Partner Compensation Practices: Cutting Edge Research – Part 1

CPA firms have struggled with their partner compensation systems forever. We’re constantly trying to build a better mousetrap.  Why is this quest never-ending?

The simple answer is that it’s difficult for financially-minded, mathematically-inclined CPA firm partners to agree on what is fair for both themselves — a subject on which they are understandably but regrettably biased — and for the firm — the politically correct position.

To drill down on the art and science of partner compensation, we conducted a survey of firms’ compensation techniques and methodologies.  Our company conducted the survey in conjunction with our colleagues at CPA Leadership Institute.

But before we begin, a clarification.  Let’s not confuse Best practices with Common practices.  Best practices, based on experience and research, reliably lead firms to the most effective results.  Common practices are simply those practices followed by a large percentage of firms, regardless if they are best practices or not. We’ll be examining those differences.

Survey participants

33% of the firms were under $5M in annual revenue; 46% were $5-15M and 21% were over $15M.

What system does your firm use to allocate income?

• 33% use a compensation committee.
• 23% use a formula.
• 18% have the managing partner personally allocate the income.

Best practice or common practice?  Both best and most common.  More than any other system, the comp committee provides firms with a great way to balance the recognition of both production metrics and intangibles such as firm management, developing staff and teamwork.

Using a compensation committee requires a level of sophistication that most small firms – say, under $10M – don’t have.  Smaller firms almost always use one of three systems:  Pay equal, Formula or MP decides.  Common practices but not best practices.

CPA Partner Compensation:  The Art and the Science explains ►Partner comp 101 ► the 12 systems used by all firms ►how to design your firm’s system ►open vs. closed systems ►the role of book of business ►differences between large and small firms’ systems ► the MP’s compensation ► trends and controversies   ►overall best practices

How many tiers of income does your system have?

The three main tiers are base salary or draw, bonus and interest on capital.  Our survey found:

• 86% of firms have a base salary tier.
• 72% of firms have a bonus tier.
• 35% of firms have a tier for interest on partner capital.

Best practice or common practice?  Common – yes.  Best practice – somewhat.  The best practice is to have all three tiers because each recognizes an aspect of partners’ contributions to the firm that is quite different from the others.  Omitting any of the three tiers ignores these differences.  The base salary, usually 65-85% of total compensation, is both the historical and street value of a partner.  The bonus, usually 10-30% of the total, rewards partners for their performance in the current year.  The interest tier rewards partners for their ownership role in the business, a feature enjoyed by shareholders in most businesses.  The key differentiator is the relative capital invested in the firm by the various partners.  It makes sense that partners with more capital invested than others should receive a higher interest amount.

How does your bonus tier work?

The two choices were:

1. The base salary and bonus tiers are allocated separately, using different criteria.
2. The base is really a draw or advance on one final income number, determined at the end of the year for each partner. The performance criteria for the base and the bonus are the same.

Our survey results showed roughly a 50-50 split between the two choices.

Best practice or common practice?  Best practice – no.  Common practice – yes.  Since the modern business world began, larger and/or sophisticated businesses have provided key people with base salaries and an incentive bonus for current period excellence, however that is measured.  The wisdom of this practice is indisputable.   In defense of the 50% of firms that don’t differentiate between base and bonus, it is very difficult to come up with coherent criteria for partner performance and income allocation when they have one tier (base and bonus combined).    Devising separate criteria for two tiers – base and bonus – is simply too challenging for many firms, especially smaller ones.

Open vs. closed

70% of our surveyed firms have an open compensation system (all partners know what each other earns) compared to 30% with closed systems (partners do not have access to what other partners earn).

Best practice or common practice?  Best practice – no.  Common – yes.  Partners should be compensated based on their value and contributions to the firm, without regard to how their comp compares to other partners.  Partners are more easily satisfied when they compare their compensation to what they expected instead of what their other partners were awarded.

The open vs. closed issue is handled dramatically different depending on the size of the firm.  Firms with less than eight partners almost always have an open system.  There may be great logic in a closed system, but when there are just a few partners and they grew up with each other, emotionally, it’s very difficult to move away from an open system. Firms with 8-12 partners are 50-50, open vs. closed.  75% of firms with 13 or more partners operate a closed system. The larger the firm, the more common it is for these firms to manage themselves like a real business.