Designing the compensation system for Partners at boutique professional service firms requires special treatment. Partners are not like other employees and getting their pay system correct requires strategic thought.
TRANSCRIPT
Sean Magennis [00:00:15] Welcome to The Boutique with Capital 54, a podcast for owners of professional services firms. My goal with this show is to help you grow scale and sell your firm at the right time for the right price and on the right terms. I’m Sean Magennis, CEO of Capital 54 and your host. On this episode, I will make the case that designing the compensation system for partners at the boutique professional services firm requires special treatment. Partners are not like other employees, and getting their pay system correct requires strategic thought. I’ll try to prove this theory by interviewing Greg Alexander, Capital 54’s chief investment officer. On this show, I typically hold up Greg, as an example to follow. This show will be different in this instance, Greg made a few mistakes that actually cost him millions of dollars. Today, he will share his mistakes in the hopes of helping you avoid them. Greg, sorry to put you on the spot. And good to see you and welcome.
Greg Alexander [00:01:31] Hey, pal, give me a minute, will you? It looks like I’m getting ready to eat some humble pie and I want to grab some extra napkins because it’s going to be messy.
Sean Magennis [00:01:40] Don’t feel bad. No one is perfect. And that includes you. I appreciate your willingness, though, Greg, to share the mistakes along with the victories.
Greg Alexander [00:01:49] Of course I’m kidding. I’ve made more than my fair share of mistakes, and I’m happy to share if it helps others.
Sean Magennis [00:01:55] I know it will. So let’s get into it. Greg, tell me about this topic. Paying partners. Why is it important to our listeners?
Greg Alexander [00:02:03] So as a firm scale’s, it adds more partners, loyal employees earn the right to have a seat at the table. When this happens, these loyal employees get any job description. Individual contributions get replaced with firm building activities. For example, partners often own recruiting and they frequently are charged with employee training. Sometimes they’re asked to head up a new industry practice or in some cases maybe move overseas to expand internationally. Whatever it is, the days of just selling and delivering work are over. It is no longer about personal billings, but rather now it’s about the success of the firm exclusively. So the question is, how should a partner be compensated for these different activities?
Sean Magennis [00:02:43] Yes, this this makes sense. So our audience members are scaling their firms some dramatically. So and you’re right, this is leading to superstars earning the job title of partner. And with the new job comes new responsibilities, which requires a new compensation system where should a listener start.
Greg Alexander [00:03:04] Well, this shows about comp. This means salary and bonus in equity is ownership, not compensation. So I will leave the equity discussion for another show. Is that right?
Sean Magennis [00:03:15] OK, yes, this show is 10 to 15 minutes. So let’s shelve equity for another episode. Give you give me your take on salary and bonus.
Greg Alexander [00:03:25] OK, so I will discuss salary first as it is easy, my advice would simply to be calculate the going rate for the role and pay at the midpoint. For instance, a quick search on salary.com tells me a business development partner in my hometown of Dallas earns one hundred and twenty six thousand dollars at the midpoint, benchmark data is widely available. Pick your source. The reason you pay at the midpoint is simple. You are not a startup and yet you are not a market leader yet you are in between the two. Therefore pay in the middle obviously can you can tweak this up or down. But I like to keep things simple. My main point is to pay according to the market rate partners are labor. Labor is a commodity priced in the open market. There are buyers and sellers for this labor. The equilibrium point between buyer and seller is the price for the commodity. If the partner quit your firm, this is what she would fetch in the open market. If you recruited a new partner to the firm, this is what you would pay. Eliminate all the subjectivity from salary discussions. Let it be a data driven decision. Does this make sense?
Sean Magennis [00:04:35] Makes perfect sense. And the simplicity of this is actually wonderful. You mentioned bonuses are harder, so let’s jump to that.
Greg Alexander [00:04:44] Yeah, bonuses are much harder. So why is that? So it’s hard to find the balance between past contributions, current contributions and investments today that will lead to future contributions. So, for instance, you may have a partner that took on a strategic initiative that runs in the red this year, breaks even next year, and turns profitable two years from now. So how do you pay this partner? If you penalize him for the short term EBITA hit, he will never take on another strategic initiative if you reward him when the strategic initiative turns profitable, is that reward forever or is there an expiration date on it? This is a very tricky decision. There are three systems available and most firms choose one of these three. You want me to briefly describe this?
Sean Magennis [00:05:37] Yes, please, Greg, because I want to save some time for your war story.
Greg Alexander [00:05:42] OK, so the first system is based on seniority. The longer your tenure, the more you make. This has the benefit of being very easy to administer. But the younger partners hate paying the old farts forever. The second system is the performance based system. Each party gets assigned some goals and he or she gets paid if they are met. This sounds great as who does not love a meritocracy. The problem with this, however, is there is no incentive to build the firm. Pay that prioritizes short term performance can destroy a boutiques ability to scale at scaling takes longer than a year or two. The third system is called a reconciliation system. This involves a compensation committee made up of the owners and awards are handed out by vote. It comes with a formula usually tied to enterprise, wealth creation or partner distributions. It is subjective, but it does allow for a judgment to be applied. And since all partners are on the jury, the system does have integrity. Personally, I believe this is the best system for firms trying to scale. It does the best job of balancing the short term with the long term. Did I describe these three systems clearly?
Sean Magennis [00:07:00] Yes, you did. Thank you. So our listeners have three choices in front of them now, one seniority to performance based, three, reconciliation and listeners I recognize the devil is in the details. So if you have questions about this, reach out to our team at Collective 54 and they will help you. OK, Greg, would you please share your personal story?
Greg Alexander [00:07:28] Oh sure. I think I would call this Confessions from a Mad Man. So as I transitioned from a startup to a boutique, I did not change the partner compensation system. This cost me millions of dollars over time and it created tension among the partners. Our system was very unsophisticated. I paid partners a very generous salary that was well above the market rate. For example, the first group of partners earned 2x what they could fetch in the open market. To make matters worse, bonuses were paid as distribution’s. The distributions were paid based on the partners equity stake.
Greg Alexander [00:08:07] For example, if a partner owned 25 percent of the firm, they got 25 percent of the distributions. This was a huge mistake. Equity is different than pay. As we became very successful, partners were pulling millions of dollars out of the business. Yet this payment had very little to do with their contributions to the firm. The root cause of this mistake is easy to identify. I felt a loyalty to the early partners. They took a risk to join me in the early days and they took equity in lieu of cash. As time went on, I wanted to reward them for their early sacrifices.
Greg Alexander [00:08:43] However, I never contemplated when this debt was paid, I just kept paying that debt in perpetuity. They took advantage of me, the right thing to do would have been to refuse the excessive compensation for obscene but greed and envy of powerful forces for humans to resist. And I’m sure they felt they deserved what they were getting. All of us, including me, tend to overstate actually worth. The problem is that a new group of partners emerged and they were way underpaid.
Greg Alexander [00:09:17] The effect they were having on the business was large and growing, it eclipsed the contribution from the legacy partners. And as time went on, this compounded the gap between the old partners and the new partners became extreme. The dollar should have shifted from the legacy parties to the new partners, yet it did not. This was a failure in leadership. I mean, this poor leadership, fractured relationships. It created some bad blood. And I deeply regret this. Friends became enemies. Sadly, the shame of it all is this was all avoidable. I just did not know any better at the time. So please learn from my mistakes. Maybe my salvation can be realized in helping you steer clear of this grief.
Sean Magennis [00:10:02] Well, Greg, I’m I’m literally speechless and not for the reason you may think I’m speechless at how honest you are with our audience. It takes great humility to share something as personal in a medium like this. And I know this will be heard by thousands of people. So on behalf of our listeners, Greg, thank you. You know, I. I know you are living your mission statement every day, my friend.
Greg Alexander [00:10:27] Thanks, pal. Now, let me get up off this therapy couch and let’s cut to the checklist.
Sean Magennis [00:10:34] OK, you got it. And now a word from our sponsor, Collective 54, Collective 54 is a membership organization for owners of professional services firms. Members joined to work with their industry peers to grow scale and someday sell their firms at the right time for the right price and on the right terms. Let us meet one of the collective 54 members.
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Sean Magennis [00:12:03] If you are trying to grow scale or sell your firm and feel you would benefit from being a part of a community of peers, visit collective54.com. So this takes us to the end of the episode, let us try to help listeners apply this, we end each show with a tool. We do so because this allows a listener to apply the lessons to his or her firm. Our preferred tool as a checklist and our style of checklist is a yes-no questionnaire. We aim to keep it simple by asking only 10 questions. In this instance, my instructions are a little different than normal. So please pay attention. Loyal listeners. If you answer yes to questions one and two, you do not need a new partner pay system if you answer no to questions one and two, you’ve got some work to do. If you answer yes to questions three, four and five, a seniority system might work for you. If you answer no to questions three, four and five, then a seniority based system is not for you. If you answer yes to questions, six, seven and eight, consider a performance based system. If you answered no to these questions, a performance based system is not a good fit for you. And lastly, if you answer yes to questions nine and ten, the reconciliation system might be best for you if you answer no to questions, nine and ten you can rule out the reconciliation system.
Greg Alexander [00:13:48] Very good.
Sean Magennis [00:13:50] Hopefully everyone gets this. Here goes number one, are you paying salaries based on external benchmarks? Number two, are you paying salaries at the midpoint of the benchmarks? Number three, are years of service, a fair way to pay partners? Number four, are senior partners past contributions contributing to today’s wealth creation?
Greg Alexander [00:14:21] Often overlooked.
Sean Magennis [00:14:22] Yes. Number five, will your younger partners stick around to wait for the senior partners to retire?
Greg Alexander [00:14:30] Oftentimes, no.
Sean Magennis [00:14:32] Number six, do you have clear objectives for each partner? Number seven, is it clear when the objectives are met? Number eight, is it possible to balance short term and long term wealth creation with these objectives? Number nine, will partners perform with integrity if placed on the bonus compensation committee?
Greg Alexander [00:15:01] Be very careful of politics there.
Sean Magennis [00:15:03] And number ten, can you develop a methodology that fairly attributes wealth creation to partner activities?
Greg Alexander [00:15:12] What’s important about number 10 is it’s about wealth creation and wealth creation attribution is hard.
Sean Magennis [00:15:18] Yep. So thank you, Greg. In summary, boutiques add partners over time. Paying partners correctly impacts the scalability of the boutique. Consider these three systems and learn from Greg’s mistakes. If you enjoyed the show and want to learn more, pick up a copy of Greg Alexander’s book titled The Boutique How to Start Scale and Sell a Professional Services Firm. I’m Sean Magennis. Thanks for your candor today, Greg, and thank you to our audience for listening.