This post is by Giles Ellis, an experienced business coach and Director at GECA Chartered Accountants.
An issue that arises up a lot with family business owners is the issue of non-commercial shareholder employee salaries. In this article I’ll explain what these are, how it can become problematic, and what you can do to safe-guard your business for the future.
Many people when they start out in business, do so with a partner – or a small group – of founders or owners (for the purposes of this article, these are the ‘shareholder employees’). During the early years, when the company is in start-up and high growth, typically there are few staff and the owners are all ‘pitching in’ on an equal footing, taking equal remuneration regardless of the roles they are performing.
As the business grows and staff are taken on, the roles of the shareholder employees can become more specialised, and often will include one shareholder employee taking on a managerial role such as CEO. However, the other shareholder employees may continue to act in roles with lessor or broader responsibilities and this leads to a situation where the roles performed by the shareholder employees often don’t reflect the commercial rate that would be paid to a standard employee. In this situation, often the CEO role is paid less than market rate and the other roles performed by shareholder employees paid above market rate. It’s an unintentional consequence of organic growth and not normally something that shareholders ever pause to consider.
While the business is performing in line with shareholder expectations and the shareholder employees are doing similar hours of work, this situation is manageable, however, ultimately it’s just not sustainable.
Impact on Business Sale Value
Typically businesses – once they become profitable – start to consider an exit strategy. This could include a sale or merger, in which the owners will want to present a normalised P&L which reflects the market value of staff resources required for business operations.
With shareholder employees on the same salaries but performing different functional roles, accountability for performance is not aligned to remuneration, and will therefore make it much harder for the incumbent to manage performance. This is of particular concern when one shareholder employee is the CEO and reporting to the other shareholder employees in their capacity as Directors of the business.
Conflicting Personal Circumstances
Personal circumstances change over time, and one or more of the shareholder employees may want to reduce their hours or give up being an employee and remain as a shareholder only. This will require consideration of how non-commercial salaries be adjusted to allow for reduced hours.
Addressing the issue of non-commercial remuneration is a particularly sensitive issue as it can be quite divisive and lead to shareholder conflict if not managed appropriately. It is common for shareholder employees in business for a length of time to be personally close (eg family members or long-standing friends) as well as professionally close and remuneration decisions are sensitive and can lead to conflict.
Therefore it is vital that shareholder employee remuneration decisions are made in a transparent way and equally applied to all shareholder employees. Ideally, these decisions would be approved by the Board as a resolution or as an approved company policy.
Solutions to deal with non-commercial shareholder employee salaries
So what are some strategies to address the issue of non-commercial salaries?
Let’s consider the following situation. A business set up 15 years earlier by two equal partners now has 50 employees, with one shareholder employee acting as CEO (a role held since the business was started) whereas the other is acting as a technician within the business reporting to a team manager. Both receive a salary of $120k and work full time hours. Clearly whilst their roles are markedly different and considerably more responsibility sits with the CEO role, the remuneration does not reflect this.
Reducing Hours – pro rating of shareholder salaries
The technician shareholder employee has asked to reduce his hours to 3 days a week and this has led to a broader discussion on how shareholder remuneration will be treated going forward.
In this instance, due to the close personal nature of their relationship and a desire to maintain parity in regard to earnings, they decided to maintain equal remuneration for shareholder employees and pro-rate based on hours worked. This allows effort to be recognised, however, does not reflect the value of the work performed.
This typically represents an interim measure before full commercialisation of shareholder employee salaries is introduced. The benefit of this approach is it allows a gradual move to align roles to commercial remuneration without the financial hardship that could arise if remuneration was moved to a commercial basis immediately.
Changing focus from personal remuneration to dividends
Still using the situation above, the technician shareholder employee reduced his hours and his salary was pro-rated accordingly. To address the reduction in salary, he wants to see his dividends increase to compensate his reduced remuneration. His focus has moved from being an employee on a personal salary to overall business performance and increasing dividends. This represents a much better alignment of Director interest’s to the requirements of the shareholder-director role.
Full commercialisation of shareholder salaries
The alternative is to move all shareholder employees on to commercial salaries for their roles based on market rates.
This represents the best commercial outcome for the business, however, needs to managed carefully to avoid personal conflicts.
Commercial profit and loss
Having all salaries are based on market rates across the business means P&L reporting is accurate and reliable and can be benchmarked with external competitors in an accurate fashion.
Alignment of Performance to Remuneration
Role responsibilities can be clearly defined within the larger Organisational Chart and alignment of performance to remuneration can be done in an objective manner. Entitlement to discretionary remuneration such as bonuses can be measured against KPIs and will provide motivation for shareholder employees to achieve targets.
Increased Organisational Robustness
If a shareholder employee is to leave suddenly and be replaced by an external hire on market rates, there will be no sudden impact on the profit and loss by moving from non-commercial salaries to commercial salary. This could be acute in the instance above where the CEO is paid substantially below market rate.
Moving shareholder salaries to market rate often leads to closer scrutiny of performance, particularly for executive management roles.
It is reasonable for shareholder employees paying a commercial salary to a CEO to be sure they have the best possible person in the role. This may not be the incumbent shareholder employee CEO and agreeing to bring a replacement can lead to personal conflict.
To mitigate this, KPIs and targets should be clearly outlined and agreed by both manager (being the Board for the CEO) and shareholder employee.
Many NZ SMEs have non-commercial salaries for shareholders working in the business. This is a sub-optimal commercial outcome and will, over time, limit business performance.
This can be addressed by moving all roles held by shareholder employees to commercial salaries. However, this is a sensitive issue and needs to be managed carefully to avoid personal conflicts and impact on business operations.
Giles Ellis is a Director at GECA Chartered Accountants – a team of Family Business Experts who specialise in working with owners of family businesses to grow profits, improve cashflow and increase their wealth.
He can be contacted on firstname.lastname@example.org or by phone at 0800 758 766.