Family businesses are all around us: the local pizza-shop on the corner, the auto dealership, the small local newspaper or your web-domain provider. They are all most likely run and owned by the founder or a small group of people – often a family. These owners have a real passion for their business and are not afraid of working outside normal office hours – they are not working for the paycheck. I prefer to call such companies owner-managed or owner-operated: they both own and manage the business at the same time. To avoid the agent-principal conflict, I believe it makes sense for outside investors to invest alongside owner-managers/operators. A lot of empirical evidence points toward outperformance for this group among public companies.
Perhaps surprisingly, plenty of public companies can be labelled as either owner-or family-managed. Let me give you a list of random companies that fit this category: Google/Alphabet, Facebook, Berkshire Hathaway, Wal-Mart, L’Oreal, Investor AB, Samsung Electronics, Oracle, BMW, Nike, FedEx, Lukoil, Comcast, Brookfield Asset Management, Constellation software, O’Reilly Automotive, Credit Acceptance Corp to name a few. According to McKinsey, 33% of the companies in S&P 500 are defined as family businesses, while 40% of the 250 biggest in France. I have no numbers from Germany, but I expect a higher percentage. This is great news! “Outside” investors thus have plenty opportunities to invest alongside successful owner-managers.
Skin in the game
Never ask anyone for their opinion, forecast, or recommendation. Just ask them what they have – or don’t have – in their portfolio… I find it profoundly unethical to talk without doing, without exposure to harm, without having one’s skin in the game, without having something at risk. You express your opinion; it can hurt others (who rely on it), yet you incur no liability. Is this fair?
– Antifragile, by Nassim Nicholas Taleb
The phrase skin in the game is made popular by Nassim Nicholas Taleb’s book by the same name. In the introduction Taleb writes that skin in the game implies symmetry in human affairs, that is, fairness, justice, responsibility, and reciprocity. If you have the rewards, you must also get some of the risks, not let others pay the price of your mistakes. The concept of skin in the game is essential to understand the world. If a well-paid CEO with insignificant ownership makes a blunder, he risks no financial loss while an owner-manager would. The real risk takers are the owners and you want to make sure the managers face the same risks as you do. This lack of symmetry is called the Agency problem:
The Agency problem
The conflict of interest between the owners and the managers is both well known, understood and covered in numerous books, periodicals and journals. The agent (manager) is expected to act in the interests of the owners (the principal), at least in theory, but in practice the interests of the agent often deviate substantially from the principal because of several reasons, something I’ll come back to in a later article. Many methods exist to align the agent and the principal, such as stock based options and long-term performance compensation. But the bottom line is this: the best way to minimize the agent-principal conflict is to have the agent owning outright a significant stake of the business. This is simply the best alignment you can have.
In a successful enterprise all parties need to work well together: a structure that keeps everyone aligned for the long-term. Peter Thiel writes about this in From Zero to One:
- Ownership: who legally owns a company?
- Possession: who runs the company from day to day?
- Control: who governs the company’s affairs?
For example, the CEO of Coca-Cola might own just a trivial part of the company, but exert a tremendous amount of “possession”. This might give him or her incentives to focus on short-term results to the detriment of long-term focus, even if he receives stock compensation. To cut costs might be a better option than to invest large sums that might pay off in ten years, and in that time he might have been fired anyway. Thus, his incentive is to maximize his salary as much as he can in the shortest amount of time. The board is supposed to govern together with the annual general meeting, but in practice this is far from reality.
This is the reason why many investors, including me, prefer to invest in companies where the manager owns a real stake of the business. At the end of the day this is the only way to make sure all parties have skin in the game.
Owner-managers outperform the market
There is a lot of evidence indicating that owner-managers have performed much better than the market (as a group):
Rüdiger Fahlenbach (2009) concluded that eleven percent of the largest publicly traded US firms are headed by a CEO that founded the firm. These CEO-led firms differ in the sense that they spend more on R&D, have higher CAPEX, and make more accretive M&As. This results in a significantly better performance than agent-CEO companies: 4.4% higher annual return compared to the benchmark from 1993 to 2002.
In a more recent study Cox and Shulman concluded that the performance of entrepreneur-managed companies from 2005 until 2011 performed substantially better than used benchmarks such as Russell 2000 and S&P 500. The results are confirmed by Horizon Kinetics Wealth Index from 1990 to 2011:
Source: Horizon Kinetics.
The most recent study, to my knowledge, is Credit-Suisse’s from September 2017, where they found family-owned companies to perform 5% better annually than other companies from 2006 until 2017. I have covered this study in an article on Seeking Alpha in 2019.
The above research is of course just based on averages and generalizations. Among the owner-managers there are many poorly managed and governed companies. A large owner or family is of course no guarantee of responsible ownership as there are plenty of cases where infighting between a family has torn a great company apart. Due diligence is required!
Governance among owner-managers
The agency problem could also be labelled as a governance problem. In a structure where most of the shareholders are passive, even the big institutions are most of the time passive, and where board members have insignificant ownership, the CEO and managers exert huge power. This is less likely to happen in an owner-operated business: they hand pick board members to avoid the agent-principal issue. 39% of the board members of family businesses are inside directors including 20% who belong to the family, compared with 23% in non-family companies, according to this study.
They might face challenges in attracting and retaining competent board members because the latter fear the decisions are made more informally (within the family) than formally. However, this might be offset by loyalty, an attribute highly regarded by an owner.
Lower Remuneration and compensation
“Last year I asked the board to reduce my salary to zero and to lower my bonus factor. CSI had a great year, so despite those modifications, my total compensation actually increased. This year I’ll take no salary, no incentive compensation, and I am no longer charging any expenses to the company.”
Most owner-managers work for the love of their work, not for the money. They expect their ownership stake to generate most if not all of their wealth. Opposite, a hired CEO works for the paycheck or the potential wealth from whatever incentives the board has given. An owner has passion, and treats the job more like a lifestyle. Many of them have wealth, which has provided them with f***-off money to pursue whatever interests they have. But they still choose to work long hours. Furthermore, many of them continue to work well beyond retirement age, just like Warren Buffett, who is still working full time in his 90th year. Another example, Trygve Hegnar, 76 years old and the owner of a newspaper and financial magazine in Norway, still writes for the daily newspaper six times a week, all year round. He has never missed one day for over 30 years. You’ll never see a hired editor do the same.
In Zero To One Peter Thiel argues that a start-up company does better the less it pays the CEO. Thiel mentions Aaron Levie that paid himself a lower salary than everyone else in the company – four years after he started Box. Every employee noticed his obvious commitment to the company’s mission and emulated it – Levie’s pay set the standard for everyone else. Levie would obviously not do this if he didn’t own a significant share of the company. This shows the power of owner-managers and leading by example.
Evidence shows most owner-managers don’t reward themselves with extravagant pay packages like a third party manager would do. Over the long-term this attitude compounds as this mentality trickles down in the organization and ultimately could result in a potential cost advantage. A serious owner leads by example.
Marshmallow CEOs: Long-term focus
Delaying gratification is a process of scheduling the pain and pleasure of life in such a way as to enhance the pleasure by meeting and experiencing the pain first and getting it over with. It is the only decent way to live.
– The Road Less Travelled, by Scott Peck
I guess you have read about the Marshmallow experiment? An American psychologist tested the ability of four-year old children to delay gratification. Just like children are bad at delaying gratification, the agent-principal problem makes managers with no skin in the game prone to instant gratification. The stock market is full of marshmallow CEOs. Perhaps even worse, there are plenty of shareholders who want these marshmallow CEOs, perhaps looking for “catalysts or triggers”. I prefer to invest in companies where the CEO has the ability to wait for the second marshmallow, in other words to wait for a long-term project to reap its full potential. I tend to think that this is most likely to happen where there is an owner-manager. When a founder or family spend all their life building a business, a long-term orientation tends to cover all areas of the business: customer relationships, product lines, investments, R&D, CAPEX, customer service, employees and salaries/compensations.
Owner-managers attract better shareholders
A respected investor told me, “You end up with the shareholders you deserve”. I’m hoping that’s true (2011 letter)…… It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell (2013 letter).
-Mark Leonard, CEO of Constellation Software
According to Harvard Business Review the average holding period for a publicly traded equity was about seven years in the 1950s, while it’s now around six months. Quite a difference! Furthermore, in the 1950s households owned about 90% of the shares of US Corporations, but today institutions own over 65% of public companies.
Owner-managers attract a different type of shareholders who understand long-term thinking and are not attracted to “coupon” investments (dividend stocks, for example), short-term catalysts, turnarounds or triggers. Warren Buffett has spent all his life “educating” his shareholders, and there is a reason for this: good shareholders are an integral part of how management can complete long-term projects that might take a decade to pan out. Without such a shareholder base, management stands no chance to make long-term investments. How management communicates this is of great importance because in most stocks the investors don’t know if there are going to be any future marshmallows: better with one bird in the hand than two in the bush. Shareholder groups put enormous pressure on both management and board, hence a CEO should better focus on attracting shareholders with this mindset and expectations.
An owner-manager manages his own money
I think it’s safe to say that most people are more careless with other people’s money than their own, just like Adam Smith wrote in The Wealth of Nations. Most people are simply more frugal with their own money than someone else’s. The economist and thinker Milton Friedman set up this matrix in Free to Choose:
|On Whom Spent|
|Whose Money||You||Someone Else|
Category 1 is you spending your money on yourself, which obviously give both incentives to be cautious on spending and how to spend it. Category 4 is the worst: Someone else is spending money on somebody else, which gives no incentives to curb spending or pay attention to how it’s spent (typical of taxpayer’s money). An owner-manager can be put in category 1 or 2, while an agent-CEO belongs to 3 and 4.
A unique founder can make authoritative decisions, inspire strong personal loyalty, and plan ahead for decades. Paradoxically, impersonal bureaucracies staffed by trained professionals can last longer than any lifetime, but they usually act with short time horizons.
– From Zero To One, by Peter Thiel
A founder and owner-manager is not setting up a business to pull strings in a bureaucratic organization. On the contrary, they want to have an innovative and decentralized structure that focuses on producing good products and services. Berkshire Hathaway is an obvious example where Buffett lets his managers operate completely on their own. An agent-CEO is much less likely to accept such a structure.
Never cross a river if it is on average four feet deep.
–Skin In The Game, by Nassim Nicholas Taleb
Family companies take on less debt than corporate peers. This might lead to underperformance in strong economic expansions, but much better performance during recessions. They are not trying to be smart by optimizing the capital structure, but rather focus on survival. Sequence matters, and there is always the presence of ruin. It does not matter how many good years a business has: if there is just one zero in the return sequence, you will end up with nothing. Taleb writes that cost-benefit analysis is flawed because there is always the possibility of ruin. If ruin is present, it might not matter if the cost-benefit is positive. If there is a 1% chance of crashing a plane we will eventually end up with no pilots left. Owner-managers understand this very well and want to err on the safe side. Why? Simply because they have skin in the game.
Access to capital
Owner-managers with a successful long-term track record are more likely to get favorable access to capital compared to agent-managed companies because of their long-term focus and lower financial leverage. According to McKinsey, family companies have lower cost of debt than corporate peers.
Owner-managers perform more rational M&A
Mergers & acquisitions have proven to be a possible minefield for the acquirer as evidence indicates underperformance due to lack of synergies and clash of cultures. Family-influenced businesses tend to be prudent when they do M&A, making smaller but more value-creating deals than their corporate counterparts. According to McKinsey, the average deal of a family business was 15% lower than corporate peers both in EU and USA in a survey done between 2000 and 2009. Agent-CEOs might have incentives to build empires and get bigger, while owner-managers focus on profitability and prudence, thus they focus on price and quite likely turn down a deal if they see it as a risky bet.
This study shows that companies with a high shareholder turnover perform badly in M&A, hence resulting in underperformance and poor results for shareholders. History shows the most intense M&A activity takes place at the end of an economic expansion when earning multiples are the highest. Owner-managers often do the opposite: they wait until prices are correct. Mark Leonard in Constellation Software writes in his letters that their most attractive acquisitions have happened during recessions. He admits that their corporate and PE divestitures are both larger than their founder businesses and more of a cultural challenge post-acquisition.
A long-term owner develops a lot of knowledge about their industry. As an example, look to what happened to Credit Acceptance Corp at the end of the 1990s: They did a lot of mistakes and subsequently experienced poor operational performance. But management learnt from their mistakes, improved their understanding of the market and the industry, and since then the same owner-managers have managed to make this an incredibly profitable business. With high management turnover this might be unachievable.
We nearly always promote from within because mutual trust and loyalty take years to build, and conversely, newly hired smart and/or manipulative mercenaries can take years to identify and root out.
– Mark Leonard, 2011 shareholder letter
The quote from Mark Leonard says it all. Berkshire Hathaway is a perfect example of succession planning because Buffett for a long time has made plans should something happen to him. Owner-managers plan ahead for years to make sure the company remains in the right hands.
Better in allocating capital
A company has five ways to allocate capital:
- Reinvest in the business.
- Pay down debt.
- Pay a dividend.
- Buy back shares.
Over time allocating decisions play a significant part of the compounding abilities of a stock. There is of course no general conclusion where the capital is of best use because this depends on company specific circumstances. However, an agent-CEO has more incentives to switch to allocations that enhances his compensation and not the return on assets.
In William Thorndike’s The Outsiders, a book that goes through eight excellent capital allocators, all CEOs are owner-managers. That could of course be a coincidence, but most likely not. They are not afraid of going against the current trends, which often means cancelling buybacks at high earning multiples and wait for better prices. The statistics reveal that most companies buy back shares during economic expansions, less in recessions, and this is often to the detriment of value creation.
Owner-managers are investment agnostics and do what makes sense given the circumstances. They are cautious to diversify, and prefer to focus on their core products and services. If something does not make sense, they don’t do it. Plain and simple. As Thorndike concluded: the successful CEOs think more like investors than managers.
Owner-managers might be valued at a discount
When the free float of shares is low, it might lead to a discount or perhaps bigger short-term volatility, or even both. Analysts and brokers often argue that a large and controlling shareholder is negative, and the company need some kind of “catalyst” to release “shareholder values”. However, for a long-term or perpetual owner this is great news: Mr. Market is our servant and we want to exploit the opportunities thrown at us. If a company trades at a discount, this means you get more “bang for your buck” by buying stocks with lower multiples.
A wider purpose than making money
Finally, most owner-managers have a much bigger purpose than just making money. Many family-companies started for example in a small or rural place and feel an obligation to give something back. Thus, they have a higher vision than just making money, which often is a good thing. Many of them can increase prices and make more money, but this can of course jeopardize the brand and long-term profits. They don’t focus on what they “could”, but what they “should”. Costco is a perfect example where the main goal is to serve their members by selling the products at practically no mark-up, and focus on their membership fees as the primary revenue and income (I wrote about Costco in 2019). Likewise, Jeff Bezos in Amazon is guided by the customer experience. At the end of the day that will lead to profits.
 Rüdiger Fahlenbach: Founder CEOs, Investment Decisions, and Stock Performance (2009), Journal of Quantitative Analysis.
 Raymond Cox and Joel Shulman (2011): The Investment Returns of International Entrepreneurs.