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JUNE 22, 2020 • BRAD FRANC
“I'm your older brother, Mike, and I was stepped over!”
“That's the way Pop wanted it.”
“It ain't the way I wanted it! I can handle things! I'm smart! Not like everybody says... like dumb... I'm smart and I want respect!”
—Fredo & Michael Corleone, The Godfather: Part II
For centuries, scholars, business owners and society have debated about how we can decide what is fair and how we can develop a fair process. After all, how can we possibly consider all the factors involved in being fair? What factors should we ignore or prioritize? Do we look to the past to determine who should be rewarded in the future? What happens if our outcome is different than what we had anticipated? Do we try to modify something else to address the unintended result?
Let me illustrate with a simple example. Imagine a mother has one candy bar but two children, Kate and Alex, who both want it. The mother decides a fair process would be to flip a coin. Since each child has an equal chance of getting that candy bar, the mother can’t be criticized for any favoritism. However, when Kate wins the candy bar and Alex does not, Alex will almost certainly argue the process was not fair.
The next day, the mother has another candy bar. Should she maintain the same coin-flipping process so each child has an equal chance of winning? Or should she change the process to equalize what had happened the day before? However, if the mother decides to change the process and give today’s candy bar to Alex, Kate may argue that changing the process at this time is unfair.
Would it have been fairer if the mother had merely split the candy bar in half and given half to Kate and half to Alex? What if Alex had just returned from a friend’s house and been given the exact same candy bar a few hours earlier? Or what if one child had done something to merit a candy bar while the other had spent the day misbehaving?
These simple examples demonstrate that determining what is fair is not as easy as one might initially think. As a business owner, you will also need to consider how or if you will want to address the thorny area of “fairness” when it comes to your business’s transition process.
I’ve heard many clients tell me they want to be “fair” to the next generation. In the same conversation, they will tell me that, in order to be fair, they want to treat everyone equally. In other words, they believe that by treating everyone equally, they are inherently treating them fairly.
In fact, a 2018 Business Owners’ Perspective study by MassMutual found that 60% of business owners want to split their assets equally among their families. Beyond this, for 64% of business owners, the business is the largest asset they have. From these statistics, it appears that, unless there is only one child in the family, multiple children will own the business interests of the senior generation.
While the decision to transfer ownership in a business is ultimately the owner’s decision, it is important to recognize the differences between fair and equal. After all, how the business owner decides to transfer his or her business interest and how the transfer is viewed by the next generation can materially impact the likelihood of a business’s successful succession.
To add to this challenge, many business owners find that the next generation of family members often each have their own definitions for what is “fair.” These various family members may not believe that dividing assets equally means that they are being treated fairly, or that their parents are acting fairly. For example, think of a next-generation family member who decides to come into the family business and sacrifices his or her other dreams for the sake of the family business. Later, the parents tell this family member that they want to be fair to all their children and think the business should be divided equally among all the siblings. Do you think the child who has contributed years of service will think he or she has been treated fairly?
Is Equal Fair?
From a definitional perspective, the term “equal” is a numerical calculation. Things are equal if they are of the same quantity, size, degree or value. With respect to the division of assets, equal would then simply mean that you take the total value of the assets, and divide it among the group you identify as your beneficiaries (whether that group consists of family members or employees).
However, it’s certainly not that simple in a business. For instance, the value of assets is seldom fixed and determinable. Almost every asset you own will either increase or decrease in value over time. Another thing to consider is that how and when you decide to determine the value of a business can also produce different results. Some assets will be more liquid than others. Some assets will have more tax and carrying costs associated with them. For example, would you rather receive an Individual Retirement Account (IRA) valued at $1,000,000, or an apartment building valued at $1,000,000? You might prefer the real estate due to the fact that, if you were a beneficiary of the IRA, you’d be required to withdraw the IRA over a 10-year period and report the entire amount as taxable income. However, the real estate can be held for years without recognizing any income. Conversely, depending on the location of the real estate, you might prefer to own the IRA because you want the liquidity associated with it.
Many years ago, an elderly client asked if I would act as the executor of his estate when he passed away. The client had three adult sons who did not get along and whom the client did not trust to handle his estate. The client wanted to divide his assets equally among his three sons. Besides a number of other assets, the client owned several residential apartment buildings. While I felt it was a compliment to be asked by my client to act as his executor, at the time, I did not realize what I was getting myself into.
When the client passed away, I discovered the rental properties were in severe disrepair, under-insured and potential fire hazards. As the executor, I was personally liable to secure the assets of the estate. I was incredibly nervous that an accident might occur on the property. Frankly, I suppose this is a perfect example of the old saying, “Be careful what you wish for.”
The three sons knew about the status of the real estate, and none of them wanted the assets transferred to them. Rather, each one wanted the other assets in the estate transferred to them. As a result, I liquidated the rental property (at a discounted value) as quickly as possible due to the potential liability associated with it. This story illustrates quite clearly how difficult it can be to determine asset value when trying to divide assets equally.
To put it bluntly: trying to be fair is a difficult task when you own a closely-held business. Even if you agree that fair does not mean equal, then how can you still be fair? When determining the value of your business and how to distribute it fairly, how do you consider the contributions made by a family member who has worked in the business? I have heard many next-generation family members argue that they helped grow the business. However, in some of those same situations, the senior generation will respond, “so did a bunch of other folks, and you don’t see them getting any ownership.”
The good news is that while trying to be fair may be difficult, there are a number of steps you can follow to help. This chapter will explain these steps so you and other important stakeholders can develop a decision-making process that everyone believes has treated them fairly.
Creating A Fair Decision-Making Process In 5 Steps
When we make decisions on difficult business issues, the goal should be a result that does the following: (i) best serves the needs of the business (ii) aligns with the business’s core principles or values, and (iii) does not harm anyone.
Next, you need to understand that decisions about what is fair can only be made with the available data. Accordingly, don’t think you will ever have everything you need to make the decision. After all, business owners make business decisions every day with the available data. You should not delay the process worrying about what the IRS, Congress or the next pandemic may bring. As the saying goes, “You can’t wait for all the lights to turn green before you start driving.”
Decisions about what is fair should also be made in an environment of honest and open dialogue, and with an attempt to remove bias. It is vital to understand and appreciate the real value of fairness is in the process of decision making, not in the outcome.
To set up a fair decision-making process for challenging issues, I recommend you follow the five steps below:
1. Include important stakeholders in the process while being as transparent as possible.
2. Have the group of stakeholders define and develop a decision-making process for the issue.
3. Explain how the decision-making process was determined to the people impacted by it.
4. Test the process against your core principles and values.
5. Consistently apply the process when needed.
Let’s take the compensation of a family member as an example. Often, next-generation owners who are not involved in the business feel that the next-generation owners currently working in the business are overpaid or enjoy too many perquisites. On the other hand, the next generation working in the business may feel that they are underpaid or not recognized for their efforts. This can put senior-generation business owners in a difficult situation. The business owner wants to be fair to their employees, but also does not want to be viewed as unfair to the family members not involved in the business. This can get even more complicated if the next generation not involved in the business actually owns a portion of the company.
In this situation, I recommend the business owner begin by involving each important stakeholder. Since compensation can be a very personal issue, the business owner may not want to seek input as to how much someone should be paid. Rather, I would suggest that the business owner ask each stakeholder how the compensation should be determined.
Once the business owner seeks the input of each important stakeholder, everyone can meet to develop a process for determining compensation. Again, I would avoid deciding on amounts and instead focus on how compensation should be determined.
One effective process to deal with sensitive compensation issues would be to form a compensation committee. If you already have an active board of directors, this is a common subcommittee. As part of forming the compensation committee, you may agree to ensure that there are independent board members or advisors on it. This will take away some of the potential personal issues that can pop up when dealing with family members.
After the compensation process is decided, you would then tell those impacted by the process. Those impacted might include the key employee, other owners, employees or in-laws of owners.
As part of the development of the process to decide compensation, one important thing to do is make sure it fits with your company’s culture. Personally, I like to do this by looking at the core values of a company to make sure the process fits in with them. When the culture squares to your process, you can be more confident that you have chosen the right approach.
If you do decide to use your compensation committee to determine the compensation of your key stakeholders, then regardless of the actual compensation paid to the employee, the key stakeholders should not complain that the process of deciding the compensation was unfair.
The final step here is to ensure this decision-making process is followed on a consistent basis. When there is a departure from the process, there should be a very compelling reason for the departure. Otherwise, the likelihood of someone complaining that they have not been treated fairly is quite high.
Acknowledge The Different Lens Of Fairness
Anytime you involve other important stakeholders in a process to determine what is fair, keep in mind that there will always be some individuals who interpret the situation differently, despite looking at the same situation with the same facts. Don’t view this as something negative, but try to embrace it as part of the process.
Like beauty, fairness is in the eye of the beholder. Depending on who you ask, you may get different answers.
For example, just imagine the wide range of answers you’d get about what would be fair with respect to transferring a closely held business interest if you were to ask each of the following:
a. The business owner
b. The business owner’s spouse
c. The next generation currently working in the business
d. The spouse of the next generation currently working in the business
e. The next generation not currently working in the business
f. The key employee in the business
Although you are likely to get many different answers, none of them are necessarily wrong. It’s important to appreciate that fairness is not solely objective, but can include subjective or qualitative elements that are hard to quantify.
This same issue may arise when you employ your child in the business—or if you have another child who is not in the business. Both children may want to follow a process that differs from each other or everyone else to arrive at a decision. Understand that this is not uncommon. However, it is important for the group, rather than a single person, to arrive at a process. When differences occur (and they will occur), I often suggest business owners go back to their determined values and principles and work from there.
One example I recently encountered dealt with the distribution policy of a very successful construction company. This company was an S corporation, so all of their net income was reported and tax was paid by the shareholder owners instead of the company. As a result, whether the company made a dividend distribution or not, the shareholders still had to report income and personally pay taxes on the income allocated to them.
As you can imagine, this could create potential problems for a shareholder who must pay tax on income they did not receive. As a result, this company agreed on a dividend distribution policy of 40% of the income. In other words, if the company made any income, it was required to distribute a minimum of 40% of its income to the shareholders regardless of the needs of the company.
As a shareholder who is not active in the business, your fairness lens may be set directly on the tax liability you might incur from the income of a business. In other words, you are likely to feel such a policy is fair because no shareholder should have to pay tax on the income they never receive.
However, in this situation, the non-shareholder CFO was concerned that the company ought not to be forced to make such a distribution. The company may encounter a need for liquidity, or a bank may try to restrict distribution due to certain bank covenants. The CFO felt a better process was to avoid forcing a set percentage of cash from the company to be in the form of a dividend. Rather, the CFO felt the decision should be made by the board on an annual basis after taking into consideration all the facts and circumstances the business is facing at that time.
I would suggest both the outside shareholder and CFO were correct in their concerns. As a shareholder, I myself would be anxious about paying my taxes associated with the income of the company. But as the CFO, I think it is also reasonable to be concerned about the liquidity of the company. Here is what these different views illustrate: you are going to run into different views no matter what. That’s why it is important to address these issues ahead of time so you can better plan and ensure people don’t feel they have been unfairly treated down the road.
Process Fairness Versus Outcome Fairness
As a business owner, you know all too well that the outcome of a decision is not always what you expect. In business as in life, while we have control over our decisions, we don’t have control over the outcomes of said decisions.
This also proves true when it comes to trying to make fair business decisions. Although your process of coming to a decision about distribution may be fair, you can still end up with a very unfair outcome. Because of this, it’s more important to be concerned about your process itself rather than the outcome of the process.
For instance, I once represented a business owner who had both a number of businesses, as well as wealth outside of these businesses. He knew he was dying, and he wanted to be fair to his three children. In an effort to be fair, he decided to divide his estate equally to each child. However, in deciding how to divide his estate, he chose to give his eldest son the business and his other children the other assets. He explained to them that he felt this son was the best person to run the company and that he did not wish to involve the other siblings as minority owners. He told them he felt this was the fairest way to secure each of their economic futures.
At the time, the children who did not get any of the business assets felt they had not been treated fairly, although they were richly rewarded with other assets. However, a few years later, as the result of some grave problems the father left behind in the business, the business the oldest son had received became almost worthless. At the same time, the assets his other children had received from their father continued to appreciate. In retrospect, I am sure the eldest son would have much preferred to receive the other assets rather than the declining business his father gave him.
As this story serves to remind us, we can seldom control the outcome, only the process.
When Should We Develop A Process For Determining Fairness?
As a business owner, you may choose to ignore fairness as part of your decision-making process. This is your right and prerogative. However, if you are a business owner who does decide to add fairness into your succession planning process, I recommend you develop a process for certain fundamental issues involved in a business. The more you can address these issues in advance and determine how your business will deal with them, the less likely someone will argue at a later date that they have been treated unfairly.
A closely held business owner may wish to consider following a decision-making process when dealing with four significant matters. These four significant matters are as follows:
a. Selecting a leader or the CEO
b. Determining compensation
c. Deciding on a dividend policy
d. Deciding on the transfer of ownership
These four succession planning issues are so fundamental that you really do want to be sure that you’ve developed a decision-making process that is seen as fair and reasonable by all. Without a deliberate process, I have found that regardless of the outcome, someone will almost always argue that they have not been treated fairly. One the other hand, if you develop a decision-making process in advance that takes into account everyone’s views, those who might not like the outcome will at least appreciate the fairness of how the decision was made.
Other Challenges To Fairness In Succession Planning
Besides the four fundamental succession planning issues covered above, there are other succession issues a business owner may want to consider in the process of a transition. Here are a few of those other issues you might run into:
a. You plan to transfer your business to the child who is currently active in the business. However, the value of the business greatly exceeds the value of the rest of your estate. How will you decide to divide the rest of your estate for the non-active family members?
b. You have had one child active in your business for years. They have become invaluable to the business. Should you exclude a portion of the value of your business that is attributable to the efforts of the active child? How will you measure that contribution? Will you use objective performance factors to determine the value attributable to the active child? How will you communicate that process to the active child as well as those who are not active in the business?
c. When you own a business, it is sometimes beneficial for estate and income tax planning purposes to transfer a portion of the business to the next generation of family members active in the business. However, you may not want to transfer other assets outside the business because you expect to use those assets for retirement. As a result, the non-active next generation must wait longer to receive their inheritance. You will need to weigh the value of estate and income tax planning against how you can be fair to other family members.
These are just a few of the issues that you may be faced with. I am certain there will be more. Of course, you can always make a decision on your own, without the input of others, rather than following the five steps I outlined above. However, be careful with big decisions like these because the way you deal with them and communicate them will almost certainly impact the success (or failure) of your transition plan.
Governance Fosters Fairness
What happens when a difficult decision needs to be made and you don’t have a defined decision-making process? How does one operate a closely held business fairly? One thing that almost always guarantees that everyone feels they have been treated fairly is making sure your company has a strong governance structure. I have found, time and time again, that when a company has a good governance structure, most family members, employees, and even in-laws will respect decisions made by the board.
Generally, good governance starts with an active board of directors. Research shows that most successfully run closely held businesses have an active board of directors. Beyond this, many of these companies also have independent directors on the board who are not employees, shareholders or family members. When a board contains independent board members, there is at the very least a perception of objectivity in the decision-making process.
When a difficult issue arises and a decision may be challenged, it is often helpful to have a strong and active board. After all, one of a board’s responsibilities is to deal with challenging issues. When such an issue is brought before the board, the board should (i) develop a decision-making process, (ii) do its due diligence, and (iii) ultimately come to a decision.
Fairness As A Tool Or A Weapon
In summary, you can either use fairness as a tool or allow it to be used as a weapon against you. When used properly, creating a fair decision-making process can be a useful tool in deciding fundamental succession and business issues. If you develop a process in advance to decide on particular issues (such as the succession of the next CEO, compensation or a dividend policy) and gain consensus in the process, it’s unlikely that anyone will argue that the decision was unfair.
Alternatively, when a fundamental decision is made without the least perception of a fair process, anyone who feels negatively treated will likely disagree with the result. In these situations, they will use fairness as a weapon against you by arguing, “This is unfair” or “I have not been treated fairly.” I’ve seen this play out enough times that I can confirm that this is not a position you want to be in nor an argument you want to have.
Here’s what it all boils down to: good companies anticipate future events to avoid conflict later and ensure confidence within the group. When individuals understand that a decision was made following a defined process with consistency and certainty, fairness becomes a valuable tool for the business owner.
Summary
1. Appreciate the differences between equal and fair. Fair may be equal, but equal may not be fair.
2. Develop a set process for making fair decisions on fundamental succession issues to improve the chances that your decision will be respected.
3. Acknowledge the different lens of fairness. Like beauty, fairness is in the eye of the beholder.
4. Understand the difference between the fairness of a process vs. the fairness of an outcome.
5. Good governance can go a long way in helping with the perception of a decision being fair.
Brad Franc is the creator of The Succession Solution, an accomplished entrepreneur, business coach, strategist, business lawyer and CPA (inactive).
This copy is for your personal, non-commercial use only. Reproductions and distribution of this news story are strictly prohibited.