A recent article published by Harvard Business Review outlines the importance of distinguishing between merit compensation and inheritance.1 In most family businesses, the second generation inherit positions and compensation, which is usually a formula for disaster. In many cases, they are not qualified for the positions that they are given in the business. This often leads to morale issues for non-family member employees and could play a significant factor in the underperformance of the business. Balancing the so-called “merit” or “inherit” factors is difficult but necessary for the survival of the business for future generations.
How the next generation are treated is challenging because it impacts non-family members and/or potential buyers, as well as the culture within the company. It is critical to avoid providing special treatment to family business members. The author calls giving the next generation special treatment as the “inherit” model vs. holding the next generation accountable and requiring them to earn their rights in the company as the “merit” model, and concludes that balancing both models is the key to a successful generational transfer of the business.
Preventing a sense of entitlement fosters a healthy environment within the business; however, constructing a win-lose scenario may create a divisive atmosphere that must be avoided at all costs. Forcing family members to work for the company is no better than handing over the keys to the kingdom.
The popular HBO show “Succession” is a profound illustration of these perils. The fictional series is based on the drama between Rupert Murdoch and his children as they fight for control of the global media and entertainment conglomerate amid uncertainty about the show’s family patriarch/company founder’s health. The children’s sense of entitlement is a key theme and cause for the company’s disfunction and (fictional) demise.
Family members must understand that they earn compensation and a company position, while they may also inherit ownership at some point during their lifetime. To avoid a damaging sibling rivalry and at the same time treat each sibling fairly, compensation should be driven by merit and reflect the market value of the role being played in the company. For example, the CFO should be paid more than the someone who works in production. Dividends should be also based on the inherit model, which clearly differentiates this profit-sharing mechanism from compensation.
In this article, the author provides an example to illustrate the difference between decisions made by management vs. those relating to ownership. In one family business, two siblings became owners by virtue of a gift from the father who was the founder of the company. The siblings made all operational and strategic decisions, and the employees respected their decisions because both siblings were fully invested in the business. The next generation in both families involved seven children, three of whom worked in the business and four who did not and had no intention of becoming involved. Who should be making company decisions when all of the children were owners and the four that were not involved owned a majority of the shares in the business? The solution to this dilemma was to distinguish the decisions needed to be made by merit vs. inherit. In this case, the siblings created a list of all decisions and developed categories for ones that should be made by management; ones that should be made by ownership and ones that should be made by ownership based upon management’s recommendations. This approach exemplifies finding the right balance between merit and inherit.
In conclusion, striking a balance between the merit and inherit models, differentiating between compensation and dividends, as well as management versus ownership decisions, and preventing a sense of entitlement are keys to a successful transition of a family business to future generations. If you have questions pertaining to a family-owned business, please contact PLDO Managing Principal Gary R. Pannone at 401-824-5100 or email gpannone@pldolaw.com.
1. Merit or Inherit: How to Approach Succession in a Family Business; Author: Josh Barron; Harvard Business Review; Sept. 2022.
