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Weekly UpdatesThe professionalized firm must evaluate the performance of managers and provide incentives that will motivate them to achieve the firm's goals. Using the agency theoretic framework we develop propositions on how differences in goals, altruistic tendencies, and strategic time horizons might affect performance evaluation and incentive compensation in family firms that employ both family and nonfamily managers and how these differences would affect the performance of the professionalized family firms relative to that of nonfamily firms.
Introduction
Many entrepreneurial firms involve family members in governance, management, and/or ownership (Chua, Chrisman, & Chang, 2004). Such family involvement may influence the goals pursued (Lee & Rogoff, 1996), the firm's strategic time horizons (Gallo & Vilaseca, 1996; Le Breton-Miller & Miller, 2006; McConaughy & Phillips, 1999; Sirmon & Hitt, 2003), and the altruistic tendencies of owners (Schulze, Lubatkin, & Dino, 2003; Schulze, Lubatkin, Dino, & Buchholtz, 2001). As these entrepreneurial family firms expand, they must by necessity start to employ nonfamily managers because there are only a limited number of able and willing family members. In the process, the family firm faces the challenge of professionalization, which involves changes in the firm's authority relationships, norms of legitimacy, and incentives (Gedajlovic, Lubatkin, & Schulze, 2004).
Of particular concern in this article are the formal performance evaluation and incentive compensation that must be developed in a professionalized firm. Studying performance evaluation and incentive compensation in professionalized family firms, aside from being important in its own right because of the ubiquity of family business (Astrachan & Shanker, 2003), can help us better understand the ways various aspects of firm governance affect one another in professionalized firms.
In this article we use agency theory to examine performance evaluation and incentive compensation in firms with and without family involvement and the implications for firm performance. Agency theory has been used extensively to explain how the working relationship between owners and managers affects firm performance (Eisenhardt, 1989) and the theory provides one of the two leading theoretical explanations for the distinctiveness of family firms (Chrisman, Chua, & Sharma, 2005). Building on the predictions of agency theory regarding incentive compensation, we focus on implementation issues arising from family involvement-induced differences in goals, altruistic tendencies, and strategic time horizons. The propositions point to reasons why professional management might be more difficult in family firms.
This article contributes to the literature by describing how professional management is more complicated and creates unique challenges for family firms. We examine how these challenges are likely to influence the relative policies and performance of family firms versus nonfamily firms using the codified agency theory framework to provide a rigorous discussion of these issues and help pave the way for other, more sophisticated applications. In the process, we explain how seemingly irrational family manager compensation and behaviors are very rational given the self-interest pursuing economic persons assumed in agency theory.
Theoretical Context
In professionalized firms, entrepreneurs must share authority with subordinated managers who have to be motivated to implement the firm's strategy. Entrepreneurs must also institute control systems to ensure that the behaviors of these managers are consistent with the achievement of firm goals. Designing effective incentive compensation and performance evaluation systems for managers is a particularly important challenge of professionalization (Hofer & Charan, 1984; Scott, 1971). Furthermore, the problems involved in performance evaluation and incentive compensation are somewhat different for family firms and nonfamily firms. The bases of such differences are discussed below.
Family Versus Nonfamily Firms
There appears to be no economic necessity requiring the strategies and structures of family firms to differ from those of nonfamily firms because the fits between resources and environment needed to compete successfully are essentially the same for all firms competing in the same market. But in spite of such similarities, family and nonfamily firms may still differ owing to the goals pursued by owners and managers. In fact, research has shown that family and nonfamily firms differ in term of strategies, structures, systems, processes, and governance mechanisms (Ensley, Pearson, & Sardeshmukh, 2007; Gallo, 1995; Karra, Tracey, & Phillips, 2006; McConaughy & Phillips, 1999; Morris, Williams, Allen, & Avila, 1997; Park, 2002; Randoy & Goel, 2003; Westhead & Cowling, 1998). Similarly, how performance is evaluated and incentives provided to these managers may be substantially different.
In this article we define a family business as "a business governed and/or managed with the intention to shape and pursue the vision of the business held by a dominant coalition controlled by members of the same family or a small number of families in a manner that is potentially sustainable across generations of the family or families" (Chua, Chrisman, & Sharma, 1999, p. 35). As Birley (2002) suggests, this definition has the advantage of considering the attitudes and the behavior of both current and future generations toward family business ownership and management, focusing on more than just purely arbitrary quantitative measures. Furthermore, it emphasizes the effect on management and governance of the controlling family's pursuit of their goals for the firm.
The definition has three implications relevant to the professionalized family firm. First, there is no requirement that the family firm pursue solely economic goals. Consequently, managers in family firms may be called upon to achieve a broader and more complex array of goals than managers in nonfamily firms. This makes the family firm examined here different from the publicly held firm, which is assumed in traditional agency theory to have the single goal of maximizing firm value or profit. Second, family members from different generations are potentially involved (Gersick, Davis, Hampton, & Lansberg, 1997). Thus, the relationship between owners and managers in family firms will be different and more complex than in nonfamily firms (Mitchell, Morse, & Sharma, 2005). Third, because ownership is the most reliable basis for preserving the potential to pursue the family's vision across generations, the likelihood is high that the family intends to transfer ownership from one generation to another. In contrast, such intention does not exist in nonfamily firms.
Agency Theory and Family Firms
The framework we use to examine the differences between professionalized family and nonfamily firms is agency theory, which is based on the idea that, due to conflicting interests, managers (agents) who are not owners will not be as diligent in managing the firm in the owners' interests as the owners (principals) would (Fama & Jensen, 1983; Jensen & Meckling, 1976; Ross, 1973). The financial burdens associated with identifying, detecting, and preventing agency problems, as well as the cost of unpreventable managerial opportunistic behaviors, have been labeled agency costs (Jensen & Meckling).
In theory, owner-managed firms in general, and family firms in particular, should have less need to control agency problems than publicly held firms because of the shared interests of principals and agents (e.g., Ang, Cole, & Lin, 2000; Jensen & Meckling, 1976). However, professionalization implies that owner-managers will delegate authority to middle level managers who are not necessarily owners (Hofer & Charan, 1984). Thus, professionalization can lead to agency problems in both privately held family and nonfamily firms.
Agency problems can also develop in family firms because a family consists of more than just the entrepreneur. When children reach adulthood and become involved in a family firm, their interests may deviate from those of the principal owner(s) despite the fact that they may have, in reality or by expectation, residual claims to the business. Schulze et al. (2001), invoking the asymmetric altruism (Bergstrom, 1989; Bernheim & Stark, 1988) and self-control (Thaler & Shefrin, 1981) literature in economics, argue that asymmetric altruism between family members can actually promote shirking and free riding in two ways. First, asymmetric altruism and lack of self-control can together make it difficult to enforce the explicit and implicit contracts between family owners and family members working in the business when the latter engage in opportunistic behavior. Second, altruism can color performance evaluations. Several studies have supported the premise that asymmetric altruism can have a significant impact on the behavior and performance of family firm (e.g., Chrisman, Chua, Kellermanns, & Chang, 2007; Karra et al., 2006; Schulze et al., 2001, 2003).
In summary, researchers suggest that shirking, free riding, and consumption of perquisites may be as common in family firms as it is in nonfamily firms, and possibly even more intractable. Although the interests of family owners and managers may overlap to a greater extent than the interests of owners and managers in nonfamily firms, asymmetric altruism could promote economic agency costs through the difficulty in enforcing contracts and biased evaluations of managers' contributions to firm performance (Schulze et al., 2001). This article provides additional reasons why agency costs could be higher for professionalized family firms.
Relevant Features of the Agency Theoretic Framework
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