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John G. Iezzi, President, Iezzi Management Group
January 1, 2003
For the past 25 years of so, I have been one of the few individuals within the law firm consulting community that has advocated a supplemental payout system to law firm owners. This is a payout over and above the usual amounts, which consists primarily of capital balances and in some cases, an arbitrary payout for “goodwill”, long term service, or whatever else you care to call seniority or longevity.
The reasons for not having such a scheme are not grounded on any logical basis; but, rather more on an emotional level and on the basis of the remaining owners not willing to accept what they perceive as the liability of those who no longer are making financial contributions to the firm.
To properly understand why I have, and continue to, advocate such a payout policy, one needs to step back and educate themselves on the foundation upon which this type of policy is developed.
First of all is the need to recognize that owners of professional service firms have the same right to accumulate equity in the organization they own similar to the owners of any other type of business. If I am the owner of the XYZ Widget Company, I expect over time to accumulate equity in that company and upon death, retirement or termination for any reason, there is an expectation that I will receive some value over and above that which I have invested. Heck! This is the American way!
For whatever reason, law firm owners do not appear to have the same expectation and thus do not take the time and energy necessary to develop a process which permits that equity to accumulate for payment at some date in the future.
If you are among the few that believe that equity accumulation in a professional services firm is appropriate and necessary, or if I have now piqued your interest in developing such a program at your firm, the next question is: How is this accomplished?
Once again, you need to buy into some concepts which are generally not understood or recognized in an environment that functions on the basis of selling services in terms of time value rather than Barbie dolls or software. These concepts are of an accounting nature, and focuses attention on some very old accounting methods that have probably been in existence since the beginning of time and these are accrual basis accounting versus cash basis.
Most professional service firms operate on the cash basis of accounting; Receipts are accounted for in the time period that the mailman delivered the checks; and expenses are accounted for when the check to the vendor is written. When the services were performed or products or services received, is not relevant. This basic practice of accounting has fostered an attitude among the owners that compensation and related ownership issues only count when cash is physically transferred into or out of the organization. This is the first myth that must be dispelled.
The fact is that the better and more successful law firms operate, internally (as opposed to for tax purposes), on the accrual basis. Revenues are not represented by cash receipts but rather by the value of billable hours. When a time entry has been recorded on a timesheet, a sale has been consummated with a willing purchaser of the service. The fact that this time is in “inventory” and not billed or collected is not important to the recognition of the revenue stream. Thus as an owner, my share of the net income is not the difference between cash receipts and expenses, but rather between the realizable value of the billable time of all the timekeepers in the firm, accounted for in the appropriate accounting period, less the expenses incurred to support and produce that billable time.
If you buy into this concept, then in reality on an annual basis, an owner actually receives a cash distribution or draw against his accrual basis earnings. The difference between the share of profits on an accrual basis and that on a cash basis, becomes his “equity” in the firm to be accumulated in an account, call it deferred compensation if you like, to be paid out on some basis as the owners agree upon the occurrence of some event, be it death, disability, retirement, etc.
Since accounts payable does not change much from year to year, the major difference between accrual basis net and cash basis net is the accumulation that occurs in the balances of work-in-process and accounts receivable. The accumulation of this difference over the lifetime of ownership in the firm, creates the pool of equity which was created while an owner, and for whatever reason or reasons, was not converted into cash and made available in cash distributions. This assumes that in most successful law firms, these balances generally increase from year to year as the number of timekeepers and value of time increases accordingly.
Now that I have really piqued your interest, you are probably wondering why there has been such opposition to developing such a plan when it makes such good logical and accounting sense. There are two major arguments against this type of payout system, neither of which can be logically supported, if you buy into the underlying methodology as noted earlier.
First of all is the argument that the amounts due are equivalent to some unfunded pension plan. A partner leaves the firm, and there is a perception that the amounts to be paid out over a 10, 15 or 20 year period is a liability which is not supported by any firm asset. This, of course, is not true. The total liability is supported by the pool of work-in-process and accounts receivable that has accumulated to the credit of the terminated partner. Thus, this argument is unfounded.
Secondly is the argument that the firm does not want to subject itself to long term payments to a terminated partner, thus depriving the current partners of their earned share of the firm’s profits. This argument is also unfounded, if you agree with the position stated earlier, that an owner’s profit share is not on current year’s cash receipts, but rather on current year’s billable time value, a share of which is not allocated to the terminated partner, but rather only to those that remain in proportion to their then income percentage interests. Law firms should not look to prior value to earn their income; rather, they should be concerned with that value that is generated during the current year, and how they can convert that to cash as quickly as possible to increase their earnings in that current year.
Does this same system apply to those firms who do not keep time records? The answer is yes with the deferred value represented not by work-in-process and accounts receivable, but rather by the expected value of future cases to be settled, less the costs to be incurred to settle those cases.
The mechanics of how this program is developed and administered is the subject of other articles of which there are many. If you want more information, please write to me at Iezzi Management Group, P. O. Box 1711, Richmond, VA 23218-1711 or email me at jgiezzi@iezzigroup.com. My website address is www.iezzigroup.com.
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