Tag: family business
Succession Dynamics in Latvian Family Firms
This policy brief examines the emergence, succession, and performance of first-generation family firms in Latvia, highlighting the unique challenges and achievements of these businesses since the early 1990s. Following Latvia’s independence, many family firms were established, providing a natural setting to study succession issues. Key findings reveal that initially, nearly half of these firms did not have a majority stake held by the founding family, but within the first few years after founding, families accumulated majority ownership. It typically took seven years for family ownership to exceed 75 percent. However, 23 years later, only 16 percent of the sample firms have second-generation shareholders. Notably, around 80 percent of these firms remain majority-owned and managed by their founders. Furthermore, family firms outperform non-family firms by 3.1 percent in return on assets (ROA). The findings underscore the need for policies that support effective succession planning, incentivize family-owned business sustainability, and provide targeted training for future generations to maintain the robust economic contributions of these firms.
Introduction
Family firms, where key decisions are controlled by individuals linked by blood or marriage, are the predominant organizational form worldwide. These firms face critical challenges, (e.g. leadership transition, generational differences, emotional ties to the business, and estate planning tax considerations) particularly during ownership succession, which is the transition from the first to the second generation of family members. This issue is especially relevant in Eastern European countries like Latvia, where the shift from a planned to a market economy in the 1990s created the first generation of family firms now approaching generational change.
Understanding how family firms manage this transition is crucial for policymakers, business leaders, and researchers. This policy brief highlights the key findings of a study (Pajuste and Berzins (2024) on Latvian family firms, focusing on ownership succession patterns, the involvement of the next generation, and the impact on firm performance.
Succession Patterns and Ownership Evolution
In Latvia, many family firms began with founders holding minority stakes, reflecting financial constraints and economic uncertainties. Over time, families gradually increased their ownership stakes, demonstrating resilience and strategic planning. On average, it took seven years for family ownership to exceed 75 percent. This gradual ownership increase helped families navigate the challenges of economic transitions and limited access to external capital. The study also reveals that 23 years after being founded, only 16 percent of the sample firms have second-generation family members as shareholders.
Involvement of the Second Generation
The emergence of the second generation in family firm ownership is a pivotal phase. Succession planning and the transmission of familial values, knowledge, and entrepreneurial ethos are crucial during this period. By 2022, only 14 percent of the sample family firms had significant second-generation involvement (defined as the second generation holding a majority of the family shares and having a board seat).
More specifically, in a sample of 266 family firms, 20 percent had involved the second generation in ownership by 2022, with significant involvement in 71 percent of these cases. At the same time, 80 percent of the firms were still majority-owned and managed by the founders. This slow involvement of the second generation highlights the challenges of succession planning and the need for a strategic approach – both from a company and a legal perspective – to ensure a smooth transition from the first to second generation.
Importantly, despite this slow transition, family firms tend to perform better than non-family firms, with a 3.1 percent higher return on assets (ROA). However, within family firms, the involvement of the second generation does not significantly impact firm performance.
Policy Implications and Recommendations
The findings of this study have several important implications for policymakers, business leaders, and researchers.
Support for Succession Planning
There is a need for policies and programs that support succession planning in family firms. This includes providing resources and guidance for families to develop succession plans, ensuring the continuity of family businesses. Ensuring some form of succession, whether within the family or through external parties, is crucial to prevent these firms from closing. Facilitating succession and supporting the survival of these firms would not only protect jobs, but also have a positive economic effect as family firms outperform their non-family counterparts.
Financial Support and Access to Capital
Another way to enable smoother transition and growth for family firms is to improve their access to capital to help them overcome financial constraints. Financial institutions and government programs should focus on providing tailored financial products for family businesses. By doing so, they not only support the longevity of these businesses but also help in maintaining employment levels and preventing the economic fallout from family firm closures.
Education and Training
Educational programs and training for the next generation of family business leaders are essential. These programs should focus on leadership, management, and the unique challenges of family businesses, preparing the next generation for successful transitions.
Awareness and Best Practices
Raising awareness about the importance of succession planning and sharing best practices can help family firms navigate generational transitions more effectively.
Research and Data Collection
Continued research and data collection on family firms and their succession patterns are crucial. This helps in understanding the challenges and opportunities faced by family businesses, informing policies and practices that support their continuation and success.
Conclusion
Latvian family firms, like their counterparts worldwide, face significant challenges during ownership succession. This study highlights the gradual and strategic increase in family ownership stakes, the slow emergence of the second generation in ownership, and the need for comprehensive succession planning. Policymakers, business leaders, and researchers must work together to support family firms in navigating these transitions, ensuring their continued contribution to the economy.
Effective succession planning is crucial for sustaining family businesses across generations, preserving their legacy, and promoting economic growth. By addressing the unique challenges faced by family firms, we can create a supportive environment that fosters the longevity and success of these vital enterprises.
Acknowledgment
This brief is based on an academic article Family Firm Succession: First-generation transitions in Latvia co-authored with Janis Berzins and forthcoming in Finance Research Letters. We acknowledge financial support from the EEA research grant Global2micro (S-BMT-21-8, LT08-2LMT-K-01-073).
References
- Pajuste, A., and Berzins, J. (2024). Family firm successions: First-generation transitions in Latvia. Finance Research Letters, 64, forthcoming.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
Ownership Structure, Acquisitions and Managerial Incentives
Both the theoretical and empirical literature assume that takeovers are less likely to occur when firms have large concentrated shareholders, e.g. family firms. Hence the disciplinary role of takeovers becomes irrelevant in incentivizing the management. We argue that this conjecture is false. Using a contracting model, we show that the existence of takeovers can work in favour of firms with controlling shareholders, amplifying the disciplinary effects relative to firms with dispersed shareholders. We further show how takeover threats interact with alternative governance structures, specifically, with monitoring and performance pay. While carrots (performance pay) and sticks (takeover threat) play substitute roles in incentive provision, the internal monitoring available to large shareholders is a substitute mechanism irrespective of the disciplinary effect of the market for corporate control.
Introduction
The nature of optimal corporate ownership has been a longstanding question in corporate governance literature. While large controlling shareholders can address managerial agency problems by monitoring management and alleviating the free-riding problem in takeovers (see e.g., Grossman and Hart, 1980; Demsetz and Lehn, 1985 and Burkart, Gromb and Panunzi, 1997), they may also expropriate other stakeholders by influencing management or deterring efficient takeovers to maintain their private control benefits (Stulz,1988). Empirical evidence about the effect of controlling shareholders, for example a founding family, on firm performance is also inconclusive (see Bertrand and Schoar (2006) who review the empirical studies on family ownership).
Amid the ongoing debate, we provide a new perspective on the role of controlling shareholders in the market disciplinary mechanism, and how it interacts with the firm’s potential synergy characteristics and internal governance mechanisms. While the use of performance pay and internal monitoring are easily justified by the extant literature, the disciplinary effects of the market for corporate control are less obvious. In many countries, there are debates about the social cost of concentrated ownership structures, and some regulators (e.g., the European Commission) have been advocating in favour of breaking up concentrated ownership structures to facilitate the market for corporate control and its managerial disciplinary function.
In contrast to this standard view, our analysis shows that the managerial disciplinary mechanism of synergistic takeover can be strengthened by the presence of controlling shareholders. Furthermore, while the control premium required by controlling shareholders reduces the incidence of synergistic takeovers, the internal monitoring performed by these shareholders can complement the market disciplinary mechanism in high synergy potential firms. Overall, it is ambiguous whether dismantling a concentrated ownership structure would increase firm value and, in particular, in firms which provide high synergy potential to acquirers.
Our analysis suggests that more sophisticated policies for the market for corporate control may improve the social welfare more effectively.
Controlling Ownership and Managerial Agency Problem
The managerial agency problem is relevant even when considering takeovers of family firms. Founders hold 15% of the CEO positions, 30% are held by descendants while the absolute majority of approximately 55% are held by professional managers (Villalonga and Amit, 2006). Bidders that operate in the same industry, for example, will be able to observe the state of demand to assess the synergistic improvements. In contrast, family owners are likely to be less actively involved in firm operations, and less informed about the industry/market situation, which suggests their lack of operational expertise vis-a-vis managers.
In the presence of potential conflicts of interest between the management and shareholders, the market for corporate control serves a disciplining role. Then why does the private benefit of controlling shareholders, which increases the takeover premium, strengthen this market disciplinary mechanism?
We argue that, notwithstanding their negative effect on the incidence of synergistic takeovers, the controlling shareholders can strengthen the managerial disciplinary effect of a takeover in firms that offer acquirers large business synergies.
To answer the question intuitively, suppose that the manager has no anti-takeover defense. In this case, the manager can secure herself from takeover threats only by increasing the market value of the firm, and, therefore, the takeover threat can discipline the manager. In firms which offer high synergy potential to the acquirers, however, the manager may find it too costly to increase the market value enough to deter a synergistic takeover. The control premium required by controlling shareholders can complement the market disciplinary mechanism in this circumstance, and, specifically, reduce the profitability of synergistic takeovers and make the acquirers’ bidding choice more sensitive to current market value. That is, it allows the managers of firms that offer high business synergies to reduce the takeover threat significantly by increasing the market value.
Technically, our model shows that the necessary and sufficient condition for the complementarity of ownership concentration and the market disciplinary mechanism is the log-convexity of the distribution function of potential business synergy. The market value increase from truthfully reporting the favorable state may, in itself, not significantly deter the takeover attempts for these firms since acquirers still find the business synergy more than offsets a high stock price. The control premium required by controlling shareholders makes truthful managerial reporting (and the corresponding market value enhancement) more effective in reducing the likelihood of a takeover. Specifically, the control premium increases the manager’s opportunity cost of misreporting and, in turn, it reduces the information rent that shareholders forgo to the manager.
Interaction with Other Governance Mechanisms
The analysis also provides implications for the relationship between ownership structure and other governance mechanisms, such as managerial compensation and the monitoring function of controlling shareholders.
Given that the managerial agency problem cannot be fully eliminated by the takeover threat and managerial compensation, the monitoring function of controlling shareholders can complement the other two governance mechanisms in our setting.
We show that the disciplinary effect of synergistic takeovers reduces the information rent paid to the manager and, thus, it diminishes managerial incentive pay. This implies that managerial pay-performance sensitivity is negatively associated with ownership concentration in firms which offer high business synergies. Furthermore, our analysis also shows that, in high synergy potential firms in which controlling shareholders strengthen the market disciplinary mechanism, monitoring function of controlling shareholders can complement the market disciplinary mechanism, and, thus, ownership concentration increases the operating efficiency relative to firms with dispersed ownership.
Conclusion
Contrary to the common prior, the disciplinary effect of synergistic takeovers can be stronger in high synergy potential firms with controlling shareholders due to improvements in incentives for managerial self-selection. Specifically, the control premium encourages the manager to deter the takeover threat by increasing the current value of the firm. In this case, managerial entrenchment is consistent with improvements in shareholder value.
The disciplinary effect acts as a complement to the internal monitoring efforts of controlling shareholders in reducing the amount of incentive pay required to induce managerial truthfulness. In contrast, the control premium in firms with few synergies isolates the manager from the takeover threat, making incentive provision reliant on internal monitoring.
However, the disciplining effect of synergistic takeovers is not without its costs, making the overall value implications ambiguous. Incentive provision requires that shareholders accept relatively low bidding prices, by allowing takeovers with negative synergies. Furthermore, tailoring correct incentive pay requires a relatively high distortion to effort levels in times of economic downturns. While controlling ownership is able to mitigate these concerns, the existence of a control premium also reduces the incidence of socially desirable synergistic improvements in firm value.
Overall, policy makers should take care when considering implementation of constraints on the controlling states in order to facilitate the market for corporate control.
References
- Anderson, Ronald C., and David M. Reeb, 2003. “Founding-family ownership and firm performance: Evidence from the S&P 500”, The Journal of Finance, 58, 1301-1327.
- Bertrand, Marianne, and Antoinette Schoar, 2006. “The role of family in family firms”, Journal of Economic Perspectives, 20, 73-96.
- Burkart, Mike, Denis Gromb, and Fausto Panunzi, 1997. “Large shareholders, monitoring and the value of the firm”, The Quarterly Journal of Economics,112, 693.
- Demsetz, Harold, and Kenneth Lehn, 1985. “The structure of corporate ownership: Causes and consequences”, Journal of Political Economy, 93, 1155-1177.
- Grossman, Sanford J., and Oliver D. Hart, 1980. “Takeover bids, the free-rider problem, and the theory of the corporation”, The Bell Journal of Economics,11, 42-64.
- Villalonga, Belen, and Raphael Amit, 2006. “How do family ownership, control and management affect firm value?”, Journal of Financial Economics, 80, 385-417.
- Stulz, Renee, 1988. “Managerial control of voting rights: Financing policies and the market for corporate control”, Journal of Financial Economics, 20, 25-54.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.