Hi guys,

Background:

I am opening this Blog because I think it would be interesting to see what can happen if too much trust is placed into managers steering a family or business with a long lasting tradition. The example I want to bring up is a company called Karstadt Quelle in Germany which was until 2007 the largest mail order firm in Europe with 20.000 employees and a turnover of 4.2 billion Euros. It had a long family history which began 82 years ago. The company declared bancruptcy in 2009 since managers have completely burned all cash resources as well as have given wrong advice to the CEO Madeleine Schickedanz which has because of that lost 5 billion Euros. To only winners of this were managers which have made millions and millions on the downfall of the company.

Problems identified:

Founder died- successor was not able to lead company and therefore placed all trust and power into external managers.

Trust in wrong management by femal successor Schickedanz- constantly received wrong and lacking information about current company issues.

What do you guys think how much trust can be placed into external managers? How could this problem have been prevented? Why was the old business model not been updated? DO you know any similar cases where too much trust has led to a disaster and the erasement of a extraordinary famous and successful business? i.e. Woolworth in the UK.

Do you think that the business model was not innovative enough anymore?

http://www.spiegel.de/international/business/0,1518,656490,00.html

giving an external, the management of the business might be very risky. even though if it is a matter of long term tradition. Even on contract basis, too much involvement is risky. i found an article on succession failure in family business.

have a look

http://www.summitadvisory.org/id20.html

I think that what happened to Karstadt Quelle in Germany is a situation that has a combination of bad luck but also a mix of unethical managers. It is very disturbing that the article says that few people were surprised, so clearly there were underlying issues that were not unknown to owners.

Also, in spite of the bad  publicity of having external, non-family managers, the truth is that if there is a certain level of trust; including trust in their capabilities, as well as their “loyalty” in the company, the advantages of having them are very big. I think that loyalty to the firm will be easier to achieve through proper compensation and fairness.

Below are extracts of an article and the key learning points summarized at the end:

Journal article by James J. Chrisman, Jess H. Chua, Reginald A. Litz; Entrepreneurship: Theory and Practice, Vol. 28, 2004

http://www.questia.com/googleScholar.qst;jsessionid=LpJTnbRqqQnyGGMSmd78mF7s6pTT7zxb3rJpvZGtBlvlsK9vFFXG!677243816!-1828655400?docId=5006658582

“Although there is no consensus about the relationship between organizational performance and the ownership and control of a firm (James, 1999), most scholars agree that separation of ownership and management creates costs that may not exist if ownership and management were combined. Agency theory is based on the idea that managers who are not owners will not watch over the affairs of a firm as diligently as owner-managers. Ross (1973) formalized this conflict of interest arising from the separation of ownership and management as a principal-agent problem and Jensen and Meckling (1976) coined the phrase “agency costs” to represent the costs of all activities and operating systems designed to align the interests and/or actions of managers (agents) with the interests of owners (principals). Myers (1977) and Smith and Warner (1979) showed that agency costs also exist in the owner-lender relationship while Morck, Shleifer, and Vishny (1988) documented the potential agency costs to minority shareholders from having an entrenched dominant shareholder. Traditionally, researchers have assumed that owner-managed firms will have either zero or insignificant agency costs (Jensen & Meckling, 1976; Fama & Jensen, 1983; Ang, Cole, & Lin, 2000). There is a tendency to extend this to family firms because family members are expected to be altruistic toward each other as a result of kinship obligations that are part of the axiomatically binding normative moral order in most cultures (Stewart, 2003). (1) Altruism could mitigate some agency costs (Wu, 2001) but, unfortunately, altruism could also lead to other agency costs, for example, free riding by family members as in the “Samaritan’s dilemma” (Bruce & Waldman, 1990), entrenchment of ineffective managers (Morck et al., 1988), or even predatory managers (Morck & Yeung, 2003).

Since nepotism does exist (Ewing, 1965) and families find it difficult to replace ineffective family members (Handler & Kram, 1988), it is hard to deny that family involvement has the potential to lower economic performance, particularly in light of Schulze et al.’s (2001, 2003) research. But agency costs arise only when firm actions contravene owners’ interests or when resources must be expended to ensure that firm actions do not contravene owners’ interests. For example, if family business owners wish to provide a minimum standard of living for relatives, any decrease in economic performance due to nepotism cannot be considered an agency cost. Thus, the nature of agency costs in family firms deserves more careful consideration.”

Key points:

1. Agency theory is based on the idea that managers who are not owners will not watch over the affairs of a firm as diligently as owner-managers. This theory applies to the cases that are more the rule than the exception as commented by Ksenia below. Clearly putting all the power in the wrong hands will lead to catastrophe from a business perspective

2. separation of ownership and management creates costs that may not exist if ownership and management were combined.

3. According to Meckling (1976) “agency costs” are the costs of all activities and operating systems designed to align the interests and/or actions of managers (agents) with the interests of owners (principals)

http://blog.business-model-innovation.com/2009/06/karstadt-death-of-a-legend-business-model/

i think sofia makes an excellent point. but i also think that along with trust between employees, amnagers and loyalty to the business, trust between family members is also equally important to give rise to a successful family business and it is the key point that provides a competitive edge to successful family businesses over unseccessful family businesses and non-family businesses.

1) trust mitigates the moral hazard problem between the principal and teh agent and raises leevl of effort and output. consequently leading to higher expected profits.

2) it obviates the need to rely on costly state-contingent wages as a mechanism to induce high effort from agent.

3) it induces the agent to internalize the cost of his actions on the principal’s welfare, thus refraining from actions that hurt the owner.

this argument is also ebenficial fromt he owner/pricipal’s point of view as:

1) a trustign parent/owner will avoid relying on monitoring or using performance based wages to induce high efforts from the child/agent.

linking this agument to Sofia’s ‘agency theory’, when trust is low or altruism is one-sided, the agency problem is excaberated.

in family firms, agency problems arise not only due to asymmetry of information, but also due to asymmetry in altruism.

thus in the absence of mitigating factors such as trust, teh agency problem may interfere with the survival of the family business.

What is different about family businesses?, issues 2001-2070, by Ralph Chami, International Monetary Fund, IMF Institute.

http://books.google.co.uk/books?hl=en&lr=&id=_SMer1UUKFkC&oi=fnd&pg=PA3&dq=non+family+manager+in+family+run+businesses&ots=vEHohDO9W7&sig=n6WHcOQnbiDu3lil9xVDmbp-PpI#v=onepage&q=non%20family%20manager%20in%20family%20run%20businesses&f=false

This kind of issue is more an exception than a rule. Family member managers could destroy the firm as well as (if not more) non-family managers.

In the situation described by Max, managers really had a strong purpose to do that thing, but where were the family members? Were they following the business? Or they completely relyed on someone? If there was fraud- than these managers could be judged.

Anyways, when the company is big and has a big turnover - family should treat it more seriously.

I found a study (based on US family firms), called “A comparison of family-member and non-family-member managers in American family businesses“. In this study “statistically-derived data indicate that the inclusion of non-family-members in the management of family firms has a . significant positive relationship with the use of sophisticated financial management methods”.

 here is chinese academic article which i found ,”The transfer of power in Family business“, i translate the main point:

“When the family business from generation to pass another generation, the management of the transition is full of all kinds of “pain”: enterprise management because of disagreements, indecision and anxiety become unbearable; heirs, successors, backbone employees and directors to resign to protest the way; the whole family disintegration; as president of his father may have been ousted; originally planned acquisition of corporate buyers have also changed their minds. Finally, the company is not closed down, is stagnant.

In general, the family perspective in which managers and internal within the family, their concern is the power management control and family selection, accession or succession. The professional manager, employees, competitors, outside directors, brokers, bankers, wives, friends, etc. in a different perspective because of its focus and role vary.”

http://www.ebusinessreview.cn/c/article-layoutId-12-contentId-3532.html

From my Oriental point of view:

The essence of Chinese thought is “balance.” Enterprises in the succession of the main problems is because uneven distribution of power and interests arising from internal family members. The intention of the introduction of external managers is to prevent internal loss. But if the transfer too much  power to external manager, the Family members will afraid of his company’s loyalty is not enough to harm the company’s affairs. So in choosing an external successor, the company should consider that external and family members within the enterprise relationship between the balance of power. Not only external successor but also family members will both have a constraint, it will reduce the incidence of problems to enterprises damage. (As described in the case)