Governance Problems in Closely-Held Corporations

This post comes to us from Venky Nagar, Associate Professor of Accounting at the University of Michigan, Kathy Petroni, Professor of Accounting at Michigan State University, and Daniel Wolfenzon, Professor of Finance and Economics at Columbia Business School.

The notion of balance of power, as any schoolchild or immigration test-taker knows, was central to our Founding Fathers’ conception of effective governance. Their deep insight on human behavior not only shaped our political institutions, but also cleanly translated to the design of modern corporations. As Berle and Means have noted, owners of a corporation that separates ownership from control have to remain ever-vigilant about expropriation by the controlling party. One way to achieve balance of power is to share ownership across individuals, so that no individual can unilaterally expropriate. However, the benefits of shared ownership are difficult to assess in public firms for two reasons. First, the large number of owners implies that each owner free rides with respect to the monitoring efforts of other owners (the individual owner may also not have the relevant expertise). Second, the liquid market of a company’s shares enables ownership structures to evolve endogenously. In equilibrium, the ownership structure of firms depends on their specific conditions and, as a result, it is difficult for an outsider to disentangle the effect of ownership structure from the effect of other firm characteristics.

Both the above problems are obviated in closely-held firms, whose owners are few, locked-in, and deeply involved with firm operations. Our forthcoming Journal of Financial and Quantitative Analysis paper titled Governance Problems in Closely-Held Corporations examines the benefits of shared ownership by using a large cross-sectional dataset of operating and financing patterns of closely-held corporations in the year 1992 provided by a large-scale survey called the 1993 National Survey of Small Business Finances (NSSBF). We find that net income before interest expense, tax expense, and depreciation and amortization (EBITDA) scaled by total assets is significantly and substantially higher for firms with diluted control relative to firms with one controlling shareholder and other minority shareholders. The magnitude of this gap is 14 percentage points. This is an economically significant figure: the mean EBITDA for our sample is 47 percent of assets and the standard deviation 113 percent; the 14 percentage point drop is greater than one tenth of the standard deviation. The results are robust to various statistical checks. In particular, they hold strongly for older firms, whose ownership structures are more likely to be artifacts of the historical legacies of past circumstances.

Our findings have clear implications for the organization of businesses. A rationalist can believe in the power of detailed ex ante contracts to allay expropriation concerns. Such contracts would make ownership patterns irrelevant. What our study suggests is that small business owners are more heuristic. Their behavior mirrors real life where most people do not write extensive contracts, but typically take some basic precautions, and then deal with contingencies (e.g., death, medical incapacitation, etc.) as they occur. Our study suggests that appropriate ownership structures can be an effective precautionary tool when it comes to running a small business.

A copy of the paper can be viewed here.

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  1. Alex Todd
    Posted Thursday, January 21, 2010 at 9:23 am | Permalink

    I wonder to what extent these findings might be due to a tendency by widely held companies to externalize costs. I suspect that closely held firms (especially family businesses) tend more toward sustainable business practices and therefore choose to internalize more costs.

    I’d like to read the paper, but the link does not appear to work.

  2. mmccabe
    Posted Thursday, January 21, 2010 at 10:05 am | Permalink

    The SSRN website can sometimes be a little spotty – the page should load eventually.

  3. Santiago A. Cueto
    Posted Thursday, January 21, 2010 at 11:37 am | Permalink

    There was one part of the study that I found particularly interesting. Although legislatures in the U.S. (and other countries) provide basic protection for minority investors in the form of boilerplate shareholder agreements that firms can choose by electing close corporation status, only around five percent of corporations elect to be covered under close corporation statutes, even though around ninety percent of the corporations in the U.S. are eligible. While data for other countries is not available, it would be interesting to see if the pattern is similar.

    I think it is a big mistake for shareholders in closely-held corporation to overlook the protections afforded by the laws of their state or province. One of the main advantages of electing close corporation status is that it provides minority shareholders with a comprehensive checklist of agreements, which they can subsequently adjust for their specific situations. This affords some semblance of control in deciding the scope of the relationship relative to the other shareholders.
    I just posted an article on this study on the International Business Law Advisor

  4. David Wilson
    Posted Thursday, January 21, 2010 at 12:08 pm | Permalink

    I was able to get the download to work by right clicking and choosing “open in a new window.”

2 Trackbacks

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