Governance Problems in Close Corporations

Abstract

More than 90 percent of all US firms are close corporations, and these firms account for 51 percent of the private sector output and 52 percent of all private employment. Understanding governance issues and agency problems facing these firms is therefore of considerable importance. The legal and finance literature argues that the main governance problem in close corporations is not so much between the management and the shareholders as between the majority and the minority shareholders. As a solution, this literature recommends that the main shareholder in close firms surrender some control to minority shareholders at the outset. With shared control rights, no shareholder can take unilateral actions for her own benefit at the expense of the firm and other shareholders. We test this hypothesis using two independent novel datasets of close corporations. We find that shared ownership firms report substantially larger return on assets (up to 14 percentage points) and lower expense-to-sales ratios and these findings persist after we control for the endogeneity of ownership structure. We thus provide one of the first evidence on the presence of governance problems among shareholders in close corporations as well as the effectiveness of shared ownership as a solution.