Ceo Compensation Contracts of Family Firms

Copyright 2006
Tai-Yuan Chen
All Rights Reserved
Dedicated to:
Dad, Mom, and Lilian
CEO COMPENSATION CONTRACTS OF FAMILY FIRMS

by
TAI-YUAN CHEN, B.B.A., M.S.
DISSERTATION
Presented to the Faculty of
The University of Texas at Dallas
in Partial Fulfillment
of the Requirements
for the Degree of
DOCTOR OF PHILOSOPHY IN
MANAGEMENT SCIENCE
THE UNIVERSITY OF TEXAS AT DALLAS

August 2006
UMI Number: 3224377
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ACKNOWLEDGEMENTS
The most wonderful thing that can happen to a Ph.D. student is to have an advisor
with not only remarkable scholarship but also great personality. In this endeavor, I am lucky
to have Dr. Ashiq Ali as my dissertation advisor. From him, I have realized that putting
consistent effort, having an open mind, and being nice are key to become a successful
scholar. He spent long hours to give me guidance and read my dissertation and that made it
possible for me to successfully complete this project. I am indebted to him for his guidance,
patience, and support.
I am also grateful to my dissertation committee members, Ram Naratajan, Suresh
Radhakrishnan, and Mark Vargus. Rams seminar on agency theory initiated my interest in
the family firm topic. From Suresh, I learned to appreciate the link between theoretical
framework and empirical studies. Being Marks research assistant dramatically enhanced my
ability to generate workable research topics and convert them into publishable papers. Their
friendship and encouragement have been crucial to the completion of this dissertation.
I also would like to thank my friends, Mu-Hwa Chang, Yong-Jen Chen, Guo-Zheng
Huang, Ju-Ping Liu, and Hong-Da Wang for their friendship and support. Thanks for
spending hours listening to my worries and frustrations.
Last but not least, I am truly grateful to my parents and my younger sister for their
endless support. Taiwanese always say family is the safest harbor for sailing boats.
Without their love, I would not have achieved what I have now. Finally, I would like to
express my love to my fiance, Lilian Chan, for her encouragement, moral support, and hours
of help with my research. I dedicate this dissertation to them.
August 2006
vi
CEO COMPENSATION CONTRACTS OF FAMILY FIRMS

Publication No. ___________________
Tai-Yuan Chen, Ph.D.
The University of Texas at Dallas, 2006
Supervising Professor:
Dr. Ashiq Ali

ABSTRACT
Compared to non-family firms, family firms with professional CEOs face less severe agency
problems arising from the separation of ownership and management. This study examines
how this characteristic affects family firms CEO compensation contracts. I consider the
following five aspects of CEO compensation contracts: (1) the proportion of compensation
that is equity-based; (2) the level of total compensation; (3) the design of CEO annual bonus
plans; (4) the pay-earnings sensitivity of annual bonus payments; and (5) the sensitivity of
future economic benefits to CEOs equity based compensation.
Using a sample of S&P 500 firms, I show that U.S. family firms are less likely to grant stock
options and restricted stocks to their professional CEOs. Further, they are less likely to adopt
target ownership plans to require their CEOs to hold a minimum level of stock ownership. I
also find that family firms pay lower levels of total CEO compensation. Moreover, the
description of annual bonus plans in the proxy statements reveals that family firms use fewer
performance measures, are less likely to use non-financial performance measures, and use
vii
more discretion in determining CEOs annual bonuses. Further, family firms exhibit higher
pay-earnings sensitivity in the actual CEO annual bonuses. Finally, family firms exhibit
greater sensitivity of future profitability to CEOs equity compensation.
viii
TABLE OF CONTENTS
Acknowledgements..............................................................................................................v
Abstract ............................................................................................................................. vii
Table of Contents............................................................................................................... ix
List of Tables ..................................................................................................................... xi
List of Figures ................................................................................................................... xii
CHAPTER 1 Introduction....................................................................................................1
CHAPTER 2 Literature Review ..........................................................................................6
2.1
Literature on family firm .............................................................................6

2.1.1
Family firms and Agency Problem I................................................6
2.1.2
Family firms and Agency Problem II ..............................................7
2.1.3
Corporate governance and CEO compensation contracts................8
CHAPTER 3 Hypothesis Development.............................................................................10

3.1
Agency problems in family firms with professional CEOs .......................11
3.2
The economics of CEO compensation contracts .......................................12
3.3
3.4
3.2.1
Equity-based CEO compensation ..................................................12
3.2.2
The level of CEO compensation ....................................................13
CEO annual bonus plans............................................................................14

3.3.1
Performance measures in CEO annual bonus plans ......................14
3.3.2
The sensitivity of CEO annual bonus to accounting earnings .......15
The sensitivity of economic benefits to stock options granted to CEOs ...17
CHAPTER 4 Sample .........................................................................................................18

CHAPTER 5 Research Design and Results.......................................................................23
5.1
Equity-based compensation .......................................................................23

5.1.1
Likelihood of receiving equity-based compensation .....................23

ix
5.1.2
Proportion of equity-based compensation to total compensation ..25
5.2
The level of compensation .........................................................................28
5.3
Annual bonus plan .....................................................................................32
5.4
5.3.1
The design of CEO annual bonus plans.........................................32
5.3.2
The sensitivity of CEO annual bonus plan to accounting earnings38
The sensitivity of future profitability to the CEO stock option grants ......40
CHAPTER 6 Conclusion ...................................................................................................45

6.1
Summary of results ....................................................................................45
6.2
Future research...........................................................................................47
Appendix A Examples of excerpts from proxy statements ...............................................48

Appendix B Examples of discretionary performance measurement from proxy
statements......................................................................................................52
Bibliography ......................................................................................................................54
Vita
LIST OF TABLES
Table 1 Descriptive Statistics of Family and Non-Family Firms ......................................19
Table 2 Number and Percent of Family and Non-Family Firms by Two-Digit SIC Code21
Table 3 Equity-based Compensation .................................................................................24
Table 4 The Ratio of CEOs Equity-based Compensation to Total Compensation ..........27
Table 5 The Level of CEO Compensation.........................................................................30
Table 6 The Transparency of Annual Bonus Plan .............................................................33
Table 7 The Design of Annual Bonus Plan .......................................................................36
Table 8 The Weight on Accounting Earnings in Annual Bonus Plan ...............................39
Table 9 The Economic Benefits of the CEO Stock Options Grants ..................................41
xi
LIST OF FIGURES
Figure 1 Theoretical Framework .......................................................................................11
xii
CHAPTER 1
INTRODUCTION
Family capitalism is the most popular system of corporate governance in the world
(La Porta, Lopez-De-Sillanes and Shleifer, 1999), and families control a substantial portion
of corporate sectors in many countries (Claessens, Djankov and Lang, 2000; Morck,
Wolfenzon and Yeung, 2004). In the U.S., founding family members manage or control
about one-third of the S&P 500 firms.1 Shleifer and Vishny (1997) emphasize the importance
of studying the characteristics of family firms to better understand the economic efficiency of
different corporate governance mechanisms.
Compared to non-family firms, family firms with professional CEOs face less severe
agency problems that arise from the separation of ownership and management, because of the
strong monitoring by founding family members. This characteristic of family firms raises
interesting issues about their CEO compensation contracts. In this study, I consider the
following four aspects of CEO compensation contracts: the proportion of compensation that
is equity-based, the level of total compensation, the pay-earnings sensitivity of annual bonus
payments, and the sensitivity of future economic benefits to CEOs equity compensation. I
also examine the structure of equity-based compensation and CEO annual bonus plans, as
reported in the proxy statements.
Following prior studies (Anderson and Reeb, 2003a, 2003b), I classify a company as a family firm if the
founders or descendants continue to hold positions in the top management or on the board, or are among the
companys largest shareholders.
2
First, I predict that family firms are less likely to rely on equity-based compensation
to align the interests of CEOs with the shareholders because compared to non-family firms,
they face less severe agency problems (Holmstrom, 1979). Empirical results support this
prediction. I find that, compared to non-family firms, family firms are less likely to grant
stock options and restricted stocks to their CEOs. Further, they are less likely to require the
CEO to hold a minimum level of stock ownership through the adoption of target ownership
plans. Moreover, an analysis of the estimated value of the equity-based compensation reveals
that the proportion of equity-based compensation to CEOs total pay is lower for family firms
than for non-family firms.
Second, I predict that professional CEOs of family firms receive lower levels of total
pay compared to professional CEOs of non-family firms. As mentioned above, due to more
severe agency problems, professional CEOs of non-family firms receive larger proportions of
their compensation in the form of incentive-based compensation. Thus, CEOs of non-family
firms would receive higher levels of pay to compensate for the higher risks embedded in their
compensation contracts. The strong monitoring by founding family members may also
prevent hired CEOs from getting excessive compensation (Core, Holthausen and Larcker,
1999; Hartzell and Starks, 2003). Consistent with this prediction, I find that the total CEO
compensation is greater for non-family firms.
Next, I predict that the structure of CEO annual bonus plans differs across family and
non-family firms, consistent with the difference in the severity of agency problems. The
description of the annual bonus plans in the proxy statements reveals the following points.
Compared to non-family firms, family firms use fewer financial performance measures and
are less likely to use non-financial performance measures in CEO annual bonus plans. Also,
3
family firms use more discretion in determining the CEO bonus. These results are consistent
with the argument that founding family members are effective monitors, and therefore they
are better able to use discretion in rewarding managers consistent with their observed effort.
Next, I examine the sensitivity of actual CEO bonus payments to accounting earnings.
The use of greater discretion by family firms in setting bonuses suggests a weaker relation
between their annual bonus payments and reported earnings. On the other hand, better
monitoring by family firms leads to higher quality earnings (Ali, Chen and Radhakrishnan
2005), suggesting higher pay-earnings sensitivity (Milgrom and Roberts, 1992). My results
show that the latter argument dominates. I find that compared to non-family firms, family
firms exhibit greater sensitivity of CEO annual bonus payments to accounting earnings.
Finally, following Hanlon, Rajgopal and Shevlin (2003), I estimate the relation
between future economic benefits and stock options granted to CEOs and compare this
relation across family and non-family firms. I find that the sensitivity of future economic
benefits to CEOs equity compensation is significantly greater for family firms. This result is
consistent with the notion that family firms are subject to less severe agency problems and
therefore are less likely to give excessive equity compensation to their managers.
This study makes the following contributions. First, it documents the effect of the
agency problem due to the separation of ownership and control on the various aspects of
CEO compensation contracts. There is only limited evidence on this issue in the literature.
Core, Holthausen and Larcker (1999) use the effectiveness of corporate governance
mechanisms to proxy for the severity of agency problems. Their analyses focus on total CEO
compensation. Hartzell and Starks (2003) use the level of institutional ownership to proxy for
the severity of agency problems. However, as they point out, the relation between
4
institutional ownership and executive compensation is subject to endogeneity problem, it
could be that institutional investors are attracted by firms with efficient compensation
contracts. This problem makes it difficult to drawn unambiguous conclusions. Family firm as
a proxy for the severity of agency problems is less susceptible to endogeneity problem.
Moreover, my study is more comprehensive than prior studies in that it considers the effect
of agency problems on various aspects of CEO compensation contracts.
My study is the first in the literature to provide direct evidence as to how the severity
of agency problems affects the structure of CEO annual bonus contracts. I examine
performance measures, performance standards, and pay-performance relation of CEO annual
bonus plans, as reported in proxy statements. The difference in the structure of CEO annual
bonus plans across family and non-family firms is consistent with the predictions of the
classic agency framework (Holmstrom, 1979). Specifically, I show that firms with less
severe agency problems are less likely to use non-financial measures and are more likely to
use discretion in determining CEO bonus. There are some prior studies that provide evidence
on non-agency problem related determinants of certain aspects of the structure of bonus
plans.2
Finally, the study complements the extant family firm literature. Prior studies have
shown that compared to non-family firms, U.S. family firms in the S&P 500 are more
profitable (Anderson and Reeb, 2003a), have lower cost of debt financing (Anderson, Mansi
Ittner, Larcker and Rajan (1997) and Davila and Venkatachalam (2004) show that the choices of non-financial
performance measures is associated with business strategies and the quality of financial measures, but find
mixed evidence on the influence of CEOs power on the use of non-financial measures. Murphy and Oyer
(2003) and Gibbs, Merchant, Van der Stede and Vargus (2004) find that the use of subjective performance
evaluation is associated with the ranks of executives, organizational forms, and the completeness of objective
performance measures.
5
and Reeb, 2003), are less diversified, have similar levels of debt (Anderson and Reeb,
2003b), and provide better quality financial disclosures (Ali, Chen and Radhakrishnan,
2005). My study contributes by examining family firms compensation contracts of
professional CEOs.
CHAPTER 2
LITERATURE REVIEW
2.1
Literature on family firm

There are two main types of agency problems in public corporations. The first type of
agency problem arises from the separation of ownership and management. The separation of
corporate managers from shareholders may lead to managers not acting in the best interest of
shareholders (Agency Problem I). The second type of agency problem arises from conflicts
between controlling and non-controlling shareholders. Controlling shareholders may seek
private benefits at the expense of non-controlling shareholders (Agency Problem II). Extant
studies focus on how the two types of agency problems affect various aspects of family
firms.
2.1.1
Family firms and Agency Problem I (Separation of management and ownership)

There are several characteristics of family firms that reduce the likelihood of
managers not acting in the best interest of shareholders. First, Demsetz and Lehn (1985) posit
that families tend to hold undiversified and concentrated equity position in their firms. Thus
unlike the free rider problem inherent with small atomistic shareholders, families are likely to
have strong incentives to monitor managers. Second, families have good knowledge about
their firms activities, which enables them to provide superior monitoring of managers
(Anderson and Reeb, 2003a). Third, founding families tend to have much longer investment
horizons than the other shareholders. For example, Anderson and Reeb (2003b) find that
7
founding family members in the S&P 500 index on average hold their stocks for over 78
years. Thus, founding families help mitigate myopic investment decisions by managers
(James, 1999; Kwak, 2003; Stein, 1988, 1989). In summary, compared to non-family firms,
family firms face less severe hidden-action and hidden-information agency problems due to
the separation of ownership and management.
Consistent with this argument, Anderson and Reeb (2003a) find that family firms in
the S&P 500 index outperform non-family firms. Villalonga and Amit (2006) also show that
Tobins q of family firms with founder CEO is significantly greater than that of family firms
with descendent CEO and non-family firms. Moreover, Family firms are shown to be less
diversified and are more valuable than non-family firms (Anderson and Reeb, 2003b), and
they enjoy lower cost of debt, and bond holders view family firm as a more efficient
organization structure as compared to non-family firms (Anderson, Mansi and Reeb, 2003).
Finally, Ali, Chen and Radhakrishnan (2005) document a positive relation between founding
family ownership and accounting earnings quality.
2.1.2 Family firms and Agency Problem II (Conflicts between controlling and noncontrolling shareholders)
Concentrated ownership of founding families gives them power to seek private
benefits at the expense of other shareholders. Controlling shareholders can seek such private
benefits by freezing out minority shareholders (Gilson and Gordon, 2003), by taking a
disproportionate share of corporate earnings in the form of special dividends (DeAngelo and
DeAngelo, 2000), by engaging in related-party transactions (Anderson and Reeb, 2003a), and
through managerial entrenchment (Shleifer and Vishny, 1997). All of these factors lead to
8
family firms facing more severe agency problems from the conflict between controlling and
non-controlling shareholders.
However, when families engage in private rent seeking their activities may get
revealed to the market and they may incur a substantial cost in the form of lower equity
value, especially since families have concentrated ownership and tend to hold their firms
equities for long periods. In addition, significant legal protection is accorded to noncontrolling shareholders in the U.S. (Shleifer and Vishny, 1997; La Porta, Lopez-de-Silanes,
Shleifer and Vishny, 1998, 1999, 2000). These two factors act as disciplining mechanisms
that mitigate excessive rent expropriation by family owners.
Extant empirical evidence suggests that family members may get entrenched and hurt
their firms performance. Morck, Shleifer and Vishny (1988) show an S-shaped relationship
between insider ownership and firm performance. Anderson and Reeb (2003a) also show that
the performance of family firms gradually decreases after family ownership exceeds 28
percent. Holderness and Sheehan (1988) show that family firms have lower Tobins q than
non-family firms. Moreover, Schack (2001) and DeAngelo and DeAngelo (2000) suggest
that founding family members have incentives to seek benefits at the expense of the other
small shareholders. Finally, Fan and Wong (2002) show that accounting earnings are less
informative in Asian firms with significant control by family members.
2.1.3 Corporate governance and CEO compensation contracts
The impact of Agency Problem I, on management compensation, is an important
research topic (Murphy, 1999). Accordingly, the association between corporate governance
mechanisms and executive compensation has been investigated by many studies. However,
the evidence is mixed. For example, Lambert, Larcker and Weigelt (1993) report that the
9
level of CEO compensation is positively related to the independence of the board of
directors, whereas Core, Holthausen and Larcker (1999) find that CEO compensation is
higher when corporate governance mechanisms is less effective. Moreover, Allen (1981),
Lambert, Larcker and Weigelt (1993) and Core, Holthausen and Larcker (1999) show that
CEOs receive lower level of compensation when CEOs ownership is higher. However,
Holderness and Sheehan (1988) find that compensation is higher for CEOs who are
controlling shareholders in the company. Prior studies also provide mixed evidence on the
relation between external monitoring and CEO compensation. Lambert, Larcker and Weigelt
(1993) show that CEOs have higher compensation when there is a non-affiliated blockholder
on the board, whereas Core, Holthausen and Larcker (1999) find the appearance of an outside
blockholder is associated with lower level of CEO compensation. Similarly, Hartzell and
Starks (2003) show that institutional ownership is associated with lower level of CEO
compensation and higher pay-performance sensitivity.
CHAPTER 3
HYPOTHESIS DEVELOPMENT
The objective of this study is to explore how agency problems that arise from the
separation of management and ownership affect CEO compensation practices. 3 To
accomplish this, I compare the compensation contracts of professional CEOs across family
and non-family firms. I do not consider family firms whose CEO is a member of the
founding family. The compensation contracts of founding family CEOs are subject to a
different type of agency problem, which arises from the conflicts between controlling and
non-controlling shareholders (Agency Problem II). These family CEOs have incentive and
enough power to expropriate minority shareholders through excessive compensation (Jensen
and Meckling, 1976; Shleifer and Vishny, 1997). Thus, including family management firms
in the sample would mix the impact of Agency Problem I and II on CEO compensation
contracts. In family firms with professional CEOs, the impact of the second type of agency
problem on CEO compensation contracts is not relevant because the concern of excessive
CEO compensation paid to founding family members does not exist. Thus, this research
setting provides clear evidence on how direct monitoring by founding family members
reduces Agency Problem I and affects CEO compensation practices. Figure 1 illustrates the
theoretical framework.
The impact of Agency Problem I on executive compensation practices has been the focus of compensation literature in the
past two decades (Murphy, 1999).
10
11
Figure 1. Theoretical Framework
Family firms
(177 firms in S&P 500)
Compensation
contracts of
family CEOs
(87 firms)
Agency Problem I and II
3.1
Non-family firms
(323 firms in S&P 500)
Compensation
contracts of
professional CEOs
(90 firms)
Compensation
contracts of
professional CEOs
Agency Problem I
Agency problems in family firms with professional CEOs

There are several characteristics of family firms that mitigate the agency problem
associated with the separation of ownership and management. First, founding family
ownership represents a distinct class of large shareholders with incentives to monitor
managers (Demsetz and Lehn, 1985). Because founding family members tend to hold
undiversified and concentrated equity positions in their firms, the free rider problem that is
inherent with small atomistic shareholders or outside blockholders (a bank or an investment
fund), is less severe. Second, founding family members possess good knowledge and
understanding of their firms activities, so they have a better ability to ratify the decisions
made by executives (Anderson and Reeb, 2003a). Third, founding family members tend to
have long investment horizons. Thus, they have stronger incentive to invest in long-term
projects. This helps mitigate myopic investment decisions by managers (James, 1999; Kwak,
2003; Stein, 1988, 1989). Fourth, founding family members have reputation concerns arising
12
from the desire to maintain the long-term survival of their firms (Demsetz and Lehn, 1985),
providing further incentive to monitor the activities of managers. In summary, compared to
non-family firms, family firms face less severe agency problem that arises from the
separation of management and ownership.4
3.2
The economics of CEO compensation contracts

According to Murphy (1999), the economics of compensation can be divided into
three parts: the composition of compensation packages, the level of pay, and the payperformance relation. Thus, I develop hypotheses for these three dimensions of compensation
contracts for examining how CEO compensation practices differ across family and nonfamily firms. Following prior studies (see Shleifer and Vishny, 1997; Core, Holthausen and
Larcker, 1999; Core, Guay and Larcker, 2003), I take the view that both family and nonfamily firms are efficient within contracting costs in designing CEO compensation contracts.
3.2.1
Equity-based CEO compensation

The escalation of employee stock options since the early 1990s is the most
pronounced change in compensation practices (Hall and Murphy, 2003), and equity-based
compensation together with stock ownership has become the major component of incentives
provided to CEOs (Murphy, 1999, 2003; Hall and Murphy, 2002, 2003). Equity-based
compensation is motivated by firms desire to motivate managers to act in the best interests
of shareholders given that managers actions are not perfectly observable. Holmstrom (1979)
posits that monitoring and incentive compensation serve as substitutes.
Although corporate governance mechanisms can alleviate the difference in agency problems between family and non
family firms, the argument that U.S. family firms face less severe agency problems is supported by the evidence that U.S.
family firms outperform non-family firms (Anderson and Reeb, 2003a).
13
As discussed in section 3.1, family firms face less severe agency problems because of
the direct and close monitoring by founding family members. Thus, according to Holmstrom
(1979), family firms would use less equity-based compensation to motivate their CEOs. In
addition, family firms have less severe myopia problem because founding family members
possess long-term investment horizons (Stein, 1988, 1989; James, 1999; Kwak, 2003). These
two reasons suggest that compared to non-family firms, family firms are less likely to grant
equity-based compensation to motivate professional CEOs. 5 Moreover, the proportion of
equity-based compensation to total compensation is likely to be smaller for family firms.
Accordingly, I predict the following.
H1a: Compared to non-family firms, family firms grant less equity-based compensation
to professional CEOs.
H1b: Equity-based compensation as a proportion of total compensation is lower for
family firms.
3.2.2
The level of CEO compensation

As discussed in the development of hypothesis H1, non-family firms are likely to
grant more equity-based compensation to motivate their professional CEOs. Thus,

professional CEOs of non-family firms would bear greater risk and therefore demand a
greater risk premium (Hall and Murphy, 2002). Accordingly, I predict that professional
CEOs of non-family firms would receive higher levels of pay than professional CEOs of
family firms.
Cheng (2004) shows that firms use stock options to mitigate managerial myopic problem.
14
Severity of agency problems has also been shown to be related to excessive CEO
compensation (Core, Holthausen and Larcker, 1999; Hartzell and Starks, 2003; Bertrand and
Mullainathan, 2001). Bertrand and Mullainathan (2001) also show that poorly governed
firms are more likely to reward their CEOs for luck instead of performance, and the presence
of a large shareholder on the board can significantly mitigate the pay for luck. Given that
family firms are subject to less severe agency problems, they are less likely to pay excessive
compensation to their CEOs.
The above discussion leads to the following hypothesis:
H2: Compared to non-family firms, family firms, pay lower levels of compensation to
professional CEOs.
3.3
CEO annual bonus plans
3.3.1 Performance measures in CEO annual bonus plans

Non-financial performance measures, such as customer satisfaction, productivity, and
strategic objectives, are increasingly being used by firms for evaluating CEO performance
(Ittner, Larcker and Rajan, 1997; Murphy, 2001). The use of non-financial performance
measures is found to be associated with company strategies, industry membership, and the
quality of financial performance measures (Ittner, Larcker and Rajan, 1997; Davila and
Venkatachalam, 2004). Milgrom and Roberts (1992) posit that direct monitoring would
increase the quality of financial performance measures. Consistent with this argument, Ali,
Chen and Radhakrishnan (2005) find that family firms, which are characterized by strong
monitoring, report higher quality accounting earnings. Thus, for family firms, there is less
need to use non-financial indicators in CEO annual bonus plans (Ittner, Larcker and Rajan,
1997; and Davila and Venkatachalam, 2004). Hypothesis H3a summarizes my expectation:
15
H3a: Compared to non-family firms, family firms use less non-financial measures in
determining CEO annual bonuses.
Subjective performance standards and subjective pay-performance structures are
often used in CEO incentive contracts (Prendergast, 1999; Murphy and Oyer, 2003). Baker,
Gibbons and Murphy (1994) show that subjective performance evaluation contracts
(relational contracts) can reduce the distortionary incentives that may result from objective
performance evaluation contracts (formal contracts). Thus, the combined use of objective and
subjective performance evaluation in executive compensation contracts provides economic
benefits (Baker, Gibbons and Murphy, 1994). Murphy and Oyer (2003) and Gibbs,
Merchant, Van der Stede and Vargus (2004) show that firms use more subjectivity when the
trust between supervisor and subordinate is greater. Compared to non-family firms, family
firms enjoy greater employee loyalty (Demsetz and Lehn, 1985; Kwak, 2003) and the
founding family is better able to monitor and observe CEOs actions. Thus, family firms are
more likely to apply subjectivity in the determination of CEO annual bonuses. Hypothesis
H3b summarizes my expectation.
H3b: Compared to non-family firms, family firms use more subjective standards and
pay-performance structures for determining CEO annual bonus.
3.3.2 The sensitivity of CEO annual bonus to accounting earnings
CEO annual bonus is related to accounting earnings (Ittner, Larcker and Rajan, 1997;
Murphy, 2001; Baber, Kang and Kumar, 1998). As discussed earlier, compared to nonfamily firms, family firms are more likely to use subjective performance standards and payperformance relations for determining CEO annual bonus plans. This argument suggests that
16
the sensitivity of CEO annual bonus to accounting earnings is likely to be lower for family
firms compared to non-family firms.
On the other hand, Milgrom and Roberts (1992) argue that direct monitoring reduces
the measurement error of objective performance measures, and this in turn leads to higher
pay-performance sensitivity. As per this argument, accounting earnings of family firms are
expected to be of higher quality and would convey more precise information about CEOs
actions because of the stronger monitoring by founding family members.6 Thus, the annual
bonus of CEOs would be more sensitive to accounting earnings for family firms compared to
non-family firms.
To summarize, the two arguments provided above lead to opposite predictions. I do
not have a priori expectation on which of the two effects would dominate. Hypothesis H4
summarizes the two alternatives.
H4a: Ceteris paribus, the relation between CEO annual bonus and accounting earnings is
weaker for family firms, consistent with family firms using more subjective
standards and pay-performance structure in determining CEO bonus.
H4b: Ceteris paribus, the relations between CEO annual bonus and accounting earning is
stronger for family firms, consistent with family firms reporting higher quality
accounting earnings.
Ali, Chen and Radhakrishnan (2005) argue that family firms face less severe agency problems compared to non-family
firms, so their reported earnings are subject to less opportunistic manipulation. Their study uses several measures, the level
of discretionary accruals in earnings, the ability of earnings components to predict future cash flows, the persistence of
earnings, and the earnings response coefficient to compare the earnings quality of family and non-family firms. Their
findings support the argument that compared to non-family firms, family firms reported accounting earnings are less subject
to opportunistic manipulation.
17
3.4
The sensitivity of economic benefits to stock options granted to CEOs

As discussed earlier, stock option pay has become the largest component of CEO
compensation packages (Hall and Murphy 2002, 2003). The efficient contracting perspective
suggests that stock option grants align the managers interests with those of shareholders, so
the grants of stock options bring positive economic benefits (Demsetz and Lehn, 1985; Core
and Guay, 1999). However, severity of agency problems have been shown to be related to
excessive CEO compensation (Core, Holthausen and Larcker, 1999; Bertrand and
mullainathan, 2001; Hartzell and Starks, 2003). If non-family firms are granted excess equity
compensation, its sensitivity to future economic benefits is likely to be lower. Hypothesis H5
summarizes my expectations:
H5: Ceteris paribus, the marginal future economic benefits from granting stock options are
for greater family firms than for non-family firms.
CHAPTER 4
SAMPLE
For my analyses, I use the Standard and Poors 500 firms for the year 2002, because
BusinessWeek classifies these companies into family and non-family firms: 177 are family
firms and the remaining are non-family firms. A firm is considered as a family firm if the
founders and/or their descendents hold positions in the top management or on the board or
are among the companies largest shareholders.7 The focus of this study are family firms
where the CEO is a professional executive and is not related to the founding family members.
Of the 177 family firms in the S&P 500, 90 (51%) are family firms whose CEOs are
professional executives not related to the founding family. Panel A of table 1 provides
descriptive statistics on the salient characteristics of family firms. I obtain this data from the
2002 proxy statements. For family firms with professional CEOs, family members and/or
descendants own 9% of cash flow rights and 15% of voting rights, family members and/or
descendants are non-CEO top level managers in 20% of the firms and sit on the board of
directors of 98% of the firms. This information indicates that founding family members have
sufficient influence and power to monitor the professional CEOs. Panel B of table 1 provides
the difference in certain firm characteristics between family and non-family firms. Compared
to non-family firms, family firms have smaller market capitalization (SIZE), greater growth
BusinessWeek adopts this definition of family firms from Anderson and Reeb (2003a). This definition has been used by
Anderson and Reeb (2003b, 2004), and Anderson, Mansi and Reeb (2003).
18
19
opportunities (MB), and better profitability (ROA, ROE). These results are consistent with
those reported by Anderson and Reeb (2003a).
Table 1. Descriptive Statistics of Family and Non-Family Firms
Panel A: Ownership and Control Characteristics of the Family Firms in S&P 500
All
Family firms
(177 firms)
Family firms
with professional
CEOs (90 firms)
Percentage of cash flow rights controlled by the

founding family members or descendents
11%
9%
Percentage of voting rights controlled by the

founding family members or descendents
18%
15%
Founding family member or descendent serve as the

CEO
49%
0%

top executive (including CEO)
63%
20%

chair person of the board of directors
67%
39%

directors (including chair person)
99%
98%
Percentage of founding families holding at least 5%

voting rights
64%
56%
Percentage of outside directors on the board
57%
60%
CEO is also the chairperson of the board of directors
65%
60%
Officers and directors ownership
12%
10%
Institutional ownership
62%
60%
CEO age
60
57
Number of firms
177
90
20
Panel B: Characteristics of Family and Non-family Firms
SIZE
MB
ROA
ROE
Family firms
with professional
CEOs
8.51
5.52
0.05
0.18
Mean
Nonfamily
firms
8.83
3.35
0.03
0.16
Difference
t-statistics
-2.68***
4.21***
1.99**
0.81
Median
NonFamily firms
with professional family
firms
CEOs
8.37
8.84
4.49
3.44
0.06
0.04
0.17
0.15
Difference
t-statistics
-3.01***
3.96***
1.98**
1.89*
Variable Definitions: Family firms with professional CEOs is a family firm where the firms
CEO is a professional CEO and is not related to the firms founding family. SIZE is the log
of market value of equity at the beginning of the fiscal period. MB is a firms market-to-book
ratio defined as the market value of equity divided by book value of equity. ROA is earnings
before extraordinary item divided by total assets. ROE is earnings before extraordinary item
divided by book value of common equity.
Notes: *** indicates significance at the 0.01 level, ** indicates significance at 0.05 level, and
* indicates significance at the 0.10 level.
Using only S&P 500 firms as the sample has the benefit of making the sample
homogeneous with respect to size. However, there are some disadvantages in using only the
S&P 500 firms for the analyses. First, it is likely to reduce the generalizability of the
findings. However, family firms operate in a broad array of industries (Anderson and Reeb,
2003), as shown in table 2, which, to some extent, should help alleviate concerns about the
generalizability of the results.
Finally, the tests of each of my hypotheses require data for different sets of variables.
For tests of the level of CEO compensation, the weight on accounting earnings in CEO
annual bonuses, the grant of equity-based compensation to CEOs, and the economic benefits
of stock options, I include in the sample all firm-year observations spanning from 1997 to
2002 for which required data are available on Compustat, CRSP, or ExecuComp. For the
21
information about the structure of equity-based plans and annual bonus plans, I manually
collect data from year 2002 proxy statements, so the sample period is only year 2002.
Table 2. Number and Percent of Family and Non-Family Firms by Two-Digit SIC Code
SIC
code
10
13
14
15
16
20
21
23
24
25
26
27
28
29
30
33
34
35
36
37
38
39
40
42
44
45
48
49
50
Industry description
Metal mining
Oil and gas extraction
Manufacturing, quarry
nonmaterial minerals
General building contractors
Heavy construction, except
buildings
Food and kindred products
Tobacco products
Apparel and other textile products
Lumber and wood products
Furniture and fixtures
Paper and allied products
Printing and publishing
Chemical and allied products
Petroleum and coal products
Rubber and miscellaneous plastic
products
Primary metal industries
Fabricated metal products
Industrial machinery and
equipment
Electronic and other electrical
equipment
Transportation equipment
Instruments and related products
Miscellaneous manufacturing
products
Railroad transportation
Trucking and warehousing
Water transportation
Transportation by air
Communications
Electric, gas, and sanitary
services
Wholesale trade durable goods
Non-family
firms
(n = 323)
1
12
Family
firms
(n = 177)
1
4
Percent of family
firms in industry
50%
33%
0%
33%
100%
11
3
1
3
1
6
3
25
4
7
0
3
1
1
4
7
11
2
39%
0%
75%
25%
50%
40%
70%
31%
33%
50%
5
6
3
1
38%
14%
17
10
37%
18
19
51%
15
14
2
9
12%
39%
50%
4
1
0
1
11
0
0
1
2
6
0%
0%
100%
67%
55%
33
11%
50%
22
51
52
53
54
55
56
57
58
59
60
61
62
63
64
67
70
72
73
75
78
79
80
82
87
99
Table 2. Continued
Wholesale trade nondurable
4
goods
Building materials and gardening
2
General merchandise stores
7
Food stores
3
Auto dealers and service stations
0
Apparel and accessory stores
1
Furniture and home furnishings
2
Eating and drinking places
4
Miscellaneous retail
2
Depositing Institutions
27
Nondepositing Credit Institutions
6
Security & Commodity Brokers
7
Insurance Carriers
23
Insurance Agents, Brokers &
1
Service
Holding, Other Investment
1
Offices
Hotels and other lodging places
0
Personal services
0
Business services
19
Auto repair, services, and parking
1
Motion pictures
1
Amusement and recreation
2
services
Health services
3
Educational services
0
Engineering and management
1
services
Nonclassification establishment
3
33%
1
5
2
2
3
2
0
5
7
1
3
7
33%
42%
40%
100%
75%
50%
0%
71%
21%
14%
30%
23%
50%
83%
3
1
17
0
0
100%
100%
47%
0%
0%
0%
2
1
40%
100%
67%
0%
CHAPTER 5
RESEARCH DESIGN AND RESULTS
5.1
Equity-based compensation
5.1.1
Likelihood of receiving equity-based compensation

In table 3, I present the percentage of family and non-family firms with professional
CEOs that granted stock options, restricted stock, and target ownership plans during the years
1997 to 2002. I select 79 pairs of family and non-family firms (158 firms). Each pair is
matched on two-digit SIC codes, size (sales), and growth opportunities (market-to-book
ratio).8
In panel A of table 3, I present information about option grants to CEOs of family and
non-family firms during 1997 to 2002. Compared to CEOs of non-family firms, CEOs of
family firms are significantly less likely to receive stock options during the years 1997 to
1999. The average term of newly granted options is 9.68 and 9.55, respectively for family
and non-family firms, and the difference is significant at the 10% level (t=1.67). Panel B of
table 3 reports percentages of firms that grant restricted stocks to the CEOs of family and
non-family firms during the years 1997 to 2002. Compared to non-family firms, family firms
are less likely to grant restricted stocks to their CEOs, and the difference is significant for
each of the six sample years.
Since BusinessWeek only classifies S&P 500 companies into family and non-family firms, I match each family firm with
non-family firm in the S&P 500. This procedure prevents me from identifying non-family firm outside S&P 500 index.
23
24
Table 3. Equity-based Compensation
Panel A: Stock Option Grants to CEOs
Percent of firms in which CEO

received options in 1997
Average option terms
All firms
Family
firms
Non-family
firms
Difference
t-statistics
0.82
0.75
0.85
-1.98**
0.81
0.74
0.86
-2.21**
0.80
0.71
0.86
-2.97***
0.87
0.85
0.88
-0.67
0.92
0.91
0.88
0.88
0.84
0.82
0.86
-0.85
9.60
9.68
9.55
All
firms
Family
firms
Non-family
firms
Difference
t-statistics
0.22
0.16
0.26
-4.86***
0.23
0.19
0.25
-2.32***
0.19
0.13
0.23
-4.81***
0.24
0.20
0.24
-2.65**
0.26
0.20
0.30
-4.77***
0.28
0.22
0.32
-4.96***
1.67*
Panel B: Restricted Stock Grants to CEOs

received restricted stocks in 1997
25
Panel C: Target Ownership Plans
Percent of firms which adopt

target ownership plan in 2002
All firms
Family
firms
Non-family
firms
Difference
t-statistics
0.46
0.25
0.50
-3.88***
Notes: The sample contains 79 pairs of family and non-family firms (158 firms) with 79
observations pertaining to family firms and 79 observations pertaining to non- family firms
in the S&P 500. The sample period is 1997 to 2002. Each pair is matched on two digit SIC
codes, size (sales), and growth opportunities (market-to-book ratio). Firms in financial
industries (SIC code 6000-6999) or in utility industries (SIC code 4900-4999) are excluded.
In each cell, the denominator is the total number of family and non-family firms and the
numerator is the number of firms that respond to the given question. *** indicates
significance at the 0.01 level, ** indicates significance at 0.05 level, and * indicates
significance at the 0.10 level.
Firms can require CEOs to maintain a certain amount of stock ownership through
target ownership plans. Panel C of table 3 indicates that 25% of family firms and 50 % of
non-family firms have such a requirement, and the difference is significant (t = -3.88).
To summarize, the results presented in table 3 indicate that compared to non-family
firms, family firms are less likely to grant stock options and restricted stocks to the CEOs,
and are less likely to require their CEOs to have a minimum level of stock ownership. These
results support hypothesis H1a.
5.1.2
Proportion of equity-based compensation to total compensation

To examine whether the proportion of equity-based compensation to total
compensation is less for family firms, I estimate the following model:

%EQUITYCOMPi,t = + 1FAMILYFIRM+ 2CEOOWN i,t-1+3EMPLOYEEi,t-1
+4INVEST i,t-1+5CASHFLOW i,t-1+6ROA i,t-1 +7RETURN i,t-1
+8LEVERAGE i,t-1+9VOLATILITY i,t-1+ Industry Dummy
+ YearDummy + error
(1)
26
where the dependent variable, % EQUITYCOMP, is the sum of the Black-Scholes value of
annual grants of stock options and the value of restricted stocks divided by total CEO
compensation. FAMILYFIRM is a binary variable that equals 1 if the firm is a family-firm
and 0 otherwise. CEOOWN is the percentage of a firms stocks held by the CEO.
EMPLOYEE is the natural logarithm of the number of employees. INVEST is defined as the
firms year-end market-to-book ratio averaged over the five years prior to the year in which
the compensation is awarded. CASHFLOW is the level of cash flow divided by the number of
employees. ROA is the ratio of earnings before tax and interest to total assets. RET is stock
returns. LEVERAGE is the ratio of total debt to total assets. VOLATILITY is the standard
deviation of annual operating income scaled by contemporaneous sales over the prior five
years. I also include dummy variables for industry membership and year. I use 12 industry
groups as in Fama and French (1997). I predict that 1 will be negative, indicating that
compared to non-family firms, family firms rely less on equity-based compensation. Other
control variables are based on prior studies (see Yermack, 1995; Ittner, Lambert and Larcker,
2003).
Panel A of table 4 provides descriptive statistics of the variables in equation (1). Most
of the control variables are systematically different across family and non-family firms. Thus,
it is important to control for these variables before drawing any inferences. Panel B of table 4
presents the regression results of equation (1). As expected, 1 is negative and significant (t =
-2.01), indicating that CEO compensation packages of family firms have proportionately less
equity-based compensation. The coefficients on the control variables, when significant, have
the predicted signs.
27
Table 4. The Ratio of CEOs Equity-based Compensation to Total Compensation

Panel A: Descriptive Statistics
% EQUITYCOMP
CEOOWN (%)
EMPLOYEE
INVEST
CASHFLOW
ROA
RET
LEVERAGE
VOLATILITY
Family
firm
0.54
0.24
3.09
5.52
30.87
0.05
0.13
0.56
0.04
396
Mean
Non-family
firm
0.58
0.18
3.36
3.35
34.31
0.03
0.06
0.66
0.03
1309
t-stat.
-2.04**
2.21**
-3.89***
4.21***
-0.89
1.99**
2.58***
-5.71***
3.21***
Family
firm
0.60
0.07
3.09
4.49
46.21
0.06
0.06
0.54
0.02
396
Median
Non-family
firm
0.64
0.07
3.51
3.44
48.71
0.04
0.03
0.67
0.02
1309
z-stat.
-1.67*
0.99
-3.71***
3.96***
-0.91
1.98**
2.61***
-5.72***
1.33
Panel B: Regression Results
Intercept
Dependent var. = % EQUITYCOMPi,t

Predicted Sign
Coefficient
t-statistics
?
0.80
9.88***
FAMILYFIRM
-0.04
-2.01**
CEOOWN i,t-1
-0.03
-3.42***
EMPLOYEE i,t-1
0.02
2.11**
INVEST i,t-1
0.05
1.79*
CASHFLOW i,t-1
-0.01
-0.95
ROA i,t-1
0.01
0.55
RET i,t-1
0.01
2.84***
LEVERAGE i,t-1
-0.12
-3.45***
VOLATILITY i,t-1
+/-
0.75
3.55***
Adjusted R2
N
0.09
1705
28
Variable Definitions: % EQUITYCOMP denotes the ratio of sum of Black-Scholes value of
annual grants of stock options and the value of restricted stocks to the CEO total
compensation. FAMILYFIRM is a binary variable that equals 1 if the firm is a family firm
and 0 otherwise. CEOOWN is the percentage of firms stocks held by the CEO. EMPLOYEE
is the natural logarithm of the number of employees. INVEST is defined as the firms year
end market-to-book ratio averaged over the five years. CASHFLOW is the level of cash flow
divided by the number of employees. ROA is the ratio of earnings before tax and interest to
total assets. RET is stock returns of year. LEVERAGE is the ratio of total debt to total assets.
VOLATILITY is the standard deviation of annual operating income scaled by
contemporaneous sales over the prior five years.
Notes: The regression model includes dummy variables for industry membership and year. I
use the Fama-French definition of industry. For brevity, I do not report the industry and year
dummy coefficients. The t-statistics are corrected using the Huber-White procedure. ***
indicates significance at the 0.01 level, ** indicates significance at 0.05 level, and * indicates
To summarize, results in table 4 indicate that the proportion of equity-based

compensation to total compensation is smaller for family firms than for non-family firms.
These results are consistent with H1b.
5.2
The level of compensation

To examine differences in the levels of CEO pay between family and non-family
firms, I estimate the following model.
Log (COMPENSATION) i,t = + 1FAMILYFIRM+ 2SIZEi,t-1 +3INVEST i,t-1

+ 4 ROA i,t -1+ 5 RET i,t-1 + 6 STD_ROA i,t+ 7 STD_RET i,t
+ 8 MEETINGS i,t+ 9 INSTITUTIONi,t + 10 CEOOWNi,t
+ 11 CEO_CHAIRi,t + 12 SEGMENTi,t +Industry Dummy
+ Year Dummy +error
(2)
where the dependent variable, Log (COMPENSATION), in equation (2) represents three
different measures, TOTAL, CASH, and SALARY. TOTAL represents total compensation and
is the sum of salary, bonus, the value of stock options and restricted stocks, long-term
29
performance plans, and other compensation. CASH is the sum of salary and annual bonus.
SALARY is the annual basic salary of the CEO. SIZE is the natural logarithm of sales.
INVEST is defined as the firms year end market-to-book ratio averaged over the prior five
years. ROA is the ratio of earnings before tax and interest to total assets of. RET is stock
returns. STD_ROA is the standard deviation of the percentage return on assets for the prior
five years. STD_RET is the standard deviation of stock return for the prior five years.
MEETINGS is the number of board meetings held. INSTITUTION is the percentage of the
companys stock owned by institutional investors. CEOOWN is the percentage of firms
stocks held by the CEO. CEO_CHAIR is a dummy variable that equals one if the CEO also
serves as the chairperson of the board. SEGMENT is square root of the number of two-digit
SIC industry codes the firm operates in. I predict that 1 is negative, indicating that the
CEOs total pay is lower for family firms than for non-family firms. Other variables in
equation (2) control for previously identified economic and governance determinants of the
level of compensation (see Core, Holthausen and Larcker, 1999; Hartzell and Starks, 2003).
Descriptive statistics for the variables in equation (2) are presented in panel A of table
5. All of the control variables are significantly different across family and non-family firms.
Thus, it is important to control for these variables. The regression results are presented in
panel B of table 5. As predicted, the coefficients on FAMILYFIRM are negative and
significant for all three measures of compensation. These results indicate that compared to
non-family firms, family firms pay lower levels of compensation in terms of salary, cash
compensation, and total compensation to their CEOs. The coefficients on the control
variables, when significant, have the predicted signs. The results in panel B of table 5 support
hypothesis H2.
30
Table 5. The Level of CEO Compensation
TOTAL($,000)
CASH($,000)
SALARY($,000)
SIZE
INVEST
ROA
RET
STD_ROA
STD_RET
MEETING
CEOOWN (%)
INSTITUTION (%)
CEO_CHAIR
SEGMENT
N
Family
firm
7,792
1,705
682
8.51
5.52
0.05
0.19
0.03
0.46
6.95
0.25
61.66
0.60
2.19
398
Mean
Non-family
firm
8,534
2,073
921
8.83
3.35
0.03
0.13
0.03
0.36
8.00
0.18
68.32
0.78
2.45
1337
t-stat.
-1.54
-3.51***
-5.75***
-2.68***
4.21***
1.99**
1.86**
-1.88**
3.59***
-6.51***
2.28**
-4.51***
-3.55***
-3.61***
Family
firm
4,458
1,471
675
8.37
4.49
0.06
0.11
0.02
0.35
6.00
0.07
60.06
1.00
2.21
398
Median
Non-family
firm
5,068
1,715
883
8.84
3.44
0.04
0.08
0.02
0.29
7.00
0.07
69.71
1.00
2.52
1337
z-stat.
-2.22**
-4.53***
-6.48***
-3.01***
3.96***
1.98**
1.99**
-1.92**
3.66***
-7.44***
0.99
-4.31***
-3.03***
-3.87***

Predicted
Sign
?
(1)
Log (SALARY)
0.02*
FAMILYFIRM
-0.08***
(-3.67)
-0.16***
(-3.48)
-0.18**
(-2.05)
SIZE
0.15***
(13.41)
0.21***
(10.45)
0.25***
(9.97)
INVEST
0.01
(0.01)
-0.01
(-0.33)
0.03***
(4.48)
ROA
0.01
(0.33)
0.01
(0.36)
0.01**
(2.15)
RET
0.01***
(3.33)
0.01***
(7.70)
0.01***
(4.44)
STD_ROA
-0.01*
(-1.78)
-0.01
(-1.14)
0.03***
(3.09)
Intercept
(2)
Log (CASH)
0.05
(3)
Log (TOTAL)
0.13
31
Table 5. Continued
-0.04
(-1.62)
-0.06
(-1.01)
0.19**
(2.04)
-0.02***
(-4.33)
-0.02*
(-1.76)
0.01
(0.23)
0.01
(0.65)
-0.02
(-0.77)
-0.05
(-0.66)
CEOOWN
-0.02***
(-4.44)
-0.02
(-1.47)
-0.05
(-1.60)
CEO_CHAIR
0.02*
(1.85)
0.03
(0.77)
0.09
(0.66)
SEGMENT
0.01
(0.06)
0.12***
(2.65)
0.13**
(2.49)
0.31
1735
0.25
1735
0.24
1735
STD_RET
MEETINGS
INSTITUTION
Adjusted R2
N
Variable Definition: The dependent variable, Log (COMPENSATION), represents three

different measures, TOTAL, CASH, and SALARY. TOTAL represents total compensation and
is the sum of salary, bonus, the value of stock options and restricted tocks, long-term
performance plans, and other compensation. CASH is the sum of salary and annual bonus.
SALARY is the annual basic salary of CEO. SIZE is the natural logarithm of sales. INVEST is
defined as the firms year end market-to-book ratio averaged over the prior five years. ROA
is the ratio of earnings before tax and interest to total assets of. RET is stock returns.
STD_ROA is the standard deviation of the percentage return on assets for the prior five years.
STD_RET is the standard deviation of stock return for the prior five years. MEETINGS is the
number of board meetings held. INSTITUION is the percentage of the companys stock
owned by institutional investors. CEOOWN is the percentage of firms stocks held by the
CEO. CEO_CHAIR is a dummy variable that equals one if the CEO also serves as the
chairperson of the board. SEGMENT is square root of the number of two-digit SIC industry
codes the firm operates in.
dummy coefficients. The t-statistics are shown in parentheses and are corrected using the
Huber-White procedure. *** indicates significance at the 0.01 level, ** indicates significance
at 0.05 level, and * indicates significance at the 0.10 level.
32
5.3
Annual bonus plan
5.3.1 The design of CEO annual bonus plans

A standard annual plan specifies the bonus as a function of the performance measures
used to evaluate the CEO (Murphy, 2001). A target bonus is paid to the CEO if the prespecified performance standard is achieved, and the bonus is adjusted if the actual
performance is greater or less than the pre-specified target. Thus, a bonus plan typically
contains three components: performance measures, performance standards, and the payperformance relation (Murphy, 2001). I obtain data from the 2002 proxy statements to
compare these components of bonus plans across family and non-family firms.9 I select 79
pairs of family and non-family firms. Each pair is matched on two-digit SIC code, size
(sales), and growth opportunities (market-to-book ratio). This approach will provide evidence
as to how the differences in severity of agency problems across family and non-family firms
affect the choice of performance measures, performance standards, and pay-performance
relation in CEO annual bonus plans.
Transparency of annual bonus plans
Ali, Chen and Radhakrishnan (2005) that family firms are less likely to voluntarily
disclose information about corporate governance practices. They argue that family members
maintain lack of transparency of corporate governance practices in order to reduce the
interference from non-controlling shareholders.
As Ittner, Larcker and Rajan (1997) and Murphy (1999) point out, using information obtained from proxy statements has a
limitation, since the information is voluntarily disclosed by firms, it may be subject to discretion. Firms that do not disclose
required information are not included in the analysis. Panel A of appendix A provides two examples of company proxy
statements with specific information about CEO annual bonus plans, and panel B provides two examples of company proxy
statements with only general information about CEO annual bonus plans.
33
Consistent with this argument, I find that family firms are less likely to provide
specific details about CEO annual bonus plans. The results are presented in table 6. 75%
(92%) of family (non-family) firms disclose specific information about the performance
measures used in CEO annual bonus plans. 53% (80%) of family (non-family) firms disclose
specific information about performance standards, and 66% (82%) of family (non-family)
firms disclose specific information about pay-performance relation in the CEO annual bonus
plans. The difference is statistically significant. The lack of transparency of CEO
compensation contracts enables founding family members to maintain more discretion in
deciding CEO annual bonus.
Table 6. The Transparency of Annual Bonus Plan
Family
firms
# of firms disclose the specific performance measures
in annual bonus plans
# of firms disclose the performance standards used in
annual bonus plans
# of firms disclose the performance standards used in
annual bonus plans
Non-Family Difference
firms
t-statistics
75%
92%
-2.71***
53%
80%
-3.37***
66%
82%
-2.09**
Performance measures
In panel A of table 7, I compare the performance measures used by family and nonfamily firms. The first and second rows of panel A show that 25% (75%) of family firms use
single (multiple) performance measure(s) in annual bonus plans, while 8% (92%) of nonfamily firms use single (multiple) performance measure(s) in annual bonus plans, and the
difference is statistically significant (t = 2.52). The third row of panel A shows that the
average number of performance measures used by family firms is 1.78, while non-family
34
firms use on average 3.92 performance measures to evaluate their CEOs, and the difference
is statistically significant (t = -1.99). These results are consistent with hypothesis H3a.
I also describe performance measures used by family and non-family firms in panel
A. 80% (79%) of family (non-family) firms use accounting earnings in annual bonus plan,
and 39% (58%) of family (non-family) firms use other kinds of financial accounting numbers
including operating income, EBITDA, and other cash flow measures. In total, 100 % (98%)
of family (non-family) firms use at least one financial accounting number, such as earnings,
EBIT, cash flow measures, and sales, in the CEO annual bonus plans.10 Compared to nonfamily firms, family firms are less likely to use economic value added (EVA) and are not
significantly different in their use of stock price and sales.
Compared to non-family firms, family firms use significantly fewer strategic
objective measures and other non-financial measures, which includes customer satisfaction,
employee related targets, quality, process improvement, new products, market share,
innovation, operational performance, and productivity or efficiency. 11 Generally, family
firms are less likely to use non-financial measures than non-family firms, so hypothesis H3a
is supported.
Performance standards
Performance standards are set with the desire to provide incentives while
simultaneously paying a competitive level of compensation (Murphy, 2001). Following
Murphy (2001), I categorize the performance standard into six groups. Budget standards
measures CEO performance against the firms annual budget targets (e.g., budgeted return on
10
11
The distribution statistic is consistent with that reported in Ittner, Larcker and Rajan (1997) and Murphy (2001).
The definition of non-financial measures follows Ittner, Larcker and Rajan (1997) and Murphy (2001).
35
assets). Prior-Year standards measures CEOs performance based on year-to-year growth
(e.g., growth in EPS). Discretionary standards are performance targets set subjectively by
the board of directors based on the firms operating plan and following a subjective
evaluation of the difficulty in achieving the performance targets.12 Peer group standards are
performance goals set relative to other companies in the same market or industry (e.g., EPS
of peer group in the same industry). Timeless standards are performance standards that are
fixed across years (e.g., 10% ROA across years). Cost of capital standards are performance
standards based on the companys cost of capital (e.g., plans based on EVA).
Panel B of table 7 reports performance standards used by family and non-family
firms.13 Compared to non-family firms, family firms are significantly less likely to adopt
Budget and Prior-Year standards (t = -2.98, and -3.07, respectively). Family firms are
also less likely to use Cost of capital standards (t = -1.66). For Peer group and
Timeless standards, family firms are not statistically different from non-family firms.
Finally, 43% of family firms use Discretionary standards, while only 11% of non-family
firms do so, and the difference is statistically significant (t = 4.22). The result that family
firms, compared to non-family firms, use more subjective performance standards is
consistent with hypothesis H3b.
Pay-performance relations
Pay-performance structures define the amount of annual bonus paid to CEO, given a
certain level of performance. Consistent with Murphy (2001), I classify the pay-performance
structures into four groups. Under a typical 80/120 plan, no bonus is paid unless the actual
12
Appendix B presents two examples of discretionary performance evaluation from proxy statements.
For panel B, I do not separate firms with single performance standard from firms with multiple performance standards, as
in Murphy (2001).
13
36
performance exceeds 80% of the performance standards, and the bonus is capped if actual
performance exceeds 120% of the performance standards. A Formula-based plan pays, for
example, 5% of net income when it exceeds 12% of ROE, and the bonus pool is allocated to
individuals based on formulas. Under a modified Sum-of-targets, the bonus pool equals the
sum of each participants target bonus, modified up or down depending on the companys
performance. Under the Discretionary plan, the board meets at the year-end and evaluates
the companys performance subjectively and then decides the amounts of bonuses. Panel C
of table 7 compares the pay-performance structures for family and non-family firms. The
most popular method is 80/120 plans. Family firms and non-family firms use this method
roughly equally. 27% (20%) of family (non-family) firms use formula-based plans. 12% of
family firms use modified Sum-of-targets plans, while 34% of non-family firms do so. The
difference is statistically significant (t = -3.21). Finally, 21% (3%) of family (non-family)
firms use a discretionary approach to decide the bonus amount, and the difference is
significant (t = 2.55). These results are consistent with hypothesis H3b.
Table 7. The Design of Annual Bonus Plan
Panel A: Performance Measures in Annual Bonus Plans
25%
75%
1.78
Non-Family
firms
8%
92%
3.92
80%
39%
36%
7%
29%
7%
24%
79%
58%
38%
7%
41%
14%
40%
Family firms
# of firms with single performance measure
# of firms with multiple performance measures
# of performance measures used
Performance measures
Earnings
EBIT
Sales
Stock Price
Strategy Goals
EVA
Non-Financial
Difference
t-statistics
2.52***
-2.52***
-1.99**
0.16
-2.20**
-1.08
-0.80
-1.71*
-1.66*
-2.13**
37
Notes: Earnings includes net income, pre-tax net income, and return on assets, equity, and
capital. EBIT denotes Earnings before Interest and Taxes includes Operating Income,
EBITDA, and other cash flow measures. EVA (Economics Value Added) usually represents a
measure of operating income minus a charge of capital. Non-Financial includes customer
satisfaction, employee related targets, quality, process improvement, new product, market
share, innovation, operational performance, and productivity or efficiency.
Panel B: Performance Standards in Annual Bonus Plans
Family firms
Performance standards
Budget standard
Prior-Year standard
Discretionary standard
Peer group standard
Timeless standard
Cost of capital standard
Non-Family firms
43%
17%
43%
29%
5%
5%
62%
38%
11%
14%
11%
14%
Difference
t-statistics
-2.98***
-3.07***
4.22***
1.48
-1.28
-1.66*
Notes: Budget standard denotes performance standards which measure CEOs performance
against the firms annual budget targets (e.g., budgeted EPS).Prior-Year standard are
standards which measure CEOs performance based on year-to-year growth (e.g., growth in
EPS).Discretionary standard are plans where the performance targets are set subjectively
by the board of directors based on the firms operating plan and following a subjective
evaluation of the difficulty in achieving the performance targets. Peer group standard are
plans where performance goals are set relative to other companies in the same market or
industry (e.g., EPS compared to a peer group in the same industry).Timeless standard are
performance standards that are fixed across years (e.g., 10% ROA across years). Cost of
capital standard are performance standards based the companys cost of capital (e.g., plans
based on EVA).
Panel C: Pay-performance Structures in Annual Bonus Plans
80/120 Plans
Formula-Based Pool
Modified Sum-of-Targets
Discretionary
Family firms
Non-Family firms
40%
27%
12%
21%
43%
20%
34%
3%
Difference
t-statistics
-0.35
1.31
-3.21***
2.55***
Notes: A typical 80/120 plan is that threshold performance is defined as 80% of target
performance, and the bonus is capped at 120% of target performance. A formula-based
plan is, for example, 5% of Net Income exceeds 12% of ROE. The pool is allocated to
individuals based on formula. A sum-of-targets approach equals the sum of each
38
participants target bonus, modified up or down depending on company performance. A
discretionary approach, top managers and the compensation committee review a variety of
year-end performance measures, and subjectively determine the magnitude of the bonus pool.
Notes: The sample contains 79 pairs of family and non-family firms (158 firms) with 79
observations pertaining to family firms and 79 observations pertaining to non- family firms
in the S&P 500. The sample period is 1997 to 2002. Each pair is matched on two digit SIC
codes, size (sales), and growth opportunities (market-to-book ratio). Firms in financial
industries (SIC code 6000-6999) or in utility industries (SIC code 4900-4999) are excluded.
In each cell, the denominator is the total number of family and non-family firms and the
numerator is the number of firms that correspond to that given question. *** indicates
significance at the 0.01 level, ** indicates significance at 0.05 level, and * indicates
5.3.2 The sensitivity of CEO annual bonus plan to accounting earnings

To assess the sensitivity of CEO annual bonus to accounting earnings, I estimate that
the following model.
Log (CASH i,t) = + 1SIZE i,t + 2ROA i,t + 3RETURN i,t + 4FAMILYFIRM
+5FAMILYFIRM*ROA i,t +6FAMILYFIRM*RETURN i,t
+7CEOOWN i,t-1*RETURN i,t +8FAMILYFIRM*RETURN i,t*CEOOWN i,t-1
+error
(3)
where the dependent variable, Log (CASH), is the change in the natural logarithm of CEO
salary and bonus compensation. FAMILYFIRM is a binary variable which equals 1 if the
firm is a family-firm and 0 otherwise. SIZE is the natural logarithm of market capitalization.
ROA is the change of the ratio of earnings before tax and interest to total assets in year t.
RETURN is stock return. CEOOWN is the percentage of firms stocks held by the CEO.
Other control variables are based on prior studies (see Baber, Janakiraman and Kang, 1996;
Baber, Kang and Kumar, 1998).
39
In panel A of table 8, I provide descriptive statistics of the variables in equation (3).
Most of the variables are significantly different across family and non-family firms. Thus, it
is important to control for the effect of these variables. The results from estimating equation
(3) are presented in panel B of table 8. In column (2), the coefficient on the interaction item,
FAMILYFIRM*ROA, is 0.99 (t = 3.45). The result indicates that family firms, compared to
non-family firms, place more weight on accounting earnings in rewarding CEOs. Thus, the
result supports hypothesis H4b, which is consistent with the notion that the better monitoring
of family firms leads to a higher quality output measures (accounting earnings), so family
firms make their CEO annual bonuses more sensitive to accounting earnings (Milgrom and
Roberts, 1992).
Table 8. The Weight on Accounting Earnings in Annual Bonus Plan
CASH($,000)
SIZE
INVEST
ROA
RETURN
CEOOWN (%)
N
Family
firm
780
8.51
5.52
0.01
0.19
0.24
396
Mean
Non-family
firm
1,023
8.83
3.35
0.00
0.13
0.18
1309
t-stat.
-3.51***
-2.68***
4.21***
0.55
1.86**
2.01**
Family
firm
529
8.37
4.49
0.01
0.11
0.07
396
Median
Non-family
firm
682
8.84
3.44
0.00
0.08
0.07
1309
z-stat.
-4.53***
-3.01***
3.96***
0.66
1.99**
0.99

Predicted
Sign
?
(1)
log (CASH)
0.19**
(2)
log (CASH)
0.20*
SIZE
-0.02**
(-2.06)
-0.02**
(-1.97)
ROA
2.38***
(14.44)
2.12***
(11.31)
Intercept
40
RETURN
Table 8. Continued
+
0.27***
(9.21)
0.25***
(8.11)
FAMILYFIRM
0.04
(1.21)
FAMILYFIRM*ROA
0.99***
(3.45)
FAMILYFIRM*RETURN
0.04
(0.79)
CEOOWN_RETURN
-0.02**
(-2.21)
FAMILYFIRM*RETURN*CEOOWN
-0.01*
(-1.86)
0.19
1705
Adjusted R2
N
0.11
1705
Variable Definitions: The dependent variable, CASH is the sum of salary and annual bonus.
FAMILYFIRM is a binary variable that equals 1 if the firm is a family firm and 0 otherwise.
SIZE is the natural logarithm of market capitalization. INVEST is defined as the firms year
end market-to-book ratio averaged over the prior five years. ROA is the change of the ratio
of earnings before tax and interest to total assets in year t. RET is prior years stock return.
CEOOWN is the percentage of the firms stocks held by the CEO.
Notes: The t-statistics are shown in parentheses and are corrected using the Huber-White
procedure. *** indicates significance at the 0.01 level, ** indicates significance at 0.05 level,
and * indicates significance at the 0.10 level.
5.4
The sensitivity of future profitability to the CEO stock option grants

Consistent with Hanlon, Rajgopal and Shevlin (2003), I estimate the following model
to evaluate the economic benefits from stock options granted to CEOs of family and nonfamily firms. Hanlon, Rajgopal and Shevlin (2003) use five lags to catch the future economic
benefits of the grant of stock options. However, I use only three lags due to data constraints.
41
3
(OI / SALES ) I ,t = 0 + 1 ( ASSET / SALES ) i ,t 1 + 2,k ( ESO / SALES ) i ,t k

k =0
k =0
3
k =0
+ 3,k ( ESO / SALES) t2k + 4 ,t k FAMILYFIRM* ( ESO / SALES) i ,t k

+ 5,t k FAMILYFIRM* ( ESO / SALES) i2,t k + 6VOLATILITYi ,t 1
k =0
+ 7 IndustryDummy + 8YearDummy + i ,t
(4)
where the dependent variable, OI is the annual operating income, before R&D expense and
after SGA expense. FAMILYFIRM is a binary variable that equals 1 if the firm is a family
firm and 0 otherwise. ASSET is the book value of total assets. VOLATILITY is the standard
deviation of (OI/SALES) estimated over the last five years. ESO is the Black-Scholes value of
new stock option grants for CEOs. All variables are scaled by SALES, which is annual
sales.14
Table 9. The Economic Benefits of the CEO Stock Options Grants
OI ($million)
VOLATILITY
ESO ($million)
ASSET($million)
N
Family
firm
2010.43
0.05
7.46
11887.25
212
Mean
Non-family
firm
2844.19
0.04
6.94
19133.07
632
t-stat.
**
-2.01
2.62***
1.22
-4.45***
Median
Family Non-family
firm
firm
821.58
1155.96
0.02
0.02
3.57
3.55
4356.78
7677.82
212
632
z-stat.
-1.94**
2.87***
0.88
-5.01***
Intercept
VOLATILITY
14
Dependent var. = OI i,t

Coefficient
t-statistics
0.14
7.85***
-0.11
-1.93*
I do not include R&D in the estimation because Hanlon, Rajgopal and Shevlin (2003) indicate that the inclusion of R&D
may underestimate the effects of ESO.
42
Table 9. Continued
0.03
ASSET
-3.51
ESO i,t
4.28
ESO i,t-1
3.51
ESO i,t-2
5.74
ESO i,t-3
2
158.32
(ESO) i,t
-112.22
(ESO)2 i,t-1
33.56
(ESO)2 i,t-2
2
-182.44
(ESO) i,t-3
8.33
FAMILYFIRM_ESO i,t
6.71
FAMILYFIRM_ESO i,t-1
1.82
-8.82
-175.62
FAMILYFIRM_ (ESO)2 i,t
80.31
FAMILYFIRM_ (ESO)2 i,t-1
-237.35
216.35
Adjusted R2
N
6.40***
-1.33
1.85*
1.22
1.66*
3.83***
-2.88***
0.55
-1.71*
3.30***
2.22**
0.55
-1.77*
-4.44***
2.05**
-1.78*
1.58
0.42
844
Panel C: Economic Benefits Evaluated at Various Points of the CEO Stock Option Grants
Distribution
cutoff
First Quartile
Median
Third Quartile
ESO
value
0.0002
0.0004
0.0020
Family firms
Estimated
Implied
effect on OI sensitivity
0.0036
0.0072
18.00
0.0352
17.50
ESO
value
0.0002
0.0005
0.0010
Non-family firms
Estimated
Implied
effect on OI sensitivity
0.0020
0.0050
10.00
0.0099
9.80
Variable Definitions: The dependent variable, OI is the annual operating income, before
R&D expense after SGA. FAMILYFIRM is a binary variable that equals 1 if the firm is a
family firm and 0 otherwise. ASSET is the book value of total assets. VOLATILITY is the
standard deviation of (OI/SALES) estimated over the prior five years. ESO is the BlackScholes value of new stock option grants for CEO. All variables are scaled by SALES, which
is annual sales.
dummy coefficients. The t-statistics are corrected using the Huber-White procedure. ***
indicates significance at the 0.01 level, ** indicates significance at 0.05 level, and * indicates
43
3
The sum of coefficients, 2,k , represents the first-order payoff to a dollar of stock
k =0
options. The sum of coefficient, 3,k , reflects the concave function of the payoff of stock
k =0
option grants. The sum of the coefficients of interactions of FAMILYFIRM and ESO, 4,k ,
k =0
captures the incremental first-order economic benefits brought by the stock options granted
by family firms. In panel A of table 9, I provide descriptive statistics for the variables in
equation (4).
3
I present the regression results in panel B of table 8. The estimated value of,
k =0
is 10.02 and is significantly greater than zero (F = 6.99), and that of
2,k
k =0
3, k
is -102.78 and is
significant (F = 9.56). The results are consistent with Hanlon, Rajgopal, and Shevlin (2003)
that stock option grants bring future economic benefits, and that the relationship is concave.
3
The estimated value of
4,k is 8.04 and is significant (F = 3.61), and that of

k =0
k =0
5, k
is -
116.31 and is significant (F = 6.77). The results suggest that stock option grants of family
firms, compared to those of non-family firms, bring greater future benefits per unit value of
option grant, and the relationship is more concave. In order to further understand the
economic benefits of stock options, I follow Hanlon, Rajgopal and Shevlin (2003) and
estimate economic benefits at the different quartiles of stock options (panel C of table 9). The
implied sensitivity of benefits to stock options is the change in OI/S divided by the change in
ESO/Sales. For family firms (non-family), when ESO/Sales changes from first quartile,
0.0002 (0.0002), to median, 0.0004 (0.0005), the OI/Sales increases from 0.0036 (0.0020) to
44
0.0072 (0.0050), so the sensitivity is 18.00 (10.00). When ESO/S moves from median to the
third quartile, family (non-family) firms have a sensitivity of 17.50 (9.80). In sum, the
results presented in panel C of table 9 show that the sensitivity of future profitability to
equity compensation is greater for family firms. This finding is consistent with hypothesis
H5.
CHAPTER 6
CONCLUSION
6.1
Summary of results
In this study, I compare the compensation contracts of professional CEOs across
family and non-family firms in the S&P 500. Compared to non-family firms, family firms
with professional CEOs face less severe agency problems arising from the separation of
ownership and management, and this characteristic influences family firms CEO
compensation practices. I consider four aspects of CEO compensation contracts: the
proportion of compensation that is equity-based, the level of total pay, the pay-earnings
sensitivity of annual bonus plans, and the sensitivity of future economic benefits to CEOs
equity compensation.
First, I find that compared to non-family firms, family firms are less likely to grant
stock options and restricted stocks to their CEOs, and are less likely to require their CEOs to
have a minimum level of stock ownership. I also find that the proportion of equity-based
compensation to CEOs total compensation is lower for family firms than non-family firms.
These findings are consistent with family firms facing less severe agency problems because
of more direct monitoring of CEOs by the family.
Second, I find that professional CEOs of family firms receive lower levels of
salary, cash compensation (salary and annual bonus), and total compensation (salary, bonus,
equity-based compensation, and other compensation) than professional CEOs of non-family
firms. This result is consistent with the notion that professional CEOs of non-family firms
45
46
receive higher pay to compensate for the higher risks embedded in their CEO compensation
contracts. This result is also consistent with the argument that stronger monitoring by
founding family members reduces the likelihood that their CEOs receive excessive
compensation (Core, Holthausen and Larcker, 1999; Bertrand and Mullainathan, 2001;
Hartzell and Starks 2003).
Third, using the data from proxy statements, I find that the design of CEO annual
bonus plans is very different across family and non-family firms. Compared to non-family
firms, family firms use fewer performance measures and are less likely to use non-financial
performance measures in their annual bonus plans. Further, family firms use more subjective
performance standards and pay-performance relations for determining CEO annual bonuses.
Finally, the sensitivity of CEO annual bonus payments to accounting earnings is greater for
family firms than for non-family firms. These results are consistent with the argument that
family firms are better able to directly monitor their CEOs, thereby reducing the need to
adopt objective methods for determining annual bonuses. Moreover, better monitoring leads
to higher quality reported earnings, and consequently higher sensitivity of CEO annual bonus
payments to accounting earnings.
Finally, I find that the sensitivity of a firms future profitability to CEOs equity
compensation is significantly greater for family firms as compared to non-family firms.
The above findings contribute towards understanding the effect of the severity of
agency problems due to the separation of ownership and management on compensation
contracts. This study is the first in the literature to provide evidence on the effect of direct
monitoring on the structure of CEO annual bonus contracts. Finally, the study complements
47
the growing literature on family firms by documenting how the professional CEOs
compensation contracts across family and non-family firms.
6.2
Future research
As discussed in section 2.2, family firm whose CEO is a member of the founding
family is subject to more severe agency problems because of the conflicts between
controlling and non-controlling shareholders (Agency Problem II). Thus, family firms with
family CEOs are more likely to expropriate minority shareholders through related-party
transactions and excessive compensation (Anderson and Reeb, 2003a). My study can be
extended to compare CEO compensation packages across family firms with family CEOs and
family firms with professional CEOs. Specifically, one can test whether the level of CEO
compensation is higher for family CEOs, and whether the determination of performancebased compensation is more subjective in family firms with family CEOs. Furthermore, one
can test Jensen and Mecklings (1976) predication that family CEOs are more likely to
consume perquisites such as company aircrafts and country club membership as compared to
professional CEOs.
Future research could also compare insider trading behavior across family and nonfamily firms. Does CEO trading behavior in family firms provide less information because
family CEOs trade solely for portfolio adjustment reasons? This research would help us
understand the relationship between agency problems and insider trading behavior.
APPENDIX A
EXAMPLES OF EXCERPTS FROM PROXY STATEMENTS
Panel A: Proxy Statements with Specific Information about Performance Measures
(1) KLA-TENCOR Corporation (Family firm)
REPORT OF THE COMPENSATION COMMITTEE ON EXECUTIVE COMPENSATION
Chief Executive Officer Compensation
For fiscal year 2002, Kenneth L. Schroeder served as Chief Executive Officer. In setting Mr.
Schroeder's compensation for fiscal year 2002, the Compensation Committee considered the
Company's revenue and profit in the prior fiscal year, the Company's market capitalization
and data from comparable companies supplied by the Company's compensation consultants,
in addition to Mr. Schroeder's performance and continuing contributions to the Company.
For fiscal year 2002, a bonus of $218,040 was paid to Mr. Schroeder, based on the
Company's performance as measured against a formula, which is based on meeting
financial and strategic objectives as well as the Company's revenue growth objectives as
compared to a peer group. This bonus formula was approved by the Compensation
Committee and the independent members of the Board of Directors last year.
Annual Incentive Plan
Each year since fiscal 1979, the Company has adopted a management incentive plan (the
"Incentive Plan") which provides for payments to officers and key employees based on the
financial performance of the Company or the relevant business unit, and on the achievement
of key strategic objectives which are set by senior management and approved by the Board of
Directors. The Incentive Plan is approved by the Compensation Committee and submitted to
the Board of Directors for ratification. For fiscal year 2002, the Incentive Plan set goals for
profitability, achievement of measurable objectives aimed at strategic corporate goals and
achievement of objectives relating to managing the ratio of assets to sales.
48
49
(2) SYMANTEC Corporation (Non-family firm)
Compensation for the CEO is determined through a process generally similar to that
discussed above for Management Committee members.
Symantec establishes its financial objectives in connection with its normal financial
budgeting process. Each year, a budget is established for the following four fiscal quarters.
Under the CEO's annual Incentive Plan for fiscal year 2002, and his six-month incentive plan
in effect during the last six months of the fiscal year, Mr. Thompson was eligible to receive
an annual bonus following the end of the fiscal year with a target payout of 100%.
During the first six months of the 2002 fiscal year, the following metrics and weightings
were considered in calculating the amount of Mr. Thompson's bonus: (a) achievement of
targeted annual revenue growth of the company (50% weighting); and (b) achievement
of targeted annual earnings per share growth of the company (50% weighting). During
the final six months of the fiscal year, the six-month incentive plan became effective and
modified the targets related to the financial metrics. Specific thresholds for each metric had
to be exceeded before the portion of the bonus associated with the respective metric was
paid. The bonus target payment for a particular metric was calculated on a linear basis in
relation to the percent of the metric achieved up to 100% of the target amount. An additional
bonus was payable for achieving more than 100% of a metric. Overall, Mr. Thompson earned
an aggregate bonus of $481,250 for the 2002 fiscal year. The Compensation Committee
believes that the CEO's performance bonuses should be paid solely in relation to the success
and strength of Symantec, and although achieving personal objectives is important, the
success and strength of Symantec is the ultimate measure of the CEO's effectiveness.
50
Panel B: Proxy Statements with General Information about Performance Measures
(1) AUTOMATIC DATA PROCESSING (Family firm)
The Committee meets annually to evaluate the performance of the Chief Executive Officer
and to determine his compensation. Mr. Weinbach received a base salary of $735,000 and a
bonus of $173,500 during fiscal 2002. Mr. Weinbach's compensation is based on the
satisfaction of specific performance objectives and the terms of his employment agreement.
Mr. Weinbach's compensation is below the median base salary and bonus compensation of
chief executive officers at companies in the S&P 500 with annual revenues between $3 and
$12 billion, as surveyed by the Company.
Total annual compensation consists of base salary, cash bonus and yearly vesting of
restricted stock. The base salaries for executives for fiscal 2002 were determined based upon
the job grade of the position, the salary range of the job grade and the performance of the
executive. Key executives earned cash bonuses in fiscal 2002 based upon individual
annual accomplishments versus individual pre-established goals.
51
(2) JC PENNEY (Non-family firm)
Fiscal Year 2002 CEO Compensation
JCP entered into an employment agreement with Mr. Questrom, effective September 13,
2000 ("Questrom Agreement"), pursuant to which Mr. Questrom serves as JCP's and the
Company's Chairman of the Board and CEO. The Questrom Agreement calls for a five-year
employment term and an initial annual base salary of $1,250,000. Effective July 2001, Mr.
Questrom's annual base salary was increased to $1,350,000. The annual base salary will be
reviewed by the Committee for possible increase at least annually. For fiscal 2002, Mr.
Questrom's bonus award was $1,957,500. The Questrom Agreement also required Mr.
Questrom to purchase for his own account a number of shares of Common Stock
Annual profit incentive compensation can be earned under the J. C. Penney Corporation, Inc.
1989 Management Incentive Compensation Program ("Incentive Program"). The Incentive
Program ties incentive compensation to Company performance, with no incentive payment
for performance well below plan and up to 200% of incentive targets for superior results. The
goals for the Incentive Program are set at the beginning of each fiscal year consistent with the
Company's business plan.
APPENDIX B
EXAMPLES OF DISCRETIONARY PERFORMANCE
MEASUREMENT FROM PROXY STATEMENTS
(1) PEOPLESOFT INC (Family firm)
The compensation for PeopleSoft's CEO is comprised of base salary, cash incentives and
longer-term equity incentives as described above. In determining the CEO's compensation,
the Committee considers PeopleSoft's overall performance, including achievement of
revenue and operating income targets and expense management, and investor return. The
Committee also considers Mr. Conway's individual performance, vision and leadership, and
market survey data for peer group companies. Based upon these factors, the
Committee established Mr. Conway's base salary for 2002 at $1,000,000, unchanged from
the prior year. Although the CEO does not participate in the Bonus Plan, the Committee
establishes each year a target cash incentive for Mr. Conway, also based on the factors
described above. For 2002, upon its review of PeopleSoft's overall financial and business
performance during the year as well as its performance relative to competitors, and the
Board's evaluation of Mr. Conway's outstanding performance in leading the Company
for the previous three years, Mr. Conway was awarded a cash incentive bonus of
$1,095,000 and an additional $500,000 discretionary bonus. Mr. Conway also received a
$325,000 retention bonus payment in 2002.
In 2002, Mr. Conway was granted options to purchase an aggregate of 4,125,000 shares of
PeopleSoft's Common Stock at exercise prices ranging from $14.88 to $29.29 per share. The
shares subject to each option vest in equal quarterly increments over a four-year period. In
addition, Mr. Conway was granted 500,000 shares of restricted stock, all of which vest on
February 1, 2006, or will vest prorata if Mr. Conway leaves the Company under certain
circumstances prior to February 2006. In awarding these grants, the Compensation
Committee considered the Mr. Conway's outstanding performance in leading PeopleSoft, the
Company's performance in 2002 and 2001 and an assessment of equity grants made to CEOs
of other companies of similar size in the industry. These grants are intended to maintain
Mr. Conway's compensation at a competitive level.
52
53
(2) ALLEGHENY TECHNOLOGIES INC (Family firm)
EXECUTIVE COMPENSATION POLICIES AND PROGRAMS
Consistent with the characteristics outlined above, the Committee has adopted the following
policies and programs: Base salary for all management positions will be at the industry or
market median for comparable positions unless there are sound reasons for significant
variations. Judgment is the guiding factor in base salary determinations, as well as other
compensation issues.
Short-term incentives under the Annual Incentive Plan ("AIP") are designed to provide a
competitive (50th percentile) award, based on the achievement of predefined performance
measures. Under the general provisions of the AIP, up to 200% of the target award is paid in
the case of significant overachievement. The majority of the award is based on financial
performance achievement and is also tied to the achievement of safety and other individual
performance goals. Discretionary adjustments of plus or minus 20% are allowed, so long as
aggregate adjustments do not exceed plus 5%. Total overall payout awards under the plan
pool in 2002 were limited to the greater of 5% of operating profit or 5% of operating cash
flow.
For 2002, 25% of the award for AIP participants was based on the achievement of
predetermined levels of operating income, 30% was based on inventory reductions (turns),
25% on cost reductions, and 10% was tied to the achievement of specific individual
objectives. Given the importance the Company placed on safety, 10% of the total award was
based on pre-established levels of safety improvement.
For 2002, the officers named in the Summary Compensation Table on page 17 achieved
the pre-established levels of targeted performance under the AIP. In light of the
difficult year experienced by the Company, however, the Committee determined not to
make AIP awards to any of the officers named in the Summary Compensation Table
and certain other top-level corporate and operating Company executives. Other
participants received AIP awards for 2002, reduced by the Committee by 20% from actual
levels of achievement because of the difficult year experienced by the Company. Awards
ranged from 0% to 75% of the 2002 target incentives based on the targets and levels of
achievement varied by business.
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VITA
Tai-Yuan Chen was born in Tainan, Taiwan on April 3, 1975, and grew up in Kaohsiung,
Taiwan. He received his Bachelor of Business Administration in Accounting from National
Cheng-Chi University, Taiwan in 1997. He worked as a financial officer and ranked as
second lieutenant in the Ministry of National Defense in Taiwan from 1997 to 1999 before
pursuing his Master of Science (M.S.). He completed his M.S. in Accountancy from the
University of Illinois at Urbana-Champaign, USA in 2001. Starting in July, 2006, he will
join the faculty of School of Business and Management at the Hong Kong University of
Science and Technology.

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CEO COMPENSATION CONTRACTS OF FAMILY FIRMS

THE UNIVERSITY OF TEXAS AT DALLAS

UMI Number: 3224377

UMI Microform 3224377

ProQuest Information and Learning Company

CEO COMPENSATION CONTRACTS OF FAMILY FIRMS

Dr. Ashiq Ali

Literature on family firm .............................................................................6

Family firms and Agency Problem I................................................6

Family firms and Agency Problem II ..............................................7

Corporate governance and CEO compensation contracts................8

CHAPTER 3 Hypothesis Development.............................................................................10

Agency problems in family firms with professional CEOs .......................11

The economics of CEO compensation contracts .......................................12

Equity-based CEO compensation ..................................................12

The level of CEO compensation ....................................................13

CEO annual bonus plans............................................................................14

Performance measures in CEO annual bonus plans ......................14

The sensitivity of CEO annual bonus to accounting earnings .......15

The sensitivity of economic benefits to stock options granted to CEOs ...17

CHAPTER 4 Sample .........................................................................................................18

Equity-based compensation .......................................................................23

Likelihood of receiving equity-based compensation .....................23

Proportion of equity-based compensation to total compensation ..25

The level of compensation .........................................................................28

Annual bonus plan .....................................................................................32

The design of CEO annual bonus plans.........................................32

The sensitivity of CEO annual bonus plan to accounting earnings38

CHAPTER 6 Conclusion ...................................................................................................45

Summary of results ....................................................................................45

Appendix A Examples of excerpts from proxy statements ...............................................48

Literature on family firm

Family firms and Agency Problem I (Separation of management and ownership)

Agency Problem I and II

Agency problems in family firms with professional CEOs

The economics of CEO compensation contracts

Equity-based CEO compensation

The level of CEO compensation

grant more equity-based compensation to motivate their professional CEOs. Thus,

CEO annual bonus plans

3.3.1 Performance measures in CEO annual bonus plans

The sensitivity of economic benefits to stock options granted to CEOs

Percentage of cash flow rights controlled by the

Percentage of voting rights controlled by the

Founding family member or descendent serve as the

Founding family member or descendent serve as the

Founding family member or descendent serve as the

Founding family member or descendent serve as the

Percentage of founding families holding at least 5%

Percentage of outside directors on the board

CEO is also the chairperson of the board of directors

Officers and directors ownership

Likelihood of receiving equity-based compensation

Percent of firms in which CEO

Panel B: Restricted Stock Grants to CEOs

Percent of firms in which CEO

Percent of firms which adopt

Proportion of equity-based compensation to total compensation

compensation is less for family firms, I estimate the following model:

Table 4. The Ratio of CEOs Equity-based Compensation to Total Compensation

Panel B: Regression Results

Dependent var. = % EQUITYCOMPi,t