Agency Theory
For family firms without family CEO, the potential agency conflicts between owners and managers may arise. In our sample, a fairly large part of the observations are entrepreneurial family firms and family firms with family CEO.
This introduces another type of agency conflict we have to address, the agency conflict between majority and minority shareholders.
Regarding family firms, agent theory is prominent and almost inevitable. Jensen and Meckling (1976, p. 308) “define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”. This relation is much discussed due to the problem arising due to conflicts of interest between the principal(s) and the agent, introducing the concept of agency cost. Based on Jensen and Meckling´s definition, Fama and Jensen (1983, p. 304) states that “agency problems arise because contracts are not costlessly written and enforced. Agency costs include the costs of structuring, monitoring and bonding a set of contracts among agents with conflicting interests. Agency costs also include the value of output lost because the costs of full enforcement of contracts exceed the benefits”. In other words, agency cost might be defined as the sum of the monitoring expenditures by the principal, the bonding expenditures by the agent and the residual loss (Jensen & Meckling, 1976, p. 308).
Agency theory will be useful in inference of the analysis regarding the family or non-family CEO distinction between the family firms. In more detail, the agency problem is categorized between different problems. Agency problem one (A1) arises between the owner and the manager of the firm (Villalonga & Amit, 2006).
In short the problem is that the manager (agent) does not have the same incentives as the owner (principal), and might use the invested capital in his best interest rather than in the owner´s best interest (Shleifer & Vishny, 1997). Agency problem two (A2) (Villalonga & Amit, 2006) arises between the controlling shareholders (or families) and the minority shareholders (Bhaumik & Gregoriou, 2010). More concretely, majority shareholders might use their voting rights to expropriate
private benefits in addition to the dividends which are the only return to the minority shareholders.
Stewardship Theory
Stewardship theory suggest that family CEO, regardless of ownership, will generally behave in the firm’s best interest, i.e. goal of the principal and agent is aligned and that the agent acts as a good steward in the interests of the principal (Davis et al., 1997). Family managers are presumed to behave this way because they share the same personal goals as to family goals, pursuing non-financial goals and behave according to the relational agreements that governs the family firm behavior (Corbetta & Salvato, 2004).
Contradictions in Agency- and Stewardship Theory
The two theories have conflicting implications on family firm behavior, regarding the mechanism on agency cost control on family CEO. The two theories predict different outcomes. By agency theory, if the family CEO behaves more like an agent, one should observe that agency cost control mechanisms being imposed on family CEO, hence improving the results. On the contrary, according to the stewardship theory, if family CEO behave more like a steward, then one should observe absence in imposition of agency cost control mechanism, thus family CEO and firm performance will have a negative relationship.
Information Asymmetry
To address the problem of information asymmetry by turning to adverse selection, an often-used metaphor is the buyer and seller of used cars, often referred to as the lemon problem (Akerloff, 1970; Brealey, Leland, & Pyle, 1977). In our case it is the relationship between the buyer and seller of a firm.
An entrepreneur starts a company and wants to get external financing simply in order to become more diversified. Due to information asymmetry, the potential investors are not sure about the quality and true value of the firm. Further, it is reasonable that bad firms are more willing to sell equity stakes to somebody else.
If the firm have a god investment opportunity the initial investors will keep it for them self, diversification is less attractive. The friction progresses when outside investors cannot tell the difference of peaches (good firms) and lemons (bad firms).
Thus, firms which are peaches have to sell equity at a discount to be attractive. To show the investors how good the opportunity is, the new investors must receive
very good terms. Like IPO underpricing, compensating investors who are afraid of overpaying, is often referred to as the “winners curse”.
The Pecking Order Theory
In accordance with the lemon problem, Myers and Majluf (1984) came up with the theory of pecking order. It is a hierarchy of financing where the firm is assumed to prefer to finance new investment opportunity with retained earnings, then issue debt, lastly issue equity.
The first argument being that the retained earnings, which are already in the company, are less troublesome to use as source of financing, since these financing decisions are less influenced by shareholders and creditors.
The second argument is that the creditors do not care about the excess return in the company as long as the company make enough to cover their debt.
Lastly, shareholders require proportional returns to their portion of equity in the company on every marginal dollar made. Hence, shareholders care about each and every small change in performance, unlike the creditors that only care about the debt repayment. Therefore, issuing equity is the most expensive way to finance the project.
The takeaway is that if a family firm has a very good investment opportunity and the funds to finance it, the company may rather prefer to fully finance the investment opportunity with internal funds, since it performs well. If the company was to source their financing from outsiders in terms of issuing shares, the company’s investors would need to sell shares at a discount. Then the question is why they would do so. The benefit of keeping the investment opportunity within the family is assumed to be greater than the cost of not being well diversified.
This might give an implication to why we might find entrepreneurial family- and family firms that finance themselves to perform better than non-family firms. The reason being that the firms that are still within family might be considered as peaches (better performers) rather than lemons (bad performers).