Many family business owners believe their privately-owned company cannot act as a public company because of too many restrictions, things like special accounting and valuation rules, family trusts, dividends to owners, restricted stock agreements, and confidentiality of information.
These issues are real but certainly not roadblocks when it comes to total compensation plans. Rather, it should be noted that a family-owned, private business can do just about anything a public company can. When it comes to compensation, effective plans usually include:
BASE SALARY
Base salary is the foundation of all compensation plans. A competitive salary goes a long way toward satisfying the basic needs of employees. Such a plan, supported by defined policies and performance programs, can motivate employees to exceptional performance.
ANNUAL CASH INCENTIVE PROGRAMS
A cash incentive plan, common to many public companies, applies equally to family-owned businesses. In fact, incentives can be designed in many different formats which measure performance against minimum, target, and stretch goals. Most incentive programs are annually based, but some are frequently extended to longer term targets of two to five years.
The question may arise in a family-owned business about sharing confidential financial information.This potential problem can be solved by developing performance ratios, not actual dollars, as indicators of performance. Most cash plans are limited to key management and sales professionals. Most are pay-for-performance and are only paid-out when the established criteria are achieved.
CAPITAL ACCUMULATION PLANS
Compensation issues become more complex with long-term, stock-based capital accumulation plans.
For stock-based programs, first ask if the family is willing to part with any of its stock? If yes, in what way? Should the stock be given away? With what restrictions should it be given? Should participants buy into the company, and does the family wish to buy back any stock distributed?
Giving or selling actual stock is a management decision the family must answer. If the answer is “no,” there are three alternatives that do not require actual stock:
1. Performance Units: Promises of cash award contingent on achieving long term goals.
- Restricted Stock Units: Grants of stock units contingent on continued employment or performance measure.
- Phantom Stocks: Awards of hypothetical shares equivalent in value to stock price or another agreed upon formula value.
These alternatives mirror stock performance but do not involve actual stock exchanges. Add long term cash, and you have a fairly broad and flexible menu.
Now, if the answer is “yes” to broader stock distribution, a new array of stock alternatives open up for the family business. The alternatives are essentially the same as for public companies.
2. Non-Qualified Stock Options (NQSO): Options to buy stock over a number of years have wide flexibility in both design and features.
3. Incentive Stock Options (ISO): Options with specific, mandated restrictions as to term, dollar value, exercise price and non-transferability. Under an ISO arrangement, the participant recognizes no income until the stock is sold. When the stock is sold,
What form of stock option to apply is largely a function of the Company’s tax appetite. NQSOs can create a tax deduction; ISOs do not. Neither alternative generates a charge to earnings under most (but not all) circumstances. Other alternatives are these:
Restricted Stock Grants (RSG): Grant of stock contingent upon continued employment or performance measure.
Unrestricted Stock Grants (USG): Outright grant of stock without restrictions.
Performance Shares: Promise of stock shares if performance goals are achieved over time.
RSGs and performance share plans create some “holding” power over the participating employee. In addition to phantom and equivalent unit plans, stock plans provide a very broad “umbrella” program.
As a word of caution, check with your attorney and CPA before embarking on any sophisticated compensation plan, particularly if repurchase of shares is involved.
IPO on the Horizon?
Be careful if an Initial Public Offering (IPO) is nearby. In some circumstances an IPO may create unwanted (and unnecessary) negative financial impact on the organization.
Valuing the Stock
Finally, relative to stock plans, is the question of determining the stock’s value. Generally, public companies know the value of their stock, while family-owned companies must seek alternative methods. There are five common methods to arrive at a fair value. They are:
- Appraisal Value: An independent professional with certified appraisal credentials can determine a fair value. This is the most common method in a closely held business and one that usually has fewer “down-the-road” problems.
- Book Value: Book value is determined by calculating total assets minus liabilities.
- Multiple of Earnings: An earnings multiple compared to a selected peer group of companies.
- Last Sale of Securities: The value per share of the latest trade (for companies who allowed outside investors to purchase company stock) is used as a basis for the share price.
- “Good Faith”: Some family-owned organizations use “Good Faith” as the basis, perhaps combining two or three of the above methods into one consensus price per share. “Good Faith” values are usually determined by the Board of Directors.
Determining the most appropriate means of measuring value is one of professional judgement. There are no stringent legal or philosophical reasons why a family-owned business cannot provide a broad-based total compensation package designed to recruit, motivate, and retain key talent.
This article was written by Howard Lund with Jim Hutcheson. Howard Lund is a compensation specialist in the Dallas, Texas office of the AAC Group.
