Family-owned firms have proven crucial in pushing an agenda for better business governance structures. The number of family enterprises has allowed this large grouping of companies’ great influence on national economic development in both developed and developing countries. In Europe, family businesses contribute between 30-60% of gross domestic product (GDP) (IFERA, 2003). According to recent surveys released by the Family Firm Institute (FFI), family firms impressively contribute an estimated 70-90% of global Gross Domestic Product (GDP) annually. Besides ownership structure, the main factors distinguishing family firms from other corporations are their management styles, the level of motivation among founders, family values and decision-making processes.
In Malaysia, it is estimated that family businesses contribute more than half of the country’s GDP, resulting in family firms supplying an essential role to one of Asia’s largest economies. Approximately 80% of the companies listed on the Bursa Malaysia (formally known as the Kuala Lumpur Stock Exchange) are family-owned with the exception of quasi-government owned firms, state development corporations, banks and multinational corporations. This current global family business trend supports recent studies which claim that family businesses experience higher firm performance than non-family businesses. In the following article, Dr. Tze San Ong of Faculty of Economics and Management, University Putra Malaysia, Malaysia, explores the challenges and advantages that come with family-ownership by way of agency theory and the correlation between board size and performance.
Advantages of family ownership
There is an emerging view, which emphasises that family-ownership could bring benefits to the private sector by creating value for firms. Based on empirical studies, family-owned firms are broadly believed to contribute greatly to entrepreneurship and are actively involved in innovation and technology. Managerial prejudice is observed at lower rates, helping the long-term strategic focus of firms. The close relationships between founding family members enable them to forge strong ties with shareholders, suppliers, customers and employees, in effect strengthening the company’s environment for good business. Furthermore, the significant presence and involvement of family members in the business often lead to family firms maintaining lower levels of debt than non-family firms.
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Family versus Non-family Firm Performance
Despite noted data published in favour of family-owned businesses, additional studies have yielded mixed results related to the performance of family firms versus non-family firms. Some argue that family firms are likely to accomplish greater performance than non-family firms due to their ability to achieve a higher sales turnover and better net profit margin than others. This is to a great deal explained through the presence of family CEOs, who serve the business with more emotional investment than managers in non-family controlled firms. Moreover, previous studies from several researchers explain that active family firms remain superior performers in terms of profitability due to the family’s vision to maintain the business for coming generations.
Conversely, there are other factors which demonstrate negative results of family-ownership. Firms with large family shareholding tend to experience agency problems, which are related to behaviour and occurs as a result of wealth expropriation. Family shareholders may misuse their power and control to shift company profits towards individual interests. In some family firms, family shareholders tend to have badly defined roles and responsibilities. Thus, there is a danger that family members may make decisions that benefit personal bottom lines before the interests of the company. Furthermore, family firms sometime show a lack of concern for maximising shareholder value and instead focus on corporate growth or maintaining the family’s reputation, which in turn provoke challenges related to greater agency costs.
Agency costs in family firms
The principle of separation between ownership and management, according to the agency theory, suggests that the principal agent conflict occurs due to differing interests. While managers may pursue individual interests, shareholding owners are more likely to target maximising the value of investment. In the case of the family business, the likelihood of this situation occurring is heightened. Contradicting interests can cause an asymmetry in motivations related to the business and higher agency costs for family managers and other shareholders. In Asia, studies have highlighted that agency problems have a significant influence on creating conflicts between family-controlled owners and minority shareholders.
A leading curiosity is whether family-ownership could provide better incentives to minimise agency costs or avoid unwanted spending altogether. Agency costs can be reduced through several means:
• If there is a concentrated family shareholdership, the right incentives for family members can minimise agency costs.
• If active family members are able to monitor their managers’ performance and thus create an effective flow of information, the likelihood of agency costs is reduced. In other words, family members and managers can act as a control mechanism for cost-based decisions, supported through effective communication. Well-established family firms tend to employ meaningful discourse, in turn avoiding opportunistic behaviour in order to protect their family name and reputation and to maintain superior performance.
• The presence of family members may allow monitoring effective operations and activities. This furthermore supports family firms’ attempts to maximise shareholder value. Meanwhile, the uniqueness of family relationships enhances loyalty and improves the efficiency of communication during decision-making processes, which may be able to reduce agency costs.
Board size matters
To reduce agency costs successfully, the role of an effective board cannot be underestimated. In the fight to counter the negative effects of the agency theory, boards play a crucial role by binding family owners, family managers and non-family managers into an interactive system.
Board size, as defined by the number of directors present, affects the governance mechanism, which in turn influences family ownership and firm performance. Recent studies have identified a negative correlation between large boards and performance. It is a widely held notion that small boards are considered more effective than their larger counterparts.
Empirical studies underline that boards which consist of more than seven or eight members are usually less effective. The studies’ results explain that larger boards lead to poorer communication, improper management and decision making, which favours a majority of directors effectively being controlled by the CEO. In addition to this, large boards can cause unnecessary conflicts as a big number of directors tend to be less united and more difficult to control.
Small boards that consist of at most five board members can be monitored more easily from an earnings point of view. Additionally, a small board is more effective at making decisions on executive replacement than a large board. However, there are downsides to having a small number of board members. One of the difficulties is the search for the right candidates to fill vital positions, especially those involving non-family directors. One cause is the lack of relevant sources of information and contact points within the company.
Family firms are crucial contributors to global GDP. Their efficiency and organisational structure are essential to maintaining a country’s financial solvency as integral members of economies in nations big and small all over the world. In order to effectively harness this potential, it is key for agency theory to be properly understood. The theory highlights the challenges of building companies with overlapping ownership and management systems.
Furthermore, large amounts of evidence point to using small and efficient boards as a tool to avoiding the pitfalls of the agency theory. Navigating agency theory and its related nuances stands as an extremely beneficial means for insuring the success of family-owned businesses in all structures.
Tharawat Magazine, Issue 20, 2013