Supporting a Non-Family Manager of a Family Business

FAMILY BUSINESS: OPPORTUNITIES AND PROBLEMS

The Grove Family

This case involves working with and providing an incentive to a non-family manager of a family business

The call came to David Reed early (early was 6:30 A M) on Monday morning, June 10th. David knew it was going to come as his high school classmate, Richard Wilson, a capable property and casualty insurance professional had called the previous Friday saying he had recommended his client, a furniture manufacturer in North Conway, New Hampshire, talk to David about a variety of problems the business was experiencing. Richard gave David some basic information to help him be ready for the call, but alerted him that this was not going to be an easy case.

The call was simple: “You have been recommended to us and we would like you to come to our business and see if you might help us.” Over the years, David was fortunate to have received many such calls and it always excited him to have the opportunity to meet a prospective client. He thoroughly enjoyed the salesman’s high of actually being hired and be able to quickly see several family business and tax problems he could solve for the benefit of the family and the family business. David’s services did not come cheaply as Richard would have warned Jim Thorne, the general manager of the company, and the caller. In this case David would earn every penny.

THE SITUATION

The Grove Furniture Company had been in business for three generations. Charles Grove, the leader of the second generation, had died three years before after a long illness. While he was still able to work, he hired Jim Thorne to come in as general manager and take over running the business. This was interesting to David as both of Charles’s sons worked in the business – Dan, age 40, managing the sawmill that produced the maple boards used to make the furniture and Jack, age 45, who was the number two person on the management team with a title of vice president. Jack helped managed the sales department, a husband and wife team, and was responsible for the facilities and equipment. His position and daily routine were not well defined but he was the senior family member on site.

David knew where the plant and office were located as he had lived 25 miles away for a few years. As was his habit, he arrived 30 minutes early at 7:30 AM and drove around the facility like a person slightly lost. A small sign pointed to the office which was a free standing building about 100 feet from a much larger building which David knew was the manufacturing plant. After taking a tour around the parking lot, David observed several employees mingling together at the south end of the plant building (he assumed it was a work break but later found out it was not. These employees had just decided to go for a cigarette, causing a work stoppage.) David parked in a visitors’ spot, dodging several pot holes and approached the office. He was surprised that the screen door was not fastened securely and there were several holes in the screen. In a way that matched what else he had seen in his short ride around the buildings: lots of scrap materials scattered about the plant yard; paper wrappings from what might have been lunches littering the area; empty soda cans on the ground; and, an aging plant building in disrepair – all in all not a good first impression and definitely did not match the reputation of the company for quality products and business success.

An Aging Plant Building in Disrespair

In a way, that matched what else he had seen – an aging plant building in disrepair. David told the receptionist who sat behind a glass barrier that he had an appointment with Mr. Thorne and sat down to wait. He always liked to hear how a receptionist answered phone calls and observe other activity visible from a reception area. He observed that the carpet and chairs in reception area were old and torn in places. The one table was covered with out of date magazines and had no materials on the company’s products. This visit was not getting any better. A couple of people came in through the front door but did not speak to David as they proceeded into the inner office area. David asked the receptionist where the rest room and she pointed out the direction. David really did not have to use the restroom but wanted to observe the office staff at work. He purposefully “got lost” and saw most of the office before asking again where the rest room was. Mission accomplished— a further view of people and space.

A few minutes later, Jim came out, introduced himself and led David into his office. David was pleasantly surprised after what he had already seen at the warm welcome from Jim and the neatness of his office including many photos of community events where he was featured. Jim opened the conversation by giving David a brief summary of the business past and present. He also commented on the roles of the two sons saying that Charles Grove when he first hired him told him he had two jobs: the one he thought he was being hired for, running the company, and the second job was to mentor the two sons until one of them would be able to take over the lead role. Jim was now 62 years old and Charles and he agreed that he would work only to age 65 and then turn the business leadership over to the son he decided was most capable of running the company. Jim then confessed to David that he did not think either son was capable of running the company. In a recent Board meeting when the sons were excused, he told the board the same thing. The Chair of the Board said Jim was being premature and he needed to figure out a way for the sons to elevate their game saying, “After all it is in their genes.” The Board chair was Charles’s longtime friend and attorney. The only other member of the board in addition to the two sons and Jim was Charles’ brother and banker. The two outside board members were also angry that the poor operating results of the last two years had not improved. The brother noted that the gross profit margin when Charles was running the company was 40% and now it was only 26% with the net income barely at break even with an EBITDA (earnings before interest depreciation and amortization) of $400,000. He also noted that inventories and accounts receivable had increased even though sales were static. David was beginning to understand why he was there. However, he still did not have the full picture. That was about to come.

David Began to Understand Why He Was There

Jim shifted in his chair and a thin line of perspiration was visible on his upper lip. David knew he was about to hear the big issues. Jim said he was working 60 to 70 hours a week to save this business as the competition had become severe. The company’s solid maple furniture products were having a hard time competing in the marketplace against Chinese imports and less expensive pressed wood products. His husband and wife sales team were having marital problems and had lost focus. The plant manager at the second plant, 7 miles away was recovering from a serious illness (David did not previously know about the second facility). The young woman who was in charge of human resources had told Jim plant morale was at an all-time low after several layoffs and shift reductions. The sons were not respectful of each other and in general of anyone else. Jim perspired even more when he said he had not had a raise for 3 years and was not sure he was going to stay as he had no real incentive for doing so. He guessed that if the business could not be improved even slightly that the Board would probably decide to sell the company within the next 5 years. The Board was quite sure the company was worth only $2 million dollars down from a high of $10 million 5 years before (they had an offer from a competitor at that amount soon after Jim joined the company). Jim then said that he was embarrassed that he had not been able to improve profits nor really help the sons. He was very discouraged. He had always been successful in previous positions and did not want to end his career like this.

He asked David if he could help. David knew now why his friend, Richard, had said this was not going to be easy but answered that he would try to see what he could do and needed to think about a logical and productive process, the timing of all, and what it would likely cost promising to get that information back to Jim within the next three days. David then left and on the hour ride back to his office went over in his mind all that had been said and all he saw. He had taken with him the most recent financial statements, a monthly sales summary, inventory, receivable and payables details, the most recent corporate tax returns, and the board minutes from the last four meetings. During the drive he stopped at a rest area and spent an hour and a half going over those materials as he knew once back at this office the blinking light of his voice mail system, the number of accumulated emails and notes on his desk from his staff, and partners would occupy his time. On these occasions he purposefully got back to the office a little after 12 noon as he knew most of his professionals would be out of the office and he would have nearly a “free” hour to bring his world under control.

The next morning, well before the other professionals in his office arrived, he prepared a work plan to send to Jim.

PROPOSED WORK PLAN

Visit the business – a full day for David and his colleague Robin. David attached Robin’s impressive resume.

7:30 AM Meet with Jim for 30 minutes to talk about expectations for the day.
8:00 AM Meet with Jack for 45 minutes privately and then have Jack and the plant manager take David and Robin on a tour of the main plant not including the sawmill.
10:00 AM Meet with Dan privately for 45 minutes and then have a tour of the sawmill.
10:30 AM Meet with George, the bookkeeper, in private. George would make available the monthly results for May and year to date, compared to budget and the previous year.
11:45 AM Meet with Sue, the HR person, for lunch (company to pay for sandwiches) in private.
1:00 PM to 2:00 PM Private time for David and Robin to discuss the mornings activities and to begin writing down the problems witnessed and possible solutions.
2:00 PM Meet with the husband and wife sales team; at first together and then maybe separately.
3:00 PM travel to the second plant to meet with the plant manager and tour that facility.
5:00 PM Call Jim with to talk about initial thoughts coming from the day’s activities

David e-mailed the work plan to Jim and within 10 minutes, Jim called to say all was ok except that he did not think Jack would want to conduct the plant tour. When asked why, David was surprised to hear that Jack had not been in the plant since his father died. Jim was not entirely sure why except he knew Jack disliked having to go “like a puppy dog” into the plant every morning with his father and be reminded over and over again in front of the men that he never had to get his hands dirty like his father did 40 years before. Working for a self- made entrepreneur, especially your dad, is often not easy.

David asked Jim to keep the schedule as is and alert Jack of his expected role. David wanted to see how this was going to go for the son who might lead the company in 3 years.

On the appointed day, David and Robin arrived early at the office. David and Robin talked on the way about what he had heard and seen on his first visit . Robin had worked with David for 3 years after coming to Maine following her MBA program at Wharton and working for a large property management firm in Philadelphia. She was bright and they made a good team. David had early in his career learned that women were great listeners and he often marveled at how much information professional women like Robin would get out of a conversation.

The meeting with Jim went as expected. However, the meeting with Jack was a little disappointing. He was quite nervous and appeared insecure especially when asked his role in the company. He was complimentary of Jim’s knowledge and work ethic and volunteered that despite all of Jim’s hard work the company was just not able to perform as well as in the past. He stated that he thought the best thing that could be done for all was to sell the company. His pessimism was bad but the tour proved to be even worse.

David and Robin put on the required hard hats and ear protectors and followed Jack into the plant area where the wood first came into the plant. It was obvious that the facility, equipment and processes were of long standing. All was quite well maintained but something was missing. Not a single one of the workmen and women smiled or said hello or waved. Neither did Jack communicate at all with anyone in the plant. David was also disappointed that the plant manager had called in sick. Robin later said this was the most hostile workplace she had ever been in. David felt the same. Outside Jack mentioned that many of the workers had gone to high school with him, played sports, drank a lot of beer, and used to push him around at school. Jack had escaped to college but had to come into the family business at the insistence of his father. Not a happy man.

The tour with Dan was different. He was outgoing and liked to talk about his farm, but was defensive when David asked him about his source of maple logs, the price of those logs and what he did to prevent staining in the summer. David had worked with many clients in the wood product business so knew many key indicators of a well-managed mill. Both David and Robin had a good impression of Dan. They were of course looking for the next company leader.

George was busy as he was trying to “close the books” for May and not having that done yet did not have the information David had asked for. David asked when he would be done with May and was told that if he worked over the weekend he would have all finished by the middle of the next week, the 23d or 24th. David asked about inventory calculations, overhead allocations, and cut offs for payables and receivables. George knew his stuff but was just overworked. They left the meeting with George a little sooner than expected as George needed to get the payroll done. He used the same internal payroll system that the company had used for 20 years. He had piles of time cards on his desk so was just at the beginning of the process.

They Were of Course Looking for the Next Company Leader

Sue, the H R. person, was ready for the meeting. She had prepared notes and was determined to get lots of information into the conversation. She first thanked David and Robin for the lunch. She said it was her first company paid lunch. Her office was small but had lots of books and manuals on HR topics. Robin asked her about her access to continuing education and found that she did not attend many programs due to the expense but would chat with her colleague at a local company in the wood products business who attended every program offered. She smiled and said that person had told her all about David as the other company was not only a client of David’s for many years but after his retirement from his accounting firm David had elected David to their board.

Sue was quite candid about the lack of morale and bad vibrations in the plant. That is how David found out about unauthorized breaks which hurt production. The crew just assumed they could get away with anything having no respect or fear of Jack or the plant manager. She said there were three individuals who seemed to cause all the trouble.

The meeting with the husband and wife sales team was revealing. Most of the company’s sales came through a combination of their catalogue and their network of furniture stores. The number of furniture stores selling the Grove products were reducing due the vigorous price competition in the industry. The husband and wife, not having any children traveled together and were each paid a salary. Robin said after the meeting that the company had a big risk here as the wife spoke about the home that “she” had just purchased in Florida while the husband kept trying to flirt with Robin.

David and Robin were shaking their heads all the way to the second plant thinking what they had seen would be a great case study for a business school and wondering how some of their obvious suggestions would be received.

Frank, the plant manager, however, was great. He was a huge man and was still recovering from hip replacement surgery. He laughed it off though, saying that it was an old football injury. They later learned that he was an all American tackle at the University of Maine. In his senior year the team was selected to play East Tennessee in a bowl game, losing 21 to 20. This plant was the opposite of the main plant. It was clean and neat; the people (mostly women) were very friendly; Frank had a quick word for all and, where not too noisy, he introduced David and Robin to the workers. This plant was an assembly and shipping plant for the children’s line of furniture including cribs, bureaus, desks, tables, chairs, and bunk beds. They received the wood already finished and cut to size from the main plant. Frank pointed out that he had to send many pieces back to be reworked and some just had to be thrown away. David asked what percent was rejected and was shocked to hear that it was 15% in May. As part of the conversation, Robin learned that Jack did come to this plant at least once a week and often had good ideas to improve systems but just glazed over when the part rejection issue was brought up. Frank had only been to the main plant twice and not since Charles died.

After the tour, Frank took David and Robin into his office and used the opportunity to express some of his concerns. He had been with the company for 20 years starting as a maintenance person and slowly working his way into the plant manager’s position. He said he thought he did a good job but the company did not keep plant profitability records so he really did not know the financial results of his plant. He simply managed to historic monthly production levels, production levels per shift, shipments per shift, customer returns and labor hours consumed. He was very conscious of maintaining the equipment and keeping staff morale high. He said he did pizza parties once a month if production goals were met and found special ways to reward key employees for exceptional work done.

After the conversation David and Robin excused themselves and returned to their car to place the scheduled call to Jim. It was brief and David tried not to sound too pessimistic saying mostly that they now had a greater understanding of the business and the family issues and would prepare and send to Jim in a couple of days the next suggested steps in their analysis process. David was conscious of the fact that Robin was eight months pregnant and very large which made him more than a little nervous and pushed him to quickly return to their office so she could get home to rest. They were talking about the day when David spotted a state trooper coming towards them and tried to slow down noticing that he was exceeding the speed limit. The trooper made a fast turn around and pulled David over. Never a good moment. David complied with the request for license, registration and proof of insurance and waited for the trooper to return from doing the checking process. The trooper, a small woman, looked again in the car and said to David, “Here is a warning and please get this young woman home before she gives birth, good day.” Ok, maybe a good sign.

Two days later, David and Robin sent the following document and requests to Jim:

WORK PLAN

Arrange a call or meeting with Board Chair and the brother on the board
Provide the following information for the company:

Jim called after receiving the above and said the two independent board members would come to David’s office the next Tuesday. He also said he would send before then all of the requested information except there was no shareholders agreement. He did not have an employment agreement. There was no retirement plan. He was also planning to cancel the fidelity coverage as it seemed too expensive for a small company. David asked him to hold off on canceling the fidelity coverage. David made a note to chat with his friend, Richard about all the insurances.

The next week David and Robin met with the two board members. It was a cordial meeting and David and Robin learned that while Charles was alive he made all the decisions with the board meetings once a year, just a formality to be completed quickly before all went out to play golf and have dinner at the Kearsarge Country Club. The company during all those years did very well, but not much was ever done for the employees beyond paying market rate wages which in a resort town were quite high. When Charles died he left all the stock to his two sons as his wife had died many years before. The board chair was a little embarrassed that he had not insisted on a shareholders agreement for Jack and Dan nor an employment agreement for Jim. He asked David to provide some suggestions for items to be in those agreements. David was happy to be asked for suggestions but knew his role was mostly financial and practical in such situations even if asked and even though he had two law degrees. It was always important to remember that each professional had their expertise and role as a team member in helping a family business.

David used this opportunity to discuss Jim’s compensation and the possibility that he might leave the company. The two board members said that it was crucial that Jim stay and turn the company around and they would like suggestions of how to facilitate that. They settled in their chairs and seemingly taking turns gave a variety of reasons why they thought the best advice David could give would be that the company should be sold. Neither of them thought that either son was capable or even interested in running the company but would be upset if the other brother was chosen to do so. They were also fearful that the decline in the U. S. furniture manufacturing business would continue and push Grove into bankruptcy. David did not want to give them false hope but said that the company right now was a poor candidate for sale as any astute buyer’s due diligence process would find lots of reasons especially in the main plant to walk away. He went on to say that some of the problems had an easy fix and others would take work but the more that could be done to enhance the business the more realistic would be the opportunity for a sale. The board members asked David to give all the help he could and plan to come to their next board meeting with an update in 45 days.

After the meeting, David called Jim and told him that the Board held him in high regard and had given David permission to talk with him about an enhancement in his compensation package designed to match the overall long term plan for the company. They scheduled a meeting in David’s office for the next week. David did not tell Jim what the enhancement was or even what the long term plan was.

David had designed many incentive compensation plans for family businesses and was heard to say that he had a lot of tools in his financial tool box but the real test was to know which one to use in a given situation. Here he knew it was an EQUITY APPRECIATION AGREEMENT.

In preparation for the meeting with Jim, David prepared the following to outline an equity appreciation (phantom stock) plan for Jim based upon the Grove facts and the long term goal of selling the company.

EQUITY APPRECIATION AGREEMENT

Purpose: The concept is to mirror stock option plans used by publicly traded companies. A family business does not usually and really should not give stock to employees but often needs to find a way to compensate a quality non-family CEO for increases in the value of the
company.
The Plan is simply a contract with the employee. It can be just for one person. It can a have vesting Schedule. It can survive death or disability. It can extend into retirement. It can have a TAIL (to be explained Later).
Suggestions for Jim’s contract:

Jim would be granted a 10% interest in the increase in the value of Grove Manufacturing Company above the current designated value of $2 million. This right would only ripen if the company is sold during the term of the agreement except as follows below. The sale price would be the measuring mark to calculate the increase in value.
Jim would have to continue to work for five years or until the company is sold whichever is less to receive the award.
Jim would be paid in the same manner as the shareholders are paid. If it is an all cash sale, Jim would receive all cash. If it is an installment sale Jim would be paid in installments.
If Jim dies or becomes disabled before the company is sold and before five years have expired, his family or him in the case of disability will have a continued right to an award if the company is sold within 5 years of the date of death or disability at an amount calculated using the TAIL.
If Jim retires after five years, he will have a continuing right to an award but only if the company is sold. The amount of that award will be designated as the TAIL and is as follows the same TAIL applies to a sale after death or disability

Award as a Percentage of the sale price Over $2 million

Year of Sale	Percentage
Sale at year one (after retirement, death or disability)	100%
Sale in year two	80%
Sale in year three	60%
Sale in year four	40%
Sale in year five	20%
Sale in year six	0%

A TAIL is used to recognize the fact that the influence of the retired, dead or disabled CEO on the value of a sale diminishes as time goes on.

David met with Jim as scheduled and presented the Plan. He had already had approval from the board chair. David could tell that Jim was at first pleased until he quickly realized that he would receive no award if the company with all its problems did not increase in value. Of course, this was the idea of such an incentive. David said the most recent year’s EBITDA was $400,000 and at a 5 multiple resulted in the $2 million value the Board had agreed upon as the base price. The task then was to improve the EBITDA and then sell the business. It would not be easy.

David then explained that he and Robin would do their best to help Jim improve the company’s financial performance and to continue to mentor the sons even though that no longer seemed as important.

Before Jim left, David told him he would prepare the first part of some operational suggestions and send them to Jim in the next two days (Robin already had prepared a draft). As Jim was going out the door David said: “Please have the office screen door repaired or replaced and painted and fix the potholes in the visitor’s parking area.” Jim just smiled.

David edited Robin’s suggestions, resulting in the following:

IMPROVEMENT SUGGESTIONS

Internal peer review
- Have Jack (main plant manager had resigned and Jack reluctantly had assumed the role) and Frank select 4 of their best people to form a team along with themselves to spend 4 morning hours in the others plant looking for suggestions for improvement. No holds barred. Nothing off limits. Each team will arrive 15 minutes before the first shift. Finish their tour by 11:00 AM and spend the next hour writing out their findings and suggestions. Before the day of the tour, Jack and Frank would select someone with a laptop or notebook to do the writing. David and Robin would join the teams at 11:00 AM to facilitate those sessions. At noon, the two groups will meet offsite to have lunch and in a formal manner present their findings with David and Robin to help if needed. The next step would be to organize a team for each plant to act upon the suggestions and then have a follow-up visit to see what has been done.(David had used this technique several times before with great results. He had been a peer review leader for KPMG and reviewed offices in Los Angeles, Jacksonville, Tampa, Toledo, and Duluth. This is how he got the idea knowing that a good reviewer learned as much as the office being reviewed.)

Change the compensation system of the sales team to commission only with a draw at 25% less than what they are making now.
Transfer Jack to the sales department to upgrade the company’s website with the goal of generating internet sales. Jack had shown that he was good with technology and actually had a small e bay business on the side. Jack also had contacts in Japan where his wife grew up in a wealthy family which owned a the multinational, retail home goods industry. Jack had been too shy to make that connection before but would now be prompted to do so. David never let on that he had met Jack’s wife at an alumni function at Gould Academy which both had attended at much different times.
- Promote the maintenance manager to the plant manager’s position.
Ask Sue to recommend any needed terminations with the presumption Jim would act on them.
Close the sawmill and buy only needed lumber from third parties. A small sawmill with a poor yield only working 2 full days a week is not economical. Let Dan retire to operate his farm as that is what he wants to do and where he can make a living.
After hours, collect the bank statements for 2013 and the electricity bills. David had seen something in his review of the financial statements that was unusual.
Ask Richard to quote on the company’s health insurance. The company had been using a local agent who was a friend of Charles and the premiums looked high.
Have the Board Chair prepare a shareholders agreement and an employment agreement with the equity appreciation right contract for Jim. All the deeds and insurance coverages were in order.
Ask Sue to chat with her local HR colleague to see what inexpensive “social” kinds of activities she arranges at her plants.
Become a member of the University of New Hampshire’ Penley Family Business Institute. Meetings should be attended by Jack, Dan (even as just a board member) and Jim.
Give George the task of researching time recording systems and outside payroll services. An integrated system should be much more accurate and save time in the monthly closing process.

RESULTS

The peer review teams were great. Each team found many items that needed improvement. The items listed and explained here are just a sample:
- The main plant exterior is filthy and needs not only a good clean up around the yard but at least patching of the paved areas if not replacement.
- The process of moving boards from the sawmill into the production process and the production process itself is way too slow with too many jam ups because some of the people on the line take unscheduled breaks or just do not care.
- No one is happy. Need a new leader and need to get rid of the malcontents. Tell the survivors they are special and show it with lunches and special rewards. It does not take much ; sometimes just a thank you from a leader.
- The boards from the sawmill have too much wane that leads to low yield and poor products. Do something about the sawmill.
- The inside of the plant is also a mess. Clean it up and put in a dust collection system.
- The time clocks only work half the time and in down time the employees waste their time doing manual entries.
- In the summer it is so hot in the plant that some of the women pass out. Get some fans.
- The parking lot in the secondary plant abuts the river and has no guide rails or other protection from skidding into the river in the winter.
- The glass roof in the secondary plant is so dirty that it is difficult to know it is even glass.
- The people in the secondary plant are too happy. Right!

It was a real high for David and Robin to witness the transformation.

The reduction in people in the main plant saved $125,000 with no loss of production. In fact the production per shift increased and the resulting furniture parts were mostly free from defects.
The saw mill closure with outsourcing saved $75,000 a year.
The new international exposure produced another $1.5 million in annual sales resulting in $200,000 of EBITDA
David’s review of the bank statements and energy bills revealed that a payables person was issuing checks over $4,000 a month payable to C. M. Power, an account he set up for himself playing off the name, Central Maine Power Company, the company’s energy supplier. The retained fidelity bond which had no deductible paid over $100,000 for the open years of the embezzlement. The payables clerk was fired, indicted, convicted, and sent to prison.
All the changes resulted in $550,000 of additional EBITDA which pushed the company value to $4,750,000.

Three years later while Jim was still CEO, the company sold for $5 million to an in-market competitor who insisted on the employment of Jack for his international connections.

Jim was delighted with his bonus of $300,000 and Jack and Dan still celebrate Christmas at the farm.