The Advantages of Family Ownership

While analysts lavish praise on entrepreneurs, they are often less generous to one of the legacies of entrepreneurship — the family firm. Many fear that founding families can too easily work to benefit their own interests at the expense of other shareholders — for example, by treating the company as a family employment service or a private bank.

As a group, however, founding families are unjustly maligned, according to a new study of large, publicly traded U.S. firms. In “Founding-Family Ownership and Firm Performance: Evidence From the S&P 500,” slated for publication in the Journal of Finance, Ronald C. Anderson and David M. Reeb report that companies with significant levels of founding-family ownership or control typically outperform industry peers.

The authors combed through proxy statements from 1992 to 1999 for 403 nonbank, nonutility members of the S&P 500 to identify companies that reported stakes held by founding-family members or had founding-family members serving on the board. Their search revealed 141 family firms, representing 35% of the sample, with an average family shareholding stake of 18%.

Their research measured return on assets as EBITDA — earnings before interest, taxes, depreciation and amortization —scaled by the book value of total assets and controlled for firm age, size, risk, growth opportunities, capital structure, corporate governance mechanisms and industry.

Using regression analysis, Anderson, an assistant professor of finance at American University, and Reeb, an assistant professor of finance at the University of Alabama, discovered that these companies were more profitable than non-family firms. For the average company, the data associated founding-family participation with a boost in return on assets — rising from 15.05% to 16.05%. Similarly, investors tended to value family firms more highly — on average, Tobin's Q, the market value of a company's assets divided by their replacement cost, was 10% higher for this group.

In theory, the same pattern could emerge even if ownership had no impact on performance. However, by employing a statistical technique known as instrumental variable regression, the researchers showed that ownership does influence performance, even if, to some extent, performance also determines ownership.

In explaining why ownership matters, co-author Reeb suggests that family firms are probably more successful at keeping ambitious managers in check. Family members have strong incentives to watch managers closely, since their stake in the business often accounts for a large proportion of their wealth. Equally important, when compared to outside investors, family members are likely to have better information about business operations. This makes it harder for managers to divert resources into activities that destroy shareholder value, such as empire-building or the consumption of executive perks.

Moreover, family ownership can have other benefits, according to John A. Davis, senior lecturer and faculty chair of the family business executive education program at Harvard Business School. Family firms typically have longer planning horizons, which can result in smarter investment decisions, he explains. They often focus more on quality because family members identify closely with the business. And when family members actively participate in management, they can command greater loyalty within the organization while promoting stability in relationships with key customers, suppliers and banks.

On average, these advantages appear to outweigh the potential hazards associated with family ownership, but as Reeb is quick to acknowledge, the potential for conflict between family and outside shareholders remains. Even family members with good intentions can clash with well-diversified investors over issues such as investment policy, while less honorable members may find ways to dip directly into the company till.

Such concerns help to explain why performance gains associated with family ownership start to fall once a family's shareholding exceeds 30%. Beyond that level, the dangers of family ownership appear to increase. “The propensity to monitor is greater, but so is the ability to expropriate,” Reeb observes.

Good corporate governance can help companies to minimize the risks of family ownership while allowing them to reap the rewards. Independent directors, for example, can reassure investors and help protect families from themselves. In addition, says Harvard's Davis, thoughtful planning can provide a more secure foundation for family firms. Founders in particular, he says, are often reluctant to dilute their holdings in the belief that “the best investment is the one you control.” A wiser policy, he believes, is for the founders to diversify into assets that can be passed on to family members whose involvement in the firm might become a liability. In this way, companies can limit ownership in the family business to those both willing and able to make it work.

Prior to publication, the paper can be downloaded at http://www.afajof.org/Pdf/forthcoming/FF_Ownership.pdf.