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Selecting the best partner compensation method; pay should be structured to achieve a firm's goals.

The issue of how partners should be compensated--and for what services or efforts--can cause contention at CPA firms. Disagreement frequently erupts along these lines:

FOUNDING PARTNER: "I started this firm with one $200 client and worked very hard--and starved--for years to build it. If not for that, the younger partners wouldn't even have a job here. And the reputation I have built brings in most of the clients. So I should always get the highest partner compensation."

NEW PARTNER: "I acknowledge your efforts and sacrifices to start and build the firm. But you did that for yourself, not for me. And you've already been handsomely compensated for it. At a time when your children are educated and gone, you've been drawing a lot of money for several years. Yet you're not putting in the hours that I do, nor are you technically proficient. Without me, you'd be in big trouble.

"As far as new business is concerned, the firm's reputation alone is not what's bringing it in. That helps, but it takes the rest of us out there hustling to convert reputation into clients. Why should you take home that much money when I am doing a lot of the work and have children to support?"

THIRD PARTNER: "This is ridiculous. You're both partly right, but we're not going to resolve anything this way. Most of what you're referring to is subjective. There must be an objective, systematic way to set partner compensation."

There is, but it isn't for everyone. Before examining the available methods, objective and subjective, it's important that firm members acknowledge the purpose of partner compensation: to keep the firm together, strong and growing.

GOALS TO ACHIEVE

Partner compensation must encourage and reward behavior that contributes to firm growth. Factors frequently used in compensation decisions include

* Chargeable and collectible time.

* Client load managed.

* New clients brought to the firm.

* Community visibility.

* Professional or association involvement.

* Technical expertise.

* Invested capital.

* Equity.

* Years as an owner.

* Firm management responsibilities.

* Firm and personnel administration assignments.

In addition, a firm's compensation method must be perceived as fair and adequate. A partner earning $250,000 won't see the method as fair if a partner perceived as less deserving earns $270,000. And a partner not earning enough to live on won't see it as adequate regardless of fairness. Although it's probably impossible to be 100% fair every year, firms should aim for relative fairness for all partners within a three-year period.

Compensation methods are based on varying ideas of what is fair and worthwhile. Choosing the best method is important to a firm's success, but it's perfectly acceptable for a firm to change its system as necessary. In most firms, new partner buy-in requirements and retirement benefits are an inherent part of compensation, so all these should be considered together.

COMMONLY USED METHODS

All partners equal. Sometimes referred to as the APE method, this assumes the value of all partners' contributions are equal. Its main advantage is that it's quick and easy. It's used primarily in small firms and when several sole practitioners are merging practices. The big disadvantage is that, realistically, not all partners contribute equally, or at least not for any length of time. Thus it leads to strain and conflict and can discourage needed contributions to firm success and prosperity.

Arbitrary. This can be any of several methods, but a common one is the variation known as historical accident. If the second partner was brought in at a compensation level $15,000 below the founder, and the third partner earned $10,000 below the second, these differentials are maintained as all increase their compensation.

This arrangement is simple but bears no relation to contribution other than a correlation with years as a partner. As time goes by, it tends to cause more strain.

Another version in this category is called the King. Here a key figure (the managing partner, regional partner or office partner in charge) makes the choice of compensation for all partners.

Objective formula. This method ties compensation to an objective measure or set of them. The only subjective elements are what is to be rewarded and how.

Formulas typically reward three or more of the following:

* Collected charge time (at 40% to 50% of the collected charge time).

* New clients (7 1/2%).

* Client load managed (7 1/2%).

* Years as a partner (on a points-per-year basis).

* Interest on tangible capital.

* Return on equity. (Allocation of equity is another subjective element.)

The automatic and objective nature of this method (it requires no annual evaluation of partner performance) is its advantage. Disadvantages include the lack of reward for necessary chores such as firm management, administration, transferring clients, training, delegation, performance evaluation, recruiting, etc. Some firms address this problem by paying for approved (and limited) management and administrative hours. Others use arbitrary payments, such as giving the managing partner an additional $15,000 and the personnel partner another $10,000.

Some firms use discretionary pools and special rules to smooth out this method. For example, one small firm caps its highest compensated partner at two times the lowest, distributing the excess to all partners on the basis of charge hours and tenure as a partner.

Compensation-by-objectives. This method is the most flexible of all, since it is tailored not only to individuals but to the firm's needs for the coming year. It thus encourages each partner to use his or her time in ways the firm views as most beneficial and sets up accountability for partner time. On the downside, it is a complex method and uses up a significant amount of partner time.

This method works in steps:

1. The managing partner or executive committee describes the firm's needs for the coming year (charge hours, growth, profit, training, new offices, etc.).

2. Each partner submits a proposed budget for the coming year describing how he or she will spend time and what will be achieved.

3. The managing partner or executive committee totals these to see if they meet the firm's needs. If not, the budgets are then revised.

4. The managing partner or executive committee (or all partners) assigns a numerical weight (points) to each partner's total budget and to each part of that budget (charge hours, new business, administrative duties, etc.). This weight is a partly subjective evaluation of that activity's contribution to the firm.

5. Partners are allowed to alter their proposed budgets after initial point values are assigned. (In which case all point values are reassigned using the new budgets.)

6. The system then only needs to measure the necessary factors (and include ways to change budgets during the year, if necessary).

Points earned are based on the realization of objectives; a partner getting 1,300 charge hours against an objective of 1,400 would get 13/14, or 93% of the points previously allocated to those charge hours.

7. Each partner's end-of-year compensation is determined by dividing his or her points earned by the total of all partner points earned and multiplying this fraction by the dollar pool available for distribution. Exhibit 1 on page 43 illustrates how this method worked in one two-partner firm.

Component part. This resembles compensation-by-objectives but has more subjective content and is not tailored to individuals. At the beginning of the year, someone (all partners working as a group, the executive committee or managing partner) allocates the firm's projected profit before partner compensation among all the activities the firm wishes to reward, in proportion to perceived value. One firm's list of activities for last year is shown in exhibit 2 on page 44.

Obviously, some activities and their percentages are highly subjective. These tend to be clustered in the lower-percentage items. The allocations in exhibit 2 are the firm's opinion of what's important in the coming year. Circumstances might, for example, greatly increase the percentage allocated to firm management or practice development.

[TABULAR DATA OMITTED]

At yearend, each activity is assigned a dollar amount equal to its percentage times the profit to be distributed. This is allocated among partners in proportion to their perceived contributions to that activity during the year. Again, some of these allocations will be subjective. And other firms might add or subtract activities to fit their individual situations.

Paper slip. A democratic and subjective approach, this method gives all partners an equal voice in setting each others' compensation. Partners describe on a piece of paper how they believe compensation should be allocated among themselves (using 100 percentage points if dollars aren't known). The opinions are then averaged to get the final allocation. This approach usually works best when used in firms that have between 3 and 10 partners.

Besides being simple, this method is usually perceived as fair. Potential disadvantages include the fact that partners may not be fully aware of what each other has accomplished and may use different weighting on the various criteria. This method also is open to grudge or hero votes that may reflect personalities rather than performance. If the number of partners is high enough, this latter problem sometimes can be solved by discarding the highest and lowest votes for each partner.

The information problem can be addressed with objective reviews of each partner's performance, sometimes augmented by partner reports on their own work. Criteria selection is more difficult, but some firms say it isn't a problem because partners should use their own criteria in voting. Those who think otherwise have a discussion of criteria before voting, which may

[TABULAR DATA OMITTED]

include each partner's contribution and how it will be evaluated. In one firm, performance and its value are discussed in the partner's absence. (None of these devices guarantees partners will use information and criteria the same way when they vote.)

Combinations. Many firms use combinations of the above methods. With a variety available, a firm can tailor a system to fit its needs, allocating a compensation pool to reward what's required each year. This usually is done by creating compensation tiers with defined dollars or percentages in each.

One of the most common methods is to give each partner a salary or draw based on that partner's market value (perceived earnings in industry). Other tiers might then reflect return on capital and current-year performance.

TIPS FOR ANY SYSTEM

If subjectivity must enter compensation decisions, as many clai, it's best if subjective evaluations are confined to defined areas with preset weights or priorities. In other words, a decision on partner A's contribution to firm administration, added to other limited-scope decisions on partner A, will result in a better decision on A's compensation than one based simply on a perception of A's overall contribution to the firm. A series of evaluations on different aspects of a partner's contribution can yield a better overall decision than trying to make one judgment of their performance.

When an existing method no longer works, change can be managed to be least disruptive to the firm. The partners might decide, for example, that the system will not allow any partner's compensation to drop by more than 2 1/2% or 5% in one year, except under exceptional circumstances. This can make necessary adjustments more acceptable.

Finally, firms should remember that nowhere is it written that the managing or senior partner must be the highest compensated firm member.

AN ACCURATE REFLECTION

A firm's compensation method can be an important factor in its growth and prosperity. The more closely compensation reflects recent contribution, the less conflict there will be. Trying to base pay on contributions made years ago can cause bad feelings and poor decisions. Compensation should reflect the firm's current goals and each partner's contribution to their achievement.

ROBERT B. MARTIN, CMC, Martin & Associates, Denver, is a consultant to the CPA profession in practice management, marketing and mergers and acquisitions. He is a member of the Horizon Group, a consortium of leading consultants to the profession that maintains an information-sharing and CPA firm M&A network.
COPYRIGHT 1991 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Martin, Robert B.
Publication:Journal of Accountancy
Date:Dec 1, 1991
Words:1992
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