Sharing your family business profits fairly
The allocation of profits from a business among its owners typically reflects their overall contributions to the business, including contributions of both human and financial capital. However, in a family-owned business the situation may not be quite that simple. For example, in family businesses, the owners may have to balance economic contributions against their status as family members when allocating the company’s economic results. How can the owners evaluate the economic contributions of different family members, if that is a consideration?
Family business owners must also consider whether an individual family member’s unique economic needs should play any role in making those capital allocation decisions. For example, if family members need significant income from the business to sustain a lifestyle or deal with an unexpected event, it may be more likely that the family business will be harmed over time through unsustainable compensation to certain family members, perhaps financed by borrowing or deferring capital expenditures. Having “owner need” rather than “company performance” drive firm economics is usually not sustainable over the long run (and sometimes not over the short run, either).
These issues become more complicated if some family owners are active in the business and others are not. The economic value of the active owners’ contributions must be determined. Active owners may be more willing than passive family owners to take business risks. Also, as a function of basic investing common sense, passive family members may be questioning how much of their net worth should be tied up in an illiquid family business managed by other family members.
There are several ways for family business owners to approach these challenges.
• Compensate performance, not need: As discussed above, avoid allocating economic results among family members based on their needs, as this can breed resentment and hurt business performance. If feasible, handle special cases of individual need outside the company financial statements — for example, by making gifts or establishing trusts for personal needs.
• Reward what you can measure: Consider adopting bonus or compensation arrangements among family members that are based — at least in part — on achievement of objectives and clearly defined financial metrics. This may help reduce the risk of bickering or disputes and, if set up properly, should better align results and rewards. If the family owners cannot agree on such an arrangement, it may make sense to bring in a third-party business consultant who can help the family devise a method of sharing economic rewards that is both reasonable and sustainable.
• Divide and conquer: Another strategy for aligning rewards and performance is to establish separate business divisions/fiefdoms for different family members if the business lends itself to that approach. This works best for family businesses that naturally divide into separate profit centers, such as car dealerships, farming operations, hotels or restaurants. This technique may not help with resolving issues that affect the business as a whole, but it can greatly reduce day-to-day friction.
• Have clear exit strategies for passive owners: Consider adopting buy-sell mechanisms that facilitate buying out the interests of family members who are no longer employed in the business. This can be particularly important for service businesses that rely more on human capital than physical or financial capital. Compare, for example, a family business that owns office buildings with one that constructs or brokers office buildings. Having passive family members continue as investors in a building may be a lot simpler than retaining them as owners of labor-intensive operating companies.
• Align risks and rewards: Make sure the family business’s finances are structured so the owners’ interests, risks and rewards are aligned. For example, if the business needs a capital infusion, do all the family owners have the capacity (and willingness) to provide proportionate equity contributions, owner loans or guarantees of third-party debt? If not, those disparities should be addressed by enhancing the upside economic potential of owners who may be required to provide more capital. This could be achieved, for example, by paying separate fees to family members who provide guarantees, creating a preferred return class of ownership for family members who are liable for capital calls or providing the financing owners with an enhanced “profits” or “promote” interest that allows them to receive a larger portion of the firm’s profits above certain designated levels.
Finally, operating the family business on a conservative financial footing, with relatively low leverage, can be very helpful in avoiding economic crises that stress family relationships and endanger the enterprise. Family business squabbles can happen any time, but they most often occur when there is not enough money — and owners feel the pinch — or when results are better than expected, prompting some owners to get greedy. Avoiding excessive borrowing can help a family firm avoid running short of cash in downturns along with the resulting stress and potential for owner conflict.
Although family businesses present unique challenges, they also can provide unique rewards. First, there are obviously all the non-economic benefits of close daily involvement with people that you love. Without having to answer to outside owners or directors, there can also be business benefits in being able to take a long — even multigenerational — view of business challenges and opportunities. Not feeling the obligation to squeeze the last few basis points of profit out of every situation in order to satisfy outside owners can be remarkably liberating for the family firm.
Richard Spore (email@example.com) is a member at Bass, Berry & Sims PLC. He advises clients in commercial real estate and lending transactions and counsels investors and private company owners in a wide variety of investment partnership, joint venture and start-up situations.