Fair game for review

Sam Lane is a family business consultant with the Aspen Family Business Group

Money and how it is distributed among stakeholders in family businesses is a source of great conflict. But if systems are set up to standardise payouts, it will serve to educate those involved and avoid resentment and conflict arising, writes Sam Lane

Many conflicts in family businesses have their roots in compensation issues in some shape, form or fashion. These difficulties exist for good reason. Firstly, it elicits strong feelings, old baggage and diverse viewpoints. Secondly, it is challenging and difficult to develop a scheme that is objective, fair and accommodates all the stakeholders in the system. Thirdly, a family business compensation system is hard to administer because some of the more available tools in a non-family business needed to make it work are not present. We will take each of these challenges in turn.

Fairness is one of the strongest emotional drivers in any family. Money is perceived as an indication of differential parental approval or love. Memories and feelings of sibling rivalry are evoked. These unresolved issues and conflicts can become emotional agendas that are not rational but relate to personal feelings. Many times the person isn't even aware of the basis of their emotional reactions. These emotional issues must be dealt with and resolved in order for a family to go forward and address more substantive issues.
 
A well-developed compensation system based on rational principles is difficult to develop for several reasons. Most families lack expertise in working with a principled approach to decision making and problem solving. They are at sea in this area and make decisions based on personalities and trade-offs. Certain issues are bound to come up such as who is giving more to the businesses, who is more capable, who has made a longer term commitment, who has made the greatest contribution and so on. Most families have great difficulty addressing these questions without falling into acrimony. A rational based compensation system is also hard to develop because most families try to work it out on their own. Everyone is perceived to have an interest and a conflict of interest in the answers. Also, many times the system to be developed will be an overlay or a replacement for what currently exists. This causes problems.

A rationale-based compensation system is hard to administer because of the two areas discussed previously. The systems are not well developed and the family has great difficulty discussing these topics without getting mired in strong emotions. Another reason is most compensation programmes in a non-family business – especially bonuses – are based on performance to some degree. If the family enterprise is large enough and a well-developed performance appraisal systems exists, then it helps. However, in most instances the family is left to evaluate performance on an informal basis.
 
Most families do not have the capability to evaluate family members' differential performance and attach any kind of monetary consequence to the outcome. In all my years of consulting with family businesses I have never seen a medium to small size family business successfully administer a performance appraisal system for family members, much less tie it to adjustments to compensation. It just presents too many difficulties. In the face of all these obstacles most families punt. They tend to pay all family members the same, sometimes use gifts and perks to make compensation adjustments or develop some kind of differential pay system based upon longevity or other vague factors.

It doesn't have to be this way. It's possible for families to develop principled compensation systems that are good for the business and good for the family. No system should be adopted from another source, rather each family should follow a set of principles to tailor-make a system for them. In my work over the years, I have developed the following principles to guide this effort.

Family employees should receive compensation and benefits from the company based on being an employee and based on each person's ownership. The source and basis of other monies that might come to an individual should be identified. This principle helps achieve clarity and tends to reduce confusion. This point also says an individual should receive a return – if not a dividend – on his or her investment in the family owned business.

Family member employees should be paid fair market value for their position in the company. The logic of this guideline is multifaceted. Firstly, the family member won't feel he or she is being overpaid or short-changed. Secondly, it is usually possible through a survey to establish the fair market value for a particular position. Third, if the person leaves his or her compensation will already be built into the cost structure of the company. Last, other family members won't feel someone is being overpaid for the job he or she is doing.
 
This principle may be challenging if the compensation policy is being retro-fitted to an existing pay scheme. Sometimes one finds a person's compensation package is not fair market value. When this happens, we build in a family factor and adjust everyone by the same amount to achieve parity. If at all possible, the compensation scheme should reflect differences in performance not longevity. Sometimes we build in a performance differential to the base pay and bonus potential that is maintained unless a major change occurs.
 
Large amounts of money should be taken out of the business only in good years and only out of available cash after the other cash needs of the company have been met. In most small to medium sized businesses cash is king. Because at any one point the actual amount of cash needed in a business is hard to calculate, some decisions are made that present surprises later on. People do not track the cumulative effect of all the decisions they make during the year that affect cash. They find themselves surprised by the lack of it at the end of the year.
 
Another pitfall is family members taking money out of the business that the business doesn't have. Worse is taking money out of the business when capital should be reinvested. This principle implies all the cash needs of the business are met and any taxes are paid before the owners take money out.

Family employees should develop lifestyles commensurate with their level of income and not depend on great amounts of money each year coming out of the company to make ends meet. Family employees need to live within their base pay and benefits and not create expectations for themselves and their families that cannot be met in the long term.
 
All money coming out of the company should be disbursed in the most tax-advantaged way. The programme should be documented and shared with all of the key players. It is important the key players have a good understanding of the system to minimise confusion. Also, it promotes clarity for people to know how other people fit into the policy. Finally, memories are short and it is good to gave a written reference point.

Developing a system to achieve these principles requires two major efforts. The first is to derive some sense of fair market value for positions, which can be done through surveys.
 
The second will take a little more effort. A specialised cash flow statement or sources and uses statement should be developed. This schedule starts with the net profit from operations, adds or subtracts any non-cash items, takes out taxes, principal payments, any anticipated capital expenditures and comes down to a line identified as cash available for shareholders. Any differential percentages based on performance should be negotiated and come out of this pool. A ceiling amount is set upon this pool. Any cash that exceeds this ceiling flows into the next pool that is distributed based upon ownership. This cash flow projection is part of the business plan. Each year another year is added to the financial projection.
 
This approach has a number of important advantages. It says the family is going to make sure the company's cash needs are met before making payouts. It also communicates what everyone can expect if the business plan for that year is achieved. This is agreed to ahead of time so there are no surprises at the end of the year. It also becomes easy for people to see how failing to achieve the profit plan will affect the money they receive. Finally, it promotes a healthy focus on debt service and capital expenditures and ensures people understand the ramifications of piece-meal decisions during the year. This approach to compensation helps reduce confusion and conflict, and it promotes constructive boundaries among the various constituencies in the family business.