The Partnership Structure Rule

Part of the lpc series The New Economic Rules

Partnerships. If a method of creating relationships between lawyers, accountants and the like was being constructed, to paraphrase the usual bon mot, it would not start from here. Partnerships work reasonably well for doctors, dentists and the like but for more commercial groupings there are a number of endemic problems.

Surely no one would seriously make often complex arrangements on the basis of partnership however comprehensive the actual agreements. It is a concept rather unsuited to today's world; nevertheless it seems that its few virtues and many problems will remain for some time.

Good times tend to iron out the creases in running partnerships. Bad times often result in the reverse.

Of course there are many different types of partnerships and generally the more partners a practice has, the more complex the arrangements become.

In a sensibly structured business there is a separation between ownership, management and service provision. In a limited company the fact that someone is a shareholder in a business does not automatically infer upon them some enhanced status. An individual may work for a company for which he or she receives a salary. If that individual does a particularly good job, he or she may receive a bonus. In addition the company may pay a dividend on its shares and shareholders will receive that dividend according to the number of shares which they own. Normally in a private company there are restrictions on selling shares other than to existing shareholders and indeed a shareholders agreement may make that mandatory on certain valuation rules.

Even though many partnerships attempt to recreate some aspects of a limited company many (most?) fail. For some reason the refrain "but I am an equity partner" seems to mean that sense and practicality are defenestrated.

To make matters worse lawyers often don't take a close enough interest in the detail of their partnership accounts; their focus is simply on the bottom line invariably exacerbating the issues. Quite often the average partner does not understand the accounts of the practice and particularly the importance of the balance sheet.

These issues of ownership, control, return and contribution (a grouping which can be called the "Core Elements") become thoroughly confused. In what other business structure does this happen? Or where a partner with no effective shareholding bears the same potential liability as someone who holds 100% of the effective value.

To successfully deal with harder times and to maximise the return from the business, it is essential to clarify the Core Elements. Some partners cling to the romantic notion of "one for all and all for one" but with the exception of liability this is a chimera. Many will retort that they have entirely satisfactory partnership relationships even though the Core Elements are not properly separated. Such satisfaction is illusory; it disguises the fact that such a business arrangement is not efficient or sufficiently challenging to the business. As stated elsewhere, in times of plenty such structural weaknesses may be more easily tolerated but in fallow times they can be ruinous.

This philosophy is not some ode to unrestrained commercialism or competition amongst individuals. A collegiate atmosphere amongst partners is something to be cherished and valued. But partners must at the same time understand and acknowledge the degree to which commercial principles are not applied. That understanding enables a calculation of the consequential costs to them and their firm. Failure to recognise this cost will ultimately sow the seeds of dissension or worse. Not everybody can be a superstar and a partnership may want to attribute the same level of profits to all equity partners even weaker ones. But unless this position is openly discussed and agreed upon then it will ultimately be to the detriment of the firm; either pressures will become intolerable or the firm will fail to maximise its return. The well being of the business is at stake.

This whole discussion is made more difficult because legal practices are very poor at costing their time realistically. To properly understand their firm those sharing profits have to perform a schizophrenic act separating the working part of their lives from the ownership part. The impact of this does vary according to the size of the firm but generally speaking the principle is universal. In larger practices equity partners often justify their existence by the time they spend on all sorts of activities, some of rather arguable value such as various committees which often arise from the failure to adopt a decisive management structure. Or some client events or activities that don't attract value to the business. In such larger business there can be partners who "hide" where the normal expectations of return, effort and ability are not met simply because the individual's belief that, as an equity partner, he or she is somehow beyond full and proper accountability.

At the other end of the scale there is the opposite problem with the partners in, say, a two partner firm simultaneously both over-trading (fearing from where the next work is coming) and failing to allow for time to both administer and invest in the business. As harder times weigh their response is often to offload assistance and reduce their leverage in an oft misguided attempt to maintain their income when inevitably a structural change is needed.

There is a need to honestly account for the time expended by the owners of the business. This is nothing to do with time recording though that may be a tool. The crux here is properly assessing the time and output value of the partners; this has to be distinguished from measuring their time spent at work. Partners need to be truthful with each other in discussing these issues in a rational way - a skill at which they are miserably poor. Problematically this shortcoming is often at its most extreme when telling the truth to themselves.

So what are the practical solutions?

Unfortunately there is no "magic" formula. The calculations underlying these Core Elements are not strictly accounting or time recording ones; one problem is how to deal with inconsistent performance and historical achievements. So typically a partner may feel he or she can rely on past glories or a particular relationship with a valued client.

For the benefit of the business there needs to be transparency in these valuations and calculations. Too often current methods are based on cosy relationships, politicking and woeful or non-existent management accounts.

The difficulty is invariably moving from the status quo to new arrangements. It is difficult not to ruffle feathers. To bruise egos. Such arrangements are much easier when there is a degree of moderation involved ideally external to the equity partners. Without resorting to psycho-babble such changes need to have a spiritual as well as commercial element. The moderator must have the respect of the partners and sufficient experience to be able to distinguish skills, abilities and contribution that do not fall within the obvious classifications of fee-earning work or rain-making.

lpc are experienced in such matters and can provide both the motivation for, and moderation to, the necessary change. There are many different levels of involvement ranging from simple consultancy on options, through a "partnership audit" to suggesting and moderating change. There is, of course, expense involved in such involvement but typically it will be a tiny figure when considered against the cost of continued failure by the partnership to address its structural issues.