Why is Your Firm Still a Partnership?

Why are law firms partnerships?

After all, across the rest of the economy, corporations are more than dominant; they own the landscape.  Ever seen a trucking company, a retail chain, or even your friendly local locksmith shop organized as a partnership? 

When economists ask such a question, it's with the deep-seated instinct that there must be a reason based on incentives and the peculiar structure of the marketplace in question; it can't possibly be chance, or tradition, or "because everyone else does it that way."   (These are all "reasons" with extremely short half-lives.)

Thanks to two professors at my alma mater, we now have a nuanced explanation of why "law firm" seems to equate to "partnership."

For the "executive summary" of their paper, check out this precis at SmartEconomist.com (a highly recommended site, by the way, although rumor has it they may soon put their stuff behind a pay-wall, which would be exceedingly antisocial of them and would negate my endorsement in a heartbeat).  

In a nutshell, partnerships prevail over corporations where:

• The key performance metric is not total profits (corporations blow away everyone on this score), but profits per partner.
• Quality of service delivered is highly dependent on human capital.
• Clients have a difficult time evaluating the actual quality of service, and therefore rely on reputation.  And, accordingly, where:
• Firms supplying the service have a rational motivation to "signal" the quality of their service by applying stringent internal standards for elevation to partnership, thus explaining the traditional up-or-out model.  In other words, the informational asymmetry between the law firm and the client about the quality of the work product motivates the firm to supply an "indicator of excellence" by ruthlessly—and at great cost—firing all but the most outstanding senior associates.

Here's the entire paper, which is both subtle and marginally dense, at least to those who don't slug down their daily dose of academic economic studies (I don't either—but I'm not too rusty).   If you do look at the full paper, Sections 2 and 3 develop the basic story-line, including the fascinating theme of all the implications that flow from the assumption that corporations strive to maximize total profits while partnerships strive to maximize profits per partner.

To begin with, partnerships will have a higher quality threshold for employment, since their interest is not to hire anyone who will not raise partners' average profit share, while corporations will theoretically hire anyone whose marginal contribution to profits is greater than zero.  Stated slightly differently, a partnership will always be striving to hire (or promote) people whose economic value is at least as great as that of the existing partners; whereas corporations feel at liberty to hire anyone who's not an absolute deadweight.

Section 4 gets more interesting yet.  While the earlier sections of the paper assumed equal per-partner division of profits, the professors now ask what happens if partner income is distributed based on a variety of performance measures—or, as we would put it here, if a firm moves from lockstep to eat-what-you-kill.   While a corporation in this situation would have an incentive to hire cheaper, albeit less talented, workers so long as the gap between their wages and their productivity is sufficiently high, partnerships will always aim to attract the most talented workers, period.  Now what  happens is that if relatively higher ability lawyers have higher "reservation wages" (what they won't take less than), an equal-sharing partnership can unravel if the most capable aren't willing to play that game—in other words, if their equal share seems less than their fair share.   As the professors put it somewhat drolly:

"This suggests that labor market competition may force partnerships to adopt more productivity-based compensation.

The basic story comes back to a theme we've sounded often:  Lateral mobility of partners changes everything.  The professors put this with slightly less pith:  "To the extent that [there has been a change] to a more active market for senior lawyers, our analysis suggests that top lawyers in firms with equal-sharing compensation might credibly threaten to leave if compensation practices were not altered."

And there's more:  The move towards "productivity-based" compensation is joined at the hip to the rise of a non-equity partnership tier.  How so?  The classic up or out model dismisses senior associates who might be of extremely high quality, and exceedingly profitable to the firm, if they are not of ne plus ultra quality.  By contrast, introducing a non-equity track permits the firm to retain them as positive contributors to total profitability, albeit at the expense of razor's-edge quality.  As the professors put it:  "The idea that an up-or-out system would become less attractive once the compensation scheme involved less strict re-distribution fits naturally with our theory."

Or, as Dick Tyler, managing partner of CMS Cameron McKenna, memorably put it:  "A tolerant lockstep system is disastrous."

And you thought partnerships were a matter of tradition?  As the central insight of the law and economics movement has it, the life of the law may not have been been logic, but it has been economically-informed experience.