A 7-part Theory of Principal Compensation

David frequently gets hired to help resolve issues at firms between multiple principles when it comes to who does what and how much each should get paid, so he’s come up with a 7-point framework he can use in each unique scenario.

Transcript

Blair: All right, David, you're continuing with the highfalutin titles, a seven-part theory of principal compensation.

David: I am in a beautiful groove with this title thing.

Blair: You're redeeming yourself for years of horrible titles.

David: No, I want to get hired as the new president at Harvard. I think if all of these titles are properly academic-- I just know that some of the Harvard corporation is reading these titles and they are starting to think differently about me.

Blair: "Who wrote this podcast title? Let's get him. Let's get them."

David: "Well, first, let's see if he borrowed the language from anywhere, but then if he didn't, yes, let's hire him."

Blair: Looking through your list, there are some things I recognize here. Some of the first things that I read from you many years ago, going back, God, it's got to be two decades now. What's the impetus for this topic?

David: The world needs more really great substantial thinking from me. No.

Blair: Ladies and gentlemen, this is the rested David Baker. He's just coming off a nice, restful Christmas break.

David: A little full of himself.

Blair: He's full of himself, a little punchy.

David: Yes.

Blair: It doesn't get any better than this. Go on.

David: It always seems like these topics come up because there's this ebb and flow. Recently we've been helping lots of people think through partnership issues and been thinking about our valuation model. I get hired a lot to be this kindergarten cop, recently by a firm with five partners, and they wanted me to help them decide how they should each get paid. It's not fun, but in a sense, it's substantial work. I think substantial work is fun. Mentally, I cannot reinvent the wheel each time I go in there. I have to establish certain principles that I then apply.

I'm trying to be really flexible about applying those. I like to have a framework, that's your word, a framework, to help me have a helpful, logical, substantial approach to solving things. People keep asking questions about how they should pay themselves, so I thought, "Okay, I'm going to turn this into a framework." I already had one, but I wanted to really think about it more deeply and make it more specific. Then when the next person calls and wants help with this, I will pull out this exact framework, and then I'll figure out how to personalize it because their situation will always be different.

Blair: Yes, that's great. It's really about how a principal pays themself. These seven points here are even more valuable in a multiple-owner scenario. As you described, the five-headed monster of a firm with five owners. I say that because one of the first firms I worked with with multiple owners, there were six owners. The principal owner said-- when I was visibly taken aback by the fact that there were six owners of the small firm, she said, "I'd like to have more." I recoiled again.

In the end, she ended up going the other way and scaling back the partners because with multiple partners comes an interesting set of problems, as I think we've talked about before, but how everybody gets paid, even though this isn't my domain, I've seen problems in this arena arise in the work that I do with my clients where there are multiple partners. There are these battles, sometimes wars over who's doing what and who is earning what. I think this is a great topic.

David: What you just said, it reminds me of something we've also talked about before. I think it was under the penultimate sort of a problem. The very next thing is always this. When this happens, right after that, this is going to happen. When principals start thinking that somebody is not pulling their weight, that is usually the end of a partnership. May not officially end for a year or two or three years, but that's where the seeds start. We're going to talk about that philosophically too. Your point about this applying way more to somebody with partners really is absolutely true.

If you're running this firm by yourself and you don't intend to have any partners, then only half of this is going to be interesting to you.

Blair: Your first part of the seven-part theory is the idea that you get paid for three things. This is what I was referring to. I think I remember reading you write about this in one of your early issues of Persuading, the newsletter that you ran for many years. I read even before I met you. What are the three things that an owner gets paid for?

David: This is so useful as a place to start. You get paid for what you own, and that shows up in the form of profit. Let's say we have three principals, they're equal owners. One of them leaves. Their salary is going to stop because that's the other thing you do. You get paid based on what you do. That shows up in your paycheck, and then you get paid based on the very specific kind of risk that you take. Usually, that's loaning the company money back where you need to attach some sort of an interest rate to cover the risk of loss and so on.

You get paid for three things, what you own, the loss that you might realize for the risk that you're taking, and what you do. Back to that example of three equal principles, one of them leaves, that person is no longer doing anything at the firm, so their compensation should stop. That has nothing to do with their ownership, that's what they own. They should still get a third of the profits as they're distributed, and legally that's required. In our minds, we somehow weave these two things together. They're not together at all. You get paid for what you do, you get paid for what you own, and you get paid for the specific potential for loss you take in a contract. Those three things, own, loss, and do.

Blair: Loss really is tied to the specific issue of lending money to the company, is it?

David: Right, it is.

Blair: You're earning an interest-- and maybe above and beyond what you would earn elsewhere in a safer investment, you're earning an interest on that money.

David: Right, and it doesn't happen that much really, it's mainly the two categories of what you own and what you do, but every once in a while, there's other stuff involved and I'd like to cover that because let's say that there's a big problem with the business, it's temporary but you run short on cash and so there's a capital call, that's what it's called, but only one of the owners has the money personally to do this. They're taking more risk because if the firm fails, they're not going to get repaid and so that's why I wanted to acknowledge that there are not just two forms of risk here but three major forms.

Blair: Not to go down a rabbit hole on that issue, but let's say there's a capital call, let's say there are three partners and only one partner has the capital to be able to re-inject back into that business, do you have a sense or is it too specific on a situation-by-situation basis, but do you have a sense of the premium over a standard safer investment that owner should be able to earn on that loan back to the company?

David: Yes, and I think the answer to that is going to change over time. It's best expressed as a formula which would probably be three to four percentage points over prime. Today, you might be earning more on your money somewhere, so you should be earning even more than that if you loan it to the company. If you're only earning 1%, then maybe you get 5% or something. It's usually somewhere like that.

Blair: Got you. Let's drill into this topic, the third topic of what it is that you do because that begs some obvious follow-on questions around should each partner be doing the same thing or the same amount of a different thing. You want to talk about that?

David: Yes. At first, it might seem a little odd that we even have this point on here. I hear we're talking in this episode about how partners should be paid, and then I'm saying partners should contribute uniquely. What's the connection there? The connection is that the best partnerships are designed so that they allow each partner to contribute in a unique way. One of the reasons you would have that, it's a minor reason, but one of the reasons why you do it that way is because it defies comparison between the two.

If you have, say, three partners and everybody is responsible for bringing in their own business and they're running micro firms, almost like a law firm, then it's really easy to compare compensation and compare that to the contribution that somebody is making, and then these discussions come up. That's not the only reason to have principals contributing uniquely, but it is a minor one. If they are doing their own things and it's not a stack of plates, it looks more like the intersecting rings of the Olympics, then this doesn't come up when it comes to how people are being paid. It's just a minor point.

We could do a whole episode on this. In general, it just simply says this, the second principle here is principals ought to be doing things uniquely. One reason for that is because it doesn't lend itself to comparison, which is going to translate into what people are paid.

Blair: That's the job. These owners who are working in the business, they have jobs, they're getting paid fair market value for what it is that they do. One might be the COO, one might be the president, one might be an art director. I can think of two examples of two firms I've worked with over the years where one of the partners was an art director, not even a creative director. That initially struck me as odd, but I assume they are getting paid to be an art director and then they're sharing in the profits based on the percentage of the business that they own and those two things are separate.

David: Sometimes they are and sometimes they aren't. I want each principal to ferociously want to be paid at least equally to everybody else. If you have somebody who's functioning as an art director and say there's two partners in the business and maybe it's a he, owns 50% and he's okay with getting paid less, I wonder if he should even be a partner. I want partners to fight for compensation but I think there needs to be some sort of a threshold above which principals should be paid equally and below which not necessarily. If you have two 45% partners and two 5% partners, it makes no sense to pay all partners equally.

If you don't pay partners equally, then it does weird things in terms of our emotional and mental states and so on. I think major partners ought to be paid the same. If we feel like somebody is not contributing at that level, then we ought to address that and not necessarily drop their pay. I just set a threshold of about 20%. I just say, "Listen, when I talk about a significant principal, I'm saying that that's somebody who owns at least 20%. Below that, this partnership money stuff just doesn't apply.

Blair: That's your third point. There should be a logical cutoff for the prior threshold, but to go back to the second point, people should contribute uniquely. Just so I understand you, they should contribute uniquely based on their skill set and what they're being asked to do, but the level of contribution should be roughly similar between partners.

David: Yes. They should be paid the same, but they should be doing something different. Otherwise, you get a model-- you see it in more typical professional firms like consulting firms, accounting firms, et cetera, where, as you say, there are these micro businesses. People are running books of business under the banner of one company, but that's not a common model in our world and I think you and I would agree it wouldn't be a healthy model in our world.

Blair: No, it isn't. It really isn't and it also has some positioning implications too because then you have firms thinking of you not as a 40-person firm but as a half-micro 20-person firm and there's a very different perception in the marketplace and what they're willing to pay for that. Yes, it's exactly right. Do different things but be paid the same as long as-- tying the third principle in here, as long as the partners we're talking about own at least 20% of the firm.

Blair: We're talking about a seven-part theory of principal compensation. There are seven principles here. The first is you get paid for three things, what you own, potential for realized loss, like basically lending money to the company, and then what you do. Your second point is principles should contribute uniquely but roughly evenly, an equal level of contribution. Your third point is that those two principles really only apply when the ownership level is at about 20% of the total value of the company in any individual or higher. You're saying if somebody is below 20%, it's a bit of an arbitrary line, but they're not a principal owner, they're a minority owner and these things wouldn't necessarily apply.

David: Right. Yes.

Blair: The fourth principle is actual pay should be greater than the highest-paid non-owner. We've talked a little bit about this before. I'm not sure we've agreed on it.

David: Yes. I should probably say usually, actual pay should be higher because philosophically, I'm on the same page you are and I'm guessing here that what you thought of as an example or several examples you know of where a really high-performing salesperson who's not a partner is paid more than the partner is and I'm okay with that, frankly. You are too, right?

Blair: Yes.

David: Yes, absolutely.

Blair: From time to time, it's a sign of another problem or even set of problems if that's an ongoing issue and maybe that problem is just over-reliance on that one person.

David: Right.

Blair: There are times when it makes me a little bit nervous on behalf of the principal owner and the other times where I feel like, "Yes, it seems logical in this case not to go down that rabbit hole."

David: Yes. When I look at a list of all the names and what everybody makes, I'm just struck if I don't see partners at the top of that list. It just seems weird to me and when that isn't true, in other words, when a non-partner is at the top of a compensation list, that almost always means there's some codependency happening. Like you said, we could go into that deeper somewhere else. Anyway, I'm going to give some suggestions in the notes, not necessarily in our discussion today, about what you should pay yourself exactly, very specifically. It's based on how big your firm is, how many people there are, and so on. You decide what you want, I'm just saying here, it seems odd to me if you're not paying yourself at least near or at the top of that list.

Blair: I've witnessed on multiple occasions over many years, a business owner would ask you, "David, how much should I be paying myself?" You respond with, "How big is the firm in, I think, revenue and headcount?" They give you a number, and then you give them quite a specific number back. You have a bit of a matrix on this, and we'll include it in the show notes.

David: Right. Yes, exactly. The easy answer is more. I don't have time to answer that in detail. The answer to pay yourself is more.

Blair: You pay yourself more. The fifth point here is that larger firms can pay more.

David: I think it just makes sense. Now, what that is is another question, but there is something about this. We have a standard expectation of 20% EBITDA after paying yourself a reasonable amount of money. If we're comparing a 20-person versus a 50-person firm, and that same 20% applies, obviously it's going to be real actual money. It just seems reasonable to me that makes more sense for larger firms to pay you more. You are taking more risk and so on, and it's harder to find somebody willing to take that job for the same amount of money they'd be willing to run a four-person firm for. Yes, that's just one part of the framework here.

Blair: The sixth point is interesting. There's no economic advantage in multiple-owners scenarios. I'm sure you can hear the smile in my voice.

David: That's a pretty big statement, isn't it?

Blair: Yes. I think we've done at least one episode on this on, I think it was, Should You Have a Partner? You're saying there are lots of reasons to take on a partner, but making more money is absolutely not one of them. Is that correct?

David: Yes. Now I'd love actually to be proven wrong here, but I've looked in detail at way more than a thousand firms, and I've looked for research on this as well, and I've never been able to find any reliable correlation between making more money and having more partners, which really surprises me.

Blair: Is there an inverse correlation?

David: There absolutely is an inverse correlation, but I haven't been able to quantify it. I don't know exactly how. There's less money to go around, obviously, and so on. It shouldn't be this way. Just honestly, it seems like, "Okay, if I'm not good at sales and I hire somebody that's good at new business, shouldn't we be doing better?" One of the theories I'd like to explore is the fact that, yes, theoretically, you could make more money if you have more partners because you can get all these experts to do work for you, but what happens is on the other side of that coin is that decision making becomes different.

Somehow that wipes out the technical advantage that seems like it would be there to have a bunch of partners. I don't know. I'm just speculating here, but I've never seen any economic advantage in multiple-owner scenarios. Why am I even including this in the framework? It's because it means that there is a financial penalty that comes with having multiple partners, and we need to acknowledge that.

Blair: It might be worth it.

David: It might be worth it. It absolutely might be worth it. In fact, I almost added a partner about five or six years ago, things that you can't even quantify sometimes, like loneliness or countering your different weaknesses, and so on. There's all kinds of great reasons to add a partner, but money is not one of them.

Blair: Yes. Freeing yourself up, sharing the burden of responsibility, having somebody who's got skin in the game who will give you honest, critical feedback, adding the skill sets that you don't have that we could probably double or triple that list. There's lots of reasons to think about taking on a partner, but your point is there's almost certainly an economic penalty to pay.

David: Yes, exactly. That's hard to tell people, but it's just the truth.

Blair: Seventh point, I'm not sure I fully understand your seven-part theory of principal compensation. Taxation is unrelated. What do you mean by that?

David: There are tax incentives to pay yourself differently here in the US I'm talking about specifically, but those are state-based issues. In some states, it makes a lot of sense for me to take no-profit distributions and take everything through-- I'm an S-corp, so to take everything through payroll. We're avoiding some taxes that way, but that's absolutely the opposite in other states. I just want to separate the idea here. Let's say that you live in a state where it doesn't make sense for you to pay yourself a W-2. How are you doing distributions? Is it monthly or quarterly? Whatever it is, whatever the fixed regular rate is, think of that as your salary and think of the variable stuff that happens or doesn't happen and that it's not evenly spaced, think of that as the EBITDA or the profit.

Just try to take taxation out of this. I recognize that you make your decision about what you should pay yourselves as partners and then it might look different on paper

Blair: Yes, somebody living in one state might prefer a different tax strategy so all distributions, no salary, another might prefer your all salary, et cetera.

David: Yes

Blair: Seven points on your seven-part theory of principal compensation. You get paid for three different things. Basically what you own, what you do, and the risk you take. Principles should contribute uniquely but at the same level. There should be a logical cutoff for the prior threshold and that's a cutoff in ownership level at 20% or higher. We consider that person to be a principal owner below 20%. They're a minority owner and a lot of these rules or principles might not apply. Number four, actual owner pay should be higher than the highest-paid non-owner.

Number five, the larger the firm, the larger you can get paid. Number six, there's no economic advantage in having a partner, and number seven, taxation is completely unrelated. Do you have some helpful tips you want people to take home on how to apply these ideas?

David: Yes. Two numbers ones and then one big one. Two numbers ones is what you pay yourselves as partners and your people shouldn't exceed 45% of your total revenue, and you want to be aiming for 20% net after paying yourselves reasonably.

Blair: 20% net profit after.

David: Net profit. Yes. If those numbers are hard to balance then there's something fundamentally wrong. You want to look at that and figure that out? The big piece of advice is figure all this stuff out while you're getting along. It's too late to do it later. Then you got to hire people like me. Figure this stuff out while you're all getting along including things like one partner is going to move away and live half the world away, seven time zones away. That comes up, but the biggest place this comes up is when a principal decides to not work full-time anymore. You ought to address that possibility while you're all getting along and working full-time.

Blair: Got you. I imagine you've been hired specifically on probably numerous occasions to come in and sort through the disagreements that not having these principles in place engenders.

David: Yes, right. Then the measure of success for me is that I've pissed everybody off.

Blair: Yes, "Nobody's happy. I've done my job."

David: Yes

Blair: That's a David Baker dream scenario. "I feel good. Nobody else does, but I feel fantastic." Thanks for this David.

David: Thanks, Blair.