Is CG necessary in family firms?

Ownership and control are rarely completely separated within any firm. Often managers have some degree of ownership of the firms they control, while some owners have some control over the firms they own. It is reasonable to presume that greater overlap between ownership and control should lead to a reduction in conflicts of interest. Ownership by a company's management, for example, can serve to better align  managers' interests with those of the company's shareholders. However, to the extent that managers' and shareholders' interests are not fully aligned, higher equity ownership can provide managers with greater freedom to pursue their own objectives without fear of reprisal.

Founding families constitute an important and distinctive class of large shareholders. They are present in nearly one-third of the largest U.S. companies and control nearly 20 percent of all board seats. Referring to Colli as many as 90 percent of all businesses in the U.S. may be family controlled. Family investors usually maintain their ownership stakes for several generations have a majority of their wealth invested in a single firm and often serve as senior executives in the firm. Founding families typically have sufficient power to ensure that the firm pursues the family’s interests, but these interests are not necessarily the same as those of the firm or other shareholders. In the following it shall be discussed if a Corporate Governance system is needed to protect minority shareholders of families’ opportunism or if the unity of ownership and control reduce conflicts of interest on its own.

Agency theory argues that families influence the firm’s policies to meet their interests. They have powerful incentives to consume the firm’s resources since they bear only a part of the total costs. If they represent their own interests over those of the firm’s other stakeholders, conflicts over the distribution of wealth occur. Barth, Gulbrandsen, and Schone (2003) found that family firms are less productive than non-family firms, while Ellington and Deane (1996) indicated that family firms are less innovative and less likely to adopt total quality management. Chandler (1990) reports that family firms under invest in emerging technologies and devote insufficient resources to research and development. Burkart, Panunzi and Shleifer (2003) argue that family management, especially by descendants, is associated with poor decision making. Schulze et al. (2001) discussed how favoritism towards heirs and siblings can lead to family earnings such as favored employment and promotions, leading to resentment by non-family managers. Burkart, Gromb, and Panunzi (1997) suggested that families acting on their own behalf can adversely affect employees' productivity and redistribute rents from employees to the family. Morck, Strangeland, and Yeung (2000) concluded that these actions by family shareholders generate excessive costs that lead to lower returns in family firms relative to non-family firms.

In summary, founding families are in exceptional control positions to pursue their interests, indicating the potential for conflicts over the distribution of wealth between opposing shareholder groups. Agency theory suggests that outside shareholders are only protected when they have the power to limit large shareholders’ opportunism or their diversion of corporate resources. In family firms, however, many well-recognized corporate governance devices are less prevalent than in non-family firms. Barclay and Holderness (1989), for example, observed that the presence of large shareholders deters bidding by outside agents, suggesting that the market for corporate control is less effective in constraining families' actions. Kole (1997) reported that executives in family firms, relative to those in non-family firms, earn significantly less incentive-based compensation. Gomez-Mejia, Larraza-Kintana, and Makri (2003) documented that family-member chief executive officers (CEOs) receive even less incentive compensation than outside CEOs in family firms. Shivdasani (1993) suggested that unaffiliated-blockholder ownership is substantially lower in family firms than in non-family firms, again indicating a lack of strong external agents to discipline and control families' actions. Because of the relative lack of some governance mechanisms in family firms, outside shareholders potentially rely on boards of directors to monitor and control families' opportunism. In family firms, independent directors remain one of the primary lines of defence that outside shareholders can employ in protecting their rights against the influence and power of large, controlling shareholders. To enhance firm performance, independent directors potentially prevent families from directly expropriating firms' resources through excessive compensation, special dividends, or unwarranted perquisites. Independent directors can also impose structural constraints on the family by limiting their participation in important board subcommittees such as the audit committee, investment committee, nominating committee, and compensation committee. Perhaps one of the largest impacts that independent directors make in protecting outside shareholders from self-dealing families occurs when the board prevents an unqualified or incompetent family member from assuming the CEO post.


Effective board structure in family firms may thus require a prudent balance between the objectivity of independent directors and the interests of family-directors. On the one hand, calling for greater levels of board independence may prompt unproductive political activity by insiders or families that counteracts the objectivity of the independent directors and also reduces cooperative interaction between families and directors. Independent directors may also lack much of the firm-specific expertise of insiders and family members, resulting in poor strategic decisions. An effective board in family firms potentially includes both independent directors and family directors. Family board representation that goes unchecked, however, increases conflicts between family shareholders and outside shareholders over the distribution of firm wealth.


Although families can manage and manipulate the firm to their private benefit, the pervasiveness, size and long-standing patterns of their ownership potentially offer a different perspective on families’ motives. The stewardship theory argues that families may identify closely with the firm and act as stewards of corporate value. The board’s composition may depend more on the ability of the directors to provide expert advice and counsel rather than oversight and control of the family’s activity. Families, acting as stewards, may therefore constitute boards to assist in decision-making processes, collaborate in defining corporate strategy, offer improved access to information and capital, and generally to promote corporate welfare. Beyond monitoring and control advantages families have longer investment horizons, leading to greater investment efficiency.


To sum up all this, corporate governance system is a needed instrument to protect the interests of the minority shareholders in a family firm. Even if family members that are in charge of the company act as stewards and try to maximize company’s income, other instances of control are needed to limit the family’s expropriation of wealth from minority shareholders. Gomez-Mejia et al. (2003), Shivdasani (1993), and Kole (1997) found that the takeover market, institutional investors and incentive compensation are potentially less prevalent governance mechanisms in family firms than in non-family firms. Westphal (1998) indicated that boards of directors can have an especially important role in promoting firm performance when alternative governance mechanisms are weak, as they are in family firms.