Profit by loss

Profit by loss The pursuit of greater profit per equity partner (PEP) has been one of the factors driving the ;de-equitisation ;of partners. But what is the impact of de-equitisation on partnerships, and what should partnerships bear in mind before initiating the process

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While de-equitisation has been common in today’s legal market, firms should not underestimate the impact upon the existing culture and remaining partners at the firm. Historically, partnership was a step taken by an individual in the safe knowledge that they had attained a role that would normally see them through to retirement. But in today’s world this can no longer be said to be the case.

Firms must ensure that any de-equitisation process is considered properly and well thought through, otherwise it may cause instability within the remaining partner group. The process should demonstrate a commitment to improve the quality and contribution of the partner group.

This will be demonstrated by those being asked to de-equitise being considered as the weaker partners, or those in areas of the business that are less valued by the firm for its future prosperity.

Profitability and PEPThe ;debate over PEP has caused some firms to focus on de-equitisation. Without a doubt, firms with higher PEPs have appeared more attractive to potential lateral partner recruits, while in general little thought is likely to be given by new recruits to how firms have actually gone about achieving their PEP figures.

Firms should not make the decision to de-equitise partners purely on the basis of the headline PEP rate – that, I believe, would be foolish. Instead, the real aim for firms must be to improve overall profitability and encourage partners to focus on this.

The benefits of a successful de-equitisation process will be improved profitability, making the firm more attractive for both future promotees and lateral hires and giving the firm an enhanced standing within the legal community.

Loss of partnersIn most cases, de-equitisation will result in a number of partners leaving the firm. It will be important to ensure that the departees are those who’s loss will have a minimal impact on the firm’s profitability. Care should be taken in selecting which partners should be de-equitised. Sometimes incorrect choices are made that will have a greater impact on the firm than was originally intended.

De-equitisation should not come as a shock to those involved and can, in some instances, be a relief to the individual who is conscious that they are not making the grade. The use of full and frank appraisal systems will make this process easier. Often this can result in any departees leaving with a favourable impression of the firm, thereby enhancing the firm’s network of referrers.

Cultural shiftFirms should not underestimate the potential for cultural change in partner thinking that may or may not be desirable. The de-equitisation of a group of partners can result in the remaining partners questioning their own positions and performances.

This might result in heightened performance, or, of greater concern, a culture of pressure and fear of failure to reach the ever-increasing benchmark for partner performance. This can result in greater insecurity, with some partners seeking less pressurised environments at other firms. Firms going though a de-equitisation process need to work hard to ensure that the continuing partner group is reassured about the aims for the de-equitisation and the views of the management going forward.

Financial compensation

Firms considering the de-equitisations of one or more partners will have a myriad of personnel issues to consider. In the first instance, the partners involved are likely to seek some form of financial compensation. This is an area where firms should tread carefully and only enter into discussions with the individuals concerned having assessed fully the potential cost and impact.

How firms deal with the issue of financial compensation will vary, but where the focus is on PEP there will be a desire that this should not affect the reported figures. This may be achieved by capitalising the cost, although this will not be efficient for tax purposes.

From a tax perspective, the simple de-equitisation of partners to salaried employees makes little sense as it results in an overall increase to the firm’s taxation burden through increased employers’ national insurance contributions. In fact, during the 1990s it was common for firms to go the opposite route to avoid incurring substantial national insurance charges.

While some firms have used the de-equitisation route to enhance financial measurements such as PEP, any such change needs to be well thought through and considered. A large-scale de-equitisation programme is rarely ideal and should not be necessary where firms actively monitor partner performance and contribution.

Perhaps recent de-equitisation events are a sign that some firms are recognising their failure to manage partner performance and indicate that these firms intend to manage this more actively in the future.

Colin Ives is head of professional services tax at BDO Stoy Hayward