Academic journal article Entrepreneurship: Theory and Practice

Comparing the Agency Costs of Family and Non-Family Firms: Conceptual Issues and Exploratory Evidence

Academic journal article Entrepreneurship: Theory and Practice

Comparing the Agency Costs of Family and Non-Family Firms: Conceptual Issues and Exploratory Evidence

Article excerpt

Family involvement in a business has the potential to both increase and decrease financial performance due to agency costs. In this article we discuss the different nature of agency costs in family firms and specify the combination of conditions necessary to determine the relative levels of agency costs in family and non-family firms through the impacts of agency cost control mechanisms on performance. We also present exploratory results based on a study of 1,141 small privately held U.S. family and non-family firms that suggest the overall agency problem in family firms could be less serious than that in non-family firms.

Introduction

Although there is no consensus about the relationship between organizational performance and the ownership and control of a firm (James, 1999), most scholars agree that separation of ownership and management creates costs that may not exist if ownership and management were combined. Agency theory is based on the idea that managers who are not owners will not watch over the affairs of a firm as diligently as owner-managers. Ross (1973) formalized this conflict of interest arising from the separation of ownership and management as a principal-agent problem and Jensen and Meckling (1976) coined the phrase "agency costs" to represent the costs of all activities and operating systems designed to align the interests and/or actions of managers (agents) with the interests of owners (principals). Myers (1977) and Smith and Warner (1979) showed that agency costs also exist in the owner-lender relationship while Morck, Shleifer, and Vishny (1988) documented the potential agency costs to minority shareholders from having an entrenched dominant shareholder.

Traditionally, researchers have assumed that owner-managed firms will have either zero or insignificant agency costs (Jensen & Meckling, 1976; Fama & Jensen, 1983; Ang, Cole, & Lin, 2000). There is a tendency to extend this to family firms because family members are expected to be altruistic toward each other as a result of kinship obligations that are part of the axiomatically binding normative moral order in most cultures (Stewart, 2003). (1) Altruism could mitigate some agency costs (Wu, 2001) but, unfortunately, altruism could also lead to other

agency costs, for example, free riding by family members as in the "Samaritan's dilemma" (Bruce & Waldman, 1990), entrenchment of ineffective managers (Morck et al., 1988), or even predatory managers (Morck & Yeung, 2003).

Two recent articles (Schulze et al., 2001; Schulze, Lubatkin, & Dino, 2003) posit that altruism may create agency problems unique to family firms because family relationships make it more difficult to resolve certain kinds of conflicts and curb unproductive behaviors. They further propose and empirically confirm that, because of these problems, family firms will gain performance benefits from the use of pay incentives and other agency cost control mechanisms such as strategic planning (Schulze et al., 2001, 2003).

Since nepotism does exist (Ewing, 1965) and families find it difficult to replace ineffective family members (Handler & Kram, 1988), it is hard to deny that family involvement has the potential to lower economic performance, particularly in light of Schulze et al.'s (2001, 2003) research. But agency costs arise only when firm actions contravene owners' interests or when resources must be expended to ensure that firm actions do not contravene owners' interests. For example, if family business owners wish to provide a minimum standard of living for relatives, any decrease in economic performance due to nepotism cannot be considered an agency cost. Thus, the nature of agency costs in family firms deserves more careful consideration.

The purpose of this article is to take another step toward a better understanding of agency costs in family firms by: (1) examining differences in the nature of agency costs in family and non-family firms; (2) discussing conditions that must be met in order to empirically examine agency costs in family firms through the impacts of agency cost control mechanisms on performance; and (3) presenting results of an exploratory study of the impact of agency cost control mechanisms on the relative economic performance of family and non-family firms. …

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