Seeing Bonuses in a Larger Framework

By James E. Barrett

The Fredericks family was getting bogged down in the details of how much to pay each of six owner-managers.

Barbara Fredericks, CEO of a chain of small department stores in the suburbs of Seattle, has been informed by her accountant that $50,000 will be available from last year’s pre-tax profits to be distributed as bonuses. Barbara, who took charge of the business after her father’s death in 1988, has to decide how to divide the bonus pot among herself and her five siblings, all shareholders who work in the business.

Together, the three older siblings—Barbara, her sister Anne, and her brother Charlie III—own 75 percent of the shares in the company. Barbara and Charlie run it, while Anne handles advertising and PR. Three younger siblings own the other 25 percent and hold lower-level jobs, two as buyers and the third as a computer specialist.

Barbara thinks the three senior shareholders should receive $10,000 each from the bonus pot and the younger three shareholders should each receive $6,333. But she is not entirely comfortable with her reasoning. Clearly, such a distribution would be more like a dividend than a performance bonus, since it was not based on the relative contributions of the six family owners active in the firm. Indeed, the CEO was herself forgoing a well-deserved salary increase of 20 percent to fund these bonus checks. Why? “They expect the money,” she told me, “and if they don’t get it, they’ll make my life miserable.”

Barbara’s approach to buying peace was hardly professional for a company that has been doing $11 million in business a year. But that wasn’t the biggest flaw in her reasoning. In deciding what to do with pre-tax profits, the CEO was ignoring the company’s current and future financial needs.

Charley Fredericks (a pseudonym) founded the firm 40 years ago and operated it as a two-store company until his sudden fatal heart attack at the age of 59. His widow inherited the business and thought it would run by itself. But in the following year the company suffered from confusion and a lack of direction. As a result, the three older children negotiated a buyout agreement in which the six siblings would control the company and Mom would receive a guaranteed income for life. Barbara became CEO at the insistence of her mother, who felt her oldest daughter had the most business acumen and experience of the group.

In the past nine years, revenues of Fredericks Stores Inc. have more than tripled, as has the number of stores and selling space. But there have been many frustrations and worrisome signs, too. Competition in the retail trade has become even fiercer as superstores add more and more product lines and cut prices, especially on their general merchandise, gifts, cosmetics, and health and beauty products. While at Fredericks Stores all debt was being serviced as scheduled, the company’s margins had been falling for three years in this consolidating industry. Operating and financial ratios, moreover, lagged behind numbers for comparable firms.

The company was falling behind competitors in one particular area: information technology. Updated systems were essential to managing sales and inventory more efficiently, and that would be expensive.

The Frederickses were facing a classic family business dilemma. By paying bonuses to the six owner-managers, Barbara would be satisfying their financial expectations. However, she might be slighting the long-term investment needs of the company. In the short run, the CEO would have peace. But long term, she might be stunting the company’s growth.

The family had to lift its sights and look at bonuses in the larger frame of the company’s overall needs. Barbara studied their capital needs for the next several years, including projected margins and requirements for debt management and a possible acquisition. She priced out a couple of projects to improve operations and brought in an information technology expert for a day to estimate what was needed and what it would cost.

When all that was pulled together on a spreadsheet, it was clear that neither the computer modernization nor the acquisition could be done if the bonuses were paid out. When she realized this, the CEO groaned. “Listen,” she said to herself, “Anne is in a new home she can’t afford. Her mortgage is too big, and she had to borrow from our Mom to make it into the house. Charlie’s wife expects the good life. She insisted on a fancy $30,000 sport utility vehicle instead of an $18,000 car. Debra has been famous her whole life for spending every dime. All her credit cards are usually ‘maxed out.’”

Barbara knew that she would have to involve all the shareholders in the decision on whether to invest the pre-tax profits or pay them out in bonuses. To frame the decision properly, she had to place it in a larger context. In this case, the question of whether bonuses were appropriate in this particular year—and the details of how much should be paid to whom—was secondary to the question of a more general policy on the use of profits. Both options had to be discussed.

Barbara prepared a grid to be used as a basis of discussion that showed the business and personal needs of the six siblings. The grid also showed the salaries of the six siblings compared with the market rate for the jobs they were doing. One revelation that might be pertinent to the discussion was that three of them were overpaid.

When Barbara presented the capital-needs summary to the shareholders, a lively discussion ensued. As often happens in such situations, when family members are divided, help comes from unexpected quarters. Debra—she of the maxed-out credit cards—made an impassioned speech. “We have to leave all this money in the business so we can grow,” she argued. “All of us have to tighten our belts. If Anne gets in a jam handling her mortgage, we’ll have to give her enough of a salary advance to get through.”

Debra’s plea carried the day. The shareholders agreed to forgo bonuses and instead put the money in a capital fund. However, decisions made at a conference table have to be carried out in an often disorderly world. So we did a “potential-problem analysis.” Three possible snags to the plan were identified: The family members felt spouses who were not present might oppose it; they also had to make sure supplier and consultant fees were affordable; and they had to make certain that they could get bank financing for the plan. The family then talked about how they would deal with any obstacles arising from these three sources.

The following week the shareholders all sold the decision to their spouses. Barbara, meanwhile, secured quotes from suppliers who would upgrade the company’s computer systems. She distributed copies of the planned proposal to their bank and identified two other sources of additional funding if the bank was not receptive.

Family businesses, I have found, make large numbers of poor decisions because they do not take the time and effort to frame them properly and examine methodically the consequences of the options. This can become a prickly problem if a choice must be made between the financial needs of the business and those of family members. It would have been easy for Barbara to just pay out the bonus money. Certainly, that decision would have gotten warm support from the shareholders. By systematically focusing the shareholders’ attention on the firm’s long-term financial needs—and forging a consensus on the ultimate decision—she increased the odds that the company will survive and perhaps one day pay out even more substantial bonuses.

 

James E. Barrett heads the family business practice of Cresheim Consultants in Philadelphia.

 

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Autumn 1997

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