CHAPTER 2

Overview of Family Business Theories

Before the reader delves into the nuts and bolts of governance, there are some theories regarding family business that need to be discussed and understood. The theories used in family business are practical and applicable. They are not what many students or business owners think of as being purely academic, not relevant, or what some feel are a waste of time. The reader needs to have a grasp of these theories because many of the governance structures work hand in hand with them. One must understand the basic theories to understand when a governance structure or mechanism does not work in a certain situation, because it is often the specific theory being used that explains its lack of effectiveness.

Agency Theory

By far one of the biggest theories when discussing governance in family business is agency (Jensen and Meckling 1976). This can be quickly explained by using the example of a real estate agent representing the sellers of a home. The real estate agent signs a contract with the sellers to represent them as their agent in the sale of their home. The agent compares the home with other similar homes and in consultation with the owners (who state they do not want to take less than $450,000) prices their home at $480,000 and puts it on the multiple listing service for all other real estate agents to see and advertises the home for sale. The agent is not an owner of the home, but represents the homeowners. The agent is not an employee. Suppose another couple wants to put in an offer on the home during one of the open houses held by the same agent who listed the house for sale. The couple asks the agent for the lowest price the sellers will take for the house. Instead of the usual splitting of the commission with another agent representing the buyers, this agent can “double-end it” or have what is called dual agency. The agent has a contract with the owners of the home, but now has an opportunity of gaining an offer from the potential buyers and will also be representing them in their purchase. In other words, the agent will earn twice as much commission! The agent is now working for both seller and buyer. What would most people do in this situation? Remember, the agent is paid on commission; he or she is not an employee and makes nothing if the house does not sell. Many people when faced with this situation and understanding they will make no money without a sale, would tell the prospective buyers, “I think they might take $450,000.”

This represents what is called the principal-agent problem. This occurs in many human transactions, and involves what is known as self-dealing, or doing what is best for oneself. People are fallible; they are only human.

Another less harmful but nonetheless negative example suggests that an employee manager would have a reduced risk tolerance than a family owner. The manager may pass on opportunities that could benefit the business if there was risk associated with them. The manager would rather keep the status quo and have continued employment than undertake a risk that could harm their employment. Obviously, risk should be minimized, but there can be no success or growth without some risk. In family firms, each generation needs to reinvent themselves to stay current and viable in the marketplace (PWC 2016), otherwise they will lose market share to competitors or fail to respond to opportunities.

Agency theory suggests that employees may engage in self-dealing behavior if not properly supervised. The reason companies have layers of management personnel can be explained by the agency problem (type I). If employers could trust with absolute certainty that their employees would always do what is best for the business and act ethically and responsibly, the company could do with less supervisory positions and save significant labor resources.

Agency theory helps to explain one of the biggest competitive advantages a family business has over its nonfamily competitors. The company has the family unit, a loving, trusting group of people who have each other’s best interest at heart. A family business can succeed with less layers of management because in the early stages of the firm the owner is the manager. In the next generation, the sons and daughters of the founder are in leadership, and they have become the owners. They have the same goals in mind. Family business researchers and scholars have recognized that because of this owner/manager situation, many family firms have eliminated much of the agency problem. Imagine the labor savings of not having to employ layers of supervisors and managers just to make sure the employees were acting in a responsible manner toward their employer. This can be an incredible competitive advantage for family businesses.

When family firms age and grow and advance through several generations of leadership, the family becomes more dispersed, there are fewer social ties with family members, they may have less commitment to the family business, less entrepreneurial orientation, and the agency problems once avoided with the founder/owner are now present (Eisenhardt 1989; Gomez-Mejia, Nunez-Nickel, and Guttierez 2001; Schulze et al. 2001).

Conversely, there are other sides to agency theory that are not positive, and some family business researchers use agency theory to explain a lack of competitive advantage. They have suggested ownership concentration has negative agency effects on strategy and performance as majority owners use their power to exploit the business, especially minority shareholders. This is defined as agency problem type II (Morck and Yeung 2003; Morck, Wolfenzon, and Yeung 2005).

As an example, a founder who started the firm and ran it successfully for multiple decades may decide not to retire. This is entrenched leadership, and the results can be a decline in sales and competitiveness due to the founder’s unwillingness to change or adapt to new situations as they arise. This puts the organization at a competitive disadvantage and takes advantage of minority shareholders. The next generation of leaders can be frustrated with their lack of advancement and responsibility. This is one of the biggest reasons the next generation leaves the family business (Lee 2006).

Compensation can also be used as a governance tool. If the company compensates their employees and managers extremely well and provides incentive compensation opportunities, it may enable the employees to feel more like owners. They are invested in the firm’s success. Now, the goals and objectives of the family and the business are aligned with those of the employees and have theoretically reduced the impact of the agency problem.

The Resource-Based View

The resource-based view (RBV; Barney 1991) of the firm states that a family firm has a set of unique capabilities, resources, and relationships that nonfamily firms do not have, and cannot develop. This may explain the competitive advantage that many family firms have over nonfamily firms (Habbershon, Williams, and MacMillan 2003). Imagine the deep relationships built by three or more generations of family members over numerous decades!

Five sources of family firm capital may help to explain the positive effects from the RBV: human capital, social capital, patient capital, survivability, and governance structures. Family business governance may be a reason why some family firms have increased performance over nonfamily firms (Habbershon and Williams 1999; Carney 2005). The advantage for a family firm comes from the interaction of the family and the business in the unique way that they manage, evaluate, acquire, discard, bundle, and leverage their resources (Chrisman, Chua, and Sharma 2003, p. 21).

The term familiness has been used to describe the unique and differing facets of a family business when compared with nonfamily businesses. The term is used to describe the interplay between the family and the business, including a social aspect that affects the strategic decisions of the business (Chrisman, Chua, and Steier 2005; Habbershon et al. 2003; Zellweger, Eddleston, and Kellermanns 2010).

Stewardship Theory

This approach believes the family should be caretakers of the family business. Members of families following this approach believe it is not merely theirs alone. Instead, the company is seen as an asset intended to be protected and nourished, so it can continue to provide wealth for the family and to pass down to future generations. Families utilizing this concept often hire professional outside management to run the business (Davis, Schoorman, and Donaldson 1997). These companies most commonly will have a BOD with specialized outside directors to aid in decision making and strategic planning. This approach is often seen with many of the well-known and larger publicly owned family-controlled firms seen on the Fortune 500 or the S&P 500. An example of this type of approach is the Walton family and Walmart, which uses a professional BOD and a strong management team to run their business.

Stakeholder Theory

Stakeholder theory (Freeman 1984) has recently come back into favor among the more modern progressive corporations who believe corporate social responsibility (CSR) is important and the right thing to do rather than the older and more common stockholder theory that states the sole purpose of corporations is to build wealth for stockholders (Friedman 1970). Companies utilizing the stakeholder approach believe there is more to consider than focusing all efforts on simply one stakeholder (that being the shareholder or stockholder of the firm). Instead, they believe in addition to the shareholders they also have a responsibility to employees, suppliers, customers, and the community. Stakeholder theory proposes that the needs and wants of all people and organizations that have a stake in the failure or success of the company should be considered. There has been an increased importance in businesses being good corporate citizens the last few decades. The general public is demanding it. The millennial generation is requiring it to be a customer of the business or an employee. This is a great competitive advantage for family-owned firms. Family business owners take pride in being respected and responsible members of the community with a reputation for fair prices and fair dealing.

As an example, a company following the stakeholder approach in a small town where they are the largest employer would consider the effect of layoffs on the economy of the town. They may still decide layoffs are needed, but at least the community, the employees, and the neighbors of the firm would be considered. It would not be purely an economic decision alone. They realize others should be considered because they would be affected by the company’s decision.

Starbucks is another example of a corporation being socially responsible. The company buys its coffee beans in ways that are sustainable and promote fair trade. This means they buy only from growers who they have inspected and approved, who are growing the beans according to their specifications. Starbucks has agreed to pay a very fair price (higher than usual).

Another responsible firm, Whole Foods, promotes sustainable fisheries. These efforts cost more and make prices higher. The companies are observing the stakeholder approach and trying to be fair, or at least recognize the needs of important stakeholders. It may seem altruistic, but it is thought of as just good business. Starbucks, through their purchasing programs with small farmers, has a guaranteed supply of high-quality coffee beans. Whole Foods was reacting to its customers’ concerns of overfishing and wasting nontargeted species that were caught in nets, thus protecting the fisheries for future generations. Both companies have developed a loyal base of customers who appreciate their responsible behavior.

Social Capital Theory

Effectively functioning social groups include factors such as positive interpersonal relationships, a shared sense of identity, norms, values, understanding, high trust, and cooperation. A family business with a high amount of social capital would have a tremendous competitive advantage over a nonfamily business. Social capital is one aspect of the RBV.

The Systems Approach

The systems approach is also called the three-circle model (see Figure 2.1). This is the preeminent approach to understanding family business and is now over 40 years old since its inception (Tagiuri and Davis 1996). The power of the model is its simplicity. By placing people within each circle of the model, it enables understanding of the various interrelationships and often overlapping roles of family members, owners, and employees. In an interview with John Davis, one of the creators of the approach, he admitted the model does not cover everything (such as wealth), but as a theory, it helps explain the majority of family business relationships and roles. Thus, it increases understanding of the vast complexity of the problems associated with the different constituencies, agendas, and the various people involved (FFI Practitioner 2018). It helps explain other theories such as agency, which fits into the model well. It consists of three overlapping circles. Each circle represents one of the three main subsystems of family business:

Figure 2.1 The systems approach (the three-circle model)

Source: Adapted from Tagiuri and Davis. 1996.

Understanding each subsystem in the model is critical for understanding family-owned business and their associated issues and opportunities. For example, some family members may also be employees and therefore would inhabit both the family and the business subsystems. However, if they were family members and employees, but not an owner, they would not inhabit the ownership subsystem. Sounds easy? Here is a scenario to show how helpful this model can be.

Imagine Bob, a member of a business-owning family. Bob is an employee of the company, as well as an owner. He resides in all three subsystems of the model. Because Bob works at the company, he understands the challenges and opportunities of the business at a deeper level than those who do not work there. Bob realizes the company needs to invest significant resources into new equipment to become more efficient and productive and to respond to competitive opportunities and threats. Bob’s cousin Michelle is a family member and an owner, but is not an employee. Michelle is only in two circles of the model. She does not earn income from the company as Bob does. Michelle relies on dividends due to her ownership share. During a meeting, a proposal is brought up discussing the need for the equipment and requesting the large capital expenditure. Bob is surprised when his cousin votes against the proposal! Because of Michelle and other like-minded shareholders, the equipment purchase is denied. Bob is very concerned the company may now be in jeopardy, and it will not be able to compete, thus making everyone’s job harder. The cousin was concerned with her dividends that could be put into jeopardy by the large financial expenditure. Bob and his cousin have two very different priorities even though both have the same main goal of seeing the company succeed and prosper.

This example shows the usefulness of the three-circle model. Another scenario could be if one person was an owner (shareholder), but not a family member or an employee. Might they have different thoughts regarding another family member being considered for a leadership position? Might they want to accept a buyout offer rather than save the firm for future generations of family leadership? The model can explain numerous similar issues and opportunities.

Social Identity Theory

This theory looks at personal behavior as well as behavior as part of a group. It has been linked to family business studies and is the foundation for the systems approach (above) as well as the socioemotional approach (following). We all have an identity or belief of who we are, and we exhibit this as individuals and as part of a group. In the context of family business, the family has a collective identity that influences the business (Waldkirch 2015).

The Socioemotional Wealth Approach

This approach is relatively recent yet has had widespread acceptance by scholars and practitioners as a way of explaining some contrary, and some would say illogical, behavior on the part of family business owners. The socioemotional wealth (SEW) approach discusses the belief that the business means more than just profits and dollars to the owners. The owning family receives a significant amount of noneconomic benefits by owning the business (Gomez-Mejia, Cruz, Berrone, and De Castro 2007, 2011). For example, a business-owning family from a small town may have a significant amount of social status among their neighbors and community members due to their large economic contribution to the community. The family may take great pride in the fact their grandfather started the company and the business has employed and helped hundreds, if not thousands, of people in its lifetime. The owners may gain a level of power and respect due to their ownership of the business. This SEW theory can be used to explain why a family business would decide to purchase from a supplier whose prices are higher than others, or why they would decline a buyout offer from another firm that valued the company at a very attractive price. Many families want to protect the founder’s legacy. Family-owned firms have been shown to avoid making layoffs during a recession (compared with nonfamily firms) out of concern for their employees and for the family to keep its social reputation (Block 2010).

It is not all about the money! To the business-owning family, some things are more important than money. This concept is very important for suppliers, employees, customers, and the BOD to understand. It explains much of what looks to outsiders as irrational behavior on the part of the family business owners. This theory explains why some family firms are called unprofessional or poorly managed. Until one understands the real underlying goals of the family and what is important to them, they will constantly be confounded by some of the family’s decisions regarding the business.

To illustrate the concept, two consultants to a large family-owned firm were shocked and surprised when they were summarily fired after recommending what they believed was a logical and rational recommendation for a layoff of employees, including family employees, who they considered too numerous and were not effectively contributing to the company. The consultants did not understand the real purpose of the company (to provide employment for family members) and the amount of pride and satisfaction the family felt in prospering and employing numerous people in their community.