The competitive advantage of managing agency issues in family businesses

Whilst many studies show family businesses outperforming other types of businesses, there are countervailing studies.  From such studies one can argue that entrenched family members in management do not fully exert themselves in their roles, and that family shareholding blocs expropriate wealth from minority shareholders through condoning wide and excessive benefits to family management.  This mixed picture is understood by reflecting on the fact that the presence of family businesses as desirable forms of business depends on the degree to which family influence is good for business performance. One can say family influence on a business is good up to a degree after which negative effects hinder business performance.  This bell curve of family influence can be elongated or even plateaued at its high point through judicious application of good governance mechanisms in family businesses thereby retaining a competitive edge for the family firm.

As family businesses grow, they have potentially growing principal-agency costs to ensure managers act in the owners’ interests.  From the smallest family business upwards, family members should ask themselves if there is a trusting atmosphere that ensures that the interests of family members in ownership and management are aligned.  To avoid family altruism (allowing family members to unduly benefit from the altruism of other family members), family members should also ask further questions.  If any act of family altruism can be identified, does it undermine the professional working relationship between family members involved with the business?  Is there any free riding going on in the business?  Are managers appointed for their merit or their just their family membership?  Does the business need a managerial incentive scheme to counter principal-agency costs?  If so, what type?  Options include performance related pay and share ownership plans.

The state of governance may demotivate non-family managers.  They may feel there is a glass ceiling, unprofessional conduct by family members and a lack of entrepreneurship and innovation in the business.  Consequently, attracting quality personnel to the business, motivating them to operate at their best and retaining them may be a problem.  Therefore, family members should ask themselves if they run a business to recognised professional standards. They should consider what kind of covenant exists between the business and the  workforce – and whether it has been kept by the management. They should consider how a non-family member can have a career in the business and not just a job.  In short, they should consider how their business can be a good place to work.

If the family has stepped back from management, they still have an important role to play as business owners.  They need to consider to what degree they have control of the business through their ownership within the capital structure of the business under the shareholders agreement and the articles of association of the companies in the business.  They should ensure they receive the information they require to act as business owners, so they can hold management to account and address underperforming management.  Employment contracts need to be consistent with this requirement.  They should assess themselves to consider if they have the knowledge, experience and skills to make the strategic decisions for the business.  They also need to devise and agree incentives and document them to align management with the owners and ensure unnecessary risk is not taken.

There is a continued risk of family majority shareholders expropriating income from minority shareholders (if they exist), which in the long term also impact other stakeholders who have a claim for payment for goods or services provided to the firm.  To minimise this, family members should ask themselves if the family uses its power to enrich itself at the cost of other shareholders.  If there are private benefits, the family should establish what they are and how much it costs.  They should consider if they are suitable private benefits.  This includes making comparisons to business competitors and to similarly sized businesses.  It should also mean considering the private benefits in light of the performance of the business and the individuals receiving the private benefits. In summary, the family should familiarise itself with the benefits and disadvantages of private benefits in the long term to the family business.

There is a risk that shareholders may come into conflict.  They may be family shareholders and/or minority shareholders.  Business monitoring costs can be disproportionately large for minority shareholders so they may have little incentive to counter issues that the larger family shareholding bloc will not pursue.  As conflicting family shareholders may have a large stake they should be motivated to pursue underperformance issues.  If conflicting family shareholders are not satisfied, they may block shareholder resolutions and obtain director changes, so satisfying them is important.  Such conflicts also create distrust, impact the business reputation and cause strategic inertia thus affecting business competitiveness.  They also lower the quality of monitoring of managerial performance through a lack of shareholder focus on this during the shareholder dispute.  Such businesses may become acquisition targets.  Sufficient family members may be tempted to sell to outside buyers in such circumstances.

This survey of agency issues in family businesses shows that in essence, family members should consider if family members are aligned in their interests and views and that these relate to their family values and vision for the business.  They should be alert to any hindrances to their collective action.  The family should review the governance mechanisms they need to have in place to ensure that unity of purpose.  This family business coherence through governance gives a competitive edge to the family firm.  My colleagues and I at Nexa can assist with such a review with the corporate, finance and employment law implications of these issues as they affect your family business.  We are interested to hear from you.

For more information please contact Henry Clarke using henry.clarke@nexa.law