Corporate Ownership & Governance Summary
1. Transaction Cost Economics as a Theory of the Firm, Management and
Governance – Ketokivi & Mahoney (2017)
Transaction Cost Economics: the theory of how business transactions are structured in
challenging decision environments.
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Mainly concerned with complex, recurring and uncertain transactions which involve
commitments that are difficult to reverse without economic loss.
It is a firm and management theory because it explains the internal organisations of
firms.
It is a governance theory because it applies to any situation where a contractual
arrangement is used to organize activities involving stakeholders.
TCE can be described as a constructive stakeholder theory with the primary objective
to ensure efficient transaction and avoidance of waste
TCE Heterogeneity: diversity of transactions and organisations
Discriminating Alignment: determining the organisational response which offers the best
feasible and low-cost solution to govern a given transaction
Cost of Transaction
For a simple transaction:
1. The price system works to the buyer’s advantage (you know how much an item costs or
can cheaply find out)
2. The system of institutions works to the buyer’s advantage (you’re assured about the
item’s quality)
- In complex settings, there are transactions costs (e.g. information costs, disputes,
renegotiation, etc.)
Vertical Integration: changes in financial ownership in the value chain
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Either purchasing assets from suppliers (backward) or from consumers (forward)
Vertical integration can cause efficiency benefits for stakeholders
Labelling VI as anti-competitive may lower product innovation
Horizontal Integration: buying the assets of a similar company such as a competitor
TCE Characteristics
TCE is based on characteristics of a contractual exchange relationship between two exchange
parties (principle unit of analysis = individual transaction)
Dimensions:
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Frequency: the volume of transactions between two exchange parties
Uncertainty: the contracting parties’ ability to predict environmental changes and one
another’s behaviour under unforeseen circumstances
Specificity: specialized investments made by one (or both) parties to enable the
exchange
o Site specificity: e.g. electric plant
o Physical asset specificity: e.g. specialized tools
o Human asset specificity: e.g. firm-specific knowledge
o Specificity gives rise to unilateral or bilateral dependency (although usually
bilateral)
o Transaction-specific know-how on the supplier side results in high switching
costs for the buyer
Holdup Problems: occur when one firm takes advantage of another firm in case of
commitment to specificity (opportunistic behaviour)
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However, this behaviour has an adverse effect on transaction efficiency
Solution: exchanging credible commitment through farsighted contracting
Simple transactions have low frequency, low uncertainty, and low specificity → can be
efficiently handled through market transactions
TCE and Financing & Legislature
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Low specificity assts are more effectively financed by debt because they are
redeployable and the lender will be covered in case of default
High specificity assets are more effectively financed by equity where the financier does
not receive a collateral-backed fixed interest
Equity-financed firms rely on the board of directors and are organized based on
discretion while debt-financed firms are organized on formalization
Legislature: representatives of different constituencies have considerable incentives to
exchange support so as to provide benefits to their supporters ➔ there’s effectively a
market where votes are bought and sold at a price. However, enforceability of bargains
becomes problematic, and the market form of exchange becomes inefficient
Embeddedness Transactions
Many exchange relationships and governance decisions are inseparable from one another (and
history matters)
Embeddedness Argument: different firms face heterogeneous embeddedness constraints;
identical transactions may well be governed in different ways in different exchange
relationships
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TCE focuses on the characteristics of the individual transaction: TCE predicts and
identical governance structure for identical transactions
Obligations inherent in personal relationship work effectively as safeguards in
securing economic exchange
TCE and Stakeholder Management
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All organizations involve several stakeholder groups with only partially overlapping
objectives and interests
Business can be understood as a set of relationships among groups (how they interact
and create value) which have a stake in the activities that make up the business
According to TCE, firms consist of heterogeneous stakeholder groups and aims to
increase shareholder (and firm) value at a rate that is acceptable to the investor
TCE embraces firm value as the main objective: efficient governance decisions are
ultimately aimed at increasing firm value, and consequently, shareholder wealth
The shareholder is a residual claimant who enjoys no contractual safeguards ➔ they
get their only bite at the apple of the distribution of the residual: they receive whatever
is left over once all the contractual obligations to other stakeholders have been met
1.2 Organizational Boundaries and Theories of Organization – Santos &
Eisenhardt (2005)
There are 4 fundamental conceptions of organizational boundaries:
1. Efficiency (cost ➔ locus of transactions)
2. Power (autonomy ➔ sphere of influence)
3. Competence (growth ➔ resource portfolio)
4. Identity (coherence ➔ mind-set)
Make predictions for horizontal boundaries (defined by the scope of products / markets) and
vertical boundaries (defined by the scope of activities undertaken in the industry value chain)
but also provides a unique view of boundaries
Boundaries of Efficiency
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Focuses on minimizing governance costs and asks whether a transaction should be
governed by a market or organization
Central argument: boundaries should be set at the point that minimizes the cost of
governing activities
Boundary management is best understood as an accumulation of discrete decisions
based on the criterion of governance cost minimization
Vertical boundaries of efficiency: every stage of production should undergo assessment of the
make-or-buy choice to minimize governance costs
Horizontal boundaries of efficiency: potential economies of scope should determine
horizontal boundaries, economies of scope can be more efficiently gained through market
exchange when governance costs created by are low ➔ depend upon governance costs
Governance Cost Sources
1. Transaction Costs: Hierarchical governance has advantages over market governance
when the transaction is: costly to define, monitor and enforce
a. Also asset specificity & small numbers bargaining increase hold-up potential
2. Measurement Difficulties: caused by information problems
a. Occur when it is costly to assign the correct value to product attributes in
market exchange → leads to adverse selection and moral hazard
b. Brining transactions within the organization can reduce information problem
costs
3. Knowledge differences: idiosyncratic knowledge may be sufficient to create
coordination costs in market exchanges, even when partners behave honestly
a. These costs can be reduced within organizations through authority relations
Transaction Attributes:
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High asset specificity → hierarchical governance
High environmental uncertainty → Hierarchical governance
High behavioral uncertainty → Hierarchical governance
Technological uncertainty → Market governance (Higher behavioral uncertainty favors
vertical integration to avoid transaction costs, while higher technological uncertainty
favors outsourcing to mitigate obsolescence and preserve flexibility)
Interdependence among transactions → Hierarchical governance
Limitations: unclear causality relationship between asset specificity and hierarchy &
production costs may be more crucial in boundary choices than governance costs
Boundaries of Power
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Focuses on how organizational members control the broader set of exchange relations
in which their organization is directly or indirectly involved, the power conception asks
what the appropriate sphere of organizational influence is
Central argument: organizational boundaries should be set at the point that maximizes
strategic control over crucial external forces
Boundary management is best understood as advantageous management of external
strategic relationships
Vertical boundaries of power: organizations expand their participation in the industry value
chain by internalizing sources of environmental uncertainty. Organizations may integrate to
reduce dependence on single exchange partners.
Horizontal boundaries of power: organizations expand their scope of product/market domains
when members want to buffer their core position through greater size and reach, and/or when
members want to reduce dependence on single markets
Dynamic Environments
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Products often have high knowledge content which means: 1) low variable cost, 2)
high switching costs and 3) network effects
These characteristics cause tipping points with other markets which puts a premium
on taking control of a market before a competitor
Sphere of Influence
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Ownership Mechanisms: expand vertical and horizontal boundaries
Non-ownership Mechanisms: board appointments, alliances, lobbying activities and
friendship ties with competitors
Extend the organization’s sphere of influence without extending its legal boundaries
Combining both mechanisms is particularly important in dynamic environments
requiring flexibility
Limitation: lack of symmetric empiric evidence as it does not address when organizations
should decrease their influence on other organizations or increase their dependence
Boundaries of Competence
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Focuses on how organizational members gather, exploit, and renew firm-specific,
resource-based advantages, the competence conception asks what resources the
organization should possess
Central argument: organizational boundaries should be set at the point that maximizes
the value of the firm’s resource portfolio
Boundary management is best understood as process of aligning resource
configurations with market opportunities
Vertical boundaries of competence: internalizing activities that leverage current resource
configurations, and outsourcing those that are based on very different resources
Horizontal boundaries of competence: expanding to nearby product/market domains that are
both financially attractive and leverage the current resource configuration
Environment
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Less dynamic environment: organizations become configurations of deeply entwined
resources
Moderately dynamic environment: resources are more loosely coupled (knowledge
and dynamic capabilities (routines) become crucial)
High-velocity environment: dynamic capabilities (simple rules) allow organizations to
improvise with loosely coupled resources in shifting environments
Limitation: little clarity on competing tensions such as path-breaking vs path-dependent
boundary trajectories and dynamic capabilities as simple rules vs routines
Boundaries of Identity
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Focuses on how organizational members define the organization holistically, the
identity conception asks who the organization is. Organizations are conceptualized as
social contexts for sensemaking
Central argument: organizational boundaries should be set to achieve coherence
between the identity of the organization and its activities
Boundary management is best understood as a process of resolving inconsistencies
between identity and organizational activities and markets
Vertical & horizontal boundaries: By shaping how members perceive what is appropriate for
the organization, identity guides decisions regarding the value-chain activities to incorporate
or product/market domains to enter
Managerial Cognition: focuses on the cognitive frames used by managers to shape their
activities and interpretations of the world
Organizational Identity: discusses the origins and role of the shared values and norms that
constitute its central and distinctive character
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Identity can be a source of competitive strength by distinguishing the organization
from potential competitors. It allows these organizations to differentiate their offering.
Identity can be a competitive weakness when for example, managers ignore
information that threatens the organization’s self-concept
Identity is particularly valuable for boundary decisions in environments characterized by
ambiguity (e.g., nascent markets), where other guides for behavior are unavailable
Limitation: modest understanding of the interplay among individuals, community and
organizational identities
1.3 Lecture Notes
Corporations/Firms: entities that own assets that are a legal person by themselves, separate
from the owners of the entities
- Disclosure obligation because there are external shareholders that are uninvolved in
the firm
- A corporation is a legal construction: corporations cannot exist without the law enabling
us to create them
- Not all corporations are PLCs (publicly listed companies): there exist quite a few other
types of incorporated firms (cooperatives, LLPs, foundations)
5 Legal Characteristics of Firms
1. Investor ownership
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Providers of financial capital to the firm own the firm in an investor ownership
Not all firms are owned by equity investors (NPOs, partnerships, state-owned
enterprises, cooperatives, etc.)
External financing (different types of investments):
1. Equity: you have a stake, so you are an owner ➔ investor makes money by dividend
payments and/or by selling your shares when value has increased ➔ doesn’t have a
guaranteed return on investment (but typically has governance rights)
2. Debt: you lend money to a firm ➔ investor makes money by interest payments and
repay of the principal
2. Freely tradable shares
PLCs must have freely tradable shares: you should be able to exchange your shares with
someone else without restrictions
- Benefit: because of tradability, the owners can diversify their portfolio and hence lower
their risk through trading shares
- Shares in a closely-held firm aren’t tradeable (e.g. family firms typically want to retain
the shares within the family)
- Drawback: the firm has growth constraints because it cannot issue shares to new
investors, and you typically cannot get the fair price (e.g. when there’s conflict) as you
don’t have a big pool of investors to sell your shares to
3. Limited liability
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Shareholders are not personally liable for debts of the company (when it goes bankrupt)
beyond the investment they made for the shares
Key characteristic as investors would refuse to be liable without having influence on the
company (this would also make shares less transferable)
Limited liability is a feature of corporate law to protect owners who aren’t involved in
the firm (they’re external to the firm and thus don’t have info / knowledge of the firm)
Defensive asset partitioning: you partition your assets as an owner to defense yourself
against the claims
4. Legal personality
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Legal personality is the mirror image of limited liability: it is about protecting the firm
against claims or creditors of the owners
If owners were allowed to withdraw their assets whenever they want, it would
jeopardize the going concern value of the firm
Liquidation protection: you protect the firm that needs assets to function against the
owners liquidating the firm and bringing it down to the liquidation value of the assets
Affirmative asset partitioning: You partition your assets to a firm that are different from
the assets of the owners
5. Delegated board / management
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Owners in a listed firm are typically unable to be actively involved in running the firm
When you incorporate as an entity of which the shares are freely tradeable ➔
automatically, most decisions are taken by the board
Why do firms exist? The Theory of the Firm
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There are costs to using the market mechanism (supply & demand) for exchange
Transaction costs: costs of using the market, the exchange value
It’s sometimes cheaper to organize exchange within the firm under authority and
direction of managers of the firm instead of operating in the market
However, there are also governance costs (such as monitoring costs) of organizing
exchange under authority within the firm (hierarchical relations)
The challenge is to maximize transactional efficiency or minimize the sum of transaction
and governance costs
Transaction cost theory
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Unit of analysis: different types of transactions that create different types of costs & on
the other hand governance structures
Discriminative alignment thesis: transactions, which differ in their attributes, are aligned with
governance structures, which differ in their costs and competencies, in a discriminating (mainly,
transaction-cost-economizing) way
Moderation effect: the cause is something that produces an outcome but managers (who want
to make lives better for everyone and for themselves) need to know whether the treatments
work
The moderator increases or decreases the influence of the effect
Treatment selection relationship: a certain cause (e.g. headache) will lead to an intermediate
action (e.g. taking an Aspirin) to mediate the effect (of the headache)
In such a case the treatment group self-selects into the treatment (e.g. you only take an
aspirin when you have to)
A multi-theoretical and comparative approach
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It’s unlikely that there will be a single theory that explains everything
Different theories look at different things (have a different unit of analysis), highlight
different properties (variables) and therefore produce different explanations
A multi-theoretical comparative approach is often useful for practical reasons (compare what
different theories look at)
- In causal inference: examine the counterfactual case (e.g. treatment vs control group)
- In solution choice: choose the best performing option from all conceivable and feasible
alternatives
Alternative theories of firm boundaries
1. Efficiency perspective: TCT, legal view ➔ we measure the outcome as efficiency,
maximizing efficiency and minimizing the sum of transaction and governance costs
2. Power perspective: resource dependence theory, industrial organization ➔ if your firm
is very much dependent on certain resources, you need to organize yourself in such a
way to have a better chance of acquiring those resources
3. Competence perspective: RBV ➔ sees firms in terms of different core competences
they have.
4. Identity perspective: organizational identity, sense making, purpose ➔ what kind of
shared purpose do parties have that enables them to create value over and above of
what they could produce individually
These theories give a different perspective on what the firm boundaries could be ➔ how
theories point to different synergies, or lack of synergies, that allow you to have differences
between a single corporate entity
2.1 Ownership of the Firm – Hansmann (1988)
The structure of ownership
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Owners: those persons who share two formal rights (control rights such as selecting the
board of directors): the right to control the firm and the right to appropriate the firm’s
residual earnings
Separation of ownership and control: It is often efficient to assign formal right of control to
persons who are not able to exercise that right very effectively.
- Control can be thought of as authority over precisely those aspects of firm policy that,
because of high transaction costs or bounded rationality, cannot be specified ex ante in
a contract
Patrons: Persons/firms who transact with a firm (as purchasers, suppliers etc.)
- Most firms are owned by persons who are also patrons ➔ e.g. the corporation is owned
by persons who lend capital to the firm
Transaction Characteristics
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Business corporations are owned by some or all the persons who lend capital to the firm
The firm’s net earnings are distributed pro rata among the lender-members according
to the amount they have lent.
Non-members receive a fixed market interest rate (they have no share in profits or
participation in control).
Ownership commonly is assigned to persons who have some other transactional
relationship with the firm ➔ the ownership relation can be used to mitigate some of
the costs that would otherwise attend these transactional relationships if they were
managed through simple market contracting
Efficiency will be best served if ownership is assigned to minimizing the sum of:
• Costs of market contracting for those patrons who aren’t owners
• Costs of ownership for the class of patrons who are assigned ownership
The costs of market contracting
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Market power: a reason for assigning ownership to a class of patrons is that the firm
has a degree of market power vis-à-vis those patrons.
o If the patrons own the firm, they can avoid the efficiency losses (which result
from setting prices above marginal cost) and the larger private costs that such
prices would impose on the patrons
• Ex post market power (lock-in): problems of price or quality exploitation can arise after
a person begins patronizing a firm.
o Once a transactional relationship has been entered into, the patron becomes
locked in to a degree, losing the option of costless exit ➔ ownership of the firm
by the patron reduces the incentives for opportunistic behavior
• Asymmetric information: contracting can also be costly when a firm has significantly
better info than its patrons ➔ ownership by the patrons reduces the incentive for the
firm to exploit such an information advantage
When the firm owns its patrons, costs of market contracting can be avoided.
- However, ownership of the patrons by the firm may also be impractical even where the
patrons are firms as it may lead to loss of incentives
Costs of ownership
1. Monitoring costs: if a class of patrons is to exercise effective control over the management
of a firm, they must incur the costs of:
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Becoming informed about the operations of the firm
Communicating among themselves for the purpose of exchanging info and making
decisions
Bringing their decisions to bear on the firm’s management
Managerial Opportunism: Managers are free to engage in self-serving transactions and
exhibit slack performance to the extent that the firm owners fail to exercise control over
them (but the costs of opportunism are sometimes lower than those of effective monitoring)
Monitoring costs denote the sum of:
• The costs actually incurred by the owners in monitoring management
• The costs of managerial opportunism that result from the failure to monitor
perfectly
If all else is equal, the patrons who are the lowest-cost monitors are the most efficient
owners but often in reality, some patrons facing high monitoring costs also face high costs
of market contracting
2. Collective decision-making costs: when ownership of a firm is shared among a class of
patrons, a method for collective decision-making must be devised
- Such collective choice mechanisms often involve substantial costs compared to market
contracting and are crucial in determining the efficiency of alternative assignments of
ownership
- When patrons have identical interests, the costs of collective-decision making are small
When patrons have divergent interests the influence of such costs is much higher
- A majority voting mechanism can be inefficient and inferior (the disfavored group may
be worse off than through market contracting)
- The process itself can have high costs (e.g. formation or break-up of coalitions)
- The costs may be low if there is some simple and salient criterion for balancing patrons’
interests, even if they diverge
3. Risk-bearing costs: one class of a firm’s patrons may be in a much better position than
others to bear the risk of the enterprise
- Market contracting with a given class of patrons itself sometimes creates a substantial
degree of risk that can be avoided by assigning ownership to those patrons
- Collective decision-making also reduces the risk on a single patron
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Monitoring costs & collective decision-making costs are associated with the first
element of ownership: the exercise of control
Risk-bearing costs are associated with the second element of ownership: the receipt of
compensation in the form of residual earnings
Investor-owned firms
Costs of market contracting
- Lenders of capital become owners of firms because of problems of asymmetric
information (owners could behave opportunistically) and lock-in (managerial
opportunism is reduced by having the lenders themselves own the firm)
- An extensive contract would be required, which is virtually impossible
Costs of Ownership
- An advantage of investor ownership is diversification and the fact that owners share a
single, well-defined objective (to maximize return on investment)
- Disadvantage: investors frequently are in a poor position to engage in meaningful
supervision of the firm’s management
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Much of the protection that the investors in a widely held investor-owned firm have
from opportunistic behavior on the part of the firm derives simply from the absence of
a class of owners with interests contrary to theirs ➔ this may be important protection
and worth the costs of some managerial slack
Retailers of Consumer Goods
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Customer-owned firms are commonly exemplified by retail stores organized as
consumer cooperatives, but they have an almost negligible share of the market for
nearly all retail items
The costs of customer ownership for many consumer goods / services is high: the
customers of any given retail firm are so numerous, transitory, and dispersed that
organizing them effectively would be excessively difficult
Besides, the costs of market contracting are low: markets are competitive and
asymmetric information is not a serious problem
The single retail market in which consumer cooperatives have established a significant
market share is the market for books, with the principal incentive of market power
Wholesale and supply firms
Costs of market contracting
• Market power appears to provide the principal incentive for customer ownership due
to economies of scale, price exploitation and use of a common brand name
• However, brand names can create lock-in because retailers can incur costs in the case
of change in brand name affiliation (due to loss of local goodwill)
Costs of ownership
• The store can oversee the affairs of the wholesaler without incurring substantial costs
beyond those it would incur under market contracting
• Risk-bearing and liquidity constraints aren’t an important obstacle to customer
ownership since interests are homogeneous
Farm supplies
Costs of contracting
• market power provides an important incentive for customer ownership because there’s
little room for competition among local distributors
• Asymmetric information is an important factor in the development of some types of
farm supply cooperatives
Costs of ownership
• Are highly favorable to farmer-owned supply cooperatives: each of the commodities in
which they have a significant market share regularly constitutes a substantial fraction of
a farmer’s budget
• There is high homogeneity of interests due to homogeneity of commodities
Other relevant costs
- Liquidity & risk-bearing: if the required capital investment is a large fraction of the
patrons’ wealth, the resulting poor diversification will lead to costly risk-bearing.
- Conflict of interest: when the owners of a cooperative also have a substantial capital
investment in the firm, heterogeneity of interest arises
Worker-owned firms
Cost of contracting
Asymmetric info could also provide an incentive for worker ownership: the principal
problem isn’t that the individual patron cannot police the firm’s behavior, but rather the
reverse
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Employees perform complex and highly skilled work so effective monitoring may be
difficult ➔ incentive to integrate vertically to eliminate conflicts of interest between the
firm and its workers ➔ workers have stronger incentives for productivity
Costs of contracting stem from lock-in as there are substantial costs related to labor
contracting for specialized workers
Costs of Ownership
- Workers are in a good position to monitor the management of the firm, compared with
other classes of patrons
- Costs of risk-bearing are often unfavorable to worker ownership ➔ especially for firms
with substantial amounts of firm-specific capital, as worker-owners in such firms will
face high costs of capital if they don’t provide a significant fraction of this capital
themselves
- Investing heavily in the firm for which they work, will cause workers’ human capital and
their savings to be very poorly diversified ➔ major problem of worker ownership
- Firms are characterized by great job and interest homogeneity (hence equal pay rule
and reduction of conflict of interests)
Utilities
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Cooperative ownership allows customers to avoid costs of monopoly and the costs of
rate regulation
However, the industry has high capital intensity: assets are highly firm-specific but due
to monopoly power and stable demand, debt-financing is easily available
Costs of ownership are much less favorable in urban than in rural markets ➔ the higher
transiency of urban customers increases the transaction costs of establishing ownership
Also, the interests rural customers are more homogenous than urban customers
Insurance
Cost of contracting
- Mutual insurance companies: firms owned by their policyholders
- Costs of contracting stem from asymmetric information and opportunism
Insurance: costs of ownership
- Cost of ownership stems from insecurity and risk (e.g. inflation rates or mortality rate
accuracy)
- The mutual form permits pooling without creating the costs associated with long-term
market contracts
Firms without owners: nonprofit enterprise
Nonprofits have no class of individuals to whom ownership can be assigned without severe
inefficiencies. Nonprofit firms emerge when:
1. There’s an extreme problem of asymmetric information between the firm and some
class of its patrons (usually a significant group of the firm’s customers) ➔ assigning
ownership to anyone other than that class of patrons would create the incentive
and the opportunity for the patrons to be severely exploited
2. Those same patrons are so situated that the costs to them of exercising effective
control over the firm are unacceptably large relative to the value of their
transactions with the firm
2.2 Are you still the best owner of your assets? – Dobbs, Huyett & Koller
(2010)
Best owners: firms whose distinctive characteristics enable them to create more value in a given
business than other potential owners could
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If a board and management team cannot add more value to a business than other
potential owners, then it may be in the best interest of shareholders to sell the
business (or to not buy it in the first place)
How can better owners add value?
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1. Valuable linkages with other businesses
A good owner can offer unique links with other businesses that they already own
These links can occur across the value chain (e.g. R&D, manufacturing, distribution…)
However, the links do not have to be unique in order for another company to be a
better owner
Ultimately, the best owner depends on the theoretical potential and the effectiveness
of a post-acquisition merger
2. Distinctive Skills
Better owners may have distinctive and replicable functional or managerial skills
o The skillset must be a driver of success in the industry
Example: manufacturing skills are not useful for a consumer-packaged goods business
while superior marketing skills may result in a competitive advantage
3. Better Governance
Owners can add value through better governance, without needing to have a hands-on
role in day-to-day operations
Better governance refers to the way a company’s owners interact with the
management team to create the greatest possible long-term value
Private equity firms can often be effective owners because they: have a strong
performance culture, replace managers quickly when needed, encourage
abandonment of sacred cows, invest more capital, and focus on the long-term view
4. Better Insight or Foresight
Owners with market/industry insights can be better owners of businesses that don’t
even exist yet, if they can use those insights to innovate and expand existing
businesses or to develop new ones
5. Distinctive Access to Talent, Capital, or Relationships
Applies primarily to companies in emerging markets, where running a business is
complicated by inherently smaller pools of managerial talent, underdeveloped capital
markets, and high levels of government involvement in business as customers,
suppliers, and regulators
The best-owner life cycle
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Best ownership isn’t permanent or static but can change over the life cycle of a business
The needs of a business change as it matures and the industry changes
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The firm’s founders are its first best owners ➔ their entrepreneurial drive, passion and
commitment are necessary to get the firm off the ground
As it grows and requires larger investments, a better owner may be a venture capital
firm that specializes in helping new firms grow by providing capital, improving
governance, and enlisting professional managers to handle the complexities and risks
Eventually, it may need to take the public company, selling shares to a range of investors
to finance further growth
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As it grows, it might find that it can no longer compete with larger corporations hence
it may sell itself to a larger firm with a stronger competitive position
As the division’s market matures, the larger firm may decide to focus on faster-growing
businesses ➔ sell division to private-equity firm
Managerial implications
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The best-owner life cycle means that executives must continually seek out new
acquisitions while at the same time divesting other businesses
For acquisitions, applying the best-owner principle often leads acquirers toward targets very
different from those that traditional target-screening approaches might uncover
- During negotiations: Instead of asking how much they can pay, they should be asking
what’s the least they need to pay to win the deal and create the most value
For divestitures, including both sales and spin-offs, the best-owner principle allows managers to
examine how the needs of the businesses they own may have evolved in different directions
- Executives may worry that divestitures are seen as an admission of corporate failure or
as a consequence of a firm’s relatively small size but stock markets react positively
2.3 Ownership Competence – Foss, Klein, Lien, Zellweger, Zenger (2019)
Ownership: a bundle of rights, the most important being possession, exclusion and control
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Agency Theory: associates ownership primarily with rights to derive residual income
from an asset and makes predictions about the effectiveness of remedies
o More concentrated ownership leads to less agency problems and higher levels
of value creation
Incomplete Contracting Theory: emphasizes the residual rights of control tied to
ownership meaning the right to make decisions over assets in situations not addressed
by contract
o Ownership provides incentives to optimally invest in resources and so rights
should be given to the party whose investments will matter most for value
creation
Property Rights Economics: focuses on the multidimensional nature of ownership and
highlights the distinction between rights to exercise choices over goods and services
(use rights), the rights to derive income from these choices (value appropriation
rights), and the right to transfer these rights (transfer rights)
The common idea is that by allocating ownership “correctly”—in accord with the respective
theoretical predictions—and thereby getting the incentives right, value creation will be
maximized
Assumptions of Ownership Competence
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Owners seek to create value under uncertainty, complexity and with unknown
resources, strategies and outcomes
Strategic factor markets for judgment are “closed,” as the costs of articulating
judgment in such a way that it can be objectively assessed by the market are
prohibitive
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The only sure path to test one's judgment and capture the value that is eventually
created is for the actor to assume ownership of the resources.
Competence Perspective of Ownership
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Classic property rights theory maintains that whenever an individual owns a resource,
he retains (a) the right to use the resource, (b) the right to appropriate the returns
from using the resource, and (c) the right to transfer these rights
In terms of ownership, these can be transformed into the matching, governance and
timing competencies
The three competencies are separate and individual, and it is not necessary for an
owner to have all three. They can hire a person with the competencies they lack.
However, all the competencies are learnable – owners can learn all three through
experience or they can improve their current competencies
For matching, governance, and timing competence to create value there must be some
inefficiency in markets for assets/resources, including management talent. If these
factor markets are perfectly efficient then ownership competence cannot add value
Matching Competence
-
-
-
Refers to an individual's capacity to foresee, judge, or theorize about valuable resource
combinations that achieve some “specific and intended purpose” or solve a unique
problem
Requires a superior understanding of the value of the resources currently possessed,
an understanding of the value of resources others possess, and a capacity to imagine
the value created through alternative configurations
Owners with better matching skills see value in available resources that can be
productively rearranged or recombined with the existing resource base of the owner
Governance Competence
-
Refers to an individual's capacity to compose an envisioned resource composition
through effective governance and organization design
-
-
If the owner chooses to delegate the management task, it may generate agency costs,
however, the superior managerial skill may more than outweigh these costs.
Manager selection is conducted under information asymmetries about the individual’s
skills and with clear market frictions in attempting to secure the optimal match
By having the owner act as manager there is no information asymmetry and there are
reduced agency costs but the owner may not have the necessary skills to reconfigure
resources
Owners with governance competence will assemble incentives, controls, and
delegation arrangements into value generating patterns. They will appropriately
deploy behavioural and outcome-based incentive systems and will be cognizant of
motivation crowding out
Timing Competence
-
-
Refers to the skill of owners to time their investment in projects in ways that maximize
value creation.
Timing skills thus include the skill to optimize “market timing” or the value generated
by expanding the valuation multiple between the time of acquisition or sale
Owners with timing competence also have capacity to schedule their investments to
optimize strategic flexibility. Staged investments not only limit risk, but provide
strategic flexibility enabling firms to balance the virtues of both commitment and
flexibility in the allocation of resources
Also involves the capacity to judge whether one is still the best owner of a business
It is important for an owner to have all three competencies and it may be harmful for the
business if the owner continues running the business while lacking a key competency.
-
However, hiring an external manager increases agency costs and can harm the owner’s
skill development
Solution: allocate ownership rights to a controlling party with a strong interest in the
success of the venture and with high levels of owner competence
Environmental Effects
-
Different competencies are important throughout the life cycle of a business
o The timing competency is more important when the firm matures
Environmental Uncertainty:
-
Ownership competence is particularly valuable in uncertain environments, as firms
scramble to adapt to unanticipated changes.
Matching competence is uniquely important under uncertainty because the optimal
owner–resource matches are difficult to discern ex ante
Governance competence is important because uncertainty complicates the process of
monitoring others' decisions, and thus increases the marginal value of governance
Timing competence is important because under uncertainty there is often no way to
resolve such uncertainty except by waiting for the outcome
2.4 Lecture Notes: Ownership of the Firm
Capitalism: an economic and political system in which a country's trade and industry are
controlled by private owners for profit, rather than by the state
- Capitalism, in the same way as markets, is built and does not simply exist
- Necessary conditions for capitalism to work: free markets where you can exchange your
products freely (however, typically these markets are highly regulated)
Foundations of capitalism:
Private ownership (of any type of asset): economically very important institution.
- Property rights: regulate relationships between people in respect to certain (in)tangible
assets
o Important developments:
o Roman law acknowledged and implemented ownership rights
o 17th century, mostly in Western-Europe (UK and NL): protection against the
state is now included (wasn’t in Roman law)
1. Private ownership of the means of production (land, labor, capital, knowledge):
a. A private rather than state-controlled enterprise system
b. The private ownership of firms (as the means of production)
2. The ownership of firms by the financiers of the firm:
a. Especially by equity financiers
b. Ownership in the hand of the providers of financial equity to the firm
What is ownership?
Ownership is typically seen as a bundle of rights
1. Residual rights of control: the right to use an asset in any way that is not:
a. Mandated or forbidden by law
b. Sold away contractually to another party
- Economically important function: when you own an asset, you have the rights of
returns from that asset resulting in motivation/incentives
- If there are no incentives to maintain something well, it will lead to negative
outcomes, hence without ownership there is no incentive to maintain things right
- Ownership reduces complexity: if anyone would just trade with one another
without firms, it would become very complicated
o Instead of everyone trading with another, it would be better to have an
appropriately incentivized owner to bring transactions together who is
rewarded with the residual
2. Residual return rights: right to the returns to an asset after:
a. Having paid all contractual obligations
b. Having paid all other obligations under the law (e.g. tax obligations)
c. This includes negative returns: the obligation to absorb risk
3. Alienation rights: the right to sell (or buy) ownership rights over an asset
a. Not all ownership rights are freely tradable
b. Ensure that ownership ultimately ends up in the hands that value it most
c. Alienation rights are often a way to realize the returns from ownership
The tragedy of the commons
-
-
When everyone owns it something, then nobody owns it
Tragedy of the Commons: in a world without ownership, everyone can do as they please
➔ there’s no incentive to maintain something well if you don’t own it
It might be economically efficient to have ownership rights assigned and let these
ownership rights be tradeable such that they end up in the hands of those who value it
the most
With ownership and free trade, the allocation will be pareto-efficient
The tragedy of the anti-commons
-
Tragedy of the Anti-commons: If there’s no ownership, nobody has the incentive to
maintain it well
o
o
There can be too much ownership: when ownership is sliced up too thinly over
different parties
Too much ownership can frustrate innovation (e.g. if all owners need to give
rights for other to use their patents in the pharmaceutical industry)
Negatives of Ownership
•
•
Ownership creates monopolies: in a monopoly you don’t have the incentive to maintain
the assets because you appropriate rents from another party
Winner-takes-all: Ownership can lead to inequalities and distributional concerns
o Ownership is increasingly concentrated which undermines economic
development and profitability
o It squeezes out others and destroy value and the market (in a monopoly there’s
no market anymore)
o It might be a good idea to sometimes reshuffle the ownership rights to create
the right incentives again
Ownership of the firm
Ownership of the firm isn’t uniform ➔ differs across firms, there are many forms of ownership
- Dual-class share structure: two or more classes of shares with different voting rights. –
o Typically insiders are given access to a class of shares that provide greater
control and voting rights, while the general public is offered a class of shares
with little or no voting rights
- Nonprofits do not have owners – having owners may minimize their social good
- For companies that are service-focused their capital is tied to humans (many service
companies such as insurance are organized in consumer cooperatives)
- Supplier Cooperatives: often set up because they need to combine forces in order to
have market power against the demand side
The professional partnership
-
-
Upper-round promotion system: you work your way into ownership (e.g. in consultancy
firms, you either become a partner or leave the firm)
Decision-making: major difficulty due to all partners having influence and different
interests and investment horizons
Financial capital is not difficult to raise, however, human capital is complicated as it
requires many years of work experience
o Highly educated and trained workforce with high levels of knowledge and
experience
o Human capital is what creates the product (through co-creation with clients and
the firm)
o Employees are highly mobile between firms (hence important to maintain them
within the firm)
Reputational capital: key competitive advantage of partnerships – reputations are
difficult to build and imitate
o The Matthew effect of reputation: attracting & retaining customers and human
capital as well as charging higher fees for services
Reasons to move from partnership to IPO
- Consolidation in the industry – when competitors are merging, an IPO can be used to
increased competitive position
- Diversification - partnerships are not able to use capital from deposits whereas public
firms can
- Access to equity markets – through an IPO, firms can raise financial capital to finance
growth
- Capital structure: the partnership didn’t have a stable capital as each partner could
withdraw their assets at will
Optimal Ownership
-
Ownership aims to minimize the sum of transaction and governance costs
o By having one person transact with all other parties, this person becomes the
owner and risk bearer
Ownership is optimally assigned so that the party economically involved in the firm that
minimizes the sum of:
1. Contracting costs for the non-owners (i.e. transaction costs in market exchange)
2. Ownership costs for the owners (i.e. a particular type of governance costs borne by
the owners)
Compare TCT: minimize the sum of transaction and governance costs (find the sweet spot)
Contracting and Ownership Costs
- Differences between contracting costs & costs of ownership:
Contracting Costs
Costs of Ownership
Power Inequalities:
Risk Bearing:
- Quasi monopolies
- Can you absorb changes in residual
- Lock-in
earnings?
Contractual Incompleteness:
Coordination and Decision-making Costs:
- Complex transactions
- Owners bring everything together
- Long term transactions
- Decision-making
with
multiple
owners
Asymmetric Information:
Agency Costs:
- Ex Ante: adverse selection
- Costs of delegating decision-making
- Ex Post: moral hazard
to others
Contracting Costs: (mostly borne by stakeholders) If you want to make a transaction with a
monopolist, or you’re locked in, there are always power inequalities. The owner benefits from
contracting costs (although not always)
Cost of Ownership: (mostly borne by owners) If you are an owner, you have agency costs due
to monitoring
Benefits of Ownership
Different owners bring different assets, preferences and capabilities to the table (e.g.
management expertise, monitoring capabilities, different forms of capital, investment horizon,
risk preferences, and investment motives)
-
It’s not clear what the best form of ownership is ➔ depends on cost and benefits of
ownership
The best owner of a firm will likely change throughout the firm’s life cycle
3.1 The Fundamental Agency Problem and Its Mitigation – Dalton, Certo (2007)
Agency Theory: when the interests of owners and managers diverge, there is potential for
mischief: the managers can extract higher rents than would otherwise be accorded to them by
the owners
Mitigating/Minimizing the Agency Problem:
1. Independence: boards of directors can monitor managers and assure their interests
don’t diverge substantially from those of owners
2. Equity: managers with equity in the firm are more likely to embrace the interests of
other equity holders and to direct the firm in their joint interests
3. Market for corporate control: corporate markets may operate to discipline
managers who inappropriately leverage their agency advantage. In such cases, selfserving executives may subject the firm to acquisition by other firms
While these are approaches are rational in principle, the efficacy in practice remains debatable
Independence of boards of directors
Boards of directors cannot be effective monitors of management due to self-interest.
This issue of board independence focuses on:
1. The composition of the board: specifically, the extent to which the board is
comprised of members who may be reasonably independent of firms’ CEOs
2. The leadership structure of the board: the issue is the extent to which CEOs
simultaneously serve as board chairperson ➔ board’s monitoring function
Composition of the board of directors
Fundamental responsibility of the board: to monitor the management of the firm
Board categories (old):
1. Inside directors = an officer of the firm
2. Affiliated directors = not in the employ of the firm but has substantive linkages to the
firm (e.g. a consultancy relationship, a relative of the CEO, a key supplier to the firm)
3. Outside directors = have no substantive relationship with the firm
a. Only outside directors are truly independent
For some observers, boards can never be independent. This is because:
- Board members are selected and retained due to being sympathetic with the CEO
- Even if board members are independent initially, this cannot persist
- If board members are appointed by the current CEO it is likely that they have a sense of
loyalty towards them
o However, board members appointed by a prior CEO are less loyal to the current
CEO and hence more independent
- Board members may be less independent as the wealth associated with their position
increases (e.g. salary, stock options, etc.)
- Independence (or deviance) can be moderated through: cooptation, personal & social
influence, reciprocity, demographic consistency in selection, and between-firm referrals
Reciprocal interlock: when an officer of firm A is on the board of firm B and an officer of firm B
is on the board of firm A ➔ no independence
- There may be a related independence issue with CEOs serving on boards, irrespective
of reciprocal interlocks
o Independence concerns:
▪ Inside directors report directly to the CEO
▪ Their positions, salary and prerequisites are attributable to the CEO
-
Resource-based Perspective: interlocking CEO board membership can establish
collective structures for managing enterprise dependencies
o Also results in networking potential and innovation diffusion across boards
-
Since the Sarbanes-Oxley Act (SOX), the number of inside & affiliated directors has
decreased dramatically ➔ many expect improved board monitoring but others argue
that because of these changes, boards have never been more dependent
Disadvantage of independent board members: lack of firm and industry-specific
knowledge – this means they depend on the management for information
-
Board Leadership Structure
CEO Duality: one person holds the positions of both CEO and board chairperson
- Main Problem: CEO grading its own homework: the awkwardness of a board evaluation
of the CEO’s practices when the CEO serves as the presiding officer of the board
- Alternative: both roles are held separately by two individuals
Unity of Command: any person in an organization should be accountable to one, and only one,
individual
- Could cause a loss of having one single leader with whom both internal and external
parties can interact
A leadership structure with a separate CEO and board chairperson isn’t necessarily indicative of
independence
- In many cases, the “separate” board chairperson is the former CEO of the firm of a
person otherwise connected to the firm beyond their service as directors of the board
- When the separate chairperson isn’t independent, potential agency issues exist but
unity of command is wholly compromised as well (confusion about authority and
uncertainty about the influence of the chairperson)
- Presiding Director: a person who serves to moderate agency costs but is still dependent
on the information provided by internal members
Equity ownership
Agency-based research suggests that the equity owned by insiders (officers & directors) and
outsiders (investors) of the firm may importantly influence firm performance
- There are two perspectives regarding the effects of equity and firm performance:
1. Alignment: the effects of insider ownership
They are neither independent nor are
2. Control: the effects of outsider ownership
they necessarily complementary
Inside ownership and firm performance
Insider Equity: equity ownership aids in aligning the interests of executives with those of
shareholders
- Managers and shareholders have diverging interests, particularly for risk-taking:
executives (with high investment) may be more risk-averse than shareholders who
diversify their holdings across firms
- As executives’ ownership stakes decline, their claim on outcomes falls, resulting in
executives increasingly appropriating larger amounts of corporate resources in the form
of perquisites
o Managers with low levels of equity may prove more inclined to shirk their duties
- Some suggest that managerial equity ownership is beneficial at low levels, but negative
at higher levels ➔ as insider ownership increases, it affords managers greater power
that may facilitate their entrenchment
o However, some conclude that there’s no relationship between the two
Executive Compensation: Agency theory predicts that compensation policy will tie the agent’s
expected utility to the principal’s objective (e.g. equity-based compensation is a useful device
to link managerial and investor incentives)
o However, some studies weren’t positive and found a propensity to misreport
corporate earnings & fraud
o Incentive compensation can also have negative effects: securities fraud
allegations, timing of option grants, options backdating and options repricing
o Hence, executive compensation as a monitoring method may cause more
agency costs than it resolves
Outside ownership and firm performance
Block Holders: There is an uncertain nature of relationships between block holders (= >5% equity
ownership, can include executives, directors, and outsiders) equity and firm performance
o There is lack of consensus on the definition of block holders, resulting in
inconclusive findings
- Agency Problem II: there exists the potential for large block holders to extract rents
from smaller shareholders
o Public shareholders will prefer a controlling shareholder if the benefits from the
reduction in managerial agency costs exceed the detriment of the controlling
shareholder’s extraction of private benefits
- Family Equity Holdings: There’s also no consensus on the impact of family equity
holdings
o Large equity holdings by founding families would mitigate the fundamental
agency problem because of their incentives to monitor firms’ management
o However, it may also facilitate the expropriation of wealth from minority
shareholders in favor of controlling shareholders
Institutional Investors: equity holders like bank trusts, investment firms (mutual funds), pension
funds etc.
- Advantage: institutional investors may monitor managers more effectively than others
because they have:
o Greater expertise and can monitor at a lower cost than individual shareholders
o Better positioning to build concentrated ownership positions in portfolio firms
o Better access to coordinating mechanisms
o Critical inside information available that is not available to other investors
- Disadvantage: institutional investors may act more as traders than investors and, thus,
encourage myopic behavior among portfolio firms
- General disadvantages of institutional investors:
o They own too many firms to be able to pay sufficient attention to a single firm
o They invest money on behalf of others
o They are not effective at monitoring managers
o They have not effectively solved corporate governance problems
Institutional Investor Types
• Pressure-resistant institutional investors = most likely to monitor firm
management and advance shareholder-oriented policies and actions
• Pressure-sensitive institutional investors
• Pressure-indeterminate institutional investors
-
-
Dedicated institutional investors (those that exhibit low portfolio turnover,
concentrated ownership, and low trading sensitivity to earnings) are associated with
more long-term firm outcomes (e.g. R&D spending)
Institutions with high levels of portfolio turnover may encourage myopic behavior on
the part of the executives of the portfolio firms; yet, some institutions take a longerterm perspective and encourage appropriate executive behaviors
Market for Corporate Control
Market for Corporate Control: suggests that the market will correct for excessive agency costs
when managers make strategic decisions designed to satisfy their own self-interest (based on
the efficient market hypothesis)
-
-
Takeovers can help protect shareholders from poor management and signal to
executives the need to manage the firm’s assets in the best interests of shareholders
rather than in their own self-interest
o Potential actions: hostile takeovers, voluntary mergers, leveraged buyouts
(LBO), stockholder buyouts, spin-offs, split-ups, divestitures, asset sales, etc.
o LBO: involves the use of debt to buy the equity of the firm and make it private
▪ The use of debt plays a significant role in reducing agency costs because
it constrains managerial discretion
Takeovers can have a negative effect on stakeholders (e.g. employees) as they require
significant organizational change, sometimes requiring a shift of resources and layoffs
Criticism regarding the market for corporate control:
• Excessive diversification and inefficiencies in firms were caused partly because of laws,
regulations, and the prevailing finance/economic theories
• The market for corporate control became active only when other means of corporate
governance had failed (It only corrects after failure, it does not prevent)
• Actions taken do not create new wealth but rather redistribute current wealth
• Agency irony: some institutions use the market for their own advantage, creating a
second set of agency costs
o Greenmail: when a corporate raider buys equity, threatening a takeover after
which the raider sells the equity back to the firm at a premium
• The heavy use of debt creates a unique set of problems that lead to the demise of
several LBO firms through increased bankruptcy risk and debt costs
• The firm may suffer in the longer term when actions cause harm to stakeholders ➔
long-term financial losses are caused by layoffs, by discontent customers who turn to
competitors, and by suppliers who no longer trust the firm
Although the market for corporate control was viewed as highly effective, it has dissipated in
recent years due to:
• Strong opposition from corporate managers (enactment of antitakeover provisions)
• Laws that made takeovers more difficult
• The collapse of many banks eliminated the available funding for takeovers
-
Acquisitions made for the purpose of gaining knowledge and learning new capabilities
can produce positive returns but require careful design, planning and implementation
Hostile takeovers rarely produce positive returns, especially if rivals enter the bidding
process
Causes of Overvalued Assets:
1. Irrational exuberance in the market: “delusions of success”, in which executives
overestimate their own capabilities and exaggerate the benefits of a given initiative
while discounting its costs and risks
2. Misrepresentation of firms’ assets in the accounting records: executives deliberately
misrepresent the firm’s assets in order to maintain high equity valuations
Alternatives to antitakeover tactics:
- Qualified Offer Guidelines: set of principles that place the board on easily defendable
high ground regarding unsolicited takeover entreaties. Elements:
o Inclusive: bids cannot be less than 100% of the stock
o
o
Minimum premium: should be set in place to be paid for the target’s shares
Minimum number of days for which the offer will remain in effect
Critiques of Agency Theory
•
•
•
•
•
•
Agency theory is not novel, has a limited scope and narrow focus: mainly applied on
larger US firms
It provides a highly simplified, even unrealistic explanation for executive and board
behavior
Centralization of authority is inescapable. All complex organizations must have some
means for compiling the preferences of their members and forging them into a decision
Disparate utilities of stakeholders: stakeholders may have a general shared preference
of increasing the value of their shares, but their preferences on other aspects may vary
Decisions to separate ownership from control have, historically, been caused by the
unintended consequences of the vastly increasing scale, capital and complexity
The agency problem is a very real and often observed problem, however, many of the
interventions (independence, equity and market for corporate control) have unclear
effectiveness
3.2 Connecting the Dots: Bringing External Corporate Governance into the
Corporate Governance Puzzle – Aguilera et al. (2015)
Corporate Governance: the design of institutions that induce or force management to
internalize the welfare of stakeholders
Governance: practices that give organizations the authority to mandate action (e.g. leadership
systems, managerial control protocols, property rights, decision rights, etc.)
Corporate governance definitions across world views:
1. Law/Finance View: the ways in which suppliers of finance to corporations assure
themselves of getting a return on their investment
2. Property Rights View: mechanisms supplying the complex set of constraints that shape
the ex post bargaining over the quasi-rents generated by the firm
3. Managerial View: the set of (in)formal structures and processes that exist in oversight
roles and responsibilities in the corporate context
4. Sociological View: a mechanism to allocate power and resource control among firm
participants
5. Stakeholder Perspective: the structure of rights and responsibilities among the parties
with a stake in the firm. Purpose is to ensure that executives respect the rights and
interests of firm stakeholders and guarantee that stakeholders act responsibly regarding
the generation, protection, and distribution of wealth invested in the firm
Key Elements of Good Governance
1. Should protect stakeholder rights and provide a means to enforce those rights by
monitoring executives and holding them accountable
2. Should help mediate between the different interests and demands of various internal
and external stakeholders
3. Should provide transparent information disclosure
4. Should involve the provision of strategic and ethical guidance for the firm
The CG Puzzle
Most research has focused on internal governance mechanisms:
1. Board of Directors: There is little systematic evidence for a positive relationship
between board independence and firm performance
2. Ownership: Grants the owenrs the incentive and capacity to directly monitor and advise
managers and the board; however the effect is negligible
3. Managerial Incentives: evidence related to equity-based incentives on financial
performance is mixed and inconclusive
-
Internal governance mechanisms do not operate in isolation: external factors play an
essential role in determining the direct and indirect effectiveness of a firm’s governance
o Additionally, research on external governance mechanisms is very limited
External Governance Mechanisms: originate from outside the focal firm and help ensure that
executives respect the rights and interests of company stakeholders, guarantee fruitful
stakeholder relationships, provide financial transparency, and offer strategic guidance.
Theoretical Perspectives of Corporate Governance
1. Agency Theory: managers and other corporate insiders have different objectives than
outside investors and will act in their self-interest whenever they can do so
a. Key assumptions: managerial self-interest, bounded rationality, risk aversion,
and information asymmetry
b. Processes that can help achieve effective CG: monitoring of agents, contractual
relations, incentives, and signaling
2. Institutional Theory: institutions bring stability and meaning to social and economic
behavior achieved because there are certain rules of the game that are taken for granted
as legitimate.
a. Institutions provide a context in which individual efforts to deal rationally with
uncertainty & constraints lead to homogeneity in structure, culture & output
b. Processes are related to: adopting practices for symbolic reasons (instead of
internalizing/decoupling) and social control function of reputation
3. Resource Dependency Theory (RDT): implies that the purpose of governance is to reach
a consensus in the mutual interdependencies between internal and external
stakeholder relationships by effectively distributing the power and allocating the
asymmetric resources
4. Team Production Theory: the corporation embodies several stakeholders who
collectively invest firm-specific resources, but jointly relinquish control over those
resources to a board of directors for their own benefit in order to solve ex ante the
problem of coordinating efforts and shirking within the team and prevent ex post free
riding among contributing members
External Governance Mechanisms
1. Legal System
Legal System: the set of structures and processes used for interpreting and enforcing the
existing law
- Establishes how property rights are defined and protected, and includes regulatory
institutions overseeing norms and rules that firms must comply with
Soft Laws: principles and norms that are enacted by the stock exchange commissions, interest
groups, or the larger society to exert influence on firm governance
Corporate Law: defines firms’ corporate governance in terms of legal personality, limited
liability, transferability of shares, management-board relations and the ownership structure of
the firm
Two important legal choices:
1. Under what legal regime the organization forms (partnership, incorporated entity,
limited liability company, etc.) ➔ grants distinct rights and responsibilities to partners,
managers, directors, and shareholders
2. Where firms chose to incorporate ➔ firms may list in a foreign stock exchange to access
foreign capital and gain legitimation from foreign investors or to avoid taxes
Rights granted to US shareholders:
- The right to vote in the annual meeting
- The right to introduce shareholder proposals in the annual meeting
- The right to sue the management in case of breach of loyalty or lack of disclosure
The legal system clearly shapes every dimension of governance effectiveness:
• It delineates rights and responsibilities of different interest groups
• It regulates relationships between parties with a stake in the firm
• It mandates the disclosure of financial and non-financial information
• It defines the purpose of the business entity and legally binding contracts
Who owns the firm?
• Agency theory: public corporations are bundles of assets collectively owned by
shareholders (principals) who hire directors to manage those assets on their behalf
• RDT: regulation stipulates who has the capacity to reduce environmental dependency
and uncertainty ➔ stakeholders can obtain critical resources from the environment to
regulate inter-corporate relations
• Team production theory: the legal requirement that corporations be managed under
the supervision of a board of directors has evolved not to reduce agency costs but to
protect the enterprise-specific investments of all the members of the corporate team
• Institutional theory: the legal system explicitly coerces corporations to comply with a
specific regulation, but it also implicitly leads corporations to conform to normative and
cognitive guidance underpinning the legal system
2. Market for Corporate Control
Market for corporate control: when firms underperform, they face an increased risk of being
taken over by outside ownership
- This CG mechanism is activated when managers make poor strategic decisions and the
firm’s assets are undervalued in the equity market ➔ when the stock price declines due
to devalued corporate assets, the firm is more susceptible to takeover
Advantages:
- Takeover threat acts as a strong motivator for executives to manage the firm’s assets in
the best interests of shareholders rather than in their own self-interest, to avoid
potential job loss and damage to managerial reputation
- Assets can be reallocated in more productive ways
Disadvantages:
Takeovers have little to no impact on shareholder wealth in the short run and produce mostly
negative returns in the long run, at least for acquiring firms, because:
• Assessing the target’s value in the acquirer’s control is difficult due to information
asymmetries between insiders and outsiders
• Antitakeover practices may be adopted to raise acquisition costs (e.g. poison pills,
greenmail, dual-class shares, or defensive changes in asset and ownership structure)
• Takeovers are expensive due to search costs, bidding and transaction costs
• Takeovers are ex post corrections; they take place after the failure has occurred
• The market for corporate control has more long-term negative effects on stakeholders
3. External Auditing
External Audit: express an opinion indicating that reasonable assurance has been obtained that:
- The financial statements are free from material misstatement (no fraud or error) and
- The financial statements are fairly presented in accordance with the relevant accounting
standards
Advantages:
- They enhance the degree of confidence that users can place on financial statements
- They reduce asymmetries of info between insiders of the firm and stakeholders, limiting
managers’ ability to manipulate info and extract wealth
- They enhance firms’ legitimacy (has become more important after the wave of scandals)
* Large (un)listed firms around the world are required by law to have an external audit while
smaller firms voluntarily decide whether they want to audit their financial statements
Two auditor characteristics have been extensively studies:
1. The level & nature of external audit fees
2. The size of the audit firm
a. Big auditors are argued to deliver higher audit quality as they have stronger
incentives to offer greater audit effort (they have more reputational capital to
protect, higher litigation risk, and greater regulatory scrutiny).
b. They’re expected to be more competent (their large size allows them to attract
& retain higher quality audit inputs
c. They have larger customer bases, making them less financially dependent on
individual clients hence increasing their independence
4. Rating Organizations
Rating Organizations: organizations that specialize in rating various aspects of the focal firm
- Mainly use publicly available info to rank firms in terms of their financial and governance
performance
- Ratings have the potential to reduce info asymmetries between managers and
shareholders by offering better info about performance and governance practices
Security Analysts: serve as legitimate external evaluators whose ratings can be seen as
certifications of CEO ability and evaluations of their corporate strategies
- Illegitimacy Discount: when corporate activities are perceived as illegitimate or don’t fit
in pre-conceived and well-known categories, firm value tends to be underestimated
Commerical Governance Rating Advantages:
- Ratings are useful to firms’ customers
- They use quantitative (flexible and yearly revised) algorithms that capture their
extensive expertise regarding the relationship between governance and performance
- They are able to employ large, rich databases from multiple data sources
5. Stakeholder Activism
Stakeholder Activism: the external pressure from stakeholders to influence firm policy and
practices. It’s a type of social movement where various parties contend with firms to try to enact
change
Key Activism Motivators:
1. Financially motivated: to increase shareholder value – embraces shareholder primacy
2. Socially motivated: to divest from conflict zones, adopt CSR practices etc.
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-
Activism tactics: letter writing, proxy battles, litigation, publicity campaigns, dialogue
with corporate management / board, asking questions at general annual meetings,
filling formal shareholder proposals
Activist Hedge Funds: tend to propose strategic, operational and financial remedies
(often with success, without seeking control)
Activism can spillover and affect other firms in the same industry
6. Media
Media: various channels of communication and the journalists who provide content for these
channels. It is an information intermediary because of its ability to distribute information
The Governance Role of Media:
- Exerts influence and on managers to adopt practices that are consistent with widely
accepted principles of good governance
o It can provide a platform to publicize the views of smaller groups of individuals
o However, the media chooses which events to cover and how they are reported
- It can broadly disseminate information and exerts a monitoring role
o Watchdog Role: the media can exercise influence by uncovering new
information through independent investigation
- It can increase transparency and reduce information asymmetries
- It can act as a propagator of legitimacy by carrying institutional norms and focusing on
positive benefits of media attention
o The media acts as a referee, encouraging appropriate behavior while
stigmatizing inappropriate behavior
- However, firms can engage in symbolic actions to gain positive media attention
7. Presence of Multiple External Corporate Governance Mechanisms
External CG mechanisms often coexist and tend to reinforce each other in a complementary
fashion:
• Legal system & market for corporate control: when antitakeover laws insulate managers
from takeovers, overall firm productivity and profitability tend to decline
• External auditors & legal system: countries with weak legal environments demands,
lower quality audits than strong legal environment countries
• Stakeholder activism & market for corporate control: reducing managerial
entrenchment, activism could precipitate activity in the market for corporate control ➔
firms targeted by activists are more at risk to be acquired
• The media & audit opinion: negative press coverage increases auditors’ perception of a
client’s bankruptcy probability and this leads auditors to modify the audit opinion, even
if no new info is presented
• Stakeholder activism & media: stakeholder activists may seek to target the firm’s
corporate image and reputation by relying on the media to broadcast illegitimate
corporate behaviors. The media offer a channel through which activists can exert more
direct pressure on corporations
How external CG enhances the effectiveness of internal CG
Legal System
Legal system has a strong influence on all 3 internal governance mechanisms as it helps to set
up the (in)formal rules of the game under which governance operates
-
-
Determines the nature of shareholder rights and provides them with voting rights
Stronger shareholder rights can grant firms higher profitability and sales growth
o However, not all firms have a one share – one vote structure
o The voting quorum necessary to elect board members differs by firm
The legal environment influences the importance of the board within the CG puzzle
As a response to a controversial debate on seemingly excessive executive pay and the
mismatch between pay and performance, listed firms are now obligated to conduct an
advisory shareholder vote on the compensation of their top executives
Market for corporate control
The market for corporate ownership has the potential to play an important role in firms with
dispersed ownership but it may play a lesser role in firms with controlling shareholders
-
Takeover threat has 2 opposing effects on compensation:
1. Competition effect in the market for managers ➔ less capability for managers
to extract higher wages
2. Risk effect ➔ increased compensation as higher takeover threat is likely to
result in an increased probability of firm-specific human capital loss or implicitly
deferred compensation
External auditors: are likely to strengthen the governance role of the board of directors ➔
especially important when the level of board independence is low or where the monitoring role
hasn’t been emphasized
Rating organizations: are likely to exert direct influence on both the boards and executive
compensations
-
o They can induce changes in board composition and executive compensation
The threat of downgrades may serve as a complementary mechanism that exerts some
pressure on boards to perform their duties well
o This effect may be reduced by reciprocity between executives and analysts
Stakeholder activism: have been increasingly successful in enhancing firm governance
effectiveness by activating internal CG mechanisms
o
-
Strongest effect is on owners as activism allows shareholders to exercise their
power as owners of the firm to influence firm behavior
The relationship between stakeholder activism and board effectiveness is more mixed
Media: likely to have moderate effects on internal CG mechanisms and it may interact with these
mechanisms to influence governance effectiveness and other important firm outcomes
-
Negative media coverage has a stronger effect on strategic change in the presence of
an independent board (it can motivate them to be more effective or active)
Media pressure could cap executive pay, however, there is weak evidence to support
this
3.3 Lecture: The Corporate Governance Challenges and Practices of PLCs
Agency problem: the incentives don’t align between the agents and principals because of
information asymmetry
- The principal gives away control to the agents but is still liable to the risk
Ownership works when you have at least 2 rights:
1. Right of Control: control the things that you own
2. Right of Return: when you also have to absorb the residual returns of the thing that you
own, you have the incentives & ability to maintain the thing that you own optimally
- When the two are separate, you have separation of ownership and control (separation
of control from return rights)
Treatments for agency problems:
- Bonding: mechanisms to artificially align incentives: contingency fees, performancedependent executive pay, stock options, managerial ownership, etc.
o Bonding Costs: incentive schemes, bonuses, stock options
- Monitoring: activities to ensure that the agent serves the principal: board monitoring,
shareholder monitoring (activism and block holding), market for corporate control, etc.
o Monitoring Costs: salaries, disclosure/compliance costs, audit fees
- Agency costs are a deadweight loss to economic exchange: value gets destroyed
because of lack of confidence (corruption also destroys value)
o Residual Loss: value destroying acquisitions, conglomerate discount, under
investment
Main Challenge: minimize the sum of all these different agency costs
Two characteristics are the foundation of agency costs (foundation for the separation of
ownership and control):
1. Freely transferable shares: the more shares are liquid and freely tradeable, the less
shareholders can be involved
2. Delegated management: because investors cannot be involved in the firms they own
they need to leave the job of running the firm to the managers
Fundamental trade-off: for shares to be liquid and freely tradeable, it means somebody has to
do the decision-making
- Main costs of the PLC: the cost resulting from the separation of ownership and control
- Unaligned incentives: Managers like to grow the firm but not the value of the firm
Corporate governance practices in PLCs
In general, there are 2 types of treatments:
1. Internal to the firm: boards (independence & diversity), block holding (ownership
concentration), executive pay, leverage
2. External to the firm: liquidity, legal protection, market for corporate control
(takeovers), shareholder/stakeholder activism, external intermediaries (gatekeepers),
media
The Board of Directors
Board independence and diversity are becoming mandatory characteristics
- Board diversity is associated with better monitoring but not per se better valuation
- Diversity can also be associated to expertise:
o Too much diversity can result in lack of industry-specific knowledge
o No diversity can result in tunnel-vision
Most countries allow a one-tier board: both executive directors (managers) and non-executive
directors (monitoring managers) on one board
- Main problem: the non-executives are monitoring the executives
- Advantage: independent directors tend to be better informed as you are closer to the
fire (e.g. meet with the CEO often)
Except for North-Western Europe: two-tier board: supervisory board (non-executives) +
management board (executives)
o Advantage: non-executives are more independent from managers
-
Best system: one-and-a-half-tier board (typically non-executives)
Consists of board committees:
• Audit committee: looks at financial disclosures
• Compensation/Renumeration committee: looks at compensation of executives
• Nominating committee: nominates board members or executives newly to be
appointed
Executive directors = directors (managers) on the board that are appointed by the
shareholders in a one-tier system or appointed by the supervisory board in a two-tier system
Non-executive directors = main responsibility is to monitor executives, not manage
Within non-executive directors, you have 2 types of directors:
1. Affiliated directors: have substantial linkages to the firm and hence have
conflicted interests
2. Independent directors: have no relationship with the firm and managers (business
and privately)
- Even though non-executive directors are formally independent, they very often know
each other from previous connections ➔ independence is a very hard concept to
apply, there’s always some relationship somewhere
Co-determination = the German system in which both labor and capital are on the board and
jointly decide on company strategy
- To bring both critical constituencies of firms (employees and capital) in the highest
organ in the firm (supervisory board) to jointly decide on what the firm should do
Staggered boards = a board in which its directors (members) have a certain appointment term
- Shareholders don’t like staggered boards because appointed directors cannot be fired,
especially during acquisitions because managers cannot be fired immediately
- However, staggard boards have the purpose of preserving continuity
Functions of the board:
-
-
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Decision-making: most of large decisions are made by the board and any conflict of
interest will be a board decision (not by the CEO)
Monitoring managers: the board is not involved in managerial decisions because their
main function is to monitor
o However, in firms where the shareholders are in control, monitoring is less
important
Securing and cementing ties with critical stakeholders: appointing board members in
a firm and the other way around to show that you have the same interests and to
share information
o Firms that do business with each other have board interlocks: they appoint
each other’s board members to cement critical ties
Reputational bonding: boards in which they position reputable people from outside
the industry to show they’re a firm worth investing in as a signal of trustworthiness
The internal functions of boards
There is lack of research about the internal functions of groups, however, some important
aspects are:
• The strength of weak ties: when people work together for long, they have strong ties
which can make it difficult to avoid bias.
o Weak ties are social ties and can often mean that family members or friends
are on a board despite lacking experience
• Authority in the board: seniors usually have more authority, however, with authority
individuals may fear speaking up which can have dangerous consequences
•
Consensus in the board: people naturally want to agree with each other; however, this
can mean that they forget to look beyond what is made available to them
o It is important to try to find non-confirming information yourself (play
advocate of the devil), otherwise, not enough alternatives are assessed
Extras
Block holding = when you have large chunks of shares
- Ownership concentration can have positive or negative outcomes
Executive pay: Stocks are more effective than stock options because managers, will have the
sane risk/benefit that shareholders do resulting in more symmetrical risk exposure
- Stock options often result in excessive risk-taking by managers
Leverage: It is often better to have a certain amount of debt to align managers’ incentives for
managers to make better decisions about what to spend the available money on
- A certain amount of debt is good for resolving agency problems but at the same time it
creates more risk for shareholders in the longer run
Liquidity: Lack of liquidity is a problem as being able to sell your shares is the only way to
appropriate value in equity (you typically don’t get dividends)
- Size of stock markets matters: if you as a shareholder want to sell your shares in a
large stock market, you won’t influence the share price but in a small one you will
- In a large equity market, you’re more likely to find a buyer of your shares so won’t
depress the price of your shares
Shareholder activism: individually they’re too small but together they can demand for change
e.g. more sustainable practices of a firm
5.1 A Primer on Governance of the Family Enterprise – Rafi & Vilalonga (2013)
The family enterprise key components:
- Family Members: individuals related by blood, marriage or adoption who have a claim
on the family business
- Family Firm - one or more family-owned, -managed, and -controlled businesses (which
may be private of public): firm characterized by a substantial presence of the founding
family who exercise significant influence through equity ownership, voting rights or
management
- Family Foundation: the organization through which the family carries out its
philanthropic activities
- Family Office: the professional organization, owned and controlled by the family,
created to serve the wealth-management and personal needs of family members
Characteristics differentiating family and non-family firms
Family firms
Non-family firms
Preference for control
Preference for cash-flows
Long investment horizon
Short investment horizon
Conflict of interest between family blockholders and
Conflict of interest between management and
minority shareholders
shareholders
Trade-offs between control, liquidity, and growth
Don’t face a significant degree of such trade-offs
Focus on investment projects with long payback periods Focus on cutting costs to maximize short-term profits
Family Enterprise Governance
Governance Theory Background:
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Resource Dependency Theory: suggests that the board of directors is an important catalyst
of resources like access to finance, legal advice and social capital
Stewardship Theory: broadens the perspective on the motivations driving managerial
behavior to highlight the self-interest motivation of managers and their role as stewards of
corporate resources, which is consistent with shareholders’ interests
The Power Perspective: managers, while being legally subordinate to directors, may acquire
extra power in certain situations, having the opportunity to circumvent the monitoring
function of the board
Family firms: by exercising substantial control on business and through their participation in
management, they often manage to align the incentives between ownership and
management
However, they’re more likely to be faced with another agency problem: the potential
conflict of interest between family and non-family shareholders ➔ the controlling family
may force managerial decisions that are in the best interest of family shareholders but not
of all shareholders, gaining private benefits at the expense of non-family shareholders
Family Enterprise Governance: the collection of mechanisms that enable family decisionmaking and implementation of family affairs, its businesses and related entities in a manner that
meets the mission and goals of the family
-
Family firms can better align incentives between ownership and management than PLCs
(through the exercise of control by participating in management)
Unique agency problem: the controlling family may force managerial decisions that are in
the best interest of the family shareholders but not all shareholders
o Gaining private benefit at the expense of non-family shareholders
Governance of the Family
Over time, families grow apart, challenging the preservation of family norms, culture and legacy
hence requiring a customized family governance system.
Family Governance: the rules, processes and institutions that enable decision-making and
implementation of policies concerning the oversight and management of family affairs
Goals of family governance:
- Enable coordinated decision-making about common assets and their management
- Enable orderly succession in ownership, management, and control
- Minimize interpersonal conflict within the family
- Enable family harmony and happiness in future generations
- Preserve and enhance family wealth
- Ensure sustainability and prosperity of the family business
- Enable long-term estate planning
Intra-group elements: the governance of relationships and decision-making within the family
- Informal elements: culture, norms, values, traditions, legacy
- Formal elements: family constitution, family council, family assembly
Inter-group elements: the relation between the family and the other family enterprise entities
like the family business / office / foundation
-
Informal elements: family culture, norms, values, traditions
Formal elements: BOD, holding Co., operating Co., succession management
Informal Elements
Family Culture: the system of shared values and norms that define appropriate attitudes and
behaviors for family members
Values: concepts and beliefs that guide selection and evaluation of actions and events
Fairness Perception: the degree to which family decisions are perceived to be fair shapes the
judgements and behaviours of the individual (main driver of happiness and main deterrent of
conflict)
Justice (related to fairness) takes 3 forms:
• Distributive: fairness of outcomes
• Procedural: fairness of decision-making processes
• Interactional: fairness of treatments
When family governance shows these 3
forms of justice, family members have a
higher fairness perception ➔ being
more satisfied and less prone to conflict
Fair Process: a construct that includes clear steps to generates better solutions through a fair
process, activating a positively reinforcing cycle. Related steps:
1. Engaging with and framing the issue
Each step should be
2. Exploring and selecting the options
characterized by 5 qualities:
3. Deciding and explaining the reasons underlying the choice
communication, clarification,
4. Implementing and executing the chosen option
consistency, changeability,
5. Evaluating the outcome and learning from it
commitment to fairness
Family Cohesion: the degree of emotional closeness among family members, which has a strong
effect on second-generation members
Family Adaptability: the degree to which the family is able to change its structure following
situations of stress
Formal Elements
The formal elements of a multi-generational, multi-branch family include:
•
•
•
•
Family Constitution: a morally binding document, containing rules and regulations
about coordinating decision-making among family members
Family Council: a forum of certain family members elected by the family, responsible
for coordinating family decision-making and managing family affairs
Family Assembly: a forum of all family members dedicated to preserving the family’s
heritage/culture/norms/traditions
Family Committees: groups of elected or appointed family members, responsible for
specific aspects of family life (e.g. education of family members and philanthropy)
The development of the formal governance structure is often visible in the 2nd and 3rd generation
Conflict Management
Family conflicts can either concern the business or personal relationships
- It can negatively affect the business by causing anxiety, less risk taking, information
asymmetries and reduced commitment
Conflicts mainly stems from:
o Lack of clarity of business leadership
o Lack of procedural justice
o Resource distribution based on need or equity rather than equality
Conflicts can arise when:
o The founder of the business has formally left control but is still present
o Great family involvement causes task conflict because of disagreements
o A high number of family members are involved in the daily business operations
o There is a large degree of social interaction among family members
Conflict Management Strategies:
- Competition: strategically using information to manipulate others in order to reach the goal
o High self-concern, low concern for others
- Collaboration: attempting to generate solutions satisfactory to all (e.g. supportive
communication)
o High self-concern, high concern for others
- Compromise: reaching an agreement where all parties are moderately satisfied
o Moderate self-concern, moderate concern for others
- Accommodation: recognizing and fulfilling the desires of others
o Low self-concern, high concern for others
- Avoidance: refusing to face conflicts and address problems
o Low self-concern, low concern for others
Governance of the Family Firm
There are 6 key aspects of family firm governance:
1. Ownership Structure: the amount of firm equity owned by the shareholders, which reflects
the right of the shareholders to the firm’s cash flows
o The family can own equity directly (owning shares without intermediate entity) or
indirectly (owning one or more investment vehicles like trusts, foundations,
corporations, or partnerships)
o Typically, firms employ a combination of direct & indirect forms of ownership
2. Control Mechanisms: the way the shareholder can influence the direction of the firm
o There are 3 main measures of control:
▪ Votes owned: no. of votes owned by the shareholder
▪ Votes controlled: no. of votes controlled by the shareholder
▪ Board seats controlled: no. of seats on the board of directors controlled by
the shareholder
There is a wedge between ownership and control: the voting control that the family has in excess
of its ownership.
- Appropriation of private benefits of control: This wedge enables the controlling
shareholder to benefit in some way at the expense of other shareholders
Control-enhancing Mechanisms:
• Dual-class stock: shares of different classes, where one class has superior voting rights
• Pyramidal structure: focal firm owns a fraction of another firm through a chain of
ownership relations
• Cross-holding: a lower-tier firm in a pyramidal structure owns equity in its owner, an
upper-tier firm in the ownership chain
• Voting agreement: different shareholders pool their votes to reach a common objective
3. Board of Directors: main role is to monitor the management on behalf of the shareholders
and ensure that management actions are in shareholders’ best interests
o Board Dependence: degree to which the board is subordinated to the management
o Board Capital: sum of directors’ human and social capital
- Family power negatively impacts both functions of the board by increasing board
dependency and negatively influencing the board’s capital
- Board independence is important as it reduces the risk of appropriation of private benefits
4. Executive Compensation: typically includes monetary and non-monetary rewards, as well
as short-term incentives (bonuses) and long-term incentives (stock options)
o The family often has substantial power in determining executive compensation
o Compensation discount/gap: family members as CEOs are paid less than non-family
members, as they differ in preferences, risk profiles and time horizons
o Lack of managerial ownership is negatively related to CEO compensation as
owners/managers can use their position to determine a higher salary
o Short-term incentives for non-family CEOs should be low when:
▪ The CEO wants to signal performance of executives to the outside market
▪ The CEO’s effort to improve short-term performance is hard to observe
▪ The CEO is more sensitive to incentives
5. Dividend Policy: can be used to compensate for or take advantage of the controlling position
in the firm
o May alleviate or exacerbate the conflict between family blockholders and nonfamily shareholders
o Firms pay higher dividends when they’re tightly affiliated with a business group and
when they have a stronger wedge between ownership and control
o The degree to which the mechanism is used depends on the economy’s financial
development
6. Succession: concerns whether and how to transfer the family firm’s ownership, control, and
management to the next generation
o Effective family succession drivers: heir preparation, nature of the relationships
among family members, and planning & control activity in the family firm
o Seat-warmer Strategy: hiring a professional CEO, even if a premium has to be paid,
until a suitable heir is available
The succession decision depends on the legal environment:
- Strong ➔ founder hires professional as CEO and sells the firm in the stock market
- Weak ➔ founder chooses the family heir as CEO and keeps the firm ownership
- Intermediate ➔ founder hires professional as CEO but keeps a controlling stake in the firm
o Agency problems with intermediate legal environment
▪
▪
Conflict between management & shareholders
Conflict between family blockholders & non-family shareholders
Successful transition can take place if:
-
The heir voluntarily took lead of the family firm
The family explicitly requested the heir to succeed the helm of the firm
The heir chose the lead because of moral duty
The family pushed the heir to take control
The transfer was implicitly predetermined without needing to make a request
Preparing for successful succession:
-
Involve the heir in the business early on
Have the heir undertake studies related to the business
Provide the heir with internal education tailored to initiate their understanding of the firm
Encourage the heir to gain work experience in other companies
Officially introduce the heir into the business
Regulate the debut of the heir into the family business through a written agreement
Governance of other family entities
Family Office
Families increasingly face the need for wealth management, hence they often choose to set up
their own family office (= a professional organization dedicated to serving the financial and
personal needs of the family)
- The services often fall into 3 broad categories: investment management services,
administrative services, and family-related services
Family offices are subject to 3 types of risk:
• Financial: e.g. cash misappropriation or inaccurate book-keeping
• Technology-related: e.g. information theft and technical problems in the system
• Employment-related: e.g. payroll fraud and tax issues
Effective Governance Controls:
- Governance practices reflecting family standards regarding ethics
- Procedures that regulate access to family funds
- Practices supporting the segregation of duties
- Processes for conducting frequent reconciliations
- Practices of documenting all significant transactions
Family Foundation
Family Foundation: the entity through which the family firm carries out its philanthropic
activities in a tax-efficient manner ➔ main activity: providing grants according to its mission
- Positive effects of family foundations:
o Tax reduction (by distributing 5% of market value for charity they are tax exempt)
o Financial education (due diligence, valuation, investment strategy)
o Family communication (meetings)
o Family discussion (emphasis on issues that would remain understated)
Main governance institution of family foundations: a governing board
- Key governance decision: hiring outsiders
- Benefits of non-family board members:
o Bringing a new level of professional management
o Enhancing the relationship between the foundation and the community
o
Bringing a fresh and objective perspective into the family
Four models of family foundation structure:
1. Trustee model: there’s no additional staff and the board performs daily administration
2. Administrator model: small staff is hired to perform daily administration while board
makes decisions
3. Director model: executive director guides the board activity
4. Presidential model: board sets policies and monitors progress while an administrator
has wide authority
Governance and Performance
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Family governance reinforces family ties, building a unified team with common goals
Families tend to prefer to keep control, this can positively affect performance because:
o Long-term, forward-looking approach
o Effort to build reputation and social capital
o Investment in business education and strong culture
o Strong relationships with the professional managers
The relation between family ownership and performance increases as family ownership
increases but decreases after a certain point (inverse U-shape)
- Insider Ownership: managers/board members have an ownership stake in the firm
o Insider ownership increases performance at moderate levels, but decreases it at
excessive levels
- Corporate Transparency: the degree to which shareholders have easy access to all
information regarding the firm ➔ an important monitoring device
o The positive relation between family ownership and family firm performance is
conditional on the family firm being transparent. If the firm isn’t transparent, the
market perceives that the family may be extracting resources from the firm
The wedge between voting rights and cash-flow rights adversely affects performance
- The use of control mechanisms is negatively related to performance
o The larger the wedge, the higher the reduction in value
- If the management group has more control rights exceeding the ownership rights, firm value
decreases
o Family firms with a more equal distribution of voting power among blockholders
perform better (even with at least one non-family blockholder)
- The environment may affect firms mainly through 2 channels: cultural (traditionally
embedded values and norms) & institutional (market development & the legal framework)
Family Management: when either the founder or a descendant manages the firm
- Family firms often perform well under a founder (positive founder-CEO effect) but not under
a descendant
- Negative descendant CEO effect: the family may make succession decisions based on
reasons other than merit (e.g. nepotism)
o Families choosing the CEO based on the firstborn child are often poorly managed
5.2 Governance of Family Firms – Villalonga et al. (2015)
The agency problems in family firms are conflicts of interest between:
- Shareholders → Managers (Agency Problem I)
- Controlling (family) shareholders →Non-controlling shareholders (Agency Problem II)
- Shareholders → Creditors (Agency Problem III)
- Family shareholders → Family outsiders (non-shareholders, non-managers) (Agency
Problem IV)
Corporate Governance: the reconciliation of conflicts of interest between various corporate
claimholders
Agency Problem I: Conflict of Interest Between Owners and Managers
When a firm isn’t managed directly by its owners, managers are likely to pursue their own
interests that are different from the principal
- Ownership concentration (and thus family ownership) serves as a mechanism to mitigate
the agency problem: owners will monitor the manager so that it does not deviate too much
from the principal’s objectives
- Individual and family shareholders are often dedicated and effective owners as their own
wealth is at stake and emotional ties act as additional motivation
- The agency benefits of family management have to be traded off against its costs (e.g.
inferior quality than hired professionals)
o Descendants of the CEO often result in an underperforming firm
Agency Problem II: Conflict of Interest Between Controlling (Family) Shareholders and
Non-controlling Shareholders
Shareholders may use their controlling position in the firm to appropriate private benefits of
control at the expense of small shareholders
- These incentives are enhanced if it is a large shareholder and an individual or family
- In family firms, Agency Problem II is likely to overshadow Agency Problem I
o Family presence in management reinforces their ownership and voting control –
enhancing Problem II while alleviating Problem I
- Separation between voting and ownership can be achieved through: dual-class stock,
pyramids, disproportionate board representation and voting agreements
Types of conflict:
1. Families hold a median of 24% of equity but 57% of the votes
2. Block Premium: paid for a controlling block of shares, relative to the price paid in minority
trades pre- or post-transaction
o Voting Premium = difference in stock price between 2 classes of shares that have
different voting rights, after controlling for differences in their cash flow rights
3. The wedge between cash flow and control rights has a negative impact on value
4. Tunneling: the transfer of assets and profits out of firms for the benefit of their controlling
shareholders
o Founding families often retain control if it provides them with a competitive
advantage while non-founding families do so if it provides them with private
benefits of control
5. Economic Entrenchment: if few families control large parts of the economy, corporate
problems can cause macroeconomic problems
o Too many family firms in countries can lead to smaller firms, lower GDP and smaller
capital markets
Agency Problem III: Conflict of Interest Between Shareholders and Creditors
From an agency perspective, debt has both benefits and costs:
• Benefits: debt can be used as governance mechanism to mitigate Agency Problem I
• Costs: debt creates a new conflict of interest between shareholders and creditors
There are 2 forms this conflict of interest can take:
1. Asset substitution / risk shifting effect
2. Underinvestment that can result from debt overhang
- Anticipating these situations, creditors will charge higher premiums and thus increase the
firm’s debt financing costs
Family shareholders’ objectives:
• Ensuring the long-term survival of the firm
• Preserving the family’s reputation
• Keeping the firm in the family
This, together with the undiversified nature of their
holdings in the firm, makes controlling families
more likely to maximize firm value rather than
shareholder value
Thus, divergence of interests between shareholders and creditors will be less severe in family
firms than in non-family firms
-
On the one hand, families’ desire to avoid dilution in their equity stake and their lower cost
of debt suggest they have higher levels of debt relative to non-family firms
On the other hand, the unique family objectives that make their incentives more aligned
with those of creditors suggest they should be less leveraged
Agency Problem IV: Conflict of Interest Between Family Shareholders & Family Outsiders
The family is a “super-principal” and family shareholders act as an agent for them
- Family shareholders are entrusted with preserving and enhancing the family legacy
Families have multi-tier structures
1. Multi-tier structures are common in concentrated ownership structures (e.g. in stateowned firms, the government is the manager’s principal but also an agent for the public)
2. The family appoints a subset of its members as shareholders to perform tasks on its
behalf
a. For example, family members choose the second/later generation successors
3. As in any agency relationship, the goals of principal and agent may diverge
a. Family shareholders are likely to share some of their principal’s objectives but
they’re also likely to have some (conflicting) objectives of their own
Governance Mechanisms in Family Firms
Ownership concentration: there are 2 versions of ownership concentration that alleviate
Agency Problem I:
- Managerial ownership: aligns the interests of managers and owners
- Outside blockholder ownership: allows for better monitoring of managers by large
shareholders
- If there are multiple blockholders, their power can become large resulting in coalitions – this
can mitigate Problems I and II but exacerbate Problems III and IV
Boards of directors
- Protects non-controlling shareholders from managerial power abuses by controlling
shareholders: mitigating Problem II
- Can improve communication and align incentives between family and non-family
shareholders: mitigating Problem IV
Executive compensation
- Well-designed contracts can align managerial and owner interests ex ante: mitigating
Problem I
- Can reduce the risk of family executives’ entrenchment: mitigating Problem II
o Family CEOs receive lower pay but higher risk protection than non-family managers
Reducing free cash flow through debt: mitigates Agency Problem I by:
- Alignment of managers’ incentives and shareholders
o The greater the leverage the greater the managers share of equity
- Higher levels of debt may induce greater effort by managers who want to avoid bankruptcy
- Useful to discipline managers due to commitments derived from debt contracts
However, can enlarge Problem IV because families remain in control of their firms
Reducing free cash flow through dividends: family firms tend to reinvest earnings instead of
paying out dividends, hence, dividends do not mitigate agency costs in family firms
The active market for corporate control: can serve as a disciplining mechanism for
underperforming managers ex post and ex ante
- Intrinsic family firm characteristics can insulate them from market’s discipline
o High ownership concentration
o Use of control-enhancing mechanisms
o Managerial entrenchment
- Dual-class firms can increase Problem II and obstruct protection against Problem I, however,
they alleviate Problem IV
Dual-class unifications: dual-class stock is often countered by unifying the multiple classes
(declassify the share structure), which increases firm value
- However, increases the likelihood of AP I and II
Legal investor protection: family control intensifies conflicts between the family and minority
shareholders when control is high and shareholder protection is low
- Increased legal protection of minority shareholders can address agency problems
- The most effective tool to prevent expropriation is the actual enforcement of law
Family Governance Mechanisms
Family governance mechanisms serve to:
-
Clarify demands and rewards
Articulate/communicate the family’s mission, vision, values, and objectives
Manage conflict
Build trust
Facilitate effective communication
Enable coordinated decision making about the broader enterprise (including the family
office or foundation, and other assets shared by the family)
Family assembly: forum bringing together all family members over a certain age that meets
around twice a year and learns them about the family and the business
-
Promotes constructive dialogue about shared visions, values etc.
Includes social activities to strengthen identity and trust
In charge of electing and governing the family council
Family council: the representative work group organizing meetings and education, rules,
policies, and statements for the family.
-
Alleviates Problem IV but can mitigate Problem I and II.
Family constitution: a written and morally binding agreement among family members that
articulates the family’s core values, mission, and vision for the family as well as the firm, and
which defines the policies, rules, and agreements on how the family relates to the firm
5.3 Lecture Notes: Family Firms
Family Firm: firm in which family members are involved in ownership (family ownership)
- A founder-owned firm without any visible transference of shares to his/her family
members probably cannot be considered a family firm
Properties of the Family Firm
1. Family ownership: the family should have controlling interest over the firm
(necessary to have controlling interest but not required to have full ownership)
2. Family involvement in management: the family is not the owner but involved in
management (in the executive board)
a. Often, this is where the first changes appear when there are no natural
successors in the family pool that could take the firm to the next step
3. Retaining & leveraging family control: families like to control the firm even though
they might not be majority owners anymore ➔ they leverage their control rights
even above their cash flow rights
4. Dynastic intentions: families prefer to leave the firm to their own family members
rather than selling the firm to outsiders
5. Social emotional wealth maximization: families member do not only want financial
returns but they also pride themselves on being owners of the firm
a. They often hang onto ownership instead of selling or they sell too late (at a
large penalty)
b. Families benefit from the status and reputation of the firm and often have
difficulties in letting go of the legacy business
Governance
features
Strategic
motivational
differences
Family Firm Characteristics
-
Family firms are very significant and prevalent around the world and are often middlesized business (they make up 80-90% if all firms in mixed market economies)
Most family firms stop being family controlled after three generations
o They sell out (due to lack of successor), they go bankrupt or they go public (IPO)
Family firms are not very likely to survive in dynamic industries
o All the wealth is in the family firm (high risk)
Life Cycle Perspective
Challenge 1: Succession
The first succession decision is about managers:
- Nepotistic bias: family firms prefer leaders from within the family than outsiders
o However, this often leads to underperformance (family is not always best suited
to manage a firm)
- The first generation of family members (founder-owned firms) outperform whereas the
second generation destroys value
o Survivor bias: in the 1st generation you see only the successful people building
the firm but moving to the 2nd generation is the biggest challenge
- When family firms become large, the family may no longer be capable to manage the
firm → this can lead to conflict which can split up the company
Challenge 2: The Ownership Dilemma
Ownership in family firms is often done through family offices: they create a family office to
manage the ownership and being able to exercise the voting rights
- Also, to educate and socialize family members into what it means to be an owner for
the good of the firm rather than being an owner for the revenues
Benefits of Family Ownership
-
-
Family firms have a long-term investment horizon
o They are patient, especially compared to non-family firms because the cash flow
from long-term investment will benefit the family
o Having dedicated & patient capital is a competitive advantage for family firms
The family name can be a reputational asset (eponymy)
o By selling the firm, the brand value of the family name would disappear
-
Given that the manager is often also the owner there is unity of ownership and control,
hence, there are less owner-manager agency problems
Family firms were known to have better enduring stakeholder relationships
o Family firms are more likely to be socially embedded in the community and have
all kinds of personalized relationship/social capital that affects their survival
Costs of Family Ownership
Governance costs of increasing ownership:
-
-
-
Decision-making costs: shares cannot be sold without incurring major losses because
these shares are not freely transferable (cannot be sold to outsiders)
o Can create costly conflicts of interest
Monitoring costs: family firms have no separation of ownership and control
o 1st and 2nd generation family members tend to be strong monitors as owners
o However, the more generations the firm goes through, the less effective
monitors they become, usually because they are not capable
o Monitoring costs increase with the number of family members and with the
heterogeneity between family members
Risk bearing costs: Family firms are relatively risk-averse compared to non-family firms
(specifically to listed firms) due to all the family wealth being tied up in the family firm
o 1st generation founders take risks, but the 2nd generation tends to be risk averse
o The 3rd generation is more willing to take risk because they need to - they
understand that the firm must renew
A disadvantage of retaining gamily owners is that it can result in underperformance of the firm
due to lack of managerial expertise and experience
- Scale-ups that bring venture capitals on board often perform better due to the
experience of bringing a high potential firm to the next development stage
- Family firms who do not bring on strategic owners can lose out on the development of
their firm
It is difficult to value family firms since there is no listed stock
- Hence, it is difficult to evaluate whether the firm is in the hands of the best owner due
to lack of valuation
Challenge 3: Minority Shareholder Expropriation
Family firms disappear fast in industries that require a lot of financial capital due to lack of equity
financing (they only use debt financing)
- To mitigate this the family can go public while to raise capital while retaining sufficient
control by bringing on minority investors
- Minority Shareholder Expropriation: when private benefits of control are captured by
the family, while not benefitting the non-family investors
o Tunneling: there is a channel through which value leaks away from one
company to another at the expense of minority shareholders
Control Enhancing Mechanisms
1. Dual class shares: some classes of shares have more voting rights than others so that
without owning the majority you retain control
2. Stock pyramids: through different stages and layers (ownership layers) of ownership,
families can retain their influence and hold many votes in the shareholder meeting
a. Allows the family to leverage votes beyond their cash flow rights
3. Family board membership: if family members and friends are on the board, there are
not enough board members that will question the actions of the family and the
consequences on non-family shareholders – excessive control is harmful
4. Shareholder agreements: family members don’t vote individually but they vote
together, often facilitated by a family office
a. Family offices because they coordinate the voting between family members
b. Shareholder agreements between shareholders allow them to vote together
because they disclose their votes in advance, however, disclosure will not
always solve every problem
Super principal: the family may not have shares but may still suffer from the actions of the family
members who own and control the firm and do all things of bad things
Agency Problems in Family Firms
1. Owner ➔ manager: because of the separation of ownership and control between
managers and shareholders
2. Controlling owners ➔ minority owners: tunneling is a manifestation of this as
minority shareholders often don’t have the same incentives/motivations as the
controlling majority shareholders
3. Owners / managers ➔ external creditors: when owners and managers collide
together to expropriate external partners. They make very risky decisions and the
chances of success are very low but they have nothing to lose anymore because the firm
is close to bankruptcy
4. Family (super principal) ➔ family owners / managers: multi-layered agency
problems, the combination of all these 3
Alternatives to Agency Cost Theory
-
Socio-emotional wealth maximization: tendency to leave the firm to the next
generation as they value the fact that the firm stays into the family
Stewardship theory: family members are stewards rather than agents of the firm
o Families can be good or bad for the firm but it depends on the conditions
Resource-based View: families bring unique resources to the firm (social capital,
intrinsic motivations, reputation)
Reason to invest in a family firm as a minority shareholder if you know the chances you’re
screwed are substantial: these firms might do very well so you might make a good return on
investment ➔ exit before you’re screwed
6.1 Resource Dependence Theory: A Review – Hillman, Withers & Collins (2009)
Resource dependence theory (RD): characterizes the corporation as an open system,
dependent on contingencies in the external environment
- It acknowledges the influence of external factors on organizational behavior and the
influence of managers
- Power over resources is a vital concept to increase advantage over others
Basic argument of the resource dependence perspective and interorganizational relations as:
- Organizations are the units for understanding intercorporate relations and society
- These organizations are not autonomous but are constrained by a network of
interdependencies with other organizations
- Interdependence can lead to uncertainty of survival and success
- Organizations take actions to manage external interdependencies, but simultaneously
produce new patterns of (in)dependence
- These patterns of dependence produce inter- and intraorganizational power that has
some effect on organizational behavior
RDT and Mergers
Organizations engage in M&As to:
1. Reduce competition by absorbing an important competitor organization
2. Manage interdependence with either sources of input or purchasers of output
3. Diversify operations & lessen dependence on organizations with which it exchanges
o Additional reasons: historical context, environmental munificence and
dynamism, prevalent institutional norms and internal considerations
RDT is criticized for:
• A lack of discrimination between power imbalance (which curtails M&As) and mutual
dependence (which increases M&As)
o Power Imbalance: the power differential between two organizations
o Mutual Dependence: the sum of the dependencies between two organizations
• Confounding normative prescriptions and theoretical predictions
• Ambiguities around its boundary conditions
• Focus on dependence of one actor on another than on reciprocal interdependence
-
Mergers often occur as a mechanism to reduce dependence and dependency predicts
the likelihood of M&A
RDT and Joint Ventures
Joint ventures (JVs) and other interorganizational relationships (e.g. strategic alliances, R&D
agreements, etc.) are often formed to reduce environmental complexity and to gain resources
- However, unlike mergers, interorganizational relationships only provide partial
absorption of the interdependencies
- Firms gain power over resource providers by entering alliances with other agencies
- Smaller firms benefit more from cooperative relationships than their large partners
- Dependence Asymmetry: alliances occur when organizations are mutually dependent
but the partner controlling more important resources retains strategic control
o Joint Dependence: reduces uncertainty and enhances firm performance
- As with mergers, many augment RDT with other theoretical perspectives (network
theory, game theory, organizational learning, transaction cost theory etc.) ➔ RDT is
valuable but doesn’t completely explain interorganizational relationships (multiplexity)
RDT and Boards of Directors
Boards enable firms to minimize dependence or gain resources
-
Early RDT studies focused on board size and composition as indicators of the board’s
ability to provide critical resources to the firm
The resources provided by the board need to be “matched” with the needs of the firm
The board composition needs to be changed as the environment of the firm changes
Directors bring 4 benefits to organizations:
1. Information in the form of advice and counsel
2. Access to channels of info between the firm and environmental contingencies
3. Preferential access to resources
4. Legitimacy
- Directors can be classified as: business experts, support specialists and community
influentials, corresponding to the different types of resources they bring to a board
- The life cycle and type of firm determine when certain directors are most beneficial
Alternatively, RTD views the board as having 2 functions:
1. Monitoring from the agency theory perspective
2. Resource provision from RDT perspective
The level of board capital (human & social
capital) along with incentives will affect
both monitoring and resource provision
RDT and Political Action
-
Organizations prefer environments that are better for their own interest and seek to
‘create’ this by shaping government regulations
As regulatory agencies control more of a firm’s financial resources, managers are more
favorably disposed toward political activity
Firms that are more dependent on the government will engage more in political action
and co-optive linkages created to accrue financial benefits
The topic of “created environment” is overlooked but research supports that:
- Political action correlates with the degree of environmental dependency the firm faces
- Firms in the same environment likely choose the same forms of political behavior
- Performance benefits accrue to firms that create linkages with the political environment
RDT and Executive Succession
Executive succession is itself a strategic response to environmental contingencies:
- The environmental context influences the distribution of power and control within firms
- That in turn affects the tenure and selection of administrators
- Policies and structures are affected by the distribution of power and control
- Administrators again affect those activities and resultant structures
If organizational behavior is misaligned with the environment, the firm may perform poorly and
the CEO should be replaced with someone capable of coping with the critical problems
- The degree of environmental uncertainty & dependence is likely to affect the rate of
executive turnover and tenure, as well as the type of new executive selected
Outsider replacement of the CEO is unlikely when: an heir is present and committed or when
the outgoing CEO has influenced the process
Executive succession is very complex, and it is accommodated with change
- The incumbent CEO should not have the power to refuse replacement
- Distribution of ownership and the proportion of insiders mitigates this
- Resource scarcity prior to succession can clarify the impact of the successor’s actions
6.2 Team Production in Business Organizations – Blair & Stout (1999)
The principal-agent approach assumes that the corporation is the shareholders’ property,
hence it implies that managers’ primary duty is to generate wealth for shareholders
-
However, in PLCs there is separation of ownership from control, hence, shareholders
cannot directly monitor the actions of managers resulting in agency costs
Solution: strengthening shareholder control rights and ability to negotiate contractual
restraints on manager opportunism
Fallacies of Principal-Agent Theory:
Assumption 1: shareholders own the corporation
-
Untrue because the firm owns its own assets (and in cases such of intangible assets
such as human capital, there is no owner)
Assumption 2: managers should only maximize shareholder wealth
-
Untrue because managers must balance shareholder and stakeholder interests
simultaneously
Assumption 3: individuals pursue self-interested behaviour reined in by legal sanctions
-
Untrue because legal sanctions tend to be a last resort and many individuals pursue
joint objectives beyond their self-interest
o By focusing on self-interest, behaviours driven by trust, loyalty and notions of
duty are overlooked which are often critical to success
Team Production
Team production problems arise when:
1. The economic production requires a team
a. Production requires the combined input of two or more individuals
2. At least some of the resources the team members must invest are team-specific
a. Team-specific resources: resources which have a higher value when used
in a team compared to when they are not
3. The economic rents (gains) are joint (or non-separable) making it difficult to
attribute them to only one team member
The Team Dilemma:
-
Each individual has made an essential contribution of resources
None can recover the full value of that contribution outside the team
o How can profits be divided in the uncertain business context, given inputs that are
difficult to monitor?
-
-
Solution 1: drafting a sharing rule ex ante
o This can increase incentives to shirk because one can still enjoy the full
benefits, due to the sharing rule, but the costs of shirking are shared with the
whole team
Solution 2: discuss the sharing of profits ex post
o This can result in wasteful ‘rent-seeking’ and arguments over who deserves a
bigger share (if this gets out of control it can destroy economic gains)
Therefore, team members need to find extracontractual means of protecting themselves
enough to encourage the team-specific investment necessary for team production
Team Production and PLCs
A PLC is a nexus of team specific assets invested by shareholders, managers, employees, and
others who hope to profit from team production.
-
Property rights over these assets are held by a separate legal entity
Control rests with a board of directors that serves as a trustee for the firm as a whole.
Solution: by putting control over the firms' assets and outputs in the hands of the board,
corporate law prevents other team members from expropriating rents
-
-
Hence, team members must appeal to the directors to gain a larger share or they may
exit the firm
Net Result: team members who cannot contract with each other use directors as a
mediating hierarchy who can decide how to divide economic rents
o However, this can result in costs associated with placing control on the board
who does not have an economic stake in the team production process
In terms of efficiency, each team member should receive at least the minimum reward
which will allow them to remain within the team
o Beyond that minimum, the question of who gets what portion of the corporate
surplus may be determined simply by relative political power.
Formal contracts are not an effective means of encouraging investment in team-specific assets
-
The notion that a corporation is a nexus of contracts is wholly inadequate as either a
positive or normative guide to understanding corporate law
Corporations should be understood as social institutions within which people form
more or less cooperative relationships that help encourage team production
The principal-agent relationship often does not capture the complexities of business relations
-
An entrepreneur puts in time, effort and expertise and a venture capital firm
contributes financial capital, advice, and monitoring
o Hence, both sides are investing team-specific resources
o However, since these inputs are often unobservable, both sides have to worry
about "moral hazard," or opportunism
o Additionally, when the venture capital has a reputation for being fair with
entrepreneurs, it can discourage opportunistic behaviour
6.3 Lecture: Stakeholders in Corporate Governance
Stakeholders are many different parties:
- Creditors
- Natural environment
- Communities
- Customers
- Suppliers
- Employees
Beneficiaries: parties that are not
necessarily involved in the business/have no formal ties but do (not) benefit from the presence
of the company (positive/negative externalities)
- Investor benefit from auditing, while the company that is audited pays for the service
- In NPOS, donors pay for the service but do not receive a benefit from it
o There is no market mechanism and no price
Stakeholder: any group or individual who can affect the achievement of the firm’s objectives
or any group or individual who is affected by the achievement of the firm’s objectives
-
However, this definition is too broad – e.g. stakeholders with voluntary involvement
must be treated differently than stakeholders with involuntary involvement
Owners
Residual claimants (right to returns, but also
duty to incur losses)
Have a governance role due to their control
rights
Residual risk bearing
Informational insider
Voluntary involvement
e.g. partner, investor
Stakeholders
Fixed claimants (no duty to incur losses)
Have no governance role – at best they have
contractually agreed to rights
No residual risk bearing
Informational outsider
May be involuntarily involved
e.g. client, creditor, tort victim
Tort Victim: an individual with a financial claim on the firm because the firm harmed them
Types of Stakeholders
1. Primary stakeholders (related parties)
a. Parties that have a voluntary relationship with the firm, very often
economically motivated (e.g. clients, creditors, suppliers)
b. They’re strategically important to the firm’s survival and can affect the firm
c. Alternatively called patrons – primary stakeholders or parties doing business
with the firm
2. Secondary stakeholders (third parties)
a. Often involuntarily related to the firm and are often unable to affect the firm
directly in return (e.g. victims of misconduct, environment, communities)
b. Parties that are affected and not involved in a transaction
c. Alternatively called: related parties, third parties or beneficiaries
Stakeholder Challenges
1. Strategic challenge: how to keep strategically dependent primary stakeholders
involved in the firm if you cannot make them owners?
a. One solution could be to make them owners
b. If they’re so important and bring the most important, asset they might be
good owners, however, it is still important to evaluate this
2. Societal challenge: how to secure the firm’s societal license to operate?
a. How can the legitimate interest of secondary stakeholders be safeguarded?
b. To what extent do corporate governance practices developed to advance
shareholder interests also help secure stakeholder interests and the societal
license to operate specifically?
Managing Strategic Dependence
Strategic Dependence: when a resource is not easily replaced but has a high impact on value
creation
- Not all inputs are strategically relevant: they must be specific
- According to resource dependence theory, firms depend on external stakeholders
with valuable resources that contribute to the firms competitive advantage
- The easiest way to remove strategic dependence is to diversify your supply chain or to
manage your supply chain in another firm
Why has strategic dependence increased over time?
- Information asymmetry has decreased over time due to the internet
o The internet has also increased the amount of monitors of a firm
- There are more ways for stakeholders to organize and interact with the firm
o Globalization has increased this as well
o
-
-
-
Stakeholder expectations have also changed and firms are expected to have a
greater duty to society, which stakeholders uphold
Value creation is becoming increasingly dependent on intangible assets
New Business Models: many components of the firm no longer must be within firm
boundaries; allowing firms with less to potentially do well
o However, new business models can also lead to more dependencies on other
parties, hence making stakeholder management more important
Vertical Disintegration: supply chains have become increasingly more complex
o The more dependent a firm is on suppliers, the more important strategic
dependencies become
o Outsourcing is becoming more efficient, however, it tends to reduce quality
o Conglomerate Discount: firms should focus on their core activities and
purchase supporting activities in the market
▪ However, this increases strategic dependencies
Platform Economy: clients or beneficiaries of your services do not pay for the services,
instead they are subsidized by parties who use the services for advertising
o Challenge: If you put too much emphasis on the parties you make money
from, you might lose your customer base
▪ If you lose your customer base, you have no value anymore
o If you focus too much on your large, subsidized user base, there might not be a
way to make money
Managing External Stakeholder Dependence
-
-
Acquire the suppliers: the ultimate solution for strategic dependence is to acquire the
supplier
Joint ventures/Alliances: results in an ownership commitment on both sides
Board of directors: the individuals within the board influence strategic dependence
o Cooptation: including a stakeholder within the board
o Board Interlock: having board members from the firm you are dependent on
within your own board and vice versa to cement business ties
o Relational Capitalism: rather than creating dependence through the market,
the firm uses its relationships (and social capital)
Political action: lobbying, stakeholder management, non-market strategy
Executive succession: also, non-executive director appointments
Transaction cost theory: the concept of unilateral dependence: you become dependent upon
another party for an important activity or resource that you need
Resource dependence theory: unit of analysis: firms and inter-organizational relationships
- Strategic dependence on external resources in contexts of uncertainty drives firms try
to manage/govern these dependencies
Political Directors
Is appointing political directors value enhancing?
Resource Dependence Theory: yes
- Politicians, specifically in highly regulated industries, can make a difference, they can
lobby, share info, build network ties etc.
Agency theory: not at all
- Politicians will act in their own political self-interest rather than shareholder valuemaximizing goals
Corruption also plays a role:
- In highly corrupt countries, politicians have more power since they are not constrained
by institutions which can have high benefits for firms
However, in highly corrupt countries, the risk is higher and there are higher costs for
shareholders (e.g. bribes)
Thus, politician appointments to corporate boards are a double-edged sword
-
Very often, we see that politicians are appointed when there’s a legitimacy crisis
- Buffering/Bridging: Sometimes they appoint a politician to the board to appease
external stakeholders or the environment
- Symbolic Response: they appoint politicians with no intention of making changes but
just to convince stakeholders that he/she will solve all problems
7.1 Integrated Strategy: Market and Nonmarket Components – Baron (1995)
Market Environment: voluntary interactions between the firm and other parties that are
intermediated by markets or private agreements
Non-market Environment: interactions between the firm and other parties that are
intermediated by the public, stakeholders, government, the media and public institutions (that
are different from the market environment)
Market Strategy: a concerted pattern of actions taken in the market environment to create
value by improving economic performance
Non-market Strategy: a concerted pattern of actions taken in the nonmarket environment to
create value by improving its overall performance
-
Purpose: to shape the firm’s market environment by tailoring the non-market strategy
to the firm’s non-market competencies
The interrelations between the market and non-market environments require that the
managers are responsible for performance in both
Theory of modern competitive strategy: concludes that strategies must be tailored to
the structure and dynamics of the market environment and to firm competencies
The 4 Is of Non-market Environment
1.
2.
3.
4.
Issues: what non-market strategies address
Institutions: the relevant institutions related to the issue at hand
Interests: individuals and groups with preferences about, or a stake in, an issue
Information: what the interested parties know or believe about the relation between
actions and consequences and about the preferences and capabilities of the interested
parties
The Significance of Non-market Strategy
Factors affecting the importance of non-market issues for the performance of the firm
- Control: non-market strategies are more important the more opportunities are
controlled by governments and less when they are controlled by markets
- Direct challenges by interest and activist groups: also affect the importance of nonmarket strategies (e.g. activists can intervene through seeking media coverage)
Examples of Integrated Strategies
1. Calgene: brought a genetically engineered food to the market and took action to
address the issue of agricultural biotechnology regulation (lobbying, developing
relationships with the regulatory institutions, cultivating the media, etc.) ➔ some of
these actions targeted politicians for approval policies while others addressed threats
from activists/interest groups
2. Cemex: entered the US market but was imposed a 58% duty on imports because of an
antidumping petition. To address this challenge, Cemex developed an integrated
strategy to maintain US presence, reduce the duty and to overturn the decisions of the
US agencies. Market components of the strategy: reducing imports by withdrawing from
markets where cement prices are low, hence, reducing the dumping margin
3. Toys ‘R’ Us: market strategy was founded on 3 principles: price, selection, and stock. Its
market strategy was to enter countries with a large population and high income and
take advantage of market opportunities in an industry in which incumbent toy retailers
were small and hadn’t developed demand for toys on a year-round basis. In Japan, it
formed a JV with McDonald’s to provide expertise in finding store locations and in
dealing with the Japanese regulatory system
Market and Non-market Strategies
Porter’s 5 Forces: an effective competitive strategy takes offensive/defensive action to create a
defendable position against the five competitive forces
- The unit of analysis for market/competitive strategy is the firm & the focus is on its
performance in industries
- Drawback: regulatory institutions differ greatly from market institutions
Alternate approach: consider non-market factors as a 6th force to be defended against
- Assess threats from government actions, interest groups, activists, and public concern
- It is important to view non-market environment as an endogenous rather than
exogenous factors since the strategies implemented by firms can influence the market
environment
Drawbacks of treating non-market strategy as separate aspects:
- However, it should not be treated as a separate aspect but should be integrated within
market strategy
- Non-market action often is directed at creating/realizing market opportunities for firms
Non-market strategies are complements to market strategies
- They can have characteristics of a public good, where the incentive to take non-market
action is diminished
o However, the private incentive can still be sufficient, particularly when a firm
has few close rivals
- Non-market strategy can act as an isolating mechanism – it can help offset competitive
disadvantage as well as realize competitive advantage
Non-market strategy can provide a competitive advantage through:
- Provide a competitive advantage by defending against rivals
- Defending against the threat of new entry and substitutes by becoming essential
- The bargaining power of buyers can in some instances be harnessed and directed
against a firm, although seldom by a rival
Non-market issues affect the firm and the industry
- Collective action by firms in their non-market environment is allowed by the law
- Firms address many non-market issues through coalitions and industry associations
Non-market Assets and Distinctive Competencies
Firms create value by employing non-market assets:
- Expertise and competency in dealing with non-market forces, government, the media,
interest and activist groups, and the public
- Reputation for responsible behavior with consumers, government, and the public
- Access to legislators
- Personal relationships between executives and members of state legislatures
- Competencies of the firm’s allies and competitors
Non-market assets should be hard to imitate and unique to be a non-market advantage
- Over time, competencies and firm-specific non-market assets can be developed or lost
- In the market environment, firms are prohibited by antitrust laws from joining together
to implement market strategies, unless in a JV or other formal alliance
- In the nonmarket environment, the law generally allows firms to join and implement
nonmarket strategies
Strategies and Borders
International Strategy: centers on transferring the parent’s expertise to foreign markets
through specific applications of policy and expertise in other countries
Global Market Strategy: products and strategies are developed to exploit an integrated unitary
world market
- Examples:
o Supporting and working for free trade in every country
o Building working relationships with governments
o Applying universal ethics principles
o Implementing environmental policies
Multidomestic Strategy: issue-specific action plans tailored to the configuration of institutions
and interests in individual countries
- Global and international strategies must consider institutions in whose context nonmarket issues are addressed as well as other country-specific factors
o Many non-market issues have domestic orientations
- Examples: antitrust policies, liability rules, safety regulation, IP rights, and
environmental regulations
7.2 Strategic CSR: A Concept Building Meta-Analysis – Vishwanathanatan (2019)
The social benefits of corporate social responsibility (CSR) with a small positive relation with
corporate financial performance (CFP) can be strategically justified
- Over time, CSR research shifted its focus on identifying the mechanisms through which
CSR activities affect firm-level financial outcomes because:
1. A small positive relationship between CSR and CFP was identified leading to the
question of how CSR affects CFP
2. Finer-grained research was increasingly undertaken, focusing on specific types of
CSR, and combatting the previously over-inclusive approach
3. CSR research became methodologically more sophisticated as scholars started to
use more advanced research designs, better data, and more rigorous techniques
Strategic CSR: firm activities that appear to further some social good, while benefitting the firm
financially by: enhancing its reputation, increasing stakeholder reciprocation, mitigating firmspecific risk and improving innovation
Causal Approach: Strategic CSR often refers to the overlap of CSR-enhancing and CFP-enhancing
activities and should be separated from activities which do not enhance CFP
Enhanced Firm Reputation Mechanism
The CSR-CFP relationship is mediated by firm reputation → CSR increases reputation which is
positively related to CFP
Benefits:
- Stakeholders (such as employees) perceive the firms as more attractive
o Signals organizational norms and values, influencing prospective employees’
perceptions and increases their willingness to be associated with the firm
o Mechanism: the example of philanthropic donations is an activity with an
established positive reputation which evokes positive attributions by
stakeholders and attract attention
- Attract positive attribution by stakeholders
o Mechanism: Firms signal their CSR activities to existing and prospective
stakeholders through advertising or via external infomediaries
- Attracts customers and increases their willingness-to-pay
o The customers are more attracted to buying products/services and paying a
premium price due to CSR
Dangers:
- Conveying a positive image without making material changes within the firm
- Philanthropy symbolism to divert attention away from misconduct
- Buying goodwill (often after being accused of misconduct)
Stakeholder Reciprocation
CSR-CFP is mediated by stakeholder reciprocation → CSR increases stakeholder reciprocation,
which increases CFP
- Stakeholder reciprocation enhances cooperative, productive and enduring relationships
Benefits:
- Benefits employees
o Improves working conditions (e.g. fair pay, safe work environment, professional
development opportunities, etc.)
o They experience improved job satisfaction and engage in more organizational
citizenship behavior
▪ Due to increased productivity, firms can contract with employees based
on trust, substantially decreasing contracting costs
Mechanisms:
- CSR activities must benefit existing shareholders but need not be externally visible
- Firms engage in voluntary reporting resulting in more favorable debt terms
o Reduces information asymmetry and agency costs
- Higher levels of community endorsement resulting in more favorable regulatory and
enforcement conditions and license to operate
Risk Mitigation Mechanism
CSR-CFP is mediated by firm risk → CSR decreases firm risk which negatively related to CFP
Benefits:
- CSR reduces stock price risk and firm default risk
o CSR are more risk-aware, allowing them to mitigate/manage risks effectively
- Creates value because it directly generates higher CFP and helps preserve it
o Reduces the likelihood that firms incur costs that burden CFP
- Identify threats early on and correct potentially illegal acts
o This can prevent litigation costs, administrative fines, criminal sanctions, etc.
Mechanisms:
1. CSR directly mitigates risk as the activities are designed to avoid harm to stakeholders
a. Implementing these initiatives can reduce the firm’s risk exposure
2. CSR may indirectly mitigate risk as closer relationships with stakeholders making them
more willing to share information with the firm
a. Instrumental for sensing changes or threats and anticipate foreseeable risks
Improved Innovation Capacity Mechanism
CSR-CFP is mediated by innovation capacity → CSR increases innovation capacity which
increases it in CFP
Benefits:
1. CSR offers a powerful means of product differentiation
2. Radical process innovations, especially in the context of environmental
management, may reduce both waste and production costs
3. May lead to new business models and offer new sources of value creation
Mechanisms:
- CSR firms tend to develop closer relationships with external stakeholders which offer
new knowledge pools that can become an important source of innovation
- Good relationships with internal stakeholders are also important for innovation:
employees may be more willing to share info with the firm
- The adoption of CSR activities requires the development of existing innovation
capabilities or triggers the creation of new capabilities
Strategic CSR can be conceptualized on3 levels:
1. Basic Level: theoretical propositions such as causes and consequences of strategic
CSR
2. Secondary Level (Intentionally): defined in terms of its causally most relevant
properties (the four mechanisms)
3. Indicator Level (Extensionally): defined in terms of observable empirical phenomena
that operationalize the causally relevant properties by which strategic CSR is defined
8.1 Video: Identifying stakeholders
There are 3 steps in a strategy process
1. Analyze issues: you analyze the strategic
issues of your firm and use hypotheses to
understand the issues
2. Formulate strategy: you formulate your
strategy to address the issues and again work
with hypotheses
3. Implement strategy: you develop a roadmap
of implementing actions
Three ways to identify stakeholders:
1. Strategic Issues: stakeholders are positively or negatively affected by strategic
issues and opportunities
2. Strategy Process: a process is needed to execute a strategy
a. This can be broken down into individuals who negatively or positively
influence the strategy
b. The process itself can also negatively or positively influence stakeholders
3. New Strategy: identify stakeholders who are positively or negatively affected by a
new strategy introduction and implementation
8.2 Video: Mapping stakeholders
Stakeholders may be affected by a strategy, but they may also influence the strategy, hence, it
is important to differentiate between these groups
Mapping the differences between stakeholders:
1. Assess stakeholder power
a. Strong: stakeholders hold power to support or sabotage the strategy process by
having important resources like insights or decision-making rights
b. Weak: stakeholders lack power to support or sabotage the strategy process
2. Assess stakeholder interests/values
a. Aligned: same or similar interests or values as the firm
b. Conflicting: different interests or values as the firm
Strong
Strong Opposing Strong Allies
Stakeholders
(e.g. happy clients
(e.g.
unhappy & partners)
clients & partners,
Conflicting competitors)
Weak
Opposing Weak Allies
Stakeholders
(e.g. consultants,
(e.g. critical media) support
staff,
alumni)
Weak
Aligned
8.3 Video: Managing stakeholders
-
Opposing stakeholders: you prefer that your stakeholders’ interests & values are
aligned with your firm
o Solution: Align the opposing stakeholders by moving them to the right side of
the map (e.g. you may align an unhappy partner by improving their incentives)
o Aligning opposing stakeholders may not always be feasible especially when
conflicts of interest are high, in this case it is best to see if you can weaken them
-
Weak allies: these allies are not particularly useful since they are weak
o Solution: Strengthen the weak allies to turn them into strong ones
Strong allies: are the ideal candidates for your strategy process but don’t take their
support for granted as your opposing stakeholders may try to get them into their camp
o Solution: Engage them in your strategy process by informing & involving them
o Strong allies may help with issue analysis and they also affect strategy
formulation
Given that stakeholder support
is necessary for strategy
implementation, it is important
to continuously monitor the
stakeholder map and make
changes when needed
4.1 Chapter 1: Corporate advantage
Corporate strategy = the strategy that multi-business corporations use to compete as a
collection of multiple businesses. The goal is the pursuit of corporate advantage.
1. Single vs.
multibusinesses
2.
Competitive
advantage
vs. corporate
advantage
Business strategy
-Involves a single business
Corporate strategy
- Involves multiple businesses
- Each business has its own business strategy
- Goal: to maximize the NPV of a business ➔
achieved by ensuring that your buyers WTP is higher
for the outputs of a business than what your
suppliers are willing to sell the inputs to you for
- Goal: not to individually maximize the NPV of each
of the businesses in the corporation but to
maximize corporate advantage by outdoing rivals in
creating a wedge between customers’ WTP and
suppliers’ WTS
- You have a competitive advantage over a
competitor when your difference between buyers’
WTP and suppliers’ WTS is greater than your
competitor’s difference
- You can increase your competitive advantage by
raising customers’ WTP and/or by lowering
suppliers’ WTS
3. Who is the
competition?
- Anyone who can influence a business’ cost or
revenues adversely: direct rivals but also buyers,
suppliers, potential entrants, and substitute firms
- Corporate advantage exists if the collection of
businesses owned together is somehow more
valuable than the sum of values of individual
businesses owned in isolation from each other
- The goal of maximizing corporate advantage may
or may not be consistent with maximizing the
competitive advantage of each business
- The competition is anyone who can assemble a
similar portfolio of businesses: investors and other
corporate strategists
Business Model = the set of choices about customers, products, and value chain activities that
every business must make ➔ the who/what/how choices (who are the customers, what are we
selling them, and how do we produce what we are selling?)
-
Businesses are different if their business models differ from each other on at least 1 of
these dimensions
Industries are usually distinguished from each other in terms of low cross-price elasticity
of demand: a price change within one industry has negligible effects on the demand for
goods in the other industry
Corporate advantage from portfolio assembly: the “selection” approach
Because investors have cash flow but no decision rights, their main strategy is portfolio
assembly
-
NPV of a portfolio of a business: value can be created by
• Influencing cash flows: investors cannot influence the cash flows of the
businesses but can capture value by “buying low and selling high”
• Decreasing the discount rate: a discount rate depends on 3 factors:
1. The timing of the cash flows: cash flows in the near future are worth more
than those in the far future
2. The riskiness of the cash flows: secure cash flows are worth more than risky
ones
3. Who is the beneficiary of the cash flows: a diversified beneficiary might be
willing to take on more risk (lower discount rate) than an undiversified
beneficiary
➔ an investor can lower a discount rate through diversification
Corporate advantage from business modification: the “synergy” approach
Synergy - describes the various ways in which the cash flows and discount rates of businesses in
a portfolio can be modified through joint operation (i.e. collaboration and joint decision-making)
across them
-
Corporate advantage is difficult to measure as it requires a comparison between
something observable (the performance of a multi-business corporation) and something
unobservable (the aggregate performance of the individual businesses if they had been
operating in isolation from each other)
4.2 Chapter 2: Synergies: benefits to collaboration
Operational Synergy - exists if 2 businesses operated jointly (decisions across the 2 businesses
are coordinated to enhance joint value) are more valuable than the 2 businesses operated
independently
Checklist of Synergy Benefits:
1. Shared know-how: covers the benefits associated with the sharing of knowledge and
competencies across the portfolio.
2. Shared tangible resources: benefits from economies of scale and elimination of
duplicated resources
3. Pooled negotiation power: compromises the cost/quality benefits that can be gained
from purchasing scale
4. Co-ordinated strategies: cover benefits that arise from aligning the strategies of 2 or
more businesses
5. Vertical integration: benefits from managing trading relationships to improve capacity
utilization, price realization and market access.
6. Combined new business creation: the creation of new businesses by combining knowhow from different units, by extracting activities from different units to put into a new
unit, and by internal joint ventures or alliances between units.
Synergy Test: V(AB) > V(A) + V(B)
-
V(A)/V(B) – NPV of business A/B when operated independently
V(AB) – NPV of businesses A and B when they operate jointly
The synergy test differs from the corporate advantage test in 2 ways:
1. Corporate advantage is defined in terms of jointly owning businesses and synergies
in terms of jointly operating them
2. The corporate advantage test is about the portfolio of businesses and the synergy
test is about any 2 businesses
-
Why is synergy is the basis for meeting the corporate advantage test when:
• Investors can diversify unsystematic risks
• Potential value capture from synergies brings partners to the table to negotiate
strategic alliances or acquisitions
• It enables acquirers to pay a premium and still make money
• It allows CEOs to justify their acquisitions and alliances to their shareholders
Where do synergies come from?
Value Chain = the set of activities that must be performed to produce a product/service and
bring it to a customer. Porter distinguishes between 2 types of activities:
•
•
Primary activities: scale of activity varies directly with the level of production
(logistics, production, marketing and sales, service)
Secondary activities: scale doesn’t depend directly on the level of production
(firm infrastructure, HR management, technology development, procurement)
What types of synergies are there?
Synergies are evaluated based on
-
Resource Similarity: similar resources produce qualitatively different effects
(advantages of scale) than linking dissimilar resources (advantages of scope)
Modification of Resources Required: the extent of modification of the resources
underlying value chain activities that are necessary for value creation
4 C’s framework:
High Modification Required
High Similarity Consolidation - involves creating
value by rationalization across
similar resources (from similar
value chain activities) by
eliminating redundancies.
Affects mostly costs and invested
capital. Examples: reduction in
headcount by merging
departments.
Low Modification Required
Combination - Entails creating value
by pooling similar resources (from
similar value chain activities).
Example: volume discounts from
increased procurement volume and
the resulting increase in bargaining
power with suppliers
Low Similarity
Customization - Involves creating Connection - Generate value by simply
value by co-specializing dissimilar pooling the outputs of dissimilar value
resources (from similar or chain activities with little modification.
dissimilar value chain activities) to In effect, the product development of
create greater joint value.
1 business is being connected to the
Results in improved value in distribution channel of another.
production or consumption (either Example: banks cross-selling insurance
the final product works better or products to their customers
costs less – producing either
revenue or cost synergies).
Example: creating a customized
bundle of products/services
Two-sided Synergy: when both businesses benefit from the synergy
One-sided Synergy when 1 business gains more than the other business loses
-
To make the pursuit of synergies worthwhile for both businesses, they must reach an
agreement on some form of side payment from one business to the other
Negative Synergies
There are situations in which the value of 2 businesses under coordinated decision-making may
be lower than the sum of their values when they operate independently. Situations of negative
synergies arise from:
•
•
•
Common instance: brand dilution (e.g. Rolex selling budget watches)
Organizational complexity: actions must be coordinated across businesses
which implies some loss of initiative, independence, and decision-making speed
Concerns about the independence of action of 2 businesses under the same
corporate umbrella: e.g. if business A is an internal supplier to business B, it may
be difficult for A to find clients outside the corporation
4.3 Chapter 3: Governance costs: impediments to collaboration
•
•
Governance Costs: are frictions between two businesses which prevent them from
operating smoothly to realize synergies
Synergies and governance costs make up the governance structures: the choice about
joint or separate ownership of businesses between which there are synergies
Where do governance costs come from?
Governance Costs: the costs of achieving effective collaboration, above the direct cost of what’s
being exchanged ➔ magnitude typically differs per type of synergy
• Ownership Costs: The governance costs that arise under common ownership
• Transaction Costs: The governance costs that arise in interactions between
independent firms
Sources of Governance Costs:
1. Cooperation: the alignment of incentives to ensure that people are motivated to work
together. Failures of cooperation are more likely if:
• There’s no shared future: e.g. 2 alliance partners know the current project is the last
• Incentives are narrow: e.g. employees are rewarded by division’s performance
rather than the performance of the firm as a whole
• There’s asymmetrical dependencies: when one party depends significantly on
another (e.g. relying on a single supplier)
• Synergies are one-sided: benefits to collaboration accrue to 1 party only
o Or the synergies need modification (Consolidation & Customization)
Solution: creating contractual agreements but there are governance costs of enforcing this
2. Coordination: the alignment of actions so that people know how best to work together.
Failures of coordination are more likely if working:
• Across different geographical locations or time zones
• With different professions (e.g. alliance between IT firm and advertising firm)
• Without a shared past (unfamiliarity of the other party’s standard procedures)
• When there is high interdependence in which the parties involved need to
interact and communicate to align with each other
The 2 Governance Structures:
•
•
Common Ownership: ultimately, each business is administratively controlled by the group
CEO and the assets are owned by the shareholders
o Under common authority, the scope for non-cooperative actions is reduced because
the CEO can hire, fire, reward, punish, monitor, and manage
o Allows for the avoidance of coordination problems through centralized decisionmaking, information channels, common language, etc.
Arm’s-length trade: trade between separately owned businesses
o Synergies that are likely to generate significant transaction costs are less likely to be
successfully realized in arm’s-length relationships
4.4 Lecture: Sum-of-the-parts (SOTP) Valuation
How much is an asset worth?
1. Book value = historical purchase price – all accumulated depreciation, amortization, and
impairments (used in balance sheet)
• Depreciation: you write-off a tangible, long-lived (non-current) asset (PPE)
• Amortization: you write-off an intangible asset (brands, patents, human capital)
• Impairments: a single shot write-off so that the book values are not out of reality
2. Market value = would you sell off an asset today, this is what the market is expected to
pay for it. Market value typically depends upon market conditions as supply and
demand, cost, and availability of capital etc.
3. Fair value / intrinsic value = the present value of the expected cash flows the assets will
yield (used for some items in the balance sheet)
Book vs Market Values
When valuing (part of) a firm, its book value need not be informative ➔ it would be way more
interesting to see the market value of the assets
• Major problem: you only observe a market value if supply and demand meet: you need
a transaction (sell assets) but you wish to know the value prior to selling/buying
• Multiples can be used to approximate
Defining Enterprise Value
Enterprise Value: the fair value of the operations of the firm attributed to all providers of capital
➔ It approximates the market value of a firm’s assets
• Problem: the assets of the firm aren’t liquidly traded as opposed to the debt and equity
titles of a listed company
• If you own stocks, what matters for you most is that you adjust to the forecast/outlook
➔ stocks are typically valued in a future way (PV of expected cash flow divided by
discount rate)
Method to find the market value of a corporation (how much are the assets worth):
1. Isolate all financial titles on the credit side of the
balance sheet to find market value of financing
side
Assets are rarely traded, but the stocks and bonds are traded
-
Given that the balance sheet should be balanced ➔
market value of the financing must equal the market
value of the assets
Thus, to find EV we need:
- Find financial liabilities: loans, accrued interests,
corporate bonds, pension fund liabilities, lease
obligations ➔ subtract the cash and cash equivalents
• Owners’ equity
Market capitalization = # outstanding shares * closing stock price
Non-controlling interest = minority investments in other firms (less than <50% ownership)
EBITDA
EBITDA can be used to analyze and compare profitability across firms and industries as it
eliminates the effects of financing and accounting decisions
• It often used in valuation ratios and compared to EV and revenue
• However, it is not defined by the IFRS or GAAP, hence there are different definitions:
o EBITDA: net income + interest + taxes + (depreciation & amortization &
impairments)
o EBITDA: EBIT + (depreciation & amortization & impairments)
o EBITDA: EBITDA + net(acq./div.) + restructuring costs + other incidental costs
•
EBITDA is not a good metric for cash flow as it ignores working capital requirements
(which requires cash, or debt or equity)
•
EBITDA makes heavy-asset companies look healthier than they truly might be as it does
not include replacement cost of old equipment
Business Diversification
Benefits:
-
Potential synergies
Less volatile income which increases debt capacity and lowers debt cots
Costs:
-
-
Decreased transparency leads to a diversification discount in stock valuation:
diversified corporations are less transparent, and consequently, investors tend to
solely pay a slightly lower price for their stocks than what they would pay for a more
transparent company
Diversified firms often have a complex governance structure
Poorly performing elements may get cross-subsidized by the outperforming ones
Managerial incentives to improve performance may get blurred