Executive pay in family firms: a principal-agent model

Abstract

A large number of family firms employ non-family executives. This chapter analyzes the optimal compensation contract for non-family executives using principal-agent analysis. It is shown that if the business-owning family is interested in long-term performance but the non-family executive is more interested in short-term performance, the compensation contract should be lowpowered with regard to short-term performance. The level of short-term incentives depends on the measurement error of effort for short-term performance, the executive’s level of risk aversion, and the executive’s responsiveness to short-term incentives. This chapter is connected to Chapter 6 and Chapter 7 by explaining how the compensation contract of a non-family executive should be designed if the business-owning family wants to pursue a long-term strategy. Furthermore, this chapter explains some of the empirical findings about the differences in executive pay between family and non-family firms (Chapter 8).

This chapter is based on Block and Henkel (2008). The paper was presented at European Business School (European Family Business Center and Department of Law, Governance, and Economics), the 2008 annual conference of the International Family Enterprise Research Academy (IFERA), the 2009 WHU Campus for Finance Research Conference, and the 2008 Academy of Management Meetings.