Family Firms Perform Worse Without Professional Management

 Economists have found that family firms that pass the company down to the next generation perform worse than if they had brought in professional management. Freakonomics confirms this view. They report that:

+ Family firms are particularly dominant in less-developed countries, which tend to have weaker markets and rule of law. Here’s Vikas Mehrotra on that point:

In the developed world, you have good contracting environments, a good system of law enforcement, and so on. So, in the developed world, you can hire professional managers and expect a certain, you know, sticking to the contract law, and so on. It’s rather more difficult to have the same kind of adherence to the rule of law in emerging economies. So, in emerging economies, family firms sort of provide a second-best solution to this poorly developed institutional problem.

+ The U.S., despite having many highly visible family firms, is in fact far less enamored of inherited leadership than most other countries; Japan, meanwhile, is an exception, a wealthy country with a lot of handoffs to the next generation — but with a very strange twist.

Photo: Alessio85

+ If the above points are of any interest to you, then you should definitely read this Journal article titled “Culture Built on Family Firms Tests Italy’s Plan for Growth.” Note that it is hard to see what is the chicken and what is the egg — e.g., does the business environment, set by the government and the courts, dictate the proliferation of family firms or does the proliferation of family firms lead to a business environment whose habits are enabled by government and the courts?

Key excerpts:

Italy’s economy today is only about 3% bigger than a decade ago. Many factors have contributed to the country’s stagnation—from its rickety education system to its low rates of employment among women, youths and older workers. But a central reason, say economists, is that its private sector consists mostly of small mom-and-pop businesses that seem unable to grow.

And:

Behind the country’s stunted businesses lie the habits and fears of a long line of family entrepreneurs who cling to control of their companies late into life. Hemmed in by a thicket of regulation and legal restrictions, many of these families have learned to survive by doing business within networks of trusted customers and suppliers, rather than taking risks by dealing with outsiders.

“These firms have less propensity to innovate, engage less in research and development and rarely penetrate emerging markets,” said Mario Draghi, ECB President and former Bank of Italy head, in a recent speech.

And:

Italy’s legal and regulatory environment discourages firms from taking a leap in size, according to recent research. Businesses need an average of 258 days to get the permits they need to open a new warehouse in Italy, compared with 26 days in the U.S., according to the World Bank. And an entrepreneur who goes to court to enforce a contract must wait an average of 1,210 days for a resolution, compared with around 300 days in the U.S. or France.

As a result, entrepreneurs prefer to deal informally with people they know, rather than rely on public institutions if anything goes wrong. Thus they stay small even when they have the chance to grow, says Bank of Italy economist Magda Bianco. “The inefficiency of the court system is a widespread problem,” she says.