Founding family: an asset or a liability?
Evidence from IPOs
Imants Paeglis[*]
and
Dogan Tirtiroglu[**]
First version: March 2005
1
Founding family: an asset or a liability?
Evidence from IPOs
Abstract
We study family firms at the time of going public. By studying the relationship betweenthe degree of a founding family’s involvement in the management and governance of the firm,on the one hand, and the reputation of its underwriters, IPO underpricing, the extent of analyst coverage, and post-IPO institutional interest, on the other, we cast new light on the differences between family and non-family firm IPOs. We find that family firms are taken public by less reputable underwriters, have higher underpricing, attract lower institutional interest in their IPOs, and receive less extensive analyst coverage. These results are especially pronounced for family firms with a dual role of founder as the CEO and the chairperson of the board. Our findings contrast with the findings of several recent studies that, using a sample of large and well established firms, have found that family ownership has a positive influence on the firm value. We also shed a new light on the role of venture capital in IPOs. Our findings suggest that venture capital provides certification of founder quality:venture-backed family firms, especially those with a dual role of founder as the CEO and the chairperson of the board, are viewed more positively by underwriters, analysts, and institutional investors than non-venture-backed family firms. Finally, we find that the importance of an independent board in mitigating the adverse influence of a founding family on various IPO characteristics varies with the degree of the family’s involvement in the management and governance of the firm.
1
Founding family: an asset or a liability?
Evidence from IPOs
1. Introduction
Mounting evidence shows that family firms are more valuable and perform better than non-family firms in the US (e.g., Anderson and Reeb, 2003, 2004; Villalonga and Amit, 2005; Palia and Ravid, 2005). The extant literature has so far focused on valuation differences in large, mature, and publicly traded family and non-family firms from the US and a number of other countries.[1]Presently, however, there is no evidence on either the prevalence or the market’s assessment of family firms in relation to non-family firms at the time of going public.
A number of reasons motivate us to study family firms in their formation stages. First, family firmsare likely to be even more dominant and prevalent among the younger firms. Second, most of the arguments made in the existing literature about the advantages and disadvantages of family ownership are likely to be even more relevant and pronounced at the IPO stage. On the one hand, to the extent that the concentration of ownership and control is likely to be higher in an IPO stage family firm than in a large and mature family firm, the founding family in an IPO stage family firm will be less interested in extracting the limited resources of the firm for private consumption.Also, as pointed out by Schwert (1985), a founder is probably the most important asset of the firm in its formative stages, including the IPO and the immediate post-IPO stages. On the other hand, larger shareholdings of founding family may make it less subject to the market discipline (e.g., replacement of ineffective managers). Third, small and young family firms are likely to face a higher level of asymmetric information than large, mature, and index-listed family firms.Fourth, firms in their formation stages tend to seek and attract venture capital. The pre-IPO presence of various forms of venture capital offers new, unique, and rich signalling insights on a family firm’s future outlook. Finally, a founder of a newly public firm is less likely to have built-up knowledge, expertise, and reputation necessary to manage the firm than is a founder of a large and mature family firm.In our view, these reasons make studying the family firms at the IPO stage more important,informative,and interesting.
Our paper casts brand-new light on the prevalence of family firms at the time of going public and the differences between family and non-family firm IPOs in the US between 1993 and 2000.Using ideas from the literature on principal-agent relationships and on the role of asymmetric information in IPOs, we examine the perception of family firms by investment bankers, analysts, and institutional investors.[2]In particular, we ask the following questions, on which, to our knowledge, no evidence is presently available:
1. Are there differences between family and non-family firms in the reputation of their IPO underwriters?
2. Do investors demand higher underpricing of family firm IPOs than non-family ones?
3. Are there any differences in the post-IPO analyst coverage, up to one year, between family firms and non-family firms?
4. Do institutional investors invest more in the shares of family firms than in the shares of non-family firms within a year after the IPO?
Going public is a crucial step not only in the evolution of a family firm into a public corporation, but also in the development of its separation of ownership and control (Schwert, 1985; Brennan and Franks, 1997). Focusing on the IPO stage allows us to recognize separately the unseasoned influence of (1) a founder chief executive officer and the chairperson of the board of directors (FCEO&CHAIR henceforth), (2) a founder chief executive officer (FCEO henceforth), or (3) a founder chairperson of the board of directors (FCHAIR henceforth), on various characteristics of IPOs, as put forth above. FCEO&CHAIRs are empowered both with the management and governance functions. FCEOs have managerial powers, but do not participate – albeit directly – in their firms’ governance while FCHAIRs maintain a visible role in the governance of their firms, but do not assume a managerial role.Holding ownership constant,each of the above three categories represents a different degree of founders’ involvement in the management and governance of their firms. Consequently, each category is likely to exhibit its own distinct differences from the non-family firms. The extant literature considers the seasoned influence of the presence of FCEOs or founder-descendant CEOs on the differential valuation of family firms over non-family firms.[3] We are, however, the first to identify explicitly and study empirically family firms with either a FCEO&CHAIR,or a FCEO, or a FCHAIR at the time of going public.
Venture capitalists and other pre-IPO corporate investorshave been an important source of financing for start-up companies. Evidence shows that venture capitalistsare actively involved in the replacement of founders andin the corporate governance of the firms they invest in (see, e.g., Hellman and Puri, 2002; Baker and Gompers, 2003; and Hochberg, 2004). Their presence and actions in family firms appear to have different signalling meanings for the quality of the firm and its management. We incorporate the presence of venture capital and pre-IPO corporate investor(s) into our analyses first to formulate some of these signalling issues and then to study them empirically. To our knowledge, no arguments for these signalling effects and no evidence on themare presently available.
Since the agency-theoretic framework highlights the importance of internal corporate governance mechanisms in mitigating the likely agency problems in firms characterized by separation of ownership and control (Jensen and Meckling, 1976; Fama and Jensen, 1983, 1985; Milgrom and Roberts, 1992), we also re-examine the above four questions, controlling for the degree of board independence. The appointment of independent directors, especially in the absence of either venture capital or pre-IPO corporate investor(s), to form a majority on a firm’s board of directors (BOD henceforth) is a strong signalto the market of its willingness to be monitored objectively.[4] We expect the family firms with an independent BOD to be viewed by the market more positively than family firms with an insider-dominated BOD. The importance of board independence, however, will vary with the degree of the family’s involvement in the management and governance of the firm.To our knowledge, no evidence is presently available on this question for family firms going public.
We find that family firms are more dominant and prevalent in the formation stage than in their maturity stage in the US.[5] Of the 2,613 common stock IPOs in our hand-collected sample, we find 1,461 to be for the family firms. This corresponds to 55.91% of our total sample and contrasts with about 35% of family firms in the S&P 500 Industrial Index between 1992 and 1999 in Anderson and Reeb (2003). Furthermore, the number of IPOs per year for the family firms is considerably more than that for non-family firms in every year (except one) of our sample period.
Our results suggest that the presence of a founding family is viewed by underwriters, financial analysts, and institutional investors as a liability. In particular, we find that family firms are brought public by less reputable underwriters, are more underpriced, receive less extensive analyst coverage, and have lower post-IPO institutional interest. These results are especially pronounced for family firms in which a founder holds a dual role as the CEO and the chairman of the BOD. Family firms with a FCHAIR, on the hand, seem to be viewed more positively by underwriters, financial analysts, and institutional investors than those with either a FCEO&CHAIR or a FCHAIR.
We also find evidence of venture capital certification of founder’s quality, especially in the case of a family firm with a FCEO&CHAIR. In particular, we find thata FCEO&CHAIR in aventure-backed family firm is viewed more positively than in a non-venture-backed family firm. Given venture capitalist’s active involvement in replacing founders, observing a FCEO&CHAIR in a venture-backed family firm reflects venture capitalist’s implicit certification of such a founder.We do not, however, find evidence of a similar certification effect in the case of a family firm with aFCEO.
Finally, we find that the importance of independent BODin mitigating the potential problems inherent in family firms varies with the type of the founding family’s and pre-IPO institutional investors’ presence. The monitoring effect of an independent BOD is more pronounced in non-venture-backed family firms and in venture-backed family firms with a FCEO&CHAIR. In the caseof a venture-backed family firm with a FCEO, however, we find that the influence of an independentBOD on the perception of the firm by its underwriters, financial analysts, and post-IPO institutional investors is less pronounced. This seems to suggest thatthe separation of the roles of CEO and chairman (most likely due to venture capitalist’s involvement), coupled with an independent board, may signal venture capitalist’s reservations about such a founder, partly offsetting benefits of increased monitoring by an independent BOD.
All of the above results are robust to controls for both a dual class share structure and the level of founding family’s ownership.
The rest of the paper is organized as follows. The next section presents empirically testable arguments either in favour or against family firms. Section 3 covers data and sample characteristics. Section 4 offers empirical methodology, variable definitions, and empirical results. Section 5 concludes the paper.
2. Family firms in the IPO process
Below, section 2.1 presents arguments, following mainly from the agencytheory, on why family firms might differ from non-family firms. Section 2.2 isbased on a synthesis of ideas from the agency theory and the theory of asymmetric information for firms in the IPO process. It considers the potential empirical implications for the difference in underwriter reputation, underpricing, financial analyst coverage, and post-IPO institutional investors’ interest in family versus non-family firms. Sections 2.3 and 2.4 offer empirically testable arguments,for the role of venture capitaland internal corporate governance mechanisms, respectively, in countering the effects of asymmetric information on various characteristics of family and non-family firm IPOs.
2.1. Founders in the management and governance of family firms
We identify three categories of founding family firms, FCEO&CHAIR, FCEO, and FCHAIR, at the time of going public and expect them to have distinct differences not only from non-family firms and but also from one another.[6] Therefore, we first discuss the likely differences between each category of family firms and non-family firms, and also explain our expectations for why and how one category might differ from the other two. We first consider the differences between family firms with a FCEO and non-family firms. This is because, starting with Jensen and Meckling’s (1976) classical paper, the rich agency-theoretic literature suggests arguments or presents empirical evidence on whether the presence of a FCEO, rather than a FCEO&CHAIR or a FCHAIR, in a family firm might be good news or bad news in relation to the presence of a professional manager in a non-family firm. Let us note that the set of authorities and responsibilities of a FCEO&CHAIR encapsulates that of a FCEO. Hence, all of the arguments for or against the presence of a FCEO in a family firm, as presented below, should fundamentally apply in the same direction, but with a more pronounced intensity, for the presence of a FCEO&CHAIR in a family firm.
A FCEO in a firm going public could be a more valuable asset than a professional manager in a non-family firm. For one, the FCEO of a firm going public has reasons and incentives to work harder than the CEO of a non-family one going public. The FCEO would most likely maintain the largest ownership position after the IPO and would also be at the helm of the firm. Furthermore, the family’s ownership in the firm will most likely represent a large and undiversified risky investment position for the FCEO and members of the family, rendering frictions among family members in firms in the IPO process less likely than in mature family firms. Thus, the incremental value created from hard work should benefit the FCEO and other members of the family more than minority shareholders.
Given a sufficient level of concentrated ownership and control in a family firm, the FCEO will be less interested in extracting the limited resources of the firm for private consumption than a professional CEO in a firm with a diffused ownership (Demsetz and Lehn, 1985). Schwert (1985), in his discussion of Johnson et al. (1985), observes that a FCEO of a family firm is probably the most important asset of the firm in its formative stages, including the IPO and the immediate post-IPO stages. Once again, the incremental value created from a lack of private consumption of the firm’s resources will benefit the FCEO and other members of the family more than minority shareholders.
Avoiding a professionally employed CEO’s myopic investment horizon, as described in Stein (1988, 1989), is another reason why a FCEO may constitute a more valuable asset. Family firms maintain a long-term investment horizon, as posited by James (1999). Taking a long-term vision offers family firms valuable opportunities and challenges.[7] Several researchers have demonstrated empirically that founder-descendant CEOs are an asset for family firms (see Smith and Amoako-Adu, 1999; Perez-Gonzalez, 2004; Anderson and Reeb, 2003; Villalonga and Amit, 2005). This research interest is, in its own right, an implicit but strong testament to the long-term ownership position of family firms.[8]
There are also reasons why a FCEO in a newly public firm could be a less valuable asset than a professional manager in a non-family firm.[9] The traditional agency theory viewpoint suggests that a family firm with concentrated ownership and control may provide grounds for the family to extract private benefits from the firm (Shleifer and Vishny, 1986; Claessens et al. 2002). Therefore, family ownership may not be as efficient an organizational structure as a non-family firm with diffused ownership and professional management (Jensen and Meckling, 1976; Fama and Jensen, 1983). Empirical evidence from the 1980s demonstrates a discount for family firms (Holderness and Sheehan, 1988; Barclay and Holderness, 1989), suggesting that the market may view family ownership as a liability.[10]Because of these and other reasons, it appears that the Wall Street views family-run businesses with scepticism (Stein, 2001).[11]
The experience and reputation of a FCEO is another important factor. It seems likely that many FCEOs of family firms in the IPO process will be first time managers, with much less experience than most professional managers, and with a lot to prove, including establishing a reputation. As indicated above, they may be motivated to work hard. But, motivation for hard work neither guarantees better managerial skills nor substitutes for an established reputation and experience in capital markets (Burkart et al. 2003; Bhattacharya and Ravikumar, 2001).[12] Chemmanur and Paeglis (2005) demonstrate empirically that quality and reputation of a firm’s management has a significant influence on various IPO characteristics.