Does Corporate Culture Matter for Investment and Financial Policies?

Does Corporate Culture Matter for Investment and Financial Policies?*



Henrik Cronqvist**
Angie Low
Mattias Nilsson
The Ohio State University
Nanyang Technological University
University of Colorado at Boulder
Fisher College of Business
Nanyang Business School
Leeds School of Business
Department of Finance
Division of Banking & Finance
Division of Finance


November 18, 2007



Abstract

Economic theories suggest that a firm’s “corporate culture,” defined as the shared beliefs within a firm
about the optimal course of action, can matter for its policy choices. In this paper, we approach culture
empirically by using a panel of parent-spinoff firm pairs that allows us to identify culture effects in
corporate finance practices from behavior that is inherited by a spinoff firm from its parent firm after the
firms split up. We find significant commonality in spinoff and parent firms’ investment and financing
policies. These similarities are found to be persistent, and cannot be explained by inertia causing
stickiness of initial policies; nor can they be explained by ownership, customer-supplier, industry or other
significant contractual links that remain between the firms. Consistent with culture theories, we find that
the commonality is stronger for internally grown spinoff firms and for those that originate from older
parent firms. In addition, we find that a firm’s culture is a latent firm characteristic that does not come
and go with a particular CEO. Finally, we also find commonality in more direct proxies for culture
related to human capital policies. Overall, we conclude that economic theories of corporate culture can
help us better understand firm behavior and decision-making in the area of corporate finance.

Keywords: Economics of corporate culture; investment policies; financing policies

JEL Classification: G32; G34; G35; L22; L25; Z10



* We thank Malcolm Baker, Nicholas Barberis, Murillo Campello, Lauren Cohen, Alex Edmans, Robert Gibbons, William
Goetzmann, David Hirshleifer, Andrew Karolyi, Sergey Sanzhar, René Stulz, Richard Thaler, Eric Van den Steen, Bruce
Weinberg, Julie Wulf, Jamie Zender, and seminar participants at Boston University, European Finance Association, Federal
Reserve Bank of Chicago, Harvard University, Nanyang Technological University, the NBER Workshop in Behavioral Finance,
Ohio State University, University of Colorado at Boulder, University of Illinois at Urbana-Champaign, and Yale School of
Management for many helpful comments. Suhail Gupta provided outstanding research assistance. Cronqvist is thankful for
financial support from the Fisher College of Business’s “Small Grant Program” and from the Dice Center for Financial
Economics Research. This paper was written in part when Cronqvist was a Visiting Whitebox Fellow in Behavioral Finance at
Yale School of Management’s International Center for Finance, which he thanks for its hospitality.
** Address correspondence to Henrik Cronqvist, The Ohio State University, Fisher College of Business, Department of Finance,
2100 Neil Avenue, Columbus, OH 43210, or e-mail at henrik.cronqvist@fisher.osu.edu.

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1. Introduction
A common view among corporate executives and in the business press is that a firm’s so-called
“corporate culture” can play an important role for firms’ decisions and policies. In addition, economists
have started to develop formal theories to explain the formation, existence, and persistence of a firm’s
culture and how it forms an integral part of any firm’s contracting and governance environment.1 So far,
the empirical literature in corporate finance has paid little attention to the role that corporate culture can
play in explaining important decisions about investments and financing. This paper’s contribution is to
be a first attempt to fill this gap in the literature. Motivated by empirical work on culture in other
economic settings, we develop an empirical framework that allows us to assess the impact of culture on
corporate finance practices using spinoff and parent firm pairs. Our empirical evidence suggests that
economic theories of corporate culture can help us better understand firm behavior and decision-making
in the area of corporate finance.
We start by defining the economic meaning of “corporate culture.” Throughout this paper, we
draw on a theoretical literature in economics, which started with the seminal work by Kreps (1990). In
these theories, a firm’s culture is the well-established shared beliefs and organizational preferences among
the firm’s managers and workers that can help solve coordination problems and incentive issues within
the firm (see, e.g., Kreps (1990), Crémer (1993), Lazear (1995), and Hermalin (2001)). Economic
theories also explain how a firm’s culture, once formed, can persist over time through (i) selection of
employees who share these beliefs, or (ii) employees’ internalization of the firm’s beliefs, preferences,
and norms (see, e.g., Lazear (1995), Akerlof and Kranton (2000, 2005), Bernhardt, Hughson and Kutsoati
(2006), and Akerlof (2007)).2 These theories imply that the shared beliefs about what the “right”

1 For example, in his review of work on corporate culture in economics, Hermalin (2001) notes that “By writing this
chapter, I’m agreeing with the proposition that corporate culture is worthy of study by economists and is amenable
to our methods. Worthy because corporate culture is an important determinant of firms’ capabilities and
performance. Moreover, it both complements and substitutes for many of the other governance structures that
economists have long studied.”
2 The Wall Street Journal’s business school rankings shows that “Fit with the corporate culture” is one of the most
important attributes for MBA recruiters, one which 74.5 percent of those surveyed say is “very important” (Wall
Street Journal, September 20, 2006).
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behavior is in a firm can directly impact a particular firm policy, or alternatively, indirectly affect
corporate finance practices through a common organizational attitude or preference, such as the risk-
aversion in a firm.
We can illustrate these arguments by looking at an example. The U.S. investment banking
industry is a large and competitive industry where many managers and other employees have a formal
business or finance education. Still, there is ample anecdotal evidence to suggest that “corporate culture”
affects policies and important decisions. For example, the book Goldman Sachs: The Culture of Success
describes the importance of the Goldman culture, i.e., which defines the shared beliefs within the firm,
and how the firm instills these beliefs into its employees, particularly newly-hired ones. Another
observation is that different firms, even within this one single industry, can have very different beliefs
about the optimal course of action and corporate policies. Morgan Stanley is often said to be conservative
and risk-averse with a “culture of no” when it comes to investments.3 In sharp contrast, many Wall Street
analysts describe Citibank as having an “aggressive culture” and the firm has a record of growth through
large and risky mergers and acquisitions.4 Thus, casual observation suggests that firm-specific beliefs and
norms play a role for important corporate finance related decisions.5
The motivation for a study of the importance of culture in corporate finance is further emphasized
when we consider recent evidence on how much of the cross-sectional variation in corporate finance
practices is firm-specific and time-invariant. For example, Lemmon, Roberts and Zender (2007) analyze
capital structure decisions and find that firm-specific effects account for more than 90 percent of the
explained variation across firms, whereas standard models account for about 6 percent. Other authors,
and also Table 4 in this paper, find similar evidence for many other policies. Thus, the main determinant
of cross-sectional variation in many corporate policies is firm-specific and time-invariant, and to explain

3 See BusinessWeek, June, 2006.
4 See BusinessWeek, October, 2004.
5 There is evidence from surveys on the importance of shared beliefs and norms within firms. For example, the
General Social Survey (GSS), an attitude survey performed by the NORC at the University of Chicago, included a
work organization module in 1991, which shows that 78 percent of those surveyed agree with the statement “I find
that my values and the organization’s values are very similar.”
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firms’ investment and financing decisions, we have to consider firm characteristics that remain largely
fixed over long periods. Based on economic theory, we hypothesize that the firm’s “corporate culture” is
one such latent firm characteristic.
Identifying culture effects in corporate finance practices is empirically very challenging. The
approach we take in this paper is to systematically examine commonality in investment and financing
decisions among spinoff-parent firm pairs. This approach is motivated by economists’ work on culture in
settings other than a corporate one. In their review of the impact of culture for economic outcomes,
Guiso, Sapienza and Zingales (2006) argue that a study of culture should focus on behavior that is
“inherited by an individual from previous generations” (p. 24). Bisin and Verdier (2000) and Fernández,
Fogli and Olivetti (2004) argue that the transmission of culture from one generation to another takes place
through parents’ tendency to instill beliefs about the “right” behavior into their children based on what
they learned from their own parents without a full reassessment of the current optimality of those beliefs.
We argue that adopting this intuition is useful also in a corporate context. In our setting, a spinoff
firm inherits its parent firm’s culture and beliefs by virtue of inheriting managers and workers with the
parent firm’s beliefs about the optimal course of action and policies. By taking this approach of
“deriving” culture effects from observed firm behavior, we want to avoid the subjective task of explicitly
measuring corporate culture.6 We recognize that our approach to examining the impact of culture of firm
policies is not without challenges, but measuring corporate culture explicitly is at least as problematic in
our assessment, so an approach of indirectly deriving culture effects might thus be the best available
starting point.
Our empirical evidence consists of two parts. First, based on the above intuition, we hypothesize
that, controlling for industry and other firm characteristics, spinoff firms choose similar policies to those

6 There is a body of work in the management literature that studies “corporate culture” (e.g., Schein (1985) and
Kotter and Heskett (1992)). However, both the empirical methodology of these studies and the firm behavior
analyzed differ substantially from the study we are undertaking. First, a lot of management studies are based on
case studies of select firms. Second, much work is based on surveying employees on some dimensions, and then
using their responses to infer the content or strength of a firm’s culture. Finally, whereas the outcomes considered in
the management literature are often process-related, e.g., a corporation’s structure or its communication practices, in
this paper we analyze policies related to investments and financing.
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of their parent firms even after the split-up, i.e., when the firms operate as separate stand-alone
companies. Consistent with this prediction, we find that spinoff firms’ corporate finance practices are
much more similar to those of their parent firms than to those of their own matched industry peer firms.
The economic magnitudes of these effects are found to be large. We also show that the similarities in
policy choices are persistent over a long period, are not due to inertia causing stickiness of the initial
policies, and cannot be explained by ownership links, customer-supplier relationships, industry links, or
other contractual links that sometimes remain between spinoff and parent firms after the split-up.
Second, because we are still concerned that the observed commonality between the spinoff and its
parent firms’ investment and financial policies is caused by an omitted variable, we also study the cross-
section of spinoff-parent firm pairs by examining among which subsets of firms the similarities are the
strongest. Our hypotheses concerning where we would a priori expect stronger effects draw on theories
of corporate culture (Lazear (1995), Hermalin (2001), Van den Steen (2005a,b) and Bernhardt, Hughson
and Kutsoati (2006)) and experimental evidence on “culture clashes” in mergers (Weber and Camerer
(2003)). Consistent with predictions yielded by these theories and experiments, we find that the
similarities are significantly stronger for internally grown spinoff firms than for spinoff firms that
previously became part of the combined firm as a result of a merger or acquisition. We also find stronger
similarities for spinoff firms that originate from older parent firms. We conclude that the observed
commonality in spinoff and parent firms’ corporate finance practices is stronger among the subset of
firms where economic theory predicts that the shared beliefs about the optimal course of action are likely
to be stronger and more ingrained.
Our paper is most closely related to the recent work on managerial “style” in firm policies by
Bertrand and Schoar (2003).7 However, we argue that the effects reported in this paper are different from,
but related to, such style effects. First, Bertrand and Schoar show that there are significant “CEO fixed
effects” in investment and financing policies, but at the same time there are also significant firm fixed

7 Malmendier and Tate (2005) and Ben-David, Graham and Harvey (2006) also have studied how managerial biases,
such as overconfidence, can affect corporate finance practices.
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effects in these policies.8 That is, while controlling for who a firm’s CEO is helps explain firm behavior,
it does not seem to alter the conclusion that the main determinant of cross-sectional variation in many
corporate policies is firm-specific and time-invariant. Second, and more importantly, because the CEO of
a spinoff firm is by definition not the same individual as the CEO of the parent firm, what we are
documenting in this paper cannot be individual CEO style effects, but rather “management culture”
effects. We view a firm’s culture as more than the specific characteristics of the firm’s CEO: it is a latent
firm characteristic that evolves slowly over time and that does not come and go with a particular CEO.
Our interpretation of the evidence in this paper of wide-spread beliefs within a firm about the “right”
corporate practices is also consistent with the recent evidence presented by Bloom and Van Reenen
(2007).9
We are not first to use the term “culture” or to find evidence of its importance in explaining
economic outcomes related to corporate finance. Previous work has studied the effects of culture and
shared beliefs at the country level. For example, using a country’s principal religion as a proxy for its
culture, Stulz and Williamson (2003) find that it predicts the cross-sectional variation in creditor rights
better than a country’s openness to international trade, its language, its income per capita, or the origin of
its legal system. In another example, Guiso, Sapienza and Zingales (2005) find that beliefs rooted in
culture impact cross-country trade, portfolio investment, and direct investment among European
countries. In contrast, we study culture at the individual firm level in this paper. Although, e.g., religion
is only one possible proxy out of many for culture at the country level, explicitly measuring culture at the
firm-level is an even more subjective task than finding a proxy at the country level. This motivates the
approach taken in this paper of indirectly deriving culture effects from observed behavior rather than
explicitly measuring culture at the firm level.

8 Firm fixed effects do not proxy for CEO fixed effects, at least when studying a longer time-series, because the
average CEO tenure from is only about seven years (Kaplan and Minton (2006)).
9 Bloom and Van Reenen (2007) use survey data on practices of middle management. They argue that “[corporate
practices] are part of the organizational structure and behavior of the firm, typically evolving slowly over time even
as CEOs and CFOs come and go.
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We also want to recognize that prior work in the corporate finance literature has analyzed the decision to
spin off a firm.10 Parent firms have been found to do spinoffs to improve incentive-based contracts
(Schipper and Smith (1983)) and to make spinoff and parent managers focus on their respective core
businesses (Daley, Mehrotra and Sivakumar (1997)). While it can be an endogenous choice to spinoff a
firm, it is not clear that this per se biases our evidence towards more commonality in spinoff and parent
firms’ policies.11 First, our evidence that spinoff firms tend to choose similar practices to their parent
firms becomes even more surprising in light of the previous literature’s evidence that the spinoff firm’s
management has much stronger incentives to focus on the stand-alone company’s business than they had
previously. Second, if a firm is spun off because it does not “fit in,” i.e., has a different “subculture” and
different beliefs about the optimal policies than its parent firm has, then we would expect to find little or
no post-spinoff commonality in policy choices.
The paper is organized as follows. Section 2 reviews existing economic theories of corporate
culture. Section 3 outlines our empirical framework. Section 4 describes our spinoff-parent firm dataset.
Section 5 reports our results. Finally, Section 6 concludes.

2. Economic theories of corporate culture
To explain why a firm’s “corporate culture” can be expected to play an important role for
corporate decisions and policy choices, we draw on an emerging theoretical literature in economics. In
this section, we review these theories.12

10 In addition to work on the spinoff decision, there has been some empirical work related to spinoff firms’ leverage
decisions (e.g., Mehrotra, Mikkelson and Partch (2003)) and investment behavior and efficiency (e.g., Gertner,
Powers and Scharfstein (2002), and Ahn and Denis (2004)). In recent work, Colak and Whited (2007) control for
differences between firms and the endogenous choice to split up the firm, and in contrast to previous work in the
literature, they find no evidence of changes in investment efficiency between firms that spin off or divest divisions
and a control sample.
11 The number of arguably exogenous firm split-ups due to, e.g., antitrust rulings, is very low, preventing us from
any meaningful statistical tests of this subset of observations. However, we do not believe that analyzing spinoff
transactions that are not due to antitrust rulings or the like would bias our results towards finding evidence of
commonality in spinoff and parent firms’ policy choices.
12 We refer to Hermalin (2001) for a more extensive review of economic theories of corporate culture.
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In a neoclassical model of the firm where the rational expectations assumption leads to all beliefs
about optimal firm behavior coinciding, there is no room for heterogeneous beliefs across firms, and
therefore corporate culture has no meaningful economic role to play in such a model. However, starting
with Kreps (1990), economists have used various economic models to explain the existence of firm-
specific beliefs about right firm behavior using the term “corporate culture.” Building on the assumption
of incomplete contracts, Kreps presents a theory in which a firm’s culture acts as a substitute for costly
coordination and communication by prescribing what the “right” behavior is in a firm. As corporate
decision makers are confronted with multiple equilibria or have to adapt to unforeseen contingencies they
find out what works and what does not work and that establishes the culture in the firm. That is, in
Kreps’s (1990) view, a firm’s culture is the set of shared beliefs about the optimal course of action and
policies in a firm and it differs across firms depending on the firm’s history.
In a related economic analysis of corporate culture, Crémer (1993) develops a model based on the
assumption that managers’ and workers’ capacity to receive, process, and transmit information is a scarce
resource. He then defines corporate culture as the stock of knowledge shared by employees of a firm, but
not by the overall population from which they come. By sharing this stock of knowledge, contracting
costs can be reduced. In particular, Crémer argues that corporate culture has three elements that will
make it an effective coordination mechanism in corporate decision making: (i) it provides a common
language; (ii) it ensures a shared knowledge about important facts; and (iii) it provides common
knowledge of the established norms of behavior in the firm.
Lazear (1995) expands on this notion of corporate culture by developing a dynamic model that
implies homogeneity in beliefs and preferences within a firm, but heterogeneity in the overall population
from which managers and workers are drawn. Lazear’s model explains how a firm’s culture, once
formed, can persist over time through (i) selection of employees who share the firm’s beliefs, or (ii)
employees’ internalization of the beliefs, preferences, and norms in a firm. In his model, workers’
preferences are like genetic endowments, so when a worker meets (or “mates with,” in Lazear’s
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terminology) another worker in the firm, his preferences evolve to be a combination of his former
preferences and those of the one he just met.
In another economic analysis of corporate culture, Van den Steen (2005a,b) models how firms
select like-minded managers and workers who share the firm’s particular beliefs about the optimal course
of action. Van den Steen’s models imply that a firm’s culture and shared beliefs are persistent, remain in
the firm even after all founders are gone, and are largely independent of management, i.e., it is a latent
firm characteristic that evolves slowly over time and that does not come and go with a particular CEO.
Finally, Bernhardt, Hughson and Kutsoati (2006) model how managers select and promote employees
with similar skills to their own because they can more easily evaluate those skills.

3. Empirical framework and predictions
An important implication of the above theories is that a firm’s culture is specific to the firm and
largely fixed over long periods. Therefore, the first step of our empirical analysis involves panel
regressions to estimate, for each corporate finance related policy of interest, the component that is specific
to that firm, controlling for industry, year, and time-varying firm characteristics. However, we are not
interested in these fixed effects per se, but rather the component of a spinoff firm’s fixed policy effect that
is shared with its parent firm, i.e., the corporate culture. Thus, in the second step, we assess the extent to
which the policy choices by spinoff firms can be explained by those of their parent firms using the
estimated spinoff and parent fixed effects from the first step. In this section, we describe this empirical
framework in more detail.

3.1. Estimating firm fixed effects
The first step is to estimate the following OLS regression specification for each policy:
y = α + β X
+ λ + λ
+ λ + λ + e s ≠ p ≠ c ≠ b


(1)
i,t
t
i,t
i,s
i, p
i,c
i,b
i,t
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where y is a firm policy variable for firm i in year t, α is a year fixed effect, X is a vector of time-
i,t
t
i,t
varying firm-level controls, and e is an error term. To account for industry effect, y and X are
i,t
i,t
i,t
industry-adjusted each year by subtracting the industry means from the raw values. We use two-digit SIC
codes to define industries, but we have checked that our findings are robust to rather using the Fama and
French (1997) industry classifications.
The remaining variables in equation (1) are firm fixed effects: the λ ’s are fixed effects for
s
spinoff firms, the λ ’s are fixed effects for parent firm, the λ ’s are fixed effects for combined firms
p
c
prior to the split-ups, and finally, the λ ’s are fixed effects for benchmark firms, i.e., Compustat firms
b
that are neither spinoff, parent, or combined firms. We do not measure the parent fixed effects using data
from years prior to the split-up as the consolidation of balance sheets may introduce a mechanical positive
relation between spinoff and parent firm fixed effects in the second step of the analysis. That is, prior to
the spinoff, we estimate one firm fixed effect for the combined firm; after the spinoff, we are able to
estimate separate fixed effects for the spinoff and parent firms.

3.2. The relation between spinoff and parent firm fixed effects
The second step involves estimating the following OLS regression specification for each policy:
λ
= a + bλ
+ u








(2)
j,s
j , p
j
where λ
and λ
are spinoff and parent firm fixed effects, u is an error term, and j denotes specific
j ,s
j, p
j
spinoff-parent firm pairs.13 Equation (2) is estimated with robust standard errors (White (1980)).
We can provide some intuition for this approach. Each spinoff and parent fixed effect can be
decomposed into two parts. The first component is shared among the spinoff firm and its parent firm.

13 We recognize that the right-hand-side variable in equation (2) is an estimated coefficient from the first step, which
is noisy by definition. This can lead to attenuation bias in an OLS estimation of b in the second step. In section
5.1.2, as an alternative, we therefore also report evidence from non-parametric and parametric estimation methods
applied on the panel dataset collapsed at the firm-level. The results from these estimation methods are stronger in
statistical terms.
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