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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