Board Independence and Expropriation Risk in Family Run Businesses

Introduction

Due to their significant stock ownership and control, founding families are generally immune from the disciplinary forces associated with the market for corporate control. As a result, founding families may spend cash on the pursuit of private benefits such as perquisite consumption, empire building, excessive compensation, and subsidizing and sustaining unprofitable projects or divisions.

Consistent with this intuition, Dittmar and Mahrt-Smith (2007) find evidence that an extra dollar of unexpected cash holding is less valuable to shareholders at poorly governed firms due to the higher risk of expropriation. One way to mitigate this problem is for family firms to appoint independent directors to the board in order to mitigate managerial self-interest and monitor corporate activities.

This study examines whether independent directors protect non-family shareholders by protecting the corporate assets from wasteful spending by controlling families. Specifically, I examine how board independence impacts a firm’s efficiency in utilizing cash reserves.

Economic theory argues that agency conflicts arise from the separation of ownership and decision control in corporations (Fama & Jensen, 1983). Agency conflicts are generated when the owner-manager sells equity claims on the corporation (Jensen & Meckling, 1976). The fractional owner-manager has an incentive to use the assets of the firm for his own benefit because he bears only a fraction of the costs of any benefits he takes out. Therefore, monitoring mechanisms are implemented to minimize agency costs by limiting managers’ aberrant activities.

Jensen and Meckling (1976) argue that managerial ownership aligns interests between managers and shareholders. This incentive alignment effect is expected to have more impact as managerial ownership increases, suggesting that as managerial ownership increases, opportunistic managerial behavior decreases monotonically. Stulz (1988), however, argues that managerial entrenchment occurs when managerial ownership is too high. Once managerial ownership exceeds a certain point, managers gain nearly full control and are wealthy enough to prefer to use firms to generate private benefits of control that are not shared by minority shareholders. Stulz (1988) presents a formal model of the roof-shaped relationship between ownership and performance.

Founding families are in an uncommon position to exert influence on key business decisions, serving as top executives or CEO in 63% of family firms and serving on the board as directors or chairman in 99% of family firms (Ali, Chen, & Radhakrishnan, 2007). Moreover, unlike managers in firms with widely dispersed ownership, founding families in family firms hold a significant stock ownership. In addition, families usually use control-enhancing mechanisms that include voting structures enabling the family’s voting rights to exceed cash flow rights. Founding families’ involvement in management, significant stock ownership, and control premium cause family firms to be more subject to entrenchment problems.

In family firms, two important governance mechanisms are more limited or constrained relative to non-family firms. For example, Shivdasani (1993) reports that ownership by blockholders unaffiliated with management is significantly lower in family firms than in nonfamily firms. Stulz (1988) also argues that when managers control a large fraction of the firm’s voting rights, hostile takeovers are very difficult or even impossible. These results suggest that the market for corporate control, and institutional investors are less effective in dealing with agency conflicts in family firms. This feature aggravates the entrenchment problems of founding families in family firms.

However, founding families have incentives to bond themselves by adopting other governance mechanisms. If the equity market anticipates that families will extract high levels of private benefits when they still hold a substantial amount of shares, outside shareholders will discount the stock price accordingly, and the families’ share value will be reduced. Therefore, founding families are likely to make an effort to commit to outside investors not to expropriate firm resources in order to convince the equity market.