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Penny Baker always considered himself the "huggy, touchy" type. Indeed, the 38-year-old Austin entrepreneur -- a former car salesman whose first business consisted of selling "Bad Cop, No Donut" T-shirts in the back of

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magazine -- is the opposite of stuffy. So in 1997, when he founded National Bankcard Systems, he wanted the provider of credit card terminals and Internet payment systems to be as friendly as possible.

He hired close friends for key positions and socialized with his staff on a regular basis, going out for happy hour or dinner as often as four nights a week. The company thrived, growing to 75 employees and $5.3 million in sales in just three years.

But Baker began to sense that his huggy, touchy managing style was no longer working. A number of employees, all of them perfectly pleasant as drinking buddies or dinner companions, had grown complacent, behaving as though they had earned some kind of tenure. Even some longtime friends were slacking off. "I figured if I hired my buddies, they'd work their butts off for me," Baker says.

Instead, he had to fire two of them. The last straw came one night at happy hour when one of his salespeople -- the brother of a college pal - -got drunk and proclaimed that he could do a better job than Baker and was starting a rival business. It was then that Baker realized he had a lot to learn about the difference between being a friend and being a boss.

The fact is, there are no clear-cut rules when it comes to mixing business and buddies. At big corporations, with their often elaborate and rigid hierarchies, this isn't much of a problem. But small companies tend to be far less formal, often behaving more like families. That puts entrepreneurs in a tough spot. Act too chummy and you risk losing employees' respect.

But behave too formally and you sacrifice the team spirit and bonhomie on which small companies thrive. "When you show employees that you care about them as people, they may feel an emotional attachment to you and work harder," says Glenn Okun, a professor at New York University's Leonard N. Stern School of Business who advises CEOs. "But there's also a significant risk involved."

In Baker's case, "hugginess" felt perfectly appropriate when his company was small. But once National Bankcard reached new levels of size and sophistication, he knew it was time to separate the ranks. "It's not that I think I'm better than my employees," he says. "But I don't want people to feel like I owe them anything because we're friends."

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The happy-hour incident only served to drive that point home. So Baker changed his approach. He still prides himself on being a nice boss who encourages employees to have fun -- say, throwing officewide pizza parties to celebrate strong sales. But he says he keeps employees at "arm's length" now, behaving in a more businesslike manner, and avoiding any involvement in their personal affairs.

Baker keeps employees at "arm's length" now, behaving in a more business-like manner and avoiding involvement in personal affairs.

Baker has also handed off nearly all human resources functions, including hiring and firing and employee evaluations, to his COO, Pete Estep. The transition was difficult for some longtime employees. But Baker thinks the company is actually stronger now. "Employees like a steady ship," he says. "I knew I needed to build a stronger foundation for them." Since changing his approach, staff turnover has decreased about 35%, he says. Meantime, he's instituted a "no-friends" hiring policy.

Of course, forming close, personal bonds in the workplace sometimes can be a smart management strategy. Employees with a strong connection to their bosses are more likely to be loyal, work harder and stick around longer, says Denise Rousseau, a professor of organizational behavior at Carnegie Mellon University, who recently asked top executives at 80 start-ups about their human resources strategies. Most of the CEOs surveyed, she says, found a friendly and congenial office atmosphere to be a competitive advantage. Such an environment "can beat off alternative job offers and itchy feet," Rousseau says, and is as effective a motivator as bonuses, raises, and other typical perks. That's especially true at small companies, where entrepreneurs often expect employees to work long hours and be willing to wear many different hats.

That said, Rousseau is not suggesting bosses open up about the nitty-gritty details of their personal lives. "But if you're having a bad week because your son's been sick," she says, "better to let them know than have them wonder if the company's in trouble." Meanwhile, explaining your personal motivations for founding the business encourages employees to buy in to the company's mission. And taking an interest in employees' home lives or kids' soccer teams conveys that you're interested not only in their professional success, but in their personal struggles, as well -- another great motivator, Rousseau says.

But having pals on the payroll can also lead to unpleasant situations. Take Mike Maddock, the 38-year-old founder and CEO of Maddock Douglas, an advertising agency in Elmhurst, Ill. Last summer, Maddock was forced to admit that one of his writers -- a close friend who had been with the company for two years -- simply lacked the skills the agency required. Maddock knew what he had to do, but put off the decision for months. "It was agony," he says. Finally, he called his friend into his office and suggested that he begin looking for a new job. Fortunately, the man was understanding. Maddock kept him on the payroll during his search, which lasted just three months. "He's still my friend," Maddock says. "But I don't think his wife is."

The experience led Maddock, like Baker, to stop hiring friends. But little else has changed. Maddock sees no reason why he can't be chummy with his 38 staffers. The work atmosphere is casual, and Maddock stays up-to-date with what's going on with his staffers' families, who are invited to the office for regular gatherings, such as a Halloween party last fall. That said, Maddock rarely socializes with his employees. "It's difficult to be objective when you know too much," he says, "so I keep a bit of distance." It's one thing, he says, to hear about an employee's wedding plans; it's an entirely different matter to get involved in marital problems. But sometimes, friendship happens. Maddock, for instance, has grown extremely close with his chief operating officer. The two men work extra hard to compartmentalize their business and personal relationships, he says. "We both give work our all and have no problem switching gears to help each other be better people outside of work," he says.

Maddock's approach wouldn't fly in every office. Employees working in highly technical fields, such as engineering, generally are uncomfortable making friends with the boss. And if you're not an open person by nature, faking it can be disastrous, making you appear insincere and phony. Says NYU's Okun: "You can't make chemistry."

Baker, for his part, had the opposite problem: too much chemistry. He'd never go back to his old huggy ways. But after two years, he recently broke his own rule against hiring friends and reluctantly brought on a longtime pal who wouldn't take no for an answer. He made it clear that working together could mean the end of the friendship if, say, the business starts to falter. "We're rolling the dice," he warned him. "If it doesn't work out, you, your parents and your wife may blame it on me." So far, Baker is happy to report, it's going pretty well. "I think there are exceptions," he says. "But is it worth losing a friend to find that out?"

Nadine Heintz is a staff writer at Inc. Magazine. This article was originally published in Inc.