How to Pay Non-Family Managers in Large Family Firms: A Principal-Agent Model

Abstract

A large number of family firms employ non-family managers. This paper analyzes the optimal compensation contracts of non-family managers employed by family firms using principal-agent analysis. The model shows that the contracts should have low incentive levels in terms of short-term performance measures. This finding is moderated by non-family managers’ responsiveness to incentives, their level of risk aversion, and measurement errors of effort related to short-term performance. The model allows a comparison between the contracts of family and non-family managers. This comparison shows that the contracts of family managers should include relatively greater incentives in terms of short-term performance measures. A number of propositions regarding the compensation of non-family managers employed by family firms are formulated. The implications of the model for family business research and practice are discussed.

Keywords: Family firms, non-family executives, executive pay, executive compensation, multi-task, incentives

JEL Classification: J30, M13, M52