Ted R. Roth
Groucho Marx once said, “Those are my principles. If you don’t like them I have others.”
Little did Groucho know that he was espousing the best profit-management strategy for the next millennium.
By definition, every firm has problems. Whether it’s varying goals, differences in direction, or how profits are allocated and distributed, these issues can cause dissension and eventually partner and staff turnover.
But the single most common cause for internal strife is economics. Simply put, I am talking about profits. For many firms, the question becomes, how do we split the pot?
You must consider two critical areas. The initial question for most people is how the profits will be allocated. But before that can be addressed, there is a more important question: what are profits?
The simplest definition would describe profit as the cash left at the end of a predetermined period. But a firm’s cash profits do not necessarily represent true economic profits. Often, services provided prior to invoicing, or expenditures incurred prior to payment, are not reflected in calendar-driven profit periods.
Some contingency services may even result in substantial fees collected several years after they are rendered. So arbitrary accounting periods like calendar years may not clearly represent the true economic cycle of a business.
As unbelievable as it sounds, many firms never address the issue of defining profits. In fact, a large number have no written agreement that clearly sets forth the profit-dividing scheme among the partners.
Generally, such procedures develop over a number of years based on practice, rather than well-reasoned analysis and negotiation. Firms simply go with what has worked in the past until the problem becomes a big issue.
An unfortunate and sometimes fatal problem that often develops is the inaccurate determination of profit distribution. Some firms strip out all available cash, leaving insufficient capital and liquidity that can make them susceptible to cash-flow shortages and harm their profile with financing institutions.
Too many firms with profitable clients have dissolved because they were undercapitalized with debt obligations that could not survive a down economic cycle.
Sometimes problems develop because firms and partners focus only on the monthly draws. Often, these partners do not understand financial statements or the budgeting process.
Other firms essentially operate as separate practices under the umbrella of a single firm. The problem here is that a divisive culture can be created as clients tend to become the “property” of a specific partner, subverting the overall needs and goals of the firm.
In many of these cases, the management group fails to clearly communicate operational issues to colleagues. Financial data is then managed to meet individual commitments, even though it distorts the overall economic picture.
For example, law firms historically emphasized seniority in terms of allocation methodology, favoring long-time partners. However, as a lawyer’s career mobility increases, the emphasis has changed from long-term goals to a more short-term focus, usually in the form of cash distributions.
There are many different formulas for allocations. Some utilize only the current period’s transactions, i.e. billings, new business generated, etc.
Yet these criteria often do not take into account the cost of the infrastructure developed over the firm’s history that enables partners to generate billings and develop new business.
Conversely, over-emphasis on seniority can dissuade new partners, who believe their efforts simply fund less productive senior partners.
The conflict between seniority and productivity is not easily resolved. Some firms consider both seniority and pure production when making annual allocations. Others firms use a combination of objective data (like billings) and subjective data (written summaries of annual performance) to calculate profit allocations.
Many large firms even form committees to decide compensation behind closed doors.
Whatever method you choose, be forewarned: disagreements will occur. It’s best to formalize and codify the process so there are no surprises, and an agreed-upon protocol can be followed.
Recently, I discovered a firm that makes allocations based on a two-year cycle. It establishes fixed draw amounts to be used for two years. These amounts are based on the prior two years’ activities, with certain adjustments.
A portion of each year’s income is then set aside to compensate individual partners who made extraordinary contributions over the year. Their philosophy is that the stabilization of income over a two-year period allows partners to gain a longer-term perspective of the business.
Whatever system you choose, it should be flexible enough to meet the partners’ expectations. In addition, the plan should be open to examination and amendment, or even abandonment if it does not accomplish the firm’s goals.
In order to survive in today’s rapidly changing economic environment, quick but effective reactions rule the day. Some firms need to change with the times to meet the demands of their current and prospective partners.
Although I think Groucho’s philosophy of shifting principles when necessary is a little flippant, there is also something to be learned. As is often the case, many a truth is spoken in jest.
Certified Public Accountant Ted Roth is a founding partner of the accounting and management consulting firm of Roth Bookstein & Zaslow, LLP and partner in charge of technical services.
Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.
