Setting Executive Compensation at Private Family Businesses

Formulating compensation plans for private family companies can be challenging, especially when family members are in the C-suite and on the board. This article outlines a framework of key principles for thinking through the issues, best practices, and available survey data to enable family company boards to make the best decisions possible.

Governance

Early establishment of a governing body (compensation committee or board) and charter with clear definitions of authority and process (an agenda, a calendar, etc.) can keep discussions and pay decisions on a timely cadence. Obtaining agreement on the process and rules of engagement are particularly important when private family company boards and the C-suite are composed of a mix of family members and external hires. There may be different levels of understanding across the leadership team and board, so leaving sufficient time for process and decision-making ensures that everyone has the shared understanding to make and agree on pay decisions. This mitigates rehashing discussions and possibly back-tracking on decisions.

Pay Philosophy 

The private family company’s governing body establishes the pay philosophy for the executives and employees. Pay philosophy includes statements about the pay positioning (such as if it is in the 50th percentile or 75th percentile), market benchmarks (such as those related to industry and size range), and pay mix between fixed and variable components.

The pay philosophy at private family companies differs from the philosophy at publicly traded and other privately held companies in several ways:

• Pay positioning and mix. In our experience, private family companies tend to set cash pay positioning (salary and bonus) above the market 50th percentile. Emphasis on cash pay compensates for lower or no long-term incentives given the illiquidity of shares in private family companies and the family’s desire to retain ownership control.

• Treatment of family member executives. The governing body will need to determine whether compensation for family member executives should be the same as or different from that of externally hired executives. The main reason for having similar treatment is that this approach is easy to explain and rationalize and seems fair to all parties. Reasons for having differentiated treatment, whether higher or lower, include the following:

  • Offering a premium for having a family member executive keep an “eye” on the business for the benefit of all family shareholders with that executive having the additional responsibility of communicating with the family shareholders.

  • Applying a discount as the family member executive may receive distributions from their ownership in the company or other benefits from being an executive that are not shared by other family members.

• The family "halo" effect. As an independent director, understanding the context of how past pay decisions were made by the family system will be important as the company formulates its go-forward pay philosophy. As an example, if a business was founded and historically run by a paternalistic or maternalistic figure, pay philosophy and programs may be on the more generous or forgiving side, which may run contrary to what the business needs on a forward-looking basis.

All privately held companies, including family-owned businesses, should annually benchmark executive compensation to ensure competitiveness just like their publicly traded counterparts. While determining a peer group of companies that is comparable can be challenging, published compensation surveys are available that cover specific industries and privately held company pay practices, including Incentive Pay Practices: Privately Held Companies, published by Compensation Advisory Partners and WorldatWork.

Incentive Plan Participation

Whether family member executives participate in annual or long-term incentives depends on several factors, including the pay philosophy regarding family members, the affordability of the plan program (overall sharing ratio), and whether it is important for the entire executive team, including family member executives and externally hired executives, to be aligned on the same metrics, goals, and payout timing. According to Family Business Executive Compensation Report, a survey conducted by Compensation Advisory Partners and MLR Media, family and non-family executives often participate in the same short-term and long-term incentive programs.

Communication

As is often the case in family situations, communication is key. Family shareholders, whether on the board or not, want transparency around how the compensation plans work, the projected incentive award values, payout dates, and the resulting impact on sharing ratios between management and shareholders of the company’s earnings and value. This information allows shareholders to understand how the compensation plans are aligned with their objectives.

Utilizing a framework of key principles (governance, pay philosophy, incentive plan design, and communication) will enable both family member and independent directors of private family companies to develop an appropriate compensation plan that aligns the interests of executives and shareholders.

Bertha Masuda is a partner at Compensation Advisory Partners.

Bertha Masuda is a partner at Compensation Advisory Partners.