By Professor CHEN Tai-Yuan
Department of Accounting
HKUST Business School
Family businesses should strive to be more transparent, and recruit more external parties to governing positions.
Family ownership is one of the most prevalent forms of corporate governance. Taking the largest 30 firms in terms of market value on the Hong Kong stock exchange as an example, more than 50% of them are controlled by their founder or founder descendants. Similar observations apply to the Taiwan stock exchange. Family firms are not only popular in the Greater China region but also in Western countries. Even in the U.S., contrary to traditional belief, family ownership appears in a wide array of industries.
Corporate governance of family firms versus non-family firms
Perhaps not surprisingly, family firms tend to have fewer independent directors on the board because they are inclined to put family members on the board. Similarly, due to family shareholdings, family firms have lower institutional ownership. If we use traditional standards of corporate governance, family firms may appear to have “worse” corporate governance as compared to non-family firms. However, family firms are found to have a better performance in particular when founders are involved. Thus, we can consider family ownership as a unique form of corporate governance which contradicts the typical academic definition of good governance.
Why are family firms unique?
In a typical firm, ownership is diffuse, with no individual block holders. Managers hold some shares, but they are not majority shareholders. For example, in Apple, the top five executives together held less than 1% of the firm’s common stocks in 2022 (after including their restricted stocks). In contrast, taking Fast Retailing as an example of a family firm, the founder Tadashi Yanai and his sons and wife together directly hold around 33.21% of Fast Retailing’s outstanding shares based on the 2022 annual report. This very different ownership structure leads to different agency problems in family versus non-family firms.
A typical agency problem in these widely held firms is the misalignment between the managers’ and shareholders’ interests. Simply put, a manager may not exert effort to maximize a firm’s performance as he or she only has small share of it. In contrast, he or she may engage in some self-dealing behavior such as using company aircraft for personal purposes or having extravagant meals on a business account. Furthermore, executive compensation in the U.S. is known to be high, and some scholars, such as Lucian Bebchuck and Jesse Fried in the Journal of Economic Perspectives Summer 2003 issue, argue that such pay is excessive and is driven by management’s self-interest.
Relative to diffuse firms, family firms are characterized by a better alignment between shareholders’ and managers’ interests when the controlling family is also the CEO, or holds any other senior management post. Notably, while family firms have stronger incentives to maximize a firm’s performance as they are also large shareholders, family firms have their own unique agency problems. With large shareholding and less monitoring by independent directors or institutional owners, controlling shareholders can undertake actions to benefit themselves at the expense of minority shareholders. For example, they can engage in related party transactions or channel benefits to other firms under their control.
How can family firms be more credible in the capital markets?
(1) Be more transparent: a company’s information consists of financial reports and information intermediaries such as auditors or financial analysts. As mentioned, family firms tend to have lower institutional ownership due to their own shareholdings. Thus, family firms are often perceived to be more opaque than non-family firms, which may lead to higher financing costs and reduce stock liquidity. While family firms may not worry about the short term stock performance of their firms, they nonetheless should increase transparency, which can help enhance investor confidence and in turn reduce their financing costs. For example, controlling families could provide more financial/non- financial information during conference calls with financial analysts or at the annual shareholder meeting. Furthermore, family firms could issue more earnings forecasts to alert investors about a better or worse than expected financial performance, and they could also offer more information on their company websites. These actions not only increase the transparency of a family firm but also change their credibility in the capital markets. Our research indeed finds that corporate transparency matters more for family firms relative to non-family firms. 1
(2) Become more externally governed: family firms, particularly those in Asia, tend to have descendants succeed the company not only as the chairman of the board but also as the CEO of the firm. While family succession has benefits such as ensuring company direction and philosophy, it unavoidably creates an image that the firm is family governed. Importantly, when founder descendants succeed to the chairman or CEO positions without competition, outsiders and shareholders may perceive the selection to be based on blood rather than merit. Indeed, both anecdotal evidence and academic research find that family firms’ superior performance disappears when founder descendants take over as management, which is consistent with the old Chinese saying that a family won’t sustain the wealth for more than three generations. One way to mitigate this downward spiral is to crown one family member as the chairman of the board and appoint a professional manager as CEO. One good example of this practice is Walmart, which is a world-renowned family firm controlled by the Walton family. When Walmart’s founder Sam Walton passed away, his elder son, Robert Walton, succeeded as the Board Chair, while a professional manager was appointed as the CEO. Under the Walton family, Walmart continued to grow to become one of the largest and most successful firms.
(3) Embrace higher ethical standards: holding key management posts and having long-term involvement with their firm accords controlling family members access to confidential company information. It is therefore easy for them to unload their shares to reap profits on the basis of undisclosed inside information. Of course, sometimes controlling families do need to dispose of some shares for personal reasons, such as paying tax. However, based on my observations, stock sales by the CEO or the Chair of the board typically lead to stock downturns, as investors consider the sales to show a lack of confidence in the firm’s prospects, and the stock downturns are more pronounced when the sales are carried out by the controlling family. As such, if it is deemed necessary to sell their shares, I would recommend the controlling family to do it “routinely” annually, in a given year, and communicate the stock transaction in a transparent way to avoid any suspicion. Further, related party transactions are often observed between firms controlled by the same family, and these can arouse investors’ concerns over self-dealing or channel stuffing. Again, if related party transitions are unavoidable, the controlling family should at least appoint an independent committee and engage an independent outside third party to review and endorse the deal, and the process should be transparent. In short, greater ability comes with great responsibility, so if controlling families would like their firms to be long-lived, they ought to impose higher ethical standards on themselves whenever they are involved in their company business.
References
- A. Ali, T. Y. Chen, and S. Radhakrishnan, “Corporate disclosures by family firms” Journal of Accounting and Economics, Vol. 44, Issues 1-2, 2007, pp. 238 – 286. T. Y. Chen, S. Dasgupta and Y. Yu, “Transparency and financing choices of family firms” Journal of Financial and Quantitative Analysis, Vol. 49, No. 2, 2014, pp. 381-408.