Corporate governance has become an industry – and a growth one at that. Conferences spring up like mushrooms after rain. Technical assistance money gets spread around like so much fertiliser, and acres of rain forest end up as expert papers on “new and improved” corporate-governance frameworks. Policymakers and investor groups seem to love it. But do the real decision-makers – business owners and managers – actually need or want corporate governance, and, if not, why should we expect them to buy into it?
Most corporate governance experts concentrate their attention on divergent incentives of managers and shareholders. Disclosure rules are intended to stop managers from inflating company performance. Boards of directors are established to guide managers’ business strategy, to monitor their reporting systems and to ensure that managers do not overpay or entrench themselves at shareholder expense. In general, the corporate-governance world pictures owners and managers as sitting on opposite sides of the table.
But what happens when the owner is the manager? This situation is more widespread – and more relevant to large companies – than many might think. Family-run businesses account for more than 85% of all firms in OECD countries. Such businesses make up 30-40% of the 500 largest companies in the United States. The 30 OECD member countries contain at least 244 family-run firms with annual revenues of more than US$1 billion, not counting giants like Microsoft or Berkshire Hathaway that are still managed by their founding generation. OECD family-run businesses with annual revenues of several million dollars probably number in the tens of thousands.
In a family-run firm, a single person or group enjoys a controlling interest and can 19 appoint family members as managers, or can unilaterally appoint, monitor, compensate and fire third-party managers. This situation may threaten minority shareholders with exploitation, but offers the controlling family the best of both worlds: it can run the business as it sees fit and gamble, at least partly, with other people’s money. As a consequence, if the purpose of corporate governance is to constrain managers and control shareholders, one may well ask whether a family-run firm would ever really want it.
The answer to this question is “yes”, but not necessarily for the reason most commonly given: better access to capital. One often hears the argument that, when investors refuse to put their money in companies with bad governance, the cost of capital for such companies goes up, making them uncompetitive. Eventually, so the argument goes, the owners/managers of such companies must either mend their ways or go out of business.
But firms can obtain external financing in a number of ways besides issuing shares to the public, such as reinvesting profits, borrowing money or selling shares through private placements.
In such cases, providers of non-public sources of capital (banks, pension funds, insurance companies, venture capitalists, private-equity investors, etc.) expect to look out for themselves. They will want to secure their loans with company assets, to be able to accelerate repayment of loans if the company’s performance falters, and to review books and records directly. They will seek direct assurances from the company’s auditor and officers, or personal guarantees from the company’s owners. They will demand the right to approve major transactions or money transfers. For these capital providers, typical corporate-governance practices, such as board review of transactions between management and the company, board committees, non-executive directors, or separate CEO/board chairmen, hold little interest.
Data on family-run firms raise additional questions about the access-to-capital argument. Of those 244 OECD family-run firms with revenues of US$1 billion or more (“large firms”), only half are publicly traded. At the same time, the average ages of publicly traded and privately held large firms are about the same, suggesting that large private firms have been able to access sufficient capital without inevitably “evolving” into publicly traded firms.
This observation is bolstered by European data showing that the average company operates for 40 years before going public, and that when such a company does go public, nearly 60% of the money raised from its initial public offerings goes into the pockets of family shareholders rather than into the business. In many cases, therefore, wealth diversification or liquidity may be a greater issue for family-run businesses than financing operations.
Studies indicate that the stronger a country’s corporate governance, the more robust its capital markets and the higher its level of external financing as a percentage of GNP. However, while these findings may persuade policymakers, at the level of the individual family firm the slogan “embrace corporate governance in order to access capital” can remain a tough sell.
Fortunately for the corporate-governance industry, a compelling case for corporate governance can still be made, and it involves the greatest challenge family-run businesses face: management succession. Succession issues resonate strongly with business owners. While the founder of a family-run firm might believe that raising money or diversifying wealth will never pose a problem, one thing he does know for sure is that some day he will die.
Will his children be interested in running the business? Will they be capable? Will they get up as early, stay as late, and work as hard as the founder did?
Keeping a business going across generations is hard. In fact, North American and UK studies indicate that only about one in six family-run firms survives to the third generation. Failure to maintain the family business can stem from any number of causes. Divisions form between those relatives enjoying both salaries and dividends and those receiving only dividends. Jealousies emerge as some family employees rise higher than others or work less hard for the same pay. Supervisors find themselves incapable of firing an under-performing subordinate who is a child or a sibling or a cousin.
As the business grows and markets evolve, finding sufficient managerial talent and experience within the family becomes harder. Where the family decides at last to hire an outside manager, failure to motivate and monitor him can damage or destroy the business.
Corporate governance goes to the heart of these problems, though many family-run firms have never thought of it in these terms. Families need corporate governance both to operate the business and to promote family harmony. This means putting in place decision-making and monitoring procedures that are open and fair, as well as possibly hiring non-family members as advisors, managers and directors.
It is not an overnight exercise, and often, by the time the need for corporate governance has been recognised, family relationships or the business’s prospects have deteriorated beyond repair.
Family-run businesses can represent the work – and the wealth – of several generations. If business owners want to preserve, enlarge and pass on this legacy, they need to make corporate governance a family affair.
Rydqvist, K. and Hogholm, K. (1995), “Going Public in the 1980s: Evidence from Sweden”, European Financial Management, Vol. 1, No. 3.
La Porta, R., et al (1997), “Legal Determinants of External Finance”, The Journal of Finance, Vol. LII, No. 3.
OECD (1997), Best Practice Policies for Small and Medium-sized Enterprises, Paris.