Spring 2006 Openers

Ask the Experts.

The sibling who wants equal pay

I work with my sister. She has an advanced degree but has spent less time working in the corporation than I have. Our responsibilities are equal. I feel that even though she was hired for more money than I was, after 25-30 years we should make equal salaries. Is equal pay for family executives appropriate?

Experts' replies:

Equal isn't always fair. Professionalized family firms develop written compensation policies that all employees, whether family or non-family, will find reasonable. Here's one example: “All employees will be paid according to the standards of the industry in our region for the job they do. Bonuses will be calculated on a percentage of the profits of the whole company.”

This kind of compensation policy implies that there will be annual reviews of all employees to determine whether they are meeting the goals for the position they hold, or whether they need to find another job, in the company or outside it. It also implies that family members will not receive bonuses if the company is not profitable. A rising tide lifts all boats, but the captain will be paid differently from the navigator.

In my column entitled “What family businesses are NOT” (FB, Spring 2003), I discussed the curious tendency of family-owned businesses to function in socialistic ways in the midst of a capitalist economy. In an effort to avoid conflict, sometimes parents pay all their sons and daughters equally. However, this practice will eventually trigger more conflict, since there will inevitably be differences in tenure, initiative and performance. Welcome to the human race.

Rewarding superior performance is essential to take any business to the next level, especially in a challenging marketplace. If siblings own equal shares of stock, at the end of the year their distributions will be equal, even if their paychecks are not.

—Ellen Frankenberg, Ph.D.
Frankenberg is a Cincinnati-based family business consultant who facilitates family meetings and coaches executives and successors (ellen@frankenberggroup.com).

Equal responsibilities, unequal pay—a classic bone of contention between family members in business together. This could be a modern “prodigal sibling” scenario: My sister went away to grad school, I stayed with the family and helped keep the business going, then my sister came home and was given a feast and a big salary. Or maybe it's just a case of uncorrected salary compression. As marketplace pressures drive up starting salaries, the salaries of longtime employees, even family members, sometimes lag behind. If one sibling joined the business several years earlier than the other one, that could account for the different starting salaries, especially if there were interim changes in industry standards or in the company's financial condition. While it might not make the salary disparity less frustrating, it's a legitimate explanation.

But let's look analytically at the current comparisons. First consider equal responsibilities, a tough term to objectify. We must decide if “equal” means parallel positions on the organizational chart, equal numbers of employees supervised, equal revenue targets or some other concrete indices. To be a useful basis for comparison, “equal” should be linked to work done or results produced. Remember that compensation disputes in family businesses don't arise as often from who-gets-paid-how-much as from who-gets-paid-how-much-for-doing-what.

Then comes the question of equal pay. Actually, I'd prefer to consider compensation, not just salary. Along with (or even instead of) salary, a family business owner-executive could be compensated in commissions, bonuses, current dividends, longer-term share value and/or perquisites. In some companies, the compensation packages of individual family owner-executives are made up of those components in varying proportions. It's important to look at total compensation, not salary alone, for purposes of judging equality.

There's also a value dimension here. Maybe the sister's advanced degree is of substantive value to the business. If the company manufactures aerospace guidance systems and she's a Ph.D. electrical engineer, her qualifications must be weighed in the compensation equation. But the same criterion should be applied to valuing the other sibling's longer, more extensive experience in the corporation. It might be an essential strategic advantage and a foundation stone of effective management. In that case, the value of experience should be reflected in compensation.

Maybe all parties should ask themselves a few probing questions. First and most obviously, can the company afford to compensate the two siblings equally? What's the company's compensation policy? If there's no policy, is there some other authority, such as a board of directors, that ensures equitability by systematically setting and periodically reviewing compensation? Finally, are there underlying interpersonal issues, such as unresolved sibling conflicts, that make the subject of comparable compensation more touchy than it might otherwise be? If so, how can those issues be either resolved or taken off the table?

There's no fundamental problem with equal compensation for family business owner-executives in equal positions. But like other executive compensation, it should be tied to the company's performance and the individuals' historical and current contributions to it.

—James Lea, Ph.D.
James Lea, a professor at the University of North Carolina at Chapel Hill, is a family business speaker and adviser (james.lea@yourfamilybusiness.net).

The issues involved are more complex than your question implies. Your words suggest your feelings and beliefs, and an unstated concern about ownership. You also raise questions of equity and policy.

You say, “I feel that even though she was hired for more money than I was, after 25-30 years we should make equal salaries.” In this statement, you are actually expressing your beliefs, not your feelings. Do you believe that any compensation that isn't equal is unfair? That you have “done your time”? That nobody offered to pay for your advanced degree (“had I known...”)? Or that policies made after the fact create unjust barriers?

Rethink your feelings. Do you feel jealous? Hurt? Conflicted? Frustrated? Angry? Can you express these feelings to your family members in a safe environment?

For family members, as for any employee joining any business, compensation should be at market, based on the position and the qualifications that the candidate brings to the position. Appropriate compensation is determined according to a blend of both experience and education; neither automatically justifies a higher salary.

If, as stated, both siblings have approximately equal responsibility at an executive level, eventual equal compensation is warranted—in five to ten years of working as an executive team with proven results, not in 25 to 30 years.

This raises the question of who makes compensation decisions, and how. There should be policies governing how salaries and other benefits are determined, as well as compensation pay scales. Any higher salary should be justified by these policies. Salaries should not, as sometimes happens, be based on a parent's decision that a child needs more money to support his or her family, or buy a new sports car. Need is not an appropriate factor in determining compensation; otherwise, everyone could demand more money.

The more difficult issue is one of ownership. Ownership has its own financial rewards—income from the investment and potential gain from the sale of the ownership stake. These rewards differ from those of an employee, who is entitled to a reasonable salary or wage, plus appropriate benefits. Ownership divided 50/50 between two people can lead to a stalemate and paralyze decision making. Assuming that these are the only children of the owner(s), how future ownership will be divided is an equally important, and potentially troubling, decision.

The parties need an open discussion among the two siblings and the compensation decision maker(s)—likely the parents or other relatives —as well as clear policies and procedures governing financial reward for family members in various roles in the family business.

—Pat Frishkoff, DBA, and Paul Frishkoff, Ph.D.
The Frishkoffs are family business advisers with Leadership In Family Enterprise in Eugene, Ore. (www.patandpaul.com).

No, equal pay for family executives is not appropriate.

While this has been a common practice, it is not in the best interest of the family or the business. Generally, this is the result of parents who feel they must treat their children the same in order to be fair. But that is a family practice as opposed to a business practice.

Consider this example: The founder of a Midwestern manufacturing company was a talented inventor but was not an astute businessman. He developed his business and then nearly lost it because he focused too much on R&D and not enough on production and sales. His four sons-in-law worked in the business. They ranged from a shop floor foreman to the new CEO. They were all paid the same salary. The young man who became CEO had many skills in management, since he had worked at larger companies and had learned the ropes there. He turned the business around and made it successful. Should he be paid the same as his brother-in-law who works on the shop floor? This family decided that this practice was not healthy for the business or the family.

The CEO and his family recognized that he would be paid significantly more if he went to work somewhere else. No one in the family wanted him to leave. They also saw how resentment could erupt when people felt their pay was not comparable to the salaries of others in similar positions elsewhere. Finally, they saw that the practice of equal family salaries sent the wrong message to employees and young family members who were considering joining the business.

They followed my recommendation to establish a family compensation policy. The family met in a family council. They discussed “best practices” and agreed with the following principles:

1. All company positions should be compensated at fair market value, whether an employee is a family member or not.

2. Bonuses would be paid if the company profitability warranted it and the individual's performance met goals that helped to achieve company financial success.

3. Distributions to shareholders would be based on the percent owned. In this case, all second-generation members held the same ownership and thus were compensated equally.

4. If the parents or other family members wanted to be generous, they would make gifts to family members rather than pay them a salary.

These principles and practices seemed fair to everyone. The challenge was how to implement them! They were worried that some of the sons-in-law who had been paid above market value would have their salaries lowered.

The group decided (before obtaining the data) that they would not lower any salary, but cap it until annual increases brought their salaries in line with the market. Those who were underpaid had their salaries increased.

I would suggest that the siblings look first at their vision for the future of the business and determine what practices will help them achieve it.

—Leslie Dashew
Dashew is president of Human Side of Enterprise in Scottsdale, Ariz., and a member of the Aspen Family Business Group (ldashew@aol.com).

Rare is the family enterprise that does not suffer from compensation dilemmas at some point in its life. Although you provide fewer details than we would need for a more individualized response, we urge you to consider a solution we find successful in empowering an individual sibling and compensating all family executives fairly and appropriately, while also benefiting the mission and strategic goals of the company as a whole. We recommend a performance-based compensation system by which equal pay for family executives might be achieved, but this result would be by coincidence rather than by design.

Find an effective forum within your company (perhaps an informal family business discussion or a meeting of your advisory council or board of directors) to suggest that a total compensation review be undertaken. Like all business systems, as a company grows, its policies and structures must be reviewed, new systems developed as needed and others overhauled completely to be effective. A compensation system is no exception. Ideally, compensation issues are placed on the table when other family and organizational issues are also in process, often at the board level. Pieces of the following plan can be adapted and implemented to provide the executives in your family with individualized, esteem-boosting, appropriate pay for their contributions to the family enterprise.

Here are the essential steps for creating a performance-based compensation plan:

•  The board of directors votes to undertake the project, creates a committee to oversee the work and, ideally, hires a compensation specialist to create an unbiased system.

•  Collaborative efforts take place over a defined time frame among the board, management and the outside compensation expert.

•  Executive roles and responsibilities are clarified.

•  A metric system of clear performance goals or benchmarks is designed for both qualitative and quantitative skills.

•  A performance evaluation system is determined, which weighs and measures a broad range of responsibilities for each executive, including leadership expectations, achievement toward the company's strategic goals, financial objectives, and required communication and relationship-building skills.

•  An implementation plan is created, including base salary and annual and long-term incentives as well as a system for evaluating family executives.

Finally, if desired, the project can also establish guidelines for a management training program to develop, motivate and appropriately compensate the next generation of family leadership. Even in the most communicative, high-functioning family businesses, discussions about money are thorny and emotionally loaded and threaten to become a stumbling block for family relationships and business growth. This is why many family companies opt to involve business psychologists in these discussions. You are wise to seek advice now on troubling issues that can be resolved through solutions with long-term value on many levels.

—Emily Abrams
Abrams is a senior associate at the Roseview Group in Boston, advisers to entrepreneurs navigating growth, change and capital markets (eabrams@roseview.com).

A business is sold, but one issue isn't settled

 

We recently completed a sale of our family company. One item that remains to be dealt with is a whole life insurance policy that was taken out by the company to insure a key man, the CEO. The CEO is also my brother. He would like to keep this policy himself and pay the other shareholders/family members so he can switch ownership of the policy to himself. I would like to know if the cash surrender value is an appropriate amount for him to purchase this policy from us or if there is a better way to estimate the true value of this policy. Currently the cash surrender value is about $133,000, and the life insurance benefit is $3 million.

Expert's reply:

Compare the cash surrender value with the policy's interpolated terminal reserve (ITR), with adjustments. The ITR is the amount that the insurer has set aside to satisfy its contractual obligation to pay policy benefits. Insurers measure the terminal reserve only once a year, so at any other time in the year you must interpolate the reserve value by adding a proportionate amount of the current year's increase to the prior year's reserve. If the cash surrender value and the ITR are similar, you could use the cash surrender value. Ask your insurance company for these values to be sure you can defend the transfer amount and avoid adverse tax consequences.

Some background information may be helpful. Companies purchase life insurance on key personnel to protect themselves against the loss of these executives' services. Proceeds from the contract can be used to replace earnings the deceased employee would have generated, provide funds for recruitment and training of a successor, meet lenders' requirements or extinguish debt. The company pays premiums after tax and receives proceeds tax-free.

Even if the company is sold, key person life insurance still has value for an executive. This person presumably is now older than when the contract was originally written, so a similar contract would likely be more expensive. If the executive has medical problems, he or she may not even be able to get coverage. The executive may also want to own the policy for its cash value and growth potential.

Here is an example of how adverse tax consequences might be generated. As stated in Section 101(a)(2) of the Internal Revenue Code, for any policy transferred for valuable consideration, the death proceeds are exempt from taxation only to the extent of the consideration. Thus, the balance would be taxed as ordinary income. Fortunately, there are exceptions. For example, if the company sells the policy to the insured executive, the death proceeds would still be tax-free.

The IRS recently has proposed regulations regarding valuation of life insurance policies relating to purchases from qualified or other employee benefit plans. These regulations penalize taxpayers who benefit from transfers that understate the fair market value of the policy.

Under these new IRS regulations, the value of a policy should not be the cash surrender value, but the ITR at the date of sale, plus any premiums paid by the employer for coverage in subsequent periods. This method may not be used, however, when it does not produce a value reflecting all relevant features of the policy.

You must ensure your transfer amount represents a defensible, fair market value. Get all the information available. Any bargain element in the value of the transfer may be subject to adverse tax consequences. As always, you should consult your accounting, tax and legal advisers for specific recommendations. Be aware, too, that insurance contracts are available today that offer much more efficient designs when compared with older contracts.

— Thomas J. Mihok
Mihok is a partner at Newton One, an M Financial Group member firm in Newark, Del. (tmihok@newtononeadvisors.com). Tom Hollinger of Newton One and Ken Nordstrom and Joseph Donovan of John Hancock Financial Services contributed to this reply.

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