Every time an apparently record-breaking compensation level is revealed in the press, we receive a wave of questions from managing partners asking, “Are our top performers paid fairly?” and “Should we increase our compensation spread?”

When an economic upturn dramatically increases profits in the profession, new rainmakers emerge, and existing rainmakers typically see their businesses grow as well. But a subtlety that some companies fail to recognize is that many established rainmakers are growing their businesses disproportionately, and unlike many new rainmakers, that growth is more likely to continue. As a result, companies must periodically reassess their pay distribution to ensure it covers the performance of all partners, especially those at the top. But this is an exercise that is easier said than done.

For some companies, economic growth improves everyone’s performance, proportionally, so that frequent adjustments are not necessary. This is easy if a company has two important characteristics:

• If a company uses a compensation structure that automatically adjusts to profits, such as a points or level structure (the most common structure among successful companies). For such companies, an existing spread will often accommodate the changing economic circumstances of all partners and will rarely require adjustment.
• If a company has rigorously enforced partnership standards so that there is consistency in the performance and contributions of its partners, making it less likely that a new top segment will need to be continually redefined.

But that second characteristic is not easy to maintain: it is simply human nature that companies become less strict in enforcing standards during good economic times. Sustained increases in profits drive companies to promote/accelerate many partners, only to later be forced to deal with inflated rewards and/or bloated partnerships that weaken the company’s reputation and economics. And since compensation is a zero-sum game, paying too much to some partners causes a company to pay less to others.

Another problem is the arbitrary ceiling that some companies place on the top of their pay dispersion. While most healthy companies set a compensation cap, failure to reexamine this in the context of rapidly changing profits can result in rainmakers being underpaid (or sometimes even overpaid) relative to the market.

How can robust checks be carried out to ensure that their pay distribution is appropriate? Unfortunately, this analysis involves subtle issues that can often lead companies to the wrong conclusion. For example, some partners will argue that their ‘colleagues’ in other companies have similar financial performance but are paid significantly more, hence the conclusion that they must be underpaid. But that comparison is superficial and ignores critical facts about what determines “market compensation levels.” A common misconception is that a partner’s market compensation can be determined by calculating a certain percentage of his/her activities, or by looking at an individual’s performance data separately. Both are widely held but mistaken beliefs. The market compensation for a given partner is based on their personal metrics, but is also heavily influenced by three additional factors that are all too often overlooked:

• The profit level of their business;
• The philosophy and reward structure in use, and increasingly so;
• The profitability of their work.

All three factors influence how much a partner can earn in his/her business, regardless of what happens in the broader market. The proof? Two partners with identical financial performance (e.g. operations, production, realization, leverage, etc.) in different businesses can vary in compensation by 40% and both be paid fairly and appropriately for their performance in their respective businesses. And unfortunately, for many leaders, the first two factors can quickly turn into a reactionary referendum on their success in keeping a business healthy and profitable.

Determining fair compensation in law firms is much more than a math problem or the application of simplistic industry hearsay. While high-profile pay figures can fuel emotional debates about equality, a more nuanced understanding of business economics, reward structures and partner performance is essential to ensure all partners are paid fairly and within the market. Ultimately, building a balanced and sustainable business requires an understanding of the competitive compensation market, but just as importantly, a deep understanding of how business economics influence compensation.

Blane Prescott is managing shareholder of Mesa Five, a management and strategy consultancy focused on the legal profession.