The good, bad and the ugly on owner compensation

Let’s put all the cards on the table right now. The amount of money one makes is directly proportional to the perceived importance or success of the person taking the money home. Sure, we all know better and there are factors that dilute this rule, but it still is a fair rule of thumb.

Why else would two, three or four partners pay themselves the same? They are all equal, right? No one can be more important than the others.

Herein lies the rub. It is very rare when two people are of equal importance or value to a business. One person will most likely outperform his or her partners. The person might change from time-to-time, but usually there is some ranking of contributions each owner will make to the success of the business.

Owner’s compensation is a very sensitive subject and it can often be the unspoken thorn in the sides of many business partners. Disputes arise when the original compensation plan is never revised, despite changes in the effort, contribution and the roles of the partners.

Compensation plans

There are several common ways that agency owners compensate themselves, each with their own pros and cons. For example, some business partners may choose to pay themselves the same salary. This is a simple solution that may foster teamwork in the beginning. Resentment might (will) eventually occur if one person slows down, yet still draws the same salary, as alluded to above.

Some agencies may pay the owners strictly for production. This method becomes unfair if one person is spending more time on management than the other owners and their production is impacted.

Oak & Associates recommends performance based compensation plans. The best plan has three components: a fee for management time, a production component piece and a share in the net agency profits.

Each agency should set aside a strategic management fee somewhere in the range of 4 percent to 8 percent of total revenues. To determine the correct percentage, think about what it would cost to hire an agency manager who would perform all the management duties that the owners currently perform.

The larger the firm, the smaller the percentage of revenue for the fee. Larger firms tend to have middle management to assist the owners with the strategic management of the firm. The owners of smaller firms need to be more active. This strategic management fee is then split up to pay the owners for their contribution to management. The management fee is split based on the typical or average amount of time spent managing the common management functions. Since each agency is unique, the specific categories and formula used should be tailored to match the efforts needed and expended for management.

The fees are for strategic management, not the day-to-day management of affairs. For example, the owner in charge of financial affairs does not handle the day-to-day accounting for the firm. Strategic management for financial affairs would include reviewing monthly financial statements and initiating the firm’s budget. Any major decisions still need to be approved by all owners. If that owner is actually doing the bookkeeping, then a separate fee should be allocated to the owner for that role, since that agency did not incur an expense for an employee bookkeeper.

The production piece

Almost all agency owners are involved in production. The second component of the compensation plan is based on each owner’s production. The formula is recommended to be the same as that for the non-owner producers in the firm. In a typical agency, the commission paid for production averages 40 percent for new business and 30 percent for renewal. This includes both commercial and employee benefits lines of business.

To encourage sales of larger, more profitable business, Oak & Associates recommends that there should be no commission paid for personal lines or small commercial accounts, unless the producer/owner does the service for those accounts. An agency cannot afford to pay two people to do the work of one.

There are exceptions to this rule. In smaller agencies or firms in rural areas the producer/owner is often heavily involved with these accounts. In some firms, the agency book of business might be mostly personal lines or small commercial accounts. In this case, the producer/owner should be compensated to handle these accounts.

Splitting up the profits

When the first two components are incorporated and if the agency has average control over other expenses, the firm should post a fair net profit. The true profitability of a typical agency today is between 15 percent and 25 percent. Any excessive perquisites that the owners receive (such as large auto, travel and entertainment allowances) will lower this net agency profit. However, owner perks are in a sense agency profits.

To be fiscally prudent, the firm should retain some of the profits for capital investments. It also makes sense to reward those that work for the success of the agency and some profits should also go to bonuses to employees and perhaps pension plans. Owners can get a lion’s share of the money in certain types of pension or 401(k) plans, which again is owner’s compensation.

The balance of profit that is left over should then be allocated to the owners based on the contribution of each owner to the firm. The recommended split would be 25 percent for new production, 25 percent for size of the owner’s book of business, 25 percent for management time and 25 percent for the owners’ equity share.

This formula allows those who generate the profit to gain from their efforts. Nothing could be more discouraging to a young successful owner/producer that generates most of the new business to receive only 10 percent of the profit because that is their stock equity percentage.

Summary

Performance-based owners’ compensation is flexible and easier to implement in most cases. Owners that choose to slow down and not work on management will receive less compensation for that component. The owners that have to pick up the slack will be compensated for their additional effort. Owners who excel in production will be compensated accordingly. It is a simple and equitable methodology.

Owner compensation plans need to be flexible to allow for the natural change in an owner’s contribution to the firm over time. The plan needs to also be fair yet rewarding to the major contributors.

While compensation is often a sensitive subject to discuss, establishing a well thought out plan that can automatically adjust to the owner’s contribution will remove the potential for disputes or hard feelings between owners.

Note: Oak & Associates is conducting its 2007 Owner and Producer Compensation Survey. Participants will receive a free copy of the survey results. Contact: info@oakandassociates.com to participate in the compensation survey.

Topics Profit Loss Talent