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Equal isn’t always fair

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Equal isn’t always fair

Three solutions for the toughest job of all: transmitting family assets.

By Ellen Frankenberg

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

What’s a fair way to compensate family members who work in the family business?

On most issues, family entrepreneurs are usually hardy capitalists, convinced that hard work and good ideas should be rewarded accordingly in the marketplace. Yet their approach to paying their own relatives is sometimes almost socialistic. 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 liked Jennifer best!” “Kevin always gets more pizza than I do!”

Some family companies underpay working relatives, on the theory that they’ll derive their rewards some day through stock ownership. Besides, these families don’t want their “children” (who may be in their 40s) to know how much they’re really worth, lest they be corrupted by their wealth.

Several studies indicate that most family businesses overpay family members. Family companies, concludes Bruce Kirchhoff of Fairleigh Dickinson University, are more likely than other corporations to allow emotion to determine compensation, for a variety of motives:

  • Guilt, because Mom and 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 emotional pressure determines salaries in a family business, it’s not just the family members who suffer; it’s the whole company. Conflict over family compensation indicates a company-wide problem, says Chicago psychologist Bernard Liebowitz: “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 isn’t tied to performance, small problems can develop centrifugal force:

  • Fighting between sibling or 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 emerge from the best intentions of loving parents, as in “He never could keep up with his brothers.... He just needs a little encouragement now” or “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. The founding or “controlling” entrepreneur called all the shots, giving out salaries in much the same way he gave out allowances, with the older kids getting a little more than the younger kids because they got there first.

When second- or third-generation sibling partners move beyond casual summer jobs and recognize different competencies and different levels of motivation among themselves, the debate about what’s “fair” intensifies—whether it’s spoken or unspoken. 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’s clear which descendants will work in the company, which ones will be fired or who will lead it. So Mom and Dad give equal amounts of stock each year (usually the maximum tax-excluded $10,000 per person) to their two sons and two daughters and their four spouses, as well as their 11 grandchildren. Of course, they want to minimize taxes through such generous gifts and be “fair” to each of their heirs.

But in practice this means 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 aren’t working as hard as he or 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 other 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 ventures; 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 compensation philosophy.

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’ll participate in the business.

When family members develop a policy about compensation that everyone understands in advance, the odds of conflict decrease. This doesn’t 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 aren’t determined by the last one to whisper sweetly in Grandpa’s ear.

Here’s a 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 business—on which the prosperity of the whole family depends—employed family members need to develop written, measurable performance goals for measuring their productivity. “The earnings of those who expect to own the company some day,” notes Chicago benefits consultant Donald Crampton, “should vary directly with their own performance and with the company’s performance even more than those of 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 they will be determined at another time, in another way.

At the tender age of 33, Jeff Earhart, second-generation president of Earhart Petroleum in Troy, Ohio, has developed clear, written job descriptions—with goals and objectives for the year—with both of his brothers, as well as with 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 advance in a collaborative way, compensation decisions fall into place much more simply when the end of the year comes around.

Solution #3: Develop a compensation committee.

As a seawall against emotional pressures, some larger and more complex family businesses develop a formal compensation committee. Usually it consists of just three or four trusted advisers who know the company well and are familiar with compensation practices.

This group may include some members of the company’s board of advisers, perhaps a trusted “Dutch uncle” who can fairly represent the family’s interests as well as other objective business professionals. But the company accountant—who already takes a fee and works at the direction of the CEO—is ordinarily 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 advisers can serve a young president, and the company, very well.

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.

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 will keep the business healthy, so the whole family can enjoy its benefits?

When your home is full of teenagers, you perfect the art of cutting the apple pie (a universal sign of love) into pieces that are exactly even. 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.