How to fix your remuneration in a closely held entity?

How can you fix your remuneration in a closely held entity?

There is always a confusion and a lot of doubts when it comes to a discussion as to how to remunerate a director/partner in a closely held business entity, where some of the director/partners are working directors/partners and others are silent.

The first and foremost principle you have to remember is there is no hard and fast rule regarding the fixing of remuneration for a closely held entity. Of course, there are some regulations like the Companies Act, 2013 and Articles of Association for companies, partnership deed for partnerships and Income Tax Act.

But the basic premises under which decisions are taken will be the mutual understanding and agreement, at the same time within the contours of the statutory regulations as above.

On a Macro level, for fixing of a compensation so many factors are to be considered.

1.    What is your organisational philosophy?

-       Sometimes you may decide that all will be paid equally irrespective of the role they carry or irrespective of effort they put in OR

-       you may decide to pay a fixed minimum for all and a variable portion depending on the rolls played by each. OR

-       you can decide that only those parties who are spending time and effort will be compensated and silent partners will not get any compensation as they are not spending any effort. OR

-       you may decide to pay a fixed minimum for all, and a variable portion based on the performance/profit of the entity.

Your mutual agreement is your philosophy.

2.    How will you give credit to the investors vis-à-vis the managers?

Here another factor may come in – the investment of each party. It may be equal or unequal. So how will you consider that aspect also? Especially in recent times, where people investing in an entity and people running the entity may be different. Some investors may be silent, and some may be working partners also. In some cases, all investors will be silent and working partners will not put any investment.

So how will you give credit for that? Everything may not be possible as per rule book. For example, company law prohibits payment of interest on equity share capital. So, you will have to be within the four corners of the law at the same time pay the remuneration.

3.    What should be the mode of compensation – in cash or in kind?

You can pay a person in cash (bank). A payment in kind means other than cash or bank. The most popular method is increased stake in the entity. In Company, we call it Sweat Equity.

A payment in cash means immediate cash outflow for the entity whereas sweat equity will not result in cash outflow in the short run. But this will have the effect of increasing the shareholding or capital of that person compared to others. Increase in capital means increased control in the entity.

4.    So how will you sort this out?

The best way is to structure it as a combination of the above.

For example, you can fix a particular percentage as return on the amount invested.  This percentage can be fixed considering the cost of funds of investors, the current bank interest rate, the return that may be available from alternate investment options etc. This will ensure an equitable compensation to the parties based on the quantum of money invested by them.

Then you can think of compensation to those who are actually working parties. Renumeration to the working parties can be based on the effort and time they put in.  The contribution of each party may be in different areas –somebody will be doing the marketing, somebody will be doing the administration and paperwork, somebody finance etc. Based on the effort and time you can mutually agree for the compensation.

But, if you are not able to assess the individual effort and time, it is better to make the compensation equal.

5.    But I was getting a fat paycheck before starting this business!

Yes, you might be. But scenario here is different. You are the owner of the business and not a mere employee. You need to have a holistic vision on the future of the business.

Entering into a business means taking huge risk on your shoulders. And the higher the risk, higher will be the returns also. And there is no limit for your earnings if you succeed in the business.

However, the remuneration need not be based on the salary he drew when he was in employment earlier or based on the salary some other multinational entities pay to a similar employee etc. Because, you are a new business and you will definitely have cash flow pressures in the initial years. So, outflow of funds on account of salary to business owners may impact the working capital of the entity and the business owners will have to pump in the funds again into the company.

But if the entity is cash rich and having no pressure on working capital, you can fix the salary at market levels.

6.    Why can’t we draw lower salary now and increase it as and when the business increases?

Yes, that is a good suggestion. You can think of a staggered compensation structure like a lower initial period compensation which can be increased as the years pass by or the business improves.

Another way of staggered compensation is pegging the compensation to the profits or performance of the entity. This can be slab based package or a percentage-based package.

A good rationale for opting staggered compensation method is the timing of taxation. You draw a fat salary and the entity may fall to loss due to that high salary. Here you may be forced to pay income tax on the salary. Of course, the entity can carry forward that loss for 7 years, but you will have cash outflow now and respective benefit may accrue to the entity after a period of time. So, the timing of the cash flow can be made in your favour if you plan the salary on staggered basis.

7.    We fixed the quantum of compensation. What next?

Once you decide on the quantum of the compensation, you can think of how it is given to the parties. As I mentioned earlier, it can be either a direct payment to them or it can be in the form of sweat equity or partly by cash and partly by equity.

In the case of sweat equity, you will have to take into confidence the other stakeholders also, as your percentage of capital will be increasing due to sweat equity and this may cause change in the equity holding equations.

Whatever profits remaining after the remuneration and taxes will accrue to all – including the active as well as passive partners and that can be paid to them in proportion to their investment.

8.    To Summarise

• In a closed held entity, the remuneration to the partners/directors is mainly based on mutual consent.
• In case of an entity where some of them are investors and some of them are working partner/director, it is better to compensate the investors by way of percentage on their investment.
• Compensation can be in cash or by way of sweat equity. But sweat equity will increase the stake of that person vis-à-vis others
• An equitable mode of compensation will be to remunerate each in accordance with the time and effort put in by each one. Due weightage can be given to experience also.
• Running a business and working in an organisation is totally different. It is better not to compare the remuneration to the paycheck he was getting while in employment.
• The business owners are the only responsible persons to put in the money whenever required. So, drawing higher remuneration, especially in the initial period, will result in drain in working capital and they themselves will be again force to pump in more amount into the business.
• Instead, you can think of a telescopic pay structure, whereby you can draw a lower amount in the initial periods and then increase it year by year in accordance with the increase in business.
• The best option will be a combination of all the above.
• Profits remaining after payment of remuneration can be distributed to investors considering the immediate fund requirement for working capital also.

  

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