Compensation in the Family Owned Business
Family-owned businesses provide unique management challenges in a number of ways, not the least of which is the compensation paid to family members. In this post, I will briefly examine some of the challenges and suggest some relatively simple solutions to what often seem to be insurmountable problems. Up front it should be noted that this post is not intended to help companies avoid or reduce tax obligations. There are practices that businesses may use that will be different based on their organizational status (e.g., “C” or “S” Corporations), and these practices are the province of appropriate tax and legal counsel. The purpose here is to discuss techniques that can be used to reduce the inherent stresses within family-owned businesses that come from the need to properly compensate those who work for the business.
In most businesses, family members don’t contribute equally to the success of the organization. The idea that everyone should be paid the same simply because of a family relationship is a recipe for disaster. Someone has to be in charge, and frequently that means working much longer and harder than family members who take less intensive roles. Someone else has to take on the difficult, time-consuming and often thankless tasks. Others have simple, comfortable jobs with minimal stress. Whether it is one of the siblings who takes the lead role in running the company, or members of multiple generations working in jobs from clerical to executive, it is a fact that family members contribute at different levels, and should be compensated appropriately. While this might seem to be obvious, the family dynamic changes things.
- Employee owners may feel that their family members who don’t work for the business should not share much as a result of their efforts, and try to keep the money by paying themselves more.
- Non-employee owners may feel that their employee family members may be taking too much, leaving less in the way of profits they feel they deserve.
- Family members who have more demanding jobs may feel taken advantage of if they are paid the same as those with less important roles, while some (generally those in those less important roles) may feel that everyone should be paid the same simply because they are family members.
What is interesting about these concerns is that they are only really taken seriously in the family environment– arguments that would be inconceivable in a Board room seem right at home at the Thanksgiving dinner table.
So how do we address this challenge? By setting up a compensation program that is fundamentally fair. Fair doesn’t mean the same. Fair means, first and foremost, paying each family member according to their contribution to the success of the organization. There are some simple things that can be done in furtherance of that objective:
Don’t create jobs for family members. At some point, little brother or sister tires of college or working in the real world and comes back to the nest, expecting a well-paying job, simply because he or she is a family member. Resist the temptation. One of the major sore points in a family-owned business is the creation of jobs for people not qualified to provide any value to the business. Why? It’s simple — it becomes an unnecessary expense that reduces the resources the company has to pay other employees, including family members, and reduces the profits available for distribution to owners. Start with a very simple principle – we only create jobs that we need, that will add value to the organization, and we only add employees when we need to fill open spots. Family members can certainly be hired when there are openings, provided they are qualified. We may even hire them over more-qualified non-family members, but the company should not pay someone for the sake of providing them with a job.
Some businesses require family members to fulfill criteria before being employed by the business. This might include completion of a college degree, or perhaps working for a non-related company for some period of time. The idea behind these types of criteria is to ensure that when they join the business, the family members will be more likely to contribute in a meaningful way. Requiring someone to work at another organization helps to ensure that they will understand what it really means to work in a setting where there is not going to be real or perceived favoritism, and is thought to improve work ethic. Just as importantly, working elsewhere is a means of bringing new ideas into the business, and keeping it from becoming stagnant.
Pay for the Work Being Performed
Separate the various roles for which family members are paid, and administer pay consistently and fairly for each role. Some of these roles are:
- the job performed by the owner-employee
- potentially added value for participation in roles related to ownership
- membership on the Board of Directors
What shouldn’t be included in the “pay” program is compensation simply for being an owner. As noted earlier, this is not a post about tax avoidance, and family-owned businesses should be careful not to violate the law in their zeal to avoid double taxation.
What is the Work Worth?
A principle that should be understood clearly within the ownership group, and preferably built into the by-laws or shareholders agreement, is that family members who are employed in the business should be paid fairly for the jobs they perform, in the same way that a non-owner employee would be paid. The best way to do this is in the context of a structured compensation program that measures 1) the value of a job to the organization, 2) the compensation paid in the market for employees in similar roles, and 3) the performance of the employee against the standards and expectations of the job.
Setting up a method for establishing pay against formal standards, rather than in a subjective comparison of people against each other, reduces stress and promotes real fairness. When every job has a pay range tied to the value of the job to the organization, and competitive in the market, all the owners, whether employees or not, know that the businesses resources are being properly allocated. When performance is measured and the owner-employee is paid based on his or her performance, everyone involved can feel that money is being properly spent. Pay ranges for employee-owners (as well as all other employees) should be updated periodically to reflect changes in the market, and individuals considered for increases on a regular basis, based on their performance.
Another unique characteristic of the family-owned business is the idea that family members should cut their pay when times are tight, or when non-family members are at risk of losing their dividends because margins get thin. If your organization does this, make sure it really does it fairly. Just like owner-employees should be paid at different rates based on their job, cutbacks should be addressed based on the jobs… cutting back everyone by the same percentage might seem fair (whether to family members or non family employees), but it isn’t. A ten percent cut to an executive pay check may mean very little, while cutting ten percent from the owner-accounting clerk could be devastating. Regardless of why or how businesses ask their family-employees to sacrifice, remember to document the sacrifices, so the they can be repaid when times are better.
How Much Does Being an Owner Mean to Management of the Business?
There is a belief in many family-owned businesses that owner-employees should be paid more for doing the same job than a non-owner employee. While there may be some logic to this, anything that constitutes paying more than is necessary is the kind of thing that might make non-employee owners wince. Some of the ways that family businesses pay more are addressed here.
It is not uncommon for family members to receive some sort of “premium” in addition to their pay. I recently ran across an organization that paid its family members 25% more than other employees in the same job, regardless of the nature of the job; the rationale given was that the owners, having a “stake” in the business, worked harder, and that they better understood the business and thus could contribute more. In truth, while being owners may give employees the opportunity or ability to contribute more, there is certainly no guarantee that they will. Businesses should be cautious in making such a blanket assumption — like the concept that all owners should earn the same amount, the idea that all family members will contribute more to their job is some what suspect.
In some family businesses, there are owner-employee groups that act as the main decision making body, and members of these groups may receive a premium or some kind of stipend. Often this group is composed solely of family members, again using the rationale that with a stake in the business, they will either be able to or be motivated to, perform at a higher level. Sometimes non-owner employees may be part of these councils, and frequently the groups will contain somewhat awkward combinations of family members who are truly in non-management roles and have little to actually contribute to the overall management of the business.
Pay for Board Membership
Perhaps the most common way to pay more to owner-employees, and often to give non-employee owners a salary, is to pay for participation on the Board of Directors. As with other ideas discussed in this post, this is somewhat unique to the family business. In most organizations, employees are not paid for participation in the Board of Directors — it is considered a part of the job. Other shareholders are also typically not paid — outside of the publicly traded environment, the only Board members who are compensated for their service are true “outside” Directors who are retained to for credibility or to provide some special skill or expertise that is lacking within management or the ownership.
Board members who are compensated typically receive some type of retainer, and then are often paid for attendance at meetings. Board officers may be paid a larger retainer, and retainers and meeting fees may also be given for participation on Board Committees.
Family-owned companies should be very careful when paying family members for participation on the Board. First, whatever the amount is, it should be reasonable. While there are certainly Fortune 500 Board members who receive more than a hundred thousand dollars in fees, the same type of pay to the Board members of a $5 million manufacturing firm might be looked at differently. Having all of the shareholders on the Board and receiving pay may look like a way of avoiding taxes, and setting pay in any way that looks like it is related to the amount of ownership can look like a way of distributing profits.
All that being said, paying for participation on the Board is an effective way of separating the “ownership” aspect from the “work” aspect, and can be a way to ensure that both aspects are compensated.
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The simplest way to avoid pay-related controversy in the family business setting is to pay according to a structured compensation program — effectively neutralizing the “family” aspect of the employment relationship. Pay for participation on the Board, or in another owner-council, can accommodate the additional value that owner-employees contribute to the business. For more information on compensation in the family-owned business, contact the author at firstname.lastname@example.org.