Family Ownership and Innovation
Innovation is the process of developing new technological knowledge and putting that knowledge to productive use. Cohen and Klepper (1996) differentiate innovation as process and product innovation – process innovation reduces production costs and product innovation increases the price that consumers are willing to pay. Both types of innovation are associated with the following risk factors: (1) The probability of the failure of R&D investment is higher than that of conventional investments; (2) new technologies tend to be opaque (Rajan & Zingales, 2001), which means that innovation is often less understood by market participants; and (3) the expected return on new technology depends on the firm's lead-time advantage, which means that the possibility of imitation by competitors may decrease the profitability of successful innovation projects (Helpman, 1993). Therefore, successful innovation requires sufficient innovation investment (such as R&D, marketing, programs to educate consumers about new technologies and products), and investment in external resourcing (such as attracting and retaining entrepreneurs and talented scientists). Therefore, well-developed financial systems are desirable for innovation (Hyytinen & Toivanen, 2005).
The ownership structure of a firm is an important determinant of its innovation activities (Lee & O'Neill, 2003) because ownership concentration may efficiently resolve agency problems or at least so it has been argued (Shleifer & Vishny, 1997). Large shareholders that care about the stability of the firm focus on long-term investment in new technology development even though it may mean temporary fluctuations in stock prices (Choi et al., 2012).
Family control is the dominant form of business around the world, but particularly in emerging markets; it is typically unchallenged by other equity holders (La Porta, Lopez-de-Silanes, & Shleifer, 1999). In many instances, family-owned businesses take the form of a small family business, whereas it is a large business employing hundreds, or even thousands of staff in other cases. For instance, studies document that one-third of the S&P 500 (Anderson & Reeb, 2003) and Fortune 500 (Shleifer & Vishny, 1986) firms are family firms. In emerging markets, the large family-controlled business structure is far more common (Manikutty, 2000), and this has particularly significant effect on innovation because these large family firms possess the advantages in R&D investment and economies of scale that are required for successful innovation. India is a good example of this type of emerging market because approximately 70 percent of Indian firms are family-controlled and large family-controlled business is a driving force of innovation in India because of the absence of any other type of concentrated ownership (e.g., Piramal, 1996).
The Extant Literature on Family Ownership and Innovation
In family-controlled businesses, it has been argued that the most severe agency problems result from the conflict of interest between majority and minority shareholders (La Porta et al., 1999). Therefore, the influence of family ownership on firm innovation originates from how well the two parties work together to reduce the agency problem and optimize resource allocation (Belloc, 2012). On the one hand, the advantage of family-controlled business is that concentrated family ownership means a high level of family involvement in the firm, particularly when the founders of the family serve as CEO or are on the board of directors. They have a strong attachment to and interest in their firms. Therefore, the incentive alignment argument is overwhelming and it reduces the agency problem between family (majority shareholder) and other equity holders of the firm (minority shareholders). More recently, there have been studies that extend agency theory to explain the impact of family ownership and innovation by incorporating stewardship theory. These studies show that the family normally holds its stakes for a long time and targets greater benefits, such as the firm's growth, technological innovation and long-term firm survival (Anderson & Reeb, 2003; Le Breton-Miller et al., 2011). Moreover, family ownership tends to invest in R&D and technological innovation rather than opting for the traditional approach of sales maximization for short-term profitability. Therefore, family ownership should have a positive effect on a firm's innovation activities.
On the other hand, however, it has also been argued that family owners tend to expropriate corporate wealth because they hold a significantly great percentage of the outstanding stock and usually dominate the board of directors (La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 2000). When this behavior arises, it creates a significant agency problem between majority and minority shareholders. When insider family owners expropriate outside investors by diverting corporate resources for their personal interests, it is difficult to raise financing for technological projects and to allocate capital to invest in innovation (Morck, Wolfenzon, & Yeung, 2005). Therefore, the impact of family ownership on innovation might be negative.
Thus far, there are only limited empirical studies to test the above theoretical arguments, and they have focused mostly on R&D activities in family-controlled business, leaving the direct examination of the role of family ownership on innovation unexamined. Moreover, because the empirical evidence comes from both developed and emerging markets, the results are inconclusive.
Studies in developed economies note that founding families – because they are aware of the learning curve of their firms – generally have insider knowledge of R&D activities (Anderson & Reeb, 2003), which enhances innovation capabilities. In addition, by holding large equity ownership portions of these firms, founding families tend to want to invest more in R&D (Block, 2012). However, using survey data collected by Banque de France, Sirmon et al. (2008) show that French family firms maintain higher investment in R&D than non-family firms, which leads to higher innovation performance, but the innovation performance decreases as the level of ownership held by families increases.
In Korea, another emerging market, Kim et al. (2008) show that family members are more willing to invest in long-term projects, such as R&D, for their firms than other shareholders. Ayyagari, Demirgüç-Kunt, and Maksimovic (2011) study 19,000 firms across 47 developing countries and find that controlling families improve a firm's innovation activities. However, investigating data from Taiwanese family firms, Chen and Hsu (2009) argue that family members may abuse their power and misuse the funds, which leads to decreasing R&D intensity.
Gaps in the Literature
The prior literature on agency theory indicates that agency theory – even when reconciled with stewardship theory – cannot provide a convincing explanation for the role of family ownership on innovation, because the agency framework has yet to fully address the influence of the institutional settings of emerging markets. La Porta et al. (1999) argue that the agency problem between majority and minority shareholders and the effectiveness of the agency framework to reduce the agency problem is largely influenced by the institutional environment, such as poor protection of minority shareholders. In addition, in emerging markets, the use of pyramidal groups to separate the cash flow rights from the voting rights of majority family owners leads to the entrenchment of the dominant family. One of the dominating mechanisms of this type of expropriation of minority shareholders in emerging markets is transferring (tunneling) a significant proportion of wealth by the family owners from firms in which they have large control rights to firms in which they have both large cash flow and control rights (Johnson, La Porta, Lopez-de-Silanes, & Shleifer, 2000; Morck & Yeung, 2003). This tunneling of assets in the pyramidal structures of family firms leads to gain by the family at the expense of other stakeholders. Recent studies have documented such problems in family business groups in Western European and East Asian markets (Claessens et al., 2000; Faccio & Lang, 2002). Because of persistent tunneling, the agency conflict may decrease revenues and affect the innovation activities of family firms. However, the literature has not fully addressed the complex relationship between family ownership and its influence on innovation, particularly in emerging economies. Therefore, the first gap we have identified in the existing literature is that there is a lack of evidence to help reconcile certain conflicting results from agency theory and the institutional perspective to explain the role of family ownership on innovation.
The second gap we have identified in the literature is that there are limited empirical studies that have examined family ownership and innovation from an external resourcing perspective in emerging markets. With respect to the external resourcing perspective, this issue is particularly important in India because a large number of Indian family firms are affiliated with business groups that are the primary channel of providing and accessing resources (Piramal, 1996). As we mentioned earlier, innovation activities significantly depend on external resourcing (technology transfers, attracting and retaining talented scientists, foreign direct investment, etc.), which is also influenced by the institutional framework of any specific country. Therefore, this raises the question of how Indian family firms can enhance innovation through external resourcing with weak institutions.
The type (and degree) of agency problems in listed firms is largely affected by ownership structure and institutional environment (La Porta et al., 2000). We will investigate how the ownership structure of listed family business shapes agency problems and how the relationship between family ownership and innovation may be affected by variation in the institutional framework.
The literature argues that, in developed economies such as the United States or the United Kingdom, better legal protection for shareholders (particularly for minority and outside shareholders) encourages founding families and the family members to dilute their equity (Peng & Jiang, 2010). The concentration of ownership in listed family business is much less in developed countries than in emerging markets (Khanna & Palepu, 2005). The ownership structure of listed family firms in developed markets is dispersed compared to that in emerging markets; thus, in developed markets, the agency problem between majority and minority shareholders is not of major concern (La Porta et al., 2000), and the dominant agency problem is conflicts of interests between owners and managers (Morck & Yeung, 2003).
A special feature of family business in India is that large firms belong to family business groups in affiliation with business groups (Chakrabarti et al., 2008). In business groups, the family firms control other firms; following a pyramid structure, each firm again controls many other firms (Morck & Yeung, 2003). Although public shareholders provide capital at different stages of the pyramid structure, they do not become the majority shareholder in any family firm affiliated with the group, and their role in providing capital and corporate governance related activities is insignificant (Morck & Yeung, 2003).
In addition to this pyramid ownership structure and similar to other emerging economies, India is also characterized by the absence of sufficient judicial and regulatory institutions, which leads to a variety of market failures that are characterized by inadequate disclosure, weak corporate governance and weak securities regulation. The combination of an undeveloped institutional framework and inefficient capital markets encourages concentrated family ownership; thus, founding families hold a majority of equity ownership of their firms to maintain sufficient control (e.g., Khanna & Palepu, 2000b). A larger proportion of ownership in the hands of few owners, such as founding families, motivates them to monitor managerial decisions, to minimize managerial agency costs (Anderson & Reeb, 2003) and to take measures to protect their firms' interests. Burkart, Panunzi, and Shleifer (2003) argue that the less that outside investors are protected legally, the greater the need for large family shareholders that can minimize the agency problem between owners and managers in an emerging market. Moreover, managers in publicly traded family firms tend to develop a reputation for not expropriating minority shareholders and, consequently, minority shareholders support the family owners because the family owners control the managers in emerging markets (Gomes, 2000). Therefore, it is expected that managers in family firms are more likely to be aligned with the founder family so that the conflict of interest between minority shareholders and family owners in India is more likely minimized.
In addition, the large shareholders of the firm can influence the allocation of scarce resources for competitive and challenging investments such as in innovation and monitor how the investments are being utilized (Hoskisson, Hitt, Johnson, & Grossman, 2002). Because of the institutional underdevelopment in the markets in India, the high level of interaction, common understanding, and natural alignment of interests between family members and employees enables the family owners to integrate any individual specialized technological knowledge either family members or employees may have (Chirico & Salvato, 2008). These firms are strongly embedded in the society (Fuller & Tian, 2006) and are often recognized as successful entrepreneurs who can communicate their new ideas more effectively with their governments. These owners can obtain social and political capital, secure the supply of raw materials, financing and government contracts (Singh & Gaur, 2009); all of which enhance technological innovation. Their economics of scale and technological competence are far superior to other types of firms (Chirico & Salvato, 2008). They also have strong social and cultural influences in the society and maintain good links with government agencies and can thus protect their innovation technologies (patents) and products (Singh & Gaur, 2009). It is plausible that concentrated Indian family firms may focus more on utilizing resources in innovation to enhance firm performance than on expropriating minority shareholders.
In summary, although the same types of agency problems in firms of developed markets afflict family firms in emerging markets such as India (e.g., the agency problem between majority and minority shareholders, between owners and managers, or between two family firms affiliated within the same business group), we argue that the degree of such agency problems, particularly between majority and minority shareholders, are less severe. The benefits of concentrated family ownership that help overcome institutional underdevelopment and facilitate in obtaining external resources outweigh these agency costs, and these benefits are essential for technological innovation. Whereas agency theory drives the internal corporate governance mechanism, external mechanisms, such as institutional development, complement the impact of family ownership on innovation in emerging markets and promote the evolution of dynamic capabilities for innovation in family firms. We thus propose our first hypothesis:
- Hypothesis 1. Family ownership in India has a positive impact on the innovation activities of family firms.
Affiliating with business groups of Indian listed family businesses enables certain institutional underdevelopment to be filled and controls certain agency problems in firms; business groups are able to perform intermediating functions and mitigate resource diversification costs.
Strong intermediary institutions provide the necessary financing, technology and management talent for innovation in developed markets (Munoz-Bullon & Sanchez-Bueno, 2011). However, these facilitating intermediary institutions are absent in emerging markets, such as India, because of institutional underdevelopment, which motivates the Indian business group to support its innovation activities. Unlike developed markets, in the emerging markets, large business groups act as intermediary institutions between family firms and the imperfect market (Khanna & Palepu, 2000b). In other words, these business groups, although they are structurally different from US conglomerates or Japanese keiretsu (owned by large banks), often replicate the function of stand-alone intermediary institutions in developed markets. The group-affiliated Indian family firms can obtain access to “internal capital markets” for funds and utilize group reputation for other essential external resources for innovation activities (Almeida & Wolfenzon, 2006). Khanna and Palepu (2000b) empirically show that affiliation with large Indian business groups increases firm performance by overcoming external institutional underdevelopment in the Indian market.
As a result, these business groups can also mitigate the cost of their diversification because they restrict the use of the internal capital markets to prop up inefficient operations, and transaction costs during business operations are minimized. In his seminal study on the role of the business group to mitigate capital market distortion, Leff (1976) argues that the group structure provides a mechanism to mobilize managerial talents and technological knowledge, in addition to helping affiliated firms to access internal capital markets, which addresses the need for efficient external capital markets (Almeida & Wolfenzon, 2006). Family ties within business groups can also provide unconditional trust and an organizational culture of altruism and stability, which combine to reduce transaction costs that result from information asymmetry and disputes. The success of innovation is often uncertain and invites risks that require trust and understanding among family members and employees. Intense interactions among group affiliates help to achieve trust and confidence and to increase the likelihood of sharing risks (Zahra, 2003). Therefore, affiliation with large business groups can help family firms perform more effectively in the presence of institutional underdevelopment and resolve certain information and transaction costs in emerging markets (Chu, 2004). Khanna and Palepu (2000b) show that the largest and the most diversified business groups in India perform well; in addition, they share their reputations and political connections among themselves.
Thus we develop our second hypothesis as follows:
- Hypothesis 2. Business group affiliation positively influences the relationship between family ownership and innovation, such that family firms affiliated with business groups are more innovative than stand-alone family firms in India.