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Principal-agent problem in family-owned businesses

Principal-agent problem in family-owned businesses

Sam Choon Yin (2003)

Understanding individuals’ behaviour is not easy. Some economists make it the easy way out by making assumptions about human behaviour that are difficult to apply in reality. Some have gone beyond the orthodox way and attempt to predict human behaviour through making more realistic assumptions. Jack Knetsch, Bruno Frey, Ng Yew Kwang, Robert Frank, Tibor Scitovsky, Richard A. Easterlin, Vernon Smith, Gary Becker, William Vickery, James Mirrless, Herbert Simon, George Akerlof, Michael Spencer and Joseph Stiglitz are some of the better-known economists who have gone beyond orthodox economics.

Vernon Smith, Gary Becker, Herbert Simon, William Vickery, James Mirrless, George Akerlof, Michael Spencer and Joseph Stiglitz have won the prestigious Nobel Prize thus giving a welcome recognition to ‘provide some support those who are willing to extend orthodox economics and to explore areas beyond or even consistent with existing orthodox economics’ (Ng, 2003, p. 81)[i]. Professor Ng Yew Kwang defines orthodox economics as ‘the rigorous  (often mathematical) analysis focusing on resource allocation by analysing rational maximization (under constraints) of consumers and producers and the equilibrium of their interaction’ (ibid, p. 82).

One of the more recognized issues in relation to studying human behaviour is the principal-agent problem. The problem is usually applied to the labour market.

Before looking at the principal-agent problem itself, it may be useful to describe the labour market. The labour market concerns the interaction between demanders of labour and suppliers of labour. The endogenous variable affecting the demand and supply of labour is the price of labour, which is represented by the wage rate. The labour market is linked to product market in two ways. First, the main players involved in both markets are essentially the same albeit in a ‘different form’. The households are the suppliers of labour in the labour market. In the product market, the households are demanders of goods and services. How about the firms? In the labour market, they represent the demanders for labour while they supply goods and services in the product market. Households and firms are thus involved in both the labour and product markets.

Second, the equilibrium (and disequilibria) situations in the product market affect the demand for labour. Since labour is used as a form of input in production, how many labour is required depends to some extent on market forces in the product market. Other things remaining unchanged, an increase in the demand for goods and services is likely to stimulate more demand for labour. The converse is true. This essentially makes labour a derived demand. This also explains why unemployment rate is often touted as a lagging macroeconomic factor.

The labour market encompasses both the firms and households. They are perhaps more commonly labelled as employers and employees respectively. However, in the latter description, it is more appropriate to state clearly what we mean by the term employees. I would include managers and directors as employees as long as they are not owners of the firms. The firm owners in other words do not constitute as employees. What about those individuals who are owners cum workers of the firms? Such a scenario is common among family-owned enterprises where the firm owners usually have a strong controlling interests and power over the firm’s resources. They can take up the positions of Chief Executive Officers (CEOs) or executive directors in their companies. This is a tricky issue. For the purpose of this study, I will not consider them as employees of the firm. The purpose is to make a clear distinction between an employee and owner. The former owns no shares in the affiliated organization. As long as a person owns the firm, he/she is not considered an employee even though he/she draws salaries from the organization.

The interests of firm’s owners with employees can be different. While the owners are generally interested in maximizing the firm’s profits, the employees may not possess the same drive. This problem is known as the principal-agent problem, an issues which I will discuss next.

The principals are the owners of the firm. In non-listed firms, the founders, their respective family members and co-owners represent the principals. In listed companies, the shareholders (including the founders and their respective family members) constitute the principals. Clearly, the principals are interested in making sure that their firms maximize profits. Sales must come in abundant while the excessive costs of production must be contained. The agents on the other hand represent the employees who have some control over the use of firms’ resources. They are in-charged of the day-to day operations of the firms. The principal-agent problem exists when the principals and agents have conflicting interests. The agents may not share the same interest with the principals in maximizing the firm’s profits. Let me give several examples.

Consider a listed company like the Development Bank of Singapore and Singapore Technologies. These are large listed company owned by many people through share ownership. Many people on the street buy the companies’ shares. However, they usually do not have the control over the use of the companies’ resources. They are not involved in their day-to-day operations. The companies’ CEOs and their staff have the control of the resources. The problem arises when the CEOs and the staff are not doing their jobs properly. They may not introduce cost-savings devices. They may shirk in their jobs. The CEOs may use the excess cash to furnish their rooms and go on expensive business travels unnecessarily rather than distributing the excess cash back to the rightful owners in the form of dividends.

The agents may deliberately pay themselves excessively in remunerations and fringe benefits. Some of these expenses may be passed on to the consumers in the form of higher prices leading to losses in consumer surpluses and long-term decline in producer surplus. The agents may adopt practices that discriminate certain groups of people therefore creating negative impressions in the general public. This leads to lower companies’ reputation and loss of business opportunities. The agents may employ more workers than necessary therefore jacking up the operating expenses. Again, some of the costs may be passed on consumers in the form of higher prices.

If the agents are poorly monitored, the above-mentioned problems can be resulted. The result? Lower shareholders value.

What are the reasons for the principal-agent problem to exist? Why are the agents non-profit maximizers? Let me address the second question first.  What the question points out is that agents do behave in a manner that is in conflict with the principals. Why is this so? The rationality concept provides an answer. In may view, a person is said to be rationale if he/she, after accounting for all alternatives that he/she has in making a decision, chooses the option that yields the highest net benefit. In theory, a rational person must have all the relevant information therefore allowing him/her to make the rational choice. In practice, it is not realistic to assume that all information is available to a person. Some information may simply be non-available (for instance, information that is confidential) or that the information is too costly to obtain. Does this mean that the rational behaviour cannot be attained? Absolutely not. A person can still be considered rational if, in his mind, he/she has done all that he/she can to obtain the information, and has considered the cost implications of acquiring the information. Upon doing so, he/she then assess all the options and chooses the one that gives him/her the highest net benefit. Rationality, to me, is a concept that explains the thinking process of individuals, rather than a tool to predict the eventual choice or option undertaken. It is not possible in reality to predict choices made by individuals simply because their actions are hidden and personal. A person may choose differently even if everything else is controlled. The actual decision made depends on the person’s personality. He/she can be utilitarian, egoistic or altruistic.

Given that individuals are rational, the agents would choose to shirk in their jobs (instead of the option ‘not shirking’) if the choice provides higher net benefits to them. Generally, the agents would not attempt to maximize the firm’s net worth if the alternative(s) provide higher yields to them. There is an implication to this. To align the interests of agents with those of the principals, the principals need to raise the benefits of non-shirking and the costs of shirking. Being rational, the agents will factor in these benefits and costs into their decisions, thus leading to more desirable choices made at least from the principals’ point of view.

Let us go back to the question of why the principal-agent problem exits. It is common that contracts are signed between the principals and agents when the firm engages the latter. The agents are responsible in managing the firm. They have direct access to the firm’s resources. In an extreme case where there is a complete separation of ownership and control, the principals rely almost exclusively on the contracts (and possible more on the agents’ personality) to protect their capital and interests by making sure that agents are doing their best to maximize the companies’ profits. The extreme case is more common among listed companies. In the contracts, the duty and responsibility of the agents are listed down together with the remunerations and other benefits. Conditions of employment are noted down and signed. The contracts are usually law-abiding.

What is the problem then? The problem arises when the contracts signed are incomplete. They are often incomplete. It is technically infeasible for example for the principals to state exactly in the contract how their agents are to allocate their time during office-hours. It is not possible to state explicitly how the agents are to distribute the company’s profits and in what proportion of the after-tax profits are to be retained. The costs associated in doing so are simply too huge. Because of the incompleteness in the contracts, agents can take advantage of the loopholes to maximize their personal benefits at the expense of the shareholders or principals. Agents possess knowledge that is hidden from the principals. They can also hide their actions, making them unknown to the principals. These two activities of hidden knowledge and action are known in the literature as adverse selection and moral hazard problems. They are both attributed to asymmetric information.

Because of imperfect information, it is said that individuals are bounded rational. It is not possible for individuals to decipher all information that is available to him/her due to limited cognitive ability a person possesses. In this case, individuals are contented with non-optimal choices. The person is said to be satisficing, a term coined by the late Herbert Simon.

In some firms, the notion of ‘separation of ownership and control’ is blur. As was mentioned before, the shareholders may work in the company as employees in addition to being the firms’ owners. This makes them both having direct access to the use of company’s resources and having a say in terms of how the company is to be managed. The magnitude of influence however differs. The founders and their respective families who own the shares and work in the company have perhaps more power in influencing than employees who obtain shares through share options plan.

The problem arises in this situation when there is a concentration of power. The problem is common among family-owned businesses. Incompetent owners may hold senior positions in the company not based on their abilities but because of their connections with other members of the family. They make poor decisions leading to worsening of the company’s value. The minority shareholders suffer. No one in the company dares to voice out their concerns over the poor decisions. They fear of losing their jobs. It may be surprising to some as to why the managers would want to make the wrong decisions when they know that doing so would result in lowering shareholders’ value. Being a shareholder himself/herself, wouldn’t it be in his/her interest to do well? Absolutely! But the problem here is that the incompetent managers cum shareholders are making genuine mistakes that destroy the company’s net worth over the longer term. They did not know that their decisions were not getting support from the ground. They did not know that the workers were talking behind their backs and criticising their work. They did not know that the employees were unhappy working in the organizations.

Consider an example. Holding a senior position gives an owner cum manager supreme power in making decisions. Perhaps because of the person’s connection with the founders, it is difficult for others to comment on his/her decisions particular if the person has the ability of firing workers. This is not uncommon in Asian businesses where respect for superiors is deemed essential. Doing otherwise is socially undesirable and condemned. To maximize profits, the manager may make decisions which he/she thinks is good for the company but not so in the longer term.

I personally know of a manager who works for a listed family-owned company. She has a close relationship with the company’s founder. Her approach in raising labour productivity is horrible. The approach essentially involves loading her staff with work without much support and care given to her staff. She expects her staff to work at home. She frequently stopped the supplies of cartridge for printing (possibly to save cost) therefore hindering works to be done at the operational level. The employee relations were poor. Electronic mails she sent were discouraging. They simply de-motivate staff. While her intention is correct, that is to maximize the company’s profits, the approach hurts the company and therefore backfires. Minority shareholders are the big losers. They have neither the control nor strong ownership to rectify the situation. Neither was the manager replaceable because of her strong connection with the founder.

Will injection of external parties into the organization help to correct the situation? I will discuss some suggestions commonly raised in tackling the principal-agent problem. 

There are several propositions to rectify the principal-agent problem. In listed companies, the most common method perhaps is the appointment of independent board of directors aimed to monitor the managers’ performance. Traditionally, the main responsibility of the board lies in defining the corporate strategy and making sure that the chief executive officers (who are also in the board) and their staff implement the strategies diligently. Lesser direct roles were played in nominating the directors and determining their remunerations. This has since changed. The board’s role has extended. Today, the board members are required to sit in sub-committees to better monitor the performance of managers. The remuneration committee for example tries to decide the directors’ remuneration making sure that the remunerations commensurate their performance. The nomination committee examines the contributions of board of directors to see that only the most appropriate ones are retained. They are also constantly on the lookout for suitable candidates to sit in the board. The audit committee checks that the firm accounting policy is written in accordance to rules and regulations set by regulatory agencies. The committee also sees that financial information is made available to shareholders promptly and accurately.

The important thing to note is that a certain number of the board members must be independent in nature. Being independent means that they have no linkages in whatsoever manner with the company they represent which could interfere with the exercise of the member’s independent judgment.

To what extent the board helps in aligning the principals and agents’ interests really depends on the nature of the business and personalities of the people involved. In family-owned businesses, the board may be less effective if the founders and their family members are very powerful. In this case, the board members are merely ceremonial figures. The family in-charged is still making all the decisions with minimal constructive inputs coming from the rest of the members. This is done perhaps unintentionally. But the problem is that the family position is so dominant that it creates a sense of fear among the rests to voice out their concerns or provide any alternative views that may go directly against the controlling voters regardless of how good the alternative views are. Such a development is of course unhealthy to the organization.

It is possible for the family to resist interference from others. This kind of structure is very much alive in family-owned businesses today. It will take the second and third generation Asian business leaders to alter the present corporate governance system and change the way their organizations are currently managed. Some family members may form the perception that they, being the core family members and owners of the firm, should have the ultimate power in deciding the direction for the firm to take. Inputs from other are simply unwelcome. Even if they are someone who dares to provide alternative voices, their inputs can be easily outvoted during meetings by the majority shareholders.

Of course, some of the family-owned businesses are very well run. Likewise, we have the multinational corporations around the world which have grown more and more powerful over the years. Aren’t they family-owned businesses when they first started? Possibly yes. The difference in management lies to some extent on the personalities of the founders. Independent thinking may be more welcomed by some of them than others. Some are more willing to accept outside ideas even though they might be different from theirs. In other words, these businesses take full advantage of diversity in views and ideas and less commanding in wanting their views to be heard at all times. They are more willing to change for the better rather than remaining rigid. A change in mindset is what is urgently required among individuals who are dominating policies in family-owned businesses if they want their organizations to advance further.

The other approach aimed to eradicate the principal-agent problem is through the issuance of stock options plan to agents. The options plan essentially provides the holders the right but not the obligation to buy the company’s share at some stated price (known as the exercise price). The plan aims to align the interests of agents with that of the principals. It hopes to encourage the agents to work harder for the company and raise the company’s share price. The agents themselves would gain in the process for they can then exercise their right to buy the share at a lower price and selling them at a higher price in the secondary market.

There are several problems with the approach. First, the incentive to work harder may be missing especially among lower positioned workers. They may have the perception that influencing the share price is beyond their control. Why would they want to work harder if it requires a collective effort to push up the company’s share price? Free ridership problem may prevail. Share prices are also influenced by external forces like economic growth which cannot be controlled by any one individual or the corporation for that matter. Second, the options holders are allowed to exercise their options only after holding the options for a certain period of time. They are usually not allowed to exercise the options in the short term. The incentives to work harder would thus be missing if the employees were short sighted, and job-hopping was common. Third, the rewards associated with the stock options are in the form of capital gains, not dividends. The shorter-term reward thus is not forthcoming.

Given the above problems with board of directors and stock options plan in tackling the principal-agent problem, are they other alternatives available to supplement (note that I did not use the word ‘replace’) them?

Interestingly, one of the untapped resources in governing businesses is the ‘employees’. It is not wrong to say that some employees want the organizations they work in to succeed. Generally, workers who are associated with a successful company often feel proud. They would not hesitate to tell others about the organization. Why wouldn’t they? They incur costs in searching for the jobs, making sacrifices like going through the necessary training and getting to know new people when coming to work for the organization, and they put in time and effort to complete the tasks given to them.

Therefore, given the opportunities, employees would want to make sure that the organization is well run and reap the highest returns possible. They know that they will be rewarded in the process. Given the above arguments, it is logical to suggest that granting the staff the ability to voice their concerns to the people at the top can help to lower the principal-agent problem. Make their demands and unhappiness known. It is better to let them sound their unhappiness internally rather than blowing the whistle and letting the general public knows about the problem. The employees should be given the opportunities to make suggestions in improving how things currently work. Establishing the staff suggestion scheme (with anonymity allowed) represents a right initial approach moving towards this direction. It is important for the senior management to ensure that the anonymity is protected.

Getting the staff involved to exert pressure on incompetent managers allows the companies to move forward. Let me explain why.

I have found that competition and pressure exerted on managers to be a useful stimulus. Powerful investors or shareholders in big corporations can exert great pressure on the CEOs and directors to perform well. Particularly significance are the institutional investors like pension funds, insurance companies, banks and holding companies. The role of institutional investors in monitoring the performance of managers in smaller organizations is unfortunately rather limited. In small family-owned businesses for example, the shareholders are mostly family-owned. The remaining shareholders are minorities who are less interested in monitoring the company’s performance. Whenever unhappy, they can easily sell-off their shares in the secondary market. Moreover, any proposals they suggest can be easily outvoted by the controlling shareholders. There is a need to have other players to do the role of monitoring. One such group is the employees.

Besides the company’s employees, institutions can exert some pressures on the managers to perform. What do I mean? To illustrate, let me consider the private education industry in Singapore. Many private schools are seeking the Singapore Quality Class (SQC) for private education organizations. Launched in February 2003, the SQC award aims to stimulate private schools to excel, upgrade and compete better with other schools in the region to capture the world market share in the area of educational services. The Standards, Productivity and Innovation Board (SPRING), a Singapore statutory board established in April 2002, administers the award. As in September 2003, a total of 38 private educational institutions have achieved SQC status.[ii] The significance of this award lies in its tangible and intangible benefits including faster application processing time for students’ passes (reduced from four weeks to two weeks) and longer validity period for students’ passes. Attaining the status is not easy. Competition is much keener. The need to upgrade is much greater than ever to achieve the status, and then retaining it.

The SPRING represents an effective institution to monitor managers’ performance in organizations, and motivate them to do better. Constant monitoring forces the managers to care for their stakeholders. They are also compelled to adopt the best practices. There is a greater pressure for managers to do better and greater likelihood for incompetent managers to upgrade themselves for fear of losing their positions. Other institutions can play the same role. In the area concerning foreign students, the Immigration Department must see that the foreign students are well behaved and do not violate rules and regulations set forth. The stakeholders can voice their concerns to the department if the executive directors are not performing up to par.

In the general sense, the SPRING and Immigration Department play the role similar to the stock exchange. The stock exchange checks that all listed companies comply with the listing requirements. Failure to do so, either from the exchange’s own investigations or tip-offs, would render the organization liable to stiff penalties. The other institution to look out for is the Securities Investors Association (Singapore) or SIAS. Formed in June 1999, SIAS is the largest organized investor lobby group in Asia, with almost 61,000 retail investors as members. The non-profit organization actively promotes Investor Education, Corporate Transparency and Corporate Governance and it is the watchdog for Investor rights (see http://www.sias.org.sg).

Perhaps more importantly, these institutions provide an avenue for the companies’ stakeholders to voice out their concerns should the companies violate procedures that are not known to the administering institutions. They are avenues for whistle blowers to highlight their concerns. They exert pressures on managers to perform in certain ways therefore giving some hope to minority shareholders that their interests are protected. The institutional approach can supplement the other approaches mentioned earlier to raise the standards of corporate governance among private organizations particularly the family-owned businesses, which lack the external and independent monitoring mechanisms.

The shareholders can play a role too. It is unfortunate that many shareholders do not recognize their rights as shareholders. This should not be the case. The shareholders should know what they could do to protect their own interests in case the principals and agents’ actions and interests diverge in a significant manner. Even minority shareholders have their rights. This is usually reflected in the company’s Memorandum and Articles of Association (known as M&A), which represents a document setting out the objectives and the manner in which the company is to be managed. Generally, the M&A provides the shareholders the right to bring the company to court if the directors are in breach of the M&A. There is a limitation in terms of what executive directors can do to manipulate and take advantage of the M&A. This is because the Singapore law provides that any proposed amendments to the M&A requires no less than three-fourths of the shareholders to vote for them at the general meeting of the company.

Shareholders, including the minorities, have the right to information like registers of shareholders, directors, secretaries, managers, auditors, substantial shareholders and debenture holders. They are also entitled by law to have access to minutes of the general meeting and audited profit and loss accounts (to provide them at least two weeks before the general meeting). Such information could assist the shareholders to know more about what is going in the company in which they have invested.

Shareholders have the right to attend, vote and call for general meetings of the company. Under the Singapore law, the shareholders have the right to be treated fairly regardless of whether they are minority or majority shareholders. Section 216 of the Companies Act for example states that any visible unfair treatment to shareholders may render the company at fault. In this case, the court may intervene to provide a remedy to the situation. The remedy may include cancelling or prohibiting an act that is linked to the complaint. The court may also authorise civil proceedings to be brought to the person(s) in the company who have breached the law. For serious matters, the court remedy may involve winding up of the company.

The rules and regulations indeed provide useful avenues for shareholders exhibit and protect their rights. Provided that they care to manage the company, the above shows that the law does protect the shareholders including minorities.

The rules are perhaps more useful to shareholders of smaller companies like family-owned businesses. In smaller companies, there is a greater tendency for them to make informal and unwritten arrangements which may benefit the majority shareholders at the expense of the minority shareholders. The situation may be worse if the minority shareholders were not aware of the changes in the first place. Such an incident is less likely in larger companies. With larger shareholder base, these companies are more inclined to introduce activities in accordance to the M&A rather than in an informal and unwritten basis. However, this is not to say that the regulations are not useful to shareholders in larger companies. Any regulations that aimed to protect the shareholders and solve the principal-agent problem are most welcome in the effort to raise the country’s standards of corporate governance.

 



[i] Ng, Yew Kwang (2003) ‘Orthodox Economics and Economists: Strengths and Weaknesses’, The Singapore Economic Review, Vol. 48, No. 1 (2003), pp. 81-94.

[ii] See Koh, Jamie (2003) ’38 Schools Achieve Singapore Quality Class for Private Education Organizations’, Productivity Digest, September 2003 issue, pp. 11-12.