Founding family ownership and the agency cost of debt
Ronald C. Andersona, Sattar A. Mansib, and David M. Reebc*
aKogod School of Business, American University, Washington, DC 20016
b Pamplin College of Business, Virginia Tech, Blacksburg, VA 24061
c Culverhouse College of Commerce, University of Alabama, Tuscaloosa, AL 35487
(Received 19 September 2001; received in revised form 11 February 2002)
We investigate the impact of founding family ownership structure on the agency cost of debt.
We find that founding family ownership is common in large, publicly traded firms and is related,
both statistically and economically, to a lower cost of debt financing. Our results are consistent with
the idea that founding family firms have incentive structures that result in fewer agency conflicts
between equity and debt claimants. This suggests that bond holders view founding family ownership
as an organizational structure that better protects their interests.
JEL Classification: G3
Key Words: Ownership Structure; Agency Costs of Debt; Corporate Governance; Blockholders
The authors would like to thank John Bizjak, Augustine Duru, Scott Lee, Cyndi McDonald,
Michel Robe, Leigh Riddick, Pat Rudolph, seminar participants at American University, and an
anonymous reviewer for their assistance and valuable insights on our research. We are also grateful
to Theodore Barnhill III of the Financial Markets Research Institute at the George Washington
University for providing firm debt data. All remaining errors are the sole responsibility of the
*Contact Information: Culverhouse College of Commerce, 200 Alston Hall, University of Alabama,
Tuscaloosa, AL 35487
E-mail Address: firstname.lastname@example.org
Prior literature suggests that equity ownership structure affects the manager-shareholder agency
conflict. Morck, Shliefer, and Vishny (1988) and McConnell and Servaes (1990) observe that
managers’ and shareholders’ interests become more closely aligned as managerial ownership
increases, resulting in improved firm performance. However, as managers’ equity stakes continue to
increase, their interests begin to diverge from those of the shareholders, leading to greater agency
problems and declining firm performance.1 Grossman and Hart (1980) and Shleifer and Vishny
(1997) suggest that large, unaffiliated stockholders can also impact manager-shareholder agency
conflicts, because they have powerful incentives to monitor managers.
Although a substantial amount of research addresses the relation between ownership structure
and the manager-shareholder agency problem, little, if any, work examines the relation between
ownership structure and the shareholder-bondholder agency conflict. Jensen and Meckling (1976)
observe that diversified shareholders have incentives to expropriate bondholder wealth by investing
in risky, high expected-return projects (asset substitution). Bondholders, anticipating such
incentives, demand higher rents, resulting in a higher cost of debt capital. However, equity holders
with large undiversified ownership stakes may have different incentive structures relative to
atomistic shareholders (Shleifer and Vishny, 1997). Since firms regularly re-enter debt markets for
financing, these concentrated equity holders, who are typically long-term investors with substantial
wealth at risk, potentially have a strong impetus to mitigate agency conflicts with bondholders.
We explore whether the presence of large, undiversified shareholders mitigates diversified equity
claimants’ incentives to expropriate bondholder wealth (i.e., the agency cost of debt). We focus on a
prevalent form of undiversified ownership in public firms, that of founding families. Gersick et al.
(1997) estimate that family firms account for 65% to 80% of all businesses. Similarly, among our
sample of Standard and Poor’s (S&P) 500 firms, one third have continued founding family
ownership, with families on average holding about 19 percent of the firm’s shares. Founding
families are a unique class of investors. The combination of undiversified family holdings, the desire
to pass the firm onto subsequent generations, and concerns over family and firm reputation suggest
that family shareholders are more likely than other shareholders to value firm survival over strict
adherence to wealth maximization. As such, we posit that the divergence of interests between
founding family shareholders and bondholders is potentially less severe than between diversified,
atomistic shareholders and bondholders. If so, we anticipate that family ownership in public firms is
associated with a lower agency cost of debt.
Using a sample of 252 industrial firms from the Lehman Brothers Index database and the S&P
500, we find evidence that family ownership is associated with a lower agency cost of debt. After
controlling for industry and firm specific characteristics, our analysis indicates the cost of debt
financing for family firms is about 32 basis points lower than in non-family firms. Our results
further indicate that the gains in debt financing are not uniform over the entire range of family
ownership. Specifically, the greatest gains accrue to those firms with less than 12% founding family
ownership.2 Overall, our investigation suggests that bond investors view founding family ownership
as an organizational structure that better protects their interests. The results are both statistically
and economically significant and are robust to concerns of endogeneity, outliers, nonlinearities in
credit markets, and alternative measures of the key variables.
1 Other research on this topic includes Woidtke (2002), Zhou (2001), DeAngelo and DeAngelo (2000), Himmelberg,
Hubbard, and Palia (1999), and Karpoff, Malatesta, and Walkling (1996). For an overview of the manager-shareholder
agency conflict and corporate governance see Shleifer and Vishny (1997).
2 We find that firms with family ownership levels of less than 12% enjoy about a 43 basis point reduction in the cost of
debt financing, while firms with greater than 12% ownership have about a 22 basis point reduction in the cost of debt
(all relative to non-family firms). This issue is explored in detail in Section 4.
Our results also indicate that founding families can have a detrimental effect on the shareholder-
bondholder relation by holding the CEO position. Specifically, we find that when family members
hold the CEO position, the cost of debt financing is higher relative to family firms with outside
CEOs. The higher debt costs are primarily attributable to founder descendents rather than founder
CEOs. This evidence implies that founders bring unique, value-adding skills to the firm, while
descendents are more likely to detract from firm performance, perhaps because they obtain the
CEO position through family ties rather than job qualifications. This interpretation is consistent
with the results in Johnson et al. (1985), Morck, Shleifer, and Vishny (1988), and Gomez-Mejia,
Nunez-Nickel, and Gutierrez (2001) suggesting that founder CEOs are associated with strong
performance early in their careers, poorer performance in later years, and that family member CEOs
are more entrenched in their positions. However, after controlling for CEO type, we find that
family firms continue to experience significantly lower costs of debt financing relative to non-family
firms. Finally, we examine another independent firm monitor, outside blockholders, that are more
likely to be strong advocates for equity value maximization rather than firm value maximization. We
find that outside blockholdings do not appear to have an impact on the cost of debt. One
interpretation is that institutional investors represent the holdings of a well-diversified stockholder
(e.g., Fidelity Investments), while founding family ownership represents a committed and
undiversified stake that generates strong incentives for the family to monitor the firm.
Our research contributes to the literature in three important ways. First, we find that family
ownership impacts the cost of debt financing, providing the first evidence that equity ownership
structure influences the cost of debt.3 Second, our analysis suggests that large blockholders have
3 The only related work is that of Bagnani et al. (1994), who explore the effect of CEO ownership on bond holding
period returns. Holding period returns are a function of interest rate variability as they are based on the annual change
in bond prices. Elton and Gruber (1995) note that holding period returns bear little resemblance to the cost of debt
financing, and that corporate decision making or capital budgeting is typically described in terms of the cost of debt
financing (i.e., yield to maturity in computing the weighted average cost of capital).
varying incentive structures. Institutional investors, such as mutual funds and insurance companies,
have a significantly different effect on the cost of debt financing than family blockholders. Third,
prior literature is divided on whether stockholders or bondholders bear the agency costs of debt.
Jensen and Meckling (1976) suggest that equity holders bear this cost, while Barnea, Haugen, and
Senbet (1981) suggests that bondholders bear the cost. Our analysis, at least in relation to family
firms, suggests that these costs are born by equity claimants through higher debt financing costs.
The remainder of this paper is organized as follows. Section 2 reviews the related literature and
presents our hypotheses. Section 3 describes our sample, data, and variable measures. Section 4
describes the research design and presents the empirical results. Section 5 tests the robustness of
our results using alternative measures and specifications, and Section 6 concludes the paper.
2. Family firms and the agency cost of debt
The agency costs of debt are typically described in terms of the asset substitution or the risk-
shifting problem. The potential conflict between equity and debt claimants is such that shareholders
expropriate wealth from bondholders by investing in new projects that are riskier than those
presently held in the firm’s portfolio. In this case, shareholders capture most of the gains (i.e., when
high-risk projects payoff), while debtholders bear most of the cost (Jensen and Meckling, 1976;
Fama and Miller, 1972). Alternatively, the potential conflict between security claimants can be
examined in an option-pricing framework. Equity holdings, or the call option, are only exercised in
those states where asset value is greater than the value of the debt claim. As firm risk increases, the
option becomes more valuable, causing the value of the debt claim to decline.
Due to the shareholder-incentive problem arising from outside debt, bondholders typically insist
on protective covenants and monitoring devices to protect themselves from risk shifting. However,
the costs of writing and enforcing such contracts are not trivial. In addition, it is not possible to
contract for all future contingencies. For example, covenants that deal with additional financing,
dividend or lease restrictions, and mergers are relatively straightforward contractual arrangements.
However, convenants that restrict managers’ ability to invest in negative NPV projects are much
more difficult to monitor and enforce. As these agency costs of debt increase, the premium that
debtholders require increases. Consequently, conflicts of interests between shareholders and
bondholders lead to higher debt costs.
2.1. Founding Family Ownership and the Agency Cost of Debt
Large public firms are often characterized as having dispersed ownership, atomistic
shareholders, and a separation between ownership and control (Demsetz and Lehn, 1985). While
the potential for conflicts of interest among shareholders, debtholders, and managers are well
recognized in the literature (Berle and Means, 1932), the presence of large shareholders can alleviate
some of these conflicts because these shareholders have advantages in monitoring and disciplining
control agents.4 Yet, costs can arise with concentrated equity holdings that are not present in firms
with diffuse ownership. These costs can take many forms, including expropriation of wealth from
small shareholders in the form of special dividends, excessive compensation packages, and risk
Founding families represent a special class of large shareholders that potentially have unique
incentive structures, a strong voice in the firm, and powerful motives to manage one particular firm.
The unique incentives of founding families suggest that these shareholders can alleviate agency
conflicts between the firm’s debt and equity claimants.5 Specifically, beyond the undiversified nature
4 Tufano (1996) notes that not all large shareholders have the same incentives to monitor managers. Institutional
investors often have large shareholdings in multiple firms (e.g., Fidelity Investments Group), suggesting they may not be
strong monitors of management but rather seek high return/risky projects similar to atomistic owners.
5 Filatotchev and Mickiewicz (2001) show how concentrated equity claimants can collude with bankers or other fixed-
claim holders to expropriate wealth from minority shareholders; suggesting that large shareholders and debtholders have
of their holdings, we argue that founding families are different from other shareholders in at least
two respects; the family’s interest in the firm’s long-term survival and the family’s concern for the
firm’s (family’s) reputation.
First, we posit that founding families are interested in firm survival as they often hold
undiversified portfolios relative to atomistic shareholders and because they seek to pass the firm to
their heirs.6 Casson (1999) and Chami (1999) propose (following Becker 1974, 1981) that founding
families view their firms as an asset to bequeath to family members or their descendents rather than
as wealth to consume during their lifetimes. Specifically, families’ interests lie in passing the firm as
a going concern to their heirs rather than merely passing their wealth. Firm survival is thus an
important concern for families, suggesting that, relative to other large shareholders, they are more
likely to maximize firm value rather than shareholder value when a divergence occurs between the
two. As such, the divergence of interests between bondholders and shareholders is potentially less
severe in family firms than in non-family firms. If so, we anticipate that family firms will exhibit
lower costs of debt relative to non-family firms.
Second, founding families face reputation concerns that arise from the family’s sustained
presence in the firm and its effect on third parties.7 The long-term nature of founding-family
ownership suggests that external parties, such as bondholders, are more likely to deal with the same
governing bodies and practices for longer periods in family firms than in non-family firms. For
example, banks and other parties often develop personal and well-informed relationships with
the same goal of firm value maximization rather than shareholder wealth maximization. In contrast, Mueller and Inderst
(2001) argue that concentrated ownership could be associated with a higher agency cost of debt.
6 Using the Forbes’ Wealthiest Americans data, we find that on average, families have more than 69% of their wealth
invested in the firm.
7 Founding family members also face a unique internal labor market that potentially creates important reputation
concerns. Specifically, family members often vie to obtain senior management positions, board seats, or voting control
of the family’s shares. This suggests that family members can gain economic benefits from building and maintaining a
favorable reputation internal to the family. These internal reputation concerns can enhance any effects that the family’s
reputation plays with external parties.
company executives, suggesting that the family’s presence allows these relationships to build over
successive generations. Consequently, an exploitive action on the part of the family is likely to lead
bondholders to expect additional similar actions in the future as long as the family maintains its ties
to the firm. Thus, the family’s reputation is more likely to create longer-lasting economic
consequences for the firm relative to non-family firms where managers and directors turnover on a
more frequent basis. If families seek to maintain favorable reputations, we expect a negative relation
between debt yields and founding family ownership.
Founding families can further influence agency conflicts by placing one of their members in the
CEO position. By holding the role of CEO, families can more closely align the firm’s actions with
their own interests; suggesting an incremental reduction in the agency cost of debt relative to non-
family firms or family firms with outside CEOs. However, choosing the CEO from a restricted
labor pool (i.e., from among family members) potentially excludes more qualified outside personnel.
Morck, Schleifer, and Vishny (1988) find that in older firms, Tobin’s Q is lower for firms that have
founding family members as CEO but the result appears to be limited to founder descendents rather
than to founders. Johnson et al. (1985) suggest that even founders have a detrimental influence on
firm performance by noting a positive stock-price reaction upon the announcement of sudden death
of a founder. Gomez-Mejia, Nunez-Nickel, and Gutierrez (2001) extend this argument and posit
that family ownership leads to greater executive entrenchment. If creditors perceive that family
CEOs lead to poorer operating performance, we expect bondholders to require higher yields from
firms with family CEOs.
Although we posit that family ownership is associated with a lower agency cost of debt, an
alternative perspective is that families can exacerbate agency conflicts because they possess the voice
as well as the power to force the firm to meet their demands. Anecdotal accounts in the popular
press commonly imply that families expropriate wealth from their firms’ other constituents. A
recent recapitalization at Ford Motor Company, for example, increased the voting power of the
Ford family’s special stock, which led to widespread criticism that the company’s board of directors
had structured a plan to benefit the family at the expense of other claimants. If family ownership
increases agency conflicts, then we expect bondholders to require higher yields from family firms.
Our central research question is the effect of equity ownership structure on the agency cost of
debt. Since founding families arguably have similar incentive structures, they provide a clean and
powerful test of whether firm ownership influences debt costs. To this end, we address two specific
questions. First, do family firms enjoy lower costs of debt financing than non-family firms? Second,
does the level or type of family participation in the firm further impact the cost of debt financing?
After controlling for other factors affecting debt costs, we posit that founding-family incentive
structures reduce agency conflicts between equity claimants and bondholders, causing debt yield
spreads to decrease. This study provides a comprehensive empirical analysis on the subject, using
firm-level data on publicly traded, non-provisional debt.
3. Data Description
For our sample, we collected information on firms that are in both the Lehman Brothers Bond
Database (LBBD) and the S&P 500 Industrial Index. The LBBD provides month-end security-
specific information on corporate bonds, including market value, coupon, yield, credit ratings from
S&P and Moody’s, duration, and maturity on nonprovisional bonds. Lehman Brothers base their
criteria for inclusion in the database on firm size, liquidity, credit ratings, subordination, and
maturity. The database contains bonds of differing maturities, differing credit ratings, and differing
debt claims (senior and subordinated debt). The database’s goal is to provide a representative
sample of outstanding, publicly traded debt. While the database does not contain the universe of
traded debt, we have no reason to suspect any systematic bias within the sample.
We manually collect data on family ownership and family board representation from proxy
statements. The literature provides no commonly accepted measure or criterion for identifying a
family firm. As such, we collect data on the fractional equity ownership of the founding family. For
some firms, the process is straightforward since the proxy statement denotes the founder, his/her
immediate family members, and their holdings. However, several generations after the founder, the
family typically expands to include distant relatives or in-laws with different last names. We resolve
descendent issues by manually examining corporate histories for each firm in the sample. Histories
are from Gale Business Resources, Hoovers, and from company press releases and literature. We
attempt to capture all family firms and their equity holdings. However, U.S. reporting requirements
could cause a downward bias in our estimates of family ownership. This creates a bias toward zero
in our testing and also suggests that a binary variable approach could be more robust.
We use the Compustat Industrial Files to garner any firm-specific financial information not
already included in the Lehman Brothers Database or in annual corporate proxy statements. This
yields 1,052 firm-year observations on 252 firms for the period 1993 through 1998. To assess the
representativeness of our sample based on the LBBD Indices data, we also collect data on the
remaining 151 industrial firms in the S&P 500 (as of 1992). We find that (in the complete S&P data)
the percentage of family firms is about 34%, family ownership is about 18%, the natural log of firm
size is $8.55, and leverage is 18.4%. Comparing these results to our data, we find that our sample is
comprised of the larger firms in the S&P 500, and that as firm size decreases, family ownership
becomes more common. Descriptive statistics on the variables used in the analysis are presented in