Hiring a CEO Without Giving Away the Store
Offering stock to a job candidate dilutes family control, and can lead to valuation problemslater.
When family businesses seek to recruit an outside, nonfamily CEO to run the company, theyusually have to offer a compensation package that promises to build the individual's net worth. In theeuphoria of a hiring decision, often the first thing the family gives away is equity in thebusiness.
Our firm has consistently advised against offering ownership as a hiring incentive. Giving away equitynot only dilutes family control, it can create weighty problems later on if the manager is notretained.
The most obvious of these problems is the determination of business value. Because of their personalinvestment in it, family members are unlikely to regard "value" the same way as an outside executive.In buyouts of stockholders and other transfers of equity, the family usually controls the valuationprocess — it hires the valuation experts — and the result may not be satisfactory to the outsideexecutive. If and when the executive is terminated, he or she may well challenge the family'svaluation. Case after case in the courts suggests that the executive and the family often cannotresolve their differences without litigation.
For the family, the nonfamily executive, and the business it is far more advantageous to find a way toemulate equity. There are a variety of equity-emulation techniques that can help to attract andretain high-level executives. Some of these substitutes include termination agreements, supplementalexecutive retirement plans, pre-tax wealth accumulation plans, and private pension plans.
Termination agreements. Such agreements define compensation in the event that an executive isterminated. In addition to defining compensation, termination agreements often include vestingschedules and definitions of termination situations. One of my firm's clients based such an agreementon whether the executive had achieved certain sales and profit goals during her tenure. If theexecutive was terminated after 10 years of service, she was entitled to specific payments if the firmhad achieved targets that depended on her reaching her goals and if she had remained a valuableemployee. Any termination prior to 10 years reduced the payment according to a vesting schedule.
SERPs. Supplemental executive retirement plans are similar to termination agreements but mostoften are based on the compensation of the executive. A SERP might define what is due an executive ata specific retirement date as a percent of his final three or five years of compensation. In the eventof early retirement or termination, the amount would be reduced by a formula, or vesting schedule. Anexample: We assisted in designing a plan for a family owned business that promised an executive 60percent of final average compensation, reduced to 40 percent for early retirement and further reducedfor termination before age 55.
Pre-tax wealth accumulation plans. Employers can set up plans that allow the executive to defertaxes on any amount of income contributed to the plan as well as on appreciation in the value ofmoney. These plans are often used in conjunction with a supplemental retirement plan, but can be usedindependently as well. As an additional incentive, the company may also match the executive'scontributions to the plan.
Any benefits received from a termination agreement, a supplemental retirement plan, or a pre-taxwealth accumulation plan are taxed as ordinary income at the time payments are made to the executive.Benefits may be made payable to the executive's designated beneficiary. In each of these types ofplans, however, the executive becomes a general creditor of the company. In the event of aninsolvency, he would have to "stand in line" with other creditors trying to get paid. If the executiveis willing to be a general creditor, the benefits of these arrangements can be very attractive. On theother hand, if he is concerned about the continued viability of the business, he may look for otherincentives.
All deductible (that is, tax-qualified) benefits work better for lower paid employees than for higherpaid employees. Both the pre-tax wealth accumulation plan and the SERP can offset this reversediscrimination effect, which is brought about by government restrictions. Because contributions to theplan are not deductible to the company, the programs can be entirely selective; the company can set updifferent retirement ages and amounts for different key people.
Private pension plans. The private pension plan differs from the wealth accumulation plan andthe SERP in several respects. Under the private pension plan, the executive does not become a generalcreditor of the company but is currently taxed on what is contributed to the plan. Thus, onlythe net amount after taxes accumulates for the executive's future use or retirement. The appreciationin value is not taxed, however, and the executive receives the benefits tax-free when he collects themoney.
Many companies look to outsiders to manage the company when there is no heir-apparent or whenmembers of the new generation aren't interested in taking over the business — or aren't qualified to doit. Often family businesses seek an interim nonfamily CEO when the present leader is ready to retire.Part of the person's job is to train the family successors for leadership.
This role calls for a highly experienced manager who is also sensitive to the family's needs andvalues. To hire such an exceptional person, the family must be willing to provide a generous benefitspackage. However, the family should consider the risks of offering equity as an incentive and avoidtemptation to give away part of the store. The types of emulated equity that I have described shouldbe sufficient to attract and keep a top-flight manager.
What a nonfamily manager expects
A top-level executive who's considering a position in a family firm expects much the samebenefits package as he would receive in a non-family company. The executive will want workable answersto the following:
- What happens if I get sick? Business typically answers this question with group healthinsurance.
- What happens if I am disabled? Either group or individual policies — or both — cover long-termincome replacement due to disability.
- What happens if I die before retiring? Most companies have life insurance plans thatprovide for a fixed amount or multiple of compensation as a death benefit. Many companies also offersupplemental coverage that allows the executive to buy more protection.
- Assuming I remain healthy, what will I have at the end of my tenure? The question ofincreased net worth may be the key to hiring the executive. Too often family firms respond by offeringpart of the business. —A.B.
Alec Berkman is CEO of Financial Kinetics Corp. in Pomona, California, specialists incorporate benefits and liability funding and a member of the M Financial Group based in Portland,Oregon.