight the value of each group’s contributions.
While firms will generally weight each group’s contributions differently, it is often best to simply allocate 33.3 percent to each group. The example in Exhibit 7–3, “Sample Finders, Minders, and Grinders Allocation,” shows how this would work in a firm. In the example, Owner A received 38 percent of the profits, Owner B received 22 percent, Owner C received 24 percent, and Owner D received 16 percent. If any one owner wants to increase his or her share of the profits in the coming year, he or she knows what to do. This type of compensation system can have complete transparency.
Whatever you decide, it is important to clearly define the allocation method and establish a formula that is fair and acceptable to the owners. This will go a long way toward avoiding annual disputes. Firms that use a formula method generally do not change the weighting often. Our experience suggests that changing a compensation system too often can lead to the dissolution of the firm. Two examples of effective use of the formula method are included in Exhibit 7–4, “Simple Unit Formula,” and Exhibit 7–5, “Law Firm Formula.”
EQUAL PAY METHOD
Thomas Jefferson may have captured it best when he said, “There is nothing more unequal than the equal treatment of unequal people.” And that’s the problem with an equal pay system.
This system generally works best when firms are just starting out and there are two to four (that is, a small number of) owners. (See Exhibits 7–1, 7–2, and 7–3 at end of this chapter). Equal pay is an easy way for owners to dodge the compensation bullet, and it usually implies that owners are afraid or do not want to have open and honest discussions about sensitive issues, deal with performance issues, or determine the relative value each owner brings to the firm. Although not always the case, these firms often lack a strong-willed or driving managing owner.
Firms that accept this approach usually have a cohesive group of owners with similar work ethics and client service philosophies, or they haven’t taken adequate time to identify what is important as a firm and what they want to reward. This system assumes everyone’s contribution is equal and works as long as all owners put forth equal effort and relatively equal results. However, when reality sets in, owners often realize they bring different skills, talents, commitment, and results to the practice.
As soon as one or more owners believe they contribute more than others, compensation problems start to arise. If we were going to create a continuum of compensation systems based on number of criteria and appropriateness of the criteria, the equal pay would be at the far left because there is no performance criteria used to determine compensation.
This system can be detrimental to a firm’s long-term health for the following reasons:
▮ It creates a culture of mediocrity.
▮ There is generally no incentive for any one owner to perform at a higher level than others.
▮ There may be no individual recognition for a job well done.
▮ It often hinders the firm’s growth.
▮ It limits the firm’s ability to be profitable.
▮ It often drives out high performers.
If we begin to get the picture that this system is so bad, why did it rank as the second most popular in our survey? There are likely several reasons:
▮ Of the 67 firms that have an equal pay system, 49 of them have four owners or fewer.
▮ This system creates a collegial culture, especially in smaller firms.
▮ Equal pay plans are easy to implement.
▮ Owners with similar work ethics—whatever they might be—often embrace this type of plan.
While equal pay is not the plan of choice for larger firms, many smaller firms find that it works just right for them.
LOCKSTEP METHOD
While we did not include a variation of equal pay method as a choice in our survey, it is often seen in law firms and is generally called the lockstep method. The lockstep income distribution system embodies a philosophy of equal sharing of income among those owners who are at the same level of tenure with the firm, without being overly concerned about their exact contributions. It rewards individual owners based on longevity. It is a variation of the equal pay method in that employees who become owners at the same time keep their income distribution in lock step.
It is based on the assumption (perhaps a false one) that the longer an individual is an owner, the more valuable he or she becomes to the firm. This system has worked well for many law firms and some accounting firms. With the trend toward the pay for performance method, however, the lock step method is becoming scarcer, even in law firms. We believe the reason is simple. Owners who embrace this method are usually not entrepreneurial or aggressive. Younger owners are willing to wait their turn to grab the golden ring.
At one extreme, this income distribution system can be detrimental to a firm’s long-term health. Assume for a moment it does not reward for current production or for building future capacity. Owners merely show up to receive a paycheck. In this scenario, you find owners who have retired but have failed to tell anyone. As the saying goes, nice work if you can get it.
In reality, the lockstep method does require that certain performance levels must be achieved for the owner to participate fully in the income opportunities, and there is an overriding philosophy that the individual owner contributions need to be reasonably equal.
This type of system usually works best in small firms with owners who are similar in age. There may have been three or four owners that started the firm under an equal pay plan, and as the next group of owners entered the practice, the second group maintains its own equal pay plan.
A positive aspect of this plan is that it forms a cohesive group out of the various owner tiers (as long as they have similar values and work production). As with any of the plans we discuss, this one works especially well when the firm is very profitable. With enough dollars to pass around, it is easier for owners to overlook another’s mediocre or poor performance.
HYBRID APPROACH METHOD
Fifty-five firms responded to our first question (“What type of owner compensation system does the firm currently use?”) by checking the “other” category rather than any of the other 10 categories. Our belief is other means these firms are using hybrid compensation methods. In other words, they use elements from one or more of the other methods. Because the responses varied across the board, we share them here so you see how firms take elements from various methods to create an approach that works for them.
For example, several respondents in this category use the equal pay method, except that the managing owner receives an additional stipend for managing the firm. Another firm uses the equal pay formula but deducts $50 per hour for excessive time off. This firm also rewards owners for working excessive hours. One firm that uses an equal pay method also uses an ownership allocation. One provides equal pay plus a bonus (equal to one-fourth of his or her production) to the partner with the highest billings. Another has equal base pay of $72,000, and profits over that amount are allocated by a formula that measures contact and managed volume.
Many firms use an algebraic formula that includes elements of pay for performance, ownership percentage, and managing owner prerogative. One firm used a 75 percent formula approach and 25 percent for performance. Still another respondent indicated his or her firm uses a combination of formula, guaranteed payment, and subjective allocation by the compensation committee. One respondent wrote, “We use a combination of formula, ownership, and achievement of firm goals. Fifty percent is firm goal achievement, 25 percent profitability (formula), and 25 percent ownership. Last year’s goal was growth of practice.”
Some firms used a combination of compensation committee and ownership percentage. The compensation committee sets the annual salary or draw, and owners receive a monthly interest payment on accrual-based capital. At the end of the year, owners are eligible for a subjective bonus. After all payments are made, remaining dollars go toward profit sharing based on ownership.
One firm provided the following, “Our base pay is determined by past history and present responsibilities. It is different for each partner. Firm profits are then split as follows: first 25 percent (but not less than $50,000) stays in the company, second 25 percent is by ownership, and third 25 percent discretionary by compensation committee (with each partner giving input for extraordinary matters done during the year be it monetary or nonmonetary). The final 25 percent is split equally amongst all owners.”
MANAGING OWNER DECIDES METHOD
Because the formula method can produce the wrong results and misguided incentives, many firms add subjective elements to the formula or move to a completely subjective approach wherein the managing owner makes all the compensation decisions, perhaps with some input.
When the managing owner makes all compensation decisions, the system is simple and is generally based on the following principle that the benevolent dictator espouses: “Trust me . . . I certainly know what everyone is worth.”
A system in which one person makes all compensation decisions tends to work best in smaller firms where the managing owner is the founder and also the major shareholder. In this scenario, most of the other owners are playing the roles of highly paid managers and have resigned themselves to the reality that authority remains with the managing owner.
In our survey, 33 firms indicated they use this method. Of the 33 firms, 26 have four owners or fewer, and six firms have from five to nine owners. Only one firm had 10 or more owners.
Leaving such an important decision to one person can create a host of problems for the firm and its owners. Consider the following situations:
▮ Owners may have abdicated their rights to discuss compensation issues.
▮ Because owners are often not allowed to discuss compensation, this may breed a low degree of trust among them.
▮ Firms that let a single individual determine everyone’s compensation usually have a larger gap between the highest and lowest paid owner.
Our survey shows the following:
▮ Owners under this scenario usually do not work as a team because one of the basic principles for developing a strong team is open and emotional discussion that leads to good conclusions.
▮ The managing owner may justify his or her worth and compensate himself or herself the most, or he or she may overcompensate specific owners to avoid conflicts or minimize the disappointment of these owners.
▮ The benevolent managing owner may have his or her favorites and compensate them accordingly.
ALL OWNERS DECIDE METHOD
We have heard some people say the “last man standing” method (all owners meet as a group and decide) is more than a compensation system, it is often a “free-for-all” or “blood bath.” When owners get together to determine each other’s compensation, there is generally one of two outcomes. Owners have an open and robust discussion about each other’s contributions and shortcomings and leave the meeting feeling good about individual and firm outcomes. Or, they have a shouting match, and the owner who screams the loudest and longest often wins.
If facilitated in the right spirit, the all owners decide method is an excellent way for owners to help each other see areas of needed improvement. If not, it can be very emotional and destructive to the firm.
Many times this system does not include preestablished goals for owners. Hence everyone scrambles at the end of the year to record their lists of accomplishments. It often becomes evident that individual accomplishments are not guided by common vision and strategic goals. For this system to work, it is critical for each owner to have a list of goals and objectives that are determined at the beginning of the year.
Our survey suggests this system generally works well for smaller firms, that is, those with 10 or fewer owners.
OWNERSHIP PERCENTAGE METHOD
We have observed more and more firms bifurcating compensation from ownership. In other words, relative compensation levels no longer track with ownership levels. Firms that tie ownership directly to compensation are usually making a mistake. While equity is important when it comes to selling a practice, apportioning the capital needs of the firm, and establishing voting rights in the management of the firm, equity should not be a primary factor in determining compensation. Marc Rosenberg commented in “Not All Owners Are Created Equal”:
Compensation for ownership and compensation for performance should be dealt with separately. Many firms provide for payments to retired owners. These payments typically are not guaranteed, and they remunerate owners for a number of things, chief among them being ownership in the firm and the value and size of the client base they originated. The mistake many firms make is mixing together ownership and performance in determining annual income allocations.1
Therefore, we would disagree with the following statement: “If I own 50 percent of the firm, I deserve 50 percent of the profits.” Determining compensation based on ownership is an entitlement program, similar to seniority. Most firms that use this method are small, with one or two owners who hold most of the equity.
In these firms, owners may take small amounts of compensation during the year, and then distribute profits based on ownership. Obviously, minority owners are not incentivized to bring in new business because they receive only a small percentage (equal to ownership) of the new business net revenue.
This system has problems similar to any entitlement system:
▮ It does not encourage owners to develop new services or talents.
▮ It does not encourage younger owners to work hard or build the practice.
▮ It encourages mediocrity.
▮ It can hinder the growth of the firm.
▮ It does not maximize profitability.
▮ It does not reward individuals for performance.
We asked a few well-known consultants about ownership percentage affecting owner compensation. Marc Rosenberg said, “It doesn’t. That’s it. Everything relating to annual compensation should be performance based.” Don Scholl told us, “A return on capital is not the same thing as compensation and should be handled as an expense of the business. Owner compensation should primarily be related to that individual’s total contribution to the firm’s current success.”
Chris Frederiksen agreed with Marc and Don. “I see many firms where the lion’s share of the pie is divided based on ownership with little regard being given to individual performance. What this does is disen-franchise the younger owners who can only realistically improve their income through superior performance. Also, sooner or later, it causes grief in the firm; the high performing owner will feel under-compensated and the under-performing owner has no way to gracefully take less money.” To read more of these interviews, see Exhibit 7–6, “Interview With High Profile Consultants About Owner Compensation,” at the end of this chapter.
PAY FOR PERFORMANCE METHOD
A real pay for performance program aligns owner and employee compensation to the firm’s strategic initiatives. The fact that many accounting firms today do not have clearly defined strategic objectives can explain in part why only 5.4 percent of the respondents to our 2006 Compensation Survey listed a pay for performance method. However, if you want to drive superior results (performance) in your firm, align owner and employee compensation to the firm’s strategic initiatives. We discuss this method thoroughly throughout the book.
EAT WHAT YOU KILL METHOD
If this sounds like a barbaric system, it is! An eat what you kill system rewards the hunter’s individual efforts, and everyone is essentially on their own. This is a simplified type of formula approach in that bringing in business and doing the work are the primary activities; nothing else matters in this compensation system. In this system, earnings are directly proportional to the business an owner brings in and executes. In a group practice, there is no cash reserve to provide a draw or salary when an owner and his team are not billable. And to keep one’s production up, there is major emphasis on bringing in new business and hoarding the business you already have. When individuals keep the spoils of their hunt, teamwork is thwarted.
As with each system we discuss in this book, of course, there may be variations in the eat what you kill approach to compensation. Each owner often pays a share of overhead and is charged for all or some of the salaries of employees who work for him or her. Because owners are directly responsible for the costs of employees who work for them, they are likely to hire hard working team members. This is one of the good points of this system.
Another strong point of the system is that owners know exactly what they must do to achieve their desired incomes. This is similar to the formula system we discussed above. To survive under this system, therefore, owners need to bring in business. If an owner does not get paid what he or she wants, he or she has no one to blame but himself or herself. Owners under this system are also very conscientious about receivables. Unless they collect on them, they are not compensated for them.
A final positive about this system is the need for almost no management time to determine compensation because each owner essentially determines his or her own compensation.
While there are a number of positive points, this system is not without problems. Many times it is difficult to get owners to spend time managing the firm, especially if there is no recognition for nonbillable time. Individual owners may train individuals who work under them, but there is generally no firm-wide consistency in training and development. In an eat what you kill environment, staff members often need to be self-starters because there is either inconsistent or little training support.
There are also problems with sharing staff members in an eat what you kill environment. Employees are often required to learn new processes and procedures because owners often set up their files differently and approach engagements in their own unique fashion. Cross-servicing does not usually happen because owners are more interested in feeding themselves than others.
Firms that follow an eat what you kill compensation system have owners who operate independently yet under the same roof. This is often called operating in silos. Owners in these firms do not need to have relationships with each other because they depend on themselves for success. This, in turn, often hinders the firm in maximizing profitability. The eat what you kill method does not contribute to building a firm of the future because total emphasis is on the here and now. A Generation X employee may tolerate this environment, but Generation Y employees may rebel because they are generally more team oriented.
COMPENSATION COMMITTEE METHOD
Our study suggests that a compensation system in which a compensation committee determines base pay and bonus is generally employed only when the firm has seven or more owners. If there are fewer than seven owners, it probably does not make as much sense to consider this method. While smaller firms sometimes use compensation committees, they generally move to consensus because they probably want to have at least 3 owners on the committee. As the number of owners grows to 10 or more, so grows the use of compensation committees.
Having a compensation committee make decisions may be preferable to having only the managing owner make decisions, provided all members of the committee are not founding owners. Also, when there is more than one person involved in determining profit allocation and even base salary, the allocation tends to be fairer. Compensation committees can often be fairer than executive committees because different members of the firm can be elected to the committee each year, whereas executive committees tend to be more stable in their membership.
Seldom does a compensation committee base its decisions purely on subjective factors. Most firms gather detailed statistics on each owner, and members of the compensation committee review the statistics prior to making decisions. The compensation committee usually interviews each owner, considers objective management reports or self evaluation reports, and makes a recommendation to the executive committee or ownership group as a whole. Depending on firm size, firm type, and the make-up of the owners, the compensation committee approach can work well.
Compensation committee membership can take on many forms, and we recommend that its membership mirror the diversity of the owner group. Larger single-office firms will also have representation from different departments within the firm (for example, tax, audit, and consulting), and multioffice firms will have representation from different regions. It is important that the committee make-up be composed of management plus one or two other owners who are elected by the remaining owners. An ideal committee make-up may consist of an owner who represents each generation of owners, plus the managing owner. Having the proper mixture of owners provides greater credibility to the committee and usually results in allocations that are fair.
Karen MacKay, a consultant with Edge International, one of the premier consulting firms to the legal profession, believes a good compensation committee should also be made up of different personality types. In her article, “Selecting the Compensation Committee: The Power of Balancing Personalities,” MacKay suggests that selection of committee members take into consideration the Myers Briggs Type Indicator (MBTI)®.2
“MBTI measures our orientation of energy—where we get our energy. This is known as the E-I Dichotomy. If you prefer introversion, you draw energy from the inside. You prefer to communicate in writing. You prefer to take the time to reflect on the issues and work out your ideas in your head. You think through the issues. If you prefer extroversion you draw energy from the external environment. You prefer to communicate by talking. You work best by doing and discussing, in short you talk through the issues.”
A balance of introverts and extroverts will enable the committee to both think through and talk through the critical issues. The introverts will give careful, thoughtful, reflective consideration while the extroverts will be sure the group has put the issues on the table—they will pull the thoughts out of the others on the committee until they are satisfied. Designing the format for the compensation committee’s deliberations requires sensitivity to the energy needs of the participants. Four days of straight meetings is tiring for anyone, but it will literally “suck the life out of the introverts. They need breathing space. They need reflective, alone time to be effective.”3
Now, think about your compensation committee.
EXECUTIVE COMMITTEE METHOD
The executive committee approach is similar to the compensation committee approach. The primary difference is that members of the executive committee are often more senior members of the firm or the largest rainmakers.
A major drawback of this method, similar to a compensation committee, is that the executive committee also determines its own members’ compensation. We have found it is not unusual for the executive committee to recommend compensation for the managing owner, but determining its own compensation can be problematic. Perhaps you could form a compensation committee to determine compensation for executive committee members!
PEN AND PAPER METHOD
The pen and paper method of determining compensation and bonuses is fairly simple and often used by smaller firms. There are several variations to this method, but the method generally works like this. Each owner is given a sheet of paper that lists all of the owners’ names as well as the total dollar amount that will be allocated for bases and bonuses. The owners then allocate the dollars among all owners, including themselves. The managing owner or firm administrator tabulates the results to obtain an average for each owner.
The individual recommendations can certainly remain a secret. In other words, owners may see what other owners have recommended, but they do not know who made which recommendation. We call this the chicken method. A variation of the chicken method is the open method, in which owners know who recommended what. The benefit of this open method is that it allows for robust dialogue among owners about why they made specific recommendations.
Exhibit 7–7, “Sample Owner Compensation and Bonus Allocation Input Form,” shows what a sample individual input sheet would look like. In this case, there are four owners in the firm, and they have $1,000,000 to allocate ($800,000 in base pay and $200,000 in bonuses).
Depending on the number of owners in the firm, the highest and lowest recommended allocation could be discarded when determining the average. This type of method can also be used to gain input for an executive or compensation committee and for the managing owner decides method.
To help owners determine their recommended allocations, many firms distribute to each owner key measures and other statistics. These usually come from an owner self-evaluation form.
FINAL THOUGHTS
There are 40 firms, and each has a different compensation method or system, and each compensation method has a profound influence on the firm’s success or failure. So, what do you do now? Simply changing from one compensation method to another is certainly not the answer.
Designing a compensation system that is right for your firm requires a detailed assessment and design (or redesign) of your mission, vision, values, and strategy to make sure the system is exactly right for your firm.
Each firm needs to determine what it values most and why this makes your firm unique. The basic question to ask and answer is, “What do owners want to accomplish, and what compensation system will help us do this?”
EXHIBIT 7–1 Compensation Systems by Firm Size—Rosenberg
| 2 Owners | 3–4 Owners | 5–7 Owners | 8–11 Owners | 12+ Owners | |
| Compensation committee | 0 | 5% | 18% | 24% | 50% |
| Formula | 23% | 56% | 42% | 48% | 36% |
| Paper and pencil | 0 | 2% | 6% | 10% | 5% |
| Ownership percentage | 16% | 9% | 4% | 0 | 9% |
| MP decides | 13% | 11% | 14% | 7% | 0 |
| Equal pay | 35% | 4% | 8% | 7% | 0 |
| All owners decide | 13% | 13% | 8% | 4% | 0 |
Source: The Rosenberg Survey, 2005, p 17
EXHIBIT 7–2 Compensation Systems by Firm Size—Boomer
| System | 2–3 Owners | 4–7 Owners | 8–10 Owners | >10 owners |
| Equal | Common | Rare | Never | Never |
| Formula | Common | Very common | Less common | Seldom |
| Spreadsheet | Rare | Effective at upper end | Can work | Too difficult |
| MP decision | Rare | Can work well | Becomes difficult | More difficult |
| Compensation committee | No | No | Becomes viable | Common |
| Points/units | No | No | No | Still in use |
| Balanced scorecard | Will work in any size firm with proper leadership, governance and a Strategic plan | |||
Gary Boomer, Owner Compensation, published by Boomer Consulting
EXHIBIT 7–3 Sample Finders, Minders, and Grinders Allocation
Owner Statistics
| Type of contributor | Weighting | Owner A | Owner B | Owner C | Owner D |
| Finder origination | 33.3 | $200,000 | $ 40,000 | $100,000 | $ 25,000 |
| Minder book | 33.3 | $ 1.2m | $460,000 | $600,000 | $260,000 |
| Grinder billable $ | 33.3 | $ 40,000 | $315,000 | $200,000 | $325,000 |
Owner Profit Sharing
| Type of Contributor | Weighting | Owner A | Owner B | Owner C | Owner D | Total | % of Total |
| Finder origination | 33.3 | $ 66,600 | $ 13,320 | $ 33,300 | $ 8,325 | $ 121,545 | 10% |
| Minder book | 33.3 | $399,600 | $153,180 | $199,800 | $ 85,580 | $ 838,160 | 67% |
| Grinder billable $ | 33.3 | $ 13,320 | $104,895 | $ 66,600 | $108,225 | $ 293,040 | 23% |
| Totals | 100% | $479,520 | $271,395 | $299,700 | $202,130 | $1,252,745 | 100% |
| % of Total | 38% | 22% | 24% | 16% | 100% |
EXHIBIT 7–4 Simple Unit Formula
In “Partner Compensation Systems in Professional Services Firms Part II,” Michael Andersen shares, “The simple unit formula is designed to reward seniority, production, client generation and non-billable activities, using a relatively straightforward and totally objective calculation. A typical formula might be that each owner receives:
▮ One unit/point for each year with the firm
▮ One unit/point for $x of production (fees billed or fees received)
▮ One unit/point for x of client generation.
The non-billable units/points are awarded on the basis that the total available number of units/points is three times the number of owners. Then, those available units/points are allocated on a pro rata basis for non-billable time recorded. Needless to say, when all of the units/points have been allocated, they are converted to percentages and then applied to the net firm profit for the fiscal year to create each owner’s individual income.
This system is not unlike the modified Hale and Dorr system in that it mainly rewards production in an objective manner. The biggest differences are that the simple unit formula also rewards longevity with the firm as well as some nonbillable efforts.”
Source: Michael J. Andersen, “Partner Compensation Systems in Professional Services Firms Part II,” http://www.edge.ai/Edge-International-1057907.html; 2007, Edge International, accessed on January 25, 2007.
The law firm of Flaster Greenberg is one of New Jersey’s largest law firms, with 60 attorneys and 7 offices in New Jersey, Pennsylvania, and Delaware. The firm posts the following on its Web site (www.flastergreenberg.com).
“Unlike most law firms, shareholder compensation is not determined by a subset of shareholders; but rather, by an objective formula equally applied to all shareholders. The mechanics of the formula are discussed below. The effect on the Firm of having this form of compensation system is dramatic. The typical politics present at many firms is absent. New shareholders need not worry about alliances, voting blocks or existing loyalties among more senior attorneys. Management and the shareholders are not preoccupied with compensation issues and instead focus on strategic decisions. Shareholders are content because they feel like owners and are confident every shareholder is treated equally.
As discussed above, shareholder compensation is determined by an objective formula. Our compensation formula tracks each shareholder’s production (cash collected on a shareholder’s time), client responsibility or minding (cash collected on files that the shareholder manages) and originations (cash collected on files originated by the shareholder).
Each year, the shareholders determine the total amount available for distribution. Twenty five percent (25%) of this amount is then allocated proportionately to the shareholders based on origination, nineteen percent (19%) is allocated proportionately to the shareholders based on client responsibility and fifty six percent (56%) is allocated to the shareholders proportionately based on production.
Each shareholder is provided reports showing these figures for all attorneys. All financial information at the Firm is shared with every shareholder. The administration of the compensation formula involves quite an extensive spreadsheet and the firm has modified the formula to address contingent fees, associate profit and certain firm service by shareholders; however, the formula is applied equally to each shareholder. The primary benefits of the compensation formula are:
▮ Shareholders receive the same production credit regardless of whether they work on a client file they originated or another attorney’s file.
▮ The typical credit for origination is divided into two categories origination and client responsibility to allow for sharing between attorneys. Accordingly, an attorney is rewarded for bringing in a client to the firm and where another shareholder manages the file; the minding attorney(s) is rewarded for servicing and growing the client.
▮ All politics associated with compensation are removed from the Firm.
▮ The delicate balance between rewarding originators and rewarding the working attorneys is maintained as evidenced by the fact that both the Firm’s high originators and high billers have remained at the Firm.
▮ Our compensation formula recognizes the varying contributions of all shareholders and the Firm does not need to differentiate shareholders by de-equitizing all but the highest originators.”
Source: “The Flaster/Greenberg Difference,” http://www.flastergreenberg.com/careers/flasterdifference.cfm; 2006, Flaster/Greenberg, accessed on January 25, 2007.
EXHIBIT 7–6 Interview With High-Profile Consultants About Owner Compensation4
Partner Advantage Advisory (PAA): All firms at one time or another ponder the following questions, and there must be as many different ways to respond as there are firms. But, just because a firm has a way of doing something, does not make it right or the best way. So when we think about the following questions, there are two ways that each one of you can respond:
▮ What are firms doing?
▮ What should firms be doing?
Here are the questions that firms should be asking:
How much accrual basis capital should a firm maintain?
Why is equity so important?
When admitting a new owner, how does the firm decide how much ownership (equity percentage) to assign to that person? If a person becomes a 5 percent owner, this is 5 percent of what?
What is the purpose of requiring new owners to buy in?
To where does the new owner buy-in amount get paid?
Should owners receive some return on their capital investment?
How should ownership percentage affect owner compensation?
How should ownership percentage affect owner retirement?
How should owners vote? One man-one vote or by ownership percentage?
Should quality review findings and/or regulatory agency disciplinary actions effect owner compensation?
How much accrual basis capital should a firm maintain? Owners are making greater investments in technology, real estate, and marketing than ever before. It seems that new owners and even existing owners only want to take money out of the firm. They often find it hard to think of a practice like a real business where you buy assets, pay people, and make investments for the future. What are you seeing the market today? How are firms determining capital accounts? What’s the rationale behind their methods and how are owners coping with keeping more money in their firms?
Bob Martin: Before the question is answered, it’s important to understand that for most firms, accrual basis capital is mostly WIP and A/R.
Don Scholl: No matter if the firm is a sole practitioner or multioffice, multiowner entity, each firm should require some capital to fund its working capital needs and any capital requirements for equipment and property. I have always felt that, at a minimum, capital accounts should be 20 percent of a firm’s budgeted collections. This minimum anticipates that the firm will be using its line of credit for some part of the year.
Further, there is a positive element about having a low capital requirement. It can force the owners to become aggressive in collecting accounts receivable.
Marc Rosenberg: Sophisticated firms will set a target for capital. The most common target is a percentage of net fees, usually 20 percent to 30 percent. But the vast majority of firms are not this formal and do not set any target for capital. Capital is as it is. The key, from a cash flow or capital-planning standpoint, is to avoid paying compensation to owners before WIP and A/R is collected.
August Aquila: I’ve noticed that the aggressive and growth oriented firms require owners to contribute 30 percent or more of collected fees. This provides the firm with the needed capital to make investments in new services or ventures.
Chris Frederiksen: I’ve seen a few firms go as high as 50 percent of fees. But that is surely not the norm. In any case, the capital should at least equal the net income of the firm before any owner compensation. With regards to Don Scholl’s comment, I would recommend to a million dollar firm with net income of $350,000 to have at least that $350,000 in capital.
Bob Martin: I would add to Chris’s net income principle above, that total amount should be allocated among owners according to their compensation, set at 1.0 or more times individual compensation.
PAA: Why is equity so important?
Marc Rosenberg: Equity is important especially when a firm is sold, when an owner retires and in some cases, in voting. Voting will be addressed later. When a firm is sold or an owner retires, there are usually two payments made—capital and goodwill. When either of these two events occurs, the owner receives their share of the equity as well as the return of their capital as outlined in the owner’s agreement.
Steve Erickson: Problems arise at firms when equity is used too heavily for owner compensation or owner retirement purposes. Benefits should be awarded based upon what each owner contributed to the creation of the earnings, in the case of compensation, and to the creation of goodwill, in the case of retirement.
PAA: When admitting a new owner, how does the firm decide how much ownership (equity percentage) to assign to that person? If a person becomes a 5 percent owner, this is 5 percent of what?
August Aquila: That’s an interesting question. Assume that the existing owner agrees that the new owner should have 10 percent equity interest in the firm. First, I think you have to determine if that means 10 percent of the earnings, then you need to decide if it is on the cash or accrual basis. Then there is the issue of goodwill. To get a true picture of the value of a firm, real businesses use accrual basis financial statements.
Marc Rosenberg: This is one of the most comical and haphazard areas of CPA firm practice management. Most firms, if they were honest, would admit that there has been no coherent or consistent system used to determine ownership percentage. This is a big mistake because if ownership is used in important ways, like allocating income or determining retirement benefits, it will make the owners very unhappy when the inevitable arises: an owner with a high ownership percentage is awarded compensation or retirement benefits that are far in excess of what he deserves.
Bob Martin: We should remember that ownership percentage has an impact on owners in five possible ways:
Voting
Compensation
Retirement benefits
Determining buy-in amount
Allocating assets and liabilities from the sale or liquidation of the firm
But, the impact and influence of ownership percentage can be eliminated in all but number five above.
Steve Erickson: The larger the role that ownership plays on the above, the more problems and complications you will have. Conversely, if you minimize the role of ownership percentage, it makes it easier to bring in new owners and deal with each of the above areas separately.
Rita Keller: When it comes to compensation, it should be allocated primarily on the basis of performance, not ownership. However, there are still a lot of small firms paying senior owners on ownership.
Chris Frederiksen: I would add that retirement benefits should be determined based upon what each owner did to contribute to the creation of the firm’s value. Bringing in clients is just one way to contribute to the value; other ways such as firm management, staff development, technical expertise, and so on, should also play important roles.
Don Scholl: Buy-in should be determined not by ownership percentage, but by what the current owners feel is a meaningful number that they want each new owner to contribute. For example, take the case of a four owner, $3 million firm with capital of $1 million. If you admit a fifth owner and want that person to be a 5 percent owner, that would result in a buy-in amount of $200,000, which today, is considered by most firms to be higher than what young people are willing to pay. The firm is better off deciding on a meaningful amount, say $50,000, and working backward to decide on the ownership percentage. In this case, the new owner would own 1.2 percent of the firm (50,000 divided by 4,050,000).
PAA: What is the purpose of requiring new owners to buy in?
Marc Rosenberg: The theory is that all owners should feel that they have a meaningful amount of money invested in the firm that is at risk. The firm is a valuable asset that is relatively liquid. Why would any owner of a valuable, liquid asset, “give away” its ownership?
Steve Erickson: Owners have to show their willingness to put their money at risk. It’s one of the major tenets of ownership. Even if they don’t fund their capital accounts at once, they should be fully funded by the end of five years.
Bob Martin: I can tell you one thing, when someone goes to the bank and takes a loan to make his or her capital contribution, there is more of a commitment to the firm. The title of owner now means a lot more.
August Aquila: Years ago when I was an owner in a CPA firm, not only did I feel committed, I always felt that the firm had some leverage over me and other owners if we decided to leave the firm and set up shop across the street. Having a significant capital account at risk surely makes owners think twice before leaving a firm.
Don Scholl: Where else would the firm find funding for its operations? I guess it could go to the bank. But I’m not sure why a bank would provide funds to a small under capitalized firm that had no capital in it.
Chris Frederiksen: Having money at stake is only equitable if you are going to share in the rewards of ownership. Normally the amount of money invested has a relationship to the amount of money you earn. Many firms adjust your investment based on your relative share of the firm’s net income.
PAA: To where does the new owner buy-in amount get paid?
Rita Keller: Buy-in amounts should be paid to the firm. Most firms find that new owner buy-ins are a simple way of financing the growth of the firm and to finance the capital payments to retired owners that are replaced by the new owners.
Marc Rosenberg: This is an aspect of this whole topic that is mishandled by many firms. Many firms have the buy-ins of new owners paid to the existing owners. This isn’t fair to the new owner for the following reasons:
He has nothing to show for it on the firm’s balance sheet. Someone cannot look at the firm’s balance sheet and determine who paid in capital to the firm.
If there is a return on capital segment of the compensation system, as there should be, he won’t get any of this.
Payment of a buy-in amount to existing owners really is an advance payment of that owner’s retirement benefits. Yet, the way many firms work it, the new owner gets no credit for these payments in determining their retirement benefits.
PAA: Should owners receive some return on their capital investment?
Marc Rosenberg: There is no doubt that a CPA firm is a valuable earning asset whose value is relatively liquid. Investors in any investment should be entitled to a reasonable return on their investment.
Chris Frederiksen: Buy-in amounts should definitely be paid to the firm and not to the retiring individual. There are already enough opportunities for conflict in these situations without creating new ones.
PAA: How should ownership percentage affect owner retirement?
Marc Rosenberg: Not at all. Retirement benefits should be determined based upon what each owner has contributed to the value of the firm.
Chris Frederiksen: Retirement benefits should be based on what the retiring owner has contributed to the firm over his or her career. There are two common ways of measuring this: (A) By the book of business an owner has amassed and leaves with the firm. For example, a firm might pay out 80 percent of the owner’s retained business over a 10-year period (that is, 8 percent of collections each year for 10 years) and (B) by the owner’s compensation level. For example, a firm might calculate the average of an owner’s highest 3 years of compensation occurring within the last 10 years. The firm might then pay out 25 percent of this amount each year for 10 years. Some firms pay the higher of (A) or (B) and some firms pay the lower of the two. Which one you pick will depend on your circumstances and what you are trying to accomplish.
PAA: How should owners vote? One man gets one vote, or by ownership percentage?
August Aquila: This is another complicated area. For the most part, problems are avoided if you vote on a one-man-one-vote basis. When votes are taken on an ownership percentage basis, it disenfranchises the lower owners, makes them feel like they are not an owner. They almost literally have no vote.
Marc Rosenberg: The biggest argument for voting on an ownership basis is one in which control is an issue. Take the situation where there are one or two found-ing/long-time owners. Now they admit a few new owners who clearly don’t have the wherewithal of the established owners. Obviously, the older owners don’t want to expose themselves to being kicked out of their own firm by a one-manone-vote system.
Chris Frederiksen: There are two ways to deal with this:
All votes are a one-man-one-vote basis, but any owner reserves the right to vote by percentage if he so chooses (that is, doesn’t like the way the first vote came out).
Stay with one-owner-one-vote, but establish a supermajority vote for key issues such as changing the owner agreement, mergers, firing an owner, etc.
EXHIBIT 7–7 Sample Owner Compensation and Bonus Allocation Input Form
| Owner | Base Compensation Recommendation | Bonus Recommendation | |
| A | |||
| B | |||
| C | |||
| D | |||
| TOTAL | $800,000 | $200,000 |
Assume that Owner A completes the form and has allocated the dollars as follows:
| Owner | Base Compensation Recommendation | Bonus Recommendation |
| A | $225,000 | $ 75,000 |
| B | $150,000 | $ 20,000 |
| C | $200,000 | $ 50,000 |
| D | $225,000 | $ 55,000 |
| TOTAL | $800,000 | $200,000 |
Each of the other three owners completes the input sheet, and the final forms for compensation and bonus may look like the following:
| Owner | Base Compensation Recommendation | Average | |||
| A | $225,000 | $190,000 | $205,000 | $211,000 | $207,750 |
| B | $150,000 | $158,000 | $143,000 | $152,000 | $150,750 |
| C | $200,000 | $205,000 | $196,000 | $210,000 | $202,750 |
| D | $225,000 | $247,000 | $256,000 | $227,000 | $238,750 |
| TOTAL | $800,000 | $800,000 | |||
| Owner | Base Compensation Recommendation | Average | |||
| A Recommendation | B Recommendation | C Recommendation | D Recommendation | ||
| A | $75,000 | $56,000 | $60,000 | $66,000 | $64,250 |
| B | $20,000 | $25,000 | $22,000 | $20,000 | $21,750 |
| C | $50,000 | $50,000 | $45,000 | $55,000 | $50,000 |
| D | $55,000 | $69,000 | $73,000 | $59,000 | $64,000 |
| TOTAL | $200,000 | $200,000 | |||