Compensating Family Members in a Family Business - Ownership
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SECTION: Ownership

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Compensating Family Members in a Family Business

By Dana Telford

Article Date: 09-01-2009
Copyright(C) 2009 Associated Equipment Distributors. All Rights Reserved.


Teach and foster an ‘owner’s mentality’ and communicate clear rules that preserve the business as well as fair treatment of both family and nonfamily employees.

A common anecdote told by family business advisors quips that the first three things a baby learns to say are “Mama,” “Daddy,” and “That’s not fair.” After working with family business owners for a dozen years, I couldn’t agree more.

One of the families I’ve worked with owns a large manufacturing company worth roughly $100 million. Four siblings and their mother each own 20 percent of the company. The siblings are each in their 50s. In the last Shareholder’s Meeting I facilitated for them, an argument about a family loan erupted. In question was whether Anne, the third oldest, had the right to borrow $5 million from the company, even though the family loan policy that she had agreed to clearly forbade it.

As the volume and emotions began to increase, I noticed how quickly the arguments for and against Anne’s loan started marching back through time. Comments about who got what money from the company last year turned into a heated discussion about the cost of a particular grandson’s college tuition which was retorted by a sharp comment about how expensive another sibling’s divorce had been and who paid for it.

In an attempt to calm the combatants, I asked Anne why she believed her request was valid, despite the clarity of the loan policy. She said that she saw an opportunity to invest in raw land in her neighborhood. I asked again if she felt that her circumstances superseded the agreement she had signed. After a few comments back and forth, the truth finally emerged. Between gasps of emotion she said, “because Daddy always gave more to them. I deserve this money. No, I demand it.”

Siblings – A “Fairly” Complicated Relationship

Though the intricacies of management compensation (wages, bonuses, retirement, benefits, stock options, perks, fair market value, etc.) may lead us to believe that complications related to family member compensation are grounded in finance and accounting, I come to a different conclusion. The early-formed and long-standing quest for fair treatment between siblings is at the heart of this emotional and complicated issue.

Like it or not, we compare how much time and resources we receive from parents and grandparents with that of our brothers and sisters. Our children keep score in the same way. This dynamic lasts throughout the sibling relationship – which on average is the longest in life – and must be confronted and managed if you stand a chance of putting together a successful compensation system for family members in your business.

Earlier this year I analyzed my 70 most recent client engagements and was not surprised at how many of them struggle with the question of family members’ compensation. A few interesting facts: 
  • 34 of the companies are controlled by one owner (49 percent), 31 by sibling partners (44 percent) and five by cousin groups (7 percent).
  • In 60 of the 70 family companies (86 percent), siblings work together on a frequent basis (at least one day per week).
  • Of those 60 family companies, compensation is a major issue in 54 (90 percent).
  • Of the six family companies that do not have compensation issues, three are publicly traded and three are third- or fourth-generation, high-functioning family businesses that actively manage the relationship between the business and family.
  • Of the 70 total companies, family member compensation is a significant issue in 58 of them (83 percent), regardless of whether siblings work together.

In summary, 90 percent of family businesses in which siblings work closely together have trouble dealing with the topic of compensation. 

Socialist at Home, Capitalist at Work

Why does family-member compensation in a family business cause so much heartburn? I believe much of the blame can be placed on parents and the incongruity between how we behave at home versus how we behave at work. I call it split economic personality disorder.

By and large, we are socialists at home and free-market capitalists at work. More often than not, family compensation tensions can be traced back to these clashing economic philosophies.

“From each according to his ability, to each according to his need.” Karl Marx said that.

When it comes to home economics, we parents are leftists. We give time and money in larger amounts and more often to the neediest, most troubled child. At the same time, the child who produces more benefit for the family – maybe by helping out around the house or earning money to defer the cost of car insurance – is rarely rewarded for his or her extra achievement.

Once we pull the car out of the driveway, however, we become free-market capitalists, intent on productively employing our resources for personal gain – gain that results, in large part, from finding, hiring and retaining skilled, productive and trustworthy employees. And we know that our chances of increasing our capital improve if we lead and reward our people based on principles of meritocracy – a system of governance that distributes responsibility, power and resources based on merit and achievement rather than relation, popularity, seniority or age.

It seems logical then, that a child raised under a socialist regime at home would expect the same principles to apply on their first day on the job at the family company. “After all,” they might surmise, “it’s the same boss.”

Not so, dear child. You’ve stepped from one world into an entirely different one.

One great challenge in compensating family members in the family business lies in replacing this expectation with the principle that family and business relationships must be different if each is to be protected in the long term.

Where to Start – The Golden Goose

Before family business owners begin to consider compensation scenarios for family members, they must first create a Golden Goose – a profitable, growing business the family can feel proud of. And they must communicate clearly and often that protecting the Goose and her Golden Eggs is a primary objective and long-term family responsibility.

Though it may seem simplistic, many of my clients use the Golden Goose analogy to teach children (and adults) about their family business. Protect the Golden Goose from the Sly Fox (primary competitor) and it will lay Golden Eggs for its owner. If the owner gets too fixated on the Golden Eggs and forgets the Sly Fox, he’ll kill the Goose. Dead geese don’t lay eggs, and families miss them when they’re gone.

Hundreds of books and articles have been written on how to start and grow a successful business. Based on lessons I’ve learned from exceptional entrepreneurs, the key ingredients are: 

1.)  A clearly defined set of guiding principles, (e.g. integrity, merit, respect for the individual, energy, collaboration, innovation, fun, productivity)
2.) An inspiring mission that includes a commitment to employees
3.) Specific growth and profitability goals
4.) Precise knowledge of individual and company core strengths
5.) Open and direct communication and information sharing patterns
6.) Up-to-date knowledge of the ideal customer 
7.) Sufficient capital for taking advantage of investment opportunities
8.) Superior hiring, retention and compensation processes

The business, when managed well, provides enormous benefit to the family. And the family, when fairly treated and cared for, provides the same for the business. Each complements, supports and strengthens the other. Think yin and yang, peanut butter and jelly, Paula and Simon.

Teach Self-Sufficiency, Autonomy and the Owner’s Mentality

Once the Golden Goose is healthy and safe, or at least increasingly so, begin to focus on preparing the family for entering the business.

A few ideas that I’ve seen families use with great success include:
  • Extol the virtues and satisfaction that come from being self-sufficient.
One of my clients takes the time to talk with his children about the satisfaction he feels from earning his own money and being able to spend it how he wants. He points out to his kids that he is able to alter his own schedule in order to attend important family events because he works hard as his own boss.
  • Help your children and grandchildren identify their “thing.”
Another client encourages her grandchildren to pay attention to where they are most successful in school and life, even at an early age. She suggests to them, in one-on-one lunch meetings and “dates” that they will be happiest in life if they can figure out their “thing” – that unique talent or skill that they can productively and enjoyably apply in order to make money. One of my wealthiest, most entrepreneurial clients has said, “The people who cause the most problems in an organization are the ones who aren’t good at anything.” In my opinion, all people are good at something, but most don’t know what.
  • Start developing the ‘Owner’s Mentality’ in your family.
One of my clients has a life slogan that he calls “Ma Stu Be” – short for “making stuff better.” He buys businesses, improves them and either sells them or takes them public. He actively teaches his kids this concept by helping them buy, fix up and sell things like bicycles, wagons, dollhouses and skateboards. Owners are interested in increasing the value of what they have. By contrast, managers tend to focus on using someone else’s assets to provide monthly income and survive. If your children or grandchildren are 8 or older, they have the capacity to begin to understand the difference between the Owner’s and Manager’s Mentality. Try this exercise the next time you are riding bicycles together: Ask them if they would rather own or rent a bike. If your children are older, perhaps late teenage years, you might ask them if they would rather own or rent a private jet or a limousine. After they respond, ask them why they chose their particular answer. Use the discussion as a teaching tool to help them begin to see that owners have a greater ability to control and personalize their “stuff.” Perhaps they would choose to paint the bike a particular color, or design the limo’s interior. If they own it, they can do with it what they want. They can use it, rent it out to others or sell it. If they rent it from someone else, they do not have the right to change it.
  • Develop a family governance process (often referred to as a Family Council).
Meet with your spouse, children, children-in-law, grandchildren, etc., at least twice a year. Create an agenda that focuses the discussions on the interaction between the business and the family and how both should complement each other. Teach them how important it is to protect the health of the Golden Goose.
  • Talk openly and consistently about family money and wealth.
During the Family Council, share information with the family about what benefits they can expect to gain from the family business. Benefits such as income (under certain circumstances), health and disability insurance, unique vacations and family retreats, vehicles, retirement funds, comfort, the ability to make the world a better place, financial security (if protected). As they increase in age and maturity, be more specific about dollar amounts and wealth.Clarifying expectations about family money early in a child’s life will make the inevitable questions about family business compensation much easier to handle. 

Develop a Family Employment Policy*

As the oldest child gets to be college age, and starts to seriously consider their career options, have the Family Council create a family employment policy.

As children mature, and as they become more aware of their friends’ families and “who has what” in the community, they will hear and see worst-case family business scenarios. If they have been appropriately included in family wealth and business discussions, they will understand the need for a family employment policy.

Working together and inclusively, develop a family employment policy that specifies part or all of the following:
  • The family’s philosophy about family employment (why this is important)
  • What the family expects of family employees (behavior and performance)
  • What age a family member must reach prior to applying for a position
  • What formal education a family member must obtain prior to applying
          • Years of education  • Degree or certificate (Associates, Bachelor’s, specialized training) 
          • Types of institutions (accredited universities, licensed training schools)
  • What knowledge the family member must have obtained before applying and through what means, such as: 
                 • Technical    • Financial/Accounting    • Leadership
  • What level of outside work experience a family member must have before applying (I strongly recommend this)
  • The process the owners will use to determine if a family member will be hired
  • How family members will be evaluated, compensated (more on this later), promoted and, if necessary, fired
  • How the next generation of family business leaders will be chosen and by whom
Take the time to get this policy right, and to make the process of developing it enjoyable. Draft a number of iterations, improving the policy with each one. Make sure that the message is clear – as owners and future owners, the family wants only the best and brightest business leaders in their company. Others need not apply.

Require family members to voice their opinion and to make concrete recommendations. Once the policy is completed, remind family members that this policy will be binding and that it can only be changed by unanimous vote of the Family Council. Then give them another week or more to review and ponder it and to come back with any final suggestions. Have each one of them sign it or agree to it with raised hand during the Family Council meeting, and keep meeting notes.

Personal Risk Detectors

Once the family employment policy is complete, share it with your top managers and executives. Warning: Do not underestimate the value of doing so.

Nonfamily employees in family businesses have highly tuned personal risk detection systems that are constantly scanning their work environment for trouble. If they know that a next generation of family members is approaching the age of full-time employment, their perceived risk of unemployment goes up. They are keenly aware that they may be replaced by a family member. They know enough about families to worry that the next generation may run the company into the ground through greed, incompetence or both.

Their personal risk detectors pick up these signals and they respond by dusting off their digital resumes and reaching out to friends and associates in their professional network just in case. As a result, productivity declines and profitability dips.

If nonfamily employees see a family employment policy that places the health of the company on a pedestal, they let out a sigh of relief. If the policy is signed by both generations, they let out two sighs and their perceived risk decreases. Now they can stop worrying about job loss and get back to work.

There is great value in communicating a family employment policy to company leaders and managers.

A Family Compensation Policy To Fit the Owner’s Mentality*

Once the employment policy is finished, turn your attention to the creation of a Family Compensation Policy.     Compensating family members is straight forward once family members understand and agree to the concept of the Owner’s Mentality. Owners want their businesses to grow profitably. Profitable growth is a result of excellent decisions made by managers. Owners understand that overpaying under qualified managers, whether family member or stranger, doesn’t reconcile with the Owner’s Mentality.

The Family Employment Policy has clarified that family members seeking employment will be evaluated and offered employment based on merit.

The Family Compensation Policy should have a parallel perspective and should address key issues very clearly:
1.) Deal with and dispel employees’ concern that advantages will be given to family members working in the business –   aka, family socialism superseding free-market (and merit-based) capitalism.
2.) Family employees will be compensated in the same manner as nonfamily employees, period.
3.) Compensation levels will be determined by fair market value analysis, just as with nonfamily employees.
4.) Family employees are expected to live within their financial means and not encumber themselves with excessive  debt or rely on special disbursements for their living expenses.
5.) Extra compensation, when deemed fair and reasonable by the Board, and not harmful to the ongoing performance of the company, will be provided through ownership channels.

As a mechanism for satisfying Point 5, consider compensating family employees as owners or future owners. Provide stipends for serving on the Board or Family Council, provide a fair and reasonable dividend taken from profits when the company performs well, pay family members for special ownership-related research projects (e.g., a review of a top competitors strategy) or to serve on an investment committee.

Be creative in distributing money if you have the means, but keep extra compensation away from the ‘personal risk detection systems’ of nonfamily employees. 

Conclusion

The question of how to compensate family members in a family business seems technical at first blush. Questions about fixed and variable pay, benefits and incentives, stock options and perks, retirement and fair market value can seem overwhelming when mixed with the emotional energy of family relationships. But when viewed from the vantage point provided by the Owner’s Mentality, compensation for family members becomes another piece of a puzzle – a colorful, energizing, maddening family business puzzle that is complex and constantly changing and must be handled lovingly, carefully and fairly.

*For specific examples of Family Employment and Family Compensation Policies that I have helped my clients create, go to danatelford.com or e-mail me.
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Article Categories:  Management