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Agency Relationships in Family Firms: Theory and Evidence

Author(s): William S. Schulze, Michael H. Lubatkin, Richard N. Dino, Ann K. Buchholtz

Source: Organization Science, Vol. 12, No. 2 (Mar. - Apr., 2001), pp. 99-116
Published by: INFORMS
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Agency Relationshipsin Family Firms:
Theory and Evidence

William S. Schulze * Michael H. Lubatkin * Richard N. Dino * Ann K. Buchholtz

Case Western Reserve University, Weatherhead School of Management, 10900 Euclid Avenue,
Cleveland, Ohio 44106-7235
University of Connecticut, Box U-41 Mgmt., 368 Fairfield Road, Storrs, Connecticut 06269
University of Connecticut, 368 Fairfield Road-U-41FB, Storrs, Connecticut 06269-2041
The University of Georgia, Terry College of Business, Department of Management, Athens, Georgia 30602-6275 * * *

The authorshave conductedthe kindof researchherethatwe all reachfor buttoo oftenfail to grasp.
Thatis, this studyof the governanceof family firmsis theoreticallyrich and practicallyrelevant.
Ourcolleagueshave pressedthe limitsof agencytheoryto explorethe controlof owners'opportunistic
behavior,behaviorthatinterestinglyjust mightbe rootedin an altruisticimpulse.They have done this
by empiricallyexaminingprivately-held,family-managed firms.Whilesuchfirmsembodythe dominant
formof organizationin the worldtoday,they areveryunderrepresented in ourstudyof organizationand
management. This researchsimultaneouslyadvances our understandingof agency theory and draws
muchneededattentionto these kindsof firms.Spendsome time withthis paper.I thinkyou will be glad
thatyou did.
James Walsh

Abstract Must privately held, family-managed firms (henceforth,

Does ownermanagementnecessarilyeliminatetheagencycosts family firms) offer pay incentives and use other formal
of ownership?Drawingon agency literatureand on the eco- governance mechanisms to mitigate agency threats to
nomictheoryof the household,we arguethatprivateownership their performance? There are no clear empirical or theo-
andownermanagementexpose privatelyheld,owner-managed retical answers to this question, largely because family
firms to agency threatsignoredby Jensen's and Meckling's firms have been virtually overlooked in the mainstream
(1976) agency model. Privateownershipand owner manage- economic and management journals.1 What makes this
mentnotonlyreducetheeffectivenessof externalcontrolmech-
anisms,they also expose firmsto a "self-control"problemcre- oversight remarkable is that family firms are far more
ated by incentives that cause owners to take actions which common than widely held public firms; have at least as
"harmthemselvesas well as those aroundthem"(Jensen1994, much economic impact and, as we will soon argue, rep-
p. 43). Thus,shareholdershave incentiveto investresourcesin resent a theoretically distinct form of governance.2
curbingboth managerialand owner opportunism.We extend Nevertheless, we can infer three reasons from Jensen's
this thesis to the domainof the family firm.Afterdeveloping and Meckling's (1976) model3 three reasons why family
hypotheseswhich describehow family dynamicsand, specifi-
firms, at least those that are privately held and family-
cally, altruism,exacerbateagency problemsexperiencedby
these privatelyheld, owner-managedfirms, we use data ob- managed, need not incur significant agency costs. First,
tainedfrom a large-scalesurveyof family businessesto field owner management should reduce agency costs because
test our hypothesesand find evidence which suggestssupport it naturally aligns the owner-managers' interests about
for ourproposedtheory.Finally,we discussthe implicationsof growth opportunities and risk. This alignment reduces
our theoryfor researchon family and othertypes of privately their incentive to be opportunistic, sparing firms the need
held, owner-managed firms. to maintain "costly mechanisms for separating the man-
(Agency Theory;Altruism;Privately-Owned Firms; Fam- agement and control of decisions" (Fama and Jensen
ily Business) 1983a, p. 332). Second, private ownership should reduce

1047-7039/01/1202/0099/$05.00 SCIENCE,? 2001 INFORMS

1526-5455electronicISSN Vol. 12, No. 2, March-April2001, pp. 99-116
W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

agency costs because propertyrights are largely restricted authority to another (the agent). This delegation of au-
to "internaldecision agents" whose personal involvement thority exposes agents to risks for which they are not fully
assures that managers will not expropriate shareholder compensated, giving them incentive to seek additional
wealth through the consumption of perquisites and the compensation through noncompensatory means such as
misallocation of resources (Fama and Jensen 1983a, p. free-riding or shirking (Jensen and Meckling 1976). It
332). Finally, family management should further reduce also creates information asymmetries that make it possi-
agency costs because shares tend to be held by ". .. agents ble for agents to engage in activities that, if left un-
whose special relations with other decision agents allow checked, would threaten firm performance and may ulti-
agency problems to be controlled without separation of mately harm the welfare of owners and agents alike.
the management and control decisions. For example, fam- Information asymmetries and incentives therefore com-
ily members ... therefore have advantages in monitoring bine and pose a moral hazard to agents, which owners
and disciplining related decision agents" (Fama and can reduce by monitoring agent conduct, gaining access
Jensen 1983b, p. 306). to their firm's internal information flows, and providing
It may not be surprising, therefore, that some have incentives that encourage agents to act in the owners' best
speculated that family firms represent one of the least interests. Accordingly, Jensen and Meckling conclude
costly (most efficient) forms of organizational gover- that the cost of reducing information asymmetries and the
nance (e.g., Daily and Dollinger 1992, Kang 2000). In- accompanying moral hazard is lowest when owners di-
deed, Jensen and Meckling (hereafterJ/M) imply that for- rectly participate in the management of the firm. Owner-
mal governance mechanisms at family firms are not managed firms thus have little need to guard against this
necessary and that their expense may even detract from agency threat.
firm performance. We disagree. Drawing from theory de- This claim is predicated on two assumptions: That
veloped by Becker (1981), Stulz (1988), Thaler and owner management is an efficient substitute for the costly
Shefrin (1981) and others, we argue that private owner- control mechanisms that non-owner-managed firms use
ship and family management expose firms to agency haz- to limit the agency costs of managerial discretion, and
ards. For example, private ownership frees firms from the that the separation of ownership and control is the source
discipline imposed by the market for corporate control of agency costs in firms (Alchian and Woodward 1988).4
(Jensen 1993) and increases the agency threat posed by We challenge both assumptions.
self-control-a problem that arises when owner-
The Agency Cost of Private Ownership. We begin our
managers have incentive to take actions that can "harm
themselves as well as those around them" (Jensen 1998, challenge by noting that the J/M model recognizes a va-
p. 48). Firms also face an increased threat of adverse se- riety of external governance mechanisms that reduce
lection due to the effect of private ownership on the ef- agency costs in publicly held firms. For example, efficient
ficiency of their labor markets. Finally, altruism alters the capital markets reduce monitoring costs by tracking firm
incentive structure of family-managed firms such that performance and making this information available in the
many of the agency benefits gained (e.g., commitment) form of share price. They also reduce the detrimentalef-
are offset by self-control and moral hazard problems. Be- fects of overinvestment by providing the firm's decision
cause these agency problems can prevent the alignment makers with liquidity and distributing the firm's risk
of ownership interests, we conclude that owner manage- among a large number of shareholders (Fama and Jensen
ment does not minimize the agency costs of ownership 1983b, Reagan and Stulz 1986). Product market compe-
within privately held, family-managed firms. tition and the market for corporate control also place a
We believe that a positive relationship exists between variety of limits on managerial discretion (Jensen 1993).
agency costs incurred by family firms and performance. Finally, competitive labor markets make it less costly for
In this paper we develop theory and field-test six hypoth- firms to recruit qualified applicants and reduce the threat
eses concerning agency costs in privately held, family- of precontractualopportunism or adverse selection which
managed firms. We conclude with a discussion of the arises when applicants are able to hide information about
implications of our theory for research on family firms, themselves that prospective employers need to properly
as well as for agency theory in general. evaluate an applicant's quality and worth (Fama 1980,
Hansmann 1996).
Agency in Privately Held and Owner-Managed Private ownership, however, compromises the effi-
ciency of the firm's factor markets and the external gov-
Agency relationships arise when one self-interested in- ernance that these markets provide. For example, econ-
dividual (the principal) delegates some decision-making omists recognize that a self-selection or sorting process

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W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

occurs in labor markets whenever the terms of the em- den information" and to postcontractual agency threats
ployment contract systematically influence the character- associated with "hidden actions." Hence, owner manage-
istics of the individuals whom firms can hire. Higher ment is not an efficient substitute for the costly control
paying jobs, for example, attract more able workers, mechanisms that non-owner-managed firms use to limit
while pay-for-performance contracts attract risk takers the agency costs of managerial discretion.
(Besanko et al. 1996). Private firms, however, cannot of-
fer prospective employees the same terms of employment The Agency Cost of Owner Management. The J/M
as public firms. For example, while public firms may offer model assumes that separation of ownership from control
stock options to prospective employees, privately held is the principal source of agency costs in firms, and that
firms cannot, due to limited liquidity and the fact that these costs are eliminated when the firm is managed by
majority shareholders are generally not willing to dilute a single owner (Fama and Jensen 1983a). The model also
their control of the firm (Lew and Kolodzeij 1993, Morck presumes that while conflicts of interest may arise when
1996). Public firms can also promise talented employees ownership is shared, these conflicts do not generally en-
promotional opportunities; typically, because important gender agency costs because they are resolved effi-
management positions are "chosen on the basis of wealth ciently.7
and willingness to bear risk as well as for decision skills" Three mechanisms make this possible. First, J/M as-
(Fama and Jensen 1983a, p. 332), such positions in pri- sume that voting minimizes the economic cost of settling
vate firms tend to be held by shareholders (La Porta et al. more divisive issues because votes are assumed to reflect
1999). the proportionate distribution of economic risks and re-
These inefficiancies have five important implications wards among the owners. Second, liquid markets limit
for the cost of governing private firms and, by extension, the agency costs of owner conflict by making it possible
for the relative efficiency of owner management. First, for conflicting parties to cut their losses simply by selling
the risk that these firms will inadvertently hire lower- their shares (Alchian and Woodward 1988; Jensen and
quality agents is increased because sorting reduces the Smith 1985). This assures economic efficiency because it
size, character,and quality of the labor pool which serves prevents any owner or group of owners from transferring
them.5 Second, firms face increased risks of hiring infe- a portion of their ownership costs onto others. Finally,
rior and/or opportunistic employees because reduced owners are assumed to be rational and principally moti-
competition and accompanying market inefficiencies vated by economic incentives: Ownership, it follows,
make it more costly for firms to guard against adverse substantially aligns their interests and gives them incen-
selection (Mohlo 1997). Third, reluctance to dilute own- tive to develop rules and policies aimed at minimizing
ership hampers these firms' ability to post the bonds that conflict and limiting the cost of settling disputes. In this
public firms offer talented applicants to assure them that light, the J/M model presumes that owner management
the firm will not take advantage of them (Rajan and minimizes, but does not eliminate, the agency cost of con-
Zingales 1998).6 Private ownership thus weakens the in- flict among owners.
stitutional safeguards that help to protect public firms However, the model recognizes that significant agency
from adverse selection and prospective agents from a costs arise when these assumptions are violated. Jensen
form of owner opportunism known as hold-up (1993), for example, notes that failures in the market for
(Williamson 1985). Fourth, private ownership increases corporate control allow inside owners to advance their
monitoring costs, because inferior compensation and lim- personal interests at the expense of outside owners. Pri-
ited promotion opportunities reduce these agents' incen- vate ownership exacerbates this problem because the ab-
tive to monitor each other's conduct (Fama and Jensen sence of a liquid market for the firms' shares increases
1983b, p. 310) and to compete with one another for ad- the threat of hold-up, which arises whenever owners use
vancement (Besanko et al. 1996). Finally, private own- their voting rights or their control over a firm-specific
ership increases the cost of monitoring firm performance resource to take the ownership interests of other owners
because share price is not determined by the market. By "hostage." As long as the loss the hostaged owners might
shielding the firm from the disciplinary pressure of the suffer from giving in to the hostage-taker is less than the
market for corporate control (Stulz 1988), "it [can be] cost they would incur from not giving in and/or selling
extremely difficult for adjustmentto take place until long their stake in the firm, the hostage-taker has incentive to
after the problems have become severe, and in some cases force the firm to take actions that favor his or her interest.
even unsolvable" (Jensen 1993, p. 847). Private owner- It follows that the ability to transferownership at low cost
ship therefore increases monitoring costs while exposing guards owners from this important agency threat
the firm to precontractualagency threats rooted in "hid- (Williamson 1985).

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W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

Finally, the notion that the agency cost of conflict which are entirely overlooked in the J/M model.9 More-
among owners is negligible rests on the assumptions over, private ownership reduces external governance and
about the economically rational behavior of owners. exacerbates the self-control problems that arise whenever
However, the assumption that all preferences can be ex- firms are led by a powerful owner-manager, a threat
pressed in economic terms is problematic because indi- which is particularly troublesome when privately held
viduals have preferences or tastes for noneconomic as firms are owned and managed by family.
well as economically motivated behaviors, and people are
naturally driven to maximize the utility they gain from
each8 (Arrow 1963; Buchanan 1975; Becker 1974, 1981; Agency Threats and Costs in the Family
Thaler and Shefrin 1981). Firm
The presence of noneconomic preferences creates two While Fama and Jensen (1983a, p. 332) contend that fam-
problems: First, while owners may be expected to share ily management is especially efficient, we propose instead
common economic interests, there is little reason to pre- that family relations tend to make agency problems as-
sume that they have common noneconomically moti- sociated with private ownership and owner management
vated preferences. Further,because the value of nonecon- more difficult to resolve due to self-control and other
omically motivated preferences cannot be fully expressed problems engendered by altruism.
or calibrated in terms of a commodity like money Economists model altruism as a trait that positively
links the welfare of an individual to the welfare of others
(Bergstrom 1989), the J/M model cannot assume that
ownership necessarily reduces agency costs because (Becker 1981, Bergstrom 1995). As such, altruismis self-
money (i.e., equity ownership and monetary incentives) reinforcing and motivated by self-interest because it
cannot guarantee the alignment of owners' attitudes to- allows the individual to simultaneously satisfy both altru-
wards growth opportunities and risk. istic (other-regarding) preferences and egotistic (self-
Second, conflicts of interests may arise because some regarding) preferences (Lunati 1997).1? Parents, it fol-
lows, are not only generous to their children because they
noneconomically motivated preferences can cause own-
ers to take actions that threaten their own welfare as well love them, but also because they would harm their own
as those around them. These "agency problems with one- (the altruist's) welfare if they acted otherwise (Becker
self' (Jensen 1998, p. 48) persist because the utility in- 1981). Simon (1993) and Eshel et al. (1998), for example,
note that altruism compels parents to care for their chil-
dividuals gain from indulging personal tastes (e.g., a taste
for drug consumption or the exercise of power) is func- dren, encourages family members to be considerate of
one another, and makes family membership valuable in
tionally indistinguishable from that gained from ration-
ways that both promote and sustain the family bond.
ally motivated pursuits (Becker and Murphy 1988, Thaler These bonds, in turn, lend family firms a history, lan-
and Shefrin 1981). Attempts to maximize one's welfare
can therefore cause individuals to take actions that do not guage, and identity that make it special. Communication
and some types of decision making are facilitated by
advance the common (economic) good. For example, a
the intimate knowledge about others that family mem-
powerful owner might veto a new venture because it bers bring into the firm (Gersick et al. 1997). Altruism
threatens the status quo, entails too much effort, or is not also fosters loyalty, as well as a commitment among its
in their personal financial interest (Jensen and Meckling
leadership to the firm's long-run prosperity (Ward
1976, Wright et al. 1996). And, because power is not 1987). Kang (2000), for example, concludes that family-
symmetrically distributed in a firm, an owner can engage managed firms are patient investors, capable of sticking
in exploitive behavior with subordinates, in what Perrow with strategies through circumstances and over periods of
(1986, p. 227) refers to as "owner opportunism." Al- time that nonfamily-managed firms cannot.
though Jensen admits that he "failed for more than a de- Buchanan (1975) notes, however, that altruism can
cade to see the generality and importance of this self- cause parents to threatentheir children with moral hazard.
control issue" (1994, p. 45), his subsequent publications, Because altruism partly stems from a parents' desire to
including the versions of Fama and Jensen (1983a, enhance their own welfare, parents have incentive to be
1983b) that appear in his 1998 book, make no mention generous even though that increased generosity may
of this agency problem when discussing owner manage- cause their children to free-ride (e.g., leave an assigned
ment. household chore for a parent to complete, or squander
In sum, we posit that private ownership not only fails their parent's money). This agency threat is likely to be
to minimize the agency costs of ownership, but can ac- pronounced in family firms, because control over the
tually engender agency costs in these firms for reasons firm's resources makes it possible for owner-managers to

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W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

be unusually generous to their children and relatives. The ride and that parent owner-managers will have difficulty
typical family firm, for example, provides family mem- monitoring and disciplining their conduct. Because altru-
bers with secure employment, as well as perquisites and ism biases parental perceptions (My kids are such hard
privileges that they would not otherwise receive (Gersick workers!) it becomes difficult for family agents to take
et al. 1997, Ward 1987). Kets De Vries (1996) reports actions that might harm another family member's wel-
that family-firm founders have a tendency to lavish their fare. One solution to this conundrum is to tie a portion of
children with gifts, perhaps to make up for their absence the family agent's wage to outcomes that can be effec-
from the household when their children were young. Al- tively monitored and objectively assessed, like firm per-
truism therefore adds a theoretically distinct set of self- formance (Andersen 1985). In this light, family agent pay
control problems to the set of agency problems identified incentives are akin to parents making a portion of their
earlier. children's allowance contingent upon completing certain
Consequently, the agency problems associated with chores. This mitigates the self-control problem by allow-
private ownership and owner management, as well as ing parent owner-managers to satisfy their need to be al-
those engendered by altruism, threaten the performance truistic while reducing the risk of spoiling (and thereby
of privately held, family-managed firms. In the next sec- harming) their children (Becker 1981, Bergstrom 1989).
tion, six hypotheses (two dealing with the costs of moni- Also, pay incentives should improve firm performanceby
toring agents, two with the costs of monitoring and set- controlling the family agents' tendency to free-ride
tling disputes among owner-managers, and two with (Chami 1997). As such, and contrary to the J/M model,
configurations of governance mechanisms) describe how we posit that privately held, family-managed firms should
family dynamics influence governance practices in these offer pay incentives to both family and nonfamily agents
firms. to mitigate agency threats to their performance.

HYPOTHESIS 1A (HIA). Pay incentives to nonfamily

agents are positively related to the performance of pri-
Hypotheses vately held, family-managed firms.
The Agency Costs of Monitoring Agents. We argued
HYPOTHESIS 1B (H1B). Pay incentives to family
previously that failures in external labor markets increase are related to the performance of
the need for privately held, owner-managed firms to agents positively
monitor agent conduct, while internal labor market fail- privately-held, family-managed firms
ures increase the cost of monitoring. Owner supervision, Jensen and Meckling (1995) note that monitoring costs
if possible, minimizes monitoring costs; if not, owner- are not only associated with observing, measuring, and
managers can discourage agents from pursuing their own rewarding various agent behaviors, but also entail costs
interests by making a portion of their pay contingent on associated with the host of administrative practices that
achieving a performance objective (Eisenhardt 1989). firms use to control agent behavior. Managerial hierar-
Given limits to owner supervision and the fact that owner- chies, for example, enhance accountability by separating
managers are unable or at least highly reluctant to use decision authority from operating responsibility. Budgets
equity to compensate or bond agents (Berk et al. 1988), help direct agent activity while their accompanying rules
it should not come as a surprise that between 73% and and regulations limit agent discretion. Finally, strategic
85% of these firms offer agents pay incentives in the form plans have both manifest (intended) and latent (unin-
of cash bonuses (Fraser 1990, Greco 1997, INC 1996, tended but nevertheless consequential) effects (Merton
Small Business Reports 1993). 1968) that enhance organizational control and limit
While theory leads us to expect a positive relationship agency costs. Jensen and Meckling (1995), for example,
between family-firm performance and incentive compen- note that strategic plans reduce information asymmetries
sation paid to nonfamily agents, the same may not be true within the firm, and hence the threat of moral hazard, by
for family agents (i.e., family members employed by fam- encouraging agents to gather and share information that
ily firms), who, as de facto owners,11 already have their does not ordinarily flow through the firm's communica-
personal wealth tied to the value of the firm. It follows tion channels. Strategic planning also requires agents to
from the J/M model that incentive compensation should systematically assess firm performancerelative to internal
not affect family agent performance because their inter- and external benchmarks. It promotes the alignment of
ests are already aligned with those of the owners. attitudes toward growth opportunities and risk by forcing
On the other hand, we infer from the economic litera- agents to define the firm's mission and values, promotes
ture on altruism that family agents have incentive to free- consensus by requiring that agents from different levels

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W. S. SCHULZE, M. H. LUBATKIN, R. N. DINO, AND A. K. BUCHHOLTZ Agency Relationships in Family Firms

in the hierarchy agree on goals and strategies, and im- nance practices which prevent these self-control problems
poses discipline by insisting that these objectives guide from underminingthe viability of the firm. Therefore,pri-
day-to-day activities. Thus, strategic planning can be a vately held, owner-managed firms need vigilant boards
valuable tool for achieving good agency, especially when whose ability to monitor and discipline top management
firms lack the discipline imposed by capital markets and is not compromised by the CEO's power and authority
are less able to assess performance objectively due to the and/or his or her hegemony over the board (Lin 1996).
absence of a market-determinedshare price. Widely held firms reduce executive or board turnover
Paradoxically, family-managed firms are less likely to (entrenchment) and increase board autonomy and vigi-
use formal monitoring and control mechanisms than other lance with rules regarding CEO and board tenure, the
firms (Daily and Dollinger 1993, Geeraerts 1984). Our appointment of outside directors, and other measures
analysis suggests an agency explanation: We believe that (Finkelstein and Hambrick 1996, Lin 1996). Privately
conflict between the self- and the other-regarding inter- held, family-managed firms, however, are less likely to
ests of the owner-managers can discourage or even pre- implement such policies because ownership rights and the
vent them from engaging in activities that they have eco- formal authority of office combine with family status to
nomic incentive to undertake. Ward (1988), for example, reduce turnover (and hence increase entrenchment)in the
observes that family owner-managers tend to view stra- board and executive ranks (Finkelstein and D'Aveni
tegic planning and similar administrative processes as la- 1994, Ford 1988). For example, family-firm CEOs can
borious and time-consuming, taking them away from run- use the promise of familial succession and/or future own-
ning the business while providing them with little in the ership to lock in continued support from board members.
way of new strategic insights or other benefits. They may The absence of a liquid market for their shares, as well
also be reluctant to commit to jointly determined courses as the opportunity to exercise their ownership rights in a
of action that limit their discretion. Finally, family mem- manner that enhances personal welfare, prolongs tenure.
bers may avoid strategic planning if it requires them to Not surprisingly, the CEOs of most family firms are
deal with emotionally charged issues like disciplining
firmly entrenched, with an average tenure of 24 years
family agents, or to make decisions that have ramifica- (Beckhard and Dyer 1983), twice what Hambrick and
tions for familial relations both inside and outside the firm
Fukutomi (1991, p. 736) observed at widely held firms.
(Meyer and Zucker 1989, Ward 1987). Thus, in contrast
to research which attributes variance in the use of stra- Family dynamics and self-control problems also com-
bine and undermine the effectiveness of outside directors.
tegic planning to exogenous factors like the competitive- The advantages of outside directors in widely held firms
ness of the markets in which privately held firms compete
are clear: They are better able to monitor firm perfor-
(e.g., Powell 1992), we attribute this variance to agency
mance; discipline or even dismiss managers since they
problems associated with self-control and the potential are not beholden to the firm and/or the powerful CEO for
for conflict among owner-managers. Hence:
their livelihood (Finkelstein and D'Aveni 1994, Lin 1996,
HYPOTHESIS 2 (H2). There is a positive relationship Walsh and Seward 1990); and bring needed expertise and
between the use of strategic planning and the perfor- perspective to boards which might otherwise lack diver-
mance of privately held, family-managed firms. sity (Finkelstein and Hambrick 1996). In spite of the ad-
vantages of outside directors, however, family firms are
TheAgency Cost of Monitoring Owners. As argued ear- less likely to use them. First, they exact an agency cost
lier, agency problems can arise in privately held, owner- on family owners in terms of a perceived loss of control
and discretion. Second, because outsiders almost never
managed firms because noneconomically motivated pref-
erences give owners incentive to take actions that threaten attain the status of large-block ownership that they some-
their personal welfare as well as the welfare of those times do in widely held firms, they are likely to be less
around them (e.g., deciding against a new venture be- motivated than family directors (Alderfer 1988). Third,
cause it threatens the status quo or refusing to take actions while their "impartial"status can enhance their ability to
which compromise their individual welfare). External offer advice on some decisions, they have little influence
governance cannot curb these forms of owner opportun- on decisions involving family members or other family
ism (e.g., hold-up) because such firms face a failed capital matters (Nelsen and Frishkoff 1991). Finally, the ten-
market and, with it, a failed market for corporate control. dency of family-firm CEOs to appoint outside directors
Consequently, all shareholders, especially those with a to their boards who are close friends and/or happen to
significant portion of their wealth invested in the firm, have a fiduciary relationship with the firm (e.g., their
have economic incentives to adopt and enforce gover- attorneys or accountants) further compromises director

SCIENCE/Vol. 12, No. 2, March-April 2001
W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

autonomy (Ward and Handy 1988).12 Thus, "hand- short- and long-term value of their efforts (Bergstrom
picking" outside directors for reasons other than strong 1989). Information asymmetries and rivalries among
board oversight can undermine their effectiveness (Ford family agents should also decline because they have little
1988, Rubenson and Gupta 1996). Consequently, we an- reason to continue lobbying the CEO for favor once his
ticipate that problems associated with family dynamics, or her share transferintentions have been declared. Thus,
self-control, and owner control make family-firm boards although principal shareholders have incentive to keep
prone to entrenchment. Hence: information about their share transfer plans private, this
HYPOTHESIS3 (H3). The greater the board entrench- secrecy increases agency costs within family firms.
ment, the lower the performance of privately held,family- HYPOTHESIS 4 (H4). Disclosure of the major share-
managed firms. holder's estate and share transfer intentions is positively
The Agency Costs of Settling Disputes Among Owners. associated with the performance of privately held,family-
Shares in privately held firms have limited transferability, managed firms.
making it necessary for owners to "specify rights in net
cash flows and procedures for transferringresidual claims Configurations and a System of Agency Threats. To
to new agents" (Fama and Jensen 1983b, p. 308). While this point, we have dealt with each agency threat and its
a seemingly straightforward process, conflicts between corresponding governance mechanism as if their effects
self- and other-regardinginterests may cause family-firm were independent and additive. The reality, however, is
CEOs to keep the specific conditions of their share trans- that agency threats tend to become causally and sequen-
fer intentions private. They may fear that they will cause tially entwined in a manner that makes their effects dif-
a jealous rift among the other family agents if they dis- ficult, if not impossible, to tease apart. Using our earlier
close their share transfer and estate plans. The involve- example, failed labor markets may engender the threatof
ment of extended family members complicates planning adverse selection, which in turn exacerbates the threat of
and virtually assures that some family agents will feel moral hazard to privately held, family-managed firms.
slighted, and perhaps even disenfranchised, once the plan While these entwined effects make it nearly impossible
is revealed (Barnes and Hershon 1976). Some CEOs to reliably trace a specific agency cost to a specific agency
might be reluctant to disclose their intentions because threat, they also make it possible that a given control
they feel that their chosen successor still lacks the skills mechanism, such as pay incentives or strategic planning,
and experience needed to lead the firm (Handler 1990). can simultaneously mitigate theoretically distinct agency
Disclosure is also risky because creditors and other stake- threats. Bonds, for example, reduce the threat posed by
holders may attempt to protect their interests by tying adverse selection and moral hazard (McAfee and
contract renewal dates to the execution date of the an- McMillan 1987). Governance mechanisms might also op-
nounced plan (Gersick et al. 1997). Still other CEOs may erate as a group, such that one governance mechanism
wish to put off the share transferor delay retirementuntil can complement and/or substitute for another (Johnson et
they have secured their "nest egg" (Rubenson and Gupta al. 1993, Rediker and Seth 1995).
1996). The result is that these plans are kept confidential. Firms may therefore end up adopting a set of control
As Ellen Gordon, principal owner and president of Toot- mechanisms whose effects on agency costs are comple-
sie Roll Industries put it, "We have a succession plan, but mentary and possibly synergistic. Over time, firms may
we don't have to announce what it is." (Forbes 2000, p. bundle some or all of the governance mechanisms high-
131) lighted in our first four hypotheses into an internally con-
Unfortunately, uncertainty regarding share transfer sistent set or configuration of governance practices that
plans increases agency problems because the ambiguous addresses the agency problems which typically arise in
promise of ownership and/or leadership serves to "lock" privately held, family-managed firms (Ketchen et al.
the hopeful heirs into a dependent relationship with the 1993). If successful, relationships among these gover-
firm (Nelton 1995). CEOs can reduce information asym- nance mechanisms should be self-reinforcing, promoting
metries, and hence the threatof hold-up and other agency enhanced control of agency costs and, presumably, firm
problems, by naming a successor and/or announcing how performance.
ownership and voting rights will be distributed (Barnes Of course, not all family-managed firms have the same
and Hershon 1976, Fama and Jensen 1983a; Gersick et goals. Some parent owner-managers may make decisions
al. 1997, Handler 1990). Incentive pay, for example, will based more on what is best for themselves than for their
be more effective because it gives family agents the in- families, or on what is best for their families as opposed
formation they need to more accurately calculate both the to what is best for the firm as a going concern. As a result,

SCIENCE/Vol. 12, No. 2, March-April 2001 105
W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

self-control problems can cause some owner-managers to While the use of secondary data can limit generaliza-
refrain from commitments that limit their discretion, bility, Ilgen (1986) and Sackett and Larsen (1990, p. 435)
block the introduction of governance practices which point out that representativeness is less of a concern when
limit their ability to use the firm's resources as they see the sample is prototypical of the relevant population and
fit, and take other actions, perhaps unintentionally, that the research question concerns whether hypothesized ef-
undermine the effectiveness of current governance prac- fects can occur as opposed to determining the frequency
tices. The path to the control of agency costs in family or relative strength of the observed effects. The Arthur
firms might therefore be like a slippery slope, with one Andersen data are well suited to this task because the
side leading to the adoption of a complimentary set of surveys were designed to obtain "reliable benchmarks"
good governance practices, and the other side leading about American family businesses (Arthur Andersen &
away from adoption of those practices. Our speculation Co. 1995, p. 3).
about the complementary and self-reinforcing character Before mailing the survey to chief executives of 37,304
of the relationships between agency costs and governance privately held U.S. family businesses, items in this survey
practice ground H5 and H6. were reviewed by a focus group of family-business own-
ers and pilot-tested on a holdout sample. A single mailing
HYPOTHESIS 5 (H5). Some privately held family-
yielded 3,860 responses within one month, or a response
managed firms are characterized by a configuration of rate of 10.3% that is comparable to "the 10-12 percent
good governance practices, while others are not. rate typical for studies which target executives in upper
HYPOTHESIS6 (H6). Privately held, family-managed
echelons" (Geletkanycz 1998, Hambrick et al. 1993,
firms characterized by a configuration of good gover- Koch and McGrath 1996), and chief executives in small
nance practices will outperformfirms that are not. to mid-sized firms (MacDougall and Robinson 1990).
Because of the a priori selection problems, Andersen
survey respondents range from "mom and pop" proprie-
Sample and Methods torships to large family-managed corporations.We there-
fore applied a number of ex post screening criteria to the
Data. Reliable information on family firms is extremely data. First, we deleted 334 partnerships and proprietor-
difficult to obtain (Wortman 1994). Public information is ships because different laws and tax policies influence
unreliable because the majority of family firms are pri- their share transfer and compensation practices. Second,
vately held and have no legal obligation to disclose in- we dropped 1,650 cases due to missing data about firm
formation. Government documents and Dunn and
ownership and/or board composition, and another 297
Bradstreet are also of little use because family-managed due to some missing information about the other (15)
firms are not listed as a separate category of business variables included in the regression. (We tested and found
organization. Finally, it is difficult for researchers to col- no difference in performance or the mean values of our
lect primary data and/or to target selected groups of model's independent variables between cases that include
family-managed firms for study because there is no reli- data about ownership or board composition and those that
able way to identify family firms a priori (Daily and do not). Finally, by deleting 203 firms that had $5 million
Dollinger 1993). Consequently, researchers are forced to or less in sales, we excluded "lifestyle firms,"-i.e., small
rely on self-reported data, sample from a broad popula- firms that might be operated mainly for the purpose of
tion, and identify family-managed firms ex post (Daily income substitution-(Allen and Panian 1982), as well as
and Dollinger 1992, 1993; Handler 1989). others for whom growth may not be a strategic objective
We field-tested our hypotheses using data from a 1995
(Carland et al. 1984, Rubenson and Gupta 1996). Larger
survey of American family businesses. The survey had firms are less likely to be operated in this mannerbecause
been designed and administered by The ArthurAndersen
the demands of managing them mitigate the family/
Center for Family Business. One of the largest and most
CEO's primary motive for suppressing growth, to more
comprehensive surveys ever conducted on family firms
easily maintain managerial and ownership control (Daily
(Gersick et al. 1997), it covers the range of agency issues and Dollinger 1992, Whisler 1988). The final sample thus
that we address. Because all of the firms in the sample
consists of 1,376 firms. Our average firm has annual sales
are privately held and the data are confidential and pro-
of $36 million, has 195 employees, and has been in busi-
prietary, we were unable to independently establish the ness for 49 years.
data's reliability. Andersen's statisticians assure us, how-
ever, that they are reliable and representative of the sam- Dependent Variable. Consistent with Jensen's and
ple. Meckling's (1976) assertion that agency relationships

106 ORGANIZATIONSCIENCE/Vol. 12, No. 2, March-April 2001

W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

within the firm have a strong bearing on its growth rate, and the fact that cash holds a greater incentive than stock
family-firm performance is defined in terms of sales for employees when the firm's equity is not publicly
growth. This is considered to be a more reliable measure traded (Berk et al. 1988).13 In total, 75% of the firms in
of family-firm performance than income-based measures our sample indicated that they offer pay incentives to
because privately held firms have incentive to minimize family members, while 72% offered the same to nonfam-
reported taxable income and no incentive to minimize ily agents, figures fully consistent with the range reported
reported sales (Daily and Dollinger 1992, Dess and in the four previously cited surveys. To assure that the
Robinson 1984). Indeed, "The goal of a good family busi- use of these incentives is not influenced by variance with
ness should be to break even each year at a record high respect to the family's involvement in the firm, we in-
level of sales" (Dreux 1997). Finally, this measure is rec- clude both the reported percentage of Family Ownership
ommended by ecologists whenever private ownership or and the Number of Family Members employed by the firm
other factors make it difficult to obtain other organization- as covariates in the regression. To assure that cash bo-
specific indicators of firm performance (Baum 1990, nuses paid to family agents are indeed contingent portions
1996; Baum and Singh 1996; Haveman 1993). of salary and not simply dividend payments that are dis-
Like Cavusgil and Zou (1994), the Andersen survey tributed as salary bonuses to reduce the tax burden on
measured Sales Growth as a five-year average, using a family members, we identify firms that pay Dividends
six-point, nominal scale ranging from Decreased, No with a dummy variable, and include it as one of the eleven
Change, Increased 1-5%, Increased 6-10%, Increased covariates described in the Appendix.
11-20%, to Increased 21% or more. The scale is appro-
priate because the construct is expected to be both right- Strategic Planning (H2) is measured by asking if the
censored (few firms experience sustained double-digit firm has a strategic plan and how well these plans are
growth) and left-censored (few firms survive a sustained known within the organization. We code the construct as
decline in sales). Although performance is self-reported, a three-level categorical variable: "No Strategic Plan,"
such measures have been shown to be reliable (Nayyar "Strategic Plan Exists but is Not Well Known to Com-
1992, Tan and Litschert 1994), particularlywhen reported pany Management," and "Strategic Plan is Well Known
by executives on anonymous surveys (Dillman 1978, by Company Management."
Nunnelly 1978). The impact of common-method bias, We use three variables to proxy for boardentrenchment
which arises when a common method (survey) is used to (H3). CEO Tenure is measured with a 5-level scale, rang-
gather data about both independent and dependent vari- ing from "11 or more years until retirement" to "Semi-
ables, should be less here than it might be for other types retired,"which conforms with other indirect measures of
of studies. Crampton and Wagner (1994) found that the tenure available from the survey. For example, the bivar-
percept-percept bias that results from common-method iate correlation between CEO tenure and CEO age is high
variance does not have the broad comprehensive effects (r = 0.62, p < 0.001), particularly because scaling dif-
that many have expected (though it does have a modest ferences naturally deflate the correlation between the two
influence on bivariate relationships). Of good news to us variables. Also, the mean age of the CEO (54 years) and
is the finding that social desirability and other sources of the mean age of the heir apparentat the time of this des-
bias are diminished when one or both of the variables are ignation (38 years) differ, as expected, by about one gen-
demographic, descriptive, and/or nonaffective, as are eration. Like Finkelstein and Hambrick (1990), we mea-
most of our variables. Spector (1987, p. 442) is more sured Average Board Tenure as the average number of
bold, stating that, "Methodvariance is a frequentcriticism years each member has served on the board. Lastly, we
of research using affective and perceptual variables. The measure Outside Board Member using a continuous vari-
data and research summarized here suggest the problem able to identify the number of outside directors (i.e., in-
dividuals who are neither family members nor employees,
may in fact be mythical."
as a percentage of the total number of board directors).
Independent Variables. We use two items to proxy for Our final variable, Transfer Intentions (H4), is measured
incentive pay, Family Pay Incentives and Nonfamily Pay with a dummy variable (1/0) that indicates whether the
Incentives. Both are dummy variables (1/0) from the sur- significant shareholdersof the business know each others'
vey which identify firms that offer pay incentives as an- estate and share transferintentions. Our notion that CEOs
nual and/or long-term cash bonuses to family members and major shareholders have incentive to keep this infor-
or to nonfamily employees. Family firms "rely heavily on mation confidential is supportedby the fact that share and
cash incentives" (Fraser 1990, p. 58) due to both a con- estate transferplans are not known in approximately one-
cern for maintaining control of the firm (Morck 1996), third of the firms.

ORGANIZATIONSCIENCE/Vol. 12, No. 2, March-April 2001 107

W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

Control Variables. We included eleven covariates to Discussion

reduce variance that is extraneous to the research question We attempt to explain why private ownership, owner
or may confound interpretation:Family Ownership,Num-
management, and family do not eliminate the agency
ber of Employed Family Members, and Dividends, Firm costs of ownership. Drawing on various economic theo-
Size, Firm Age, Technological Intensity, Export Sales, ries, we describe problems that accompany private own-
Capital Intensity, Industry Growth Rate, Multiple Family ership and owner management, noting that each exposes
Ownership, and Ownership Goal. A complete description the firm to agency problems that are overlooked by the
of each is provided in the Appendix. J/M model. Next, we inferred that agency problems may
be more pronounced in family-managed firms due to self-
control and other agency threats engendered by altruism.
Results Conflict of interests, both within and among family-firm
Table 1 contains descriptive statistics (unstandardized)
owners, combine with the effects of external market fail-
and Pearson correlations while regression results are re- ures to threatenperformancein this type of privately held,
ported in Table 2. The F-statistic associated with the co- owner-managed firm. Contrary to conventional wisdom,
variate set is 5.40 (p < 0.00), and the F-statistic associ- we conclude it is essential that family-managed firms in-
ated with the set of seven hypothesized variables, after
cur agency costs (i.e., invest in the kinds of internal con-
hierarchically adjusting for the set of eleven covariates, trol mechanisms that are deemed necessary for widely
is 5.66 (p < 0.00).
held firms). Secondary data from 1,376 family firms
Consistent with the notion that agency conditions in
yielded evidence that is consistent with our thesis. Thus,
family-managed firms engender a variety of agency costs, owner management in general, and family ownership in
the data indicate supportfor H1A but not H1B: A positive
- particular, may not be the kind of governance panacea
relationship is found for Nonfamily Pay Incentives (p that agency theory assumes it to be.
0.03), but not for Family Pay Incentives (p 0.23). The
data also indicate support for H2 (Strategic Planning (p Ironically, the tenets of the J/M model may have pre-
< 0.04) was positively related to firm performance) and vented this governance theory from being explicitly ex-
tended to privately held, family-managed firms, a domain
for H3: CEO Tenure is negatively associated with firm
performance (p < 0.05), Average Board Tenure (p
- "plagued by conflict" and governance failures (Levinson
- 1971, p. 90; Meyer and Zucker 1989). We try to suggest
0.01) and Outside Directors (p 0.00). Finally, H4:
such an extension, and point the way toward a fruitful
Transfer Intentions is positively associated with firm per-
formance (p - 0.09). research agenda. In addition to further research on pri-
Using the seven independent variables used to test the vately held, family-managed firms, the influence of fam-
first four hypotheses, we performed a complete linkage ily management on public corporations merits investiga-
cluster analysis and identified two sets of internally con- tion. There is a need to develop more fully specified
sistent configurations of governance mechanisms posited agency models for different types of owner-managed or
by H5. Complete linkage is preferred because it requires privately held firms (e.g., new ventures). Finally, our the-
potential cluster members to bear similarity to all mem- ory underscores the importance of incorporatingboth al-
bers of the cluster (Norusis 1993). Following generally truism and the agency problem of self-control into exist-
accepted procedures (Ketchen et al. 1993), we visually ing agency literature.
inspected dendograms to identify the number of clusters, Our agency model of the family firm and our empirical
and then confirmed cluster membership using K-means results also extend understanding of the owner manage-
iterative partitioning. Table 3 shows the results of the ment/firm performance relationship that was theorized by
cluster analysis along with a test of pairwise differences. Stulz (1988) and empirically examined by Demsetz and
Consistent with H5, two distinct profiles emerged, the one Lehn (1985), McConnell and Servaes (1990), and Morck
that shows generally high values for our seven gover- et al. (1988). Specifically, these studies found that the
nance variables and the other showing generally low val- impact of the market for corporate control on owner con-
ues. Further,univariate F-statistics show that all but mean duct is positive up to the point that insider ownership is
CEO tenure differ between groups as predicted. Finally, about 40 and 50 percent, after which the relationship be-
ANCOVA results (Table 4) confirm that the two profiles gins to slope downward. Due to theoretical and sampling
differ as predicted (H6) with respect to firm performance restrictions,'4 however, these studies are silent about the
(F = 5.11, p - 0.02). This finding is consistent with the nature of the slope at higher levels of inside ownership.
logic used in H5 to define "good" family governance Our study, the first to theorize and examine this relation-
practices. ship in privately held family-managed firms (see Endnote

108 ORGANIZATIONSCIENCE/Vol. 12, No. 2, March-April 2001



Table 1 Descriptive Statistics1

O Variable S.D. 1 2 3 4 5 6 7 8 9 10 11 12 13 14

1. Sales Growth 3.96 1.38 -

2. Sales Revenues 36.21 83.79 0.08 -

I 3. CompanyAge 49.47 27.44 -0.12 0.05

4. FamilyOwnership(%) 73.40 38.60 0.03 -0.12 -0.02
a- 0.56 0.49 0.07 0.03 -0.01 -0.08
5. IndustryGrowth
0 6. CapitalIntensity 0.70 0.45 0.05 0.06 -0.01 -0.03 0.51
7. MultipleFamilyOwnership 1.16 0.53 0.02 0.02 -0.02 -0.07 0.02 -0.01
8. No. FamilyEmployees 3.47 2.06 0.05 0.08 0.02 -0.06 0.03 -0.02 -0.06 -
9. ExportSales 1.51 0.81 0.08 0.08 0.03 -0.06 0.27 0.19 -0.03 -0.06 -
10. OwnershipGoal 1.61 0.92 0.05 -0.03 -0.04 0.03 0.10 0.07 -0.02 -0.13 0.06
11. ITIntensity 3.08 0.91 0.15 0.16 -0.01 0.07 -0.01 0.04 0.03 -0.03 0.04 0.10 -
12. Dividends 0.17 0.37 -0.02 0.08 0.08 -0.05 0.02 0.03 0.03 0.07 0.03 0.01 0.09 -
13. NonfamilyPay Incentives 0.72 0.45 0.15 0.15 -0.06 0.03 -0.04 -0.08 -0.06 -0.05 0.06 -0.02 0.04 0.03
14. FamilyPay Incentives 0.75 0.43 0.17 0.09 -0.01 0.06 -0.05 -0.07 0.02 -0.04 0.02 0.01 0.03 0.08 0.61
15. StrategicPlanning 1.41 1.36 0.08 0.13 0.04 0.02 0.02 -0.02 0.03 -0.05 0.09 -0.01 0.18 -0.01 0.04
16. OutsideBoardMember 0.06 0.18 -0.06 0.16 0.05 -0.10 0.09 0.04 -0.01 -0.11 0.11 0.04 0.05 0.14 0.0
17. CEOTenure 2.42 1.12 -0.07 -0.11 -0.09 0.01 0.02 -0.01 -0.01 0.11 -0.04 -0.11 -0.06 -0.02 -0.03
18. Average BoardTenure 17.34 7.61 -0.05 0.02 0.05 0.06 0.03 -0.02 0.02 0.10 -0.11 -0.02 -0.01 0.01 -0.05
19. TransferIntentions 0.67 0.46 0.02 -0.07 -0.01 -0.01 -0.12 -0.04 -0.04 -0.05 -0.07 -0.08 0.04 -0.08 -0.03

Note. 1N = 1,376;Correlationslargerthan0.06 are significantat p < 0.05

W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

Table 2 ModeratedHierarchicalRegressions Table 4 Results of ANCOVATest of Performance

Difference Between Governance Profiles
Variables Sales Growth
Variable F
1. Sales Revenue 0.07**
2. CompanyAge -0.11*** Model 6.78***
3. FamilyOwnership(%) 0.01 1. Sales Revenue 6.80**
4. IndustryGrowth 0.08** 2. CompanyAge 31.94***
5. CapitalIntensity -0.00 3. FamilyOwnership(%) 0.89
6. MultipleFamilyOwnership 0.01 4. IndustryGrowth 4.37*
7. No. FamilyEmployees 0.04 5. CapitalIntensity 0.87
8. ExportSales 0.03 6. MultipleFamilyOwnership 0.38
9. OwnershipGoal 0.04 7. No. FamilyEmployees 3.13t
10. ITIntensity 0.08** 8. ExportSales 0.49
11. Dividends 0.00 9. OwnershipGoal 1.75
12. NonfamilyPay Incentives 0.07* 10. ITIntensity 13.88***
13. FamilyPay Incentives 0.04 11. Dividends 0.49
14. StrategicPlanning 0.06* 12. GovernanceProfile 5.10**
15. Outside BoardMember -0.08**
16. CEOTenure R2 0.07
17. Average BoardTenure N 1376
18. TransferIntentions 0.05t Note. p < 10t; p < 0.05*;p < 0.01**;p < 0.001***
Fcovariate 5.40***
Fregression 5.66***
R2 0.07
1), shows that ownership structure engenders various
Adj R2 0.06
N 1,376
agency threats to firm performance, threats that originate
with altruism, market failures, and self-control.
Note. p < 10t; p < 0.05*;p < 0.01**;p _ 0.001*** The importance of altruism in the family firm should
not be understated.Litz (1995) and others have struggled
with the question of whether family firms represent a
form of governance that is theoretically distinct from
Table 3 Results of Analysis of Variance: Governance other closely held forms. In our view, altruism makes
Profiles agency relationships in these owner-managed firms dif-
ferent from those found in other organizational forms, a
ProfileOne ProfileTwo notion consistent with Litz and others who suggest that
Variable Mean/sd Mean/sd UnivariateF family firms are distinguished by both the active involve-
ment of family in firm management and the intent that
1. NonfamilyPay Incentives 0.70 0.75 4.05* future ownership will remain in the hands of family mem-
(0.45) (0.43) bers. Our theoretical approach allows us to specify, in
2. FamilyPay Incentives 0.73 0.79 6.05*
relatively precise terms, how altruism alters agency re-
(0.44) (0.41)
3. StrategicPlanning 0.04 2.66 206.10***
lationships and hence owner-manager conduct, and to
show how many of the assumed benefits of family owner
(0.20) (0.47)
4. Outside BoardMember 0.05 0.09 20.34*** management are offset by agency costs as well as other
(0.13) (0.20)
costs of ownership (see Endnote 4). In this light, altruism
5. CEOTenure 2.42 2.43 0.00 helps explain why family firms can ask for and receive
(1.16) (1.12) the types of employee self-sacrifice and commitment re-
6. Average BoardTenure 17.78 16.97 4.48* quired to found and grow firms, and yet have so much
(7.68) (7.55) difficulty managing conflict. A better understanding of
7. TransferIntentions 0.61 0.75 37.36*** these dynamics may explain why family-controlled and
(0.49) (0.43) family-managed firms are, in fact, more common than
N 771 882 ostensibly superior widely held firms (La Porta et al.
Note. p < 10t; p < 0.05*;p _ 0.01**;p < 0.001*** Why do a large percentage of the firms in our sample

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W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

offer pay incentives to family agents, even though these Finally, this anomaly could be the product of ineffec-
incentives do not appear to be positively associated with tive governance, and not evidence that outside directors,
firm performance? The justice literature suggests that if when properly used, threaten the performance of family
pay incentives are offered to nonfamily agents to moti- firms. For example, few firms in the sample have outside
vate them and signal professionalism, then fairness con- directors, the average board size is four members, and
cerns may obligate the family-firm CEO to do the same board directors, as a rule, are not compensated for the one
for family agents. We would then expect a null perfor- to two meetings that the average firm in this sample held
mance effect, because the principal purpose of the family each year. In contrast, family firm experts recommend
agent pay incentive is to avoid the harmthat the perceived that these boards have 30 to 40 percent outside represen-
inequities might cause, rather than to enhance firm per- tation, consist of five to nine member boards, and com-
formance. Altruism, on the other hand, can make parent pensate directors for meeting frequently (Nash 1988). Lin
owner-managers unable or unwilling to properly admin- (1996) agrees, citing the need to expand the board to in-
ister incentive programs. The altruist's ability to enforce clude more outside directors, hold frequent meetings, del-
agreements is often compromised by the ramifications egate certain tasks to outside directors, offer director
that such actions might have on familial relationships, compensation, and limit director tenure.
both within and among the extended family. Both phe- The findings for pay incentives and board representa-
nomenons, if carried into the family firm, make it difficult tion from the cluster analysis are intriguing because they
for owner-managers to discipline family agents and en-
highlight the complementary and self-reinforcing nature
force agreements. The Small Business Administration, of governance mechanisms. Furthermore, they may ex-
for example, reports that family business owners find it
plain why some family firms, prosper while others fail.
extremely difficult to fire relatives (Levinson 1989), and Simply put, and as our fifth and sixth hypotheses suggest,
a well-intentioned family-firm CEO recently told us that there may be two types of family firms, one that recog-
he felt obligated to give a car to every family member nizes the need to adopt the kind of internal governance
employed by the firm after giving a company car to the mechanisms used by successful widely held firms to com-
child responsible for outside sales!
Another possibility is that well-governed firms show pensate for the agency problems that they face, and an-
other that does not.
higher levels of firm performance and are more apt to The slippery slope leading to poor governance and an
offer pay incentives to family agents than those that are
increased risk of firm failure is not the product of malev-
not, suggesting that family agent pay incentives may con- olent leadership. To the contrary, altruism adds a distinc-
tribute to superior performance when coupled with other
tive set of self-control problems to those that arise from
complementary governance mechanisms, and yet have a
being privately held and owner-managed, making it very
negligible independent effect on firm performance. More difficult for family-business owners to make decisions
research and different research designs are needed to sort
that represent their own best interests, much less those of
out which explanation is responsible for our results.
the firm or other family members. For example, altruism
Why does outsider representation on family-firm can make a well-intentioned family CEO a "bad agent"
boards show a significant negative independent effect on
in the sense that the CEO's generosity increases the threat
firm performance? While Ford (1988) found the same,
of moral hazardwithin the firm. Similarly, a heartfeltcon-
our findings are nevertheless at odds with the conven-
tional understanding of the role of outsider directors. cern for the firm's prosperity may cause some CEOs to
remain in office long after they have ceased to be effec-
First, consistent with the logic of H3, outside directors
tive, harming firm performance and increasing the agency
may be ineffective because they lack the independence
costs of hold-up. Interestingly, while neither act is selfish
they enjoy when serving on the boards of widely held
firms. Second, the observed relationship might be spuri- in the conventional sense-both require that CEOs sac-
ous if the relatively few firms that placed outsiders on the rifice their own welfare for the ostensible benefit of oth-
board (only 19% percent of our sample) have done so ers-altruism explains why these behaviors are common
because they were already experiencing performance and yet so difficult to circumscribe. We attributethe per-
sistence of these and other family-firm behaviors to the
problems.15Third, the independent performance effect of
outsiders may not tell the whole story, because well- firm's incentive structure, the context in which gover-
governed family firms show higher overall levels of out- nance decision are made, and the trade-offs these deci-
sider representationthan do firms in the poorly governed sions involve, as opposed to family conflict or the host of
configuration. As with pay incentives, outsiders may im- other situationally dependent variables often cited in the
part a positive effect only when coupled with comple- family-business literature (Gersick et al. 1997, Wortman
mentary governance mechanisms. 1994).

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W. S. SCHULZE, M. H. LUBATKIN, R. N. DINO, AND A. K. BUCHHOLTZ Agency Relationships in Family Firms

This study suggests a theoretical grounding for this continuous measure calibrated in years. Age may be linked to perfor-
mance due to a self-selection bias; older firms might be present simply
economically important yet underresearched domain of
firms. The purpose of this empirical study was to lend because they are successful. Differences in rates of sales growth as-
sociated with Export Sales are controlled using a five-level indicator
credibility to our concepts, not to confirm their validity.
ranging from 0 through >50%. Variance in performance and agency
Indeed, we cannot claim that our tests were confirmatory
due to Technological Intensity is controlled using an item which asked:
because we used cross-sectional data and relied upon sur-
How important are investments in information technology for the ac-
vey data gathered for other purposes. However, we think complishment of your future goals? This item is measured with a four-
these tests lend credibility to our theory because the firms level scale, ranging from Not Important to Very Important. The poten-
represented by the Andersen survey are prototypical of a tial influence of Multiple Family Ownership on the CEO's ability to
population of firms that is rarely studied and whose data determine compensation and other management practices is controlled
are difficult (and quite expensive) to obtain (Gersick et with a dummy variable that identifies firms in which two or more fam-
al. 1997, p. 25 Sackett and Larsen 1990). The size of the ilies own at least 15% of the firm. We controlled for the Number of
sample also gives us sufficient power to detect small ef- Employed Family Members, because family compensation practices
fects and yet conclude with a high degree of confidence should have more impact in firms that employ a larger number of fam-
that these results are not the product of chance. Although ily members. We use Family Ownership to control for the effect of
some of the measures are coarser than we would have ownership concentration on governance practices, measuring this vari-
able as the reported percentage of the firm's shares held by the eight
liked (i.e., the use of categorical instead of continuous
largest family shareholders. It is not necessary to use an independent
measures), that coarseness also lends a conservative bias control for the percentage of firm ownership represented on the board
to the analysis, because categorical measures deflate the because it is empirically indistinguishable from the reportedpercentage
amount of variance explained by the regression equation, of the firm owned by family members. (The correlation between the
as well as the likelihood of obtaining significant results two is 0.96). Finally, an item which asked the respondent to rate the
(Hunter and Schmidt 1990). We are also encouraged that likelihood that the family will retain control of the firm in the foresee-
these coarse indicators produced results consistent with able future, Ownership Goal, controls for variance in the strategic di-
those of other studies (e.g., the influence of outside di- rection of the family firm.
rectors on firm performance and these firms' use of in- We also control for Capital Intensity, because the agency effects of
centive compensation), and that, despite the quality of the debt (Fama 1980) are likely to have greater salience in capital-
measures and the use of eleven covariates, the general intensive, as opposed to non-capital-intensive industries. Because the
pattern of positive and negative results is consistent with industry categories identified in the Andersen survey do not correspond
directly to SIC-based industry descriptions, Capital Intensity was
theory. This consistency lends convergent validity to our
coded 1 if the mean on the reported debt/equity ratio for the industry
measures and results.
category was greater than the median debt/equity ratio for all industry
Family business research to date has been hamperedby categories, and 0 if below the median. The resulting dummy variable
the absence of well-developed theory, as well as by a thus identifies industries which rely more heavily on debt relative to
paucity of data about this important segment of the econ- other industries. Another dummy variable, Industry Growth, controls
omy (Wortman 1994). Our extension of agency theory to for variation in sales growth across the industries represented in the
this domain, coupled with the Arthur Andersen data, sample and is coded in the same manner. While coarse-grained, the
helps to illuminate the insidious characterof agency prob- resulting measures distinguish capital-intensive industries (e.g., manu-
lems in family firms while paving the way to future av- facturing, real estate, and transportation),from those that are not (e.g.,
enues for research. retail and other service-based industries), as well as industries that en-
joyed high levels of sales growth during this period (e.g., manufactur-
Acknowledgments ing and telecommunications), from those that did not. Further,we were
The authorswould like to thankJack Veiga, Steve Floyd, DeborahKidder, unable to employ financial statistics derived from SIC-based data for
PeterLane, and the anonymousreviewers at OrganizationScience for their control purposes because such data includes information from large,
encouragementand critique of earlier versions of the paper. Survey data widely held businesses whose capital structure differs markedly from
were providedcourtesyof the ArthurAndersenCenterfor Family Business. that of family firms.
The support of the Family Business Program at the University of Con-
necticut is also acknowledged. Endnotes
'We identified only one study that examined these firms in the Academy
Appendix of Management Journal (Trostel and Nichols 1982) and only three such
studies in Administrative Science Quarterly (Trow 1961, Davis 1968,
Description of the Eleven Covariates Employed in the Study
Geeraerts 1984). The bulk of existing research has been published by
Eleven covariates were included to reduce variance that is extraneous a fairly recently founded journal, The Family Business Review. We
to the research question or may confound interpretation.We controlled updated Chrisman et al. (1996) to find the number of articles published
for Firm Size using the log transformation of total firm sales to correct by majorjournals since 1956. They are: Harvard Business Review (17),
for its skewed distribution. We controlled for Firm Age by using a Entrepreneurship, Theory and Practice (8), Organization Dynamics

112 ORGANIZATIONSCIENCE/Vl. 12, No. 2, March-April 2001

W. S. SCHULZE, M. H. LUBATKIN, R. N. DINO, AND A. K. BUCHHOLTZ Agency Relationships in Family Firms

(5), Journal of Small Business Management (7), Administrative Science technology than when residual claims allow unrestricted risk-bearing
Quarterly (3), Human Relations (3), Sloan Management Review (2), arrangements. These organizations survive in the face of such ineffi-
Academy of Management Journal (1), Academy of Management Re- ciency when the agency costs that are avoided by restricting residual
view (1), Journal of Management (1), Journal of Management Studies claims to decision agents exceed the higher costs induced by forgone
(1), Organization Studies (1), and Journal of Business Venturing (2). investments and inefficiency in residual riskbearing"(Fama and Jensen
2The Internal Revenue Service (1996) reports that about 215,000 U.S. 1985, p. 119). Of course, the conclusion that private ownership and
firms had $5 million or more in annual revenues. Of these, only 15,000 family management reduce the efficiency (and hence value) of the firm
were widely-held corporations (i.e., listed by the NASDAQ, NYSE, or is somewhat at odds with La Porta et al., (1999: 28) who conclude that
other exchange). While we do not know the precise figure (neither the "by far the dominant form of controlling ownership in the world is not
government nor Dun and Bradstreet track this data), experts estimate that by banks or corporations but by families."
that sixty to eighty percent are likely to be family managed (Gersick 5Akerloff (1972) observed that inefficient markets lower the average
et al. 1997, The Economist 1996). These estimates are consistent with quality and price of goods traded. Ironically, poor-quality goods oc-
the results of the 1993 National Survey of Small Business Finance, casionally get a premium price and attract more poor-quality goods,
conducted by the Federal Reserve, which found that a single family further suppressing average product quality. The lemon effect, in this
controlled at least 50% of the ownership in approximately 65% of the manner, sorts markets by the quality of the goods and services offered.
firms that had more than $5 million in revenue. Besanko et al. (1996) describe the effect of sorting in labor markets on
Family ownership of public corporations is also important. In their managerial talent in their text.
authoritative study of corporate ownership around the world, La Porta, 6The threat of hold-up explains, at least in part, why firms grant some
Lopez-de-Salanes, and Shleifer (1999) found that family members par- executives and other potentially valuable employees stock options as
ticipate in the management of at least 69% of the firms they control. terms of employment. This "bond"protects the prospective agent from
(Control is defined as 10% ownership). Moreover, families on average employer (owner) opportunism (Reagan and Stulz 1986).
control 35% of the largest firms in the richest countries in the world, 7The model recognizes that conflicts of interest arise with fractional
compared to the 24% that are widely held and the 20% that are con- ownership of the firm because every owners' ability and/or willingness
trolled by the state. Family control becomes more prevalent as firm to bear risk varies with the relative size of their stake in the firm and
size falls, with families controlling approximately 53% of the world's their personal preference for risk (Fama and Jensen 1983a, 1983b;
medium-sized firms ($500 million in revenues), compared to the 20% Reagan and Stulz 1986; Wiseman and Gomez-Mejia 1998). For ex-
that are state-controlled and 11% that are widely held. (The remaining ample, owners who have a large portion of their wealth invested in the
percentage of firms in these samples are owned by financial institutions firm may prefer less risk than more diversified investors, and older
or by cooperatives, trusts, or other groups that lack a single controlling owners are likely to be more risk averse than younger owners.
investor). 8While single-preference utility functions are the norm in neoclassical
Of course, the importance of family management varies greatly around economics, dual-preference utility functions are found in a variety of
the world. In the United States and Canada, families control about 30% literatures (Lunati 1997, p. 28), including the economic theory of the
of the largest public firms and directly participate in the management household (Becker 1974), public choice (Buchanan 1975), cooperation
in about a third of them (Forbes 2000, Kang 2000). And while families (Arthur 1991, Margolis 1982), and sociobiology (Krebs 1987, Nowak
and May 1992).
control only 10% of the largest firms in Australia, Japan, Finland, and
9Jensen (1994: 45) states "Constrained at the time (1976) by our econ-
Germany, they control 50% of the largest firms in Belgium and Israel,
omists' view of rationality, Meckling and I discussed only one source
55% in Sweden, 65% in Argentina and Greece, 70% in Hong Kong,
of agency costs, that which emanate from the conflicts of interests
and 100% in Mexico (La Porta et al. 1999). As these statistics indicate,
between people. There is clearly a second major source of agency costs,
the influence of the family on firm governance is an important but
the costs incurred as a result of self control problems .. ."
astonishingly neglected topic in management research.
'?While this definition of altruism is "impure"in the sense that it views
3While we focus on the 1976 J/M model due to its clarity and wide-
altruism as being driven, at least in part, by exchange, it is common,
spread acceptance, our discussion of that model is informed by more and "for many (economists) the only acceptable" approach to altruism
recent research, including Fama (1980), Fama and Jensen (1983a,
(Lunati 1997, p. 22). She and Piliavan and Chamg (1990) explore the
1983b, 1985), Jensen (1993, 1994, 1998), Jensen and Meckling (1995) implications of this definition at length.
and Jensen and Murphy (1990). Important exceptions and/or modifi- " Family members are de facto owners of the firm in the sense that
cations to the 1976 J/M model by these or other researchers are noted. each acts in the belief that they have a residual claim on the family's
4More formally, Fama and Jensen (1985, p. 118) state that the "restric- wealth, and/or the right to have a say in determining its use (Holtz-
tion of residual claims (to decision agents) avoids the costs of con- Eakin et al. 1993, Stark and Falk 1998). This belief is not only en-
trolling agency problems between decision agents and residual claim- hanced by the extent to which altruistic CEOs grant family members
ants, but at the cost of inefficiency in risk-bearing and a tendency perquisites and privileges, but also in the common law which, in the
toward under-investment." The effect is that the choice of organiza- absence of a will, distributes the family estate in equal shares among
tional form (i.e., public vs. private) involves a trade-off between agency the surviving members.
costs and other costs that accompany private ownership. These other 12Family-firm CEOs most frequently identify attorneys and accountants
costs arise because "The residual claimant-decision agents (of closed as their closest and most trusted advisors (ArthurAndersen & Co. 1995,
corporations) tend to choose lower levels of investment in plant, equip- Ward and Handy 1988). Gersick et al. (1997) lament their tendency to
ment, etc. that reduce future production costs, and they choose different name them to their boards.

ORGANIZATIONSCIENCE/Vol. 12, No. 2, March-April 2001 113

W. S. SCHULZE,M. H. LUBATKIN,R. N. DINO, AND A. K. BUCHHOLTZ AgencyRelationshipsin FamilyFirms

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Accepted by James Walsh; received July 12, 2000.

SCIENCE/Vl. 12, No. 2, March-April 2001