What to Look For In a Partnership Agreement
By Janice Mucalov, LL.B.
All those years of hard work have finally paid off and you’ve been invited into the partnership! Now you have the opportunity to make more money; you can join the players at the partnership table and have an active say in the operation of the firm. Your future in the firm is assured. Or so you think…
A law firm partnership is basically a form of business ownership; the partnership agreement is principally an ownership agreement. Each partnership is different, and the partnership that has made you an offer is unique to the collective of those particular lawyers. Before signing an agreement, consider carefully what being an owner in that firm means – just as you would advise any client who was interested in buying into a business.
Types of Partnerships
Law firms typically operate as a general partnership or, where permitted, a limited liability partnership (LLP).
In a general partnership, the partners are jointly and severally liable for the debts and obligations of the firm. In addition, each partner is personally responsible for the liabilities of all other partners and is potentially on the hook for the full amount of all partnership liabilities.
Limited Liability Partnership
In a limited liability partnership, each partner is only responsible for their own liabilities. Partners are not liable for the negligence or wrongdoing of other partners and, unless a partner is involved in the negligence or malpractice, their personal assets will be sheltered. However, the partnership as a whole continues to be liable for the negligence of its partners, so partnership assets remain at risk.
Limited liability partnerships are fairly new to Canada but an increasing number of law firms are switching to limited liability status. LLPs must be registered under the relevant provincial partnership legislation and with the applicable law society.
As a new partner, you’re likely to find an LLP more appealing than a general partnership, says Nick Jarrett-Kerr, a law firm management consultant with Edge International, who previously practised “law firm partnership law” with a major U.K. firm. This is especially true if you’re signing on with a large firm, where you may be unfamiliar with the partners’ practices and where the potential dollar exposure on files could be extremely high.
Equity vs. Non-Equity Partners
At many firms, there are two levels of partners – equity and non-equity partners.
Full equity partners can vote and participate in the sharing of profits. Non-equity partners, also known as salaried or junior partners, usually cannot vote (although they can attend partnership meetings) and they don’t share in the profits. Non-equity partners are also excused from contributing capital to the firm. Often a non-equity partnership position is for a trial or probationary period of two to three years before an offer of full partnership is made.
The main downside to being a salaried partner is that, to the outside world, you’re held out as a partner. In a general partnership, that means you’re still potentially liable for the firm’s debts and obligations. So while a salaried partner, you want to ensure that you obtain full indemnity from the profit-sharing partners for any liabilities of the partners or the firm. (The partnership agreement will ordinarily set out the basis upon which partners are liable to indemnify other partners or the partnership for liabilities.)
Why Do You Want To Be a Partner?
“Ask yourself – what are the benefits to being a partner at this particular firm?” advises Richard Ferguson, who practises with Lynass, Ferguson & Schoctor in Edmonton. Part of your compensation will depend on the firm’s success. You may fare better as a non-partner; occasionally lawyers on contract earn more than partners.
Being a partner may also hinder you from pursuing alternative work arrangements. If you’re not keen on working full-time, but the partnership agreement requires partners to contribute equally to overhead, that’s a strong financial incentive against working part-time. Or what if you simply want to do your work well and get paid for it, but would prefer to avoid all the marketing, management and other non-billable activities that go along with partnership?
Partnership has many benefits, but you don’t necessarily have to progress from associate to partner. It may be possible to carve out your own relationship with the firm.
Firm Governance and Decision-Making
The partnership agreement should cover the decision-making process for important issues. Otherwise, the firm runs the risk of stagnating if partners can simply sidestep decision-making.
In many smaller firms, all partners generally participate in the management of the firm through regular monthly meetings. In larger firms, decisions about the firm’s day-to-day operations may be delegated to a management committee or even a board of directors. But a partnership vote is required for fundamental changes and major decisions like changing the firm name, merging with another firm, winding up the partnership, significant investments, amending the partnership agreement and changing the compensation structure.
Day-to-day decisions usually require a simple majority. Fundamental changes and important matters often need a two-thirds or three-quarters majority vote of partners. Note that not all votes may be equal. In firms where partners are allocated points or partnership units, the firm may have weighted votes – so if a partner has 100 partnership points, they will have double your voting power if you come in with 50 points.
If there’s a management committee, consider what decisions the committee is responsible for and what decisions you as a new partner will be able to vote on. Unless you’re with a very large or national firm, you’ll probably want a say in matters like choosing new partners.
“You want to have a thorough understanding of the firm’s compensation system,” advises Richard Stock, a partner with the legal services consulting firm of Catalyst Consulting. The terms should be set out in the partnership agreement or written documents that form part of the agreement by reference.
There are many possible compensation schemes, including:
- equal profit-sharing among all partners
- a lock-step system – all partners at a particular seniority level are recognized and paid equally
- an “eat-what-you-kill” system based solely on individual billings and collections
- a formula scheme based on billings and seniority
- merit-based on billable and non-billable performance
- any combination of the above
Consider how non-billable activities are recognized. How will you be remunerated if you’re head of the articling committee and must travel to law schools talking to students? Is there a formula or discretionary fund available for compensating you for this time?
Also look at originating lawyer credits. What if you introduce a banking client to the firm, generating $1 million dollars in fees? How will you be compensated for work you bring in, but don’t do?
In larger firms, you can expect partner compensation to be set according to a balanced score card of practice skills/competencies, billings/collections and non-billable performance such as client marketing, hosting lawyer-update seminars and contributing to firm or team management. The result may be an allocation of a certain number of partnership points or units – more points mean a greater compensation figure.
Ferguson prefers a combined compensation scheme. “The best approach is where part of the compensation figure is known and ascertainable in advance, then the gravy or a bonus deals with the super-performers.”
You want to know what the performance requirements are once you become a partner, and if they’re enforced. While the agreement is likely to cover a partner’s general duties, it’s unlikely to deal with any performance criteria, normally found in other paperwork relating to the compensation system.
Some firms have a professional development plan for each partner, agreed to by the partner and the management or compensation committee. Each partner’s compensation is then pegged to meeting the goals set out in their professional development plan.
Who Decides the Compensation?
Where the compensation is discretionary, a compensation committee in some firms has absolute power over determining the amount. The other extreme is where the whole partnership votes annually on each partner’s compensation (referred to as “the night of the long knives”). Some firms don’t publish a table of partners’ compensation, so you only know your own compensation, but not that of others.
You should satisfy yourself that the compensation provisions are sufficiently flexible to allow for contingencies. “If you have a rigid formula for the distribution of profits or bonuses, you don’t know how that will play out for you as a new partner,” says Ferguson. “It’s nice to know that there’s some room for adjustment if the formula doesn’t fairly recognize what happened in a particular partnership year.”
When Are Draws Paid?
The partnership agreement may indicate when draws are to be made – typically based on 80 per cent of projected net profits, with the balance of net profits being paid after the annual financial statements are prepared. Most medium-size and larger firms have resources (such as bank lines of credit) to distribute regular monthly draws to partners, whether or not work-in-progress has been turned into cash in hand. But in some smaller firms, the timing and amount of partner payments may vary, depending on the cash flow of the firm. This can be a shock if, as a new partner, you’re depending on regular monthly draws to pay the mortgage and other household bills.
Most partnerships require new partners to make a capital contribution to the firm. However, the provisions in the partnership agreement are likely to be quite general and state only that each partner must ante up a capital contribution in an amount and at such a time as shall be decided. So, obtain details from discussions with the managing partner and an examination of the firm’s financial statements.
The sum can vary, from $10,000 to considerably more than $100,000. “$100K is not an atypical figure”, says Jarrett-Kerr. Sometimes the amount is determined by the number of points or partnership units allocated to each partner; the more points you have, the more capital you must contribute, and every time your point allocation changes, you chip in more capital.
What are you buying into?
“You should understand what your capital contribution is for,” says Stock. Are you merely helping to capitalize the working operations of the firm? Or are you buying into fixed assets, such as premises owned by the firm?
Typically, your payment goes toward working capital, which is used as the general funds of the firm. As firms commonly have funds tied up in work-in-progress, there can be a three to six-month time lag before work is billed and collected. Your capital contribution helps to pay staff salaries, partner draws and bills during this time-lag and also helps finance other operating expenses (computers, library books, etc.).
Even if your contribution is an initial one-time payment, you may be expected to pony up additional payments over the years, depending on the firm’s capital requirements.
Funding your capital contribution
Some firms will help a new partner to build up their capital contribution from undrawn profits left in the firm, so you take home a smaller monthly draw until your contribution is paid. More often, however, the firm will refer you to its bank, which offers you a low interest rate to borrow the required amount.
Do you get your capital back?
Consider carefully the provisions for the return of your capital contribution, which should be set out in the partnership agreement. “You want to be sure the firm will treat you fairly when you join the firm and on your way out, whether by resignation, death or expulsion,” says Cliff Johnson, Calgary-based regional managing partner for the Alberta office of McCarthy Tetrault.
Expect to get back what you paid – though at some firms, you may forfeit part or even all of your capital contribution if, for example, you leave the partnership within five years of buying in. (In this sense, your capital contribution isn’t a good investment, and should be viewed more like a “membership fee” that gains you entry into a profit-sharing club.) Note that there should be no deduction from the refund if your departure from the firm is at their request.
Ideally, the partnership agreement should say that you’ll receive the return of your capital contribution within one month of leaving the firm. But as that can be a significant strain on a firm’s cash resources (for example, where several partners leave or retire at the same time), be aware that some firms hold up a partner’s return of capital for years. As Johnson notes, if you make a lateral move between firms, and your capital contribution (for which you borrowed) is tied up, that can make it difficult for you to come up with the capital required at your new firm.
Overhead and Liabilities
The partnership agreement may say that the management committee or managing partner is responsible for the day-to-day management and control of overhead expenses. Expenses may be allocated equally among partners, or shared differentially according to a pre-determined arrangement. If shared unequally, you’ll want to know who decides what your portion will be and how that decision is made.
It’s also important that you understand the long-term liabilities you’ll be assuming – professional liability, lease costs, bank debts, and so on.
The firm’s insurance coverage, both professional liability and general liability, is one of your main protections. Look at the claims history of the firm. If there is a significant claims record, confirm that the factors which precipitated those claims are no longer a concern, and that programs designed to minimize future claims (like continuing legal education requirements) are in place.
Also find out if you have to sign any personal covenants, for example, on the firm’s premises lease (if held through a management company). If the firm has an established relationship with its bank and/or owns assets, the bank may not insist on personal guarantees. Otherwise it’s common for banks to request guarantees. While joint and several, they’re often limited guarantees, so each individual partner’s exposure is not unduly excessive.
Parental Leaves and Sabbaticals
Consider the agreement’s provisions on maternity and parental leaves, sabbaticals, and alternative working arrangements. Do they support an environment that welcomes the hiring and retention of female associates and partners?
Various reports have been published in this area, and model policies are available against which you can compare your firm’s partnership agreement provisions.
For policies on parental leaves and alternative work arrangements, refer to The Law Society of British Columbia’s website at www.lawsociety.bc.ca – go to “Practice and Services” in the left navigation bar, then “Practice Resources.”
You may also contact the CBA Publications department at 1-800-267-8860 or via e-mail at email@example.com for copies of the following:
- Touchstone for Change: Equality, Diversity and Accountability, Model Policies (an appendix to the Bertha Wilson report)
- The Legal Duty to Accommodate Lawyers With Family Responsibilities
Retirement and Termination
“Every agreement worth its salt should cover the retirement age,” says Jarrett-Kerr. The mandatory retirement age is usually set between 67 to 75; 70 is fairly common. The age is important. Finances will be less of an issue for you if the retirement age is 70, but you may not be able to afford to retire if you have to quit at 60.
Apart from the agreement, consider the age structure of the firm. Is there a cluster of partners within a certain age group? If several partners are on the verge of retiring (and taking with them their capital contributions), will this result in a shortage of senior people? Could the firm handle the withdrawal of capital? Ideally, the firm should have a good mix of ages with younger partners moving up the ranks on a continuous basis.
For more information, see the CBA PracticeLink article on Planning Ahead for Partner Retirement.
The Partnership Act in most provinces provides that “a majority of the partners can not expel any partner unless a power to do so has been conferred by express agreement between the partners and the power is exercised in good faith.” Therefore, ensure that the partnership agreement allows for the termination of a partner; otherwise, the partnership may be stuck with an undesirable member.
Normally, the agreement will say that a majority vote of two-thirds or three-quarters of partners is necessary to expel a partner; the notice period may be six months to a year. (In reality, partners are rarely ejected this way – usually the partner is asked whether they would prefer instead to resign.) Note that if a decision to expel a partner doesn’t require and isn’t supported by a significant majority of partners, that action can result in a split of the firm, says Ferguson.
Consider too what non-competition covenants there are. If you leave the firm, the agreement may restrict you from taking clients with you (considered the firm’s “property”). It’s not uncommon to see covenants that prevent you from approaching clients for one year after your departure or establishing your own practice within a certain radius of the office. Although the legal effect of such clauses is questionable, especially if they’re onerous, the last thing you want is a dispute over your right to act for clients that you’ve brought into the firm yourself.
You also need to know what professional conduct rules may apply. In B.C., for example, the Professional Conduct Handbook contains a rule that says the right of the client to choose their own solicitor cannot be curtailed by any contractual or other arrangement. When a lawyer leaves a law firm to set up their own practice or join another firm, there’s a duty upon both the departing lawyer and the firm to inform the lawyer’s clients of their right to choose who they wish to represent them.
Documents You Should Review
Other documents you should examine in addition to the partnership agreement include:
- financial statements
- compensation criteria, including information about your partnership points (and compensation) and the draw policy
- any personal compensation forms you must submit to be recognized for non-billable contributions
- information about funding your capital contribution
- documents detailing long-term lease, bank loans or other liabilities of the firm that you’re expected to shoulder
- any documents changing or amending the partnership agreement since it was written
In many firms, especially the larger ones, an offer of partnership is accompanied by a new partner information pack or orientation manual. If the information isn’t offered though, simply ask to see it.
Financial statements (preferably audited) going back at least three years will be key to understanding the firm’s profitability and should uncover any worrisome trends. Be alert to banner years – especially if due to one-time factors, such as a client who happened to require extensive legal services in a particular year or a big contingency “win.” Look at the balance sheet to see what assets are shown, as well as the profit and loss statements. A well-run firm will also prepare management accounts on a periodic basis (usually monthly) so partners can see how the firm is progressing throughout the year.
Negotiating a Better Partner Position
Partnership agreements are rarely changed, and then only when necessary; for example, when merging with another law firm. If you want to negotiate an item of the partnership position offered to you, say your compensation, the agreement itself is unlikely to require any changes.
Where to Go for Advice
“Ask a friend, colleague or trusted confidante at another firm to review the partnership agreement, or retain another lawyer to look it over,” recommends legal recruiter Adam Pekarsky.
Grill the managing partner or administrator for information, and find out from other partners in the firm how they’ve fared historically in terms of compensation.
Have your family accountant or another lawyer examine the financial statements with you.
In larger firms, the partnership offer is usually a take-it-or-leave-it proposition. But in a smaller local firm, it’s a mistake to think you can’t ask for changes for fear the partnership offer might be withdrawn.
“Associates do have an opportunity to ask for amendments to be made,” says Adam Pekarsky, Calgary-based division director for Robert Half Legal, a North American legal recruiting firm. “It’s all about leverage. If you’re a superstar biller who’s been invited into the partnership after only a few years and the firm runs the risk of you walking across the street to another firm, you can ask for changes. The firm needs you more than you need it.”
To fully assess the partnership offer, you also need to take into account other “soft” factors:
- Does the firm have a good direction for the future?
- What is the firm’s client base and main practice area? Is the work what you want to do?
- What ongoing training and educational opportunities are provided?
- Is the partnership a cohesive group, or is there dissension among the partners?
- Do you trust the partners?
- Is the firm culture compatible with your lifestyle? Are your values met by the partnership? How does the firm treat minorities – will you be comfortable if you’re disabled, black, gay?
- Is there a glass ceiling for women?
- Will you attain job satisfaction?
In the end, however, joining a partnership is somewhat of a leap of faith. A thorough consideration of the legal and financial terms of the offer, as well as your “fit” with the other partners, should help to ensure a successful and fulfilling career at the firm. However, if things don’t work out, you can leave the firm knowing that your interests have been reasonably protected.
So You’ve Been Invited to Become a Partner! – a 1997 Canadian Bar Association Guide to legal partnership in Canada. Contact CBA Publications at 1-800-267-8860; firstname.lastname@example.org.
Business Relationships Within the Professions: Selected Business and Legal Issues (see the chapter on “Professional Partnerships”) – found on the Law Society of British Columbia’s website at www.lawsociety.bc.ca in the Practice Resources section.
Janice Mucalov is a freelance writer in Vancouver.
Neither the author nor the CBA should be construed as endorsing any product or website listed in this article. The views expressed in this article are those of the author and do not necessarily reflect the views of the CBA.|
In this document, any reference to "jurist" or "lawyer" includes, where appropriate, "Québec notary".