1. Designing the Pay Program

Sustaining the business and fostering profitable growth over time are key objectives for family businesses. Such businesses may also focus on values, culture, and causes as part of their strategies. As a board member for a family-owned company, the director should consider the financial needs and desires of the family along with the well-being of the company.

“Long term” means something different to family businesses. While publicly traded companies and transaction-focused private companies define the long term as three to five years or the time required for a value-realizing event, family businesses often think in terms of decades and generations.

Business structure can play a role in private company executive compensation programs. Some family businesses are structured as S corporations. S corporations are flow-through entities, so profits are distributed to shareholders annually and are taxed at the individual level. Shareholders in S corporations who are also executives may have different pay structures from other executives to account for annual profit distributions. In addition, business structure can impact long-term incentive vehicle selection and other executive pay programs, such as non-qualified deferred compensation.

a. Typical Pay Program

A typical pay program for a family business or ongoing private company focuses on cash pay elements.

Aspect	Market Practice
Base Salary	Emphasized Typically positioned at or above market median Typically one-third to one-half of total compensation
Annual Incentives	Emphasized and offered by nearly all companies One to three performance measures are common Financial measures, such as profitability, are most common, but individual performance is also considered; revenue/growth included for companies with a growth focus Maximum upside is 150% to 200% of target
Long-Term Incentives	Offered by half of companies Limited to executive team Cash-based vehicles favored, including multiyear cash plans and phantom stock (including full-value and stock appreciation rights) As a rule of thumb, annualized long-term incentive opportunities are equal to or slightly greater than the annual incentive opportunity Annualized long-term incentive opportunities are less than those offered by publicly traded companies

b. Benchmark Data

Benchmarking executive pay can be more challenging for family businesses given that peer compensation data is harder to assemble. Publicly traded companies are required to disclose compensation levels for top executives in annual proxy statements, so public companies almost always use peer data to benchmark top roles.

A starting point for the family business board or compensation committee in selecting benchmark data is to ensure that the company has a well-defined market for talent. The market for executive talent should encompass frequent recruitment sources or market competitors. The definition of the market for talent generally includes company size and industry. Other defining traits may include ownership, location, business economics, stage of development, and business situation (i.e., high growth, turnaround).

Large family businesses and those with numerous direct, publicly-traded peers may include public companies in their markets for talent and be able to use public company data in their benchmarking studies. However, family businesses should use public company data with caution and care, as long-term incentive practices are different for publicly traded stock. Family businesses with similarly sized public company peers can use some elements of the data reported in public company proxy statements:

Useful Proxy Elements

Proxy Elements to Use with Caution or Avoid

Short-term and long-term incentive design elements, including performance metrics, goal-setting approaches and ranges, vesting period and leverage (i.e., threshold and upside) Other executive compensation elements, such as deferred compensation, perquisites, employment contract provisions, etc.

Compensation levels: Top executives at a public company earn higher compensation relative to private peers because of the regulatory burden and public scrutiny. This is particularly true of the CEO and CFO roles Long-term incentive values: These are typically two or more times higher at public companies because of the liquid stock market. Private companies can consider discounting public company long-term incentives, but the discount rate requires analysis Stock ownership guidelines are useless for privately held companies

While some elements of public company executive compensation disclosure can be helpful, family businesses will likely need to use published compensation surveys as a supplement or as a primary source to inform compensation decisions. Having a defined market for talent will drive survey selection. Survey sources should be carefully reviewed to ensure the availability of appropriate data cuts based on industry and size. Family businesses need to carefully assess long-term incentive data reported in surveys to understand whether the data is skewed by public company participants.

c. Pay Positioning

Given public companies’ disclosure requirements and shareholder scrutiny, most publicly traded companies target the market median, with above- and below-median payouts based on company performance outcomes. In contrast, family business pay positioning is more likely to deviate from market median.

Our research into family business pay practices shows that these companies are more likely to target cash pay between median and 75th percentile or at 75th percentile and above. Some family businesses do not provide long-term incentives to executives, so they fill the gap with above-market cash pay.

d. Long-Term Incentives

Long-term incentives can be a challenging compensation element for family businesses because they lack stock traded on public exchanges. Unlike public companies, where incentive compensation is emphasized and long-term incentives are often the largest component of executive pay, family businesses tend to emphasize base salary and annual incentives. Based on CAP’s ongoing research into private company incentive pay practices, approximately 60 percent of privately held companies, including family businesses, offer long-term incentives to key executives. The prevalence of long-term incentives is higher among large family businesses.

Family businesses offer long-term incentives for several reasons: To retain executives, to align executives’ incentives with the owners’ long-term goals, and to compete for talent in the market. During recent tight labor markets, competing for talent increased in importance as a long-term incentive goal for private companies.

When designing a long-term incentive program for a family business, the first step is to understand owners’ willingness to share real equity with executives. Most family businesses stay away from granting real equity because of the desire to avoid minority shareholders and the associated complexity. The next step in long-term incentive design is to understand the owners’ willingness to share value in the form of an economic interest or real equity with executives. For family businesses that offer long-term incentives, typical sharing percentages range from 5% to 10%. However, the sharing percentage may be above or below that range depending on factors including the business situation, company economics, market for talent, and long-term incentive vehicle selected.

Long-term incentive vehicle selection varies based on many factors, including corporate structure, company strategy and business situation, and owner preferences. The following chart provides an overview of long-term incentive vehicle selection:

	Real Equity	Phantom Equity	Long-Term Cash
Common Vehicles	Restricted stock Performance shares Stock options Profit interests (for limited liability companies (LLCs) – typically pre-IPO and private-equity backed	Phantom stock Stock appreciation rights (SARs) – a phantom stock option	Long-term cash plan (multiyear bonus) Performance units (dollar-denominated units awarded based on performance)
Company Business Structure	C Corp S Corp (with limitations) LLCs (with limitations)	Any	Any
Key Requirements	Owners willing to share equity	Comfort with plan complexity Communications support	Solid financial budgeting and forecasting Transparency of key financials
Suitable for	Start-up/high growth Moving toward value-realizing event Private-equity ownership Succession planning	Family business Ongoing private company Business as usual	Family business Ongoing private company Business as usual Mature business Turnaround

Other

 Considerations

Family vs. Non-Family Executives

Another consideration for family businesses is how to compensate family members relative to non-family members. Some family businesses may undercompensate family executives because of past practice or because the executives are shareholders in the business and receive compensation through dividends or distributions. Family businesses that have undercompensated a family executive may be surprised by market compensation levels when they need to replace the executive with an external hire.

While underpaying family members does occur, CAP research with Family Business Magazine shows that the most common practice is to compensate both family and non-family executives based on the market value of their roles. In addition, most family businesses include family executives in annual incentive and long-term incentive programs. Businesses see value in having all executives participate in the same incentive plans and working toward the same goals. An exception is a family executive who is also a major shareholder; this executive may not participate in a long-term incentive plan because of sufficient alignment through ownership with long-term company goals.

Distributions and Dividends

Executives who are also shareholders may be eligible to receive distributions and/or dividends from the company. These distributions and/or dividends may be viewed by some companies as a portion of total compensation. CAP and Family Business Magazine have found that a majority of family businesses pay dividends, with typical amounts ranging from 10% to 15% of net income (Dividends will vary based on company performance and overall economic conditions.)

Shareholders at private companies can choose to pay themselves special distributions. Board and/or compensation committee members should be aware of such distributions and any impact they might have on compensation programs. For instance, a special distribution can impact company financials and potential incentive payouts for executives. In order to ensure that executives who are not shareholders are treated fairly, private companies should establish rules around distributions and other financial adjustments to incentive plan performance metrics.

Key Questions for Committee Members to Ask:

• What are the family’s long-term objectives for the business?
• What are the companies that we compete with for talent? Are public companies used for reference, and if so, are we comfortable with the rationale? How is public company data used?
• How is pay positioned relative to market?
• Does the company offer long-term incentives, and if not, should it?