By David Harland CPA
The end of the financial year is upon us, making it a great opportunity to discuss sensitive issues like compensation and profit sharing policies.
If a family firm doesn’t have formal policies around compensation, it can lead to family conflicts about ownership, profit sharing, and reinvestment in the business. With many owners looking toward retirement, those family businesses will also find themselves confronting liquidity issues and strategic decisions about firm direction.
Conversation around compensation should seek to answer several questions:
- How are employees compensated for their work?
- Are family members who don’t work in the business entitled to profits?
- How are firm profits divided?
- What investment is necessary to fund future growth?
- What will the firm’s capital requirements be in the years to come?
- What liquidity issues must be considered?
Start with clear lines of communication
A little structured conversation can go a long way toward opening communication around sensitive issues. If family members aren’t accustomed to speaking openly about business or compensation, it’s important to start the process with relatively low-stakes issues. Some firms use formal governance structures like a Family Council or Board to handle these discussions while others cover them through mediation or family retreats.
Consider the family’s needs
If a business is still in its first generation, the compensation structures may be simple since owners will likely work within the business; however, it’s wise to separate business and family finances as much as possible to protect against lawsuits and diversify family wealth.
If a business is in its second or third generation, multiple kinds of stakeholders may exist and compensation structures become more complicated. Conflicts often arise if compensation structures don’t distinguish between ownership and labour. We strongly recommend that multigenerational businesses formally institute ownership structures and professionalise employment standards within the business so that workers are fairly compensated and profits can flow through shared ownership agreements.
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Many multigenerational businesses have family members who are close to the business, working within the firm, or serving on the Board. Natural conflicts can arise between these business “insiders” and family members who don’t have a close relationship with the firm. Often, insiders are willing to take less money out of the business to fund future growth – foregoing personal compensation – while outsiders are more interested in getting the most short-term value out of their ownership stake.
These conversations frequently revolve around competing visions of the firm; some family members may view the firm purely from a profits standpoint while others care about the family legacy. If competing visions and priorities are not discussed and resolved, conflicts that pit insiders against outsiders can arise.
Consider the firm’s capital needs
Family businesses tend to pay lower dividends and reinvest more profits back into the business to fuel future growth. Family business experts speak about “patient capital”: the equity provided by business owners who are willing to balance the current return on their investment against the future long-term value of the firm and the continuation of the family’s business tradition. In a family business context, patient capital encompasses all the foregone income, profits and sweat equity poured into a business by generations of a family and represents more than just financial capital.
From a business context, patient capital has a high tolerance for risk and long-time horizons and allows family businesses to weather capital crunches and financial issues by sacrificing short-term returns. When discussing profit sharing and family compensation, it’s critical to ensure that every stakeholder is on the same page regarding the funding mechanisms of future growth and the long-term strategy of the firm.
Consider how to handle business exits
For many business owners and their dependents, income and equity in the family business is their primary source of wealth. When proper diversification strategies aren’t followed, crises can occur when a business owner (or owners) want to exit the business. Thinking about future liquidity events – such as when a family member might want to sell part of their ownership stake – is critical to the long-term financial success of the firm.
Good compensation policies are flexible enough to adapt to the ups and downs of business cycles while still respecting the needs of insider and outsider shareholders. While there’s no easy way to ensure that every stakeholder is satisfied forever, making ad-hoc decisions year-to-year suits neither the needs of the business or its owners. We strongly recommend allowing different stakeholders to present their views of compensation and future growth strategies to help overcome family division and foster family unity.
David Harland CPA is managing director of FINH, an organisation that specialises in the provision of advice to family groups in business across the Asia-Pacific region.
The opinions expressed in this article are those of the author.
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