Monday, November 06, 2006

Apathy Abounds, Until The Walls Come Tumbling Down

I was inspired to write this blog after an interesting discussion with Jim Belshaw and other attorneys regarding the lack of succession planning at medium and large firms. We have all seen the walls come tumbling down at many large firms when certain partners (in the undiversified portfolio) leave, retire, or die. In this blog I offer a unique perspective on why this is happening and why good succession planning is not likely to occur in the near future at the large firms: APATHY!

If you think about it, being a partner in (and therefore owning a piece of) a law firm is like owning 100 shares on Intel Corp. stock. You own just enough to want it to go up in value, not enough to make a contribution to its success, and if the management is doing a poor job you are more likely to just sell your shares and buy something else then fly across the country to its annual meeting hoping to have a loud enough voice to make a difference. It is a crisis of apathy. You see, partnerships lack the checks and balances that exist in a regular corporation to ensure the long-term health of the organization. . . there is no oversight body (such as a board of directors) making sure that the partners are not acting in self-interest (taking out all of the profit for themselves leaving little or no working capital and putting the longevity of the organization at risk). What's worse, partnerships, by definition, incent the partners to take everything out and put it in their pockets, leaving little or nothing to continue running the business. It is no wonder that succession planning does is nearly non-existent at the big firms. Here is why our profession does not invest in the next generation and why it is unlikely that they will anytime soon:

1) Lacking Majority Owners: Unlike a corporation, there is no "majority shareholder(s)" who has a vested interest in maintaining the long-term health of the organization (through capital appreciation of the shares). Imagine if Intel Corp (how many billions of shares do they have?) were run by a million shareholders each owning only 100 shares? Not one person has a loud enough voice to make a difference. What's worse, NOBODY owns enough to be held accountable for poor management or poor results!!!!!!

2) No Outside Shareholders: In a normal company, there are manager shareholders and there are shareholders and stakeholders on the outside of the company. The outside shareholders work through the board of directors to hold management accountable for maximizing the return on investment to the shareholders of the company. In a law firm, all of the shareholders are partners (employees), so there is nobody outside of the firm keeping partners from acting in complete and utter self-interest with regard to the distribution of profits.

3) Buyback Rights Incent Short-Term View: Since law firms compel the buyback of shares when a partner leaves the firm, (thus, all shareholders work at the firm) there is simply no incentive to invest in the future of an organization that you are "prevented" from investing in long-term. Since you are not able to leave the firm (by quitting or being asked to leave) and maintain an interest in the firm, to invest your money into the firm is a "gamble." Under these circumstances, why wouldn't partners take all of their money out now rather than give the money away to the partners who will be there in the future?

4) The Corruption Trifecta: Owning 100 shares of Intel does not guarantee you a cash flow stream unless they declare a dividend. Even so, the cash flow stream is not locked to ownership percentage. What's more, owning 50,000 shares cannot buy you a position on the management team. Why do you care? Well, if you are an owner of a regular company you are happy that the board of directors is looking out for your interest and selecting the right people with the right skills regardless of who owns how many shares. In fact, they find the "right" people for the job first and then align their interest with the company by giving them shares rather than what law firms do (putting the richest partners in power by virtue of their ownership and regardless of their ability to manage a business . . . . most lawyers don't know how to manage people, let alone a whole business). The "Bundling' of rights of ownership, cash flow, and power is a Corruption Trifecta!! If you look at the incentives created here (with no accountability to anyone and no oversight) then it is blatantly clear who self-interest prevails at the partnership level of most large firms.

5) Tax Treatment Discourages Reinvestment: Don't just blame the partners. . . blame uncle Sam! Partnerships discourage long-term investment and longevity by design. Partnerships are technically designed to dissolve when a partner leaves - the incentives are BACKWARDS from a normal company with regard to business longevity. We may have to do some math here, so be patient.

Let's compare the corporation to the Partnership.

Corporation: Here, profits are taxed at the corporate level FIRST. Then, management decides how much money it wants to reinvest in growth of the enterprise and how much it wants to pay in a dividend (profit sharing). Whatever is paid out gets taxed at the individual shareholder level. Here is the psychology behind this if you can follow: FIRST, the profit belongs to the COMPANY. LASTLY, a decision is made on how much to give to shareholders. (** Note that there is no individual tax liability for owners who do not receive a dividend)

Partnership: In a partnership the opposite is true. Profits of a partnership are treated by the IRS AS IF they are paid out to all partners in proportion to their ownership share of the partnership and taxed at their individual tax rate. So, each partner has tax liability on every dollar of profit whether or not it is reinvested (each at different individual tax rates). Here, the psychology is the opposite: FIRST, it is the Partners' money, LASTLY, the partners would have to choose to part with their post-tax earnings to reinvest in their firm. Will that happen? With professional satisfaction at all time lows, partners selling their books from firm to firm, and a trust-free environment, I think not.

6) LOW RETURNS: Seriously, I can get a better return in my savings account. With a billing model that discourages innovation and efficiency, the legal industry is one of the most stayed and stagnant industries in the global economy. Law firms don't invest in themselves, why should anyone invest in them? Most people want to put their money somewhere they can watch it grow. . . . if you invest in your firm, you are more likely to die watching than you are to see it grow. This is a sad reality that I hope we can change.

Fortunately, we are beginning to see innovative models popping up (like Exemplar) in the marketplace that are adopting more corporate-like structures that put the incentives in the right place. Over time, we hope to create an ideal environment for our people, investors, customers, and our stakeholders!

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