How Do Founders Compensate New Partners?

Many CPA firm founding partners are generous in casting off some of their compensation to incoming partners in the form of a promotion raise. At the same time, few founders would give up a sizeable chunk of what they have created to date. In other words, just because the new partners join as owners, they aren’t entitled to a large piece of the existing partners’ income.

However, ownership does entitle a new partner to be on the equity partner team and earn their share of the growth of the profits during their tenure as an equity partner. Their share should be proportional to what they did to create that growth. And it’s not just client base or billable hours. It’s the whole package a partner contributes: originating new business, cross-selling, developing team members, recruiting, implementing new software, overseeing an acquisition, being the go-to person for questions (and complaints) … the list goes on.

How much should new partners make?

The variance between the highest and lowest earning partners can be significant. Here are some data points from the 2021 Rosenberg Survey:

• Average annual partner income for high-earning sole practitioners is $948,000, but it’s worth noting that for small multi-partner firms, it is $258,000.(*)
• For multi-partner firms with $5–$10M in revenue
  • Typical compensation for new partners averages $190k
  • New partner compensation ranges from $110k–$345k (plus one outlier at $600k)
  • Average income per partner is $504k
• For multi-partner firms with $2M–$5M in revenue
  • Typical compensation for new partners averages $158k
  • New partner compensation ranges from $88k–$260k
  • Average income per partner is $343k

Most of our clients offer their new partners a promotion raise sufficient to cover a buy-in paid over 5–7 years while still allowing them to take home more than the previous year. The increase in take-home pay (net of the buy-in) helps them feel like a new partner. In other practices, new partners make less than they did before the buy-in period, which as you can imagine, doesn’t exactly feel consistent with being promoted.

Should new partners be paid based on their ownership percentage?

The traditional owner-operator model of a CPA firm rewards owners who are also contributors to the functioning and profit generation of the firm. In this model, there are no passive investors. No one gets to take home profits if they didn’t personally contribute to the creation of those profits. The value a founder creates by taking on the initial burden of developing the business, creating a pipeline of clients/referral sources/reputation in the industry, and purchasing smaller firms via M&A is an ongoing contribution to the profit of the firm.

It’s common to believe that if a person owns a certain percentage of a business, they are entitled to a matching percentage of profits. This is how it often works in traditional corporate models and is where the idea comes from. But professional service firms, including public accounting, often operate differently.

Note: This article focuses on the overall allocation of income, not the specific requirements or tax strategies related to your entity type. While those must be considered, many firms prefer to think first about what the appropriate allocation is, then fit that allocation with their legal structure.

Our book How to Bring in New Partners is written for firms fortunate enough to have staff with the right stuff to be a partner. This book addresses all of these areas and more, including: ►how do firms develop staff into partners and when are they ready ► should we have non-equity partners ► what is the process for bringing in a new partner ► how do new partners get compensated ► what should the buy-in amount be.

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What are the risks with using ownership percentage to allocate income?

If everyone agrees that owners should take home their percentage interest in profits, then this is fine. However, the risk of this ownership-percentage model is that the partners have now “purchased” their income. They are no longer required to perform at their best because they feel entitled to the profits, whether they personally have a crap year or a phenomenal year. The problem sets in when partners’ performances vary from their ownership percentages, which is almost always the case.

On occasion, we do see equal splits working well; for example, when two founders agree they each contribute differently but equally. A 50/50 split, often matching a 50/50 ownership split, can work well for a number of years. But there often comes a time that even two previously equal founders find that they are not contributing in the same way and compensation should vary.

Another challenge with using ownership percentage to dictate income allocation is that sometimes a partner wants to work noticeably less than a peer who owns the same percentage of the firm. This partner would prefer not to feel they are required to contribute the same volume of hours as another partner (which often, but not always, correlates to their value contribution). In this case, the partner wishing to work less feels better earning a smaller allocation of the income because that follows the logic of rewarding contributions to the firm as an owner-operator, rather than valuing their status as a passive shareholder.

How else can a firm allocate income?

The most difficult part of allocating income in a CPA firm partnership model, regardless of entity structure, is sorting out who will decide what the allocation is, and how they will decide; that is, what data and information they will obtain and review to determine the allocation. At many founder- or dominant-partner led firms, the who is the founder or managing partner. We call this the “Managing Partner Decides” system.

Sometimes a two-person compensation committee makes sense (e.g., in the case of two founders bringing in a third partner). Sometimes other partners, or all partners, weigh in or participate in a compensation discussion. But in the end, the final say is often up to the founder(s)/MP.

The how is optimally a performance-based plan that accomplishes the following:

• Define current year partner expectations: tangible performance metrics, individual strategic goals and intangible actions and behaviors.
• Set a base pay or draw amount based on past performance (as an indicator of likely future performance). Many firms pay out only 60%-80% of anticipated total partner compensation in the base amount.
• Check in at least once or twice throughout the year to monitor progress against performance goals. Some firms do this as often as monthly or even weekly.
• Once your year-end allocable income is known or predictable enough, review the data supporting your stated current-year partner expectations, along with historical contributions that continue to provide value to the firm.
• Using the data and your best judgment (whoever your who person or team is), determine what the final allocation should be.

It’s not easy, is it?

It can be tempting to chalk this all up as too difficult and head for a formula or ownership percentage system instead. If simplicity is prioritized and partners agree they all contribute according to their given percentages, this may be workable. But it rarely does as a firm gets larger. Keep an eye on performance changes over time, as this would warrant a new look at the system.

In the end, there is no answer key to partner compensation. The right system for your firm might not be the right system for the firm next door. Figuring out how to allocate income fairly requires evaluation, professional judgment and strong partner relations, including trust, for it to be well received by the partner group.

PS: If you made it this far, you might enjoy our satire piece detailing the Magic Formula for partner compensation.

(*) Data points are from the 2021 Rosenberg Survey. 18 firms participated with < $2M in revenue, 12 firms participated as sole practitioners.