When the Main Course Will Be Shrinking Pie, It’s Always Best to Plan the Meal Early
By: Carl Koerner
I was on a flight one time when the pilot announced a delay to check a mechanical issue. He said it was probably nothing, but “we always prefer to be down here wishing we were up there, than up there wishing we were down here.” It stayed with me. Of late there has been much chatter about the global economy and whether the tea leaves are predicting a correction or worse in our economy at home. So much so, that I wonder if the iconic phrase “winter is coming” will be worn out before the final season of Game of Thrones even begins. Maybe what we are experiencing is just uncertainty before the next big growth spurt. But like our pilot, wouldn’t we all be better off if we prepared for a recession that never comes rather than finding ourselves unprepared for one that does?
I have been practicing law for quite a few decades now. Most of my practice is dedicated to helping startups grow and realize value. My practice also includes representing those companies in distress when business plans aren’t realized or they are overcome by external forces. Many times I encounter situations where a company could have mitigated the damage of the downturn or avoided it entirely had they attended to the need when things were going well. I never cease to be amazed at how in one type of company structure the same problem repeatedly leads to heartbreaking consequences.
We are talking about owner-managed companies. Not the ones with institutional or other outside investors. The presence of outside investors usually brings with it discipline to clearly define rights and obligations of the owner/manager to the company and themselves. The problem is especially prevalent where there are two or more owners, none of whom has control, but where one or more have the ability to block the company from acting. The symptoms present when the pie shared by the owners starts to shrink, as is often the case during a down business cycle. But the condition started earlier.
When I work with company owner/managers drafting agreements that govern how the enterprise will be run and how the owner/managers will relate to each other (operating agreements for limited liability companies or shareholder agreements for corporations), I find that the most awkward subject for discussion is how the owner/managers should set compensation. Often the owner/managers conflate the notion of compensation, which is the reward for effort, with profits, which is the reward for investment. Even if I can get the parties to separate the two, they are most likely to agree upon a static description of the current compensation understanding rather than working through a mechanism or formula that can adjust with changing conditions. Many times the owner/managers will avoid addressing the subject of compensation entirely. Or else, it becomes a [TO COME] in a draft agreement after all of the other points are completed and the draft remains incomplete and unsigned.
So long as the company is growing, or at least not contracting, this arrangement works for most of these companies. There is the occasional griping when one owner feels that he or she is having a bigger impact on the business than the income received. Sometimes that leads to disharmony and a breakup or reorganization of some type, but mostly things just hum along. However, when the pie begins to shrink, what may have been unspoken becomes the main topic of discussion. The company considers whether it should pull back from planned expansion, reduce its services or cut back operations. It considers whether to lay off staff. Compensation and profit share to owner/managers is frequently one of the largest line items on the profit and loss statement. Owner/manager payments become part of the whole triage conversation. Should the company stick with its growth plan and fund it by cutting owner/manager payments? The discussion takes place in an environment already stressed by weakness in the business. Now the discussion become even more complex as individual lifestyle choices made by the owners, such as mortgages and tuitions to pay, become part of the discussion. Lifestyle differences may cause the owners to see the sacrifice required differently.
A similar dysfunction occurs where cutting compensation and profits is insufficient and the company needs to bring in additional capital. Owners may not have equal capacity to contribute additional capital. I have seen companies where a beneficent owner ponies up to help the company in return for modest compensation in recognition of the bond the owners share as founders of the business. I have seen other companies where the capital need is used to force the cash strapped owner to significantly reduce his ownership or be bought out entirely at distress prices. But most frequently what I have seen is conflict which distracts from the business and ultimately leads to a loss of value for all of the owners.
Even in situations where some of the parties can absorb the cut in compensation or make the capital contribution, they are unwilling to do so because the parties haven’t addressed a fair way to address the inequality.
The fix is easy to say, but harder to do. When times are good, and especially before it is certain how each owner/manager will be impacted, address the hypothetical challenges and establish a mechanism to respond to each. Parties are more likely to set a fair price before they know who will be the buyer and who will be the seller.
Addressing Compensation in Owner-Managed Companies
- Separate the concepts of compensation and profit. Compensation should be a reward for the contribution that each manager makes to the success of the business. Profit is reward for ownership and capital investment.
- Set compensation with a modest salary component and a bonus component. Whatever formula is used to determine the bonus for each owner/manager, make sure that it is based upon actual profits. This will automatically impose fiscal discipline fairly among the owner/managers during a contraction phase.
- Provide a mechanism for owner/managers to invest additional capital in the business when it is needed. The mechanism must address disproportionate investment. If the company asks all of the owner/managers to contribute additional capital and only some do, those who invest must be treated equitably. Otherwise, those willing to take the additional risk will be reluctant to do so.
- Start the conversation now while it is unnecessary.