Unfair compensation between company owners is a red flag signaling a potential business breakup.

This scenario typically unfolds in the following way. Individual A is the founder of the business. He is older, experienced in the business, is the rainmaker and is the sole owner of the business. Individual B is younger, less experienced in the business, has little or no clients and is a salaried employee. Think Ebenezer Scrooge and Bob Cratchit.

Fast forward five years. Based on Individual B’s great work performance and increased business generation, Individual A makes Individual B an equity partner in the business. Individual A either (1) maintains the lion’s share of ownership and continues to maintain the same level of work; or (2) makes Individual B an equal partner but goes into semi-retirement mode.

Jump ahead another five years. Individual B has really hit his stride. He now brings in as much business as Individual A, and has a level of experience that allows him to work independently without the supervision of Individual A. Although Individual A still has more experience, for the purpose of generating income for the business, they are equals.

Individual A, however, fails to recognize the realities of the situation. He still sees himself as the founder of the business, feels he is entitled to the lion’s share of the profits, and thinks that Individual B’s reward will come when Individual A retires and leaves Individual B the business.

Individual B, however, sees things differently. Individual B feels like he has paid his dues and has objectively earned the right to equal ownership and compensation now. Or, in the case of Individual A spending too much time golfing and vacationing while Individual B toils late nights to pick up the slack, Individual B feels resentment towards Individual A for not pulling his own weight. In either case, Individual B starts to have thoughts about going out on his own and taking key clients and employees with him.

As set forth in the example above, the conflict stems not from unequal compensation, but unfair compensation. It is unfair because when two owners bring the same business skillset and income-generating ability to the table, they should generally share equally in the profits and the workload.

The potential for a business breakup rears its head when the owners reach equilibrium and the changed circumstances are not recognized. The test is as follows: if Individual A and Individual B decided to become business partners today, would they have the same arrangement? If the answer is no, then chances are there is a business divorce brewing.

The following case study from my own family shows why unfair compensation between business owners can lead to a breakup of the business.

 

The case study

My father in law, Richard, was the youngest of three children. Both of his parents were first generation Sicilian Americans. Richard’s dad, Michael, attended Johns Hopkins at the young age of 16 to become a physician, but was forced to transfer to the University of Alabama due to the Depression.

Michael was the author of a true American success story. In one generation, he was able to propel himself and his family from the lower middle class to the upper middle class. As the only son, Richard was the heir apparent to his father’s business.

Richard, however, had his own plans — at first. He lived a colorful life in his teen years. In the early 1960s, Richard and a few of his friends formed a Doo-Wop group, the Ducanes. They caught the attention of a record producer by the name of Phil Spector when they performed at a high school talent show. The Ducanes’ most famous song, “I’m So Happy,” was a Top 40 hit, and made young Richard and his friends celebrities.

The Ducanes rubbed elbows with some other young talent. For example, they met in Phil Spector’s recording studio a young and, at the time, unknown guitarist by the name of Jimi Hendrix (Hendrix played guitar on “I’m So Happy”); Bobby LaKind, the Doobie Brothers’ drummer; and Leslie Gore who sang such hits as “It’s My Party.” The Ducanes performed with Chubby Checker, The Earls, The Capris, The Jive Five, Dion & The Belmonts and The Dream Lovers.

All this fame and stardom at a young age unfortunately went to their heads. When asked to perform what the group thought was a terrible country song called “Tennessee,” Richard and his friends did their best barnyard imitations. Unfortunately, the head of the studio happened to be listening and fired them on the spot. That was a mistake from which they would never recover.

That was the last time the Ducanes would ever see the inside of a recording studio. Heartbroken by his brief celebrity, Richard returned back to earth and turned his attention to the more mundane things in life: school. Richard, although keenly intelligent, had never been a star student due to his disinterest in school. At the bottom of his Catholic high school class, he managed with the intervention of a friendly priest who taught at the high school to get accepted into the University of Dayton. Like high school, college did not hold Richard’s attention for long. He dropped out after two years and started working in the construction business.

After several years of working for other construction outfits and honing his estimating and general contractor skills, Richard and his dad decided to go into business together as 50/50 partners. At that point in time, Michael was nearing retirement age. Richard was the workhorse, and did most of the legwork, serving as the general contractor on substantial commercial and government buildings and residential housing projects. Michael supervised Richard’s work, and taught him everything he knew about building, supervising and estimating.

A few years into the business, it became painfully clear to Richard that although he and his dad were sharing the profits equally, they were not doing the same with the workload. Michael was becoming more and more aloof with his responsibilities. It was not uncommon for Richard to learn the night before an estimate was due that Michael failed to prepare the estimate. The plans needed to do the estimate would invariably be in the backseat of his dad’s car, and Richard would pull an all-nighter to prepare the estimate and submit it before the bid deadline the next morning.

Another issue compounding the problem was Michael’s treatment of the business as his personal piggybank. At the point at which he was doing little to no work, Michael would frequently, without consulting Richard, withdraw substantial funds from the business for his personal expenses.

One memorable example was at a lean time when there were barely enough funds in the business account to cover expenses, Michael withdrew funds to pay for a paint job for his wife’s Cadillac.

Richard continued to carry his father on his back for several years. But Michael’s continued drain on the company’s finances brought the business in the red. At this juncture, Richard, married and the father of three young children (including my wife), could no longer continue being the “good son” and support his father. He had to support his own family. Richard confronted his dad and told him he could not continue the gravy train, but would buy Michael out. And that is what he did at a great sacrifice. It took Richard years to get the business back in the black and pay off his dad’s buyout.

Not surprisingly, all of this caused a great strain on Richard’s relationships with his family. In particular, Richard’s oldest sister accused him of stealing the business from their father and demanded to see the books. This accusation caused his reputation within his family to be tarnished.  The years of financial strain also detrimentally affected Richard’s relationship with his wife. She had sold her own hair salon business and invested the profits into Richard’s business. His wife was bitter that those funds were used to support her father-in-law’s lifestyle when he failed to pull his weight.

 

Summary

The story of my father-in-law painfully demonstrates how unfair compensation can lead to business breakups. While family relationships add a complex layer of haze over business decisions, fairness must nevertheless prevail if the business is to survive. Whether or not family is involved, the root cause of the problem is not unequal compensation, but unfair compensation. The unfairness usually stems from two scenarios: (1) equal ability, equal work and unequal compensation; or (2) equal ability, unequal work and equal compensation.

The owners must regularly ask themselves, especially as the junior owner progresses to new levels of experience and business development, or if the senior owner unilaterally decreases his workload: if they decided to become business partners today, would they have the same arrangement?  If the answer is no, then there is substantial risk that the business will not last.