18.2Management Shareholdings and Market Value

Despite the diversification motive suggested by portfolio theory, the ownership of

shares in many corporations is actually quite concentrated. Demsetz and Lehn (1985)

and Morck, Shleifer, and Vishny (1988) documented that, for many firms, a large indi-

vidual shareholder or an institution owns a significant percentage of the outstanding

shares. Many of the large shareholders are the company’s founders. For example, at the

end of 2000 Michael Dell owned about 12 percent of Dell Computer, and Jerry Yang

owned about 10 percent of Yahoo!. Other notable examples of company founders main-

taining large shareholdings are Bill Gates of Microsoft and the Walton family of Wal-

Mart. Outside the United States, large ownership concentration by company founders

is much more common. As one might expect from the discussion in the previous sub-

section, this is especially true in countries that have the weakest legal protection for

outside shareholders.

The Effect of Management Shareholdings on Stock Prices

As Chapter 15 discussed, tax reasons might explain why Bill Gates may choose not to

sell his Microsoft stock to diversify his portfolio. An entrepreneur like Bill Gates may

also be concerned about how the sale of his stock would affect the firm’s share price.

By selling shares, an entrepreneur may be indirectly communicating unfavorable

information to the firm’s shareholders. Holding a large number of shares tells investors

that the entrepreneur is confident about the firm’s prospects and that he or she plans

on implementing a strategy that maximizes the value of the company’s shares.⁸

⁶An article by Boycko, Shleifer, and Vishny (1994) provides an in-depth analysis of the incentive and

governance issues in Russia.

⁷See, for example, La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) and Levine and Zervos

(1998).

⁸See Chapter 19 for more discussion of this issue.

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Chapter 18

How Managerial Incentives Affect Financial Decisions

635

Demsetz and Lehn suggested that executives in industries with the greatest poten-

tial for incentive problems retain the largest share of ownership in their firms. For

example, the CEOs of media companies, which are likely to be fraught with incentive

problems, typically hold a relatively large fraction of the firms that they manage. In

contrast, the top managers of companies that are monitored more easily are likely to

own a smaller fraction of the firms they work for.

Example 18.2 illustrates the trade-off between the benefits of retaining shares to

improve incentives and the diversification benefits of selling shares.

Example 18.2:Inside Ownership and Firm Value

Bates Productions is owned exclusively by John Bates who would like to sell a significant

fraction of the firm in an IPO.Bates’s investment bankers have asserted that the value of

Bates Productions is tied very closely to the efforts of John Bates.They believe the firm is

worth $100 million based on the way it is currently operating.They also believe that if Bates

sells over 50 percent of the shares in the IPO, they will value the company at only $80 million

because investors will not be assured that Bates will put in the same effort that he had been

expending in the past.However, if Bates retains two-thirds of the shares, the investment

bankers believe they can price the firm at about $90 million.What should John Bates do?

Answer:If John Bates sells half of the firm, he will end up with $40 million in cash and

shares worth $40 million.However, if he sells one-third of the firm, he will end up with $30

million in cash and shares worth $60 million.The amount that he should sell depends not

only on the value of his cash and shares but also on his aversion to effort (we are assum-

ing that he will put in less effort if he owns less stock) and his aversion to risk.

Result 18.3

Entrepreneurs may obtain a better price for their shares if they commit to holding a largerfraction of the firm’s outstanding shares. The entrepreneur’s incentives to hold shares ishigher for those firms with the largest incentives to “consume on the job.” The incentive tohold shares is also related to risk aversion.

Empirical studies by Downes and Heinkel (1982) and Ritter (1984) provide evi-

dence that when entrepreneurs retain a higher stake in their firms when they go pub-

lic, they do indeed get higher prices for the shares they sell. The following subsection

reviews a number of empirical studies that examine the relation between management

ownership stakes and firm values for larger, more established firms.

Management Shareholdings and Firm Value: The Empirical Evidence

Morck, Shleifer, and Vishny (1988) examined the relation between market values and

management shareholdings in a sample of Fortune 500 firms. They found that, for

relatively small shareholdings, firms with higher concentrations of management

ownership have higher market values relative to their book values. However, as

management’s holdings rise above 5 percent, the firms become less valuable. This

suggests that as the managers’holdings become too large, managers become

entrenched,allowing them more freedom to pursue their own agendas in lieu of value-

maximizing policies.⁹

⁹McConnell and Servaes (1990), Hermalin and Weisbach (1991), and Kole (1995) provide further

evidence that share prices increase with the concentration of management holdings, but, beyond a certain

point, increased management ownership can depress firm values.

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Strategy, Second Edition		Decisions

636Part VIncentives, Information, and Corporate Control

Unfortunately, it is difficult to interpret the evidence on the relation between value

creation and ownership concentration because the ratio of a firm’s market value to its

book value, which is used in these studies as a measure of value creation, measures

more than how well the firm is managed. For example, firms with substantial intangi-

ble assets, such as patents and brand names, may have high market-to-book ratios even

if they are poorly managed. Similarly, well-managed firms may have relatively low

market-to-book ratios because they own few intangible assets. Perhaps management

ownership is related to market-to-book ratios because there are more benefits attached

to the control of intangible assets. We would expect, for instance, that it would be a

great deal more fun to own a controlling interest in a baseball team or a movie studio,

where most assets are intangible, than a copper mine, where most assets are tangible.

Measuring the value created by managers is much easier in the case of closed-end

mutual funds, which are publicly traded mutual funds with a fixed number of shares that

can be bought and sold on the open market rather than bought and redeemed directly from

the fund at their net asset values, as is the case for open-end mutual funds. The ratio of

the share price of the closed-end mutual fund to the net asset value per share of the port-

folio it holds provides an excellent measure of the value created by the fund’s managers,

since the net asset value of the fund provides a good measure of the market value that

could be achieved without the manager (for example, if the fund were liquidated). If

investors believe a fund is badly managed or that it generates excessive expenses, they

will not be willing to pay the full net asset value of the shares. Indeed, there have been

many cases of closed-end funds selling at more than a 25 percent discount.

Barclay, Holderness, and Pontiff (1993) found that the average discount was

14.2percent for closed-end funds with a large shareholder but only 4.1 percent for funds

without a large shareholder. This evidence indicates that large shareholders tend to

depress values, suggesting that the negative effects of management ownership in this

case outweighed the positive benefits.¹⁰