Family Business Succession Planning: The Perils of Pay and Dividends

Final installment in the series…

Transfers of business interests to the next generation create all sorts of thorny issues, but one of the very thorniest is money. Picture four siblings, Sam, Jane, John and Jim Sanford, who inherited all the shares of their family business, Privco, upon their father’s sudden death last summer. Each now owns 25% of the company. Sam, the oldest, is President of the company, Jane works for the company part time in the accounting department, John teaches seventh grade at a local junior high school, and Jim, who joined the company five years ago when he graduated from business school, is head of marketing.

This past December, Sam proposed to PrivCo’s newly-constituted board (which includes his siblings and two outsiders) that he should receive a healthy bonus and raise, citing his successful leadership of Privco during the recession. (Sam has been somewhat disgruntled that his salary is less than half the pay his father received when he was president of the company.) Sam also proposed that Privco minimize dividends to conserve cash needed to fund capital investments. Christmas dinner was uncomfortable – John grumbled that their father had wanted them to share the company’s profits equally and must be rolling in his grave to see Sam take a big payout while giving his siblings so little. Jane and John fretted that they wouldn’t be able to pay their children’s private school tuition, and Jim’s fiancée mumbled that Jim deserved the top job more than Sam did.

To avoid uncomfortable gatherings like the Sanfords’ Christmas dinner, family members need to understand the difference between compensation and distributions. Furthermore, the methods by which both compensation and dividends are determined need to be sensible, systematic and well-documented. Otherwise, family members may well see themselves as victims of a rigged system.

Family business shareholders need to understand that compensation is paid to managers in payment for their work on behalf of the company, while distributions or dividends are paid to owners as a return on their capital investment. An owner-manager like Sam (or Jane or Jim) is entitled to receive two steams of income from the company: compensation for doing the job, dividends or distributions on his ownership interest. (The Sanford kids’ father, Pete, an owner-manager, never had to face the issue of determining an appropriate compensation model, and probably didn’t think much about it when he asked his lawyer to draft his estate plan, or when he discussed his succession plan with the board of directors - assuming he had a board, and assuming he even raised the issue of succession with them before his death. Pete was the sole owner and manager of the business, and whether he pulled money out of the company in the form of salary, bonus or dividend was largely a question for his tax advisors.)

For the second generation Sanfords, the issues of compensation and distributions are much more complicated, and uncomfortably intertwined. First, whatever is paid to management isn’t available for distribution to shareholders, creating a zero-sum game. Coming up with an appropriate compensation program for the president of the company is a tough job for any board of directors, but particularly tough in a family context, where a sole owner-manager like Pete has set the bar by which the next generation consciously or unconsciously measures its own compensation. Sam in turn is responsible for setting compensation for PrivCo employees. Using market survey data or bringing in a compensation consultant to determine an appropriate compensation package can help to ensure the process is fair and justifiable.

Coming up with an appropriate dividend policy is also challenging. Successor managers who want to invest for growth may seek to cut or eliminate dividends, arguing that reinvestment now will boost future returns. Successor shareholders who don’t understand the role of patient capital or agree with the capital reinvestment plans may pressure management to distribute all or most of the company’s free cash flow. Sibling shareholders often downplay the role of management in generating profits and argue that family managers use their roles as insiders to boost manager compensation at the expense of dividends. Building trust among family stakeholders can be achieved by increasing manager accountability, educating shareholders about the role of equity capital in the company’s growth and long-term profitability, and developing policies at the board level that seek to balance shareholders’ desire for distributions with management’s plans for growth. A thoughtful strategic planning process, accepted by management and shareholders alike and implemented with rigor and discipline, can increase transparency and accountability, minimizing tension and distrust.