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Family-Owned Businesses: Director Pay

Family-Owned Businesses: Director Pay

By: James F. Reda

There is much data on director pay for publicly traded companies, little data for private companies, and virtually no data for family-owned business that have a unique corporate governance structure. This article focuses on director pay for family-owned businesses and will provide a guideline on how to structure the oversight entity and pay members, accordingly. It will also provide information on usually difficult situations that may arise as a result of the unique nature of family owned businesses.

Family-owned businesses will benefit from board members that include not only family members but also wellinformed, seasoned, independent directors who may serve in an advisory capacity or as members of the more formal board of directors. The corporate governance structure will evolve in tandem with the company.

As with public companies and non-family-owned private companies, employees of a family-owned business will not receive any additional compensation for board service, whether they are a family member or not. But what about non-employee family directors (which we refer to as “NEFDs”)? These cases can be a little more complicated.

It is important to understand the corporate governance structure among family-owned businesses, which can vary by company size (and in some cases, by the number of family generations involved). Typically, there is an evolution of corporate governance to provide the board oversight necessary to maximize the value of the company. In general, there are three major governing bodies at a family-owned business, which are as follows (we collectively refer to this as the “Corporate Governance Structure”):

1. The Family Council (“FC”): This council is the “inner circle” that consists only of unpaid family members who are focused on the coexistence of the business and the family. These family members may be employees or NEFDs. Typically the FC meets on a regular basis to discuss challenges and business strategy. The company founder(s) or owner(s) will usually retain decision making authority over the FC. The FC is generally the first governing body formed and in some cases—particularly at smaller companies—is the only oversight.

2. The Advisory Board (“AB”): The next step that most family-owned businesses consider is an AB. Some companies adopt an AB that can fill in the gaps of knowledge and experience, and members may have certain technical expertise in key areas. The AB typically assists in facilitating communication between generations, monitoring the transition of ownership and succession planning, and objectively assessing family members’ abilities and strengths. The AB may include both outside, independent talent and family members. Sometimes, an AB will function as a bridge from an FC to a more formal board of directors. Unlike a board of directors, the AB is not generally subjected to fiduciary duties. Members of an AB are typically paid much less than independent directors that sit on a formal board.

3. The Board of Directors (“BOD”): The final step in constructing a strong Corporate Governance Structure is to create a BOD, which may replace the AB or coexist with the AB. This level of governance introduces independent, outside directors who have no other tie to the company or relation to the family. Generally, the BOD is a mix of these independent directors and some family members. Some companies rotate family members from the more contained family council and onto the BOD (and back).

The processes of the BOD are formalized and operations are similar to that of a public company board. Committees may be formed and there is a focus on objectivity. Board members are exposed to a variety of standards and risk including legislated liabilities, fiduciary and other duties. As detailed in this article, the independent directors that sit on the BOD of private, family owned companies typically receive cash compensation at the same level as the independent directors of publicly traded companies.

Smaller companies and companies that are just starting out will almost always have a FC in place, and will sometimes fill in knowledge gaps with an AB. As companies grow in size and complexity, they are more likely to adopt a BOD. This is particularly important for companies contemplating a strategic transaction, as a BOD provides comfort to potential investors who are used to a more formal Corporate Governance Structure.

Once a company reaches a certain size, it is almost guaranteed to have a BOD in place, and the AB may or may not remain intact. See Figure 1.

As noted above, some companies rotate FC members on and off of the FC and onto the BOD. Some larger companies will also rotate FC members onto an AB, if there is one in place. Similarly, company management (both family executives and non-family executives) commonly hold board seats.

Whether they sit on the BOD or AB, independent board members who serve as advisors are particularly important for the following reasons:

  • Outside knowledge: While any organization will benefit from the different and diverse perspectives that outsiders can offer, this is particularly true for family-owned entities run mostly by family members who may not have much experience outside the organization.
  • Succession planning: in a family-owned business, management is often hesitant to address the issue of succession planning due to complications surrounding the family dynamic. A board that consists of outside advisors can work around those concerns, helping ensure that a successor is selected based on merit and appropriate fit rather than nepotism.
  • Accountability: Having an outside board to report to on a regular basis ensures that family members are applying best business practices. In a 2016 research study (“Private Family-Owned Study”), Gallagher’s executive compensation consulting team set out to understand exactly how much both outside independent directors and NEFDs of family-owned companies are paid by conducting phone and electronic mail inquiries to a number of large family held business. The outreach was successful, with nineteen companies responding. These companies spanned various industries, including retail, food processing, consumer products and general manufacturing. The median revenue of these nineteen companies was $6.9 billion.

We found that outside directors of family-owned companies are paid similarly to directors of other private companies, with a focus on cash and little to no equity awards. Some key findings were as follows:

  • The median annual cash retainer was $75,000.
  • Median annual total compensation was $100,250.¹
  • Only 11 percent of companies used equity as part of their director compensation package.
  • 42 percent of companies paid a lead director premium.
  • 47 percent of companies paid their committee chairs a leadership premium.
  • 42 percent of companies paid board meeting fees with a range of $1,958 to $2,650 per meeting (25th and 75th percentiles).
  • 32 percent of companies pay committee meeting fees with a range of $1,531 to $2,294 per committee meeting (25th and 75th percentiles).

CASH COMPENSATION

In recent years, the bar has been raised with respect to private company governance, despite the fact that requirements (Sarbanes-Oxley, Dodd- Frank, etc.) imposed by various governing bodies (SEC, stock exchanges) apply only to public companies. In today’s business environment, the talent pool is becoming more homogeneous as executives and directors move freely between organizations that are small and large, and public and private. No longer able to afford the informal corporate governance practices of the past, private companies are under increasing pressure to implement or improve board oversight. These companies are embracing public company governance style, including formation of boards that include outside directors and standard committees.

This movement has also affected family businesses, particularly as shareholders of family-run companies have become less concentrated with each passing generation. Most private companies, including family-owned, pay cash compensation to directors at the same rate as public companies. Like non-familyowned private companies, cash levels among our study sample were similar to what we would expect to see among public companies.

In fact, our recent study of public company director pay among companies in the Russell 3000 (‘Russell 3000 Study”) found that public companies with revenues ranging from $3 to $9.9 billion had a median cash retainer of $75,000, the same median cash retainer level identified in our Private Family-Owned Study sample.

EQUITY COMPENSATION

The biggest difference in director pay at private versus public companies is equity. Private companies do not generally use equity as a key element of their compensation programs. This lack of equity awards, which make up over half of total compensation for public company directors, results in lower total compensation at private companies.

Consistent with expectations, the lack of equity awards (present at only 11 percent of our family-owned company sample) creates a large disparity in total compensation levels compared to the same group of Russell 3000 companies. Median total compensation among these public companies was $227,005 (consisting of 57 percent equity and 43 percent cash).

This is 126 percent higher than median total compensation of $100,250 among the family-owned sample. This difference is due to the equity award; if we were to extricate only the 43 percent cash portion of $227,005, the resulting $98,000 (inclusive of cash retainer and committee member fees) is right in line with total compensation of $100,250 at family-owned companies. As discussed previously, this is one way that private companies, family-owned or not, set director pay—by stripping out the equity portion of comparable public company total director pay.

The arguments against implementing an equity-based incentive program in a private company generally fall into four categories:

  1. The owners do not want to dilute their voting control;
  2. The owners are concerned about opening up the primary shareholders to potential legal actions with dissatisfied minority shareholders (e.g. the employees who received stock awards);
  3. The executives and directors— and in some cases, the business owners— don’t want the risk and complications associated with illiquid, non-publicly traded stock; and,
  4. Equity is more complex that cash. Considerations such as number of shareholders, form of ownership (such as IRS Subchapter S incorporation or a limited liability partnership) and other related issues make it more difficult to institute a program.

NEFD COMPENSATION

Twelve of the nineteen companies (63 percent) had family members serving on the board that were also senior members of the management team. In line with common practices for all types of companies, these family members received no compensation for board service.

Six of the nineteen companies (32 percent) had family members who were not employed by the company serving on the board. In speaking with these companies, it was evident that many business owners believe it is the duty of an NEFD to serve the company without compensation. In other words, the NEFD should have an inherent, vested interest in the outcome of the company, and compensation for board service is neither appropriate nor necessary. Accordingly, four of these six companies paid no compensation to the NEFDs.

However, two of these companies paid NEFDs at a discounted rate from what they paid outside directors. In one case, the payment was on a meeting basis, and in the other case, the payment was on a retainer basis. In both examples, the discount compared to outside director pay was significant. As described below, the average discount for NEFD pay compared to outside director pay was a steep 72 percent.

  • Example 1: Outside director is paid annual cash retainer of approximately $15,000 plus $2,000 per meeting; NEFD received $1,000 per meeting only, without any retainer. Based on eight annual meetings, the outside director received a total of $31,000 and the NEFD received $8,000 (a 74 percent discount).
  • Example 2: Outside director is paid a $126,000 annual cash retainer and the NEFD is paid a $40,000 annual cash retainer (a 68 percent discount).
  • For these two companies, the average discount is 72 percent.

Our discussions with these companies uncovered that owners generally agreed upon the following considerations with regard to the NEFD role:

  • All NEFDs should be paid the same—either no payment or payment at the same discounted rate compared to outside directors.
  • There is no basis in making a distinction between third and fourth generation, ownership positions, or dividend rights.
  • It is possible to distinguish board pay based on contributions to the board such as committee work or even leadership positions. However, the general practice is to not assign NEFDs to a board committee, which is typically organized according to experience, knowledge and overall contributions that lead to increased company value.

SUMMARY AND CONCLUSION

Director pay depends on the governance role. We expect that the pay guidelines we have seen among the various governing bodies that exist at family-owned businesses will continue. Figure 5 summarizes these guidelines.

Some information on director pay is being made available by the sharing of information among groups of companies on a friendly basis. This information sharing sometimes causes changes in the arrangement and compensation of the Corporate Governance Structure. I expect that more companies will review their Corporate Governance Structure (separate FC, AB, and BOD) and pay levels as determined by their business needs. The Corporate Governance Structure should adapt to the environment and may change as needs change.

NOTES:

¹Total Compensation includes annual cash retainer and “Other Payments” such as board and committee meeting fees (paid in the form of cash) and for 11% of companies, equity. Since only 11% of companies included equity in their programs, compensation for the 25th percentile, Median, and 75th percentile includes cash only.

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