Equal pay for equal work equals a lack of equanimity

By Lloyd E. Shefsky

The parental temptation to pay all offspring the same, regardless of their value to the business, leads to trouble down the road.

Of all the challenges facing a family-owned business, one of the most difficult is how to compensate family members working in the business. It’s not just pay for performance; there’s much more involved.

Equal pay: the default option

In most Americans’ estate planning—unless a child has an obvious and serious special need—all offspring tend to be treated the same. After all, notions of equality are deeply embedded in the American psyche, so allocating on any other basis seems unfair. Furthermore, quantifying anticipated or even real differences is difficult at best. Yet after all that effort, there will certainly still be hurt feelings, possibly even from those who receive more. (The good news is that the bad feelings may be deferrable until the will is read.)

When the family estate includes a family business (typically the largest percentage of the estate’s value), the parent/CEO is generally confronted by a desire to make lifetime allocations through employment opportunities and compensation. There is a tendency to make “equal pay” the default option. While it may be true that “all men are created equal,” no one believes that all siblings will perform equally. Yet in many family businesses, all the siblings receive the same compensation and perquisites, despite their varying talents, capabilities, dedication, roles and market values.

Treating all of one’s children the same is understandable in many aspects of life; it is consistent with the family doctrine of loving one’s children equally. The condemned political model of “separate but equal” is not just tolerable in child rearing; it’s preferable. If one child wants ice cream and the other wants pretzels, what’s the harm in separate but equal? But extending the “no harm, no foul” principle to family businesses is problematic, because there the kids may be truly unequal, and the consequences are measurable.

When children first enter the family business, they are likely to be at the stage of least differentiation. Even at the start, they may have varying levels of education and even experience, but most likely, years of working at the family business will multiply the degrees of differentiation, making those initial differences seem inconsequential. In other words, one might justify equal pay at entry level, but the problem tends to be continually exacerbated as each child gains in-house practical experience and demonstrates his or her specific performance and achievement along the way.

As time goes on, siblings who believe they are performing better will start to wonder why they are not being compensated better. And if fraternal love enables the subjugation of such feelings, their spouses frequently are up to the task of causing the feelings to surface. Sometimes, more than one sibling, or even all of them, have such feelings. After all, as each sibling comes home, bragging to his wife about his conquering heroics at the office that day and expressing workday frustrations by deriding the mistakes and work ethic of his sibling, his value elevates, perhaps even unrealistically, in his loving wife’s eyes. She can’t imagine how her father-in-law could be so unfair as not to reward the “obvious” higher value of her husband.

Untangling the compensation quagmire

The parent, who is content burying his head in the sand, will not see the brewing compensation problems until it is too late. Indeed, by then, the remainder of the parent’s body may have joined the head in the ground, thereby avoiding having to deal with the uncomfortable situation entirely. In that case, the dilemma is left for the directly interested parties to resolve—not a pretty picture. And if instead of equally compensated siblings, we have equally compensated cousins, in addition to general inertia, there is also the inertia bred by the “equality was good enough for our parents” factor. And in that case, when the recognition that “fair isn’t equal” finally hits, the parties don’t even have fraternal love to soften the blows.

The beginning of any solution is understanding the problems and their causes. All family members should understand, for example, that compensation in family businesses, while generally stated as a single number, frequently has several components:

a. Fair value for the services provided. This is actually determined in two fundamentally different ways:

i. How much the business would have to pay to hire a non-family member to perform the same services.

ii. How much the particular family member could earn elsewhere, working for a totally independent employer.

To most, the first factor seems compelling, while the second factor appears slanted in favor of the particular family member (i.e., nepotism) by paying her more than the business should pay to get the job done. However, there are situations in which hiring above the required talent level is recommended, such as if the company is on a growth trend and is anticipating near-future needs.

In family businesses, paying a family member more than could be earned elsewhere may also be dictated by the desire to continue family involvement in the business, part of the long-term perspective. Such involvement, and even advance investments to achieve that, is justified by the likelihood of better financial results when family members are involved in a business (20% to 25% higher return on investment capital), according to research by John Ward, my colleague and co-director at the Kellogg School’s Center for Family Enterprises.

b. The equivalent of dividends. Even if the family employee is not a shareholder, compensation is a convenient way for a parent to move assets from his estate and perhaps higher income tax bracket to a child’s lower bracket and, in certain circumstances, to avoid double taxation. The dividend equivalent, if it had been paid to the parent, would be taxed at his income tax bracket (let’s assume 40% for state and federal), and the balance (60%) would be in his estate, so on his death, transfers to his children would be subject to an estate tax (let’s assume 55%). Therefore, the child would receive only $27 for every $100 taken as a dividend. If instead, the company increased the child’s bonus by that $100, the child would receive $70 (assuming she is in the 30% combined bracket), and that would not be subject to estate tax when the parents die. The result would be skewed even more if the business were operated as a C corporation, which gets no deduction for dividends but does get a deduction for bonuses paid. There, the amount of a dividend to be received by the parent would be reduced by the income tax the employer must pay on its corporate income (approximately 35% to 40%), and the balance, say $65, would be subject to the parent’s income tax bracket, so the parent would get only $45, which would then be subject to estate tax, leaving only $20.25 left for the children. (In these examples, I have ignored employment taxes, such as FICA.)

c. Family businesses are generally more willing to adapt to family needs by allowing flex-time employment. In some cases, this is done so that a family employee can take care of children, siblings or parents, thus effectively fulfilling the familial obligations of other family members (e.g., care for the CEO’s parents, children or grandchildren). The child of the CEO, who gets full pay even though she “starts work” at 1 p.m. every day, after spending all morning caring for the CEO’s mother (or, worse yet, her child, who is the CEO’s only grandchild), is an example of a family business effectively paying for care given to the CEO’s mother/grandchild. Assuming the CEO owns all the company stock, the issues include: (i) whether the offspring’s compensation is fair value (see a. i. and ii. above), a difficult issue at best, and (ii) whether the siblings are comfortable with the arrangement.

d. To supplement a child’s income and thus support a lifestyle desired by the child, the parent or both. The child might crave a better lifestyle, or the parent may wish the same or even more for the child. The cause for this desire may simply be parental love, or it can be far more complex—a parent’s desire to keep the child in the same town or to control the child’s future. The effect of switching some compensation from the parent to the child is the same as explained in b. above.

e. Once the decision is made to provide quasi-dividends or flex-needs and lifestyle adjustments for a child, the parent generally considers “The Family Theory of Relativity,” i.e., the differences in family members’ pay, regardless of their value to the company. The child earning less than his siblings is often unhappy about that discrepancy, even if he earns far more than he is worth. The “relativity adjustment” is the equalizing factor, which the parent applies to avoid having to choose one child over another. While such choosing is not by any means as grave as that depicted in the movie Sophie’s Choice, the “head-in-sand” approach of many parents running family businesses clearly indicates that they loathe making even these choices.

f. For a variety of obvious reasons, these components usually are not dealt with separately, and only an aggregate dollar amount is used as the children’s compensation. An example of two children, each making $200,000, might be helpful:

 

Components Child A Child B
A. Fair Value for Services $115,000 $80,000
B. Quasi Dividend 50,000 50,000
C. Flex-Needs Make-up 25,000
D. Lifestyle Adjustment 35,000 35,000
E. Relativity Equalizer 10,000

 

Even though the total of $200,000 is the only number recorded, it is incumbent on all involved to determine and to understand those separate components and to be mindful of the components during discussions with family members regarding compensation.

Bringing clarity to the compensation plan

In addition to the reluctance of the parent/CEO to address the compensation issue, a further complicating factor can be legal agreements that emerged, somewhat as a result of the “head in the sand” approach and somewhat because a lawyer, trying to serve his or her client by being extremely sensitive to the need for corroborating evidence, may not have been thinking about the price one might pay for everything being so precisely and all-inclusively documented.

Lawyers frequently urge the documentation of existing arrangements. Sometimes doing so is necessary; family members must think carefully about whether documentation serves their overall interests. To the extent that shareholder and/or employment agreements exist, the solutions to equal pay may be more difficult to achieve, requiring resolution of legal as well as emotional commitments.

Finding solutions to sibling compensation issues

Once the problem is recognized, solutions must be found quickly, hopefully by the preceding generation and before it is too late, i.e., before latent feelings grow into bitter or openly hostile reactions. Both the solutions and the processes to get there can be extremely painful, but steps can be taken to avoid or reduce the pain.

Resolving such problems may be daunting for a parent but may be easier if handled by the independent directors on the family business’s board. Indeed, the decisions of the board, if supplemented by lessons and mentoring, can help the owner’s children develop better and more rapidly in the company. Of course, the authority of and respect for such directors tends to increase over time, so for this and many other reasons, steps should be taken to have such directors in place earlier rather than later.

Because compensation issues often surface years or even decades after equality was put into place, the delay itself creates its own inertia. There are implicit promises made to family members who are paid more than they are worth—namely, “equality is a family value that you can rely on.” In fact, there most likely never was a discussion or determination of such a family value; at best it resulted from apathy or, more likely, from a desire to avoid confrontation. However, as often happens, perception trumps reality. Therefore, it becomes a contest between the fairness of reliance on such implicit promises vs. the fairness of compensation.

In the final analysis, unfair compensation, even if hidden in equality, is an artificial form of price fixing, and in the long run, no price fixing can float. In these circumstances, price fixing might end upon the parent’s passing, unless employment and shareholder agreements were the parent’s attempt to control from the grave.

It is possible and advisable to establish compensation systems for family members employed in the family’s business that recognize the different value factors that each family member brings to the business. Each member of a generation deserves to be dealt with in a fair manner. If the parent/CEO cannot muster the fortitude to create and implement a sound and reasonable compensation program for her progeny, she should at least install mechanisms, like good governance structure, to facilitate accomplishing the goal—and, of course, she should do so before it’s too late. For reasons stated above, the earlier independent directors are brought on board, the better the odds that they will be helpful when issues like compensation become relevant. If nothing else, it will reduce the need for antacids and sleeping pills and put the family business on the path to long-term success. Outlasting the average limited life expectancy of family businesses is tough enough; why not avoid any solvable pitfalls? Compensation issues can and should be solved without the customary default option of equality.

Lloyd E. Shefsky is a clinical professor at the Kellogg School of Management, Northwestern University, with extensive experience in counseling family businesses. He is founder and co-director of Kellogg’s Center for Family Enterprises, which sponsors the executive education program “Governing the Family Business” (www.kellogg.northwestern.edu/exceed/programs/LEAD06/index.htm).

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Agenda 2007

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