When it comes to financing the growth of a family business, whether it’s through joint ventures, strategic partners or going public, “there is no free lunch,” says Wharton management and entrepreneurship professor Raphael (Raffi) Amit. “There will be a loss in terms of control, which the family will not like.”
In early November, Amit, who is academic director of The Goergen Entrepreneurial Management Program and chairman of the executive committee of the Wharton Global Family Alliance, gave a talk to a group of entrepreneurs in Shanghai on the costs and benefits associated with a range of mechanisms used by families to maintain voting control of their firms. Following his speech, titled “Managing and Financing the Growth of Family Businesses,” Amit answered audience questions about succession and other issues, and in a separate interview with qq.com — one of China’s top online media companies — he discussed the unique challenges facing family enterprises in China.
During his lecture in Shanghai, Amit highlighted a range of alternatives to finance the growth of family firms, including retained earnings, bank debts, internal capital of family groups, joint venture partners, strategic partners, private equity, public equity and public debt, among others. Although each method has its pros and cons, he said, the deeper issue “is that a family business owner is very reluctant to share the control or even give up control in some cases to any external capital provider.”
For example, he said, an argument against going public might be that by using public sources of financing, one has to disclose valuable business information to competitors and be subject to the short-term orientation of public capital markets.
But there are also advantages, he noted. “By being public, you have a lot of flexibility. You have the currency — your stock — to use for acquisitions; it provides the potential for liquidity to family members and other shareholders, and it provides transparency for consumers and investors. Public companies can also use stocks as incentives for professional managers, as one of the biggest problems that family businesses have is to try to attract and retain professional managers.”
But families don’t like to relinquish control, Amit said, and often put in place potentially “costly” mechanisms like dual-class shares with different voting power, pyramidal ownership and disproportional board representation.
“By far the most prevalent control mechanism used by families is dual-class stock. The reason is that it gives the largest wedge between their ownership (i.e., their economic interest) and their voting control. But it’s also the most costly in the sense that dual-class shares have the most negative impact on the value of the firm’s stock,” Amit said.
“In general, my joint research with Professor Villalonga of Harvard Business School on large family businesses has validated empirically that dual-class shares and disproportional board representation negatively affect the value of the firm,” he added. “However, voting agreements have a positive impact on value. So, while the downside of a voting agreement is that it doesn’t provide as large a wedge as dual-class shares, you don’t suffer in firm value.”
Following his speech in Shanghai, Amit answered questions from the audience, some of which are excerpted below:
Audience Member: Why would non-family shareholders be willing to accept the control mechanisms you described?
Amit: This is a very important question…. When shareholders buy shares in a widely held public company, there is a conflict between shareholders and managers. This is a classic “agency problem,” whereby managers who control the day–to-day business of the firm tend to manage the company for their own benefit — for example, they want to have a very stable company so that their job is secure. This may not be in the best interest of shareholders and hence a conflict.
In a family-owned company, that problem goes away, because the owner is the manager. There is, however, another problem: namely, the conflict between the family shareholders and non-family shareholders. The reason for the adverse effect on valuation when the family puts in place a control mechanism, such as dual-class shares, is because other shareholders are concerned about the appropriation of private benefits of control by the family.
My research with [Harvard Business School] professor [Belen] Villalonga revealed that as long as the founder is the chairman and CEO, or chairman with a hired CEO, the conflict between family shareholders and non-family shareholders is less severe than the traditional conflict between owner and managers. This implies, in turn, that shareholders would be better off in this situation — to hold the shares of family companies rather than non-family firms.
Audience Member: Do you see differences in succession issues between family businesses in Asia and in the West?
Amit: I think that Western families are better able than Asian families to deal with mortality. I know mortality is difficult for all the people in the world, but it’s a difficult situation when there is no succession plan beforehand and the second generation has to jump into a situation which is unstructured. It’s very important to expose the next generation, over many years, to [the idea that] they have the responsibility for a family business which employs thousands of people.
Audience Member: Why is succession so challenging for family businesses?
Amit: Succession in the family business context is very different than succession in widely held public organizations. Why? I have been a board member for a public organization for many years; my job is to find the next CEO of the company. But in a family business, it’s different because the person who will be the new head of the family may not be the same person who will be the head of the operational business….
Suppose you have two children. You love both of your children the same way, but they are very different. The older brother is a very talented artist who has no interest in business, and the daughter studied finance, management and other business courses; she is a natural. So, you have a little bit of a problem. One of the issues is that you love both of them and you have to treat them equally; but in business, the younger one will be higher than the elder one, which may cause a problem if there is no appropriate education and communication. This is just one example. There are many other challenges that you need to overcome.
Audience Member: Which is more important, family or business?
Amit: This is a very important question. Some families define themselves as “a family in business,” while others define themselves “a business family.” For the business family, business comes first; for the family in business, family comes first. What’s right for your family may not be right for another person’s family. It’s very personal, and it’s how the family feels about it.
Audience Member: What are you interested to learn about China’s family businesses?
Amit: What I am particularly interested in is the governance structure of family business in China; succession issues which might be critical for survival of the family business here and financing growth issues. I would also like to study the family office, which manages the wealth of the family. These organizations deal with asset management but also with very important issues [concerning] family culture, legacy and educating the next generation so as to preserve the founder’s legacy and the culture of the family.
The following questions are from a subsequent video interview Amit had with qq.com in Beijing:
QQ: 35% of Fortune 500 companies are family controlled firms, and more than 70% of them are family originated. What’s your definition of the family business?
Amit: Two important things I want to share with you. First of all, there is no one way to define a family firm. A very liberal definition would basically say that family firms are those in which a family holding block of shares, either as a group or individually, is greater than 5%. A more conservative definition would be that these are firms with family as the largest vote holder or the largest shareholder, or a firm with the second generation or later involved in management, or the family involved on the board of directors. Depending on how you define a family firm, you will get different conclusions on whether a family firm is worth more or less than the non-family firm.
Another important thing I want to share with you is that my research with professor Wu of Peking University, about private firms in China, suggests that in China, privately owned firms have better governance than state-owned enterprises. You might think that is surprising. But in fact, when you try to think why, the explanation is that family firms have strong incentives to have very strong governance. In order to mitigate the control that public shareholders might have, the family appropriates private benefits of control. So, families understand the issue and have better governance, as measured by more independent directors, more committees and more meetings of the board every year. Families are more concerned than state-owned companies in China about showing to shareholders that they have nothing to hide. That is a very powerful observation, and an important observation for the public to know.
QQ: China has a saying that “family fortune never lasts longer than three generations.” Are there any data to approve it?
Amit: Succession, which is a key issue for family business, is a particularly difficult problem in China: First, most of the family businesses are first generation; second, there is one-child policy in major cities; and third, there is a cultural issue of being very reluctant to welcome professional managers to run the family business.
So in China, when it comes to succession, there is an issue of whether the founder is ready to retire. If something happens to you, who will take over the business? If your child is not willing or able to take it on and you don’t want an outsider in it, then most likely the business will be sold. From that standpoint, it is more difficult to see later generations of the family business in China.
I can tell you that as you quoted, 35% of Fortune 500 companies are family controlled firms but none of them is first generation — these are later generation firms and in all these cases, families welcomed professional managers to the firm. So, there is one way the family can maintain the ownership of the firm even though a family member may not run it. For example, the Ford Company in America, they had professional managers in it, but from time to time, family members came in. In 2000, the Ford family owned about 6% of the shares but controlled close to 40% of the votes. Despite the fact they are very large companies, families are still able to maintain substantial control of their firms.
The message is that Chinese first generation owners should not hesitate so much to consider bringing in professional managers. Our research findings suggest that one can expect the value of the firm to increase on average when an outsider comes in as CEO. But our research also finds that when descendants serve as CEOs, firm value is destroyed.
QQ: If the second generation are mostly better educated than their fathers, why are they not doing well?
Amit: In research we always do statistics on averages. But I can tell you some very successful stories when the father hands it over to the son. For example, there is a big company in the United States called Comcast which is the largest cable company in the U.S. The father gave the CEO [position] to his son and the company is very successful. The family still controls 34% of the company even though they only have less than 10% of the equity.
But the point is that perhaps what drives the father or the founder may not be present in the son. It’s not just about education, it’s also about leadership, about charisma, belief, etc., that the father had. So there are many factors here, with no one reason that one can identify.
QQ: Is hiring professional CEOs from outside the family the only way to improve family businesses in the second generation?
Amit: Indeed, the major challenge is how to attract and retain top-notch professional managers. In family business, compare to non-family business, there are very few ways you can provide incentives. In particular, outsiders always know the family members can get the top job, so there is less incentive to go to the company; also if it’s not publicly traded, you can’t get compensation [by way of] options or shares in the company, so there needs to be a big pay-off for the work of these guys. Family business is struggling with these issues and there is no doubt about it.
But there are some creative solutions for the family firms to attract professional managers. For example, phantom stock option plans work exactly like those stock option plans, except they are phantom because the stocks are not publicly traded. But they [mirror] the increase of the value of the firm. So there are ways family businesses can attract professional managers, and there are ways family businesses can work with professional managers in the firm. All in all, I believe this is a big challenge for the family: Those who are open and willing to accept professional managers can succeed.
QQ: But maybe the family owners are worried that the professional manager will take over the company….
Amit: Or hijack the firm. I had a conversation with some local people and found they are afraid that a professional manager might hijack the company from the family. But these concerns do not have support in the data. Proper corporate governance can alleviate this concern. As long as the family sits on the board, they can fire the CEO if that person doesn’t perform. I think the risks are not that high. I understand the emotional feeling and the fear, but if you think about it rationally — you know, you don’t hire the guy just off the street, you look at his track record. And if she or he does something that’s not good, they have a lot to lose as well. I think if there is proper corporate governance and a proper contract in place, the risk of stealing or hijacking companies from the families is minimum. And the data is very strong in suggesting that the value of a family business goes up when professional managers are brought in.
QQ: Obviously, we have a different business culture here in Asia than in America. What’s the difference between family businesses in the East and the West?
Amit: In principle, the problems are the same: succession problems, growth problems and management problems. However, the culture is different. I think that on average, it’s fair to say that Asian families are more reluctant to bring outsiders into the company; they won’t necessarily trust the person who is not blood related. Second, it is a new phenomenon in Asia that most of the family firms are first generation firms with a short tradition, so that the ways for the families to preserve their values, culture, heritage and legacy are not well established. We have done a lot of research and I think families are figuring this out, and you will see the beginning of that.
QQ: As you know, most of the family businesses in China are very small. So maybe you could share with us some les