Are You Worth $5 Million?

The Wall Street Journal’s front page reported that litigator Jamie Wareham “will make about $5 million a year, a significant raise from his pay at Paul, Hastings, Janofsky & Walker LLP, where he has been one of the highest paid partners.”

This phenomenon – superstar lateral hiring – is nothing new, but in recent years it has become more common. For those who remember the 1980s, it’s vaguely reminiscent of the period when ill-fated Finley Kumble turned that strategy into a losing business model.

Of course, Finley failed for many reasons that may distinguish it from current trends. Still, those running that firm into extinction as they signed up marquee players who couldn’t carry their own economic weight probably wished they’d asked this question:

How can you determine whether a lawyer is worth $5 million?

Reserved for another day are the broader implications, including the challenges that significant lateral desertions and insertions at the top present to the very concept of firm partnership. This article focuses solely on underlying financial considerations associated with the superstar lateral hire.

Presumably, bringing in a big-name player makes economic sense for a firm operating under the prevailing business model, which means that at least one of the following conditions are met:

First, the proposed lateral has an independent book of business suitable for delivery to the new firm. That would be simple, but for the clients themselves. Even if they hired and regularly use a particular partner, they probably also like his or her package of assembled talent. Consequently, the lateral must bring along a team of capable junior lawyers. Alternatively, the new firm may have excess attorney inventory that it can deploy, but that requires the lateral to persuade clients to use new lawyers who can quickly and efficiently climb their learning curves.

Second, even absent a short-term economic justification, a firm could rationally conclude that anticipated events make the talent investment worthwhile for its future strategic positioning. Recent examples include firms that loaded up on bankruptcy attorneys when the economy was still strong. The crash of 2008 made them look like geniuses. More speculative are the “if you hire them, clients will come” bets that managers sometimes make. Former government employees, along with high-profile attorneys who lack a portable client following but are on everyone’s short-list of best lawyers, fall into this category.

For the first category, short-term value is simple arithmetic. According to the latest Am Law 100 report, Wareham’s old firm, Paul Hastings, had a 41% profit margin in 2009. If the “substantially less” than $5 million he’ll make at DLA Piper was — say, $4 million – he would have needed revenues of $10 million to earn his keep there, assuming no other equity partners claimed any part of that gross. At a total blended attorney rate for all attorneys on his client matters of $500/hour, that translates into 20,000 billable hours.

But at DLA Piper and its reportedly lower profit margin (26%), Wareham will have to produce almost $20 million to support a $5 million share of firm profits. At a blended hourly rate of $500, that means more than 40,000 hours. (If he is selling clients on a move with him on the promise of lower hourly rates, the billables requirement at DLA Piper would become even higher.)

If one of the 20 or so attorneys on Wareham’s team is another equity partner earning, say, $1 million, then the minimum break-even billables bogey moves proportionately higher. (Assuming a 26% profit ratio, it takes about $4 million gross — 8,000 hours at a blended rate of $500/hour — to net $1 million.)

Insofar as the lateral acquisition’s value relates to the second category – future payoff — big name players get a grace period. But at some point, the economic imperatives of the first category will surface. When that happens, they’ll feel the revenue and related billable hours heat even more than everyone else — except, of course, the attorneys working for them.

Such is the economically successful lateral hire outcome. Failure on a sufficiently large scale produces Finley Kumble.

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14 thoughts on “Are You Worth $5 Million?

  1. As always, Steve, an absolutely outstanding piece and with arithmetic included.

    As a survivor of Finley Kumble, I bear first hand witness to the wisdom and accuracy of your post. Among the smartest lawyers I ever met were those who declined outlandishly lucrative partnership offers from Finley Kumble twenty-five years ago and, more recently, from Marc Dreier. While Steve Kumble was the firm’s recruiter, I regularly worked with him in processing new candidates. It was and still remains remarkable to me that virtually no offerree ever asked “how can you afford to pay me that?” Indeed even to this day, potential lateral partners rarely, if ever raise that question or even conduct the most elementary due diligence before joining a new firm, unless prodded to do so by an experienced adviser. http://kowalskiandassociatesblog.com/2011/01/27/going-lateral-the-essential-guide-for-a-law-firm-partner-seeking-to-make-a-lateral-move/

    The Finley Kumble credo was grow, open branch offices, recruit other law firm’s big business producers by offering them substantially more money than anybody else and expect to get the highest margin work from the wealthiest clients around. The credo was simply grow for growth’s sake and wow the world with the astronomical profits paid to its partners. That isn’t a strategy nor is it a plan, it’s been proven too often to be a metastasizing carcinoma.

    Interestingly enough, the long time chairman of Paul Hastings, Seth Zachary, is a former Finley Kumble partner. He and I (as did most — but not all — of our former partners) left that war torn landscape with a deeper understanding of what is required to build a strong viable and enduring law firm. Seth led Paul Hastings careful and deliberate growth over the past twenty years to a top tier extremely profitable, as you note, with a well articulated plan which he followed assiduously. Seth doubled the size of the firm and quadrupled the profits per partner and took the time and care needed to do so.

    Howrey will be the 39th AmLaw 200 law firm to fail since Finley Kumble. An irony of the significant number of large law firm failures is that many of these law firms include partners who previously were partners at large law firms that also failed. Included in Howrey’s ranks, are a large wad of Thelen partners. The financial and reputational pain of being a survivor are enormous and catastrophic (http://kowalskiandassociatesblog.com/2011/02/03/the-financial-and-legal-consequences-of-a-law-firm-dissolution-on-the-partners-of-the-defunct-firm/ ). A double whammy is almost unimaginable.

    There are no government bailouts for failing law firms. And there are no law firms too big to fail: at the time of its demise, Finley Kumble was the second largest law firm in the world.

    DLA has certainly created a mighty behemoth and it boasts of some absolutely outstanding lawyers. Mr. Wareham enjoys an outstanding reputation, no doubt richly deserved. I have some degree of confidence that having been Seth Zachary’s partner, Mr. Wareham had the intelligence to ask that question: How can you afford to pay me that? And, I trust that he received a satisfactory response.

    Jerry Kowalski

  2. As always, cogent analysis.

    (I have no statistically valid data to support what I’m about to say here, only my conclusions based on serving as sales coach to thousands of partners in firms of very description over almost 20 years.)

    The big lie in most lateral recruitment is that the lateral will be able to bring that putative $10 million book with him. My observation is that few manage to transfer more than half of what they had at the previous firm.

    The reasons you cite cover a lot of it, but laterals and those who recruit them also ignore that the previous firm is going to go all out to keep that client. The lateral is not used to having such a motivated, well-informed competitor who, like him, has the luxury of operating from inside the client, with largely unfettered sales access to the stakeholders who will decide the fate of any such proposed transfer. The incumbent firm also has the advantage of inertia.

    It may be true that clients hire lawyers, not firms, but that’s a brand value that only influences the marketing/sales end of the spectrum. Once hired, that value diminishes at a rate commensurate with the degree of service-delivery collaboration between the two organizations. Post-purchase, the client value proposition shifts entirely to the firm’s fulfillment capability, which determines the quality of communication and service delivery that’s critical to client satisfaction.

    There are meaningful switching costs that have to do with corporate risk. Yes, your clients have become pals, they like doing business with you, etc. But will they expose themselves to internal criticism if your move turns out to degrade what they’re used to, if only temporarily? Not as much as you’d think. Your clients like you, but not that much.

    Years ago, when Bank of America purchased NationsBank, a West Coast attorney with a $600k IP relationship with NB, preparing for a visit from BA’s GC, was understandably anxious that the acquiring bank would switch the work to an incumbent BA law firm. During our discussion, something made him mention that they BA’s files occupied about 300 linear feet of cabinets. I told him to make sure the GC walked past those and knew what they were. While it’s not much of a physical task to transfer those files, psychologically they communicated, “We’re pretty embedded here. Are we sure we want to uproot everything? Are we sure it’s as consequence-free as the (self-interested) person who’s urging us to do so assures us?”

    Corporate America embraces the if-it-ain’t-broke-don’t-fit-it mentality. “We know our operating relationship with your current firm works smoothly. The only reassurance that the new, untested one will work equally smoothly is your say-so, and you don’t even work there yet.”

    Laterals also don’t know how many enemies they have within the client, who will spot an opportunity in the uncertainty.

    The bottom line: Unless the lateral has discussed the impending move with each client on his list, and gotten an explicit commitment to sustain billings at a specific level, the recruiting firm is making a big bet on assurances without foundation. It’s not important that the lateral secure commitments for 100% of the current portfolio; that may not be possible. But he or she — and the firm recruiting them — absolutely must have a reliable number.

    If you can’t or won’t verify the book, make laterals’ compensation a “make-good” contingency that correlates directly with actual billings realized from specific clients. “OK, Joe, you claim to have $10 million in transferrable business from these six named clients. After a three-month grace period to effect the transition, we’ll measure your average run-rate each month, and each quarter we’ll adjust your comp up or down by the % of variance from your projections.”

    This business is either transferrable or it isn’t. If it is, he has nothing to worry about. If it isn’t, or he doesn’t know, he’ll balk; an alarm should go off in your head. Now is the time for the receiving firm to clarify this. (This is also a conversation that headhunters should have with candidates.)

    If laterals want to be paid like commission salespeople, i.e., with huge upside, great. But, let them also accept the downside risk that commission salespeople bear.

  3. Responding to Mike’s observations, it is certainly almost always true that the real acid test of a lateral’s bona fides is his or her willingness to take some degree of the risk. It is equally true that there is always some tug and tension with regard to how much business the lateral will actually produce, particularly in the current market. Often, some law firms perform bear hugs on clients in order to keep as much of the business as possible as a partner seeks to check out. And, at the same time, there are often other surprises in the other direction: A departing partner frequently takes along clients for which he or she did not get “origination credit,” but for which he or she has done a great deal of work, particularly in the lateral’s practice area. This market poses additional risks and uncertainties (http://kowalskiandassociatesblog.com/2011/01/02/the-lateral-market-for-law-firm-partners-in-2011/ ).

    While it is of course essential to have a lateral discuss an impending move with each client, no client will provide an assurance that it will send along a fixed amount of business. There is never a conversation in which a client says in words or substance “Sure, Jane, we’ll be sure to continue to send you at least $500,000 worth of litigation business each year.”

    The fact is that DLA’s business model apparently includes paying a premium for a marquis name, as they did, for example, several years ago in recruiting Roger Meltzer from Cahill, with much fanfare. Does it work long term? As Yogi Berra said, “the future’s hard to predict because it hasn’t happened yet.” But the uncertainty of the future can be tempered with adequate due diligence (http://kowalskiandassociatesblog.com/2011/01/05/essential-due-diligence-in-lateral-law-firm-partner-movement/

    Jerry Kowalski

  4. I’m not an accountant, nor am I familiar with typical partnership compensation schemes at this level. Is it typical for a $5M partner to get some sort of guaranteed draw, and if so, would that figure into the profit margin calculations? Put another way, are such partners *only* compensated from gross profits, or does some of their compensation figure into operating costs?

    If, for example, a guaranteed $1M was built into the profit margin, that would change the math a little. But I could use some enlightenment.

    • Jerry Kowalski — a regular blog reader and commentator — can better address the guarantee question. To be sure, the accounting would be different for initial guarantees that are built into firm overhead. But I think the bottom line is that, at some point — for partners who get guarantees — the lateral who fails to carry his economic weight in the traditional sense becomes problematic. Guarantees mean that everyone else is carrying the lateral until he or she does.

  5. I rise to the challenge:

    Ordinarily, partner draws are advances against profit distributions. Guaranteed payments are those made by a partnership to a partner which are determined without regard to the partnership’s income. At the end of a partnership’s fiscal year, the partnership closes its books and calculates its profits and losses, with profits distributed in accordance with each partner’s respective rights to profits under the firm’s partnership agreement. When the partnership makes its year end profit distributions, all draws, guaranteed or or not, and previous profit ditributions made on account (usually quarterly) are debited against the final distribution. In other words, if a particular partner receives $1,000,000 in guaranteed draws and an additional total of $1,000,000 in quarterly profit distributions, and that partner is entitled to receive a total profit distribution of $5,000,000, the final distribution is $3,000,000.

    A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses only.

    For other tax purposes, guaranteed payments are treated as a partner’s distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.

    However, should the partnership wind up in a bankruptcy, such guaranteed draws are ordinarily subject to clawbacks.

    Jerry Kowalski

  6. Jerry: I agree that a client won’t guarantee the future business in the sense of creating an enforceable obligation, but it’s not a stretch to envision a conversation with a very good client, in which the soon-to-move lateral explains his plans and concludes with something like this: “For the past __ years, we’ve averaged $___ million/yr in [practice], [practice] and [practice]. I want to represent myself fairly to my new partners. Taking into consideration all factors, some of which I realize are none of my business, how accurate would I be if I projected a similar economic relationship with your company going forward at my new firm?”

    This allows the client to factor in not only his comfort with the new firm re: certain categories of work, or his opinion of how well the lawyer is likely to organize the transition, but also things that have nothing to do with the two law firms, e.g., diminution of activity/demand, restructuring, planned expansion of in-house capability, offshoring, etc.

    He needn’t reveal particulars, but could still give a reality check to his trusted advisor: “Without going into particulars that I can’t share, we have some changes afoot. I think you’d be prudent to be a lot more conservative in your projections, say, maybe 70% of what we’ve done together in the past.”

    There will be plenty of opportunities for the lateral to drill down into that post-move, but for the moment, he’s armed with a far more reliable projection than he may have assumed before this revealing discussion.

  7. Isn’t it the rare case that a company can reliably predict doing a certain amount of business with specific attorneys/firms? when I’ve used outside counsel, except in routine matters or for specific litigations where we have a multi-year plan and budget, it is often impossible to predict over multiple years what sort of litigation and transactions might be on the horizon for the company, and w/o that knowledge promising any attorney that a specified level of business will continue into the future, even w/o the change in firm, seems fraught.

    Yet it is just such non-routine litigation or transactional work that generates the really big fees that might justify paying a lateral hire such a high guarantee. The lawyer who litigates the bet the company case for client x is that much more likely to be retained by client y for its bet the company case, even if after client x wins the case it never needs to contact the star litigator again.

    Ditto the corporate or bank finance lawyer who helps the client through a period of potential insolvency and negotiates a new revolving credit facility on client x’s behalf, or represents the company in a transformational acquisition or sale.

    • Yes and no. Some partners rely heavily on a stable of clients who provide a steady revenue stream. The particular matters vary, but their predictable need for outside attorneys doesn’t. Personal relationships between in-house counsel and their favored outside attorneys often govern retention decisions. That’s why many headhunters who contacted me while I was practicing focused on my “portable business.” But you are correct; that approach is perilous for the potential partner and his new firm. There’s much that can slip between the cup and the lip when testing the portability proposition in a real world lateral move. As for the non-routine work, you’re describing a second category — the “if you hire them, clients will come” attorney. The problem for them and their firms arises when the clients and their big matters don’t arrive as hoped or promised. That can lead to the Finley Kumble problem.

  8. A brilliant blog that often speaks my mind and my experience both as a consumer and provider of legal services.

    A question. In a recent post you write “the challenges that significant lateral desertions and insertions at the top present to the very concept of firm partnership” will be the subject of another post. Have you written that post, and if so, where?

    I am particularly interested in your thoughts on what partnerships in the profession have come to mean. (In large part because, as a consumer who follows the old adage of hiring the lawyer and not the firm, I am getting lost as to the value of not just big firms, but all firms.) And last, whether the issues you describe are solely the affliction of “big law”.

    • Thanks. The answer to your first question is yes. Take a look at my series, “Howrey’s Lessons” — Part I, Part II, and A National Conversation.
      As to your second question — what partnerships in the profession have come to mean — you might want to take a look at my novel, The Partnership. (http://www.amazon.com/Partnership-Novel-Steven-J-Harper/dp/0984369104). While you’re waiting for it to arrive (unless you download as an e-book for $0.99), you can click on the “Biglaw Trends?” category on the right margin of The Belly of the Beast main page.
      As for your final question, not all of the current trends and resulting difficulties are unique to big law — or even to the legal profession. But the prevailing large firm business model encourages behavior that results in a culture that exacerbates most of the problems.

  9. Klarinette:
    If you’re interested in trends, you’ll want to take a look at a scenario-planning exercise released by Alman-Weil in 2009, titled, “The Legal Transformation Study: Your 20/20 Vision of the Future.”

    It presents four plausible scenarios, each based on different assumptions, one of which is “Expertopia,” i.e., where individual lawyers create personal mega-brands, based on expertise, that transcend firms.

    The other three scenarios are “Mega-mania,” which is large-scale consolidation; the “E-Marketplace,” characterized by commoditization and cheap decision tools; and “Techno-Law” in which many services are automated.

    One particularly interesting outcome is the “likelihood of occurrence” poll they conducted among a couple of thousand law-biz stakeholders of various types, who were asked to choose which scenario they found most likely. The result was a spread of 23%-27%, i.e., all four scenarios were considered equally likely, despite their being so completely different and based on very different drivers.

  10. Stephen,
    I wish I’d known your novel was available for a buck as an e-book before I paid Amazon $10 for the Kindle edition. Nonetheless, it was a good read, kind of like a BigLaw version of Grisham.

    • You bought it at the lowest price then available. The Kindle version (which is what I meant by e-book) was $9.99 for the first year of its release. Only last week did it drop to $0.99. You wouldn’t have wanted to wait all year for the pleasure of reading it, right?

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