Family firms and their nonfamily investors

Firms have multiple stakeholders whose interests are often in conflict. Some of the most important conflicts are:

-        Conflicts between shareholders and managers (also known as the first or the vertical agency problem);

-        Conflicts between majority and minority shareholders (also known as the second or the horizontal agency problem);

-        Conflicts between shareholders and debt holders (also known as the third agency problem).

The first agency problem is most prevalent in firms with dispersed ownership. Family firms have large shareholders with the power and incentives to monitor the management of the firm, so the first agency problem is less of an issue. Indeed, the CEO of the family firm is often a family member, ensuring that the interests of the  CEO and the family owner(s) are highly aligned. 

Evidence suggests that the third agency problem may also be less important in family firms. Because the controlling family is usually a long-term owner committed to the survival of the firm and has the bulk of its wealth tied up in the firm, family owners have less incentives to take excessive risk, which in turns lowers the cost of debt finance.

In contrast, family firms have a larger potential for conflicts between majority  (family) and minority shareholders. For example, majority shareholders may appropriate free cash flow produced by the firm ( tunneling) rather than paying it out as dividends and sharing with other owners. The temptation to do so may be larger if the majority shareholder owns a relatively small share of equity, and consequently receives only a small share of the dividends. If external investors believe family owners are likely to behave self-interested in economic affairs, they are likely to require a discount to purchase the shares of the family firm. 

Evidence suggests that family owners can reduce external investors' fears that they diverge cash flow from the firm by building a reputation for being a consistent dividend payer. 

A CCGR study of Norwegian firms finds that firms where the controlling owners' equity stake is lower – and the temptation to extract private benefits is therefore higher – pay higher dividends:

This result suggests that controlling shareholders try to build a reputation for treating minority investors fairly. The study also finds that a high dividend payout is linked to a higher probability of raising capital from outside investors, which indicates the good reputation is indeed useful.

A subsequent study shows that when the Norwegian 2006 dividend tax reform significantly increased the cost of paying dividends, it was the firms with the highest potential for conflicts between majority and minority shareholders that decreased their dividend payout the least.