Family Business Transition Series - Why You Need a Compensation Policy

April 06, 2017

The success and longevity of any family business is dependent upon a well-thought-out succession plan. Our Family Business Transition Series is intended to provide the information and advice you need to find a solution that works best for your family and your business.

Compensation is an emotional topic for all of us, and it is definitely something that can trigger issues within a family business. It is one of the frequently-cited obstacles to a smooth transition as it is an area where many business families find it difficult to set aside their personal and family values to focus on the principles of running a good business.

Cathy Penmaen is the VP of Sales and Marketing for Penmaenship Tool and Die, a company founded by her father, Thom. At age 40, Cathy is the eldest child and the only one of three siblings directly involved in the business. Her sister Diane has made it very clear that she is not interested in working in the family business.

As the only son and the baby of the family, Derek is the favourite to eventually take over the company from Thom. However, Derek doesn't seem interested in his father's pride and joy. Much to Thom's dismay, he has aspirations of a music career and wants to take his share of the business to fund his venture.

Thom struggles with how best to support Derek, and Cathy gets upset at what she perceives as inequality among the siblings. “I feel I'm working for my money while Derek isn't. Yet he reaps the benefits,” complains Cathy. Does Cathy have a legitimate concern? Is Derek entitled to financial support and/or a share of the business?

The 3-circle model that depicts the need for balance in all areas of the family-owned business also provides business families with a more professional approach to determining compensation. It helps them separate family from business and continue to meet the differing objectives when it comes to:

  • Providing monetary support for family members
  • Delivering a return on investment to shareholders
  • Determining fair compensation for those involved in the day-to-day operations

The Business Circle

The objective of the Business Circle is to build wealth by running a profitable business. To this end, compensation should be determined by assigning market value to each role, regardless of whether that position is held by a family member or a non-family employee. Contribution in this area can be in the form of salary, bonuses or benefits such as health or dental plans. In some cases it may also be appropriate to include perks such as company cars or club memberships.

Thom has made it clear that all three children can choose to work in the business. However, it is important that Thom also makes it clear that each would be paid for the job that they do rather than an arbitrary amount because they are part of the family.

Compensation for a job well done belongs in the Business Circle. Therefore Cathy is entitled to fair compensation for her direct contribution to the operation of the business. If Derek chooses not to work in the business, it follows that he is not eligible for a salary. On the other hand, if Derek came to work in the company, he would be paid market value for the role he played.

Thom needs to be cautioned against paying his children the same amount in an effort to treat family members equally. Equality is a family principle and therefore must be addressed in the family circle. Paying market value for the job also ensures that non-family members are given the same level of respect. Thom values the contribution his employees make to the business and it is important for him to recognize that contribution financially.

Read more: Beware the Golden Handcuffs

The Ownership Circle

The focus of the Ownership Circle is to protect and manage the wealth that the family business has generated ― it is the family's Wealth Capital. In terms of compensation, the objective of the Ownership Circle is to ensure that shareholders are compensated fairly based on their continued financial investment in the business.

This compensation should be independent of the fact that a shareholder is a family member or employed in the business; is not therefore dependent upon the salary for any day-to-day role in the company. For example, shareholders might receive rewards for their investment in the form of a dividend appropriate to the number of shares they own.

A number of years ago, on the advice of his accountant, Thom assigned some shares to each of his three children. In recognition of their current investment or ownership in the company, each child could receive compensation in the form of a dividend based on the annual profitability of the company. This is one way Thom could support financial independence for Cathy, Diane and Derek while being fair to each, and maintaining the separation from business and family compensation.

Read more: Don't Put the Cart Before the Horse

The Family / Personal Circle

We call this circle the Emotional Capital as the key principle here is to support the individual family members and help them achieve their goals and objectives. Understandably, these goals include the ability for family members to have a level of financial independence so they can meet their respective financial responsibilities.

Families need to be clear that it is not the responsibility of the business to meet their personal needs. In other words, family members should not expect to be compensated for their role in the business based on the fact that they happen to be members of the family. Rather, financial support within the family circle might take the form of a gift or a bequest, or a personal loan between individuals.

If Thom wants to support Derek financially, there are other ways to achieve that goal. Financial support for family members might take the form of a gift or a personal loan between individuals. It is in this circle that Thom should begin to address Cathy's concern about preferential treatment for Derek!

There are many factors to be considered in developing a structured Compensation Plan. If you would welcome help to develop policies that meet your needs, contact us at 1.800.598.6400.

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