What are Boards For? Evidence from Closely Held Firms

Belén Villalonga is Professor of Management and Professor of Finance (by courtesy), at NYU Stern School of Business. This post is based on a recent paper authored by Prof. Villalonga; María-Andrea Trujillo, Professor of Accounting at CESA School of Business, Colombia; Alexander Guzmán, Professor of Finance at CESA School of Business, Colombia; and Neila Cáceres, Researcher at Superintendencia de Sociedades, Colombia.

What role(s) do boards of directors play? Existing research generally assumes the model of a corporation described by Berle and Means (1932)—one with a widely dispersed base of shareholders in which control is exercised by management. Yet a growing volume of research shows that most companies around the world have a controlling shareholder or group thereof, for the most part individuals or families. This is true in even in countries where corporate ownership is relatively more widely held, and increasingly so: the number of public corporations in the United States has almost halved over the last 20 years, and a similar phenomenon has taken place in the United Kingdom.

The fact that most of what we know about boards is based on widely held US corporations is of concern because the governance problems these companies face are fundamentally different from those faced by closely held or controlled companies. Thus, the board’s role in these companies is also likely to be different, in accordance with the problems that it is—or should be—designed to solve. Moreover, because corporations are legally required to have a board, prior research offers little insight into why companies may or may not want to have one; they simply have no choice.

In this paper, we use a large sample of closely held firms for which establishing a board is voluntary to investigate the role of the board and the drivers of the decision to have one. Our sample includes 55,313 firm-year observations from 21,417 closely held Colombian firms during the period 2007-2012, of which only 56% have a board. Using detailed data from a survey about these companies’ governance practices, we examine why firms have boards as well as the role played by the board in the balance of power between controlling and minority shareholders, by examining the impact that each of these three groups have on performance, leverage, and payout policy.

We find that the number and identity of shareholders are more important determinants of firms’ propensity to have a board of directors than the size of their equity stakes. As can be expected, the larger the number of shareholders, the greater the probability of their having a board of directors to represent them. Being a family firm also increases the probability of having a board, especially when the firm is its second and later-generation relative to the founder’s. These findings suggest that the larger the number of shareholders, the greater the collective action problem and/or the potential for conflicts, and thus also the perceived need for a board of directors as a way to mitigate those problems. This perception seems particularly pronounced among family shareholders, perhaps driven by their concern for maintaining unity and harmony in the family. Indeed, after controlling for the endogeneity of the decision to establish a board, we find that all shareholders benefit from having a board in the form of higher profitability.

Yet we also find that when the preferences of controlling and minority shareholders diverge, boards align with controlling shareholders, as may be expected from the fact that it is this group of shareholders who effectively delegates to the board some of the valuable decision rights that come with their controlling position. Specifically, boards and controlling shareholders favor greater leverage and lower dividends, which help these shareholders preserve their controlling equity stake, whereas minority shareholders favor lower leverage and higher dividends, which provide them with a safer return on their investment. The implication is that boards sharpen both edges of the double-edged sword that large shareholders represent for minority shareholders in the same firm: while they help controlling shareholders monitor managers for the collective benefit of all shareholders, they also facilitate the appropriation of private benefits of control by large shareholders.

The full paper is available for download here.

Both comments and trackbacks are currently closed.