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Making Tough Decisions about Transmitting Family Assets

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Equal Isn't Always Fair: Making Tough Decisions about Transmitting Family Assets

by Ellen Frankenberg, Ph.D.

Sometimes parents lie awake in the night, struggling to decide how to be "fair" to each of their children. They understand the differences in their sons' and daughters' contributions to the family business all too well: the eldest, responsible son, who works at least until 3 pm every Saturday; the middle daughter who charms the party, but misses work the next day; the youngest, lucky to get a GED, but now brilliant webmaster for the company's new E strategy.

What is a fair way to compensate family members who work in the family business?
Even though most family entrepreneurs are hardy capitalists, convinced that hard work and good ideas should be well rewarded in the marketplace, some family firms still pay all siblings of the same generation the same wage, regardless of who contributes what. Why is such a fundamental American perspective on competitive wages upset when family members are concerned? Is it echoes of childhood complaints? "You always did like Jennifer best!" "Kevin always gets much more pizza than I do!"

Other companies underpay family members, because they expect them to enjoy stock ownership someday. And of course, they don't want their "children" to know how much they really are worth, because, even though they're now in their 40s, they still aren't responsible enough to handle large amounts of money.

Some studies, including one by Bruce Kirchhoff of Fairleigh Dickinson University, indicate that most family businesses overpay family members. They are more likely than other corporations to allow emotion to determine compensation, for a variety of motives:

  • Guilt, because mom & pop were so busy working when the kids were young…
  • Fear of conflict, because someone's wife threatens not to come to the family picnic…
  • Resistance to change, because "That's the way we've always done it…"
  • Inability to confront family members who feel "entitled" to inflated salaries…
  • Determination to minimize estate taxes by transferring wealth through compensation…

When Compensation is Decided By Emotion, Problems Multiply.
When emotional pressure determines salaries in a family business, not only the family members, but the whole company suffers. Bernard Liebowitz, a Chicago based psychologist, writes that conflict over family compensation indicates a company-wide problem: "They haven't faced up to the need to tie compensation to performance, performance to work responsibilities, responsibilities to an overall strategic plan, and all of these to a company work ethic…"

When compensation is not tied to performance, small problems develop centrifugal force:

  • Fighting between sibling/cousin partners increases.
  • Hard-working family members and employees lose morale.
  • Well-motivated, competent employees leave the company.
  • The company loses its competitive edge and growth potential.
  • Family harmony decreases.
  • The value of the company declines, or it is sold - for the wrong reasons.

This kind of trouble can, ironically, emerge from the best intentions of loving parents. "He never could keep up with his brothers… He just needs a little encouragement now…" "Maybe if we give her a raise, she'll feel better about herself and stop drinking …"

Tension over salaries is especially potent when the family begins the transition from one generation to the next, from the founding or "controlling" entrepreneur who called all the shots, and gave out salaries somewhat the way he gave out allowances, with the older kids getting a little more than the younger kids, because they got there first.

When 2nd or 3rd generation sibling partners move beyond casual summer jobs, and recognize different competencies and different levels of motivation among themselves, the debate about what is "fair", whether spoken or unspoken, intensifies. When Dad finally does retire to Florida, who will make those tough decisions about compensation? As sibling/cousin partnerships develop new expectations about sharing company information and decision-making, clear standards for compensation may become job #1.

What is a "fair" way to transmit ownership of the company?
Sometimes estate planning drives the distribution of stock prematurely, before it is clear which descendents will work in the company, which ones will be fired, or who will lead it. So Mom and Dad, Grandpa and Grandma, give equal amounts of stock each year (usually $10,000 per person) to their two sons and two daughters and their four spouses, as well as their eleven grandchildren. Of course, they want to minimize taxes through such generous gifts, and be "fair" to each of their heirs.

What this means is that the family member who ends up leading the company may own 1/19 of the stock, even though most of the other family members are not working as hard as he/she is, nor struggling to build the kind of consensus around major decisions that a closely held business requires. Sometimes families create two kinds of stock, voting and non-voting, to provide those in management with control of the company, even while their siblings still enjoy the benefits of ownership.

Whatever the family decides about transmitting ownership, the distribution probably won't be equal. Some heirs may choose to sell their stock to fund other endeavors; others will purchase more. It won't end up exactly "fair" and that's not a bad outcome for healthy family relationships: it's more honest than pretending that everyone contributes equally, and is equally motivated to invest in the family firm, when they aren't. Equal isn't always fair.

Solution #1: Develop a Clear Philosophy of Compensation.
In my work as a consultant to family firms, we usually develop together, over time, a Family Strategic Plan that complements the business strategic plan. We convene the family stakeholders so they can clarify their values and eventually build consensus about the policies that determine how they will participate in the business. When family members develop a policy about compensation that everyone understands in advance, the odds of conflict decrease. This does not mean that each family member knows all the numbers; it does mean that every member knows the standards by which individuals are paid, and that salaries are not determined by the last one who whispered sweetly in Grandpa's ear.

Here is sample written policy that one family developed:

"Family members employed in the business will be paid according to the standards of our industry in our region, as reported by our trade association, for a specific position, in companies of our size. In order to retain good employees we will pay all employed family members and other managers within the top quartile of our industry's standards. Additional compensation will be based on success in reaching specific company goals, with bonuses shared among all members of the management team. Individual incentives will be determined according to measurable goals for job performance determined each year, and reviewed by the appropriate manager."

Solution #2: Develop Job Descriptions and Goals for an Annual Performance Review.
To protect the "golden goose", the business on which the prosperity of the whole family depends, employed family members need to develop written, measurable performance goals against which their productivity will be measured. Donald Crampton of Chicago's Crampton, Lewis & Company, a benefits consulting firm, wrote: "The earnings of those who expect to own the company some day should vary directly with their own performance and with the company's performance even more than other employees". In performance-based companies, compensation for an employed family member has nothing to do with the percentage of stock owned, now or in the future; the benefits and risks of ownership are treated separately, and will be determined at another time, in another way.

At Earhart Petroleum in Troy, Ohio, the 33 year old 2nd generation president, Jeff Earhart, has developed clear, written job descriptions, with goals and objectives for the year, with both of his two brothers, as well as other management team members. Each team member helps build his own goals, so he has clear benchmarks against which to measure his own successes - and to seek the support of other team members through the inevitable downfalls. When such concrete standards are developed in a collaborative way in advance, at the end of the year, compensation decisions fall into place much more simply

Solution #3: Develop a Compensation Committee
In order to increase objectivity within the emotional vortex of more complex family businesses, some develop a Compensation Committee, usually including no more than three or four trusted advisors, who know the company well, and are familiar with compensation practices.

This group may include some members of the Board of Advisors, perhaps a trusted "Dutch Uncle" who can fairly represent the family's interests, and other objective business professionals. Ordinarily, the company accountant, who already takes a fee, and works at the direction of the CEO, is not included in this committee.

The value of such a committee is that it can recommend executive salaries more objectively, avoid inflated compensation, reward and motivate those who contribute most to the company's growth, and assure both family and non-family executives that compensation will be determined in a professional manner. Especially in an emerging sibling partnership, when Dad is no longer on the scene, such a group of advisors can serve a young president, and the company, very well.

"Shirtsleeves to Shirtsleeves in Three Generations…."
One saying about family businesses is universal: "Shirtsleeves to shirtsleeves in three generations" or "Clogs to clogs…" or "Rice paddies to rice paddies…" A successor generation that has enjoyed the benefits of affluence may not be motivated to work as effectively as those who founded the company, unless the benefits they receive are somehow tied to the contributions they make.

Developing clear policies about compensation and transmitting the ownership of your family business may be one of the most effective moves you can make to insure its continuing profitability. No matter how much you love each of your sons and daughters, decisions about compensation and ownership need to be made from the perspective of the business: What is best for the continuing success of the business? What will keep the "Golden Goose" healthy, so the whole family can enjoy its benefits?

When your home was full of teenagers, you perfected the art of cutting the apple pie (a universal sign of love) into exactly even pieces. When they become adults, responsible for their own behavior, the pieces of the pie will no longer be even, because equal isn't always fair.

Ellen Frankenberg, Ph.D. is a Cincinnati-based psychologist who consults with family businesses.

 
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