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Pros and Cons of Compensation Philosophies

By Norbert Schwarz

In developing policy concerning compensation for family members, the first step is to adopt a compensation philosophy, the principles that guide compensation decisions. Generally speaking, there are four basic compensation philosophies: market pay, equal pay, flexible pay or tailored pay. Each approach has its pros and cons.

Market Pay

With a philosophy of market pay, compensation is determined by breaking down jobs into various elements that are graded in terms of value. Compensation is generally based on the difficulty of the job as well as the background and experience necessary to function in the position. Positions normally are assigned a salary range with low, midpoint and high indicated levels. The assumption is that an individual may begin at the low point and progress to the high point if he or she is performing well in the position. Compensation is based on what similar companies are paying for similar positions, comparing geographical area, industry and company size. Thus, pay is determined by merit within a market. In addition to base salary, some studies also give information on performance-based compensation such as bonuses and stock options.

The market pay compensation philosophy tends to eliminate subjective judgment from the process. Compensation decisions can be more easily accepted because they are based on nonemotional, rational criteria. What can be a very personal issue is thus depersonalized.

What market pay does not, however, take into account is unique individual contributions to an overall effort, longevity or a company's capacity to pay competitive wages. Nor are other perks and benefits taken into account, although some studies do include information on benefits normally available. In a family business, this approach does not accommodate the concept of equality for family members, nor does it take individual needs into account. Finally, it would not take into account a family owner's desire to pay less or more than market standards.

Equal Pay

Some family businesses believe in equal pay for all. All jobs held by family owners get the same amount of pay, regardless of position or complexity (sometimes pay is adjusted for longevity). Those who adopt this philosophy generally place equality at the top of their priorities. Their belief is that the business exists for the benefit of the family and every family member should benefit equally. In multifamily companies, this philosophy may also tend to minimize conflict between families due to perceptions of compensation favoritism. This philosophy tends to work best when family members have very similar responsibilities and contribute equally to the success of the overall business.

The downside of this philosophy comes when positions do not carry equal responsibilities or impact on the overall success of the business. Even in cases where jobs are similar, individuals often believe their own jobs to be more important and therefore worth more. Generally, this philosophy tends to favor those in lesser positions and may demotivate those aspiring to greater responsibilities and rewards. While this method might seem feasible for a second generation of two or three siblings and two parents, as the family grows and generations pass, few companies can financially support equal pay for a growing base of cousins. Equal pay may also tend to encourage entitlement. Moreover, the distinction between rewards for ownership and those for performance can be distorted.

Flexible Pay

This philosophy relates to compensation determined by a board or individual based on a variety of factors. Some companies that use this method maintain that it provides greater flexibility and allows subjective factors as well as objective methods to be used in determining compensation. This method will frequently combine market study information with individual company cultural measures to arrive at compensation. It also allows for the family to make allowances for differing needs within its ranks. Many family business owners tend to favor this method because of the flexibility and authority it offers the senior manager or board.

In cases where the decision-making authority rests with an individual, such as with a parent, perceived favoritism can cause conflict with the parent as well as within the family. The parent is placed at the center of this sensitive issue, with a very real prospect of being the source of family disharmony. In many cases, final decisions are arrived at through individual negotiation, which increases perception of lack of fairness. Likewise, because the family system is based in part on equality and in part on emotionally based decision making, justification of individual compensation becomes difficult.

Tailored Pay

In some cases, we have seen companies that have combined various factors in determining compensation. To accommodate the desire to support all family members of the coming generation, a base dividend or related compensation is set at a level that enhances the standard of living and can be distributed consistently year to year. The amount is generally kept low enough to avoid the development of a sense of entitlement. Those employed in the business receive salaries the range of which is determined by market conditions. They also receive performance compensation based on achieving personal goals as well as on the overall performance of the company. Inactive family members also may have an opportunity to participate in exceptional company performance through extra dividends or distributions.

Summary

Before any philosophy is adopted, the board and senior managers should understand shareholder expectations and guidelines for compensation. If unrealistic or potentially detrimental guidelines exist, the board should negotiate an acceptable solution with shareholders. None of the foregoing philosophies is guaranteed to eliminate dissent within the ranks of the family. One can only strive to minimize conflict arising from compensation. Perhaps the most potent tool for minimizing conflict is to clarify family values and family philosophy toward the business and to educate the family on the concept of compensation. Management and the board should also understand the realistic expectations of shareholders for dividends and the prospect for an acceptable increase in value for their investment. Managing expectations and limiting attitudes of entitlement can be the most effective tools in motivating management and rewarding shareholders for their patient provision of capital.

 

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