The Dangerous Mythology About Partner Compensation Formulas

What exactly is a partner compensation formula?

Income is allocated based on an algebraic equation that pays the bulk of the firm’s income based on various production factors. The main factors are always Finding (business origination), Minding (size of client base managed, which may or may not be the same as Finding) and Grinding (billable hours x rate x realization).

Usage of formulas by firm size

CPA firm management practices vary widely depending on firm size. This is clearly the case with partner comp systems, as the following data taken from the most recent Rosenberg MAP Survey shows:

• Firms over $10M – 71% use a comp committee and 13% use formulas.
• Firms $5-10M – 28% use a CC and 30% use formulas.
• Firms $3-5M – 7% use a CC and 38% use formulas.

The larger the firm, the more likely it is that a firm uses a comp committee to allocate partner income. Conversely, smaller firms are more likely to use formulas.

Why formulas have a natural appeal to CPA firm partners

1. They are accountants and numbers/formulas have great appeal.
2. Partners think that formulas eliminate politics and arguments (spoiler alert: they’re wrong!).
3. Partners like being able to compute their income at any point during the year; no uncertainty.

But all of the above are tragically misguided attitudes. The remainder of this blog explains why.

Two types of flaws in formula comp systems

1. Formulas themselves embrace the anti-firm philosophy of eat-what-you-kill.
2. Formulas are so much less effective when compared to the other major method – the comp committee – because formulas have a narrow focus, production, thus ignoring many other critically important partner performance traits (detailed below) that make CPA firms successful.

Myth #1: No arguments with formulas.  It is what it is.

Most of our partner comp consulting is with firms who have used formulas for years and want to change to a comp committee. Why? Because partners argue incessantly about (a) the weight of each formula factor and (b) the unfairness of certain formula features (we’ve got a list of nearly 100 of these arguments). They complain about the absence of intangibles. That certain partners are overpaid while others are underpaid. Partners nit-pick to death why this factor or that factor isn’t in the formula. Don’t tell me that formulas avoid arguments.  It’s a fallacy.

Myth #2: Firms make more money when partners maximize their finding, minding and grinding. The formula incentivizes partners to be production superstars. What can be more basic, simple and beautiful? This philosophy may have worked when firms were just getting started or smaller. But as firms grow, they find that there are important non-billable performance traits that greatly impact the firm’s success. Management. Staff mentoring. Leadership. Accountability. Achieving goals. To exclude these areas in the comp system ignores their importance. The reason it may work early on is because partners when they first become partners, are relatively aligned. But add in a few years, a few new partners, a dash of mergers, and you’ve got a whole different ballgame. And one in which it becomes painfully obvious which partners aren’t pulling their weight as a true partner, even if their production is still on track.

Myth #3: No subjective judgments to be second-guessed. No back-room shenanigans. No question: If the people being judged (the partners) don’t trust the judges (the comp committee), the system won’t work. Period. The CC method is clearly different from a formula, but in a good way. The BEAUTY of the comp committee method is the ability of the firm’s management to use their good, sound, credible judgment and sense of fairness in linking the performance of each partner and their pay to the success of the firm. The committee isn’t unduly restricted by a narrow formula. But the real acid-test of a CC’s effectiveness is the quality and quantity of their communication with each partner regarding how their income was determined and what they can do to earn more. Good communication largely eliminates the mystery and fear of biasness.

Think about all other forms of corporations; manufacturers; transportation companies, financial institutions and non-profits, to name a few. They all have high-level officer-level people like CPA firm partners. How many of these key people are compensated based on a formula? Very few. Why should CPAs be any different?

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Myth #4: Yes, intangibles such as management, staff mentoring, teamwork, leadership are important, but it’s not practical to include them as a factor in allocating income. They can’t be measured. And besides, all partners are expected to perform well in these areas. The biggest fallacy here is that intangibles cannot be measured. Nothing could be farther from the truth. It might not be as easy to measure intangibles as production, but it can be done. Just ask the thousand or so firms over $10M who use the comp committee to allocate income.

And let us vent about all partners being equally responsible for intangibles so, therefore, they don’t need separate comp recognition for it. There is no way on God’s green earth that all partners are equally skilled at helping staff learn and grow.  It’s a pipedream to think that all partners buy into and embrace the firm’s core values equally. It’s pure fantasy to say that all partners are equally good team players. There are wide variations in performance in these areas and these gaps need to be recognized in allocating partner income.

Myth #5: That’s the way we’ve always done it. Why fix something that’s not broken? No civilization or organization can improve and excel if they are content with the status quo. Partners may feel their firm’s comp formula has served them well in the past but in reality, formula vagaries have likely been masked for many years. Examples:

• A firm’s staff is weak and lacking partner potentials. Part of the reason is usually that since there are no financial rewards for excelling at staff mentoring, the partners have focused on production to the near-exclusion of developing people. You get what you measure and reward.
• Succession planning is in jeopardy because for years, partners have gamed the comp system by hoarding clients and billable hours. As they approach retirement age, client transition is difficult and awkward because no one else in the firm knows their clients and there is an unhealthy attachment of the clients to one person in the firm
• Partner relations are strained because they haven’t prioritized communicating about the intangibles that have always been unspoken expectations but aren’t consistently followed. This makes for more problems with retention because they can sense the discord, and it’s not an appealing work environment.

When we work with firms, the partners who claim the “why fix something that’s not broken” argument are often the ones who fear the most being accountable for their performance and behavior. It illustrates one of the most precious lines partners ever uttered: We ask them how they feel about partner accountability. They say, “I’m all for it…as long as it doesn’t affect me.”

A final note

To be honest, in over 20 years of consulting to CPA firms, we have worked with several firms, large and small, who are quite successful and are in the upper echelon of partner income… AND swear by their compensation formulas. It can be done. (In particular, thinking of our friend Ron in the northeast.) But these firms are extreme examples. The vast majority of firms eventually move from their formulas to a comp committee as they grow, and the needs of their firms become more diverse.