Compensation & Benefits

Aligning management compensation and shareholder earnings

The boards of family businesses must find the proper balance between compensation for the management team working in the business and earnings for the family shareholders who own the business. It is likely that some family members will wear both hats, which heightens the challenge of distinguishing the return on labor (management) from the return on capital (shareholders).

The good news is that a healthy and well-performing family business will be able to fund both management compensation and shareholder earnings. A properly structured management compensation plan is based on performance measures and goals that are aligned with the objectives of family shareholders.

Evaluating your management compensation program to ensure it strikes the right balance between management compensation and shareholder earnings involves answering four main questions:

1. What are competitive practices and expectations with respect to management pay and shareholder returns?
2. How is company performance defined?
3. What are the critical points of alignment?
4. How are management compensation and shareholder earnings structured?

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Sharing your family business profits fairly

The allocation of profits from a business among its owners typically reflects their overall contributions to the business, including contributions of both human and financial capital. However, in a family-owned business the situation may not be quite that simple. For example, in family businesses, the owners may have to balance economic contributions against their status as family members when allocating the company’s economic results. How can the owners evaluate the economic contributions of different family members, if that is a consideration?

Family business owners must also consider whether an individual family member’s unique economic needs should play any role in making those capital allocation decisions. For example, if family members need significant income from the business to sustain a lifestyle or deal with an unexpected event, it may be more likely that the family business will be harmed over time through unsustainable compensation to certain family members, perhaps financed by borrowing or deferring capital expenditures. Having “owner need” rather than “company performance” drive firm economics is usually not sustainable over the long run (and sometimes not over the short run, either).

These issues become more complicated if some family owners are active in the business and others are not. The economic value of the active owners’ contributions must be determined. Active owners may be more willing than passive family owners to take business risks. Also, as a function of basic investing common sense, passive family members may be questioning how much of their net worth should be tied up in an illiquid family business managed by other family members.

There are several ways for family business owners to approach these challenges.

Compensate performance, not need: As discussed above, avoid allocating economic results among family members based on their needs, as this can breed resentment and hurt business performance. If feasible, handle special cases of individual need outside the company financial statements — for example, by making gifts or establishing trusts for personal needs.

Reward what you can measure: Consider adopting bonus or compensation arrangements among family members that are based — at least in part — on achievement of objectives and clearly defined financial metrics. This may help reduce the risk of bickering or disputes and, if set up properly, should better align results and rewards. If the family owners cannot agree on such an arrangement, it may make sense to bring in a third-party business consultant who can help the family devise a method of sharing economic rewards that is both reasonable and sustainable.

Divide and conquer: Another strategy for aligning rewards and performance is to establish separate business divisions/fiefdoms for different family members if the business lends itself to that approach. This works best for family businesses that naturally divide into separate profit centers, such as car dealerships, farming operations, hotels or restaurants. This technique may not help with resolving issues that affect the business as a whole, but it can greatly reduce day-to-day friction.

Have clear exit strategies for passive owners: Consider adopting buy-sell mechanisms that facilitate buying out the interests of family members who are no longer employed in the business. This can be particularly important for service businesses that rely more on human capital than physical or financial capital. Compare, for example, a family business that owns office buildings with one that constructs or brokers office buildings. Having passive family members continue as investors in a building may be a lot simpler than retaining them as owners of labor-intensive operating companies.

Align risks and rewards: Make sure the family business’s finances are structured so the owners’ interests, risks and rewards are aligned. For example, if the business needs a capital infusion, do all the family owners have the capacity (and willingness) to provide proportionate equity contributions, owner loans or guarantees of third-party debt? If not, those disparities should be addressed by enhancing the upside economic potential of owners who may be required to provide more capital. This could be achieved, for example, by paying separate fees to family members who provide guarantees, creating a preferred return class of ownership for family members who are liable for capital calls or providing the financing owners with an enhanced “profits” or “promote” interest that allows them to receive a larger portion of the firm’s profits above certain designated levels. 

Finally, operating the family business on a conservative financial footing, with relatively low leverage, can be very helpful in avoiding economic crises that stress family relationships and endanger the enterprise. Family business squabbles can happen any time, but they most often occur when there is not enough money — and owners feel the pinch — or when results are better than expected, prompting some owners to get greedy. Avoiding excessive borrowing can help a family firm avoid running short of cash in downturns along with the resulting stress and potential for owner conflict.

Although family businesses present unique challenges, they also can provide unique rewards. First, there are obviously all the non-economic benefits of close daily involvement with people that you love. Without having to answer to outside owners or directors, there can also be business benefits in being able to take a long — even multigenerational — view of business challenges and opportunities. Not feeling the obligation to squeeze the last few basis points of profit out of every situation in order to satisfy outside owners can be remarkably liberating for the family firm.

Richard Spore (rspore@bassberry.com) is a member at Bass, Berry & Sims PLC. He advises clients in commercial real estate and lending transactions and counsels investors and private company owners in a wide variety of investment partnership, joint venture and start-up situations.
 

Designing incentive compensation for key non-family executives

Many family businesses will reach a point where non-family executives are needed to manage the company and take it to the next level. There are myriad challenges to overcome in attracting outside talent to a family firm. Some executives are concerned about the uncertainty of family dynamics. Others are discouraged by what they see as the slim chance of a lucrative exit.

One of the biggest hurdles for family businesses is the need to develop an attractive long-term incentive (LTI) plan that recognizes enterprise value created over time and is competitive with plans offered by public companies and private equity–owned businesses. There are several ways to offset the inability to offer publicly traded stock or stock options.

Non-Family Executives

Read more...

When a non-family member leads the family business

The role of culture in recruitment of non-family executive

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Family firms must consider the role of compensation in the war for talent

Executive pay tactics are a potentially powerful set of tools for any business to use in recruiting, retaining, motivating and rewarding the key executives who are most responsible for sustaining and growing a business. However, there are important additional considerations for family-owned businesses.

Family companies must resolve two unique issues: (1) how to compensate family members in a way that is fair for the family executive as well as fair for other family owners who don't work in the business; and (2) how to create and maintain a compensation plan that is attractive to non-family executives you are trying to recruit, retain or motivate.

Compensating family members

Many family businesses have run into big problems when compensating family members—and, in some cases, the issue has destroyed businesses and families. There are many traps to avoid.

This risk is amplified when some family members work in the business and others do not. Family members who work in the business might feel they are undercompensated. On the other hand, family members not in the business might feel those in the business are overcompensated.

Family businesses that have successfully avoided problems share several best practices:

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Compensation in family businesses: The advantages and the challenges

 

As a private, family-controlled company matures, it faces complex business challenges if it is to continue on a profitable growth trajectory through future generations. One of the major challenges is recruiting, retaining and engaging outside executive talent. In addition, the current executive team must be compensated in a manner that encourages continued value creation and maximizes the compensation investment.

Executive compensation is an area that can either help facilitate the development of the leadership team and encourage generational transition, or serve as a barrier to continued business growth. Family companies must capitalize on their competitive advantages, while mitigating the most common challenges.

Compensation advantages

When competing for talent in the executive labor market, family companies have several inherent executive compensation advantages to help attract, engage and retain executive talent.

Freedom to design: Family companies, especially those that are private, have the freedom to design and structure executive compensation in any way that the owners believe is optimal for the business. Unlike public companies, private companies are not under the microscope of institutional shareholder advisers and investors with short time horizons. These outside forces exert extreme pressure on public company boards to offer plain-vanilla, one-size-fits-all executive compensation plans and often base their recommendations on simple checklists. Programs and features that are outside the market norm are red-flagged, sometimes solely for being different. The result is a continued homogenization of executive compensation programs in the public market that does not necessarily serve the needs of each company. Private firms, by contrast, can design programs more strategically.

Unique pay programs: Given this freedom from public scrutiny, family-controlled entities often have unique compensation programs. In many cases, the plans were developed by founding family members and have become part of the fabric of the culture. Often these programs have nuances and features that one would not find at a public company, such as innovative deferred compensation plans, long-term incentive plans based on economic value drivers, and internal stock valuations insulated from the vagaries of the public stock market. These differentiated and unique pay programs provide family-controlled companies with a potential competitive advantage over increasingly generic plans at public companies.

Long time horizons: Family companies have naturally long-term perspectives on the business. There is a sense of history and legacy as ownership is passed down through generations. This long-term view stands in stark contrast to a public company, where there is enormous pressure to meet quarterly earnings-per-share targets. This extended perspective at family companies provides the leadership with more flexibility to develop and execute a long-term business strategy. From an executive compensation standpoint, pay plans may be designed in a manner that rewards true long-term success of the enterprise. For example, a 2015-2016 survey of private family business boards by the National Association of Corporate Directors showed that almost 50% of respondents considered a time horizon greater than three years for executive performance plans, in contrast to the almost universal three-year period for public companies.

Less equity volatility: Private, family-controlled companies are more insulated from the rollercoaster ride of the public stock markets. Many private family companies offer some form of long-term incentive tied to the value of the business, which may be an actual stock interest, phantom stock or some other form of long-term reward based on the value of the private equity. This private valuation is not subject to the manic behavior of the public equity markets, making it a more stable basis for long-term compensation.

Great company culture: Family-controlled entities can offer a very attractive company culture. For many senior executives, the family culture is a refreshing contrast to the bureaucracy and politics that all too often exist in public companies. In fact, strong corporate culture is a key reason that family businesses often top the lists of "best places to work." These companies can foster tremendous executive loyalty. Many executives choose to stay with family firms for reasons well beyond compensation.

Compensation challenges

Despite these significant competitive advantages when it comes to executive compensation, privately owned family firms also face several common compensation challenges.

Informal pay governance process: Compensation governance in private family firms tends to be a bit more informal and less structured than in public companies. According to the NACD family business board survey, about 72% of companies have a compensation committee, which typically meets four times per year. However, there is often less clarity around the purview of the committee, and its compensation decision rights and meeting agendas may be more fluid than in the public realm. Also, the committee usually consists of family shareholders and insiders, rather than independent directors. In a public company, stock exchange listing rules require an independent committee. When insiders serve on a compensation committee, executive pay discussions can be more personal and potentially contentious.

Opaque compensation plans: Many family companies offer unique compensation programs, but these programs are sometimes opaque and not fully understood by all stakeholders. Overall, executive compensation is not subject to the same transparency as in a public company; there is no requirement to summarize the programs in an annual proxy statement. Thus, obscure features of the compensation plan may persist, and executives may lack a complete understanding and appreciation of the value of the total package. In such cases, the company may be failing to maximize the return on investment of the compensation program. Indeed, the compensation committee itself may not fully understand the plans.

Below-market long-term incentives: In most instances, private companies will offer long-term incentives that are well below market compared with those offered by public companies. There are numerous reasons why family companies offer below-market long-term incentives. These reasons include the family's unwillingness to share equity and thus dilute both ownership and earnings. Thus, it is often unrealistic for a private family company to match the long-term incentive compensation levels offered by public companies, and the total compensation strategy must consider this shortfall.

Absence of a total compensation strategy: Family companies often lack a cohesive compensation strategy covering all elements of executive pay: base salary, annual incentive, long-term incentives and benefits/perquisites. The company leaders may not understand how all of the elements of pay fit together as well as the trade-offs between various elements. Further, while family culture can be a significant competitive advantage, there is a downside to the culture as well. At the extreme, the family company may find itself leaning too much on the culture and goodwill of executives, believing that loyal, long-tenured executives are less concerned about compensation. In some cases, the owners erroneously believe that company culture offsets any competitive shortfalls in compensation.

Lack of external market knowledge: Private family companies often lack an understanding of current market practices and norms. Small companies place less emphasis on the external labor market. They tend to promote executive talent from within the company, until that is no longer tenable. A lack of knowledge about executive compensation trends can hinder the ability to compete for talent. Just as a family company should not ignore its competitors' business practices, it is not advantageous to put one's head in the sand and ignore market practices for executive compensation. As with everything in business, "ignorance is not bliss."

Considerations

How can family-controlled companies better capitalize on these competitive advantages and address these common pay challenges?

Refine the executive pay governance process: Family companies should customize the governance process to fit the board structure and culture. Typically, the pay governance process will be a bit more informal than in a public company, but several best practices can be adopted. These include clarifying the committee's purview, defining decision rights, and establishing a calendar of events and a predictable annual agenda. Furthermore, the committee should monitor market practices, including trends in executive pay levels, plan design and technical issues (e.g., tax, accounting and the SEC).

Study the specifics: Executive leadership and the compensation committee should seek to fully understand the details of the company's pay programs. This includes all elements of total compensation. Further, the committee should be familiar with current market practices of comparable private and public companies. The committee should recognize how the company's practices differ from market and what makes the compensation value proposition unique. There is no benefit to be gained by having one's head in the sand.

Develop a realistic total compensation strategy: Family companies must articulate a thoughtful but realistic compensation strategy. Armed with quality information about the company's own pay programs and the market, the business leaders are in much a better position to set a total compensation strategy—one that is realistic, customized to the company culture and based on compensation realities. The strategy should go beyond simple platitudes such as "be market competitive."

Better communicate compensation programs: Family-controlled companies must do a much better job of communicating the executive compensation "deal." Companies must make their unique—but often opaque—compensation programs more transparent. Executives should be aware of and appreciate the total economic value of all pay elements. In addition, they must fully grasp the concept of incentive plans in order for these incentive plans to actually influence executive behavior. Finally, compensation committees themselves must understand total compensation programs in order to make informed, rational pay decisions.

Winning the war for talent

Executive compensation can be a challenging issue in the family enterprise. However, just as the business must evolve to continue profitable growth, so must the executive compensation system. With some careful planning and structure, family-controlled companies can manage executive compensation in a manner that addresses the most common challenges, while maximizing their inherent competitive pay advantages. This will enable them to build the right teams that can advance the long-term growth strategy of the business at the same time.

David Seitz is managing director at Pearl Meyer & Partners LLC (www.pearlmeyer.com).

Executive Compensation at Family-Controlled Companies

Compensation Advantages       Compensation Challenges

• Freedom to design          • Informal pay governance process

• Unique pay programs          • Opaque compensation plans

• Long business time horizons    • Absence of a total compensation strategy

• Less equity volatility          • Below-market long-term incentives

• Great company culture        • Lack of market knowledge

Copyright 2016 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permission from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.

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ESOPs offer liquidity solutions

Most later-generation family businesses will face a liquidity crisis at some point in their life cycle—all too often when it is least expected, and when the family can least afford to be divided by a contentious issue.

A company, for example, may require reinvestment of profits to meet business needs while, at the same time, family owners inactive in the business may need dividends to help support their lifestyles. There also may be liquidity issues related to the death of a senior business leader—cash may be needed to fund taxes, estate administration fees and other expenses related to the senior leader’s estate.

Unfortunately, in many cases these situations result in conflict among family members that can affect the business. Employee Stock Ownership Plans—commonly known as ESOPs—can be an effective way of resolving liquidity issues such as these while maintaining family harmony. What’s more, ESOPs are a way of rewarding employees, who receive stock in the company without paying for it (but must vest over time). The owners can maintain control over the company if there are different classes of stock. There is yet another benefit—if a vehicle known as a “1042 rollover” is used, an ESOP program offers significant tax advantages.

What is an ESOP?

An ESOP is a type of qualified defined contribution plan that is invested primarily in employer stock. ESOP assets are held in trust for the benefit of plan participants. ESOPs are regulated by the Internal Revenue Service and the Department of Labor under the Employment Retirement and Income Security Act of 1974 (ERISA).

A simple way to think of an ESOP is as a profit-sharing plan that purchases company-owned stock instead of other public or private company stock.

Altogether, there are about 11,000 ESOPs covering 13 million employees, almost all in closely held companies. Another estimated 15 million employees participate in one or more of these plans in public companies.

Studies in Massachusetts, Ohio and Washington show that, on average, employees participating in ESOPs have considerably more in retirement assets than comparable employees in non-ESOP firms. The most comprehensive of the studies, a report on all ESOP firms in the state of Washington, found that the retirement assets were about three times as great, and the diversified portion of employee retirement plans was about the same, as the total retirement assets of comparable employees in non-ESOP firms. Many more ESOPs would be in place if individuals were properly educated on the functionality and overall structure of an ESOP.

Defined contribution vs. defined benefit plans

A defined contribution plan—such as an ESOP, a 401(k) or a 403(b) plan—is a retirement savings program under which an employer promises certain contributions to a participant’s account during employment, but with no guaranteed retirement benefit. The ultimate benefit is based exclusively upon the contributions to the plan and the plan’s investment earnings. The benefit ceases when the account balance is depleted, regardless of the retiree’s age or circumstances.

By contrast, a defined benefit plan is a pension plan (traditional pension or fixed pension) under which an employee receives a set monthly amount upon retirement, guaranteed for the life of the plan member or the joint lives of the member and spouse. This benefit may also include a cost-of-living increase each year during retirement. The monthly benefit amount is based upon the participant’s wages and length of service.

Leveraged and unleveraged ESOPs

There are two types of ESOPs: leveraged and unleveraged.

• In an unleveraged ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares.

• A leveraged ESOP borrows money to buy new or existing shares. The company makes cash contributions to the plan to enable it to repay the loan.

Funding the ESOP

The accompanying diagrams illustrate a leveraged ESOP transaction structure and movement of money over time. Figure 1 shows a financial institution lending money to the company (Step 1). Next (Step 2), the company lends an equal amount to an ESOP Trust to facilitate the purchase of stock, thereby creating an internal loan between the company and the ESOP Trust. Then (Step 3), the ESOP Trust uses the proceeds the company has lent to it to purchase shares of company stock from the selling shareholder(s).

Figure 2 shows the internal loan and the external loan from the financial institution being repaid over time. In Step 1, the company makes a contribution to the ESOP Trust. This contribution is tax-deductible because the ESOP is a qualified retirement plan. In Step 2, the ESOP Trust repays the principal and interest due on the portion of the internal loan between the company and the ESOP. In Step 3, the company uses the proceeds received from the ESOP Trust to repay the principal and interest on the loans provided by the lender.

 

Employee vesting

An ESOP must comply with one of two minimum schedules for vesting. (Plans more generous to participants may provide different standards).

• “Cliff” vesting: No vesting at all in the first years, followed by a sudden 100% vesting after not more than three years of service.

• “Graded” vesting: 20% vesting after the second year of service, with 20% more each year until 100% vesting occurs after the sixth year of service.

A “year of service” generally refers to a plan year in which a participant has worked 1,000 hours; it may include past service—to reward long-term employees for their contributions toward building the company and to motivate them going forward. If an employee has worked at the company for five years, for example, the company can elect to have a certain percentage of stock vested immediately.

ESOP stock is allocated to employees based on ongoing eligible compensation (up to $245,000 per year per employee). When employees leave the company before they are fully vested in their accounts, they forfeit the amount that is not vested. The forfeited stock is then reallocated to remaining participants. This may limit the amount of other contributions that can be allocated to such participants.

When employees leave the company, they receive their stock. The company must buy the stock back from them at its fair market value (unless there is a public market for the shares).

ESOP valuation

Since ESOPs exist within a regulated environment, it is required for the underlying shares held within an ESOP to be valued at the time of an ESOP transaction as well on an annual basis. An independent valuation is performed and presented to the ESOP trustee for review. The ESOP trustee reviews and negotiates the initial ESOP transaction and sets the valuation price annually thereafter.

In a leveraged ESOP scenario, the company’s equity value just before and after the ESOP transaction differs significantly. Let’s assume that in order to facilitate the transaction, the company must take on debt to acquire shares from shareholders. Thus, the company’s capital structure changes, and the company’s balance sheet has additional debt on a post-transaction basis. This has the effect of reducing the company’s equity value immediately after the transaction. Figure 3 shows the company’s equity value vs. its enterprise value and how equity value subsequently recovers as the financing is repaid over time.

Deferring taxation using the ‘1042 rollover’

Under Section 1042 of the Internal Revenue Code, an owner of a closely held C corporation can defer capital gains taxes on stock he or she sells to an ESOP if (1) the ESOP owns 30% or more of each class of outstanding stock or of the total value of all outstanding stock, excluding nonconvertible, non-voting preferred stock; and (2) the seller reinvests (“rolls over”) the sale proceeds into qualified replacement property (stocks or bonds of domestic operating companies) between three months before and 12 months after the sale.

The money “rolled over” into replacement property need not be the actual proceeds from the sale; it can be an equivalent amount of money from another source. Any or all of the proceeds can be rolled over; the seller(s) will simply pay taxes on the rest. Two or more owners may combine their sales to meet the 30% requirement if the sales are part of a single, integrated transaction.

Sellers using the Section 1042 rollover often avoid taxation completely by retaining the replacement property until death, at which time the property transfers to their heirs with a stepped-up basis. Section 1042 is a powerful tool for avoiding taxes within one’s estate planning.

The regulations allow for a fair amount of structural flexibility in meeting corporate objectives and timing expectations. Knowledge of the structural limits is critical in the implementation of an ESOP.

Tax benefits of an ESOP

Because of the ESOP’s status as a qualified retirement plan, there are several tax benefits.

• Contributions used to repay a loan that the ESOP takes on to buy company shares are tax-deductible. Contributions to repay the loan principal are deductible for up to 25% of the company’s eligible payroll of plan participants.

• Interest associated with the ESOP is tax-deductible.

• Dividends are tax-deductible when they are used to repay the ESOP loan (but only dividends on the shares bought with the loan can be used to make such payments).

• Cash and stock contributions are tax-deductible.

• Employees pay no tax on the contributions to the ESOP. They pay tax only on the distribution of their accounts.

• Sellers in a C corporation can get a tax deferral under Section 1042 of the Internal Revenue Code.

• Any profits attributable to the ESOP’s ownership of stock in an S corporation are not subject to federal income tax. A 30% ESOP pays no tax on 30% of its income; a 100% ESOP pays no tax at all.

Family involvement

The former family owners who have sold their shares to the ESOP can continue to be involved in the company’s operations in the following ways:

• Continuing to participate as a member of the company’s board of directors.

• Continuing to participate in the company’s day-to-day operations by performing the ongoing duties of a corporate officer. (This implies that former family owners are active managers in the business.)

• Becoming an internal ESOP trustee after the transaction. (Like other trusteeships, this involves risks.)

Two case studies

The owners of two companies recently were researching various alternatives, including selling the companies on the open market. In both cases, the M&A market was not receptive because the economic downturn had compressed valuation multiples significantly.

• Partial ESOP purchase: The owners of an industrial company implemented a partial sale via a 30% ESOP transaction that provided the sellers with the ESOP tax-deferred qualification. The entire transaction was funded with senior financing from a financial institution. Principal and interest payments were effectively tax-deductible to the company. The controlling shareholders plan to sell additional shares to the ESOP Trust before testing the market in the future. If the market does not yield an expected range of value that is suitable for shareholders, then a sale of the remaining shares to the ESOP may occur.

• Total ESOP purchase: The owners of a health-care company sold 100% of the company to an ESOP Trust through a combination of senior mezzanine and subordinated financing. The sellers elected to defer their proceeds using Section 1042 of IRS code. At the close of the transaction, the company elected S Corporation status and currently pays no taxes because the company is 100% owned by an ESOP.

Key points

Family business owners who sell stock to an ESOP receive fair market value for the stock (as if public) and can defer capital gains taxes indefinitely by electing the “1042 rollover” tax provision. Debt principal and interest is amortized with pre-tax dollars, thereby increasing working capital by saving 35% to 40% of every dollar repaid to the lender. If preferred dividend-bearing stock is used within the ESOP, the dividend can be deducted from the company’s profits for tax purposes.

For an ESOP to function properly, the company must have consistent earnings and a substantial non-union payroll. Always conduct a feasibility study before adopting an ESOP.

An ESOP can provide many financial advantages—but each situation should be financially analyzed in depth before implementation.

Richard Houlihan, CPA/ABV, ASA, is co-founder and chairman of Houlihan Smith & Company (www.houlihansmith.com), a national investment banking firm that provides financial options, valuation and corporate advisory services to public and private businesses.

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A better way to pay

How to compensate workers has been a dilemma since the hunting and gathering societies. From communism to capitalism mankind has questioned the value of work, education, time and brawn. Even within capitalism, employment reward systems range from “performance bonus” to “union scale.”

During our last economic boom, surveys showed that employees favored job security, “being valued” and good communication above compensation. In today’s economic downturn, compensation—income—would likely rise on the list. Certainly, these economic times have made all businesses more keenly aware of their compensation policy. If you haven’t already revamped your family businesses compensation, there is no better time than the present.

Family businesses are notorious for confusing the business and family systems. It is no different when it comes to compensation. Family members are usually exempt from the compensation policy used to reward the rest of the employees. Bad practices include bonuses for house down payments or having babies as well as underpayment with the promise that “one day this will all be yours.” Probably the practice that heads the top ten list of bad practices is paying all the children equally regardless of their relative value to the business, educational background, experience or expertise —which in some cases even means paying someone for doing nothing.

While there is no “right” compensation policy, there is a process that will eliminate inequities and annual debates. Make no mistake, you do have a policy, even if it isn’t in writing. If you are not sure what it is, just ask around. If you don’t have written compensation guidelines, your employees will say the policy is “management discretion,” or something similar. While that is, in fact, a policy, you may want to draft something more specific that will provide for both family and non-family employees in a fair manner.

Philosophy

Start with a compensation philosophy. How does your industry pay? How does your company compare with the industry standard? Is your compensation policy based on individual performance, or is it a team effort reward system? Do you reward goal achievement? Do you promote from within to increase compensation potential? Is your fringe benefit package optimal or minimal? How are profits shared, if at all?

Draft a few paragraphs that state your company’s compensation philosophy. This will make the rest of the task easier. Keep in mind that you want to be competitive in your market in order to attract and retain good employees.

Fair market value

There is a fair market value for each job, and it is possible to find the range of compensation for that job. Many websites offer compensation data based on job description, industry, company size, location, etc. The difficult task is matching the actual job to the job description on the site you chose to use. You may have to combine salaries and average them. If you can find a site that is specific to your industry, you stand a better chance of finding parallel job descriptions.

If you don’t have job descriptions, you will have to start there. You might ask your employees to create their own first, and have their superiors work with them to fine-tune the results. Again, many websites can help with this task. Once final drafts have been obtained, your executive team should review the results for omissions and overlaps. This task will offer an opportunity to streamline your organization. Organizational mapping would be very useful.

Next, go the site you have decided to use and research the job descriptions it provides. If you don’t find solid matches, you will need to improvise a bit. Then, you should be able to apply your philosophy to the data you have obtained and come up with a range of compensation. The data will break down the compensation into salaries, bonuses and fringe benefits. It will give you a selection based on percentages. This is where your philosophy will help you to establish your range.

Let’s say you decide to pay on the low end of regular salary, but offer larger incentive bonuses based on profitability. You also want to offer a fringe benefit package in keeping with your industry and location. You might develop a range of pay within the 25th to 50th percentiles for that job description, and define your bonus plan and fringe benefit package. This allows you to reward employees based on their jobs and individual skill sets. Top performers should be at the top of the range. New hires with little experience would be at the bottom. You can adjust for education, attitude, seniority and other skills you find desirable.

You can then decide what to do from year to year. I suggest an annual cost of living increase based on a relevant Consumer Price Index with a re-ratchet every three years. This allows you some flexibility to offer raises to those who deserve to move up within the pay range and to adjust the pay range every three years. It also prevents overpaying for a job. Once someone maxes out at the pay range, the only options are to adjust for CPI or re-ratchet increases. To make more money, the employee must get a promotion to a higher-level position.

This policy should hold for family and non-family alike. It is best administered by a small committee (three members are recomended) to add objectivity.

Bonuses

Bonuses are a key element of compensation. Employees come to expect a bonus after the first one they receive. Any compensation policy should address how bonuses will be determined and paid. Usually, bonuses are based on individual performance against some goal, such as sales or profit. Keep in mind that if you offer a formula, the data used to establish the numbers will be questioned. If the bonus is based on profitability, your accounting is likely to be challenged. If you do not intend to share financial information, it is preferable to find a way to offer bonus incentives that won’t be based on the way you do your accounting or take your income. Units of widgets, sales volume and percentage increases over a previous time frame are ways of eliminating the need to share financial information.

If family members are part of the bonus plan, and you intend to treat their bonuses differently from those for non-family, you must clarify exactly what constitutes their bonus. You might want to write two checks—one for the regular plan and one for the family plan. Often the family plan is really a dividend or distribution of profit given merely because someone is family! These distributions may be given to family members who are not owners; that amounts to the owners sharing their return on their investment. The key is that whoever gets a check should know what it is for and feel deserving. Otherwise, you are contradicting the message that a bonus is an incentive.

Be mindful about a bonus formula that pays out in lean years, or when there might not be sufficient cash. Remember, too, that bonuses reward past performance. They offer incentive only if they are anticipated in the future. Most employees consider them a part of regular compensation and feel cheated if the bonus decreases or is omitted.

Evaluation

Any compensation policy requires a corresponding evaluation process. To add objectivity, it is best if the evaluation is done by a small committee. It’s also best if the evaluation is delivered to the employee at some time other than when compensation is being adjusted. Otherwise, it is likely that the only message will be the compensation adjustment and not the other facets of the evaluation.

Use caution

Getting buy-in from key em-ployees will go a long way toward preventing disorder. Working with a small committee to obtain job descriptions and determine fair market value will help achieve employee acceptance.

If you decide to revamp your entire compensation policy, you must crunch the numbers and compare them to your current payroll. Any revamping will likely result in some employees getting increases while others suffer decreases. You might choose to soften decreases by spreading the pain over time, or increasing bonus incentives. Remember, the idea is to develop a compensation policy addressing fair market value and not to merely find a way to increase wages.

It is strongly recommended that you retain a competent professional to guide you through this process. In the end, you will find that a systematic approach to pay makes great sense for both your business and your family.

Richard M. Segal (rmsegal@segalconsulting.biz) is a family business consultant and chairs the Family Business Council, a membership organization for family firms in Southeastern Michigan. He has served as an adviser and a director on several family business boards.

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Worth their salt

The word “salary” comes from the Latin word salerium, a payment made in salt. In ancient times, salt was a valuable commodity, used not only for seasoning but also to preserve food. According to Roman historian Pliny the Elder, soldiers were paid in salt, hence the term “worth one’s salt.” Pay scales presumably were set by the Emperor of Rome.

In family businesses today, however, the subject of compensation is peppered with questions of equality, fairness and paternalism. Emotions run high. The risk of damaging family harmony can make this subject “the elephant in the living room,” one of the most sensitive issues.

According to my father-in-law, Milton L. Rock—patriarch of our family business and former managing director of the Hay Group, a consulting firm that specializes in compensation practices—a family business should be run as much like a public corporation as possible. Employees, including family members, should be rewarded based on their performance and accountabilities. Problems arise when family employees feel a sense of entitlement as owners, or when those who are not working in the business feel it is their inheritance. This can lead to family conflicts and claims of inequality. Fair is not always equal.

However, Milt allows that outside the core compensation objectives of the business, family members may want to have extra compensation that will enable them to contribute to, or maintain a position in, the community. This extra payment may come in the form of dividends or profit sharing. When the business is small, Milt explains, one can exert more family influence over how much should be reinvested and how much can be paid out. His experience shows that there is a life cycle for family businesses. When the business is just beginning, the family is willing to take less pay, just as in periods of economic downturns, the family should take the hit first.

When it comes time for the next generation to enter the business, my husband, Bob—who sits on a number of boards of family-owned and family-controlled businesses—advocates bringing in a professional to help develop the compensation philosophy, which the entire family should sign off on. From there, compensation programs can be devised with individual pay moving up or down based on performance evaluations. Defining the rules ahead of time is essential and can save much aggravation.

In The Family Business Compensation Handbook, family business adviser Robert H. Brockhaus concurs that family salaries should be based on responsibilities, abilities and performance levels equal to those of non-family executives. Compensation should not be based on need; a distinction should be made between relatives who do not work in the business and those who do. It is wise to call a gift a gift and not pay, according to experts Stephen L. McClure and Paul L. Sessions. Separating salary from gifts signals that pay must be earned. Family members must earn their keep—to achieve success, to gain confidence and, especially, to feel worth their salt!

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How to avoid common traps when setting pay for family

There are ten basic traps that business families can fall into when making compensation decisions. These traps can cause the individuals controlling compensation—most often the parents —to generate feelings of unfairness and family disharmony. In most cases, this happens unintentionally; few business leaders realize what they are doing is unfair.

Consider this situation: A child working in the business goes to the parent to discuss his or her “needs.” The parent often assists in fulfilling the “need” by raising the individual’s compensation. The trap is set! Other family members working in the business, usually siblings of the child whose pay was raised, learn about the increase. Next comes something we like to call the “slow internal burn.” Siblings discuss the situation among themselves, generating feelings of resentment toward the parents and distain toward the sibling receiving what is perceived as unfair compensation.

The siblings believe they are being penalized for being better organized, better money managers or less frivolous than the “in need” child. The trap has sprung. Soon enough, the spouses become involved. These are the people who know the number of hours and the dedication their significant others give to the business. They have joined the others in the trap and have also developed feelings of unfairness and disharmony.

Everyone is on the defensive, and it is usually most obvious at family functions. Conversations are strained and there is little interaction among family members. Unfortunately, the issue is rarely discussed until everyone in the family is at the breaking point.

The challenges of family compensation

Here are the ten traps, along with suggestions for avoiding them. Use this list as a guide to save you and your family from heartache and unnecessary conflict.

1. Compensation based on family status rather than on an individual’s contribution to the business. For example, the parents rationalize that because John lives at home, he does not need as much money as Joe, who is married, even though John has a more responsible position. The question that should guide compensation decisions: “What is each job really worth in the marketplace?”

2. Highly inflated paychecks as a means of saving on taxes. Paying higher wages to family members in an attempt to gain a savings on taxes, dividends, etc., is a practice that builds an “I deserve it” mentality. This can create more family conflict and a cash crunch in “lean” times. Remember: “Don’t create an entitlement attitude.”

3. Assuming your pay decisions will be OK with all family members. Set pay policies to avoid mistrust of your decisions and conflict between family members who believe you are “playing favorites.” Getting other people who are trusted by all family members working in the business involved in the pay policies will go a long way toward adding credibility to the process. Placing these policies in a “Family Policy Manual” can be helpful as well. Consider these questions: “Should you be the only one making the pay decisions? Could a board help? Would it be wise to involve other trusted advisers in this process?”

4. Letting wages for managers and dividends for owners be mixed. There must be a separation between pay for those working in the business and distributions to shareholders. Managers as shareholders should receive the appropriate wage for their position plus a return for being a shareholder of the company. A performance bonus for meeting certain goals set by the shareholders should also be considered. Remuneration for employees’ contributions should not be mixed with what they could receive as shareholders. Remember: “Fair is not always equal.”

5. Letting the finances of the company and/or how much Dad and Mom make be a secret. Many adult children do not understand the career opportunities they could attain because they do not know the financial reward the company can create. “I don’t want to go into the family business because I have watched how hard Mom and Dad work and I don’t believe they have ever made a lot of money.” Too often the senior generation in a family business does not take the time to lay out the realistic opportunities for financial rewards and career growth for the next generation. Question: “How can adult children make a career choice when they don’t know the opportunities?”

6. Emotional issues and threat of conflict used to determine pay. This leads to giving raises in order to avoid conflict or to get other family members “off my back.” A very natural tendency of a family is to strive to avoid conflict (even though some families will say the opposite is true). Using money as a way to achieve harmony never works. Remember: “Avoidance of conflict only adds to it.”

7. Not regularly or formally discussing individual performance expectations and results with each family member. When this is not done, family members do not know if they are being properly judged when raises and bonuses are distributed. Does everyone in the family business really understand what is expected of him? Evaluations must be realistic, based on specific job criteria and put in writing. Remember: “When I am not told how I am doing, I must be doing great!”

8. Goals not established for each family member in the business regarding career development, retirement or lifestyle. Without them, it is often perceived that someone may be getting paid more than others to do less. There must be clear communication between generations so everyone understands the financial expectations of one another in advance. Otherwise, what one person believes he needs to live on for retirement could cause the business to fail, or what another person believes she should receive as compensation could cause hardship for a retiring family member. Example: If a senior-generation member receives a retirement paycheck that is as large as what he earned while working, a cash crunch and family bitterness could result. On the other hand, paying a next-generation member an excessively large salary can create hardship for retiring family members. Remember: “What I don’t know, I assume! Open communication is the key.”

9. Establishing “perks” to keep family members happy instead of being honest about their productivity and contributions to the company. Perks should go only to those people in the company who contribute to the success of the business. Giving a perk to one family member because “he hasn’t been to a hockey game in a while” is not a good policy. We are all for extra perks for family members, but they must be understood, controlled and earned. Remember: “ ‘He who makes the most noise gets what he wants’ is a bad policy!”

10. Setting a negative example by overpaying yourself. Set the rules and live by them. Remember: “Actions speak louder than words.”

That doesn’t mean you don’t deserve the rewards of the company you built. It means keeping wages as clear and understandable as possible. If you don’t, the person in line to take over your position may perceive that she deserves the over-inflated wages you were paying yourself. This can cause a split with other family members who find the wage gap unfair. Owner equity withdrawals, quarterly distributions and other tools can be used to get money out of the company without corrupting the wage policy for family members.

Create a written policy

Making compensation decisions in a family business is never easy. Without a clearly written policy for family compensation, conflict will arise and family relationships will be strained or possibly destroyed. There also may be a tendency to withhold information affecting company decisions owing to a resentful “I am not getting paid for this” attitude.

Put the right rules in place concerning compensation for your family members. Be sure each of the working family members understands how compensation is determined. Put your compensation plan in writing.

Don’t let these traps befall your family and business. Avoid them by keeping your family in focus and your business on track.

Jim and Ann Marie Kwaiser, family business consultants and speakers, are the principals of C.H.A.L.L.E.N.G.E.S. Inc. in Mercer, Pa. (www.challengesinc.com).

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Incentive compensation in family businesses

Between now and the year 2015, family-owned businesses are going to have to learn to cope with at least three new realities. First, business in general will continue to get more competitive and faster paced, thereby requiring greater management skills. Next, the demand for highly qualified personnel will become even more acute than it is today, which will make it increasingly more difficult, and even more important, to retain key employees. Lastly, family issues will continue and, in some situations, will be exacerbated as the baton is passed from one generation to another, and leadership moves further away from the founder.

In many ways, family-owned and closely held businesses have been insulated from the demands placed on their public counterparts. They are not covered by the rigid requirements of the Sarbanes-Oxley Act and the regulations of the Securities and Exchange Commission, and many of the IRS regulations covering executive compensation have not affected privately held companies. The transparency demanded by stakeholders of publicly traded companies and among non-profits has eluded privately held firms, so “family secrets” will continue to remain sacred, at least for now.

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