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The Relational Structure of Family Businesses

Posted By Benjamin Means On February 22, 2013 @ 3:00 pm In Corporate Law, Family & Personal Law, Uncategorized, William and Mary Law Review | No Comments

Corporate law scholarship has largely failed to account for the distinctive needs of family businesses.1 In a forthcoming  article in the William & Mary Law Review,2 I argue that family businesses are an extension of family relationships and include both nonmarket and market values.  In particular, successful family businesses must find ways to mediate the tension between expectations rooted in family life and expectations inherent to the marketplace.  This Editorial summarizes the principal claim, identifies its departures from more traditional corporate law scholarship, and advocates further engagement with family law scholars who have explored the relationship of economic exchange and intimacy.


I.

One of the great insights we owe to the economic analysis of law is its characterization of the corporation as a “nexus of contracts.”3 Rather than seeking to understand the corporation as a metaphysical entity—a person created by law and invested with certain rights—it is often better to think of a corporation or other business entity as a web of voluntary agreements among the various participants.

According to this “contractarian” view, business enterprise laws mainly offer default rules rather than a fixed structure.  Investors do not have to write a brand new contract, because most of the provisions that they would want are already included in the basic statute.  And choosing the business entity form is itself a contractual choice.  Of course, investors should also negotiate specific provisions to protect interests not covered by the general default rules.  And this is particularly true in a small business in which tailored negotiation is more feasible than in a large, public corporation.

If business organizations are essentially arm’s length contracts, then market values govern their formation and interpretation.  Before a contract comes into being, the parties owe each other nothing and their rights and obligations are spelled out in the bargain they enter.  We assume that each individual will act rationally to protect herself, gathering sufficient information and negotiating to maximize her interests, usually assumed to be an economic return on the investment.

This story seems to leave little room for family relationships and values.  Assuming that the goal is to maximize economic return, it is not particularly relevant whether fellow investors are also family members.  As a rational actor, in fact, a person would only pursue an investment in a family business if it offered the highest risk-adjusted return compared with other available alternatives.4 Also, that individual would invest (and negotiate) knowing that the applicable legal rules in the event of a dispute would be supplied by partnership law, corporate law, or LLC law, as the case might be, and not by any separate family code of conduct.

From the standpoint of rational-choice economics, the chief advantage of family relationships may be the lowering of transaction costs associated with investment in a business venture.  When it is cost prohibitive to negotiate a particular issue, a rational actor may rely instead on the trust that often exists among family members and that makes opportunism less likely.

Thus, in the standard approach to corporate law, which is heavily influenced by law and economics, family-owned businesses are economic institutions on the same footing as any other.  Preexisting relationships among investors do not count.  What matters is the investors’ choice of entity and specific bargaining that further identifies choices with respect to governance, taxation, financial return, and the like.

II.

Although family businesses seek to earn profits, they are not simply economic organizations governed by the logic of an impersonal marketplace.  They are also a continuation of family relationships—the business system is embedded in a family system and the two are deeply interrelated.  This is more than a story about solving transaction costs.  Notably, while relationships of trust and loyalty can lower transaction costs, the strength of family ties offers an intrinsic benefit for family business participants apart from any economic return that might be achieved.

Getting the story right matters, in part, because family businesses are hugely important to the economy:  they are the clear majority of all businesses, employ about half the nation’s workforce, and contribute a substantial amount to the nation’s gross domestic product.5 The typical family business operates on a small scale, but some of the nation’s and the world’s largest enterprises are family controlled.

For present purposes, a simple definition of family business will suffice.   First, the family must be able to control or strongly influence business decisions—typically, this means appointing top management.  Second, at least two family members must be involved as owners or managers.  Defining family business also presupposes the answer to a more basic question:  what do we mean by family? Without invoking a formal definition or seeking to resolve hard cases, we can rely on the participants’ own understanding of their mutual relationship—in a prototypical case, there are parents and children, siblings, and sometimes cousins involved.  In those businesses, social identities overlap and may clash.

According to social identity theory, we find our way in different social environments by relying upon roles that help us to define our place and our responsibilities.  For most of us, our workplace identity is very different from the role that we play in family life.  But in a family business, role separation becomes more difficult.  If Mom is the boss, when she talks to one of her employees she is also addressing one of her children.  The expectations that we have (or would like to have) of members of our family—that we put the family’s interests first, that we take care of each other—may conflict with the goal of maximizing economic return in a business.  To the extent social roles are incompatible, family business has a built-in conflict.

Also, the overlap of family and business means that conflict, whatever its source, can spread.  For instance, if there is a dispute among family members, it may spill over into the business environment.  In one case, an individual who worked for the family business married outside the religious faith and was then frozen out of the business by his father and by his brother.  Family problems become business problems and vice versa.  Depending on how they are managed, family relationships can serve the interests of the business or fatally undermine them.

Role transitions are a particular problem.  If a family business is to survive as such, each generation must eventually cede control to the next—and yet, because work and family are linked, stepping down as a business leader may amount to a surrender of status as a family patriarch or matriarch.  Or the power structure of the family may work at odds with any changes of control contemplated for the business.

Role conflicts aside, there are some fundamental issues concerning the relative priority a family business will place on family needs versus business objectives:  Should the family business try to guarantee employment for family members even if outside workers might be more competent or willing to work for lower wages? Should proceeds from the business be distributed to meet family needs or should the money be reinvested?  When the time comes to transfer control, is it important to treat all heirs equally or should control rest with the most able member of the next generation?

III.

All this leads back to a question for business law scholars:  Do family businesses merit separate study?  In other words, does it matter that family businesses are embedded within family systems, and that participants may feel constrained by family as well as by business obligations? Not every social fact has legal significance.  It might be argued that intimacy has no proper explanatory role in the business domain—regardless of any intimate associations, business organizations seek to generate profits for investors, and employees alienate their labor in exchange for negotiated compensation.

However, by highlighting some distinctive features of family businesses, I hope to show that there is reason for corporate law scholars to more carefully examine the relationship of economic exchange and intimacy.  Indeed, family law scholars have already developed fruitful connections.  For instance, family law scholars have explored potential uses of contract and even of business-entity forms in contexts—such as marriage, procreation, and the household—in which domesticity and nonmarket values are the assumed norm and in which the role of economic exchange is contested.

Thus, I am coming at the problem from the other direction, but it is essentially the same problem.  Using Professor Viviana Zelizer’s work, The Purchase of Intimacy, as a guide, I’ll suggest three possible frameworks for thinking about market values and nonmarket values in family businesses.6 The first possibility is to maintain that businesses ought to be run solely according to market values—a “hostile worlds” approach in Zelizer’s terminology.  In other words, even if we admit that family relationships may sometimes motivate business choices, we could take the position that this influence is inherently corrupting, both of intimacy and of efficient economic ordering.  The severity of disputes in family businesses offers some support for such a view, especially when governance breakdowns lead to the collapse of otherwise viable businesses and to the poisoning of family relationships.

A second possibility would be to reject the distinction and to argue that separate spheres collapse into a single organizing concept; this is what Professor Zelizer calls a “nothing-but” approach.  It is all culture, or it is all power dynamics.  Or, for business-law scholars, it is all economics.  According to the economic view, family relationships matter to the extent that they reduce transaction costs.  And if family members have goals other than profit maximization, we can acknowledge whatever provides them utility without abandoning the presumption of rationality.  Even preferences for the welfare of others can be described, in the language of economics, as “inter-subjective utility functions.”  So long as rational actors pursue utility, however they define it, family businesses are just one available investment choice.

These contrasting approaches overstate their case.  On the one hand, it is certainly possible to corrupt intimate relationships by introducing money, just as it is possible for affection to cloud business judgment.  Yet, hardly any situation is free from both considerations; households have always involved the economics of production and consumption.  Likewise, short of banning business ventures involving family members, it is not realistic to expect family relationships to end where business relationships begin.

On the other hand, the fact that any set of preferences can be described in economic terms does not mean that formal, economic analysis offers the truest insights into family businesses or that nonmarket considerations are illusory.  For instance, the social significance of different forms of economic exchange may depend upon the preservation of distinct social categories.  The reciprocity of gift exchanges sends a very different message than an arm’s length, bargained-for exchange, even if the economic consequences are the same.  Bringing a twenty-dollar bottle of wine to a dinner party might be appropriate; offering the host twenty dollars would not be taken well.  Perhaps, similar social considerations explain why, transaction costs aside, participants in family businesses avoid explicit contracts—behaving as though trust does not exist is a recipe for destroying it.

A third possible framework, which I adopt in the Article upon which this Editorial is based, is what Zelizer would call a “connected worlds” view—neither rejecting the role of family intimacy nor seeking to redescribe it entirely in terms of something else:  economics, culture, or power.  If we are to appreciate why family businesses organize themselves as they do, we must account for the influence of family relationships and values.  Like other business ventures, family businesses are long-term, relational contracts.  However, the individuals involved typically have deep ties of affection that precede the investment and share values relevant to their business expectations.  In order to respect private ordering, the law should respond to the ways that individuals actually choose to order their affairs.

In sum, family businesses are market institutions that aim to make a profit, but they can also provide intrinsic value for family members who find meaning in shared effort, mutual support, and the preservation of family traditions and wealth across generations.  The norms of family life as well as economic considerations shape the choice of investment and the structure of internal governance.  Developing a more nuanced understanding of family business could help us to consider a fuller range of options for the collective pursuit of shared purposes.

Acknowledgements:

Benjamin Means is an Assistant Professor of Law at the University of South Carolina School of Law.

  1. For an example of previous scholarship on the same subject, see Steven H. Hobbs & Fay Wilson Hobbs, Family Businesses and the Business of Families: A Consideration of the Role of the Lawyer, 4 Tex. Wesleyan L. Rev. 153, 158 (1998) (“Socially and culturally, the family business offers the opportunity to unify work and family concerns for the benefit of succeeding generations.” (quoting David Bork, Family Business, Risky Business: How to Make it Work 7 (1986)).
  2. Benjamin Means, Nonmarket Values in Family Businesses, 54 Wm. & Mary L. Rev. 1185 (forthcoming Mar. 2013).
  3. See, e.g., Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976).
  4. See Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law 231-32 (1991).
  5. See Dwight Drake, Business Planning: Closely Held Enterprises 274 (2d ed. 2008); Ernesto J. Poza, Family Business 1 (3d ed. 2004).
  6. See generally Viviana A. Zelizer, The Purchase of Intimacy (2005).

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