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Why is my brother paid so much?

It’s time to tackle a common problem in family companies: the compensation of the family CEO. The story that is relayed usually goes something like this.

“My brother is overpaid. Yes, I know he’s the CEO and he works hard.  But he’s not efficient with his time, he doesn’t tell me what he’s doing to strengthen the business, and when I make suggestions for how to improve things, he doesn’t listen to me.  We’re paying him a high base salary. No one knows what he takes in the way of a bonus.  He says we can’t afford to make big distributions because we need to reinvest in the company.  How do we know that?  He doesn’t update us about what he’s doing.  So tell me, what am I getting for my money?  And why is he the center of attention anyway?  What about me?  It’s not my fault I don’t work in the business.”

Often it’s hard to say whose situation is more challenging – the family member who is both an owner of a family business and works as head of the business, or the family member who is an owner but doesn’t work in the business.  There is no one recipe for successful relations between family owner and family CEO.  In addition, the common ways of addressing factors for the CEO’s success – compensation package components, bonus criteria, comparable job benchmarks, a family employment policy – are not the root issue.  They are the results of how a family addresses the situation, but they are not the first items a family should consider.  There are other, prior, more fundamental considerations.

What does the law say?

The first consideration is one of people: who is in the family that owns the business?  Next arises a consideration that is simple, subtle, and sometimes controversial.  The harsh truth is that as far as the law is concerned, the owners of a family company, whoever they are, do not manage the company.  In a corporation, the shareholders are not the board of directors.  In an LLC, the members are not necessarily the managers.  Rather, in a corporation, the shareholders elect the directors, who in turn appoint the officers.  And in an LLC, the members decide who the managers will be.  Ownership is one thing; management is another. 

Often family members do not understand this distinction.  For example, the shareholder daughter who is neither a director nor an officer (and never wanted to be) complains about not receiving enough information from her CEO brother.  Or the sons who want to be bought out immediately upon the death of their father blame their sister for having charged the LLC for services that needed to be performed to make the buyout happen.  Or the child who lives in California, does not inform herself about the business, and does not have an aptitude for finance is constantly suspicious of her CEO brother, even (or maybe especially) when the quarterly distribution check arrives.

Of course, the legal structure of a business does not necessarily reflect how the family actually runs the business.  For example, in a family company often the board of directors is just a formality. The owners collapse management of the company into ownership, and they treat the board as a curious structure the lawyers created.  The board occupies a tab in the corporate record book, but the board does not do much.  It may even atrophy due to disuse.  It does little to establish or implement a compensation plan for the CEO.  It does not function as a vehicle for addressing owner questions about the CEO’s pay. 

What about the natural governance?

When outsiders peer into such companies – so as to sort out problems involving CEO compensation – frequently they advise the family to formalize or professionalize the board.  They recommend using outside directors.  But this way of thinking, though popular, presumes a type of decision-making that may not match how the family actually makes decisions.  One must ask a prior, more fundamental question: what is the natural way that this family makes decisions together?  If the family does not by nature make decisions through the board of directors, amping up the board will not, by itself, improve the process or quality of deciding the CEO’s compensation.  Boards of directors exemplify an important point: a family’s non-use of certain types of formal decision-making structures does not mean the family is not making decisions.  Every family has a natural way of deciding.  Perhaps the family simply does not use the board of directors to make decisions.  The challenge is to identify the specific family’s natural way of proceeding and determine whether it contributes to effective decisions.     

In analyzing a family company’s natural governance, one must not minimize the fact that the owners own the company.  Shareholders own a corporation.  Members own an LLC.  Partners own a partnership.  Ultimately the ownership interests in the company reflect the owners’ money.  The CEO and the other officers work for the owners. 

This means that to address issues such as the CEO’s compensation, the company needs to have a fitting forum for the owners to discuss what happens to their money.  This does not mean all the owners get to vote on how much the CEO is paid.  Rather, it means there needs to a forum for the owners, as owners, to discuss concerns that affect them – and it means the board or management, as management, must have a forum to discuss board-level concerns such as the CEO’s pay.  The type of forum depends partly on how big the family is.  Once a company is large enough that not every owner is an employee, there probably need to be separate forums that are conducive to the respective concerns of owners and management – with each being treated on its own terms.  And very large family (dozens of owners) may need a separate family assembly in addition to the board of director or managers. 

Only when effective forums are put together can a family company address the issue of the CEO’s compensation effectively – on the merits, without undue back-seat driving, and with attention to the distinctions between owner and management.

Your brother as fund manager

Two problems commonly arise when thinking about how the CEO should be paid.  One, noted above, is the difficulty people have in differentiating between being an owner and being part of management.  Another is the difficulty of differentiating between the nature and value of the work being performed and the identity of the person performing it.  A helpful way to conceive of this latter problem is to think of your CEO brother as an asset manager.  Like other investors, you have a portfolio of assets.  You own cash.  You own stock in publicly-traded companies.  You probably own some bonds.  You own real estate.  In addition to these assets, you happen to own stock in a private business that your family owns.  Functionally, the CEO of the family business is no different than the manager of a stock or bond fund.  It is in your best interest for him to succeed.  If he succeeds, the value of your asset increases.  Just as there are criteria for judging and paying for performance of a bond fund manager, so too it is possible to establish criteria for judging and paying for performance of the family business’s CEO.  But the fact that the CEO is a family member does not remove your family business stock from your overall portfolio.  The stock is within your portfolio, just as your other assets are. 

To be clear, the fund manager analogy is subject to an important limit.  Families almost always own their own enterprises for more than a financial rate of return.  Whether the family puts a premium on maximizing the financial rate of return is itself an issue that affects how they make decisions together.  Financial returns are not the only ones.  For example, family members may own a company because they are entrepreneurial and prefer working for themselves, or to provide employment opportunities for the family, or for civic reasons.  What kind of enterprise-owning family the members want to be is itself a crucial question.  For now, the point is simply that an ownership interest in a family company is part of each family member’s overall portfolio of assets.

What about communication?         

Between the legal structure and the natural governance of the company lies the troublesome human factor – communication.  Often, a family owner’s uncertainty about whether the family CEO is “succeeding,” as that owner (and note, not the CEO) defines the term, results from ineffective communication between management and the owners.  All sorts of reasons contribute to this.  Some people simply aren’t skilled at communicating.  The family CEO may fear subjecting his compensation to “government by committee” or being punished for poor financial results that bureaucracy can create.  Sometimes non-management family owners do not understand that owners do not run the company day-to-day.  Regardless, communication problems cannot be divorced from both the legal structure the business inhabits and the family’s natural way of making decisions.  In a family company, communication is part of the enterprise’s governance, not simply a phenomenon.  Addressing how the family members communicate must account for what the family members are communicating about – the making of decisions that affect all of them in the asset they own together. 

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In this way, the issue of CEO compensation illustrates the fundamental factors of decision-making in a family enterprise.  One must take account of the applicable law and the existing legal structures.  Yet one must see whether the current structures fit how the family actually makes decisions.  One does this by taking account of the family’s natural governance – especially by identifying who is in the family and taking account of how the family members communicate.  There must also be an honest recognition of where the family company fits within each owner’s portfolio of assets.  Once these more fundamental factors are accounted for, the family is ready to tackle the concrete subjects typically associated with CEO pay – compensation package components, performance benchmarking, incentivizing value creation, and the like.  To understand why your brother is paid so much, you must begin at the beginning.