Rewards for the modern law firm

The introduction of ABSs looks set to change ways in which talented lawyers in many firms are rewarded, as Andrew Cromby rightly points out (‘No pot at the end of the rainbow’: Solicitors Journal, 5 March 2013). Investors’ requirements to obtain a financial return will undoubtedly leave less in the pot to reward the lawyers. But it is not all doom and gloom.

Any business, ABSs included, will ?need to reward those who create its wealth. A firm that is heavily reliant on highly-skilled lawyers will need to reward them ?at a sufficient level to secure their commitment and energy. The position is similar with firms providing more commoditised services, except that the key people may comprise fewer lawyers and more managers and technologists. Without adequate and market reward, talent will leave, and the firm’s revenues – and value – will quickly diminish.

Many ABSs, perhaps most or even all, ?will want their reward arrangements to be ?at least partly performance linked. They may therefore want to identify a reward linked to performance for all those who make a strategic contribution to long-term success, not just their senior lawyers but also, for example, the chief executive and other senior management team members. Some may want to go further and include ?all or most employees in performance-?linked reward.

Capital growth

How can an ABS with external ownership achieve the necessary balance between delivering a financial return to investors and ensuring that its people are motivated to deliver the performance that it is seeking?

An obvious starting point is to think about a cash-based bonus, linked to individual, team or firm-wide performance. A firm that wishes to build a culture of team working may not favour individual targets. It can be complex and time consuming to assess whether they have been achieved, so business unit or whole firm performance may be a better measure. It is also important to think about the performance period. If the firm is investing in long-term growth, with no boost to shorter term profits anticipated, any performance-based reward should focus on performance over a period of years, rather than looking to the next year-end.

While an employee would receive any bonus as part of their taxable salary, a partner or limited liability partnership (LLP) member would be taxed under self-assessment. Where the ABS was a company, profits could be paid as dividends to those key people who were also shareholders.

The investors in at least one ABS have announced their intention to create capital growth for its owners, in other words the ability to sell their stake in the business for more than they paid for it. This is not traditionally what law firm ownership has meant: partners may have been required to “buy” their way in by investing some capital, but when they have retired they have simply got their capital back, perhaps earning some interest on it along the way. Where capital growth in a professional services firm is possible, those involved in the firm’s ownership have the prospect of making a long-term capital gain, which under current rules will be taxed at significantly lower rates than any cash reward.

Legal structure

The degree to which capital growth is realistic will depend on the type of firm and its business. A firm which remains largely reliant on the talents and reputations of individual lawyers working independently may find it hard to create a capital value having a life beyond their continued presence in the firm. However, a firm that was genuinely successful in building a collegiate and team-based culture may find that the value of the whole became greater than that of the sum of its parts. A firm ?that invested in technology to deliver ?more commoditised legal services or successfully built a strong brand might enjoy the same benefit.

On this basis, we may see a growing number of firms intending to deliver capital growth to their owners, so that at first sight at least this will be a realistic goal. However, that is not quite the full picture, since there will also have to be a workable way for owners to realise the value they have built up. Under the conventional ‘Anglo-Saxon’ private equity model, equity investors will habitually expect to sell the business they have invested in within approximately five years, or in some cases to float its shares on a stock exchange. However, an outright sale will be likely to terminate key people’s ownership, risking a flight of talent, and flotation will only be a solution in a minority of cases. Firms wishing to enable their key people to share in the capital ownership may therefore need to plan for internal sales, which may mean the firm should reserve part of its profits to fund buy backs.

How a person working in an ABS becomes involved in its capital ownership will depend on the legal structure of the ABS. Traditional partnership is unlikely to be an attractive model for most ABSs seeking external ownership, especially where this is to be combined with extending ownership to relatively large numbers of individuals working in the business, as they are likely to be resistant to taking on personal liability.

Using an LLP structure might address this concern, but if it involves trading employment status for LLP membership it may still be unattractive.

An ABS operated by a limited company may be able to take advantage of tax incentives which are aimed to encourage employee share ownership.

For a company wishing selected key people to become owners, it could consider granting them approved Company Share Option Plan (CSOP) options. Participants enjoy the right to acquire shares from a future date at today’s value. If they leave before that future date has arrived, they would lose the right, potentially creating an incentive to stay if share value rises after the option grant, and a reward once they are able to sell their shares.

For a company wishing to make all its employees shareholders, the Share Incentive Plan (SIP) enables employees to buy or be given shares, in each case with tax relief. Any subsequent growth in share value is exempt from CGT.

An opportunity?

If ABS encourages providers of legal services to step back and think deeply about reward and ownership, one result may be that this becomes better aligned to the firm’s long-term business goals. If it helps with their achievement, a better-performing business should result.

Less rigid forms of ownership may result allowing a wider range of talented people to become owners, unlocking hitherto unrealised potential.

Although external investors will take their share of the resulting rewards, there will be a bigger slice of the cake available to be shared with those creating the firm’s success. The world may be changing but there will continue to be opportunities, both for talented lawyers and other key people.