Compensation ranks second only to succession as one of the thorny issues facing family businesses. Understanding the changes family businesses go through as they pass from the first to second and subsequent generations of family ownership is one way of anticipating potentially contentious questions about pay. Each of the three stages in family-business evolution — the founding or entrepreneurial stage, the sibling ownership stage, and the “cousin” or “family dynasty” stage — raises new issues of family participation, teambuilding and shareholder unity. Similarly, each of these new stages tends to create certain predictable questions about pay.

Here is a summary of some of the pay issues most common to businesses in each stage.

The Entrepreneurial Stage

Compensation can seem simple when the business is run by the founder or by one offspring of the founder, and the next generation is only beginning to enter the business. At this stage, parents set the culture and the tone of any discussions about compensation. Attitudes toward saving on taxes, family gifting, phantom jobs and other pay practices are conveyed and absorbed uncritically by offspring. With one or two people in unquestioned control, few conflicts erupt.

One issue that may arise is whether parents have sufficient savings to ensure their security in retirement. If parents lack an adequate retirement cushion, that needs to be communicated to the next generation and resolved. Estate planning can raise the same issues.

If parents are financially secure independent of the business, they also need to let the next generation know that. The way the message is conveyed, however, can either enhance or distort children’s understanding of compensation. If children are allowed to believe that the business owner’s salary was the sole source of the wealth accumulated over the years, they may form unrealistic expectations about their own income potential in the business. On the other hand, the business owner can use the opportunity to inform children about the difference between compensation and dividends or other sources of wealth.

The Sibling or Second-Generation Stage

A large number of second-generation family businesses today are owned and managed by a team of siblings. Some embrace a “partnership vision” whereby two to four siblings co-own and co-lead the business with very few, if any, inactive family shareholders or non family shareholders. Some prefer to choose a new leader from among several siblings.

Complaints about compensation often arise at this stage, but that does not necessarily mean that the underlying resentments or inequities did not exist before. It may mean only that the presence of older family members was such a powerful influence that younger members did not focus on, or feel free to express, their questions or concerns.

Several issues are common. Do the children view the family business as a money tree rather than a proving ground? How does the family deal with differences in lifestyle? Are children prepared for the fact that multiple siblings will lead the business in the future, and for the questions about compensation that raises? If a son enters the business as expected and is awarded an artificially high and ever-increasing rate of pay, what happens 15 years later when another son opts for a family-business career and begins wondering why he can’t earn the same exalted salary? What perks are fair and how will they be allotted? How will information about compensation be communicated among family members?

Ideally, the parent generation has already shaped the pay expectations of second-generation leaders as they enter the business. In one family business, the principle that siblings would be paid differently based on the nature of their jobs and their backgrounds, among other things, was accepted. Yet all were aware that the policy posed risks to the team’s relationships. When the three sisters in the business began speculating about pay behind each other’s backs, they were offered a chance to meet to discuss their questions, with the help of the outside board’s compensation committee. The sisters’ right to privacy was respected; the meeting was presented as a voluntary team-building effort, and no one was pressured to participate. All three chose to take part, and the result was a candid, relaxed exchange.

One by one, the sisters discussed their pay, the reasons for it and any frustrations with it. The youngest was making more than the middle sister because she was paid at the median for her graduating class at an outstanding journalism school. But her bonus potential in her current job is limited, she told her sisters.

The older sister admitted some discomfort over her lower pay, but supported the principles behind it. Her job offered more bonus potential, and she told siblings of her plans to increase her base pay by expanding her job responsibilities.

The middle sister said she was happy with the broad management, line and strategic responsibility afforded by her job. Though her bonus was up to 25 percent of her pay, she said she would like even greater incentive opportunities.

After each had spoken, all discussed with directors some key characteristics of jobs that justify higher pay levels. They also talked about threats to their team relationship. Though odds were against harmony, all the sisters said they were committed to making it work. “If we fail, I would feel I had failed,” one sister said.

The discussion defused suspicions and heightened the sisters’ commitment to teamwork. It also underscored to each how important their relationship was to each of them and laid the groundwork for honest, open and mutually respectful communications in the future.

The Third-Generation or “Cousin” Stage

Toward the end of the sibling stage or at the third generation of family-business ownership, a new era begins. At this point, the business usually no longer employs all shareholders. The family business begins to resemble a public company. It becomes increasingly important for the managers of the business to be fair to all family members.

The advent of owners who lack day-to-day contact with the business can raise issues that transform the compensation system — or sometimes, wreak havoc with it. Family shareholders may begin to suspect that their siblings or cousins in the business are overpaid, at the expense of their dividends or shareholder value. They may begin speculating or trying to conduct their own independent pay assessment.

Family members not in leadership roles rarely appreciate the unique emotional burdens of leadership. They usually underestimate top managers’ sense of stewardship for their interests. They also don’t realize the degree to which top executives “live the job” mentally and socially, reflecting on business problems and attending business-related gatherings during their “time off.” The person who understands these unspoken pressures best is the top executive’s spouse. And he or she is likely to resent any indignation that may arise among siblings about executive pay. Therein lie the seeds of conflict that can eventually pull apart a family business — and a family.

These pressures often lead second- or third-generation family businesses to move toward a rational, open and professional compensation plan similar to those embraced by publicly held companies. At this stage, an external source of information and advice, such as a compensation consultant, an active outside board or both, is often necessary to win the trust of active and inactive shareholders alike.

Other questions arise at this stage about how to reward both owners and employees fairly. As growth in the family dilutes individuals’ equity stakes, managers may need additional incentives, beyond their existing ownership of shares, to build shareholder value. This may lead to a long-term incentive plan tied to measures based upon increases in shareholder value.

From Family Business Compensation by Craig E. Aronoff and John L. Ward. Copyright, 1993, Family Enterprise Publishers.