Compensation & Benefits

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

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Non-family CEOs need trust, support

About a decade ago, we saw private companies shift dramatically toward LTI plans. According to a 2012 World at Work survey of private companies’ incentive pay practices, 61% of the respondents used LTI plans in 2011, compared with 35% in 2007. The 2017 edition of the survey found that the prevalence of these plans has settled in at about 55%.

Around 2009, I began receiving requests from clients at private and family companies to design new LTI plans as part of the overarching executive compensation plans. The clients noted that it was becoming more difficult to pull talented executives out of public or private equity–owned companies. Why would these talented individuals join a business where all the enterprise value they helped create would go to someone else, while all they would get was a base salary and possibly a nice bonus each year? Executives wanted a piece of the action.

After almost a decade of tinkering, we have identified the most prominent plan designs and a typical path that a plan follows as it evolves. Let’s start with the alternative plans.

General plan types
Equity instruments. These are actual shares that represent real equity and put executives in the same position as family shareholders. While there are advantages to this type of arrangement, many family business owners are reluctant to grant shares to non-family members. These shares might be afforded voting and other rights under state and federal securities laws.

One upside to his type of arrangement is that executives are aligned with shareholders when it comes to building enterprise value. If the valuation of the company increases, so does the wealth of the family owners and the executives alike. Further, if dividends are paid on the shares, the executives receive the same proportional cash payment as the other shareholders.

Issuing actual shares to executives raises at least two areas of concern for family shareholders. First, the tax structure of the business can be affected. For example, S corporations cannot have two classes of stock, so if the family does not want new voting shareholders, granting real equity to executives is a non-starter. Second, if the executives want liquidity, the company could end up with a large cash liability. Long-term planning is required if liquidity is offered during an executive’s employment.

In almost all cases, a valuation of the business is necessary to understand and communicate the value of the shares on the date they are granted, and to assess the value accruing to the executive over time. The valuation is typically conducted annually and can be costly.

In my experience, few family firms issue actual equity to non-family executives. The drawbacks outweigh the positive aspects, and the positives can often be replicated by using other LTI plan designs.

Phantom equity. Phantom equity, or equity-like instruments, seek to mimic the value of equity without actually issuing shares in the company. Plans can mirror stock options (called stock appreciation rights, or SARs) or shares of stock (called restricted stock units, or RSUs). This approach has the added benefit of providing flexibility in the way phantom equity is valued. 

These plans track the value that would accrue if actual shares were granted. Rather than having the stock valued each year, a formula for the stock price is set at the beginning of the plan so it can be easily calculated at any time. For example, stock values are often viewed as a multiple of earnings. So if an industry valuation multiple is 5x earnings, we would apply that multiple to the earnings of the business in order to determine the grant value and subsequent value of the phantom shares.

SARs and RSUs act similarly to actual shares in terms of the value delivered to executives. The payout value is given in cash, typically on a schedule set up at the time of the grant. For example, if $100,000 is the ending value of a grant, there might be an agreement stating that it will be distributed in two payments (for example, 50% at the third anniversary of the grant and 50% at the fourth anniversary). The performance period of the grant is usually three years, corresponding to the first 50% payout. Often some of the cash payment is delayed in order to add retention power for another year while a follow-on grant gains value and to spread out the cash cost. Of course, because of the cash payout feature, this type of grant represents a cash liability for the company, which can be a drawback.

Pool and allocation. Private companies, including many family businesses, often will strive for a simpler way to provide long-term incentive value to executives. When communicating the plan to a broad spectrum of family shareholders, it is prudent to provide a model that is easy to understand and shows the highest and lowest payouts available to the executives.

One way to achieve this simplicity is through pool and allocation designs. This type of plan merely sets aside a fixed percentage of earnings or revenue (the “pool”) to be paid to executives at a pre-defined rate (the “allocation”). A very simple calculation is used to determine the total value being reallocated from the shareholders to the executives: percentage of earnings x earnings. For example, if 2% of earnings is being set aside and earnings are $50 million, the split is $49 million for shareholders and $1 million for executives. The $1 million is divided among executives based on a predetermined percentage of the pool.

When a family shareholder asks how much of their potential dividend is being paid to the executives, an easy answer is available. It is also a benefit that the answer is in aggregate (e.g., $1 million is being taken from earnings to pay to executives), which is really what the shareholder is looking for. There is no need to get into how much each executive is paid.

Plan design alternatives
Elements of these plans can be altered to tailor the plan to an individual business or compensation philosophy. Once the best plan type for the company is determined, specific design features can be incorporated to provide incentive value to executives and leverage in the payment or protection for the family shareholders. Let’s take a look at a few of these features.

Performance orientation. The better the performance of the executives and the company, the more the executives feel they should be rewarded. This is typical in any company, whether public, private with institutional backing or family-owned. The plans above can be tweaked to provide the kind of upside typically seen in public companies.

Instead of merely granting equity or phantom equity or carving out a percentage of earnings, the number of shares or percentage of earning can be adjusted based on the performance of the company during a set time frame. When equity or phantom equity is granted, the number of shares that will be paid out can be based on how well the company performs. For example, consider an executive who is granted 100 shares. If revenue growth is above 10% over a three-year period, the executive is paid out 150 shares. If revenue growth is below 5%, no shares are paid out. If growth is between 5% and 10%, 75 to 100 shares are paid out based on the level of growth.

The metric by which the number of shares paid out is determined can be tailored to the company’s specific business and strategy. We have seen metrics based on revenue, earnings, return on capital, free cash flow and many others.

This concept can also be applied to pool and allocation plans by adjusting the percentage of earnings that are set aside based on the company’s financial performance.

Leverage. Incentive plans are generally more effective when executives see the benefit of outperforming expectations. In incentive designs, that means providing more than 100% payout if actual performance (however that is defined) exceeds target performance. Upside ranges can be anywhere from 150% to 300% of target. For example, if target performance was 5% earnings growth and the number of target shares was 100, at 7% growth the payout would be 150 shares. In the case of 10% growth, the payout might be 200 shares.

Of course, if family shareholders provide upside, executives should also be willing to accept downside risk. In our example, if growth were only 3%, 50 shares would be paid out. If growth were below 3%, no shares would be paid out.

This can also be applied to pool and allocation plans through different mechanisms.

In any case, providing more leverage should be accompanied by layers of more difficult performance metrics.

Protection for family shareholders. We have seen many well-intended plan designs fail to be approved because family shareholders do not feel they have protection against payments or granted share values that eat into shareholder value too much. There is a fairly simple fix for this: payment or value caps. These can take the form of maximum payouts or caps on the number of shares that an executive can liquidate.

In the pool and allocation design, the maximum payout is controlled by the percentage of earnings being set aside.

Typical progression of plans in family businesses
We have been involved in developing long-term compensation plans for many family businesses. In our experience, finding the right plan can take some time. The more mature a company is, the easier it is to use an equity-like plan because methods of forecasting financial performance and planning for larger cash liabilities are more developed. On the other hand, less mature companies tend to migrate toward pool and allocation plans because they are simple and provide built-in limits on the amount of value transfer to executives.

In almost all cases, plans evolve over a number of years. In one case, a client started with a performance-based pseudo-equity plan. Three years later the company moved to a hybrid pseudo-equity/pool and allocation plan. Since then, the client has adopted a more complex version of a pool and allocation plan with no equity component. Much of the change occurred because family shareholders had difficulty understanding how to measure the possible value transfer from the family to the executives.

Things to consider
First, gauge shareholders’ level of sophistication. This will guide you to a starting point with regard to the complexity of the plan you design.

Second, benchmark the compensation of the executives working in your company and those you would like to attract. When you add a component of compensation, it must be viewed through the lens of total direct compensation and should be reasonable in amount and design.

Third, look at more than one design. When you compare two compensation plans side by side, you understand more about both.

Fourth, model the possible outcomes. Spend the painstaking time to build a model of the plan so you can be confident that there will not be an unanticipated outcome.

Finally: Communicate, communicate, communicate. Build enough time into the design schedule to sit with each family shareholder multiple times and walk through the plan design and plan modeling. If a shareholder has a vague feeling that they are missing something, the plan will very likely fail, as there will be consistent questions and misunderstandings. Also, create communication materials for both the executives and the family shareholders that illustrate simply the performance and the associated payouts.                                                   

Theodore Sharp is a senior client partner for Korn Ferry Hay Group, based in the firm’s Boston office (www.kornferry.com). He is a member of the Executive Pay and Governance team.

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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:

1. They use external independent compensation data to benchmark their family members' compensation packages against the practices of comparable companies in terms of size, industry, growth, profitability and geographic market.

2. They have explicit equity and pay philosophies that are clearly communicated to all family shareholders and employees. Some family companies allocate equity to all family members equally, regardless of whether they are in the business. Others allocate equity based on family members' involvement in the business. Either can work, but the equity philosophy should be communicated and understood up front to minimize the possibility of conflict.

3. In companies that do not award equity to family members based on their role and active involvement in the business, other compensation mechanisms (e.g., salaries, bonuses, benefits and perks) are used to compensate family employees competitively. Again, benchmarking to ensure fairness and objectivity is important.

4. Many large family enterprises have family councils that elect representatives to serve on the company's board of directors. The family council representative serves as the voice of the family shareholders who are not active in the business.

Compensating non-family members

Successful family companies also work hard to develop competitive compensation packages to attract and retain talented non-family members, but the track record among family businesses is mixed. According to the new CEO and Senior Executive Compensation Report for Private Companies, which gathered data from more than 1,300 private companies, the compensation for the CEO of the average family business is competitive with CEO pay for all privately owned companies—whether the chief executive is a family member or not.

However, many family firms don't pay their CEOs competitive compensation packages, particularly among companies with annual revenues in the $10 million to $100 million range. Beyond the CEO and chairman positions, the average family business is not compensating its executives competitively, the CEO and Senior Executive Compensation Report for Private Companies found.

Chairmen in family businesses were paid 32% more than their peers across all private ownership types, and family business CEOs made 99% of the median across all ownership types (virtual parity). But other senior executives in family businesses, on average, were paid less than their peers in other types of privately held companies.

This compensation gap between family-owned businesses and other privately held businesses is even more pronounced among select ownership types and job titles. For example, the median compensation for a CFO in a family-owned business was 41% less than the median compensation for a CFO in a private equity-owned company. The median pay for the head of R&D in a family-owned business was 37% less than the median pay for the head of R&D in a venture capital-owned company.

Although the median total pay package for CEOs in family-owned companies with revenues of $10 million to $99.9 million was competitive with other ownership types, top-quartile CEO total pay packages in private equity- and venture capital-owned companies in this size range were substantially higher than top-quartile CEO pay packages in family businesses. In companies with revenues exceeding $100 million, both the median and top-quartile total pay packages of family business CEOs were substantially less than at other types of privately owned companies.

The large gaps in median compensation packages indicate that most family businesses are not paying their senior executives (other than the chairman and CEO) competitively. These family firms are likely losing the war for executive talent. In order to attract and retain top performers in key positions, these companies must change their approach to executive compensation.

Here are some ideas to consider when developing your compensation philosophy and program:

1. Consider how your company's performance would improve if you had top-quartile executives in various executive roles, vs. average performers. For example, in a manufacturing or technology-based company, there is tremendous leverage in having a great head of R&D rather than an average player. In a company that is highly leveraged, a great CFO can more than pay for himself or herself. Family businesses should be willing to pay top-quartile compensation packages to recruit and retain stars in their key positions.

2. Create a pay philosophy that is consistent with your business strategy. You needn't have the highest guaranteed payments (e.g., salary, benefits and perquisites) and the highest variable compensation (bonuses and/or long-term incentives), but companies that beat their competitors in one of these dimensions tend to have an advantage in recruiting and retaining a segment of employees (either the risk-averse or the risk-takers). It's better to have an advantage with either segment than to be average across the board.

3. Benchmark your compensation packages to make sure they are competitive for new recruits as well as your existing employees. If your current employees feel they are undercompensated, hard feelings often fester, and by the time you find out about it, it's too late to turn them around. Use external benchmarks, or see if your association or chamber of commerce conducts an executive compensation study for your industry or local market.

4. Many closely held family businesses do not grant equity to key executives, because they want to keep ownership within the family. But there are other ways to compete with companies that use equity incentives. Some family firms use long-term bonus programs. Others create equity appreciation rights or other synthetic programs that mirror the incentive of stock options to reward employees for helping build the long-term equity value of the business without granting stock.

Wayne Cooper is the CEO of The Chief Executive Network, a peer network organization for CEOs and senior executives. He is the author of the CEO and Senior Executive Compensation Report for Private Companies (www.ChiefExecutive.net/compreport).

Copyright 2017 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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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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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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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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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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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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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.

However, to a great degree, public and private companies swim in the same labor pool. This means that family companies must provide compensation programs that contain similar, if not the same, components while offering comparable value within the overall compensation package. The typical components often sought by executives coming into privately held firms include the following:

• Competitive base salary: Executives expect that their base salary will be commensurate with their experience. The base salary for a position is predicated on market value and takes into consideration the hierarchical level of the position; the industry; the size, scope and complexity of the job; and the geographic region.

• Short-term incentive compensation: Short-term incentives are the primary motivators and a key way of recognizing performance; they help ensure the executive’s desire to contribute to the success of the organization. Executives want a clear link between their performance in achieving established goals and the payout at year-end. The design of effective short-term incentive plans is where many family-owned businesses struggle because they are reluctant to disclose financial data. Many of these companies forgo short-term compensation in favor of discretionary bonuses, in which the owner/manager makes a subjective determination of each bonus based on gut feeling, random statistical data or a Ouija board.

• Long-term incentive compensation: Executives who have worked in publicly traded companies typically are accustomed to receiving additional compensation in the form of long-term incentives, whether cash- or equity-based. In public companies, it’s common to award stock as a long-term incentive. But most private company owners are not prepared to provide equity in their firms, even to their most critical management team members. They don’t want “partners” and don’t want to share control with outsiders. However, with relatively few fish in the talent pool, in order to attract and retain highly qualified executives, more and more family-owned organizations are considering adoption of some form of long-term incentives. This additional element of the compensation package allows them to compete for qualified executives, particularly those working in public companies, and to hold on to those they have. Often, the long-term incentives are cash-based. They add another element to the compensation package and provide the company with the means to focus these executives’ attention on the future, long-term success of the organization.

A number of variations of phantom stock programs can be developed. Each allows participants to share in the company’s growth without the use of equity. It’s important to note that in order to establish performance measures that drive success and ultimate payouts of long-term incentives, business owners must define goals and provide executives with targets they need to achieve in order to obtain the reward. Equity is often used as a measure of performance, but given the owner’s goals, the awards are typically made in cash.

In privately held businesses where the stock is not traded and therefore no ready market value exists, the company must obtain an annual valuation, which is expensive and problematic for the owners. Other non-equity measurements can be used that consider the increased growth of the company, as an absolute or against long-term pre-established objectives.

A combination of financial and operational objectives can be used for short-term incentives; for long-term incentive plans, generally only financial goals are used as performance targets.

Ensuring a common focus

Since family members tend to be paid differently from non-family employees, to what degree should separate pay plans be developed for non-family executives? Considering the competitive market for qualified individuals, compensation programs should have provisions for the inclusion of family members. This will ensure that all managers have the same focus on achieving common goals, with a direct relationship to the level of rewards provided at the conclusion of the performance period.

In family-owned companies, the trend in compensation program design is moving away from subjective plans toward more formulaic annual and long-term incentives that are based on actual results achieved. The level of achievement is compared to established goals in order to determine the size of the award that has been earned. Every performance-based system requires that the organization have the ability to actually track and measure performance. This may seem elementary, but experience has shown that the finer points of goal setting and strategic planning are foreign to a lot of companies.

A reason often given by family-owned companies for not establishing performance measures is the owners’ reluctance to share financial information with even their most senior executives. If they are afraid to share information, then how can an executive be expected to manage effectively?

Clearly, there is some information that family members do not want to make public, such as their own compensation and the amount of return to the shareholders. But if executives know what the target is, they are much more likely to know what to do in order to hit it! Specific performance objectives can be developed without divulging any sensitive information; this allows effective and true pay-for-performance programs to be developed. These can be in the form of quantitative objectives (e.g., increases in net income) or qualitative objectives (e.g., enhanced customer service).

A delicate art

The success of incentive compensation plans is based on the effective use of a combination of financial, operational and individual objectives that are indicative of the participant’s ability to affect results. Properly designed plans provide a direct correlation between performance and size of rewards.

Critical to this process is the family’s commitment to providing ongoing feedback to non-family executives concerning their progress toward meeting their goals. Since detailed financial reports will not be shared with these individuals, it is imperative that family members provide some gauge of performance and success to these executives, in order to maintain focus and motivation.

Regardless of the composition of the total compensation package, performance metrics must be defined that motivate the executive to succeed. It is a delicate art, however, to define performance objective in relative, not absolute, terms. If the company is serious about retaining key management and competing in the marketplace, well-designed incentive plans with performance goals that focus executives on achieving the company’s objectives will enhance its ability to keep these individuals over the long run. The organization must offer a competitive compensation package consisting of all three components: base salary, annual incentive and a longer-term plan. Each component of the compensation package should carry specific performance measures, which, when properly established and achieved, should ensure the success of the company.

Bottom line: After a swim in the talent pool, make sure to save room for SHRIMP: share the right information that is meaningful to performance.

Paul R. Dorf, Ph.D., is managing director of Compensation Resources Inc., compensation consultants in Upper Saddle River, N.J. (www.compensationresources.com).

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The sibling who wants equal pay

I work with my sister. She has an advanced degree but has spent less time working in the corporation than I have. Our responsibilities are equal. I feel that even though she was hired for more money than I was, after 25-30 years we should make equal salaries. Is equal pay for family executives appropriate?

Experts' replies:

Equal isn't always fair. Professionalized family firms develop written compensation policies that all employees, whether family or non-family, will find reasonable. Here's one example: “All employees will be paid according to the standards of the industry in our region for the job they do. Bonuses will be calculated on a percentage of the profits of the whole company.”

This kind of compensation policy implies that there will be annual reviews of all employees to determine whether they are meeting the goals for the position they hold, or whether they need to find another job, in the company or outside it. It also implies that family members will not receive bonuses if the company is not profitable. A rising tide lifts all boats, but the captain will be paid differently from the navigator.

In my column entitled “What family businesses are NOT” (FB, Spring 2003), I discussed the curious tendency of family-owned businesses to function in socialistic ways in the midst of a capitalist economy. In an effort to avoid conflict, sometimes parents pay all their sons and daughters equally. However, this practice will eventually trigger more conflict, since there will inevitably be differences in tenure, initiative and performance. Welcome to the human race.

Rewarding superior performance is essential to take any business to the next level, especially in a challenging marketplace. If siblings own equal shares of stock, at the end of the year their distributions will be equal, even if their paychecks are not.

—Ellen Frankenberg, Ph.D.
Frankenberg is a Cincinnati-based family business consultant who facilitates family meetings and coaches executives and successors (ellen@frankenberggroup.com).

Equal responsibilities, unequal pay—a classic bone of contention between family members in business together. This could be a modern “prodigal sibling” scenario: My sister went away to grad school, I stayed with the family and helped keep the business going, then my sister came home and was given a feast and a big salary. Or maybe it's just a case of uncorrected salary compression. As marketplace pressures drive up starting salaries, the salaries of longtime employees, even family members, sometimes lag behind. If one sibling joined the business several years earlier than the other one, that could account for the different starting salaries, especially if there were interim changes in industry standards or in the company's financial condition. While it might not make the salary disparity less frustrating, it's a legitimate explanation.

But let's look analytically at the current comparisons. First consider equal responsibilities, a tough term to objectify. We must decide if “equal” means parallel positions on the organizational chart, equal numbers of employees supervised, equal revenue targets or some other concrete indices. To be a useful basis for comparison, “equal” should be linked to work done or results produced. Remember that compensation disputes in family businesses don't arise as often from who-gets-paid-how-much as from who-gets-paid-how-much-for-doing-what.

Then comes the question of equal pay. Actually, I'd prefer to consider compensation, not just salary. Along with (or even instead of) salary, a family business owner-executive could be compensated in commissions, bonuses, current dividends, longer-term share value and/or perquisites. In some companies, the compensation packages of individual family owner-executives are made up of those components in varying proportions. It's important to look at total compensation, not salary alone, for purposes of judging equality.

There's also a value dimension here. Maybe the sister's advanced degree is of substantive value to the business. If the company manufactures aerospace guidance systems and she's a Ph.D. electrical engineer, her qualifications must be weighed in the compensation equation. But the same criterion should be applied to valuing the other sibling's longer, more extensive experience in the corporation. It might be an essential strategic advantage and a foundation stone of effective management. In that case, the value of experience should be reflected in compensation.

Maybe all parties should ask themselves a few probing questions. First and most obviously, can the company afford to compensate the two siblings equally? What's the company's compensation policy? If there's no policy, is there some other authority, such as a board of directors, that ensures equitability by systematically setting and periodically reviewing compensation? Finally, are there underlying interpersonal issues, such as unresolved sibling conflicts, that make the subject of comparable compensation more touchy than it might otherwise be? If so, how can those issues be either resolved or taken off the table?

There's no fundamental problem with equal compensation for family business owner-executives in equal positions. But like other executive compensation, it should be tied to the company's performance and the individuals' historical and current contributions to it.

—James Lea, Ph.D.
James Lea, a professor at the University of North Carolina at Chapel Hill, is a family business speaker and adviser (james.lea@yourfamilybusiness.net).

The issues involved are more complex than your question implies. Your words suggest your feelings and beliefs, and an unstated concern about ownership. You also raise questions of equity and policy.

You say, “I feel that even though she was hired for more money than I was, after 25-30 years we should make equal salaries.” In this statement, you are actually expressing your beliefs, not your feelings. Do you believe that any compensation that isn't equal is unfair? That you have “done your time”? That nobody offered to pay for your advanced degree (“had I known...”)? Or that policies made after the fact create unjust barriers?

Rethink your feelings. Do you feel jealous? Hurt? Conflicted? Frustrated? Angry? Can you express these feelings to your family members in a safe environment?

For family members, as for any employee joining any business, compensation should be at market, based on the position and the qualifications that the candidate brings to the position. Appropriate compensation is determined according to a blend of both experience and education; neither automatically justifies a higher salary.

If, as stated, both siblings have approximately equal responsibility at an executive level, eventual equal compensation is warranted—in five to ten years of working as an executive team with proven results, not in 25 to 30 years.

This raises the question of who makes compensation decisions, and how. There should be policies governing how salaries and other benefits are determined, as well as compensation pay scales. Any higher salary should be justified by these policies. Salaries should not, as sometimes happens, be based on a parent's decision that a child needs more money to support his or her family, or buy a new sports car. Need is not an appropriate factor in determining compensation; otherwise, everyone could demand more money.

The more difficult issue is one of ownership. Ownership has its own financial rewards—income from the investment and potential gain from the sale of the ownership stake. These rewards differ from those of an employee, who is entitled to a reasonable salary or wage, plus appropriate benefits. Ownership divided 50/50 between two people can lead to a stalemate and paralyze decision making. Assuming that these are the only children of the owner(s), how future ownership will be divided is an equally important, and potentially troubling, decision.

The parties need an open discussion among the two siblings and the compensation decision maker(s)—likely the parents or other relatives —as well as clear policies and procedures governing financial reward for family members in various roles in the family business.

—Pat Frishkoff, DBA, and Paul Frishkoff, Ph.D.
The Frishkoffs are family business advisers with Leadership In Family Enterprise in Eugene, Ore. (www.patandpaul.com).

No, equal pay for family executives is not appropriate.

While this has been a common practice, it is not in the best interest of the family or the business. Generally, this is the result of parents who feel they must treat their children the same in order to be fair. But that is a family practice as opposed to a business practice.

Consider this example: The founder of a Midwestern manufacturing company was a talented inventor but was not an astute businessman. He developed his business and then nearly lost it because he focused too much on R&D and not enough on production and sales. His four sons-in-law worked in the business. They ranged from a shop floor foreman to the new CEO. They were all paid the same salary. The young man who became CEO had many skills in management, since he had worked at larger companies and had learned the ropes there. He turned the business around and made it successful. Should he be paid the same as his brother-in-law who works on the shop floor? This family decided that this practice was not healthy for the business or the family.

The CEO and his family recognized that he would be paid significantly more if he went to work somewhere else. No one in the family wanted him to leave. They also saw how resentment could erupt when people felt their pay was not comparable to the salaries of others in similar positions elsewhere. Finally, they saw that the practice of equal family salaries sent the wrong message to employees and young family members who were considering joining the business.

They followed my recommendation to establish a family compensation policy. The family met in a family council. They discussed “best practices” and agreed with the following principles:

1. All company positions should be compensated at fair market value, whether an employee is a family member or not.

2. Bonuses would be paid if the company profitability warranted it and the individual's performance met goals that helped to achieve company financial success.

3. Distributions to shareholders would be based on the percent owned. In this case, all second-generation members held the same ownership and thus were compensated equally.

4. If the parents or other family members wanted to be generous, they would make gifts to family members rather than pay them a salary.

These principles and practices seemed fair to everyone. The challenge was how to implement them! They were worried that some of the sons-in-law who had been paid above market value would have their salaries lowered.

The group decided (before obtaining the data) that they would not lower any salary, but cap it until annual increases brought their salaries in line with the market. Those who were underpaid had their salaries increased.

I would suggest that the siblings look first at their vision for the future of the business and determine what practices will help them achieve it.

—Leslie Dashew
Dashew is president of Human Side of Enterprise in Scottsdale, Ariz., and a member of the Aspen Family Business Group (ldashew@aol.com).

Rare is the family enterprise that does not suffer from compensation dilemmas at some point in its life. Although you provide fewer details than we would need for a more individualized response, we urge you to consider a solution we find successful in empowering an individual sibling and compensating all family executives fairly and appropriately, while also benefiting the mission and strategic goals of the company as a whole. We recommend a performance-based compensation system by which equal pay for family executives might be achieved, but this result would be by coincidence rather than by design.

Find an effective forum within your company (perhaps an informal family business discussion or a meeting of your advisory council or board of directors) to suggest that a total compensation review be undertaken. Like all business systems, as a company grows, its policies and structures must be reviewed, new systems developed as needed and others overhauled completely to be effective. A compensation system is no exception. Ideally, compensation issues are placed on the table when other family and organizational issues are also in process, often at the board level. Pieces of the following plan can be adapted and implemented to provide the executives in your family with individualized, esteem-boosting, appropriate pay for their contributions to the family enterprise.

Here are the essential steps for creating a performance-based compensation plan:

•  The board of directors votes to undertake the project, creates a committee to oversee the work and, ideally, hires a compensation specialist to create an unbiased system.

•  Collaborative efforts take place over a defined time frame among the board, management and the outside compensation expert.

•  Executive roles and responsibilities are clarified.

•  A metric system of clear performance goals or benchmarks is designed for both qualitative and quantitative skills.

•  A performance evaluation system is determined, which weighs and measures a broad range of responsibilities for each executive, including leadership expectations, achievement toward the company's strategic goals, financial objectives, and required communication and relationship-building skills.

•  An implementation plan is created, including base salary and annual and long-term incentives as well as a system for evaluating family executives.

Finally, if desired, the project can also establish guidelines for a management training program to develop, motivate and appropriately compensate the next generation of family leadership. Even in the most communicative, high-functioning family businesses, discussions about money are thorny and emotionally loaded and threaten to become a stumbling block for family relationships and business growth. This is why many family companies opt to involve business psychologists in these discussions. You are wise to seek advice now on troubling issues that can be resolved through solutions with long-term value on many levels.

—Emily Abrams
Abrams is a senior associate at the Roseview Group in Boston, advisers to entrepreneurs navigating growth, change and capital markets (eabrams@roseview.com).

A business is sold, but one issue isn't settled

 

We recently completed a sale of our family company. One item that remains to be dealt with is a whole life insurance policy that was taken out by the company to insure a key man, the CEO. The CEO is also my brother. He would like to keep this policy himself and pay the other shareholders/family members so he can switch ownership of the policy to himself. I would like to know if the cash surrender value is an appropriate amount for him to purchase this policy from us or if there is a better way to estimate the true value of this policy. Currently the cash surrender value is about $133,000, and the life insurance benefit is $3 million.

Expert's reply:

Compare the cash surrender value with the policy's interpolated terminal reserve (ITR), with adjustments. The ITR is the amount that the insurer has set aside to satisfy its contractual obligation to pay policy benefits. Insurers measure the terminal reserve only once a year, so at any other time in the year you must interpolate the reserve value by adding a proportionate amount of the current year's increase to the prior year's reserve. If the cash surrender value and the ITR are similar, you could use the cash surrender value. Ask your insurance company for these values to be sure you can defend the transfer amount and avoid adverse tax consequences.

Some background information may be helpful. Companies purchase life insurance on key personnel to protect themselves against the loss of these executives' services. Proceeds from the contract can be used to replace earnings the deceased employee would have generated, provide funds for recruitment and training of a successor, meet lenders' requirements or extinguish debt. The company pays premiums after tax and receives proceeds tax-free.

Even if the company is sold, key person life insurance still has value for an executive. This person presumably is now older than when the contract was originally written, so a similar contract would likely be more expensive. If the executive has medical problems, he or she may not even be able to get coverage. The executive may also want to own the policy for its cash value and growth potential.

Here is an example of how adverse tax consequences might be generated. As stated in Section 101(a)(2) of the Internal Revenue Code, for any policy transferred for valuable consideration, the death proceeds are exempt from taxation only to the extent of the consideration. Thus, the balance would be taxed as ordinary income. Fortunately, there are exceptions. For example, if the company sells the policy to the insured executive, the death proceeds would still be tax-free.

The IRS recently has proposed regulations regarding valuation of life insurance policies relating to purchases from qualified or other employee benefit plans. These regulations penalize taxpayers who benefit from transfers that understate the fair market value of the policy.

Under these new IRS regulations, the value of a policy should not be the cash surrender value, but the ITR at the date of sale, plus any premiums paid by the employer for coverage in subsequent periods. This method may not be used, however, when it does not produce a value reflecting all relevant features of the policy.

You must ensure your transfer amount represents a defensible, fair market value. Get all the information available. Any bargain element in the value of the transfer may be subject to adverse tax consequences. As always, you should consult your accounting, tax and legal advisers for specific recommendations. Be aware, too, that insurance contracts are available today that offer much more efficient designs when compared with older contracts.

— Thomas J. Mihok
Mihok is a partner at Newton One, an M Financial Group member firm in Newark, Del. (tmihok@newtononeadvisors.com). Tom Hollinger of Newton One and Ken Nordstrom and Joseph Donovan of John Hancock Financial Services contributed to this reply.

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Most family business owners want to ensure that their employees receive adequate benefits without severely affecting the company's bottom line. But rising health care costs have made this goal quite a challenge. The Henry J. Kaiser Family Foundation noted that medical premiums rose 14% in 2003. It's no wonder that two-thirds of the small-business owners who responded to a 2004 survey by the National Federation of Independent Businesses listed health care costs as a “critical problem,” up 18% over a four-year period.

Of course, smaller family-owned businesses can't offer the super-sized benefit packages that large corporations can. But they can still provide attractive packages that take care of employees while keeping costs down.

Flexible benefit plans

Cafeteria employee benefit plans, also known as flexible benefit plans or Section 125 plans (after Internal Revenue Code 125), have been around since the 1980s but have gained popularity as businesses seek innovative ways of creating cost-effective benefit packages. These plans provide the most options for family businesses at a reasonable cost. If the plan qualifies, money that was previously taxable can be used to pay benefits on a pre-tax basis.

Flex plans enable employers to offer a variety of benefit options while providing tax advantages to both the company and the worker. Employees contribute money to these accounts to pay insurance premiums, unreimbursed medical expenses and dependent care expenses. Employers save by not paying Social Security, worker's compensation and unemployment tax on money contributed to the plan. Employees save because money deposited into the account is not taxable income, which means they pay less in Social Security, income and unemployment taxes.

One of our clients, a 125-employee, family-run dairy products company, introduced the flex plan to its workers. Employees received a debit card, which they can use to pay for qualifying medical services. When the card is used, funds are withdrawn from the employee's Section 125 account. The debit card eliminates the need for claim forms submission and out-of-pocket payments that take weeks for reimbursement. The company saves time and money by eliminating paperwork.

Many employees divert their tax savings into their 401(k) plans. This enables highly compensated family employees to contribute more to their retirement plans, since their contribution amount is a function of the amount that lower-paid employees contribute. Because the plan enables the lower-paid workers to save on taxes and contribute more to their 401(k)s, the higher-paid workers also can contribute more.

To qualify for tax advantages, the flex plan must be stated in writing and made available to all employees. It cannot be offered only to highly compensated employees.

The advantages go beyond tax savings. Because a “cafeteria” list of benefits is offered, employees may select benefits based on their individual needs. Each employee decides how much he or she is willing to spend on benefits, which takes some of the burden of rising costs off the employer.

Health savings accounts

Health savings accounts (HSAs) are new to the employee benefits mix. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 included a provision establishing HSAs, which are tax-advantaged savings accounts that can be used to pay for medical expenses. HSAs are available to any worker with a high-deductible health insurance plan (at least $1,000 for individual coverage and $2,000 for family coverage). Money from the accounts can go toward paying medical and insurance expenses until the deductible is met. Unused contributions can be rolled over to the following year.

HSAs allow employers and employees to contribute to the account on a pre-tax basis; employees enjoy above-the-line salary reductions for contributions made to the HSA. Because the individual, rather than the employer, owns the HSA, the account moves with the individual if he or she changes jobs. HSA funds can also pay for COBRA insurance coverage, qualified long-term care insurance, health insurance while an individual is receiving unemployment compensation, and Medicare insurance premiums for those 65 and over.

HSAs can be part of a 125 plan. The HSA component is set up as an investment account; the account balance can roll over into subsequent years. (Non-HSA 125 funds cannot be rolled over.)

Money used for medical expenses is withdrawn tax-free. Distributions from HSAs for non-qualified expenses are taxed as ordinary income and are subject to a 10% tax penalty. The 10% tax does not apply if the account beneficiary becomes disabled or dies. The account can be transferred to a surviving spouse.

With HSAs, employers can offer insurance plans with higher deductibles, thus saving on insurance costs. HSAs essentially enable employers to transfer more health care costs to higher users and away from healthier people. The downside is that most insurance carriers currently do not offer HSAs. A list of insurance companies offering HSAs can be found at www.hsainsider.com. More carriers will come aboard once it's clear that a strong market exists for the product.

Savings from automation

Advancing technology has made employee benefits administration easier and more cost-efficient. Online systems enable employees to enroll in a plan, review and select benefits and pricing options, and update personal data electronically. The information is transmitted directly to the insurance carrier. Because these systems are completely automated, it's easy to generate management reports, which can help businesses analyze their health care costs and coverage options.

Before introducing new benefit options, it makes sense to learn about the kinds of benefits employees want. Employee surveys can help determine what benefits are most important to them. Results may indicate that the company is paying for benefits that employees do not highly value; it might instead provide less costly provisions that are perceived as more valuable. Some benefit providers offer these surveys to clients at no cost. But you must be careful about how the questionnaire is presented, or else employees may believe that items on a “wish list” of benefits in a survey question will eventually be available to them.

It's true that the news concerning rising employee benefit costs is not encouraging. But creative use of available programs can help keep employees happy and company costs down.

Paul S. Devore, CLU, CFP, is chief executive officer of Financial Management Services, Inc. in Encino, Calif. (pdevore@fms3.com). He is also chairman of the board of PartnersFinancial, an independent financial service company with more than 200 member firms.

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