Going Two-Tier? Not So Fast

Thinking of going to a two-tier (equity and non-equity) partnership?  Or of increasing the non-equity ranks if (like 80% of the AmLaw 100) you're already two-tier?

I'm here to counsel extreme skepticism.  And I'm tempted to be even more absolutist:  Don't do it.

At least, that is, if the economics of the situation govern your decision.  Because—let me hasten to add—there are many perfectly praiseworthy and legitimate non-economic reasons to do so, including:

• Being able to retain valuable practitioners and producers—good citizens, if you will—who just don't quite cut it when it comes to joining the equity ranks.
• Providing an alternative career path, attractive in and of itself, for those who would prefer to avoid the ceaseless pressure of high billable hours and high expectations for business development that come with the equity partner pay grade.
• Creating a niche where practitioners with a peculiar, intrinsically valuable but somewhat arcane, specialty can be placed so as to remain available as needed.

And there's actually a fourth reason to introduce a non-equity tier which does not harm and may demonstrably benefit your firm's economics, as long as you're disciplined about it (as firms such as Kirkland & Ellis are):

• Introducing a non-equity, time-limited, period of, say, five years, between being a senior associate and a full equity junior partner, with these conditions:
  • To all appearances to the outside world, the non-equity partners appear to be, simply, partners;
  • They have access to all of the business development tools any partner would have;
  • They have a finite period of time to demonstrate—or not—that, armed with these competitive assets, they can indeed generate business;
  • Internally, they have the opportunity to demonstrate their leadership, team-building, and project management skills (with all of the implied authority that comes from being a "partner"); but lastly
  • Ascension to the ranks of non-equity does not entitle people to an indefinite stay conditioned only on good behavior:  Rather, it starts a second shot-clock running, during the pendency of which they must demonstrate the qualities expected of a full equity partner, or else be excused.
  • Oh, and if you think this is inhumane or too "tough" on general principles, I remind you to think of it from the perspective of the non-equity partner who's about to be shown the door:  Would you rather be job-seeking as a "partner" at Kirkland & Ellis or as a 9th-year associate at Davis Polk?

Now, why am I so skeptical about the supposed beneficent economics of non-equities?  Haven't we all been told for the past 20+ years, by consultants who shall remain nameless, that introducing a non-equity tier can improve your performance by boosting leverage and allowing you to retain proven and productive talent? 

Would the world were so simple.

As it turns out, what comes with introducing a non-equity tier is a subtly changed dynamic in the incentive set facing your talent.  Firms with a single-tier partnership attract the true Type A's:  Those of us who have never finished anywhere but at the top of a class and have no intention of starting to do otherwise.  But the two-tier firms hold out a veiled alternative:  If you keep your nose clean and work (reasonably but not insanely) hard, you might find yourself taking home (say)  $400,000 per year, adjusted for inflation, for the duration.   And you won't have to kill yourself in either billable hours or business generation.

I guarantee you plenty of people walking outside your windows right now would jump at that offer.

And my hunch is that, over time, that changes, ever so slightly, the composition of the people who put your firm into their consideration set.

But don't take my word for it.

Let's look at the numbers.  Fortunately, the just-released 2008 AmLaw 100 give us plenty of numbers, and I've been analyzing them off and on for the last few days.    Let's start with some correlation coefficients.

 (Correlation coefficients, for those of you who skipped statistics, are a mathematical measure of the strength and direction [positive or negative] of a relationship between two variables.   To use simple examples, red hair is correlated with green eyes; being of Asian extraction is negatively correlated with blond hair; and for people from birth to about age 16, age is highly correlated with height and weight.    Correlation coefficients can range in value from +1.0 to -1.0 and, in general, a correlation coefficient of +1.0 implies perfect correlation (being a resident of New York City correlates perfectly with being a resident of New York State); 0.0 implies no discernible relationship; and -1.0 implies no correlation whatsoever—or, in other words, that the presence of one connotes the absence of the other.   Correlation does not, please note, imply causation.) 

So here we have a few numbers.  Many of the figures are available in the AmLaw 100 directly as reported whereas others I calculated.  For example, what I call the "Non-Equity Partner Ratio" is simply (the total number of non-equity partners) divided by (the total number of equity partners).  For a single-tier firm, it's therefore 0 and for a firm with more non-equity than equity partners it exceeds 100%.

• Correlation between Non-Equity Partner Ratio and Revenue per Lawyer:  -0.4254
• Correlation between Non-Equity Partner Ratio and Profit Margin:  -0.7102
• And lastly, Correlation between Non-Equity Partner Ratio and Profits per Partner:  -0.4189

In other words, the higher your firm's proportion of non-equity partners, the lower your:

• Revenue per lawyer
• Profit margin, and
• Profits per Partner.

Here's another way of looking at it.  We know that Revenue per Lawyer and PPP are highly correlated (+0.8923 by my calculations), so I segmented the AmLaw 100 into five cohorts according to the proportion of Non-Equity Partners:

What's going on here?

I've already mentioned my theory that it makes your firm more attractive to those who aren't at the absolute top of the alpha-competitive distribution, but there are also concrete reasons to think that non-equity partners are: (a) getting more numerous, not less; and (b) constitute the most expensive tranche of leverage you have onboard.

This chart shows the breakdown, from 2000 to 2006, of all lawyers in AmLaw firms who are not equity partners.  The large red bars are of course associates and the two small grey bars are, per the survey's methodology (don't ask me!) "other non-equity lawyer" (darker grey) and "non-equity partners" (lighter grey).  The moral is very clear:  Associates are a shrinking component of the ranks of lawyers that give you leverage.  The problem with this is that associates are the cheapest form of leverage, and non-equity partners the most expensive form.

But wait, it gets worse.

Not only are non-equity lawyers the most expensive, they're the least hard-working.  Take a look:

On both charts ("higher" and "lower" profit firms) the two cohorts of lawyers that bill the fewest hours per year are "income partner" and "other non-equity lawyer."  Associates, not surprisingly, bill the most (the 3rd bar on each chart) and equity partners come in a close second (the 1st bars).  To summarize, then:  (1) There are more non-equity lawyers, as a proportion of headcount, than ever; (2) they're the most expensive cohort other than equity partners; and (3) they're the least productive.

So I ask you:  Are you still thinking of going two-tier, or going "more so" if you already are? 

There may be meet and right reasons to do so for the sake of specific individuals, for the sake of  your firm's "culture," or to preserve domestic tranquility, but if you're doing it because people who ought to know better have told you it will help your leverage, increase revenues, boost profitability, and help you retain highly productive people, I have just one question for you:

Can we talk?