By |Published On: January 6th, 2016|Categories: Corporate Governance|

Families are a basic and universal institution of human society that provide a network of relationships, safety and support, allowing the transmission of values and education across generations. Blood is truly thicker than water.

These characteristics uniquely position families to guide and sustain organizations over time. For instance, the loyal bonds of family, when paired with ownership of a corporation, can be a powerful business driver. Yet family ownership in a corporation sets up some basic conflicts, or agency problems, that must be resolved for the corporation to flourish.

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What are “Agency Problems?”

In academia, the term “agency problem” refers to the conflict of interest that can arise between a principal and an agent who acts on behalf of that principal. The conflict arises when the self-interest of the agent influences him to act in a way that is inconsistent with the principal’s best interests.

In a corporation, managers (agents) make decisions that are supposed to benefit stockholders (principals), but the problem is they don’t always do so. For instance, a manager might draw excessive compensation, reducing corporate capital available for reinvestment or distribution that would otherwise benefit the company’s owners. In the context of investment management, a hired investment manager may avoid the best long-term investment opportunities and, instead, choose to “closet index” as a way to minimize career risk concerns.

This is the classical agency problem, as first discussed by Berle & Means back in 1932, and later expounded upon in a seminal paper by Jensen and Meckling. Since then the literature has expanded to incorporate the interests of various stakeholders and different types of organizations, notably family-owned firms.

In a recent paper, “Governance of Family Firms,” by Villalonga et al. (a copy is here), the authors explore traditional agency problems in the context of family-owned firms, and identify a new dimension to agency conflicts in family firms.

The authors divide agency problems into 4 areas:

Agency Problem I: Conflict of interest between owners and managers

This is the classical agency problem, as discussed above, which can add complexity for family-owned firms due to such factors as a family’s emotional ties to the business, shared family wealth, and nepotism.

Agency Problem II: Conflict of interest between controlling (family) shareholders and non-controlling shareholders

This problem relates to how large family shareholders can acquire “private benefits of control” that hurt smaller non-family shareholders. These include the following: excessive voting rights or board control, entrenched family managers, mismatch of control rights versus cash-flow rights, and “tunnelling,” or the “transfer of assets and profits out of firms for the benefit of their controlling shareholders.” In extreme cases, when “dynasty” families control large swaths of an industry, it can lead to corruption and inefficiencies that can have implications at a macroeconomic level.

Agency Problem III: Conflict of interest between shareholders and creditors

This agency problem typically involves a tradeoff between two forms of equity/debt conflict:

  1. The “asset substitution” effect describes how equity holders use debt financing to invest in riskier projects, which add option value to their equity ownership, but make the debt riskier
  2. “Debt overhang” has the opposite effect. Equity owners, fearing bankruptcy, underinvest in positive NPV projects, since the benefits of investment cash flows will go to debt holders

Agency Problem IV: Conflict of interest between family shareholders and family outsiders

Here the authors introduce a new agency problem: conflicts between family shareholders and the broader family who are not managers or shareholders. These “super-principals” may have an interest in non-financial aspects of the firm, including preserving the family’s reputation and legacy, giving back to the community, or protecting the environment. Here, family shareholders’s financial interests (e.g., maximizing the value of a share or increasing the dividend) can conflict with these objectives.

Governance Mechanisms in Family Firms

Next, through the lens of family-owned firms, the paper examines how various governance mechanisms can address these 4 agency problems:

Ownership Concentration

  • Family-owned companies in the aggregate seem to offer a good solution to Agency Problem I, since ownership in family businesses tends to be concentrated in small groups that are motivated to monitor managers by 1) their significant ownership stake, as well as by 2) their emotional ties to the business. Additionally, when owner family members are also managers, this can further diminish the risk of conflicts.

Boards of Directors

  • Boards address Agency Problem I by monitoring management, and Agency Problem II by protecting non-control shareholders from expropriation. In family-owned firms, the presence of family board members can also manage Agency Problem IV by increasing communication among family shareholders and super-principals.

Executive compensation

  • When properly structured, executive compensation packages can align owner/manager interests and reduce Agency Problem I, and can reduce entrenchment associated with Agency Problem II, for instance through the use of options and severance pay.

Reducing free cash flow through debt or dividends

  • Debt focuses managers on avoiding bankruptcy, aligning them with owners on Agency Problem I. Additionally, the use of debt or dividends, which reduces free cash flow available for expropriation or for projects that may be value destroying, is a useful tool to discipline managers. Also, the use of debt reduces the need to issue equity, which keeps ownership in the hands of the family, thus addressing Agency Problem IV. The authors find that family-owned firms are a special type of shareholder, since the evidence shows they have lower debt costs, and better alignment of interests with bondholders.

Family governance mechanisms

  • Because of shared family bonds, families have some special tools they can use to govern themselves and their connection to the business. For instance, the Family Assembly convenes once or twice a year to update the family on the business, and encourages an ongoing exchange on shared values and vision, and enhances solidarity. The Family Council or Owner’s Council represents the family, drafts family policies, such as a family constitution, resolves disputes, and can advise the board on family-specific concerns. These governance devices can address a range of agency problems. For instance, these might allow only family managers to own equity in the firm, which could mitigate Agency Problem I, or act as a quality control mechanism to insure that family managers have adequate qualifications, which relates to Agency Problem II. They might set terms for family loans to the business, which is related to Agency Problem III. They can also provide a forum for non-owner family members to be heard, and maintain alignment of the broader family with the company, which addresses Agency Problem IV.


The existence of family members within the ownership structure of a firm can clearly complicate traditional agency theory questions. Family ownership creates a set of challenges and opportunities that distinguish family firms from the broader corporate landscape. While the academic literature around “family governance” topics continues to grow, there is much fertile ground to investigate. We look forward to additional analysis on how family corporate governance can address the unique agency problems faced by family-owned firms.

As an aside, I’ve personally lived through some family business governance challenges and I’m happy to share my thoughts and insights for those who are struggling and looking for a sounding board. Just contact us and ask for “David.”

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About the Author: David Foulke

David Foulke
David Foulke is an operations manager at Tradingfront, Inc., a provider of automated digital wealth management solutions. Previously, he was at Alpha Architect, where he focused on business development, firm operations, and blogging on quantitative investing and finance topics. Prior to Alpha Architect, he was involved in investing and strategy at Pardee Resources Company, a manager of natural resource and renewable assets. Prior to Pardee, he worked in investment banking and capital markets roles at several firms in the financial services industry, including Houlihan Lokey, GE Capital and Burnham Financial. He also founded two internet companies, E-lingo, and Stonelocator. Mr. Foulke received an M.B.A. from The Wharton School of the University of Pennsylvania, and an A.B. from Dartmouth College.

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For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

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