Journal of Financial and Quantitative Analysis

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JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS doi:10.1017/S0022109011000226

Vol. 46, No. 4, Aug. 2011, pp. 943–966

COPYRIGHT 2011, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195

Governance Problems in Closely Held Corporations
Venky Nagar, Kathy Petroni, and Daniel Wolfenzon ∗

Abstract
A major governance problem in closely held corporations is the majority shareholders’ expropriation of minority shareholders. As a solution, legal and finance research recommends that the main shareholder surrender some control to minority shareholders via ownership rights. We test this proposition on a large data set of closely held corporations. We find that shared-ownership firms report a substantially larger return on assets and lower expense-to-sales ratios. These findings are robust to institutionally motivated corrections for endogeneity of ownership structure. We provide evidence on the presence of governance problems and the effectiveness of shared ownership as a solution in settings characterized by illiquidity of ownership.

I.

Introduction

The corporate finance and governance literature with very few exceptions has focused on two extreme ownership structures: i) exclusively atomistic shareholders, and ii) atomistic shareholders and a single large shareholder (see Laeven and Levine’s (2008) extensive review). It is only recently that studies are beginning to explore the intermediate ownership structure with multiple large shareholders. Most of the empirical studies in this emerging literature examine European public firms (Laeven and Levine (2008), Lehmann and Weigand (2000), Faccio, Lang, and Young (2001), and Maury and Pajuste (2005)).1 However, a recent body of analytical research suggests that multiple large owners are particularly relevant to governance when ownership is illiquid (e.g., Bennedsen and Wolfenzon (2000)).

∗ Nagar, venky@umich.edu, Ross School of Business, University of Michigan, 701 Tappan St., Ann Arbor, MI 48109; Petroni, petroni@msu.edu, Broad College of Business, Michigan State University, 315 Eppley Center, East Lansing, MI 48824; Wolfenzon, dw2382@columbia.edu, Graduate School of Business, Columbia University, 3022 Broadway, New York, NY 10027, and NBER. We are especially grateful to Luc Laeven (the referee), whose comments on the paper substantially improved the exposition and analyses. We also thank Jill Fisch, Paul Malatesta (the editor), Andrei Shleifer, and seminar participants at INSEAD, University of Michigan, New York University (NYU), Massachusetts Institute of Technology, and the 2007 NYU/Penn Conference on Law and Finance. 1 A notable exception is Faccio and Lang (2002), who document the ownership patterns of both public and private western European firms.

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Journal of Financial and Quantitative Analysis

We therefore examine the role of multiple large shareholders in an important illiquid ownership setting: closely held corporations in the United States. The vast majority of firms in the United States are closely held corporations.2 The latest U.S. Census indicates 7 million corporate tax filers, of which only about 8,000 are public firms. Closely held corporations are also vitally important to the economy: They produce 51% of the private sector output and employ 52% of the labor force.3 Closely held corporations are also an important part of the business landscape in other countries, constituting the private corporation in Britain, the close corporation in Japan, the GmbH firm in Germany, and the SARL firm in France (Armour, Hansmann, and Kraakman (2009)). As a result, governance problems in closely held corporations constitute an important economic problem. Firms in general face two types of governance problems: the governance problem between managers and shareholders, and the governance problem between majority and minority shareholders (Shleifer and Vishny (1997)). While both governance problems exist in private firms, legal...
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