Strategic Succession in Family Businesses: Evidences from Bio-energy companies in Brazil Fabio Matuoka Mizumoto Professor at Fundação Getúlio Vargas EESP fabio.mizumoto@fgv.br Matheus Kfouri Marino Professor at Fundação Getúlio Vargas EESP matheus.marino@fgv.br Introduction Family business succession is a recurrent topic of research. Previous studies investigated the reasons for succession failure (Handler, 1990; Zahra & Sharma, 2004); proposed succession patterns relative to the required changes in strategy, organization and governance (Le Breton-Miller et al, 2004; Miller et al, 2006); and discussed the particularities of agency relationship on a family business succession process (Chua et al, 2003; Villalonga & Amit, 2006). We tackled the succession topic in a different angle in this paper. It is proposed the investigation of two discrete alternatives of succession by means of ownership and management succession. One alternative is to split both the ownership and the management of the current business to the heirs. The other alternative is to keep the current business united with shared ownership and management among the heirs. We rely on the literature of agency theory (Berle & Means, 1932; Jensen & Meckling, 1976) and on transaction cost economics (Coase, 1991; Williamson, 1985, 1999) to draw conjectures about potential advantages of each alternative. Considering the two alternatives, we investigated the family s decision trade-off and its impact to the business. For instance, splitting both the ownership and the management of the current business might reduce the costs to align and converge the interests among the representatives of the next generation. Thus, each of the heirs will have the decision rights and the residual claims (Fama & Jensen, 1983), ameliorating the potential conflicts that lead to the succession failure (Handler, 1990; Zahra & Sharma, 2004). Although this alternative ameliorates the potential conflict at the family system (Davis & Tagiuri, 1982), the separation of the current business may impose additional challenges to the business; for instance, the reduction of bargain power in the relationship to suppliers and to clients, and the increase of transaction costs (Coase, 1991; Williamson, 1985, 1999).
Alternatively, the family decides to share the ownership and the management among the heirs without splitting the business. In fact, this alternative preserves the bargain power and might reduce the transaction costs that benefit the business system (Davis & Tagiuris, 1982). Even thought families are favored by a reduced agency costs compared to nonfamily businesses (Chua et al, 2003), this alternative will impose convergence costs among the heirs. In fact, Villalonga & Amit (2006) argued that family businesses manage a higher agency cost in the relationship among shareholders (which they called type II) than the cost to align the interests between agent and principal (the classical agency cost they called type I). We are aware that our investigated alternatives are not comprehensive to fit all succession cases. Indeed, we focused on two discrete alternatives to shed light on agency costs and transaction costs trade-offs. This paper is organized in five sections, beginning with this introduction. The second section presents the Brazilian bio-energy industry and discusses the reasons why it is an appropriate context to derive our conjectures. A theoretical reference is presented at section three. The following section provides further discussions that precede the final section of concluding remarks. Family businesses in Brazilian bio-energy industry The bio-energy companies are largely family businesses in Brazil. Most of the companies have already faced at least one generational succession and some of them are preparing the third generation. We investigated the modes by which the companies had conducted the succession processes in order to share ownership and to align divergent interests. This is especially relevant in this context because the bioenergy industry is under consolidation pressure. We observed family companies becoming bigger by acquiring other family companies. Moreover, we identified foreign investors acquiring family companies to anticipate gains from the increasing market for bio-energy. Market experts estimate that the value of all 300 Brazilian bio-energy companies may reach up to 70 billion US-dollars. This value seems a large amount of investment but not for the petro-chemical companies. In fact, petro-chemical and trading companies are investors in bio-energy industry. There is room for consolidation in this sector, considering that the largest company in Brazil accounts for about 10% of the market share. Figure 1 Bio-energy (partial) value chain 1 - Agricultural Input Industry 2 - Farm 3 - Ethanol and Sugar Mill Industry Most of the companies were founded by mid-70s encouraged by government programs to develop the production of ethanol from sugar cane and later on by 2
initiatives to support the production of sugar. The common line among all the traditional bio-energy companies is that the founders were farmers. In fact, the families usually manage both businesses (see figure 1): the farming business and the ethanol / sugar business. There is a strategic reasoning for the vertical integration (the same firm develop the farming and milling activities). The viability of sugar cane production depends on the proximity to the mill and vice-versa. Due to the low value of the sugar cane, the transport is economically worth within a 20-50 kilometers perimeter. Thus, the succession process includes the ownership and management dimension to both businesses. Theoretical References The discussion on the firm s strategy to economize on the transaction costs began with Coase s (1937) seminal work, The Nature of the Firm. Williamson (1985) developed a theory to predict the efficient governance structure owing to the characteristics of specificity, frequency, and uncertainty involved in the transaction. In this sense, transaction-cost economics predicts the adoption of contractual arrangements in the presence of idiosyncratic investments (Williamson, 1985) to avoid quasi-rent appropriation (Klein et al, 1978). Alternatively, a firm may vertically integrate the upward or downward relationship instead of managing a contract with the supplier or buyer. The decision scope in the transaction-cost perspective relates to answer the make or buy question. While Williamson (1985) approach on transaction-cost economics emphasized the firm relationship with other stakeholders in the value chain, other scholars focused the internal costs of a firm. These costs emerge when defining the property rights in the firm that leads to disputes over residual claims and decision control (Fama & Jensen, 1983). In this case, several problems may emerge. A free rider problem emerges when someone take private advantages from a resource obtained by the efforts or costs paid by others. In the presence of a central authority managing a wide range of activities, the decision maker is exposed to influence and lobby activities (Milgrom & Roberts, 1992), both are sources of costs to the firm. A control problem (Jensen & Meckling, 1976) emerges when trying to converge the interests of the shareholders (principal) with the management (agent). The decision scope in the agency-cost perspective relates to how to avoid the problems that generate internal costs. To what extend the family contributes to the business was studied to North American listed-companies by Villalonga & Amit (2006). Additional to the classic owner - manager Agency Problem (type I agency cost), they address a second agency problem that may arise commonly in family business. It happens when the owner take advantage of accumulating the manager role to expropriate value from the other shareholders (type II agency cost). Even thought, according to their findings, family ownership consistently creates value when the founder is the CEO or when it is the president of the Board of Directors with a hired CEO. Discussion 3
We grounded on agency theory and transaction cost economics as our analytical framework. The investigation of internal costs to align divergent interests between shareholders and the management team was supported by agency theory. The analysis of costs to identify, to negotiate and to enforce an agreement or contract was supported by transaction cost economics. Alternative 1 Sharing the ownership and management The succession process in the first case was conducted in order to share the equity of both farming and milling businesses in similar shares. Considering the transition from one founder to four heirs, each of the heir received 25% of the farm and 25% of the mill, as indicated in figure 2. Remember the strategic reasoning for the vertical integration discussed in figure 1, the viability of sugar cane production depends on the proximity to the mill and vice-versa. In this alternative, the supply of sugar cane for the mill is guaranteed because the business continued to vertically integrate the farming activity. We observed lower transaction costs in the supply relationship in this case, considering that the profit from both businesses was shared at the same ratio among the heirs. Moreover, this alternative ameliorates the disputes for pricing the sugar cane that commonly emerges when the mill pressures to lower the price of its raw material while the farms defends a higher prince for the sugar cane. Figure 2 Alternative 1: Sharing the ownership and management First Generation Second Generation Farm Heir 4 Heir 1 Mill!"#$% Heir 1,2,3,4 Heir 3 Heir 2 However, a company that follows this alternative may experience higher agency costs to align the interest among the shareholders (Villalonga & Amit, 2006, type II agency cost). If the alignment of interests among the shareholders became time consuming, a company in the context of bio-energy may lose investment opportunities or even face difficulties to access financial credit. 4
Considering the free rider problem, all heirs are exposed to this type of problem and, indeed, all heirs may behave as free riders. Although the company may establish control mechanisms to prevent the free rider problem, all of them are costly. What would guarantee that the individual performance is correctly captured by the control mechanisms? How the company can assure that the heirs are not shirking on the job? Even if the company identify who is the free rider family member, what could be done? Considering the influence problem, it is worth to note that the founder of the business is the most exposed family member to the lobby activities from the heirs. In fact, each heir will induce the founder to choose the succession alternative that best fit with his / her private interests. If one of the heirs centralize the decision rights, he / she may experience the influence problem. To what extend the heir with decision rights would be influenced by his brother s particular interest? What mechanisms would prevent the influence costs? Considering the control problem, there are widely used mechanisms to align the interests among the shareholders. However, most of them were developed for publicly held companies on which the market disciplines the decisions by signaling an evaluation or depreciation on the value of the shares. When sharing the ownership and management, the heirs are exposed to conflicts over investment decisions, dividends, and priorities, for instance. What mechanisms should the company develops to prevent the control mechanisms in a privately held business? How the family business expects to share the residual claims in the absence of the founder of the business? Alternative 2 Splitting the farming and milling activities The succession process in the second alternative was conducted in order to keep the mill owned and managed by one of the heirs. Considering the transition from one founder to four heirs, three of them received the farms and the other received the mill, as indicated in figure 3. Figure 3 Alternative 2: splitting the farming and milling activities First Generation Second Generation Farm Mill!"#$% Heir 3 Heir 4 Heir 1 Heir 2 5
In this case each of the heir will conduct its own business, thus, the heirs avoid the free rider, influence and control problems. The relationship with others heirs will be a commercial one, not a shareholder relationship. This change the need for internal controls once the allocation of property rights is fully understandable. For instance, if one of the heirs shirks and the sugar cane productivity decreases, the profit losses will not be shared with the others. In fact, this alternative promotes the individual efficiency. However, by splitting the business, the heirs will experience transaction costs to identify, to negotiate and to enforce an agreement or contract. The owner of the mill will have to negotiate the supply of sugar cane with each of the farmers. What will be the reasonable price for the sugar cane? In this case, the profitability of the mill depends on the lowest price paid on sugar cane supply. Moreover one heir will accumulate the mill profit. In fact, the mill does not concentrate the bargain power in negotiation with suppliers. It may happen that one of the farmers substitute the sugar cane production for a different crop. This threat disciplines the mill that depends on regional (short distance) suppliers. This fact reinforces the increased transaction costs between farmers and miller that occurs in alternative 2. Concluding remarks The discussion of two discrete alternatives for ownership and management succession for family business provided contributions and insights for this field. There are important agency costs and transaction costs trade-offs illustrated in the context of Brazilian bio-energy industry. The transaction cost economics, agency costs and related free rider problem, influence problem and control problem were widely investigated for corporations, cooperatives and private companies. Indeed, the developed mechanisms to ameliorate these costs and problems may be applicable to family business. In this paper, we addressed how the concerns with agency costs and transaction costs influence the succession path that a family business may chose. Although our contribution grounds on agency costs and transactions costs trade-offs, we are aware that emotional dimensions (Astrachan, J.H. & Jaskiewicz, P., 2008; Labaki et al, 2010) play an important role at the succession arena. Moreover, families may differ on cohesion (Pieper & Klein, 2007) that imposes different changes to the business strategy, organization and governance (Miller et al, 2006). Still, our contributions to the field of succession are focused on the incentives to discipline the behavior of family members by economic reasoning. Sharing the ownership and management of the family business make the heirs less willing to bargain for profit between the business units because they share the residuals of the business. Alternatively, the family business may split the business among the heirs, 6
creating incentives for individual performance that prevents the free rider problem, the influence costs and the control problem. The appropriate solution is contingent to the context of the family business. We may expect that in some cases splitting the business is not an alternative because it would not be possible or not economically viable. Indeed, the appropriate solution will take into account the emotional dimensions of each family business. Thus, we claim for future researches that integrate behavior assumptions of both economic and emotional perspectives. 7
References Astrachan, J.H.; Jaskiewicz, P. (2008). Emotional returns and emotional costs in privately held family businesses: advancing traditional business valuation. Family Business Review, 21 (2), 139-149p. Berle, A.; Means, G. (1932). The modern corporation and private property. New York: MacMillan. Chua, J.; Chrisman, J.; Sharma, P. (2003). Succession and nonsuccession concerns of family firms and agency relationships with nonfamily managers. Family Business Review, 16 (2), 89-107. Coase, Ronald H. (1991). The nature of the firm, Economica N.S. p. 386-405. 1937 In: Williamson, Oliver E.; Winter, S. (Org) The Nature of the Firm: Origins, Evolution, Development, New York: Oxford University Press. p. 18-33. Davis, J. A.; Tagiuri, R. Bivalent attributes of the family firm. Owner Managed Business Institute. Santa Barbara-CA, 1982. Fama, E.; Jensen, E. (1983). Separation of ownership and control. Journal of Law and Economics, 26, pp. 301-325. Handler, W. (1990). Succession in family business. Entrepreneurship Theory and Practice. 15 (1), 37-51. Jensen, M. W.; Meckling, W. (1976). Theory of the firm: managerial behavior, agency costs, and capital structure, Journal of Financial Economics, 3, pp. 305-360. Klein, B.; Crawford, R. G.; Alchian, A. A. (1978). Vertical integration, appropriable rents, and the competitive contracting process. Journal of Law and Economics. 21 (2). October, 297-326p. Le Breton-Miller, I.; Miller, D.; Steier, L. (2004). Toward and integrative model of effective FOB succession. Entrepreneurship Theory and Practice (summer), 305-328p. Miller, D.; Steier, L.; Le Breton-Miller, I. (2006). Lost in time: intergenerational succession, change and failure in family business. In: Poutziouris, P.; Smyrnios K,; Klein, S. (2006) Handbook of Research on Family Business. 1 ed. Edward Elgar. 371-387p. Milgrom, P.; Roberts, J. (1992). Economics, Organization and Management. Prenctice Hall: New Jersey. Pieper, T.M.; Klein, S.B. (2007). The Bulleye: a systems approach to modeling family firms. Family Business Review, 20 (4), 301-319p. Zahra, S.; Sharma, P. (2004). Family business research: a strategic reflection. Family Business Review. 17 (4), 331-346. 8
Villalonga, B. Amit, R. (2006). How Do Family Ownership, Control, and Management Affect Firm Value? Journal of Financial Economics. 80 (2), 385-417p. Williamson, O. E. (1985). The economic institutions of capitalism, New York: The Free Press. Williamson, O. E. (1999). Strategy research: governance and competence perspectives, Strategic Management Journal, 20 (12), 1087-1108. 9