University of Pennsylvania ScholarlyCommons Management Papers Wharton Faculty Research 8-2009 How Are U.S. Family Firms Controlled? Belén Villalonga Raphael H. Amit University of Pennsylvania Follow this and additional works at: https://repository.upenn.edu/mgmt_papers Part of the Business Administration, Management, and Operations Commons, Entrepreneurial and Small Business Operations Commons, and the Finance and Financial Management Commons Recommended Citation Villalonga, B., & Amit, R. H. (2009). How Are U.S. Family Firms Controlled?. The Review of Financial Studies, 22 (8), 3047-3091. http://dx.doi.org/10.1093/rfs/hhn080 This paper is posted at ScholarlyCommons. https://repository.upenn.edu/mgmt_papers/93 For more information, please contact [email protected]. How Are U.S. Family Firms Controlled? Abstract In large U.S. corporations, founding families are the only blockholders whose control rights on average exceed their cash-flow rights. eW analyze how they achieve this wedge, and at what cost. Indirect ownership through trusts, foundations, limited partnerships, and other corporations is prevalent but rarely creates a wedge (a pyramid). The primary sources of the wedge are dual-class stock, disproportionate board representation, and voting agreements. Each control-enhancing mechanism has a different impact on value. Our findings suggest that the potential agency conflict between large shareholders and public shareholders in the United States is as relevant as elsewhere in the world. Disciplines Business Administration, Management, and Operations | Entrepreneurial and Small Business Operations | Finance and Financial Management This journal article is available at ScholarlyCommons: https://repository.upenn.edu/mgmt_papers/93 How are U.S. Family Firms Controlled? Belén Villalonga Harvard Business School Soldiers Field Boston, MA 02163 Telephone: (617) 495-5061 Fax: (617) 496-8443 E-Mail: [email protected] Raphael Amit The Wharton School University of Pennsylvania 3620 Locust walk Philadelphia, PA 19104 Telephone: (215) 898-7731 Fax: (215) 573-7189 E-Mail: [email protected] August 2008 Forthcoming, Review of Financial Studies _____________________________ An earlier version of this paper was circulated under the title “Benefits and costs of control-enhancing mechanisms in U.S. family firms.” We would like to thank an anonymous referee, Michael Weisbach (the editor), José Manuel Campa, Gary Dushnitsky, Mara Faccio, Stuart Gilson, Josh Lerner, Asís Martínez-Jerez, Randall Morck, Stewart Myers, Lynn Paine, Gordon Phillips, David Scharfstein, Andrei Shleifer, Jordan Siegel, Eric Van den Steen, Daniel Wolfenzon, Bernard Yeung, Luigi Zingales, and seminar participants at the Conference on Corporate Governance in Family / Unlisted Firms in Thun (Switzerland), Drexel University, Harvard Business School, Harvard University, IESE, MIT, New York University, the Real Colegio Complutense at Harvard, the University of Maryland, the University of North Carolina, and the University of Wisconsin for their comments. We thank Mary Margaret Spence, Amee Kamdar, and Anna Wroblewska for their assistance with the development of the data set. Belén Villalonga gratefully acknowledges the financial support of the Division of Research at the Harvard Business School. Raphael Amit is grateful for the financial support of the Robert B. Goergen Chair at the Wharton School, the Wharton Global Family Alliance, and the Rodney L. White Center for Financial Research. All errors are our own. 1 Electronic copy available at: http://ssrn.com/abstract=891004 Abstract In large U.S. corporations, founding families are the only blockholders whose control rights on average exceed their cash flow rights. We analyze how they achieve this wedge, and at what cost. Indirect ownership through trusts, foundations, limited partnerships, and other corporations is prevalent but rarely creates a wedge (a pyramid). The primary sources of the wedge are dual- class stock, disproportionate board representation, and voting agreements. Each control- enhancing mechanism has a different impact on value. Our findings suggest that the potential agency conflict between large shareholders and public shareholders in the United States is as relevant as elsewhere in the world. 2 Electronic copy available at: http://ssrn.com/abstract=891004 Corporate governance scholars and regulators in the United States have traditionally been concerned about protecting investors from managerial entrenchment and expropriation––the classic agency problem described by Berle and Means (1932) and Jensen and Meckling (1976). Yet, a growing body of literature has shifted attention toward a different agency problem that seems to be of greater concern in most of the world: the expropriation of small investors by large controlling shareholders [Shleifer and Vishny (1997)]. We suggest that this second type of agency problem is also significant in the U.S. Several important findings have emerged from the international corporate ownership literature. First, most firms around the world are controlled by a large shareholder, typically founders or their families [La Porta, López de Silanes, and Shleifer (1999); Claessens, Djankov, and Lang (2000); and Faccio and Lang (2002)]. Even in the U.S., where ownership dispersion is at its highest, founding families exercise a significant degree of control over a third of the 500 largest corporations [Anderson and Reeb (2003); and Villalonga and Amit (2006)], and over more than half of all public corporations [Villalonga and Amit (2008)]. Second, founding families are often able to leverage their control over and above their sheer equity stake through mechanisms such as dual-class stock, pyramidal ownership, and cross-holdings [La Porta, López de Silanes, and Shleifer (1999); Claessens, Djankov, and Lang (2000); and Faccio and Lang (2002)]. Here again, the U.S. is no exception. La Porta, López de Silanes, and Shleifer (1999) show that, in 17 of the 27 countries in their sample, the deviations from the one-share one-vote norm are lower than they are in the U.S.; in fact, among the 12 countries they classify as having high investor protection, only Norway exhibits greater deviations. 3 It is important to note that the most widely researched of these mechanisms, dual-class stock, has traditionally been studied in the context of insider holdings, and interpreted as a manifestation of the agency problem between owners and managers [e.g., Partch (1987); and Jarrell and Poulsen (1988)]. However, DeAngelo and DeAngelo (1985) and Nenova (2001), who look at the identity of those insiders, show that the primary beneficiaries among them are also founding families: Nenova (2001) reports that this is the case for 79% of dual-class firms in her comprehensive international sample, and for 95% of U.S. dual-class firms. Relatedly, Gompers, Ishii, and Metrick (2008) find that the single most important determinant of dual-class status is having a person’s name in the firm’s name (e.g., Wrigley, or Ford), an obvious proxy for family control. These results suggest that the separation of ownership and control enabled by dual-class stock is in fact a manifestation of the second agency problem, the one between large (family) shareholders and small (non-family) shareholders. Third, when founders or their families use control-enhancing mechanisms to create a wedge between their cash flow and control rights, firm value is reduced [La Porta, López de Silanes, Shleifer, and Vishny (2002); Claessens, Djankov, Fan, and Lang (2002); Barontini and Caprio (2006); and Villalonga and Amit (2006)]. This paper builds on these findings to develop and empirically test a unifying framework that shows how different mechanisms contribute to the wedge between the cash-flow and control rights of founding families or other controlling shareholders. The framework reconciles the discrepancies in the way the wedge has been measured in earlier studies. In addition to dual-class stock and pyramidal ownership (the two primary mechanisms considered in earlier studies), we analyze the wedge between cash flow and control rights created by voting agreements, whereby voting power is transferred from one shareholder to another, and 4 disproportionate board representation––control of the board of directors in excess of voting control. Further, we argue that, because some mechanisms can serve purposes other than pure control enhancement, different mechanisms should have a different impact on value. In fact, the value effect of some mechanisms may be non-negative, even when those mechanisms enhance control rights over and above cash flow rights. We apply our wedge decomposition framework and test our hypotheses using a uniquely detailed dataset about the ultimate ownership and control of large U.S. corporations. The sample comprises 3,006 firm-year observations from 515 firms between 1994 and 2000. Our data enable us to observe six different forms of share ownership––by one sole person (or family group) or shared with another investor; and with investment and voting power, or with only one of the two powers. Through voting agreements among shareholders, this multiplicity of share ownership forms creates a divergence between cash-flow and control rights, independent of that created via dual-class stock and pyramids, which has not been captured by earlier studies. We begin by identifying which types of blockholders have control rights in excess of their cash flow rights in U.S. corporations, and find that this is only the