Reprint permission from the September, 1993 issue of Crain's Small Business.

One way to protect both the family and the new executive is to create a compensation package that features the financial rewards of stock ownership, without the drawbacks.

More often than not, high-level executives joining family-run businesses expect an equity stake in the company.

After all, the business' long-term success will depend on the chief executive's leadership, and that person should be fairly rewarded for performance.

In many cases, however, an out-right grant of stock is in nobody's best interest. The family is better served by creating an incentive for the CEO to work hard and well, not by giving away shares just because a new executive is joining the company.

And the executive gains little by becoming a minority shareholder in a closely held company unlikely to pay substantial dividends.

Both sides may lose if the executive leaves the company sooner than expected and the shares must be bought back at a disputed fair market value.

One way to protect both the family and the executive may be to create a compensation package that features the financial rewards of stock ownership, without the drawbacks.

The simplest approach is to enter into a "termination agreement," in which the family and the new CEO agree on sales or profit goals to be achieved by a given date.

If the CEO remains with the company until then and the goals are met, the executive earns a predetermined bonus. From there, new goals can be established.

A variation on that theme: A bonus payment based on the executive's compensation can be made payable on a specified retirement date.

• If the executive leaves the company prematurely, the bonus can be forfeited or scaled back by a vesting schedule.
  
  
• But if the executive sticks it out and does the job, that tenacity and performance will be rewarded.

Carefully designed compensation strategies such as these generally defer the executive's tax bite -- and the company's tax deduction -- until income is received.

But there is also a risk with payouts, particularly for executives of entrepreneurial companies. The executive who patiently awaits a future payout date could find that the company cannot then meet its contractual obligations.

And the executive of an insolvent company stands in line with its other creditors, perhaps never to be paid.

There are solutions, and here's how an increasingly popular one works: The company pays bonuses into a specifically designed life insurance contract on the CEO's life.

The fund grows tax-free and, at retirement, the executive receives tax-free income through withdrawals and loans from the contract's cash value. Should the executive die, his or her designated beneficiaries receive either a lump-sum payment or an annual income.

Because these are commitments of a strong insurance company and not of the employer, the executive's eventual payment is not dependent on the employer's long-term fiscal health.

The CEO's price for the security: an income tax payment on every year's bonus as it is deposited with the insurance company. Some employers fund this employee income tax cost through an "extra" cash bonus, made less painful by the employer's current tax deductions for all the bonuses it pays.

The prudent family-owned business and its new CEO should establish reasonable expectations and, with knowledgeable counsel, tailor the compensation package most likely to encourage productive service over time.

As often as not, equity ownership may be passed over in favor of an alternative with more rewards and less risk for both the company and its executive.

Marc J. Lane (mlane@marcjlane.com) is a Chicago lawyer and financial planner and an adjunct professor of law at Northwestern University School of Law.