How to Negotiate a Compensation Plan, Painlessly
The hired gun
"McElvany's asking too much," Sam Bensen told me. Sam was founder of Bensen Steel Co., a steel service center in Illinois. Jack McElvany, his controller, had been with him for eight years, and had started prowling around Sam's turf, looking for a "fair share," even (gasp!) equity. Sam, it was clear, was circling his wagons against a nonfamily employee with a sudden taste for a piece of the action.
I was helping Sam reorganize his management team, so he could begin backing away from operating responsibility and allow some room for his son, Dale, to grow as a successor. Dale had joined the company two years before, and Sam figured that might be the cause of Jack's discontent.
Dale was working his way through the sales department and doing a good job, as far as I could see. He was a little immature, with a penchant for fast cars and young female friends, and Sam was convinced Jack resented the kid. He asked me to talk to him and find out for sure.
Jack was upset, but, as I expected, not about Dale's status as "crown prince." He knew that in family companies, blood is thicker than bearing-grease.
"He's okay," Jack told me. "He has a lot to learn, but he'll probably handle it. Dale will get the company unless he totally blows it. That's fine. The problem is, time's passing really fast and I'm stuck in a rut here. If I even try to bring it up with Sam, be blows a seal."
I asked Jack about his salary, and how he felt about having stock in the company. "The pay's okay, for now," he answered, "but I'm at a ceiling. Sam won't talk about where we're going or what might be there for me if we make it. As for stock, sure, I would like some as protection, I guess, but Sam will never go for it. Actually, I don't even know if it's appropriate- — I probably wouldn't let go of it if I were in Sam's place."
The situation was all too familiar. Sam, thinking like a business owner — aggressive, ambitious, independent, semi-addicted to risk-taking — was assuming his key man thought the same way. What I was hearing from Jack was very different. Jack, like most key employees I've met, didn't want to be in business for himself. Sure, he expected to get more if he were to take the risk and put in the effort of staying around, but it didn't have to be the whole store. Jack just wanted to be paid well and to participate fairly in the company's eventual success.
"I'm looking for some income potential, and a nest egg for the future," Jack explained. "If Sam and Dale do fine, that's great. But I'll have a lot to do with that and I'd like to benefit, too. Besides, I didn't just roll off the watermelon truck, you know. This is my second family company. If they decide to sell, I want to be covered. It's their right, but I'll have a lot of years invested here."
Sam Bensen was guarding his business, his ownership, and control of it — with the fierceness of a sleep-starved grizzly. Rightly so. He built the place. But by assuming Jack was insecure and greedy, and that his questions were an attack, Sam could scare off one of the key people be needed to nurture and develop his business.
What Sam needed, and what we put together, was a new compensation prograin that met three simple objectives:
- The key managers (Dale included) would be paid a base salary competitive with similar positions elsewhere. This was their "guarantee," the amount competition would have to beat to hire them away. Because Sam didn't have any really accurate estimate of managers' salaries in his industry, we used Sam's salary as the index. (Jack's responsibilities were about 60 percent of Sam's; his base was set at 60 percent of Sam's salary. Bases for Dale and two other key people were set in the same way.)
- A simple, but significant bonus system was developed to help remove the pay ceiling and to encourage managers to work for growth. Sam decided that he wanted to keep the equivalent of 15 percent of the prior year's net worth as the "company's share" of pre-tax profits. But any pre-tax profit above that amount was the bonus pool.
The pool would be distributed according to a key managers' percentage of total management salaries, adjusted to percentage of goal achievement. (Thus, assuming a $450,000 pre-tax profit and a prior year's net worth of $2.8 million, 15 percent of the $2.3 million, or $345,000, would be the company's share and $105,000 went to the bonus pool. Then Jack, whose salary was 40 percent of total management salaries, therefore would have a maximum bonus potential of $42,000 if he reached 100 percent of his individual goals.)
- Additionally Jack was given a contract defining his rights to a share in appreciation of company value. This "growth participation agreement" granted him a 5 percent interest in the company's book value growth, to be vested over five years, and payable over 10 years after his departure. Sam eventually did the same thing for his other key managers, with different percentage participation and vesting periods.
The growth participation was a key feature of Sam's new compensation system, but not the most important part. In fact, all three components were essential: keeping good people by paying as well as the competition; providing short-term incentive by using profit growth to break the compensation ceiling; and offering financial "protection" by allowing participation in long-term growth.
Sam Bensen's program is only one example of a compensation philosophy. The specifics can take almost as many forms as there are companies. In growth participation agreements, for instance, "phantom stock" (sometimes called "shadow stock") can be used to distribute numbers of pseudo-shares instead of a set percentage of growth. This gives the employee rights to appreciation that equals the change in the value of an equivalent number of shares of company stock. This approach avoids distributing ownership rights and prevents dilution of real stock ownership.
There are other options. Valuation can be based on a formula rather than book value. Often, employment contracts include potential for even greater participation, and require trade-offs like non-compete clauses. Sometimes, using real stock is appropriate, with the caution that the company and other shareholders should be well protected through buy/sell agreements and stock restrictions.
Whatever approach is taken, however, the important thing to remember is that family business "hired guns" usually have legitimate needs that must be met — and they don't necessarily include becoming the boss, or taking over ownership of the company.
Donald Jonovic, founder of Cleveland's Family Business Management Services, is author of the book, Someday It'll All Be Yours . . . or Will It?