Hiring a CEO without giving away the store

Offering stock to a job candidate dilutes family control, and can lead to valuation problems later.

By Alec Berkman

When family businesses seek to recruit an outside, nonfamily CEO to run the company, they usually have to offer a compensation package that promises to build the individual's net worth. In the euphoria of a hiring decision, often the first thing the family gives away is equity in the business.

Our firm has consistently advised against offering ownership as a hiring incentive. Giving away equity not only dilutes family control, it can create weighty problems later on if the manager is not retained.

The most obvious of these problems is the determination of business value. Because of their personal investment 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 valuation process — it hires the valuation experts — and the result may not be satisfactory to the outside executive. If and when the executive is terminated, he or she may well challenge the family's valuation. Case after case in the courts suggests that the executive and the family often cannot resolve their differences without litigation.

For the family, the nonfamily executive, and the business it is far more advantageous to find a way to emulate equity. There are a variety of equity-emulation techniques that can help to attract and retain high-level executives. Some of these substitutes include termination agreements, supplemental executive retirement plans, pre-tax wealth accumulation plans, and private pension plans.

 

Termination agreements. Such agreements define compensation in the event that an executive is terminated. In addition to defining compensation, termination agreements often include vesting schedules and definitions of termination situations. One of my firm's clients based such an agreement on whether the executive had achieved certain sales and profit goals during her tenure. If the executive was terminated after 10 years of service, she was entitled to specific payments if the firm had achieved targets that depended on her reaching her goals and if she had remained a valuable employee. 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 most often are based on the compensation of the executive. A SERP might define what is due an executive at a specific retirement date as a percent of his final three or five years of compensation. In the event of early retirement or termination, the amount would be reduced by a formula, or vesting schedule. An example: We assisted in designing a plan for a family owned business that promised an executive 60 percent of final average compensation, reduced to 40 percent for early retirement and further reduced for termination before age 55.

 

Pre-tax wealth accumulation plans. Employers can set up plans that allow the executive to defer taxes on any amount of income contributed to the plan as well as on appreciation in the value of money. These plans are often used in conjunction with a supplemental retirement plan, but can be used independently as well. As an additional incentive, the company may also match the executive's contributions to the plan.

Any benefits received from a termination agreement, a supplemental retirement plan, or a pre-tax wealth 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 of plans, however, the executive becomes a general creditor of the company. In the event of an insolvency, he would have to "stand in line" with other creditors trying to get paid. If the executive is willing to be a general creditor, the benefits of these arrangements can be very attractive. On the other hand, if he is concerned about the continued viability of the business, he may look for other incentives.

All deductible (that is, tax-qualified) benefits work better for lower paid employees than for higher paid employees. Both the pre-tax wealth accumulation plan and the SERP can offset this reverse discrimination effect, which is brought about by government restrictions. Because contributions to the plan are not deductible to the company, the programs can be entirely selective; the company can set up different retirement ages and amounts for different key people.

 

Private pension plans. The private pension plan differs from the wealth accumulation plan and the SERP in several respects. Under the private pension plan, the executive does not become a general creditor of the company but is currently taxed on what is contributed to the plan. Thus, only the net amount after taxes accumulates for the executive's future use or retirement. The appreciation in value is not taxed, however, and the executive receives the benefits tax-free when he collects the money.

 

Many companies look to outsiders to manage the company when there is no heir-apparent or when members of the new generation aren't interested in taking over the business — or aren't qualified to do it. 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 and values. To hire such an exceptional person, the family must be willing to provide a generous benefits package. However, the family should consider the risks of offering equity as an incentive and avoid temptation to give away part of the store. The types of emulated equity that I have described should be 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 same benefits package as he would receive in a non-family company. The executive will want workable answers to the following:


Alec Berkman is CEO of Financial Kinetics Corp. in Pomona, California, specialists in corporate benefits and liability funding and a member of the M Financial Group based in Portland, Oregon.