Role of Boards in Family Firms - Literature review Example

Role of Boards in Family Firms Introduction Boards play a significant role in the management of family businessesjust like other firms. Several researches and studies have been carried out regarding the role of boards in family firms. While some researches support the agency theory when explaining the role of boards in family firms, others focus on resource based view. In terms of agency theory, researchers argue that family firm management needs to be controlled by boards. On the other hand, resource-based view is a multi-theoretic approach in which boards are considered as resources that give the family firm useful advice and know-how. According to the agency theory, an external board is needed to control the actions and decisions of firm managers in order to create shareholders’ wealth. This normally applies exclusively to non-family firms. However, in family firms multi-theoretic approaches apply, especially the resource-based view. The boards that give advice to managers of family firms in the resource based view can be family-internal, affiliate or external. Board of Directors plays an important role in developing behaviour and instilling some values of good governance in the management of family firms. In terms of agency theory, boards play monitoring functions in order to deal with agency problems. The agency theory can therefore be used to explain the role of boards in enhancing corporate governance performance. In corporate governance, there are three parties involved: managers, owners, and board of directors. The board of directors intermediate between the other parties in order to protect the interests of shareholders and deal with agency problems that may arise. When the ownership and monitoring functions are separated in family-owned businesses, agency problems occur. Board of Directors enters the picture to deal with that problem. The resource-based view affects the entrepreneurship and performance in family-owned businesses. According to the Resource-Based View (RBV), there are no two completely identical organisations because capabilities and resources of are heterogeneous across firms. Firm resources can be strengths or weaknesses to the firm. Board of Directors is an intangible resource which varies across firms. They offer knowledge, management skills, cognitive skills and information needed to improve the performance of the firm. In this literature review, it is clear that researchers in the past have taken different positions on the role of Board of Directors. It is clear that the Board of Directors of family businesses is both a custodian of shareholders’ wealth and provider of important skills, capabilities and knowledge needed to improve the performance of the family business. Therefore, agency theory and resource based view play a significant role in explaining the role of boards in family firms. In fact, some researchers provide accounts for the roles of boards in family firms using both the agency theory and the resource-based view. After all, it is normal for different members of an organisation to play more than one role. Boards can play the role of dealing with agency problems while at the same time provide advice and know-how to the family-owned business. Agency Role of Boards in Family Firms Several researchers and theorists argue that agency theory is an important aspect of explaining the role of boards in family firms. In this case, family firms hire outside directors to monitor the actions of the managers of the company in order to protect the interests of the owners and the shareholders, and solve agency problems that may arise between the managers and the owners of the family firms. One of the studies that provided a case of agency theory on the role of boards in family firms is the study of De La Torre et al (2011) which provides arguments for both the resource based view and agency theory of the role of boards in family firms. In terms of agency theory, De La Torre et al (2011) suggest that Board of Directors deal with agency problems through effective monitoring function which influences firm behaviour. Family firm behaviour is influenced by appropriate internal control mechanism which can be achieved through effective governance. According to this research, the agency theory looks at the role played by board of directors in enhancing effective corporate governance. According to De La Torre et al (2011), a family firm usually undergoes generational phases which are linked to the need for board control. One of the main findings of De La Torre et al (2011) is that there is a difference between the behaviour of first generation family firm and subsequent generations. In the first generation, the interests of the principle align with those of the agent to ensure that the shareholders’ wealth is maximized rather than being misappropriated by the management. In the second and subsequent generations, the interests of the management and the family owners diverge. This causes increased agency costs. In order to represent each family member’s interests, fully trusted relatives are chosen to protect the interests of the family. An excessive inclusion of family members and relatives in the board leads to excessive misappropriation of firm’s resources and the protection of shareholder’s interests will be negatively affected. In this case, the role of control by directors in family firms becomes successful only to the extent that family members and relatives are not over-represented in the board. If family members set in, agency costs increase rather than decreasing. This research argues that the relationship between outside directors and family firm performance is positive for the first generation of managers. However, the relationship becomes negative when the management of the company is passed from one family generation to the next. Having outsiders on the board during the first generation improves performance in the family firm. This can be explained using the agency theory. During the first generation, outside directors moderate family power effectively and solve agency among various stakeholders within the organisation. During second and subsequent generations, the presence of outsiders in the board leads to negative effects on performance because the outsiders fail to act objectively due to overlapping interests with the family firm. This may be caused by the changing methods of choosing directors whereby personal friendships play influential roles. From this perspective, it is clear that De La Torre et al (2011) support the application of agency theory in defining the roles of boards in family firms. This is clear from the fact that the study sees firm performance as a result of effective monitoring mechanisms from outside directors, especially during the first generation of management. The declining performance caused by outsiders in subsequent generations does not mean that boards play a negative role in solving agency problems. It only means that the interests of directors start to conflict with the interests of the firm in second and subsequent generations. This problem can be solved using an appropriate selection process that will lead to the selection of trustworthy and responsible directors who can protect the interest of shareholders sufficiently. Similarly, a study by Prabowo and Simpson (2011) on family-controlled firms of Indonesia also found out that the proportion of independent directors does not have a significant impact on the firm performance. Like De La Torre et al (2011), these researchers have also attributed this finding to problems involved in appointment of the independent directors. Prabowo and Simpson (2011) further argue that family ownership and involvement of family in the board leads to negative impact on firm performance. These researchers argue that firm performance is lowest when the family owners of the business are involved in control decisions. This means that it is more important to include independent directors. However, the study has found that this also causes negative impact on firm performance if the selection process is not conducted in an appropriate manner. This research proposes that governance resources should prevent family majority owners from exercising excessive control over firms. From the definition of agency theory, it is clear that Prabowo and Simpson (2011) considers agency roles of control as detrimental to business performance of family firms, especially if the family members are involved in excessive control of the firm. The owners of the business should give the board an independence to implement appropriate governance policies and exercise effective control over the management of the family firm in order to achieve good performance in the organisation. The conflict that arises between managers and owners can be solved by including independent directors with appropriate rules of governance. Some researchers suggest that an increased number of outsiders in the board of directors of a family firm lead to a positive effect on firm performance (Shleifer and Vishny, 1997). This is because outside directors play a more independent monitoring role in family firms. This supports the agency theory function of monitoring by Board of Directors in family firms. In this case, a higher proportion of outside directors in family firms monitors management self-interests more independently and causes positive results and performance of the organisation. According to Prabowo and Simpson (2011), family firms usually lack good governance mechanisms. As a result, shareholders rely on the participation of independent directors to monitor control business activities, personal interests and opportunities of family firms. In situations of weak corporate governance, a board of directors can be used in family firms to improve the behaviour of managers and enhance firm performance. Outside or independent boards stand up against family opportunism in order to protect shareholders’ interests and rights. For instance, a large proportion of outside directors in the organisation can prevent an incompetent or unqualified member of the family from taking up an important position of management such as the CEO (Shleifer and Vishny, 1997). This reduces the chances of poor performance or failure in various sections of the organisation. From the context of an agency theory, fewer moral hazard conflicts are expected between family shareholders and outside shareholders if outside directors are hired to form a Board of Directors in family firms (De La Torre et al, 2011). In this case, outside directors serve to eliminate or at least reduce the conflicts between family shareholders and outside shareholders; hence causing an increased firm performance. Research also suggests that the role of boards is to minimize agency costs in firms. Agency costs include the costs of having divergent interests between the owners and managers of firms as well as the costs of monitoring the manager to reduce divergence. When the costs of minimizing divergence exceed the costs of having divergent interests, then the role of boards in family firms becomes negatively related to performance. However, if the costs of controlling managers or reducing divergence of interests are less than the costs of maintaining divergent interests, then controlling roles of boards in family firms become positively related to performance in the firm. Most often, the latter is true. According to Jensen and Meckling (1976), family firms are always likely to incur fewer costs because the interests of owners (family members) are aligned with those of managers (agents) because they are usually the same. In most cases, the family becomes the manager and at the same time, the owner. Therefore, the families are always encouraged to reduce agency costs in order to improve their wellbeing through the benefits derived from the business. This increases performance. Families may also have common goals, objectives, high trust and shared values which promote good governance and eliminate the need for monitoring mechanisms (Jensen and Meckling, 1976). In this case, involvement of family in ownership and management of the firm reduces agency costs and improves firm performance. From the suggestions of Jensen and Meckling (1976), it is clear that it is not necessary to have an external board of directors which would interfere with the engagement of family members in management and ownership of the family firm. Proponents of this argument suggest that family members should participate in the governance of the business because they are shareholders just like other external shareholders; hence they are likely to maximize the interests of all shareholders as they protect their own interests as the major shareholders of the firm. Involvement of family members in managing and governing the family business also encourages altruism which leads to loyalty, effective communication and good decision making; hence significantly reducing agency costs. In this perspective, boards in family businesses should be derived from the family members in order to protect the interests of the company and maximize its value as opposed to external directors. Whether internal or internal, it is clear that boards play a significant role in reducing agency costs and increasing performance with in the organisation through effective governance which improves managerial behaviour. Despite the proposition that family management and ownership reduces agency costs, Jones et al (2008) argue that family ownership without outside directors is likely to increase agency costs. In this perspective, family conflicts are considered to exacerbate agency costs. In family managed firms, family members usually exercise concentrated block holding which they use to expropriate wealth from minority shareholders. Expropriation of minority stakeholders may occur as family members who are the major stockholders award themselves hefty compensations, party transactions and special dividends. Family members are always likely to pursue their own interests ahead of those of outside shareholders; hence causing agency costs. Family managers are also unable to monitor each other effectively. Therefore, it is important to have an independent outside board of directors. According to Jones et al (2008), outside directors monitor the actions of family managers and provide appropriate advice and knowhow to reduce agency costs that result from expropriation of family managers. In the first generation of family firms, there is a positive relationship between family ownership concentration and firm performance. However, when the concentration of family members increases in subsequent generations, expropriation of wealth from minority shareholders increases. This leads to high levels of agency costs and low performance of the firm. Expropriations can be reduced through outside board of directors who monitor and advice managers appropriately. García-Ramos and García-Olalla (2011) suggest that the role of boards in family firms from an agency theory perspective is to monitor the firm’s management order to reduce agency costs and improve the performance of the family firm. This finding agrees with the findings of the other studies studied so far in this literature review. However, this study suggests that the board’s role of reducing agency costs is related to the role of monitoring management. One of the roles impacts on the other. So far we have recognized that shareholder-manager conflict leads to agency costs, but García-Ramos and García-Olalla (2011) argues that agency costs may also be caused by owner-owner conflicts in family firms. This conflict results from the divergent interests of majority shareholders who are mainly family members and the minority shareholders who are outsiders. This supports the general idea that divergence of interests leads to agency costs. Shleifer and Vishny (1997) support this argument by suggesting that family interests may conflict as the family owners become divergent on whether to pursue economic interests or non-economic interests. Resource-based view There are studies and researches that explore the roles of boards in family firms from a resource-based perspective. This perspective posits that resources increase the value of firms and make them unique, inimitable, and differentiated in order to enhance competitive advantage for the company. Research also suggests that family-controlled businesses have unique governance conditions that create sustainable competitive advantage through asymmetric or inimitable capabilities. Researchers supporting the resource-based view argue that boards provide human capabilities including infrastructure, knowledge, and research and development that that enhance long-term relationships among various stakeholders of the family firms (Dyer, 2006). Board of Directors provides a family firm the necessary human capital needed to gain competitive advantage. Some of the features of human capital that promote competitive advantage in family firms include: culture, shared values, reputation, trust and commitment. Directors also provide companies with necessary capabilities and strategic resources needed for long-term success of the family firm. In order to enhance success in family firms, it is important to have directors who can provide tacit collective knowledge that can be used in routine activities of the firm to integrate, mobilize and coordinate resources and capabilities in order to achieve competitive advantage. Dyer (2006) suggests that family management leads to lower delegation of decision making responsibilities in family firms. In this case, the family influence is high and managers are unlikely to give up control of the firm. In this case, family management usually pursues defender strategies rather than prospector strategy which lead to lower performance for the firm. Therefore, directors are required in order to provide appropriate capabilities and advice needed to improve the organisation’s performance. Another resource based view of the role of boards in family firms is that directors provide capabilities that may not be available in family management. Dyer (2006) indicates that family firms may lack sufficient knowledge and capabilities to manage and utilize resources efficiently to improve firm performance. Family firms may fail to achieve enough potential recruits within the family. Therefore, the family may not be able to supply enough talented people to manage operations effectively (Dye, 2006). In this regard, family firms should have independent boards to provide the required human capabilities to manage operations and enhance effective governance within the firm. References list De La Torre, B.A., Jainaga, T.I. and Garcia, A.M. (2011). Firm Performance and Board of Director’s Structure: Evidence from Spanish Non-Listed Firms. Bulletin BSU. Avg., 3(2), 81-85. Dyer, W.G. (2006). Examining the “Family Effect” on Firm Performance. Family Business Review, 19(4), 253-273 García-Ramos, R., and García-Olalla, M. (2011). Board characteristics and firm performance in public founder- and nonfounder-led family business. Journal of Family Business Strategy, 2, 220-231. Jensen, M.C. and Meckling, W.F. (1976). Theory of the Firm: Managerial behaviour, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. Jones, C.D., Makri, M., and Gómez-Mejía, L.R. (2008). Affiliate Directors and Perceived Risk Bearing in Publicly Traded, Family-Controlled Firms: The Case of Diversification. Entrepreneurship Theory and Practice, 32(6), 1007-1026. Prabowo, M.A. and Simpson, J.L. (2011). Independent Directors and Firm Performance in Family Controlled Firms: Evidence from Indonesia. Asian-Pacific Economic Literature, 25(1), 121-132. Shleifer, A. and Vishny, R.W. (1997). A survey of corporate governance. Journal of Finance, 52, 737–783. Read More