Performance Standards In Family Business Transfers

Performance standards can be utilized in a way that keeps both a family and its values intact.

Maintaining family harmony begins with setting your objectives and then creating and communicating a written objectives-based plan.

Once objectives are set, you must manage the issues of merit and fairness in the transfer of ownership to children. Unless you address these issues up-front, inaction is likely to create conditions for family discord.

Let’s assume that Meredith distributes ownership to her oldest child based on the time and effort he has put into successfully growing the business. His siblings can easily view that distribution as, “My parents have always loved him more.” Meredith knows that is not true, and repeatedly reinforces to her children and her husband that she loves all of her children equally. When these assurances are not accepted it is time to take a step back to address this in an open and transparent way with the family.

It can be helpful to examine the issue of merit as it relates to the child assuming ownership. Our experience tells us that basing transfers of ownership to a child on business reasons is the best way to prevent siblings from accusing parents of one-sidedness and unfairness.

Ownership Based on Merit, not Emotion

Let’s consider two scenarios.

Scenario 1: Ideal and Uncommon. Owners in this small group had the foresight to avoid the inherent difficulty in having multiple children but only one company: they only had one child. Further, that child is ambitious, capable and wants ownership. Transferring a business to this only child makes sense, and isn’t difficult to accomplish.

Scenario 2: Real and Common. Owners in this group have one business but more than one child. This situation usually plays out in one of three ways:

1. All children are active in the business. The principal issue is determining how the children will share the control and ownership of one company.
2. One or more children are active in the business and one or more are not. How does an owner give the business (or at least a controlling interest) to the active children provided they merit it, while being fair to the others?
3. Every child, active or not, gets an equal share of the business as well as all other assets.

Performance Standards

If a business-active child does not merit business ownership, owners know it and so do their other children. When owners transfer a business to a non-deserving business-active child, the non-business-active children see it as nothing more than a gift. They believe they should receive the same gift or a gift of equal value at the same time as parents “give” ownership to their sibling.

Set objective performance standards in awarding ownership to a child to remove yourself from any real or imagined game of “playing favorites”.

You can utilize performance standards in both transfers to key employees and transfers to children: children in a business earn ownership in the same manner as do key employees.

Use performance standards to motivate and reward management and key employees to increase business value over time. If employees meet the standard, they receive a cash bonus. Similarly, if a child meets performance standards, the child’s reward is ownership in the business.

Performance standards can be designed in many ways to reward children with ownership. They can also be used to allocate ownership among active children. For example, if one child is president of the company, the performance standard might relate to the company reaching a revenue or market-share target, cash flow level, industry benchmark or other goal. The child who achieves the performance standard receives an award of ownership. The other business-active children also receive designated awards if they reach and surpass their own performance standards.

Consider this story of an owner who brought his daughter and son into the business when his company was worth about $5 million. Due to the daughter’s efforts, the company increased in value to $50 million. The daughter benefited from her value-building efforts in two ways. First, her annual compensation increased to $1 million. Second, the value of her ownership increased in value from about $1,000,000 to nearly $12 million. The son was working as the company’s accountant. His salary was $125,000 per year. His father gifted him, in trust, a small amount of ownership.

When asked about whether that salary and ownership disparity had created resentment in the relationship, the owner was surprised. “None at all. Early on, I told both kids how I planned to transfer the business and about the performance standards I expected. Both knew the rules of the game going in and neither had any complaints.”

Early and thorough communication of your goals and how the Transition Plan is designed to achieve them is essential. In this example, both children had the opportunity to grab the ring. One accepted the challenge with great results, while the other decided to remain active, but less involved, in the business.

Performance standards vary from business to business, but, at a minimum, they should:

• Be attainable.
• Be clearly communicated to all parties.
• Be tied closely to increasing business value.
• Be written.
• Control the incremental awards of ownership over a multi-year time span. As standards are met, the child earns, and is awarded, ownership via stock bonus, gift or purchase.
• Describe exactly the attributes and performance expected from any key employee seeking ownership.
• Result in the owner’s financial security.

Benefits of Performance Standards

One of the valuable results of performance standards is that the child who meets or exceeds them effectively demonstrates their ability to operate the business successfully.

Another is that the business-active child can earn ownership under the same conditions as would a key employee can earn a cash award.

If you choose to use performance standards based on cash flow increases or other key performance indicators you can achieve other benefits:

• As a child meets the standard, he or she creates additional cash. This cash can be distributed to the parent and used to invest in non-business assets.
  • Owners are able to leave their businesses sooner or leave as originally intended with more money.
  • The additional non-business assets can eventually be transferred to non-business active children to offset future gifting of business interests to the business-active children.
• As a child increases cash flow, he or she increases business value. This can give the parent multiple bites at the valuation apple if the stock is transferred to children at continually-increasing value.

Performance standards also take away the argument of non-business-active children who may demand that offsetting assets be transferred to them in an amount equal to the gift of ownership to the business-active child.

Use performance standards as a means of awarding ownership to business-active children and do so before beginning to deal with one of the most difficult aspects of family transfers: fairness.