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The Fourth Asian Roundtable on Corporate Governance

Shareholder Rights and the Equitable Treatment of Shareholders

Robert ZafftOECD

“Large, Family-Run Firms: the OECD Experience”

Mumbai, India11-12 November 2002

The views expressed in this paper are those of the author and do not necessarily represent the opinions of the OECD or its Member countries, the ADB or the World Bank

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Good corporate governance matters, even for families that control and manage their own firmsGood corporate governance matters, even for families that control and manage their own firms

Large, family-run firms (both listed and privately held) play a major role in OECD economies

To succeed, family-firm owners must grow, diversify and pass on their wealth

These three challenges become harder where governance is poor

By improving governance, policy makers and owners improve both the functioning of firms and the welfare of the families that run them

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Family-run firms predominate in OECD economies Family-run firms predominate in OECD economies

75

80

85

90

90

99

0 50 100 150

UK

Spain

EU

Sweden

US

Italy

Proportion of OECD Firms That are Family-RunPercent

Source: Nancy Upton and William Petty, “Venture Capital Investment in Family Business,” Venture Capital, 2000, Vol. 2, No. 1, pp. 27-39

• Over 85% of EU/US businesses are family run

• Over 85% of EU/US businesses are family run

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Family-run firms contribute disproportionately to business profits Family-run firms contribute disproportionately to business profits

0 100 200

UK

US

Average Family-RunProfitability

Average Non-FamilyRun Profitability

Profitability of Family-Run and Non-Family-Run Firms, 1970-1990Percent

Source: BDO Stoy Hayward

180

100

100

130

Average non-family-run profit-ability = 100

• US-UK family-run “premium” ranges from 30%-80%

• US-UK family-run “premium” ranges from 30%-80%

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Family-run firms (both listed and private) make up a significant percentage of all major firms Family-run firms (both listed and private) make up a significant percentage of all major firms

Family-Run Firms among US S&P 500 Percent

* Excludes firms like Microsoft and Berkshire Hathaway that are still run by the founding generationSource: University of Notre Dame and IMF Institute; Family Business Magazine

40

60

Family-Run

Other

244 OECD multi-generation family-run firms have revenues over US$ 1 billion*

• Family-run firms constitute 40% of the US S&P 500

• Family-run firms constitute 40% of the US S&P 500

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While privately held, large* family-run firms are 30% smaller than their listed counterparts... While privately held, large* family-run firms are 30% smaller than their listed counterparts...

Average Revenues of Large, Family-Run FirmsBillion Dollars

* “Large” means annual revenues greater than or equal to US$ 1 billion; comparison excludes Ford (US$ 170 billion) and Wal-Mart (US$ 191 billion)** US companies onlySource: Family Business Magazine

6.2

8.9

Private

Listed

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...They are as numerous... ...They are as numerous...

Listed v. Privately Held Large Family-Run Firms in OECD Countries Percent

Source: Family Business Magazine

5050

PrivatelyHeldListed100% = 244

• Half of all large, OECD family-run firms are privately held

• Half of all large, OECD family-run firms are privately held

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…And comparably represented across industry sectors …And comparably represented across industry sectors

0 20 40 60

Private

Listed

Distribution of Large, Family-Run Firms across SectorsNo. of Firms

Source: Family Business Magazine; OECD Analysis

• Listing does not appear to confer any clear advantage across sectors

• Listing does not appear to confer any clear advantage across sectors

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ChallengeChallenge

Whether family-run firms are listed or privately held, to succeed, their owners must access capital, diversify wealth and manage successionWhether family-run firms are listed or privately held, to succeed, their owners must access capital, diversify wealth and manage succession

Challenges for Family-Business Owners

Source: OECD Analysis

IssuesIssues

Access CapitalAccess Capital• Finance growth• Balance debt/equity

• Finance growth• Balance debt/equity

Diversify wealthDiversify wealth

• Manage risk• Provide liquidity

• Manage risk• Provide liquidity

Manage succession

Manage succession

• Appoint competent directors/managers • Adjust shareholdings pursuant to inter-generational hand-over • Finance share transfers • Balance jobs/compensation for family employees with returns to family shareholders

• Appoint competent directors/managers • Adjust shareholdings pursuant to inter-generational hand-over • Finance share transfers • Balance jobs/compensation for family employees with returns to family shareholders

• These challenges and issues exist for all closely controlled firms

• These challenges and issues exist for all closely controlled firms

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Although firms going public most commonly cite accessing capital to finance growth as a motivation for listing...Although firms going public most commonly cite accessing capital to finance growth as a motivation for listing...

24

36

38

48

59

64

0 20 40 60 80 100

Attract betterpersonnel

Equitizestakeholders

Equitize employees

Finance acquisitions

Raise firm's profile

Finance Growth

Frequency of Rationale Appearing in IPO Prospectuses, Sweden 1980-90Percent

Source: Kristian Rydqvist and Kenneth Hogholm, “Going Public in the 1980s: Evidence from Sweden,”European Financial Management, Vol. 1, No. 3, 1995, pp. 287-315

Growth rationale

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...IPO data indicate that access to capital has not been a major problem for mid-size and large, family-run companies ...IPO data indicate that access to capital has not been a major problem for mid-size and large, family-run companies

Primary v. Secondary IPO Shares, Select European Countries, 1980-90* Percent

* France, Germany, Italy, Netherlands, Sweden, Switzerland, and UKSource: Rydqvist and Hogholm

58

42

SecondaryPrimary • Late average age at

IPO shows firms have not needed to tap public equity markets• Almost 60% of all money raised in IPOs is used for cashing out the owners rather than growing the business

• Late average age at IPO shows firms have not needed to tap public equity markets• Almost 60% of all money raised in IPOs is used for cashing out the owners rather than growing the business

29

30

30

34

38

40

55

57

Spain

Italy

Finland

Belgium

Sweden

European Avg.

Switzerland

Germany

Average Age at IPOYears

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Family members can diversify their wealth by expanding firm operations or by passively investing dividends and compensation in other companies. Family members can diversify their wealth by expanding firm operations or by passively investing dividends and compensation in other companies.

Source: OECD Analysis

Operational v. Portfolio Diversification

SH

Co. 1

Bus 1 Bus 2 Bus 3

SH

Co. 1

Bus 2 Bus 3

Co. 2 Co. 3

Bus 1

Operational Diversification (“Conglomerate”) Portfolio Diversification

• Investing in other companies offers fuller diversification than creating a conglomerate because it diversifies senior management and directors, as well as sectors of activity and business-unit managers

ActivePassive

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The fact that conglomerates comprise only 3% of large, family-run firms evidences a clear preference for portfolio diversificationThe fact that conglomerates comprise only 3% of large, family-run firms evidences a clear preference for portfolio diversification

Family-Run Conglomerates in OECD Countries Percent; Number

Source: Family Business Magazine; OECD Analysis

3

97

Conglomerate

Non-Conglomerate • Portfolio diversification is preferred over operational diversification• The competitive advantage of family-run firms is deep sectoral experience and contacts that cannot be exploited in the conglomerate structure

• Portfolio diversification is preferred over operational diversification• The competitive advantage of family-run firms is deep sectoral experience and contacts that cannot be exploited in the conglomerate structure

100% = 244

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Succession represents the biggest challenge to family-run firms. Succession represents the biggest challenge to family-run firms.

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1712

0

10

20

30

40

50

60

70

80

90

100

1st to 2 Generation 2d to 3rd Generation 3rd to 4th Generation

Intergenerational Succession, UKPercent

Source: Per-Olof Bjuggren and Lars-Goran Sund, “Strategic Decision Making in Intergenerational Successions of Small- and Medium-Size Family-Owned Businesses,” Family Business Review, 2001, Vol. 14, Part 1, pp.11-24

• Only one in six family-run firms survives to the 3rd generation• One in eight family-run firms survives to the 4th generation

• Only one in six family-run firms survives to the 3rd generation• One in eight family-run firms survives to the 4th generation

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However, successful succession can also mean selling all or a part of the firm at the right price However, successful succession can also mean selling all or a part of the firm at the right price

Source: Utpal Bhattacharya and B. Ravikumar, “Capital Markets and the Evolution of Family Businesses,” JEL: G10, D92

Sales Price for a Family-Run Firm

Return from family firm

Return from offer to buy firm

Capital Invested

Return on Invested Capital • The owners’

goal should be maximising family welfare.•Sell the family firm when the marginal return from the offer meets or exceeds the firm’s marginal return

• The owners’ goal should be maximising family welfare.•Sell the family firm when the marginal return from the offer meets or exceeds the firm’s marginal return

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ChallengeChallenge

Where public and corporate governance are poor, the challenges of accessing capital, diversifying wealth and managing succession become harder.Where public and corporate governance are poor, the challenges of accessing capital, diversifying wealth and managing succession become harder.

Effects of Bad Governance

Source: OECD Analysis

EffectEffect

Access CapitalAccess Capital

• Harder to start firm• Harder to grow firm• Harder to sell firm

• Harder to start firm• Harder to grow firm• Harder to sell firm

Diversify wealthDiversify wealth

• Portfolio diversification becomes less attractive• Firm becomes overcapitalised, increasing risk and lowering performance

• Portfolio diversification becomes less attractive• Firm becomes overcapitalised, increasing risk and lowering performance

Manage succession

Manage succession

• Harder to import talented outside managers• Harder to remove disgruntled or superfluous family shareholders and employees• Lack of alternative employment and increasing number of family employees worsens infighting over succession

• Harder to import talented outside managers• Harder to remove disgruntled or superfluous family shareholders and employees• Lack of alternative employment and increasing number of family employees worsens infighting over succession

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If governance is poor, potential investors will discount the firm’s returns more steeply If governance is poor, potential investors will discount the firm’s returns more steeply

Source: OECD Analysis

Net Present Value of Cash Flows (“Intrinsic Value”)

Investors’ Confidence in Ability to Determine and Enjoy Cash Flows•Political risk•Corporate Governance Risk

XExtrinsic Value

Effect of Governance on a Firm’s Extrinsic Value

• Extrinsic value is less than intrinsic value

• Extrinsic value is less than intrinsic value

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This discounting reduces access to capital This discounting reduces access to capital

40

53

59

79

Avg. Ruleof Law

Best inClass Rule

of Law

High Dir.Account.

Mandatory1 Share 1

Vote

Effect of Governance on Access to Capital, 49-Country SurveyPercent of GNP

* Private sector bank debt plus outstanding non-financial bondsSource: Rafael La Porta, et. al., “Legal Determinants of External Finance,” The Journal of Finance, Vol. LII, No. 3, July 1997, pp. 1131-1150

Market Capitalization of Minority Equity Percent of GNP

• Firms in countries with poor governance must finance operations and growth internally to a much greater degree

• Firms in countries with poor governance must finance operations and growth internally to a much greater degree

Value of Debt* Percent of GNP

59

79

Avg. Ruleof Law

Best inClass Rule

of Law

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Without good governance, portfolio diversification becomes less attractive...Without good governance, portfolio diversification becomes less attractive...

Source: OECD Analysis

Operational v. Portfolio Diversification

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Co. 1

Bus 1 Bus 2 Bus 3

SH

Co. 1

Bus 2 Bus 3

Co. 2 Co. 3

Bus 1

Operational Diversification (“Conglomerate”) Portfolio Diversification

• Owners discount investment opportunities in other people’s companies just as other people discount investments in the owners’ company• Owners need not apply corporate governance discounts on returns from businesses they control and manage

ActivePassive

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Discounts on outside diversification opportunities also encourage family-business owners to invest more capital in their firms than they otherwise should

Discounts on outside diversification opportunities also encourage family-business owners to invest more capital in their firms than they otherwise should

Source: Bhattacharya and Ravikumar,

Capital Invested at Time of Sale

Intrinsic return from offer to buy firm

Capital Invested

Return on Invested Capital

• The extrinsic value of returns from offers to buy the family firm is less than their intrinsic value•Sale of part or all of firm is delayed and the family continues to invest capital in the firm as marginal returns diminish, impeding both performance and risk management

• The extrinsic value of returns from offers to buy the family firm is less than their intrinsic value•Sale of part or all of firm is delayed and the family continues to invest capital in the firm as marginal returns diminish, impeding both performance and risk management

Extrinsic return from offer to buy firm

Over-investment

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Poor governance also hinders succession by nurturing an insider-only culturePoor governance also hinders succession by nurturing an insider-only culture

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1

2

3

4

5

6

7

0 10 20 30 40 50 60

* T test is 5.2, based on limited data setSource: Sue Birley, Entrepreneurship: Theory and Practice, December 22, 2001, Vol 26, No. 2, pp. 63; Transparency International.

R2=0.76*

Correlation of Insider-only Culture and Poor Public Governance, Select European Countries

/Preliminary Data/

• Firms in insider-only cultures are less willing to bring in talented outsiders• Family members (talented or not) are less likely to find employment outside the family firm •Lack of outside job opportunities pressures owners to maintain and expand the firm as a source of family

employment

• Firms in insider-only cultures are less willing to bring in talented outsiders• Family members (talented or not) are less likely to find employment outside the family firm •Lack of outside job opportunities pressures owners to maintain and expand the firm as a source of family

employment

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Over time, the rising complexity of succession necessitates either formal governance mechanisms or takeover of the business by one branch of the family, with possible expropriation of the other branches’ wealth

Over time, the rising complexity of succession necessitates either formal governance mechanisms or takeover of the business by one branch of the family, with possible expropriation of the other branches’ wealth

Source: Paul Westhead and Carole Howorth, “A Comparison of Ownership and Management Practices in First and Multi-Generational Family Firms,” 24th ISBA National Small Firms Conference, 2001

Succession in Family-Run Firms

First Generation

Second Generation

Third Generation

Controlling Owner

Sibling Partnership

Cousin Consortium

Simple

Complex

Evolutio

nary

Success

ion

Devolutionary

Succession

• Good corporate governance becomes necessary to run the business and to preserve family harmony

• Good corporate governance becomes necessary to run the business and to preserve family harmony

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ChallengeChallenge

Promoting good governance will therefore better enable family-business owners to meet and overcome the challenges for long-term successPromoting good governance will therefore better enable family-business owners to meet and overcome the challenges for long-term success

Benefits of Good Governance

Source: OECD Analysis

EffectEffect

Access CapitalAccess Capital

• Easier to start firm• Easier to grow firm• Easier to sell firm

• Easier to start firm• Easier to grow firm• Easier to sell firm

Diversify wealthDiversify wealth• Firm functions with optimal capital• Portfolio diversification becomes more attractive

• Firm functions with optimal capital• Portfolio diversification becomes more attractive

Manage succession

Manage succession

• Easier to import talented outsiders• Easier to remove disgruntled or superfluous family members• Exit and cash out options reduce infighting over succession

• Easier to import talented outsiders• Easier to remove disgruntled or superfluous family members• Exit and cash out options reduce infighting over succession