INTERNATIONAL and ALTERNATIVE
TWO TIER BOARD(or supervisory board) e.g., Germany
- Employees - Supervisory Board - Shareholder representatives - Management Board Under the German Corporate Governance Code, a company that has at least 500 employees must allocate one-third of its supervisory board seats to labor representatives; a company with at least 2,000 employees must allocate half to labor
Alternative models of governance
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Advisory Boards
Advantages Disadvantages -Easy to recruit since members have no legal responsibilities -Provides company with additional skills, technical expertise and knowledge. -Advice is usually unbiased -Members may offer new contacts leading to sales or source of capital. -Advice may not be followed by the company. -No authority to request information from the company. -No influence over strategy and performance oversight of the management. -Cannot be held accountable for their advice. -May not take their role seriously.
EFFICIENT MARKETS PROTECT AGAINST:
Adverse Selection One party in a transaction has an information advantage, and uses this advantage to receive preferential pricing or risk transfer. Moral Hazard One party does not bear the full risk of its actions and so engages in excessively risky transactions.
NONPROFIT ORGANIZATIONS (part 2)
Governance quality varies significantly across organizations: •Many board members do not fully understand their obligations as directors. •Many do not understand strategy, mission, and performance of the organization. •Many nonprofits lack formal governance processes (external audit, internal controls, succession planning, board evaluations). •Nonprofits with weak controls are more likely to exhibit agency problems (e.g., understate or shift costs to appear more efficient).
CORPORATE GOVERNANCE (part 2)
Governance systems are diverse because these factors combine in different ways in different countries.
Senior Management - Key Considerations
ØSenior managers are an integral part of family governance structure. ØThey manage the day to day operations of the business and the direction that is set out by the board of directors. ØThe founder(s) initially manage the family business but as it grows in size a formal management structure is required. Ultimately, Senior Mgt must transform for long-term sustainability. For example: üEnsure that the right senior managers are in place. üDecision-making processes are not unilateral (e.g., only Family CEO/Chairman) - consider Executive Committee üRemuneration system based solely on performance Evaluations of Senior Executives conducted fairly and objectively
Board of Directors - Key Considerations
ØThe Board of Directors is the central institution in the governance of family-owned business. ØInitial stage of the board is only to comply with the legal requirements but as the business grows. ØAs interim step, many family cos. consider Advisory Board that complements the skills and qualifications of their current directors. Ultimately, the board must transform for long-term sustainability. For example: üMove to a full professional board with outside members. ü üClearly define the roles of the board and separation between family institutions and senior management. ü üEnsure Board has full autonomy to direct and control the organization, separate from family influence.
INDIA
•"Clause 49:" improved governance standards for listed companies (revised 2004): -Majority of non-executives on the board. -If chairman is a non-executive (executive), 33% (50%) of board must be independent. -Board must meet at least four times a year. -A director cannot be a member of more than 10 committees across all companies. -Independent, financially literate audit committee. -Extensive disclosure of related party transactions •Challenges to reform: -Underdeveloped capital markets. -Continued dominance of family-controlled business groups.
What are family owned businesses?
•... where the dominant shareholder is a family member (broad view) • •... which are run by heirs of the people previously in charge, or by families that are clearly in the process of transferring control to heirs (narrow view) • •A family business refers to a company where the voting majority is in the hands of the controlling family; including the founder(s) who intend to pass the business on to their descendants.
2. LEGAL TRADITION
•A country's legal system has important implications on the rights afforded to business owners: -Protection of property against expropriation. -Predictability of how claims will be resolved. -Enforceability of contracts. -Efficiency and honesty of judiciary. •A strong legal system mitigates agency problems because self-interested managers know illegal actions will be punished. A corrupted political system reduces economic development by discouraging investment.
What is a family business?
•A firm of any size is a family business if: •The majority of decision making rights are the possession of the natural person(s) who: •Establish the firm •Acquired the share capital of the firm •Are family members of the above (spouses, parents or direct heirs) •The majority of decision-making rights are direct or indirect •At least one representative of the family or kin is formally involved in the governance of the firm •Listed companies meet the decision-making rights mandated by their share capital
Prevalence (part 2)
•According to EY estimates for North America (US and Canada) family firms employed 57% of the North American workforce, and generated 57% of the US GDP and 60% of the Canadian GDP in 2013. •In Europe, the European Commission determined in 2008 that family firms represented between 70% and 80% of all businesses, and accounted for 40% to 50% of the employment (European Commission, 2008). •KPMG estimated in 2015 that family businesses accounted for 70% of global GDP and over 50% of all jobs.
3. RELIABILITY OF ACCOUNTING STANDARDS
•Accounting standards give investors confidence that financial reports are correct and can be relied upon to evaluate risk and reward. •If accounting standards are compromised, manipulated, or lack transparency: -Investment decisions will suffer. -Oversight of management will suffer. -Management incentives will be inappropriate. Companies that adopt international standards receive an "accounting premium" from investors.
Agency problems in Family Firms
•Agency Problem I: Conflict of Interest Between Owners and Managers •Agency Problem II: Conflict of Interest Between Controlling (Family) Shareholders and Non-Controlling Shareholders •Agency Problem III: Conflict of Interest Between Shareholders and Creditors
Agency Problem III: Conflict of Interest Between Shareholders and Creditors (part 2)
•Altogether, the empirical evidence regarding Agency Problem III in family firms suggests that: •Family shareholders' incentives are better aligned with those of creditors than of other types of shareholders, so family firms typically have better and cheaper access to credit.
ALTERNATIVE MODELS OF GOVERNANCE
•Among public companies, governance features are imposed by regulators, listing exchanges, and capital-market pressure. •However, other organizational structures exist: •Family-controlled businesses •Venture-backed companies •Private equity-owned companies •Nonprofit organizations •The governance features of these firms will reflect the issues they face regarding purpose, ownership, and control.
Agency Problem II - Conflict of Interest between majority and minority shareholders
•As they hold substantial ownership and have controlling positions in the firm, majority shareholders may seek private benefits at the expense of minority shareholders •As such, family firms are subject to severe agency problems between family owners and minority shareholders. •Monetary and non-monetary benefits (see next slide)
NONPROFIT ORGANIZATIONS (part 3)
•Board of directors •Large: 16 members. •CEO rarely serves as chairman. •Directors often have significant fundraising obligations. •Audit committee not required. •Executive compensation •Significantly lower than for-profit companies ($130,000 median). •Comprised of salary and cash bonus.
PRIVATE EQUITY-OWNED COMPANIES (part 2)
•Board of directors •Small: 5 to 7 directors, heavily represented by insiders. •Closely involved in strategic and operating decisions. •Require more time than public boards (54 days v. 19 days, per year). •Executive compensation •Lower salary but higher total pay opportunity than public company CEOs. •CEO equity stake in company doubles following sale to PE firm. •Performance targets shifted from qualitative to profitability measures. •Equity awards contain a mix of performance and time-vested awards. •Capital structure •Debt-to-equity ratio triples following acquisition (25% to 71%).
VENTURE-BACKED COMPANIES
•Board of directors •Tightly controlled: 4 directors, 2 of whom are members of VC firm. •Low independence (56% of directors); CEO rarely serves as chairman (15%). •No formal audit, comp, or governance committees until run-up to IPO. •Executive compensation •Heavily weighted toward equity-based awards. •Prior to IPO, CEO holds 15% of equity, top five managers 26%, total directors and officers 63%. •Antitakeover protections •Remain tightly controlled following IPO. •77% staggered board, 15% dual-class shares, 69% restrict shareholder rights
What are the weaknesses of family businesses?
•Complexity •Family businesses are usually more complex in terms of governance, due to the addition of family emotions and issues. Conflicts among family members. •Informality •As families usually run the business themselves, there is little adoption of business practices and procedures. •Lack of discipline •Many family businesses do not pay attention to succession planning, family member employment, or attracting and retaining talent outside of family. •Might be excessively risk-averse.
SOUTH KOREA
•Dominated by "chaebol" (affiliated companies that operate under the strategic and financial guidance of headquarters): -Led redevelopment following Korean War. -Benefited from subsidized government loans. •Deficiencies brought to light by Asian Financial Crisis of 1997: -Low profitability. -Hidden debts. -Shielded from disciplining force of capital markets. •Reforms to stabilize the system: -Eliminate inter-group guarantees (foster self-sufficiency). -Greater independence standards. -Greater rights to minority shareholders.
4. ENFORCEMENT OF REGULATIONS
•Even if legal system is strong, officials must be willing to enforce regulations in a fair and consistent manner. •Regulatory enforcement signals that management is being monitored, which contributes to investor confidence that their interests will be protected. Companies apply more conservative accounting when enforcement of securities regulations is strong. Participation in equity markets increases when countries adopt insider trading laws.
Prevalence
•Family business constitutes world's oldest form of business organization. •Family firms range from small and medium sized companies to large conglomerates that operate in multiple industries and countries. •The actual size of the family business sector is very hard to quantify, due both to the lack of an agreed definition and reliable statistics (particularly for unlisted family firms).
Family firms and governance
•For the family-owned business, good governance makes all the difference. •Family firms with effective governance practices are more likely to do strategic planning and to do succession planning. •On average, they grow faster and live longer.
Key Success Factors for FOEs: Set Formal Corporate Governance Structure
•Formalities - They Really Do Matter! •Clarify roles and responsibilities between board, management and shareholders •Codify structures and processes for all to see •Create strong Advisory Board •Guarantees non-compromising standards of meritocracy in personnel decisions •Allows clear lines of authority for different areas of business •Ensures the stability and continuity of family policies and values •Distinction made between matters of day-to-day mgmt. and strategy •Allows strategic issues to be properly & objectively addressed •Nominate outside directors •To complement the family's business skills with the fresh strategic perspectives •Infusion of new ideas due to a broader range of expertise •Ensure equal treatment between family and non-family executives
Agency Problem III: Conflict of Interest Between Shareholders and Creditors
•From an agency theory perspective, debt has both benefits and costs. •On the benefits side, debt can be used as a governance mechanism to attenuate Agency Problem I. •On the cost side, debt creates a new conflict of interest between shareholders and creditors (Agency Problem III) •Controlling families more likely to maximize firm value as a whole rather than just shareholder value. •Want the firm to last to the next generation and more likely to value employees, etc. •Thus, the divergence of interests between shareholders and creditors will be less severe in family firms.
BRAZIL
•Governance characterized by weak protection: -Excessive influence by insiders. -Low levels of disclosure. - Limited voting rights for minority shareholders. •Three markets for listing based on a company's governance: -Nivel 1 (lowest); Nivel 2 (mid); Novo Mercado (best). •To list on the Novo Mercado, a company must have: -Equal voting rights. -20% independent directors. -Financials prepared according to U.S. GAAP or IFRS.
CORPORATE GOVERNANCE
•Governance systems are not uniform across countries. •They are shaped by a variety of factors that are inherent to the business environment: 1.Efficiency of local capital markets 2.Protections afforded by legal system 3.Reliability of accounting standards 4.Enforcement of regulations 5.Societal and cultural values •Differences in these factors impact the prevalence of agency problems and the control mechanisms needed to prevent them.
GLOBALIZATION
•Governance systems vary greatly around the world. •Formerly "closed" economies face the pressure of globalization: -Capital market financing. -International investors demanding rights and returns. -Hostile market for corporate control (activist investors, hedge funds, private equity). •Trend toward international standards of governance. •Unlikely that a standard system will work well in all countries. •Challenge of adapting to international standards while staying true to societal values.
JAPAN
•History of strong interconnections among firms ("keiretsu"): -Cross-ownership among customers, suppliers, affiliates, and financiers. -Systems encourage business relations and cooperation toward shared objectives. •Stakeholder-centric: -Maintain healthy employment. -Preserve wages and benefits. -Discourage hostile interactions among firms. •Large boards comprised mostly of executive directors.
1. CAPITAL MARKET EFFICIENCY (part 3)
•If a country does not have efficient capital markets, firms must rely on other sources of financing, such as influential wealthy families, large banking institutions, other companies, or governments. -As capital providers, these parties actively monitor their investments. -But their objectives may not be to maximize shareholder value. •E.g., a wealthy family might be okay with below-market returns if it can use the company to extract private benefits (such as corporate perquisites, social prestige, or political influence).
1. CAPITAL MARKET EFFICIENCY (part 5)
•If a country lacks an efficient capital market, something must take its place: -Wealthy families -Large banking institutions •These institutions "discipline" corporations in order to protect their investments. •However, their interests may be different from those of minority shareholders and stakeholders. •On average, private parties are less effective at monitoring companies than capital markets.
THE UNITED STATES
•Large and liquid capital markets; active market for corporate control. •Investor interests protected by the Securities and Exchange Commission. •Accounting standards defined by professional body (FASB). •Governance standards established by: -Exchange listings (NYSE, NASDAQ). -Legislation (Sarbanes Oxley, Dodd Frank).
5. SOCIETAL AND CULTURAL VALUES
•Managerial behavior is influenced by the society where company operates. •Activities that are acceptable in one culture may be unacceptable in another (such as conspicuous consumption). •Executives in a country that values "individualism" may be more likely to take self-interested actions than executives in a country that values "collectivism," because they do not risk the same level of scorn for their behavior. -E.g., South Korea vs Russia •Societal values will also influence whether the company takes a more shareholder-centric or stakeholder-centric approach. -E.g., US or UK vs. Germany, Sweden, or Japan Survey: Should company lay off workers to maintain dividend? Japanese execs - 3% yes U.S. and U.K. execs - 89% yes
1. CAPITAL MARKET EFFICIENCY (Part 4)
•Masulis, Pham, and Zein (2011) showed that family-controlled business groups are more prevalent in countries with weak capital markets. -Families important source of financing in such countries.
Senior Management Succession
•Most important issue for family-owned business is Senior Management Succession plan. •Poor senior management succession is the main reason why family businesses collapse before they reach the third generation. •Formal succession plan should allow selection of the most competent person (whether it is a family member or not). •Family members must be involved in the selection process as also the board, key senior managers, and other important external stakeholders and they all must agree on the choice.
A, B, C
•Mr. Brin and Mr. Page control the super-voting Class B stock, which have 10 votes per share and provide the two co-founders with voting control over Google. •The publicly-traded shares have just 1 vote per share. •Since the Google structure was set up about a decade ago, it no longer represents the state of the art in public companies. •Zynga has a dual-class stock that gives Mark Pincus, a co-founder and the chief executive, 70 votes per share. •By simple math, Mr. Pincus can sell a substantially greater number of his shares than the Google founders and still retain control of Zynga.
NONPROFIT ORGANIZATIONS
•Nonprofit organizations operate in a wide range of activities, including: •Education •Social and legal services •Arts and culture •Health services •Civic, fraternal, and religious organizations. •Tax-exempt under rule 501(c) of the Internal Revenue Code. •Have a stakeholder (rather than shareholder) orientation
CHINA
•Partial transition from communism to capitalism: -Government continues to be the primary owner. -Protects societal concerns (maintain employment, protect key industries from foreign competition). •Two-tiered board: -Board of directors: mostly company executives. -Board of supervisors: 33% employee representation. •Individual shareholders are minority owners with little voting power. •Little foreign ownership.
Agency Problem II - Conflicts of Interest Between majority and minority shareholders
•Private benefits from running a firm may provide monetary and non-monetary benefits. •For example, when discussing the CEO turnover decision in Ford Corporation, Business Week (August 2006) comments that "[given his poor performance,] CEO Bill Ford would have been fired by now by most boards if his name were Smith." •Families are also capable of expropriating wealth from the firm through excessive compensation, related-party transactions, •Another important source of potential family entrenchment is the difference between their control rights and cash-flow rights or special dividends (think: dual class firms)
PRIVATE EQUITY-OWNED COMPANIES
•Private equity firms are privately held investment firms that invest in businesses for the benefit of retail and institutional investors. •Tend to target mature companies that generate substantial free cash flow to support a leveraged capital structure. •Following acquisition, the target undergoes a complete change in management, board, strategy, and capital structure. •If successful, the private equity firm sells the company back to the public or to a strategic or financial buyer. •The private equity firm earns a carried interest and returns the remaining proceeds to investors.
PRIVATE EQUITY-OWNED COMPANIES (part 3)
•Private equity owners have an uncertain impact on the firms they invest in: •Tend to outperform publicly traded companies. •Are aggressive in redirecting investment from less productive to more productive activities. •Still, it is unclear the extent to which returns are driven by operating improvement, rather than increases in leverage and tax reduction. •Research is mixed on how private and public equity returns compare on a risk-adjusted basis
1. CAPITAL MARKET EFFICIENCY (part 2)
•Rajan and Zingales (1998) showed the relationship between capital market efficiency and economic growth across countries. -Industries that need external financing grow faster in countries with efficient capital markets. -They concluded that a well-developed financial market is a source of competitive advantage for firms relying on external capital for growth.
2. LEGAL TRADITION (part 2)
•Research shows that firms in countries where legal systems protect minority interests have higher stock market valuations. •Similarly, political corruption has a negative impact on economic development. •If the legal system is corrupt, unpredictable, or ineffective, alternative disciplining mechanisms necessary. -For example, if contracts not enforced through traditional legal channels, they may be "enforced" by threat of not engaging in future business. -Or, firms could have directors on their supplier's or customer's boards. -These mechanisms allow firms to bypass legal system to ensure shareholder and stakeholder interests protected.
THE UNITED KINGDOM
•Similar to the United States (the "Anglo-Saxon model"). •"U.K. Corporate Governance Code" recommends: -Separation of chairman and CEO roles. -Senior independent director. -Independent board and committees. -Board, directors, and committees subject to an annual review. -Emphasis on transparency of procedures and decisions. -Maintain sound internal controls. •Companies required to disclose reasons for non-compliance with these standards ("comply or explain" approach).
Prevalence (part 4)
•Similarly, a 2013 McKinsey study looking at companies with revenues in excess of US$1 billion estimates that 80 to 90% of these firms in Southeast Asia were family owned, 70 to 80% in India and Latin America, and 60 to 70% in the Middle East •One third of all companies in the S & P 500 index and 40 % of the 250 largest companies in France and Germany are family businesses •Percentage of large corporations that are family-controlled: •Emerging markets: 60% •Europe: 40% •United States: 30%
Prevalence (part 3)
•The Global Family Business Index is comprised of the 500 largest family businesses in the world. •According to the 2015 figures, these 500 firms generated nearly US$7 trillion in revenues and employed over 24 million people. •Nearly 45% of the companies in the index are incorporated in Europe and accounted for an estimated 14.5% of the European GDP in 2015.10
Agency problem I - Conflict of Interests Between Owners and Managers
•The extent of Type I agency problems is reduced in family firms for several reasons. •Family owners tend to hold concentrated and under-diversified ownership of their firms. As a result, family owners are likely to have strong incentives to monitor managers, reducing the free rider problem that is prevalent among other firms •Founding families tend to have much longer investment horizons than other shareholders. Their long-term presence in the firm implies that family owners are willing to invest in long-term projects. •Founding families are concerned with the family's reputation. They are more willing to build and protect their reputation, which is likely to have long-term effects on third parties, and hence the family business. •In founder and descendant CEO firms, the owner and the CEO are one so there is no incentive misalignment - no Type I agency problem.
Weaknesses of Family Business
•Two-thirds to three-quarters collapse or are sold by the founders during their own tenure. •Family Businesses have short life span. 95% do not survive third generation of ownership.
GERMANY
•Two-tiered board structure: -Management board: "runs the company" -Supervisory board: "oversees the company"
GERMANY (part 2)
•Two-tiered board structure: -Management board: "runs the company" -Supervisory board: "oversees the company" •Supervisory board: -Appoints members to the management board -Up to 50% labor representatives ("co-determination") -Includes founding family members, financial institutions, retired mgmt, etc. •Board structure is a legal requirement. •Public shareholder voting rights are somewhat limited.
THE UNITED STATES (part 2)
•U.S. governance system is shareholder-centric. -Directors have legal obligation to act "in the interest of the corporation," which the courts have defined to mean "in the interest of shareholders." -With rare exceptions, employees are not represented on boards. -Although shareholders have submitted proxy proposals to further goals of shareholder responsibility (e.g., environmentalism, fair labor practices, and internal pay equity) - few have succeeded. -Effective controls on company behavior: •Active market for corporate control •Threat of litigation
2. VENTURE-BACKED COMPANIES
•Venture capital (VC) firms: •Provide initial and early-stage capital to small, high-growth companies. •Focus on rapidly changing industries where potential returns and risk are high. •Reduce risk by investing in a diversified portfolio (a few highly successful investments offset a large number of losses). •Venture capital funds: •Structured as a limited partnership. •Capital is committed for 11-years. •Capital is returned to investors when companies are sold or go public (IPO) •VC firm receives percent of the profits ("carried interest"
VENTURE-BACKED COMPANIES (part 2)
•Venture-capitalists tend to positively impact the firms they invest in: •Contribute to the "professionalization" of start-ups by replacing founder with outside CEO, introducing stock options, and influencing HR policies. •Encourage innovation, investment in research, and deal activity. •Demonstrate higher earnings quality. •Positive effects are most pronounced among companies backed by "high-quality" VC firms.
RUSSIA
•Weak governance systems: -Concentrated ownership of shares. -Control by insiders. -Weak legal protections for minority shareholders. -Lack of disclosure. -Inefficient capital markets. -Heavy involvement by government. •Controlling shareholders use influence to gain advantages: -Manipulation of transfer pricing to siphon money. -Forced dilution of minority interests. •Government has tendency to intervene in business to promote its own interests.
1. CAPITAL MARKET EFFICIENCY
•When capital markets are efficient, prices (labor, capital, and natural resources) are "correct," which improves decision making. •Efficient capital markets "discipline" corporations: -Poor decisions are punished. -Stock prices decline. -Cost of capital increases. -Risk of bankruptcy or being taken over increases.
Family businesses can be very...
•large •profitable (even more than non-family) •sustainable •innovative •meritocratic
What are the strengths of family businesses?
•strong set of values •commitment of family management to their company (continuity) •long-term view in decision-making (consistent with investors) •possibility of unconventional strategy (flexibility) •desire to build a business for future generations (sustainability) = the family business edge (profit)