This is Why You Should Think Twice Before Mixing Business and Family

Wesley Gray  |

Families are a basic and universal institution of human society that provide a network of relationships, safety and support, allowing the transmission of values and education across generations. Blood is truly thicker than water.

These characteristics uniquely position families to guide and sustain organizations over time. For instance, the loyal bonds of family, when paired with ownership of a corporation, can be a powerful business driver. Yet, family ownership in a corporation sets up some basic conflicts, or agency problems, that must be resolved for the corporation to flourish.

fat cat

In academia, the term “agency problem” refers to the conflict of interest that can arise between a principal and an agent who acts on behalf of that principal. The conflict arises when the self-interest of the agent influences him to act in a way that is inconsistent with the principal’s best interests.

In a corporation, managers (agents) make decisions that are supposed to benefit stockholders (principals), but problems arise when they don’t do so. For instance, a manager might draw excessive compensation, reducing corporate capital available for reinvestment or distribution that would otherwise benefit the company’s owners. In the context of investment management, a hired investment manager may avoid the best long-term investment opportunities and, instead, choose to “closet index” as a way to minimize career risk concerns.

This is the classical agency problem, as first discussed by Berle & Means back in 1932, and later expounded upon in a seminal paper by Jensen and Meckling. Since then, the literature has expanded to incorporate the interests of various stakeholders and different types of organizations, notably including family-owned firms.

In a recent paper, “Governance of Family Firms,” by Villalonga et al., the authors explore traditional agency problems in the context of family-owned firms, and identify a new dimension to agency conflicts in family firms.

The authors divide agency problems into four areas:

This is the classical agency problem, as discussed above, which can add complexity for family-owned firms due to such factors as a family’s emotional ties to the business, shared family wealth, and nepotism.

This problem relates to how large family shareholders can acquire “private benefits of control” that hurt smaller non-family shareholders. These include the following: excessive voting rights or board control, entrenched family managers, mismatch of control rights versus cash-flow rights, and “tunnelling,” or the “transfer of assets and profits out of firms for the benefit of their controlling shareholders.” In extreme cases, when “dynasty” families control large swaths of an industry, it can lead to corruption and inefficiencies that can have implications at a macroeconomic level.

This agency problem typically involves a tradeoff between two forms of equity/debt conflict:

Here, the authors introduce a new agency problem: conflicts between family shareholders and the broader family who are not managers or shareholders. These “super-principals” may have an interest in non-financial aspects of the firm, including preserving the family’s reputation and legacy, giving back to the community, or protecting the environment. Here, family shareholders’ financial interests (e.g., maximizing the value of a share or increasing the dividend) can conflict with these objectives.



Next, through the lens of family-owned firms, the paper examines how various governance mechanisms can address these 4 agency problems:

Ownership Concentration

Boards of Directors

Executive compensation

Reducing free cash flow through debt or dividends

Family governance mechanisms

The existence of family members within the ownership structure of a firm can clearly complicate traditional agency theory questions. Family ownership creates a set of challenges and opportunities that distinguish family firms from the broader corporate landscape. While the academic literature around “family governance” topics continues to grow, there is much fertile ground to investigate. We look forward to additional analysis on how family corporate governance can address the unique agency problems faced by family-owned firms.

As an aside, I’ve personally lived through some family business governance challenges and I’m happy to share my thoughts and insights for those who are struggling and looking for a sounding board. Just contact us and ask for “David.”

This is Why You Should Think Twice Before Mixing Business and Family was originally posted by David Foulke at Alpha Architect. Please read the Alpha Architect Disclosures at your convenience.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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