family firm executice compensation

Promotion Incentives and Executive Compensation in Family Firms

Thomas BatesRichard Ivey School Of Business

University of Western OntarioLondon, Ontario, N6A3K7

[email protected]

Tomas JandikKatz Graduate School of Business

University of PittsburghPittsburgh, PA, 15260

[email protected]

Kenneth LehnKatz Graduate School of Business

University of PittsburghPittsburgh, PA, 15260

[email protected]

March 2000

Submitted to the research conference jointly sponsored byTuck’s Center for Corporate Governance

andThe Journal of Financial Economics

at the Tuck School of Business at Dartmouth

July 7-8, 2000

The authors would like to thank Kevin Murphy and seminar participants at the 1999 American EconomicAssociation annual meetings for their comments and suggestions.

Promotion Incentives and Executive Compensation in Family Firms

Abstract

Family firms are the predominant form of business organization throughout the world, yet littleis known about the types of incentive problems these firms face and how they are resolved.This paper examines a particular incentive problem, the dampening of promotion incentives, infamily firms in which children succeed parents as president, chief executive officer, or chairman.The relatively young age of the successor child, combined with the family’s voting control,diminishes the promotion incentives for non-family, senior managers in the firms. This hasimplications for the level and structure of executive compensation in these firms.

As tournament theory predicts, the level of compensation for top officers of family firms issignificantly lower than it is for the corresponding officers in nonfamily firms. Relatedly, theinter-rank spread in compensation levels of top officers and non-family senior managers issignificantly smaller for family firms than it is for nonfamily firms. The results are consistentwith the hypothesis that there is less of a “prize component” in the compensation levels of topofficers of family firms than there is in nonfamily firms that rely more on tournaments as anincentive device.

We also examine whether family firms rely more on incentive compensation for non-familysenior managers as a substitute for diminished promotion incentives. Family firms relysignificantly less on executive stock options than the control firms, presumably because they donot want to dilute the family’s control. Among family firms, however, those with dual classesof common stock rely significantly more on executive stock options, suggesting that low votingstock serves as an important compensation device in family firms. Finally, no significantdifference exists in performance-based cash bonuses paid to senior managers of family versuscontrol firms. Overall, the results show that the level and structure of executive compensation isdifferent for family firms than it is for other firms. To a large degree, however, the ways inwhich family firms resolve their incentive problems remains a puzzle.

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1. Introduction

This paper examines incentive issues for a unique set of firms -- family firms in which

children succeed parents as the firms’ presidents, chief executive officers, or chairmen. Since

children usually ascend to these positions when they are young, and since families control the

firms, children have a long expected tenure as the top officers in these firms. This creates a

potentially thorny incentive problem, since it diminishes the promotion incentives facing senior

managers who are not members of the controlling family.

We focus on how the structure and level of executive compensation in family firms is

affected by the diminished promotion incentives facing non-family executives. Specifically, we

examine two sets of issues. First, these firms provide a unique setting for testing the tournament

theory of executive compensation. Since there is a high ex ante probability that the child will be

selected as the heir apparent to the top position in these family firms, any tournament effectively

ends at the senior vice-president level for the non-family managers of these firms. This leads to

several testable hypotheses under the tournament theory. First, the prize component associated

with the top position in these family firms should be less than it is in other similar, but non-

family, firms. Second, prior to succession, the level of compensation for non-family managers at

the senior vice president level should be higher than that of similar level managers in non-family

firms. Finally, the difference in the level of compensation between top managers and senior VPs

should be lower than it is in other, non-family firms.

The paper also examines the use and form of incentive compensation for senior managers of

family firms. Diminished promotion incentives in family firms suggest that these organizations

should rely more on substitute incentive mechanisms, such as performance sensitive

compensation plans. While a major component of incentive compensation consists of stock

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option grants, the families’ desire to retain control over the firm’s voting rights makes this an

unlikely margin on which compensation is adjusted. It is more likely that an adjustment will

occur on other margins that strengthen incentives without diluting the families’ equity control,

such as cash bonuses, grants of phantom stock, or option grants of non-voting or low voting

shares in firms with dual classes of common stock.

We find significant differences in the level and structure of executive compensation for a

sample of 34 publicly traded family firms versus a control sample of firms matched on size and

industry. First, the difference in total compensation between top managers and their direct

subordinates is significantly lower in family firms as compared with the control firms. Further

investigation reveals that this difference is attributable primarily to significantly lower cash

compensation for top managers, rather than higher compensation of senior, non-family

managers. This result is consistent with the prediction that the prize component of “winning” a

top job in a family firm is lower than it is in other firms.

Second, we find that the proportion of executive compensation accounted for by stock option

grants is significantly lower in family firms than it is in other firms. This result is consistent

with the argument that families are reluctant to grant stock options for fear of diluting the

family’s control. Further support for this argument is found in the fact that stock options are

used substantially more in family firms with two classes of common stock, where the non-family

executives can be granted options on the low voting stock without diluting family control.

Finally, we find that family firms use cash bonuses based on accounting measures of

performance for senior managers, especially those who are not president, CEO, or chairman,

slightly more than the control firms, but this difference is not statistically significant.

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The paper contributes to the literature in several ways. First, it provides additional evidence

on the hierarchical incentives associated with promotion in organizations. The parent-child

succession pattern in our family firms provides a unique setting in which these promotion

incentives are truncated at the senior vice president level, and can be compared to similar firms

that lack such promotion constraints. Second, many of our findings regarding promotion

incentives in family firms can be extended to the more general case of firms run by young CEOs

and/or CEOs with voting control over the firm (e.g., large e-commerce firms with young CEOs

and concentrated ownership). Third, the paper provides evidence on the substitutability of

various forms of incentive compensation and hierarchical incentives. Finally, the paper is among

the first to explore executive compensation issues in family firms, which have received little

attention in the academic literature, despite their predominance as the primary form of business

organization throughout the world.

2. Compensation in family firms: Theory and predictions

2.1 Tournament theory

The tournament theory of executive compensation proposed by Lazear and Rosen (1981) and

Rosen (1986) depicts promotion and wage outcomes as resulting from sequential elimination

tournaments within the firm. Succession in each stage of the tournament guarantees the winner a

predefined compensation contract, where promotion is based on the relative performance of the

competitors at a particular rung of the tournament. The prospect of receiving a promotion to a

more prestigious and higher paying position, and the option associated with further tournament

competition, is presumed to create stronger incentives for lower level managers to perform well

without the necessity of imposing extensive constraints on their behavior. Given finite and

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diminishing succession opportunities, however, managers competing at the higher rungs of an

organization’s tournament attribute a lower value on the option associated with further

competition. At the extreme the option has no value for those who compete in the final

tournament for the firm’s top management position. To provide an incentive for managers to

compete in this final tournament, Rosen (1986) argues that a significant difference exists

between the compensation of top managers and their immediate subordinates. This difference

includes a “prize” which causes compensation to diverge from the marginal product of the top

manager, but also serves to make the final promotion more attractive. Baker, Gibbs, and

Holmstrom (1994) provide a similar framework for hierarchical incentives, where promotions

within the organization are directly linked to increases in pay.

A few previous studies have examined the empirical validity of tournament theory within

firms. For example, Lambert, Larcker, and Weigelt (1993) analyze compensation data for 303

large, publicly traded U.S. industrial firms from 1982-1984. Consistent with tournament theory,

the authors find that the level of total compensation is a convex function of the employee’s

position within the firm’s hierarchy. They further find that even after controlling for the size of

the assets managed, executive compensation remains a positive function of the level of

employment in the organization. O’Reilly, Main, and Crystal (1988), analyzing data from

Business Week’s 1984 executive compensation survey, do not find evidence supporting the

tournament theory. Specifically these authors do not find that the difference in total

compensation between a firm’s CEO and its senior VPs is positively associated with the

competitiveness of the tournament (as proxied by the number of senior VPs).1

1 Tests of tournament theory have also been undertaken in the context of professional sports and individual effort.Ehrenberg and Bognanno (1990) and Becker and Huselid (1992) examine the role of prize money and competitorperformance in the settings of the European Professional Golf Tour and NASCAR racing circuit respectively.

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2.2 Compensation levels

In the family firms under study in this paper, the child is selected at a relatively young

age to lead the firm as president, CEO, or chairman. Combined with the fact that in all cases, the

families own a controlling stake in their firm’s voting equity shares, the expected tenure of the

child in the firm’s top position is quite long. This effectively precludes other senior managers

from landing the top job in these firms. In this case, any tournament in these firms effectively

ends one rung below where it ends in most other firms (i.e. at the senior VP level). Since, as a

practical matter there is no tournament for the top position in the family firm, there is little need

for a prize component to be embedded in the compensation of the firm’s top officer. As a result,

we predict that if tournament theory accurately depicts wage and promotion outcomes within the

firm, compensation of the top officers of family run firms should be lower than the compensation

received by the top officers in a matched sample of non-family firms.

A second prediction involves the compensation of senior managers one rung below the top

officers. Since these senior management positions are likely to represent the final round of the

tournament in family firms, the prize component embedded in the compensation of these

managers is expected to be higher than for their counterparts in non-family firms. In addition,

the senior managers of family firms must be compensated for the lack of promotion opportunity.

Otherwise, in equilibrium their services would be bid away by other firms that do offer an

additional “prize” for promotion to the firm’s top management position. Therefore, our second

prediction is that the level of compensation of senior managers, one rung below the top position,

is higher in family firms than it is in other firms.

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Finally, a third prediction emerges from the first two. Since the level of compensation is

predicted to be lower for top managers and higher for other senior managers in family firms, the

difference in the compensation levels between these two groups of managers is expected to be

smaller in family firms than in other firms.

2.3 Incentive compensation

Since family firms are the predominant form of business organization throughout the

world, at least in terms of number, we presume that they have solved the problem of dulled

promotion incentives associated with the long expected tenure of children as top officers in these

firms. In the absence of hierarchical incentives, we expect firms to adjust the incentives of non-

family senior management in other ways. The most obvious substitute for promotion incentives

is a greater reliance on incentive compensation.

Stock-based compensation plans are frequently employed as a method of aligning the

interests of managers to those of shareholders. Family firms may be reluctant to rely heavily on

stock-based compensation, however, since awards of stock and stock options may dilute their

voting control over the firm. DeAngelo and DeAngelo (1985) suggest that these concerns are

not unique to family-run firms, but also extend to the more general case of majority owner-

manager firms.

Family firms may solve their incentive compensation problem in two ways. First, as

suggested by DeAngelo and DeAngelo (1985), such firms may issue dual classes of common

stock so that stock-based compensation awards may be offered using only non-voting shares.

Family firms, concerned both with the diminution of promotion incentives and the dilution of

voting control, may also align the incentives of managers through the use of incentive

mechanisms that do not directly involve grants of stock or stock options, such as cash bonuses

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and phantom-stock allocations. Since these forms of incentive compensation are likely to be

close substitutes, we predict that family firms will rely more on dual class stock compensation,

cash bonuses, and phantom stock awards more than non-family firms.

3. Sample and data

Our sample consists of 34 publicly traded firms in which a child succeeded his parent as the

firm’s president, CEO, or chairman. We identified the sample in the following way. First, we

recorded all firms, excluding utilities and banks, listed in issues of Value Line during the fourth

quarter of 1997 in which the president, CEO, or chairman shared the same last name. We also

included firms in which the president, CEO or chairman shared the same last name as a

controlling stockholder in the company. We further required that the family control at least 25%

of the voting rights in the firm.2

After identifying these firms, we consulted Dun & Bradstreet’s for the birth dates of the two

people who shared the same last name. Firms were retained if the age difference between the

incumbent president, CEO, and/or chairman and his successor was at least 20 years. To identify

the year in which succession occurred, we consulted Moody’s Industrial and OTC Manuals.

After identifying this year, the Wall Street Journal Index was used to verify that a child had

indeed succeeded his parent as president, CEO, or chairman of the board. Once the year of

succession was identified, we attempted to obtain proxy statements for each of the six years

surrounding the year of succession for each firm in the sample (i.e. three years prior to, and three

years following the fiscal year of succession). In all, 45 firms were identified using the above

methodology. However, only 37 of the firms had the requisite proxy data to carry out the study.3

2 Given constraints on our ability to accurately measure all of the various family relationships, family members areidentified solely by a common last name.3 Proxy statements were collected using Lexis Nexus and the collection held by The Ohio State University.

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While this draft includes data for only 34 of the 37 sample firms, future versions of this research

will incorporate the complete sample.

For comparison purposes, each sample firm is matched to single publicly traded firm selected

on the basis of firm size and industry. Specifically, we identified all firms on Compustat that

shared the same SIC code as the family firm in the year of succession, under the constraint that at

least ten firms on Compustat satisfied this condition. If fewer than 10 firms could be identified,

we then identified potential control firms based on the first 3-digits of the SIC (2-digits if

necessary). Using this group of SIC match firms, we then selected the firm that was closest in

market value of equity to the sample firm at the end of the fiscal year in which succession

occurred. Proxy statements for each control firm were then obtained for the six years around the

sample firm’s year of succession. Thus far, compensation data has been extracted for 34 of the

37 matched pairs. It is these firms that comprise the sample for this draft of the paper.

Table 1 provides a brief summary of the matched pairs used in the paper. The table includes

the company names of the family and matched firms, as well as the last name of the controlling

family. Also included is the year of succession as well as the age of the child on the succession

date. The ages of successors range from 30 to 52. The mean and median age at succession is 39

and 38, respectively. The young age at which the children succeed their parents suggests that

these successors can expect to enjoy relatively long tenures as the firms’ top managers.

Brickley, Linck, and Coles (1999) find that the mean (median) age of successors for a sample of

CEOs appearing in the Forbes executive compensation surveys who left office between 1989 and

1993, was 51.6 (55.0) years, considerably older than the mean and median age of the child-

successors in our sample. As of the writing of this paper most of the child-successors continue

on as their firms’ senior managers, which makes it difficult to compare their average tenure to

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their counterparts in non-family firms. Currently the mean and median tenure of the children in

top management spots is nine and eight years, respectively.4

Summary statistics presented in table 2 reveal little difference in the mean size of the two

samples. This is expected since we matched the family firms on size. The mean book value of

assets is more than twice as large for the control firms than it is for family firms, but the

difference is not statistically significant. The median value of this variable is considerably

smaller than the mean value for both sets of firms, suggesting the presence of outliers in both

samples. The difference in median total assets is also not significantly different from zero.

Neither result is unexpected, of course, since we matched the family and control firms on another

size metric, the market value of equity.

Summary statistics for two performance measures are included in table 2. The first is the

market-to-book ratio, computed as the ratio of the market value of a firm’s assets (defined as the

sum of the book value of debt and preferred stock plus the market value of common equity) to

the book value of its assets. This measure, which also is used frequently as a proxy for growth

opportunities, does not differ significantly across the matched pairs of family and control firms.

The second performance measure is return on assets (ROA), defined as the ratio of operating

income to the book value of assets. Neither the mean or median values of ROA differ

significantly between the samples of family and control firms. While both performance

measures decline in the years following succession in family firms (with the exception of the

median market-to-book), similar performance declines are observed for the sample of control

4 Brickley, Linck, and Coles (1999) find that for a sample of CEOs appearing on the Forbes annual executivecompensation surveys who left office between 1989 and 1993, the average (median) tenure of these executives inthe CEO position was 9.6 (8.0) years.

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firms. None of the differences between the pre and post-succession intervals are significantly

different from zero.

Overall, the performance data suggests that family firms not only survive, but also effectively

solve the incentive problems described above. This evidence is consistent with the results of

Holderness and Sheehan (1988), who find that the performance of majority-owned firms is

indistinguishable from the performance of firms with more diffuse ownership.

We also document that the ownership structure of the two groups of firms differs

substantially. The mean percent of equity controlled by families in the sample of family firms is

39%. On average, outside blocks (i.e., blocks not represented on the board) own 8.1% of family

firms, versus 18% of the control firms. This difference is significant at the 0.01 level. The

percentage of equity held by officers and directors is 35% for family firms versus 23% for the

control firms. This difference is significant at the 0.05 level. Similar results hold for the median

values of these variables.

4. Empirical results

4.1 Tournament predictions

As described in section 2, three predictions emerge from tournament theory for our sample.

First, the level of compensation for the top managers in our sample of family firms should be

lower than the corresponding level of compensation for top managers in other firms. Second,

the level of compensation for other senior managers in family firms should be higher than it is in

other firms. Third, the difference in compensation between the top managers and other senior

managers should be smaller in our sample of family firms than it is in other firms.

Results from empirical tests of these predictions are contained in tables 3, 4, and 5. In table 3

we report on the univariate differences in compensation variables between the family and control

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firms. In table 4 we report similar results decomposed by pre and post-succession periods.

Table 5 provides regression results illustrating the determinants of the various components of the

compensation contracts granted to the executives of the family and control firms.

The results in table 3 provide some support for the tournament theory. Mean and median

values of compensation are reported for two levels of managers. “Upper-level” managers are

defined as managers with the title of president, CEO, or chairman. “Lower-level” managers are

defined as other managers for whom compensation data is listed in the firm’s proxy statements.

The ascending child and/or other family members often serve in the lower level management

group, however, compensation awards to these individuals are excluded from the results that

follow.

The mean and median values of three compensation variables for the two samples are

reported in table 3. First, the table reports the mean and median values for cash compensation,

defined as the sum of the managers’ salary, bonus, and other cash compensation. Second, the

mean and median value of stock options granted to the managers is reported. Stock option grants

are valued using the Black-Scholes model with continuously paid dividends. Third, the mean

and median values of total compensation, defined as the sum of the cash and option components,

are reported in the table. All compensation data is reported in constant 1997 dollars.

Results in table 3 reveal that the mean and median levels of total compensation are lower for

the top managers of family firms than they are for the top managers in control firms. The

median level of total compensation for upper managers is $548,468 in family firms versus

$796,456 for the control firms. This difference is significant at the 0.10 level. This result is

consistent with the tournament theory prediction that the prize component of top executive

compensation should be smaller in family firm than in their control firms.

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No significant difference is found in the mean or median total compensation of lower level

managers across the two samples. Median total compensation of lower level managers in family

firms is actually lower than the corresponding value in control firms -- $285,161, versus

$386,156. This result is not consistent with the tournament theory prediction that the

compensation of lower level managers should be significantly higher in the family firms, where

these managers have little prospect of ascending to the top position.

Table 3 also reports the mean and median percent differences in the total compensation of

upper versus lower level managers across the two samples. The median value of the “inter-rank”

spread in total compensation is 71% for the family firms versus 86% for the control firms. This

difference, which is significant at the 0.10 level, is consistent with the tournament theory

prediction. The result is driven completely by lower total compensation for upper level

managers in family firms and not by higher total compensation for lower level managers in these

firms.

A somewhat different picture emerges for the differences in cash compensation of upper

versus lower managers between the two groups of firms. No significant differences exist in the

mean and median levels of cash compensation for upper and lower managers in the family and

control firms. The median percent difference in cash compensation for upper versus lower

managers, however, is lower for family firms (69%) than it is for their control firms (95%), a

difference that is significant at the 0.01 level. Similar differences in mean cash compensation are

also significant. To the extent that the prize component of compensation manifests as a non-

contingent cash payment, this result is consistent with the tournament theory prediction.

Table 4 presents similar comparisons to those in table 3, decomposed into the three years

before and after the year of succession. Any uncertainty about the child’s ascension to the top

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position is resolved in the years following succession in family firms. Combined with the

ownership position of the controlling family, and the child’s lengthy expected tenure, the

tournament predictions are expected to be most observable in the years following succession.

However, Vancil (1987) suggests that a successor is often chosen several years before the actual

date of turnover in the top-management position. If so, the tournament is effectively over before

the year of succession. In this case, non-family senior managers of family firms are expected to

have compensation contracts in the three years before succession that look similar to contracts

granted after the child’s succession.

Consistent with this latter observation, we find that the level of total compensation is not

significantly different across the two groups of firms for lower level managers in years before

and after succession. For upper level managers, we find no significant difference in total

compensation before succession. However, after succession, the median level of compensation

for upper level managers of family firms is $517,501 versus $760,146 for their counterparts in

the control firms. This result is significant at the 0.10 level. Similar results hold for the mean

values of this variable.

The mean and median values of cash compensation are slightly higher for lower level

managers of family firms, than for the low level managers in the control firms, although this

difference is not significant. Conversely, the mean and median levels of cash compensation are

smaller for upper level managers in family firms as compared to their counterparts in the

matched control firms, but these differences are also not significantly different from zero. We do

find that the mean and median percent differences in cash compensation of upper versus lower

managers is significantly lower in the family firms compared to the matched control firms, but

only in the post-succession years. The median value of this “inter-rank” spread is 61% for

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family firms in the post-succession years, versus 102% for the control firms. This finding is

consistent with the prediction under tournament theory that the prize component associated with

winning the top job in a family firm should fall significantly after a young child is selected for

the firm’s top job. However, we cannot presently distinguish this interpretation from another,

more obvious explanation – the child who is selected is paid less than his predecessor who was

older and had a greater experience.

To control for other variables that might affect the difference in the compensation of upper

vs. lower managers, we estimate two sets of ordinary least squares regressions. In the first set we

regress the level of upper manager compensation on a series of independent variables, including

the level of lower manager compensation, firm size as measured by the natural log of equity

value, market-to-book ratio, and return on assets. We also include a dummy variable equal to

one if the firm is family run, as well as a dummy variable equal to one in post-succession years.

These regressions are estimated for equations in which both total compensation and cash

compensation are included as dependent variables. The results are presented in table 5A.

The regression equations reported in table 5A have respectable R-squareds, ranging from

0.46 to 0.53, largely because the average compensation of lower managers is included as an

independent variable. As expected, a highly significant and positive relation exists between the

average compensation of upper mangers and the corresponding measure for lower managers.

The coefficients associated with this variable range from 1.65 to 1.89 in the four equations

reported in table 5A, and all coefficients are significant at the 0.01 level. A family firm dummy

variable enters with a negative coefficient in all four equations, but it is statistically significant

only in the two cash compensation equations. Its coefficient in the two cash compensation

equations implies that the average cash compensation of top managers of family firms in which a

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child succeeds a parent is approximately $135,030 to $146,410 lower than it is in other firms.

The coefficient on the dummy variable for family firms in post-succession years is negative but

not significantly different from zero in the two equations in which it enters as an independent

variable.

Two additional variables enter significantly into the equations in table 5A. The natural log of

equity value has a positive coefficient in both the total and cash compensation equations.

Consistent with the results of Jensen and Murphy (1990), this indicates that the top managers of

large firms are paid more than their counterparts in smaller firms, even after controlling for the

level of lower management compensation. This suggests a higher relative marginal product of

top managers in large firms. In addition, it could be explained by a larger prize component in the

compensation of top managers in large firms. The latter interpretation is consistent with the

conjecture that larger firms are more likely to rely on tournaments as an incentive device. The

market-to-book ratio enters with a negative and significant coefficient in both the total and cash

compensation regressions. To the extent that this variable proxies for growth opportunities, this

is a surprising result, since the value of tournament competition would seem to be greater for

firms with good growth opportunities (Baker, Jensen, and Murphy (1988)).

In table 5B, we report the results from a second set of regressions in which the percent

difference in the compensation of upper versus lower level managers is used as the dependent

variable. The independent variables used in these regressions are identical to those employed in

the regressions in table 5A except for the average level of compensation for the firm’s lower

managers. The adjusted R-squareds are much lower for these regressions, ranging from 0.015 to

0.033. The variable of most interest, the dummy variable for family firms, enters with a negative

coefficient in all four equations, and is significant in three of the four, including the two cash

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compensation equations. In these two equations, the coefficients are –17.30 and –26.32,

revealing that the spread in cash compensation for upper versus lower managers is roughly 17%

to 26% lower in the sample of family firms. This result, is consistent with the predictions under

tournament theory. The dummy variable for family firms in the post-succession period is

negative, but not significantly different from zero. This latter finding makes it less likely that our

results are due to the relatively lower pay that a young and less experienced child can be

expected to receive in the post-succession years of our family firms.

4.2. Incentive compensation

As discussed in section 2, the diminished opportunities for senior, non-family, managers to

be promoted to the top position in family firms is likely to dampen their incentives compared

with those facing senior managers of other firms. In equilibrium, one would expect adjustments

on other margins to compensate for the lack of hierarchical incentives in family firms, including

a greater reliance on various forms of incentive compensation. Data in tables 3 and 4 allow us to

examine whether this is indeed the case.

Stock options

An obvious candidate as an adjustment in incentive compensation is a greater reliance on

option-based compensation. This adjustment, however, is unlikely to be attractive to a

controlling family, since stock option grants may dilute their voting control. The data in tables 3

and 4 reveal that option grants are far less common in our sample of family firms compared to

their control firms matched on size and industry.

Table 3 shows that the median value of option grants to lower level managers is higher for

the control firms ($64,621) than it is for the family firms ($20,519). This difference is

statistically significant at the 0.05 level. Similar results hold for the mean value of this variable,

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although these results are not significant. The median value of option grants also differs

significantly for upper level managers in the two groups of firms. The mean value of this

variable also differs for the two groups of upper managers, but not significantly. Less

dependence on option grants for the upper management of family firms is expected, as family

ownership makes the wealth of these managers substantially sensitive the value of the firm’s

shares.

The results on stock option grants are more striking when one examines the percent of total

compensation accounted for by stock option grants in family versus control firms. Table 3

shows that the median percent of total compensation accounted for by stock option grants is only

7.1% for lower level managers of family firms, versus 22.47% for their counterparts in control

firms. This difference is significant at the 0.05 level. Similar results hold for the mean values of

this variable. The median and mean values of this variable are also significantly lower for upper

level managers of family firms (2.43% and 12.44%, respectively) versus their counterparts in the

control sample (20.36% and 24.46%, respectively). Table 4 presents similar results for the pre

and post-succession years. The results generally show that in both periods, lower level managers

receive fewer stock option grants, both in dollar value and as a percent of total compensation, in

family firms versus their matched control firms. These differences are generally more significant

in the post-succession years.

The results on stock options are consistent with the view that family firms are reluctant to

grant stock options to non-family senior managers for fear of diluting the families’ control.

Family firms with dual classes of common stock with different voting rights can avoid this

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problem by granting stock options on the low voting stock to managers who are not members of

the family.5

Univariate data shows that family firms with dual classes of common stock use executive

stock options significantly more than other family firms, especially for lower level managers.

The median percent of total compensation accounted for by stock option grants for lower level

managers is 26.28% for the six family firms with dual classes of common stock, versus 5.23%

for family firms with only one class of common stock. This result is statistically significant at

the 0.05 level. Similar, but even stronger, results hold for the mean values of this variable. It is

worth noting that the family firms with dual classes of common stock use executive stock

options to roughly the same extent as the control firms. This suggests a potentially important

benefit of dual classes of common stock – its role as a compensation device.

Regression results on the relation between the use of executive stock options and dual classes

of common stock are reported in table 6. The dependent variables in the equations are the

percent of total compensation accounted for by stock option grants. One set of regressions

pertains to lower level managers and the other set pertains to upper level managers. Following

Smith and Watts (1992), we include firm size, as measured by the market value of equity, and

the market-to-book ratio as independent variables. We also include a dummy variable that takes

the value of 1 for family firms and 0 otherwise, as well as a dummy variable that takes the value

of 1 for family firms with a single class of common stock and 0 otherwise.

The results support the univariate results described above. When the dummy variable for

family firms with a single class of stock is omitted from the model, the dummy variable for

family firms enters with a negative coefficient that is significant at the 0.01 level. The

coefficient on the family firm dummy is –12.26 in the equation for lower level managers,

5 We thank Kevin Murphy for this suggestion.

19

indicating that the percent of total compensation accounted for by stock option grants is 12.26

percentage points lower in family versus control firms. The corresponding coefficient in the

equation for upper level managers is –9.69.

When the dummy variable for family firms with one class of common stock is included as an

independent variable, the dummy variable on family firms is no longer significant. The

coefficient on the dummy for family firms with one class of common stock is negative and

significant at the 0.05 level in the equation for lower level managers. This result indicates that

the low use of stock options in family firms is confined to family firms with only one class of

common stock. In the equation for upper level managers, the dummy variable for family firms

with one class of common stock enters with a negative coefficient that is not significant.

Cash bonuses

Since family firms rely less on both hierarchical incentives and stock option-based

compensation, it is worthwhile to consider whether these firms substitute other types of incentive

mechanisms for non-family senior managers, such as performance-based cash bonuses or

phantom stock. In the current version of this paper we examine whether sample firms are more

or less likely to use cash bonuses.

Table 3 shows that the median cash bonus paid to lower level managers in family firms is

$15,984, which is higher, but not significantly so, from the corresponding median of $10,352

paid to their counterparts in the control firms. Similar results hold for the mean value of this

variable. Qualitatively similar results also obtain when comparing the mean and median percent

of cash bonuses as a fraction of total compensation between the lower level managers of family

and control firms. The results suggest that family firms do not substitute a greater reliance on the

20

use of performance-based cash bonuses for dampened promotion incentives and less reliance on

executive stock options.

5. Conclusion

Family firms remain a predominant organizational form, yet little is known about the types of

incentive problems that exist in these firms, and how they are resolved. This paper attempts to

identify some incentive problems that arise in family firms when a child succeeds a parent as the

firm’s top manager. A controlling ownership stake held by the family, combined with the

relatively young age of the child at the time of succession, is likely to dull the promotion

incentives for other senior managers in these firms. This possibility leads to several testable

hypotheses about the level and structure of compensation of managers in family firms.

Our empirical results bear out some, but not all, of the predictions. Specifically, we find that

the difference in the compensation levels of upper versus lower managers is significantly smaller

in the sample of family firms. This result is consistent with the notion that incentives associated

with promotion to the highest position are significantly less important in family firms than they

are in other firms.

We find no evidence that family firms rely more heavily on incentive compensation as a

substitute for the dampened promotion incentives. Family firms award significantly fewer stock

option grants to their lower level managers than the control firms do, presumably because the

controlling families want to avoid dilution of their control. We find that dual classes of common

stock provide a mechanism for mitigating the aversion of family firms to use executive stock

options. Finally, family firms do not rely more heavily on performance-based cash bonuses than

other firms. In the next version of the paper, we will examine whether family firms use

phantom stock more heavily than other firms.

21

The ways in which family firms resolve their incentive problems remains puzzling, to a large

degree. One additional way in which family firms may resolve the dulling of promotion

incentives for senior managers is through more effective monitoring. Since the ownership

structure of family firms is highly concentrated among individuals actively engage in managing

the firm, the costs of monitoring the performance of low level managers is presumably lower

than might otherwise be the case. As a result, there may be less of a need, not only for

promotion incentives, but also for various forms of incentive compensation. We believe that this

is an area that also deserves attention in future research on this subject.

References

Baker, G.P., Gibbs, M. and Holmstrom, B., 1994, The internal economics of a firm: Evidencefrom personnel data, Quarterly Journal of Economics, 109, 881-919.

Baker, G.P., Jensen, M.C. and Murphy, K.J., 1988, Compensation and incentives: practice vs.theory, Journal of Finance, 593-616.

Becker, B. and Huselid, M., 1992, The incentive effects of tournament compensation systems,Administrative Science Quarterly, 37, 336-350.

Brickley, James A., Linck James S., and Coles, Jeffrey L., 1999, What happens to CEOs afterthey retire? New evidence on career concerns, horizon problems, and CEO incentives,Journal of Financial Economics, 52, 341-377.

DeAngelo, Harry and DeAngelo, Linda, 1985, Managerial ownership of voting rights: A study ofpublic corporations with dual classes of common stock, Journal of Financial Economics, 17,33-69.

Ehrenberg, R. and Bognanno, M., 1990, The incentive effects of tournaments revisited: Evidencefor the European PGA Tour, Industrial Labor Relations Review, 43, 74-89.

Holderness, Clifford G. and Sheehan, David P., 1988, The role of majority shareholders inpublicly held corporations, Journal of Financial Economics, 20, 317-346.

Jensen, Michael C. and Murphy, Kevin J., 1990, Performance pay and top-managementincentives, Journal of Political Economy, 98, 225-264.

Lambert, Richard A., Larcker, David F. and Weigelt, Keith, 1993, The structure oforganizational incentives, Administrative Science Quarterly, 38, 438-461.

Lazear, Edward P. and Rosen, Sherwin, 1981, Rank order tournaments as optimum laborcontracts, Journal of Political Economy, 89, 841-864.

O’Reilly, Charles A., Main, Bran G. and Graef, Crystal S., 1988, CEO compensation astournament and social comparison: A tale of two theories, Administrative ScienceQuarterly, 33, 257-274.

Prendergast, Candice, 1999, The provision of incentives in firms, Journal of EconomicLiterature, 38, 7-63.

Rosen, S., 1986, Prizes and incentives in elimination tournaments, American Economic Review,701-715.

Smith, Clifford and Watts, Ross, 1992, The investment opportunity set and corporate financing,dividend, and compensation policies, Journal of Financial Economics, 32, 263-292.

Vancil, R., 1987, Passing the baton: Managing the process of CEO succession. Harvard BusinessSchool Press, Boston, MA.

Table 1

Sample of fam

ily firms and control firm

s, along with year in w

hich succession occurred in family firm

s, the age of the child in the year of succession, and the family

firm’s principal SIC

code and industry. Family firm

s were identified by searching the 4th quarter 1997 issues of Value Line for firm

s in which the chairm

an and eitherchief executive officer or president had the sam

e last name and the fam

ily owns at least 25%

of the firm’s stock. A

fter identifying these firms, w

e searched variousissues of M

oody’s Industrial and OTC M

anuals to identify the year in which the chief executive officer or president ascended to their position. W

e then searched proxystatem

ents for each family firm

to verify that a child had actually succeeded their parent as chief executive officer, president, of chairman of the board. The child’s age

also was recorded from

the proxy statements. The control firm

s were selected as firm

s in the same SIC

code (containing at least 10 firms) that w

ere closest to thefam

ily firm in m

arket value in the year of succession.

Year of

Age of child in

Family firm

Family succession year of sucession. Industry (SIC

) Control firm

Allied Products

Drexler

198235

Farm m

achinery and equipment (3523)

Toro Co.

Bandag

Carver

198234

Patent owners and lessors (6794)

Cum

mins Engine

Barnes G

roupB

arnes1995

46Steel springs (3493)

Acm

e Metals

Brow

n Forman

Brow

n1983

41D

ist. and blended liquor (2085)U

niversal FoodsC

ablevision Systems

Dolan

199540

Cable and pay TV

services. (4841)TC

A C

able TVC

omcast

Roberts

199030

Cable and pay TV

services. (4841)Tele-C

omm

TCI G

roupC

ulbroC

ullman

198438

Cigars (2121)

UST Inc.

Daniel Industries

Griffin

199147

Totalizing fluid meters (3824)

Dionex C

orp.D

illard. Dept. Stores

Dillard

197631

Departm

ent stores (5311)Jacobson Stores

Dollar G

eneralTurner

197737

Departm

ent stores (5311)A

mes D

ept. StoresEthyl

Gottw

ald1992

35Industrial organic chem

icals (2860)R

ohm&

Haas

Hechinger

Hechinger

198939

Lumber and building m

aterials retail (5211)G

rossmans Inc.

International Rectifier

Lidow1992

37Sem

iconductors (3674)V

ishay IntertechnologyK

imball International

Habig

198136

Wood office furniture (2521)

Tab ProductsLancaster C

olonyG

erlach1993

38Fruit, veget., sauces, seasonings (2035)

Seneca FoodsM

anor Care

Bainum

198640

Skilled nursing care fac. (8051)B

everly EnterprisesM

edia General

Bryan

199052

New

spaper publishing and printing (2711)A

.H. B

eloN

UI C

orp.K

ean1994

44N

atural gas distribution (4924)C

ascade Natural G

asN

ational Presto Ind.C

ohen1989

37Electric housew

ares and fans (3634)W

indmere D

urable Holdings

Nordstrom

Nordstrom

199532

Departm

ent stores (5311)Federated D

ept. StoresO

lstenO

lsten1990

37H

elp supply svcs. (7363)C

DI C

orp.O

wens &

Minor

Minor

198444

Med., dental, hosp. eqpm

ent – whsl. (5047)

Vallen C

orp.O

xford IndustriesLanier

197939

Mens, boys, w

ork clothing (2320)H

ampton Industries

Parker Drilling

Parker1991

42D

rilling oil & gas w

ells (1381)G

lobal Marine

Showboat

Houssels

199535

Coin-op am

usement devices (7993)

Aztar C

orp.Sm

ucker (J.M.)

Smucker

198036

Can fruit, veget., preserv., jam

, jel (2033)O

range Co.

Stand. Motor Prods.

Sills1986

47Electric eq. com

bust engin. (3694)Evans&

SutherlandSteel Technologies

Ray

199436

Cold roll steel sheet (3316)

Northw

estern Steel & W

ireTecum

seh ProductsH

errick1986

44M

easuring and dispensing pumps (3586)

Standex International Corp.

Wackenhut

Wackenhut

198639

Detect, guard, arm

or car service(7381)Executone Info System

sW

ashington PostG

raham1991

46N

ewspaper publishing &

print (2711)K

night Ridder

Werner Enterprises

Werner

199337

Trucking (4213)A

rnold Industries

Winn D

ixie StoresD

avis1982

37G

rocery stores (5411)Southland C

orp.W

olohan Lumber

Wolohan

198736

Lumber and bld. m

at. retl. (5211)R

iverside Group

Table 2

Summ

ary statistics on total assets, market to book ratio, and return on assets (R

OA

) for family and control firm

s. Total assets (in constant 1997 dollars) are defined asthe book value of assets, m

arket to book ratio as the ratio of the market value of assets (i.e., the sum

of the book value of debt and preferred stock plus the market value

of comm

on stock) to the book value of assets, and RO

A is defined as the ratio of operating incom

e to the book value of assets. All of the data used in these calculations

are taken from the C

ompustat tape. The data are averaged over all years, the years preceding the year of succession, and the years follow

ing the year of succession. Thesam

ple consists of 34 pairs of family and control firm

s. Thirty pairs have sufficient data on pre- and post-acquisition periods. The difference in medians is tested using

Rank-sum

z-test

Family firm

Control firm

Family firm

Control firm

Variable m

ean mean t-statistic m

edian median z-statistic

Total assets ($m)

All years

7091235

1.05305

275-0.18

All years (N

=30)786

13511.03

343374

0.16 Pre-succession

7411159

0.85281

3180.19

Post-succession838

15811.16

393377

-0.05

Market to book ratio

All years

1.1841.123

-0.491.063

1.004-0.70

All years (N

=30)1.250

1.172-0.58

1.0951.019

0.78 Pre-succession

1.2501.208

-0.311.149

1.0970.64

Post-succession1.256

1.142-0.82

1.1080.966

1.028

Return on assets

All years

0.06650.0686

0.260.0680

0.0610-0.40

All years (N

=30)0.0637

0.06670.35

0.06600.0615

0.16 Pre-succession

0.06800.0719

0.410.0690

0.0670-0.28


0.0583-0.22

0.06450.0520

0.73

Table 3

Summ

ary statistics for various compensation data for 34 pairs of fam

ily and control firms. A

ll compensation data are taken from

proxy statements and collected for the six years surrounding the year of

succession for the family firm

. Total compensation is com

puted as the sum of cash com

pensation (salary, bonus, and other cash compensation) and the value of stock option grants. Stock options are valued by

the Black-Scholes m

odel with continuously paid dividends. The stock price and com

pany dividend information, w

hich are used in the Black-Scholes valuation, are draw

n from the CR

SP and Com

pustat tapes.Estim

ates of the standard deviation of stock returns, also used in this calculation, are derived using stock return data for the year before the option grant. Interest rates on 10-year Treasury bonds are obtainedfrom

Federal Reserve B

oard statistical releases. All com

pensation data are presented in constant 1997 dollars using CPI discounts (obtained from

Missouri state w

eb server).

Variable

Family Firm

Control Firm

Family firm

Control firm

Mean M

ean t statistic median m

edian z-stat.

Total com

pensation Low

er managers

$452,519 $505,809

0.51$285,161

$386,156-0.75

Upper m

anagers 795,218

1,058,2631.06

548,468 796,456

-1.63 I

Percent differencein total com

pensationof upper versus

85.28115.09

1.64 70.98

86.051.71

*

lower m

anagers

Cash com

pensation Low

er managers

334,003316,356

-0.38280,635

282,934 0.44

Upper m

anagers562,993

670,383 1.02

474,122593,775

-0.79

Percent difference incash com

pensation ofupper versus

81.40107.85

2.05**

69.3595.25

-2.63***

lower m

anagers

Salary Low

er managers

241,343251,624

0.36211,746

238,630-0.30

Upper m

anagers408,845

508,2211.79

*382,215

501,919-1.34

Bonus

Lower m

anagers65,059

41,503-1.15

15,98410,352

0.99 U

pper managers

91,11388,294

-0.0818,000

12,7230.50

Other cash com

p. Low

er managers

27,60123,229

-0.314,434

1,6870.73

Upper m

anagers63,035

73,868-0.19

9,0702,198

1.20

Value of option grants

Lower m

anagers118,516

189,4531.00

20,519 64,621

-2.05**

Upper m

anagers232,225

387,8800.88

11,458138,363

-1.89*


as % of total com

pensation Low

er managers

13.2625.32

2.60**

7.1022.47

-2.53**

Upper m

anagers12.44

24.462.28

*** 2.43

20.36-1.83

*

Bonus as %

of total compensation

Lower m

anagers13.03

7.25-1.65

5.70

2.401.50

Upper m

anagers12.53

8.12-1.07

3.161.96

1.19

***, **, *, Denotes significance at 1%

, 5%, and 10%

, respectively

Table 4

Summ

ary statistics for various compensation data, before and after a child succeeds his/her parent as president or chief executive officer of the com

pany. All com

pensation data are taken from proxy statem

ents and averaged over the threeyears before and three years after the year of succession. Total com

pensation is computed as the sum

of cash compensation, the value ofstock option grants, and other com

pensation listed in the proxy. Stock options are valued by the Black-

Scholes model w

ith continuously paid dividends. The stock price, company dividend inform

ation, and the interest rate on constant maturity ten-year Treasury bonds, w

hich are used in the Black-Scholes valuation, are draw

n from the C

RSP

tape. Estimates of the standard deviation of stock returns, also used in this calculation, are derived using stock return data for the year before the option grant. Interest rates on 10-year treasury bonds are obtained from

the Federal Reserve

Board statistical releases. All com

pensation data are presented in constant 1997 dollars using CPI discounts (obtained from

Missouri: state w

eb server).

Variable

Family Firm

Control Firm

Family firm

Control firm

Mean M

ean t statistic rank sum z m

edian median z-statistic

Total com

pensationLow

er managers

Pre-succession$491,212

$538,2830.34

$305,390$353,860

-0.57 Post-succession

413,958 477,294

0.75 298,445

390,350-0.51

Upper M

anagers Pre-succession

916,1351,075,153

0.46556,035

619,690-0.58

Post-succession674,019

1,093,4341.79

* 517,501

760,146-1.93

*

Percent differencein total com

pensation Pre-succession

93.14110.37

0.6682.12

88.55-0.41


125.022.77 ***

61.01101.98

-2.41 **

Cash com

pensationLow

er managers

Pre-succession$332,106

$301,933-0.67

278,796266,248

0.57 Post-succession

338,957 330,054

-0.18290,781

298,793 0.30

Upper m


577,512608,732

0.35480,860

541,447-0.15


727,9621.35

487,764585,506

-1.03

Percent difference incash com

pensation Pre-succession

90.54 98.28

0.5478.86

96.35-1.08


112.912.75

***57.44

102.90-2.68

***


Lower m


159,106236,349

0.66 6,282

42,714-1.53 I

Post-succession 75,001

147,2401.65

14,60272,198

-1.77*

Upper m


338,623466,420

0.425,886

27,289-1.02


365,4722.01

** 319

120,803-1.80

*


as % of total com

pensationLow

er managers

Pre-succession12.88

23.731.92

*2.61

18.72-1.62


22.122.56

**4.68

20.87-2.23

**

Top managers

Pre-succession11.39

20.601.61

1.14 7.60

-0.91 Post-succession

10.7223.09

2.47 **

0.0616.30

-1.81*


, 5%, and 10%

, respectively

Table 5A

Ordinary panel data least squares regressions of (i) the total com

pensation of top managers and (ii) the cash com

pensation of the top managers. Independent variables

include the average compensation of the low

er managers, the m

arket to book ratio, return on assets, and the two dum

my variables denoting fam

ily firms in the pre- and

post-succession years. T-statistics are in parentheses

Dependent V

ariable:Total C

ompensation

Dependent V

ariable:C

ash Com

pensationIndependent V

ariablesIntercept

195.89-25.25

81.23-42.28

(1.45)(-0.11)

(1.65) *(-0.43)

Average com

pensation of lower m

anagers1.86

1.811.89

1.65(19.07) ***

(16.32) ***(17.03) ***

(11.56) ***

Ln (Equity value)74.39

61.67(1.65)

(2.79) ***


-203.65-107.95

(-1.78) *(-2.22) **

Return on assets

1.08-1.69

(0.07)(-0.28)

Family dum

my

-161.07-107.66

-146.41-135.03

(-1.55)(-0.84)

(-3.33) ***(-2.50) **

Family post-succession dum

my

-103.81-31.03

(-0.72)(-0.51)

N346

346346

346A

dj. R-Square

0.52430.5264

0.46490.4752

Note:

Family dum

my plus

-211.47-166.06

Family post-succession dum

my

(-1.68) *(-3.17) ***


, 5%, 10%

, respectively

Table 5B

Ordinary panel data least squares regressions of (i) the percent difference in the com

pensation of top managers and the com


anagers and (ii) the level of the topm

anagers’ compensation. The percent difference in the com

pensation of the top managers and the com


anagers is defined as the compensation of the top

manager m

inus the average compensation of low

er managers, divided by the average com


anagers. This percentage difference is computed for both total and

cash compensation. In regressions in w

hich these percentage differences are the dependent variable, the independent variables include the market value of the firm

(defined as thesum

of the book value of debt and preferred stock plus the market value of com

mon stock), the m

arket to book ratio (defined as the market value of the firm

divided by the bookvalue of its assets), return on assets (defined as operating incom

e divided by the book value of assets), a dumm

y variable that takes the value of one for family firm

s in the pre-succession years and zero otherw

ise, and a dumm

y variable that takes the value of one for family firm

s in the post-succession years and zero otherwise. T-statistics in parentheses.

Dependent V

ariable: Percent difference in totalcom

pensation for upper v. lower m

anagersD

ependent Variable: Percent difference in total

compensation for upper v. low

er managers

Independent Variable

Intercept143.56

127.36118.41

106.55(10.63) ***

(5.26) ***(13.50) ***

(6.19) ***

Ln(Equity Value)

0.492.89

(0.11)(0.93)


1.28-5.03

(0.11)(-0.58)

Return on assets

-2.31-2.40

-1.45-1.18

(-1.70) *(-1.58)

(-1.49)(-1.09)

Family dum

my

-26.45-15.87

-26.32-17.30

(-2.41) **(-1.17)

(-3.37) ***(-1.79) *

Family, post-succession dum

my

-20.51-17.42

(-1.35)(-1.61)

N346

346346

346A

dj. R-Square

0.01830.0151

0.03160.0328

Note:

Family dum

my plus

-36.38-34.73

Family, post-succession dum

my

(-2.76) ***(3.71) ***


, 5%, 10%

, respectively

Table 6

Ordinary panel data least squares regressions of equity as percentage of total com

pensation. In regressions in which these percentages are the dependent variable, the independent

variables include the market value of the firm

(defined as the sum of the book value of debt and preferred stock plus the m

arket value of comm

on stock), the market to book ratio

(defined as the market value of the firm

divided by the book value of its assets), return on assets (defined as operating income divided by the book value of assets), free cash

flows/assets (m

easured as in Lehn and Poulsen, 1989) a dumm

y variable that takes the value of one for family, and a dum

my variable that takes value of one for com

panies with

single stock structure. T-statistics in parentheses.

Dependent V

ariable: equity/total compensation

*100 (lower m

anagers)D

ependent Variable: equity/total com

pensation*100 (upper m

anagers)Independent V

ariableIntercept

-6.97-2.36

0.003.38

0.261.84

(-1.55)(-0.54)

(0.00)(0.48)

(0.05)(0.38)

Ln(Equity Value)

3.203.46

3.232.96

3.163.00

(3.66) ***(4.11) ***

(3.84) ***(3.16) ***

(3.45) ***(3.27) ***


3.764.10

3.120.42

0.690.03

(1.68) *(1.91) *

(1.44)(0.18)

(0.29)(0.01)

Family dum

my

-12.26-3.49

-9.69-3.82

(-5.65) ***(-0.86)

(-4.10) ***(-0.85)

Family*single stock class

-10.41-6.97

(-2.53) **(-1.55)

N352

352352

352352

352A

dj. R-Square

0.06700.1429

0.15600.0309

0.07300.0767

Note:

Family dum

my plus

-13.90-10.79

Family*single stock class

(-6.18) ***(-4.38) ***

***,**,*,I denotes statistical significance on 1%, 5%

, 10%, respectively.

family firm executice compensation

Documents

officers of family firms

nonfamily firms

infamily firms

firms presidents

ways inwhich family

unique set of firms

incentive compensation

nonfamily senior managers