Corporate governance mechanisms as entry mode determinant

Corporate governance mechanisms as entry mode

determinant

Name: Bas Maessen Date: 30-01-2015

Student number: 10727345 Track: International Management

Supervisor: Dr. Ilir Haxhi Study: Business Studies

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Statement of originality

This document is written by Bas Maessen who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no source other than those mentioned in the text and its references have been used creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Preface

The World Investment Report 2014 (UNCTAD, 2014) states that in today’s world there are almost 900.000 multinational enterprises, from which 800.000 are affiliates of parent companies. This tremendous number of worldwide expansions has developed a more globalized, interconnected and competitive business world. Such an environment brings the challenge for enterprises to search for internationalization strategies that will keep them competitive while controlling the uncertainty that comes along with doing business abroad. It is of vital importance for a firm to make the right strategic choice when it comes to the selection of an entry mode. That urgency caused questions about modes of entry to be among the most central questions for international business scholars (Lai, Chen & Chang, 2012).

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Table of content

2.2CORPORATE GOVERNANCE MECHANISMS ... 16

Ownership structure ... 16

Board of directors ... 17

Executive compensation ... 18

2.3ENTRY MODES ... 19

Entry mode structures ... 20

Entry mode determinants... 20

Firm-specific determinants ... 21

2.4LINKING CORPORATE GOVERNANCE MECHANISMS AND ENTRY MODE CHOICE ... 22

OWNERSHIP STRUCTURE... 23 BOARD CHARACTERISTICS ... 24 Education ... 24 Experience ... 25 Age ... 25 Director ownership ... 26 EXECUTIVE COMPENSATION ... 27 2.5CONCEPTUAL MODEL ... 28 3. Method ... 29 3.1DATA COLLECTION ... 29 3.2VARIABLES ... 30 Dependent variable ... 30 Independent variable ... 30 Control variable ... 31 3.3DATA ANALYSIS ... 31 4. Results ... 33 4.1DESCRIPTIVE ANALYSIS ... 33 4.2STATISTICAL ANALYSIS ... 35 Correlation analysis ... 35 Regression analysis ... 38 5. Discussion ... 41 5.1LIMITATIONS ... 44 5.2FUTURE RESEARCH ... 44 6. Conclusion ... 45 7. References ... 49

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List of tables

Table 3.1: Stepwise regression for Entry Mode ... 32

Table 4.1: Industries ... 34

Table 4.2: Descriptive Statistics ... 34

Table 4.3: Collinearity Statistics ... 36

Table 4.4: Correlation Matrix ... 37

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Acknowledgements

I would like to thank all of the people who have offered their help and supported me during the process of writing my thesis. My thanks go to Dr. Ilir Haxhi for his guidance and feedback, to my girlfriend for her patience and understanding and to my family and friends for their kind words of support.

Bas Maessen

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Abstract

This study examines the relationship between the ownership structure of the firm, the characteristics of the board, executive compensation and the selection of entry modes. We argue that the characteristics of the board of directors and the two mechanisms that shape the role and motivate the board, ownership structure and executive compensation, can affect the degree of resource commitment in the entry mode selection. The board characteristics that are used in this study are education, experience, age and director ownership. Executive compensation is measured in fixed and variable compensation. The proposed relationships are examined for a sample of 130 American-based companies whom together made 300 foreign direct investments. The results showed that the level of experience had a positive relationship with the selection of entry modes, whereas the hypotheses were not supported. These results add to a field of research that has so far been underdeveloped and adds to the existing body of literature regarding the effect of corporate governance mechanisms on strategic choice. On a practical side this studies offers understanding how the establishment of corporate governance factors and characteristics of directors reflect in organizational decision making.

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1. Introduction

The separation of ownership and control in publicly owned firms has the potential to create conflicts between the interest of managers and shareholders. The agency theory describes how the conflict of interest can cause governance issues for the firm to arise. Agency theory conceives the corporation as a nexus of contracts between principals (risk-bearing shareholders) and agents (managers with specialized expertise) (Jensen & Meckling, 1976). Shareholders are assumed to maximize returns at reasonable risk, focusing on high dividends and rising stock prices. Conversely, management may prefer growth to profits and may maintain product standards above the necessary competitive minimum. This divergence in objectives may lead different decisions regarding the strategic orientation of the firm (Baysinger, Kosnik & Turk, 1991).

Monitoring if management decisions are made in the interests of the shareholders causes agency costs to arise (Eisenhardt, 1989). Agency theorist argue that in order to control agency costs, corporate governance mechanisms have to be institutionalized to ensure that decisions taken are in the interest of shareholders (Jensen & Meckling, 1976; Fama & Jensen, 1983). Resource-dependence theorists on the other hand, argue that corporate governance mechanisms can support and enhance organizational decision-making by adding an advisory in complement to the monitoring role (Pfeffer & Salancik, 1978). This provides two perspectives on the added value of corporate governance mechanisms. Companies have a range of internal and external mechanisms in order to align the interest and support the decision making process. Internal mechanisms deal with an effectively structured board of directors, a compensation structure that encourages a shareholder orientation and the ownership structure whereas external mechanisms rely on the takeover market in addition to the legal and regulatory system (Omran, Bolbol & Fatheldin, 2014). Internal mechanisms will be the subject of this study.

The effect of these internal mechanisms on firm related outcomes has been subject of research. Members of the board are involved in many critical company decisions, which enables them to impact the strategy and the decision-making process of the firm. The composition of the board has been shown to positively affect corporate R&D spending (Baysinger et al, 1991), firm environmental performance (Villiers, Naiker & Van Staden, 2011) and to have a direct effect on firm strategic

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decisions (Deutsch, 2005). The compensation structure influences board member behavior and performance as compensation is an incentive for directors to protect shareholder interest (Yermack, 2004). Incentive-misalignment has been noted as a cause of the breakdown in monitoring (Hirshleifer & Thakor, 1994) and it could lead to increased risk taking behavior (Dennis et al., 2006; Chen & Ma, 2011). Ownership structure influences the role of the board of directors, as large shareholders have an obvious incentive to monitor the management closely, reducing the influence of the board. In a firm with more dispersed ownership and, thus less shareholders interference, the influences of the board increases (Alchian & Demsetz, 1972). The effect of ownership on firm performance provides conflicting results, as there are studies stating a positive effect (Thomsen & Pedersen, 2000; Gedajlovic & Shapiro, 2002) while other studies find a negative relation (Leech & Leahy, 1991; Lehmann & Weigand, 2000) between ownership concentration and firm performance. Overall there is clear evidence that these three mechanisms have an influence on firm outcomes.

The choice of entry mode has been regarded as one of the most crucial decisions in the internationalization process of a firm with a huge impact on performance (Erramilli & Rao, 1993; Wrona & Trapczynski, 2012). It determines whether a company has full control over a subsidiary or has to share the control with a partner (Arregle, Hébert & Beamish, 2006). Greater control requires higher resource commitment and the decision regarding the degree of resource commitment may be related to risk preferences and decision-making horizons of managers and shareholders (Filatotchev et al., 2007). Current literature is formed with the presumption that the decisions of entry modes are made in the best interest of shareholders. However, shareholders’ interests are to maximize returns at reasonable risk and thus could prefer high-risk actions. Risk adverse managers may in turn make choices that reduce their personal risk exposure at the expense of shareholders, causing agency problems to arise (Lai, Chen, Chang, 2012).

International entry modes are a domain in international business scholars that is relatively well developed and which received growing attention for several decades. The growing attention is caused by the desire to answer questions on why and how firms decide to invest abroad, which comes down to answering the question why firms pick one destination over another and why firms’ choose a certain mode of entry over another (Mwiti, 2014). Different theoretical approaches have been adopted to explain the determinants on which entry mode decisions are made but without an empirical

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consensus regarding the effect of some variables (Morschett, Schramm-Klein & Swoboda. 2010). There is however a consensus that company-specific variables are one of the factors that influence entry mode decisions (Erramilli, Krishna & Rao, 1993; Kumar & Subramaniam, 1997). Company-specific variables can be seen as resources and capabilities that other firms are incapable of imitating, which enables a firm to obtain a sustainable competitive advantage (Foss, 1993). The way the corporate governance mechanisms are established within the firm could function as a unique resource, the board of directors for example due to their skills and knowledge and the compensation and ownership by the way they enable the board members to do their work. This is supported by the upper echelon theory of Hambrick & Mason (1984) that suggests that the characteristics of the key decision makers in an organization influence strategy and subsequent performance.

Up to this research the relationship between corporate governance mechanisms and entry mode selection has been underdeveloped. For instance, Rhoades and Rechner (2001) only found a relationship between ownership concentration and high-risk entry mode selection, but present their findings with caution due to limitations in data availability. Lai et al. (2012) focused their research on the relationship of board characteristics on entry mode selection and find that directors with experience and equity ownership are better able to guide a firm’s international expansion strategies. The relationships that were found by both studies are weak in comparison to other studies that examined the corporate governance mechanisms and strategic choices such as acquisition, diversification, innovation, and integration has been shown in several studies (e.g. Hoskisson et al., 2002; Brick, Palmon & Wald, 2006; Boumosleh, 2009). Both studies however leave out director compensation as well, where it is likely that compensation has an effect on risk-taking behavior of directors (Crutchley & Minnick, 2012).

In line with Desender et al. (2013) we argue that studies examining a single governance mechanisms often overlook the broader linkages among various governance practices and could neglect their complimentary or substitutive impact on different firm outcomes, pointing out a shortcoming in the prior two studies into corporate governance and entry mode selection. We will investigate the relationship between corporate governance and entry mode selection by using a more comprehensive framework, which is more in line with studies in regard to strategic choices. In order to research how all three internal corporate governance mechanisms effect the entry mode selection the following

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research questions have been formulated: What is the influence of the (1) ownership structure, and (2) board characteristics, and (3) executive compensation on the selection of entry modes?

We argue that the establishment of the ownership structure, the board characteristics and the executive compensation in a certain way will lead to the selection of entry modes with a higher equity percentage. In line with studies regarding the effect of corporate governance on strategic decisions we expect the following results. We expect a positive relationship between owner-controlled firms, the level of education, experience, director ownership, variable pay and the selection of entry modes with a higher equity percentage. We expect a negative relationship between the average age of the board members, and fixed pay, and the selection of entry modes with a higher equity percentage.

We collected data on 130 American-based companies who together made 300 foreign direct investments between 2004 and 2014 will be used. The data on the foreign direct investments have been retrieved from the Thomson One database, the compensation data from Execucomp database of Compustat, the ownership data from Orbis, and the board characteristics data from the board the Risk Metrics database from Wharton Research Data Service and the Boardex database. A hierarchical multiple regression was used to test the proposed hypotheses.

This study will contribute to the current body of literature on entry mode research and provide a better understanding of how company-specific variables can influence the selection. Second, it will contribute to the developing amount of scholars that examine how corporate governance mechanisms influence strategic choices. Specifically, it will offer a deeper understanding of the contribution that internal corporate governance mechanisms have on the entry mode selection of a firm. That understanding will be provided by extending the two prior studies in regard to this relationship by examining the combined effect of the ownership structure, compensation structure and the characteristics of the firm.

From a practical point of view this study will give insight in the behavioral risk that comes with the establishment, choices and composition of governance mechanics and how that will effect decision making within the internationalization process. With this knowledge firms can align the organizational choices regarding the ownership structure, their compensation process and characteristics of board members with the desired internationalization strategy.

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The second chapter will give an overview on the existing literature on corporate governance and entry mode selection. First, both concepts will be elaborated upon individually and second, those will be integrated. Based upon that integration hypothesis on the expected relationships will be formed. In the third chapter, the sample and the research strategy used to analyze the hypothesis will be explained. In the fourth chapter the results of the tested hypothesis are presented and these are discussed in the fifth chapter. The sixth chapter concludes the thesis with an overview of the research and managerial implications.

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2. Literature review

2.1 Corporate Governance

Corporate governance is broadly defined by Aguilera and Jackson (2010) as the study of power and influence over decision making within the corporation. This involves various participants in the corporation such as managers, shareholders, the board of directors and other stakeholders like employees, suppliers and consumers (Aguilera, 2004). The OECD (2004, p.11) described what corporate governance involves and provides as: “Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring. The presence of an effective corporate governance system, within an individual company and across an economy as a whole, helps to provide a degree of confidence that is necessary for the proper functioning of a market economy. As a result, the cost of capital is lower and firms are encouraged to use resources more efficiently, thereby underpinning growth”.

Providing a clear and universal definition of corporate governance remains challenging, due to the multitude of theoretical perspectives available and the diversity of corporate governance practices around the world. In management scholarships, stakeholder theory has become a useful framework to explain the complex relationship among different stakeholders in the firm (Donaldson & Preston, 1995). In legal scholars a greater role is given here to the institutional context, which shapes the rights and responsibilities of corporate actors, and defines corporate governance as “the rules that sustain and regulate the mode of decision making within the corporations as a mechanism of social choice and in relation to a public interest (Parkinson, 1993)”. From an economic perspective, Shleifer and Vishny (1997) approach corporate governance from an agency perspective, arguing that corporate governance “deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on investment”. The emphasis in this perspective is on economic problems of making investments in a firm, the principal-agent view (Aguilera & Jackson, 2010). With the different

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perspectives taken into account, corporate governance will be defined in this research as “the set of mechanisms – both institutional and market-based – that induce self-interested managers to make decisions that maximize the value of the firm to its shareholders (Denis & McConnell, 2003).”

The foundation of the named definitions, and the corporate governance domain, is the agency theory (Jensen & Meckling, 1976), despite the proliferation of multiple other theories. Without undermining the importance of the agency theory, it could be said that it lacks the grounds for explanations of relationships between constructs in the corporate governance system. Therefore, both the agency theory and the resource-dependency theory (Pfeffer & Salancik, 1978) will be explained.

Agency theory

The agency relationship can be described as a “contract under which one or more persons (the principal[s]) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent (Jensen & Meckling, 1976).” Agency theory, when applied to corporations, describes the governance issues that arise when the ownership of a corporation is separated from its management. It conceives the corporation as a junction of contracts between principals (financial risk-bearing shareholders) and agents (managers). According to the theory, the management of a firm has the task of directing the firms’ corporate strategy towards the benefits and interests of shareholders. While shareholders would prefer to maximize their profits, managers may invest the free cash flow at a return below the cost of capital, or use it inefficiently, in order to secure sustainability of the company or to increase their power and control. This results in two agency problems, (1) moral hazard (lack of effort on the part of the agent) and (2) adverse selection (misrepresentation of ability by the agent). Monitoring the agent to act in the interests of the principal leads to agency costs (Aguilera & Jackson, 2010; Brink, 2010; Eisenhardt, 1989).

The essence of the agency theory is that by reducing the agency costs and the inefficiencies in the function of the firm, the firm as a whole will benefit since these elements are directly linked to the risks, and returns, associated with the investment (Udayasankar, 2008). The aim of agency theorists is to understand how shareholders manage to align managers towards their interests, hence minimize the agency costs and describing the corporate governance mechanisms available that limit the agent’s self-serving behavior (Shleifer & Vishny, 1997). The agency theory dominates corporate

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governance literature and provides a sound theoretical mechanism for the external monitoring of a firm’s management by its directors, but there are many additional theoretical perspectives that are complementing the agency theory. Daily et al. (2003) states that a multi-theoretic approach to corporate governance is essential for recognizing the many mechanisms and structures that might reasonably enhance organizational functioning and the strategic role these mechanisms can fulfil. The resource-dependency theory (Pfeffer & Salancik, 1978) provides a foundation for the resource role of the board of directors.

Resource-dependency theory

The foundation of the resource-dependency theory (Pfeffer & Salancik, 1978) is that organizations attempt to exert control over their environment by co-opting the resources needed to survive. This concept of co-optation has important implications for the role of the board and its structure. The theory stems from the fundamental logic that various elements of corporate governance can act as critical resources to a firm (Udayasankar, 2008). Pfeffer and Salancik (1978) argue that inter-organizational linkages, such as the ratio of outside directors, can be of value by managing environmental contingencies. An organization that appoints an individual to a board, expects that the individual will come to support the organization, will concern himself with its problems, will favorably present it to others, and will try to aid it.

Directors contribute to a firm through their knowledge, expertise and their linkages to other firms and institutions, which can be a source of timely information for executives who make the operational decisions. With this contribution an advisory role to assist managers in formulating important decisions by virtue of their experience and expertise emerges (Hillman & Dalziel, 2003). This assistance is believed to raise organizational performance, and increase returns to shareholders (Dalton et al., 1999; Pfeffer, 1972; Pfeffer & Salancik, 1978; Udayasankar, 2008)

The board of directors can be a key source of various firm resources, which is described as the board capital (Hillman & Dalziel, 2003). In recent scholars the board capital has received growing attention, as researched tried to expand the various resources and functions of the directors. The board has been viewed as a tool to manage uncertainty (Boyd, 1995), as a network mechanism that supports firm decision-making in various ways (Carpenter & Westphal, 2001; Hillman & Dalziel, 2003).

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2.2 Corporate governance mechanisms

Corporate governance mechanisms aim to align principal-agent interests. They provide shareholders with some assurance that managers will strive to achieve outcomes that are in the shareholders’ interest (Shleifer & Vishny, 1997). Shareholders have a wide array of both internal and external available mechanisms in order to align the interests. Internal mechanisms include the structure of ownership, an effectively structured board and compensation that encourage shareholder orientation. External mechanisms are the market for corporate control, accounting rules, and so on (Aguilera & Jackson, 2010). Agency theorists argue that mechanisms are needed to ensure that the managerial decisions taken are in the interests of the principals (Jensen & Meckling, 1976; Fama & Jensen, 1983), while resource-dependence theorists extend this with the argument that mechanisms can support and enhance organizational decision making as well (Pfeffer & Salancik, 1978). In this study the internal mechanisms that contribute directly to the mode of entry decision-making process are used, thus, the structure of ownership, the board structure and the executive compensation will be explained.

Ownership structure

In public corporations investors can purchase and hold equity shares which, in return for bearing residual risk, make them shareholders (i.e. equity owners) and entitle them to any positive residuals generated by the production and sale of products (Baysinger & Hoskisson, 1990). The ownership structure is defined by the distribution of equity with regards to votes and capital but also by the identity of the equity owners. Ownership structures play a central role in corporate governance because they affect the incentives of managers, and thereby the efficiency of firms (Jensen & Meckling, 1976). Overall it could be said that there are two ownership structures, (1) controlled ownership and (2) dispersed ownership. In a controlled ownership structure there are a few shareholders that hold a high ownership stake which gives them more influence on the management of the firm and strategic decisions.

In a dispersed ownership structure there is a wide[r] distribution of equity, giving each equity owner less influence. As a result the management may govern the organization more independent, but a bigger monitoring role for the board of directors emerges (Heubischl, 2006). Two consequences arise

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due to the differences in ownership structures. On the one hand, the dominant shareholders have both the incentive and the power to discipline management, and on the other hand, in concentrated ownership the interests of the controlling and the minority shareholders are not aligned which creates conditions for a new problem (Morck, Wolfenzon & Yeung, 2005). Shareholders are able to protect their interest individually by selling their stocks through the organized securities exchanges, but this option is not available for the collective group of shareholders. Therefore, shareholders are viewed as “the only voluntary constituency whose relation with the corporation does not come up for periodic renewal” (Williamson, 1985), and their interest must be protected by governance mechanisms such as the board of directors.

Board of directors

The majority of corporations in developed countries are governed by a board of directors. The board of directors is by definition the internal corporate governance mechanism that shapes the governance of the firm, given the direct access of the board to the two other axes in the corporate governance triangle, the managers and the shareholders (Desender, 2009). The board of directors is charged with representing the interests of the shareholders. The traditional view is that the board exists primarily to hire, fire, monitor, and compensate management, all with an eye to maximize shareholder value (Williamson, 1984). It could be seen as the official first ‘line of defense’ against managers who would act contrary to shareholders’ interests (Fama & Jensen, 1983; Eisenhardt, 1989). However, a too narrow view of corporate governance, restricting it to only monitoring activities may potentially undervalue the role that corporate governance can play in organizations (Korn/Ferry, 1999; Cohen, Krishnamoorthy & Wright, 2004). The second perspective is derived from the resource-dependency theory (Pfeffer & Salancik, 1978), and states that firm performance relies on the provisions of resources by the board of directors and, thus, delegates an advisory and counsel task to the board of director.

Research shows that in practice boards both monitor and advise. That dual role may influence the choices regarding entry mode. The advisory role is consistent with the resource-dependency theory and the monitoring role with the agency theory. In the service role, board members are expected to provide advice and counsel to the CEO and top management team of the firm (Alibrandi, 1985) and they can also provide access to valued resources and information (including their own), facilitate

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outside commitment, and establish legitimacy (Bazerman & Schoorman, 1983). In the monitoring role, the board act as legal representative of the firm’s shareholders and is expected to monitor the actions and activities of the firm’s managers. The demand for the required monitoring is argued to be influenced by the distribution of power amongst the stakeholders, indicating that the focus of the board depends heavily on the ownership structure. When ownership is diffuse, the monitoring role of the outside directors is more important. With concentrated ownership, the large shareholder(s) can effectively influence and monitor the management (Shleifer & Vishny, 1986).

The board of directors plays a substantial role in the management of the firm by actively participating in the choice and implementation of strategic decisions, advising management and observing the consequences of those decisions (Haunschild, 1993). Research on board influence on firm performance is based on the upper echelon theory (Hambrick & Mason, 1984), which states the importance of the role of knowledge and experience of key decision makers. The theory suggests that the demographic characteristics of managers act as observable measures to what they add in the decision-making process. The underlying assumption of the upper echelon perspective is that those demographic characteristics serve as surrogates for the beliefs, values, and cognitions of managers (Goll et al., 2001). The composition of the demographic characteristics in the board of directors has been found to influence the internationalization process (Barrso, Villegas & Perez-Calero, 2011), R&D intensity (Datta & Guthrie, 1994; Hill & Snell, 1988), and firm performance (Norburn & Birley, 1988).

Executive compensation

Directors are involved in many critical and strategic decisions and can have tremendous impact in companies; therefore it is critical that the directors are focused on optimizing shareholder value (Johnson et al., 1996). Yermack (2004) suggests that directors have two incentives to protect shareholders: reputation and compensation. Directors aim to develop reputations as monitoring specialists, as the more directorships a director has successfully held, the greater increase in prestige, visibility, social status, and commercial contacts (Fama & Jensen, 1983). Compensation is the second incentive because as the value of a firm increases, outside board members experience higher compensation. In contrast, when the value decreases, board members may lose their board seats (Fich & Shivdasani, 2006).

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Compensation can be defined as “the remuneration that shareholders pay to staff based on their labor input (Murphy, 1986). Executive compensation is often composed of a fixed salary, an incentive based bonus and (optionally) stock options. Research how compensation effects board behavior found that when director compensation is tied to CEO compensation “mutual back-scratching” occurs (Brick et al., 2006), the likelihood of fraud positively is related to unrestricted stock holdings and that incentive compensation could result in increased risk-taking by the recipients (Dennis et al., 2006; Chen & Ma, 2011).

Advocates of incentive compensation argue that director option pay motivate directors to focus on shareholder return by giving them ownership incentives (e.g. Becher et al., 2005; Ryan & Wiggins, 2004). On the contrary, other studies show that option compensation causes misalignment with shareholders (e.g. Brick et al., 2006; Boumosleh, 2009) and the wrong compensation may lead to decisions that have excessive risk to increase the value of the options. However, the majority of the existing literature shows that option compensation aggravates incentive alignment issues, leading to agency problems (Crutchley & Minnick, 2012)

2.3 Entry modes

The forces of a growing internationalization drive firms to expand outside their home markets. The choice that follows regarding the mode of entry is perceived as one of the most crucial decisions in the internationalization process of the firm (Wrona & Trapczynski, 2012; Anderson & Gatignon, 1986; Erramilli & Rao, 1993), as research has shown that it has a significant effect on firm performance (Brouthers, 2002; Brouthers & Hennart, 2007). An entry mode can be defined as “a structural agreement that allows a firm to implement its product market strategy in a host country either by carrying out only the marketing operations (i.e., via export modes) or both production and marketing operations there by itself or in partnerships with others (contractual modes, joint ventures, wholly owned operations” (Sharma & Erramilli, 2004).

The process of choosing the right entry mode is important as it determines whether a company has full control over the subsidiary or has to share control with a partner (Arregle et al., 2006) and, on top of that, research shows that the mode of entry is difficult to change once established, because it will have long term consequences for the company (Pedersen, Petersen, & Benito, 2002).

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There is no complete listing of entry mode structures at hand. Brouthers and Hennart (2007) identified 16 different mode types which have been included in previous studies in their research. These 16 different types can be attributed to three main entry mode structures: (1) contracts, (2) joint ventures and (3) wholly owned subsidiary. The meaning of and the differences between the three entry modes can be explained from two perspectives. The first perspective arranges contracts (e.g. licensing), joint ventures (JV) and wholly owned subsidiaries (WOS) along a continuum of increasing control, commitment, risk related to the complexity of the foreign environment and profit potential from export to WOS. WOS is chosen when firms’ want maximum control and are willing to make maximum commitment and take on maximum risk (e.g. Anderson & Gatignon, 1986; Hill, Hwang, & Kim, 1990). The second perspective, articulated by Hennart (1989, 2000), classifies modes of entry into two categories, contracts and equity, with both JV and WOSs in the equity category.

The two perspectives are conceptualized by Pan and Tse (2000) in the hierarchical model of choice of entry modes. They argue that the choice of entry can be examined from a hierarchical perspective, in which managers would first structure various entry modes into a multi-level hierarchy and define a set of evaluation criteria for each level based on the control, commitment and risk. The first level of hierarchy is the choice between equity or non-equity (i.e. contracts) modes. When considering both options firm need to assess the investment risk and return, location choice, control of operation and so on. At the secondary level, once the decision to commit equity is made, managers evaluate the option of partnering with a local firm through JVs weighted against the cost and benefits of setting up a WOS. In conclusion, entry modes can be viewed as two major categories of equity-based modes (WOS and JV) and non-equity-based modes (contractual agreements and export). The equity-based entry modes are the primary focus of this research.

Entry mode determinants

The determinants of entry mode decisions are a well-researched domain in international business scholars. Over the years different theoretical approaches, like the transaction cost theory (Brouthers & Brouthers, 2003; Meyer, 2001), internalization theory (Buckley & Casson, 1976; Buckley & Casson, 1998), eclectic theory (Dunning, 1993) the resource-based view (Meyer & Estrin, 2001), and institutional theories (Brouthers & Bamossy, 1997; Brouthers & Brouthers, 2001), have been adopted

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to explain why firms pick one entry mode over another which resulted in a number of explanatory variables. However, the results derived from the various perspectives and empirical research has not led to a clear consensus regarding the effect of certain variables (Morschett et al., 2010).

The explanatory variables forthcoming out of the different theoretical approaches, factors that influence entry mode decision making, can generally be attributed to three levels of analysis, (1) environmental-specific (home and host country) variables (Anderson & Gatignon, 1986; Kogut & Singh, 1988), (2) company-specific variables (Erramilli & Rao, 1993; Kumar & Subramaniam, 1997) and (3) venture-specific variables (Hill et al., 1990; Malhotra et al., 2004). The environmental-specific variables are well researched and have frequently shown to exert a strong influence on entry mode decision (Shama, 2000; Zhao et al., 2004). The aim of this study is to investigate the influence of firm-specific (corporate governance) variables, the role of these variables as determinants in the entry mode decision process will be examined.

Firm-specific determinants

On the first level of hierarchy (Pan & Tse, 2000) firms assess three key issues, the resource commitment, degree of control and the risk related to the complexity of the foreign environment and, with that, the potential loss of invested resources (Anderson & Gatignon, 1986; Tallman & Shenkar, 1994). The risk related to the complexity of the foreign environment is described in international management literature as the “liability of foreignness”, which in other word means the cost of doing business abroad (Peng, 2001). To overcome such liability, both the transaction cost theory (Buckley & Casson, 1976) and the eclectic theory (Dunning, 1993) stress that firms need certain firm-specific advantages. Firm-specific advantages can be unique resources and capabilities. The resource-based view (RBV) argues that a firm’s internal resources and capabilities such as administrative heritage, organizational practices and bargaining power determine are its competitive advantages and thereby shape it strategic options and decisions (Barney, 1991; Meyer & Estrin, 2001).

Entry mode decisions can be characterized as high strategic by nature as they are ill-defined, complex and dynamic (Kumar & Subramaniam, 1997). In the process individual values and attitudes, which could be characterized as unique resources, play an important role for decision making (Wrona & Breuer, 2008). One of the first examples of internal resources to be explored in relationship to entry

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mode was experience. As Johanson & Vahlne (1977) stated in the internationalization theory that firms over time gain experience in foreign markets and therefore move from simple exporting operations towards more complex entry mode structures such as JVs and WOSs. International experience was found to increase the preference for entry modes with higher resource commitment (e.g. Anderson and Gatignon, 1986; Erramilli, 1991), but on the other hand a negative relationship could be observed (Chung & Enderwick, 2001).

Since the new century more researchers have attempted to identify measures and test other resource-based advantages. Ekeledo and Sivakumar (2004) measured firm specific resources like proprietary technology, tacit know-how, firm reputation and international business experience. Claver and Quer (2005) looked at two measures of experience, general international and country-specific, and three firm measures, firm size, financial performance and high- or low-technology industry). Lai et al. (2012) examined the board mechanism as resource-based advantage. Although the general conclusion is that a relationship between these resources and the mode of entry is present, our knowledge about how resources (knowledge and/or capabilities) influence entry mode choice remains very limited.

2.4 Linking corporate governance mechanisms and entry mode choice

The reasons behind the selection of entry modes may not purely lie in rational analysis, but could depend on a conflict of interests between shareholders and management. The current theories on entry mode determinants are based on the presumption that entry mode decisions are made in the best interest of shareholders. However, with risk being one of the key elements in the entry mode decision process, the focus in the majority of studies in on international organizational risks (e.g. expropriation or loss of proprietary knowledge) or related macro-economic risks (e.g. country legal restrictions or industry structural factors) (Vernon, 1985; Contractor, 1990).

The main objective of shareholders is to maximize their returns and they are therefore assumed to prefer potentially higher risk-taking types of action when it comes to entering a foreign market as those often lead to a potentially higher return. High risk actions, due to the uncertainty of operating in a foreign environment, often go hand in hand with higher resource commitment and cost of operation. The cost of failure tend to fall heavily on the managers of the firm, which may result in a preference of

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managers for a safer short-term strategy when it comes to entering a foreign market even though it might lead to a lower financial pay-off (Pan, Li & Tse, 1999; Geringer et al., 1989).

The agency problem which arises due to the conflict between management and the shareholder is described by Miller (1992) as behavioral risk. In addition to the agency problem, corporate governance mechanisms can enhance the results of foreign activities with their resources (e.g. knowledge, experience, contacts). Sander and Carpenter (1998) argue that firms respond to international complexity through their governing bodies, which stresses the importance for qualified directors that understand the logic and dynamics of the foreign markets to overcome information asymmetries (Barrso et al., 2011). Researching the relationship between the board of directors and internationalization strategies has increased in the recent years and positive results were found (Filatotchev & Wright, 2011). However, the majority of scholars have limited their research to a relationship between the board and the degree of internationalization, leaving entry mode selection, a component of internationalization, unaddressed. It could be assumed that governance mechanisms effect the components of internationalization as well, which implies that there is a relationship between corporate governance mechanisms and entry mode selection. The linkages will be explained for three internal corporate governance mechanisms: ownership structure, board characteristics and executive compensation.

Ownership structure

The type of ownership determines the degree of independence of the board of directors. In a firm with a controller ownership structure, large shareholders monitor top management more closely resulting in more alignment between agent and principal and less incentive for the board to monitor. In a firm with dispersed ownership, the management may govern the organization more independent and thus, a bigger monitoring role for the government emerges because the management has a bigger chance to act in their own interests. Research has shown that firm performance improves when ownership and managerial interest are aligned through concentration of ownership (e.g. Agrawal & Mandelke, 1987; Castianas & Helfat, 1991; Baker & Weiner, 1992). In this structure control can easily be disputed and the resulting concentration of ownership might lower the agency cost (Anderson et al. 1997) because owners may choose to engage in monitoring directly (Hunt, 1986). Owner control has been associated with actions that support the long-term sustainability of the firm such as export

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propensity and export performance (Lu et al., 2009), higher levels of R&D spending (Baysinger et al., 1991), greater use of debt (Claxton, Otuteye, & Srinvasan, 1993) and lower executive compensation (Werner & Tosi, 1995). High R&D spending can best be compared to entry mode, due to similarities in uncertainty and return on investment. Thus, the following hypothesis emerges:

Hypothesis 1: There will be a positive relationship between owner-controlled firms and the selection of a high equity entry mode.

Board characteristics

The composition of the board has a key role in the strategic decisions of a firm (e.g. Hill & Snell, 1988; Kesner, 1988; Norburn; 1986), and therefore essential in the entry mode selection process. The boards of directors are likely to differ from one another in education, experience, age, and director ownership.

Education

The level of education provides an important demographic characteristic that can act as one measure for an individual’s knowledge and skill base (Hambrick & Mason, 1984). It has an important influence on in shaping an executive cognitive base, which is the basis for decision-making (Bantel & Jackson, 1989). The level of education has been linked to firm performance (Norburn & Birley, 1988), the degree of firm innovation (Bantel & Jackson, 1989), and change in corporate strategies (Wiersema & Bantel, 1992).

The choice of entry mode is subject to information asymmetries, which requires the board of directors to overcome those. As the level of education gives an indication of the cognitive ability and the preferences, which shapes risk propensity, of a director, we argue assumed that directors with a higher level of education are better fit to overcome the information asymmetries regarding a foreign direct investment. Therefore, the following hypothesis is presented:

Hypothesis 2: There will be a positive relationship between higher educated boards and the selection of a high equity entry mode.

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The board has beside a monitoring role, according to the resource-dependency theory, a role to assist managers in formulating decisions by virtue of their experience and expertise (Hillman & Dalziel, 2003). Experience shapes the directors’ thinking, frame of reference, and perceptions. This allows them to develop specific skills and knowledge about how firms’ operate. Possessing the knowledge about the environment in which the firm competes is essential in contributing to the strategic decision making within the firm (Kroll et al., 2008). The experience of directors has been found to affect the decision making of corporate boards on several strategic issues (e.g. Mizuchi & Sterns, 1993). The demand for that director advice is greater in uncertain and high-risk situations when making the optimal choice requires thorough deliberation, such as the internationalization process and entry mode choice (McDonald et al., 2008).

The experience regarding entry mode decision-making that directors bring to the table can teach managers how others have done the same thing that they are doing now. We argue that experience, similar with education, can help overcome information asymmetries and in line with prior resource will lead to more risk-taking behavior. This has been shown in prior research as knowledge from directors’ in prior undertakings reduces the liability of foreignness, and it could even allow them to gain second-mover advantages (Beckman & Haunschild, 2002). This is also supported by Johanson & Vahlne (1977) who argued that prior international experience has a positive influence on the resource commitment in entry mode decisions. Therefore, the following hypothesis is presented:

Hypothesis 3: There will be a positive relationship between experienced boards and the selection of a high equity entry mode.

Age

Age is a demographic that has shown to affect risk-related behavior. Wiersema and Bantel (1992) found that risk-taking propensity is expected to decrease with age and Barker and Mueller (2002) found that managerial age is related to the formulation of innovative strategies. This could be explained with the presumption that older executives are more concerned financial and career security, which may give them a greater incentive to support the status quo and avoid risky decisions (Child, 1974; Hambrick & Mason, 1984). Age is also associated with the level of cognitive ability,

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which may affect strategic decision-making perspectives and choices. Hambrick and Mason (1984) state that older executives are seen as possessing less physical and mental stamina to make organizational changes and as having difficulties in grasping new ideas, learning new behaviors and making decisions rapidly.

The entry mode choice requires a high degree of risk taking propensity and making the right choice might present a challenge for the board of directors. We argue that younger boards are prone to task more risk resulting in selection of higher equity entry modes. That relationship has been proven as scholars have found that younger top management teams may pursue more risky strategies (Hambrick & Mason, 1984) and that a younger top management team show superior performance (Child, 1974; Norburn & Birley, 1988).

Hypothesis 4: There will be a negative relationship between older boards and the selection of a high equity entry mode.

Director ownership

Managerial risk aversion can by reduced by providing directors with equity ownership. This creates a situation in which the reward for the directors is the same as the reward for the shareholders, which can align the risk preferences of both parties (Jensen, 1993). Since the value of the options has a boundary loss of zero, director ownership may even further encourage risk-taking. Barker and Mueller (2002) and Ghosh et al. (2007) have shown that shares held by the board of directors have a positive relationship with R&D investments, which are long-term and risk-orientated investments as well. Director ownership has also been found to positively affect innovation (Zahra et al., 2000), with more long-term capital expenditures (Aggarwal & Samwick, 2006), and better long-term performance (Kaserer & Moldenhauer, 2008).

Hence, by providing directors with equity ownership they are expected to be more supportive of a high equity entry mode because this has the greatest potential for a higher long-term return on investment. Therefore, the following hypothesis is presented:

Hypothesis 5: There will be a positive relationship between the shares held by directors and the selection of a high equity entry mode.

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Executive compensation

As shown before, decisions regarding the internationalization of a firm subject to risk preferences of key decision makers. Executive compensation plays an important role in aligning the interest of manager and shareholder. Compensation is one, beside reputation, incentive for the board of directors to protect shareholders because when as the value of a firm increases, outside board members experience higher compensation. The compensation is often composed of a fixed salary, an incentive bonus and stock options. An incentive bonus for the management has shown to have a direct impact on international diversification (Tihanyi et al., 2010). The incentive bonus provides a reason for managers to take the risk because of the possibility that they can obtain greater awards. The opposite would be the case for fixed compensation (Filatotchev & Wright, 2011).

High fixed compensation may tie executives to the firm and they could therefore be less willing to risk their continued employment by engaging in high risk-decisions. Hence, a high fixed compensation may cause risk adverse behavior in the entry mode selection and a high variable compensation may increase risk-taking behavior. That is supported by the agency theory, which states that fixed compensation may encourage risk aversion and more conservative strategies (Jensen & Murphy, 1990). Therefore, the following hypotheses are presented:

Hypothesis 6: There will be a negative relationship between high fixed compensation and the selection of a high equity entry mode.

Hypothesis 7: There will be a positive relationship between high variable compensation and the selection of a high equity entry mode.

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2.5 Conceptual model

The formulated hypotheses are schematically presented in the conceptual framework below.

Ownership structure Education Experience Age Directorownership Fixedcompensation

Entry mode

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3. Method

The method chapter will elaborate on the methodology and the analysis. In the first section of the chapter the sample is presented. The second section describes the variables that are used in the third section the data analysis is explained.

3.1 Data collection

The sample for this study is buildup of 130 American-based companies who together made 300 foreign direct investments between 2004 and 2014 in 53 different countries. Appendix one includes all the names of the companies that are in the sample. The majority of the firms is large, except for some small investment corporation, and operates in various industries. America was chosen as home country for this research due to the availability of information the board composition and compensation structure.

The data collection on information about entry mode was done in multiple steps, starting by consulting the ‘Thomson One’ database. All available entry mode information that was labeled as ‘effective’, meaning the investment went through, was used. This resulted in an initial database of 4.269 foreign direct investments made by 1908 companies that covers all cross-border investments of American companies between the year 2004 and 2014. All foreign direct investments with missing values on the equity stake acquired in the acquisition were deleted. This left 3.488 foreign direct investment, from these 1.099 were labeled joint ventures and 2.388 were labeled wholly owned subsidiary The ‘Thomson One’ database supplied all the information needed to assess the entry mode.

To gather information about compensation structure of the company the ‘ExecuComp’ database of Compustat was used. The required information was not listed for all of the companies in the database. Due to the unavailability of data 2.800 entries had to be excluded from the database. The reason for the exclusion was because fixed pay, variable pay and/or shares owned by directors data was missing for the year the foreign direct investment was made.

Information about the board composition was retrieved by using the ‘Risk Metrics’ database from Wharton Research Data Service and the ‘Boardex’ relationship capital management databank. The required information about the board composition was found for 332 foreign direct investments. At

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last, the Orbis database was used for information about the ownership structure. Due to data unavailability in the year that the entry was made, 32 foreign direct investments had to be excluded from the sample.

3.2 Variables

Dependent variable

The dependent variable is entry mode. If the parent firm owns 95% or higher of the share it is called a wholly owned subsidiary. An acquisition with less than 95% of the shares owned by the parent firm is then defined as a collaborative entry mode following the approach of Brouthers and Hennart (2007) and Slangen and van Tulder (2009). The entry mode is measures as the equity percentage held by the acquirer firm after the acquisition.

Independent variable

This study has seven independent variables that measure the percentage held by the acquirer after the acquisition: ownership structure, board education, board experience, board age, director ownership, fixed pay and variable pay.

The (1) ownership structure indicates how concentrated the distribution of the outstanding shares of the company is and is described as ownership concentration. Ownership concentration is measured as the total proportion of shareholdings held by the five largest shareholders, in line with Demsetz and Villalonga (2001), De Miguel et al. (2004), and Boubraki et al. (2005).

The (2) education of the board indicated what level of education the directors on the board followed. Directors with a master degree or higher have been coded as ‘1’. Directors with an education lower than a master degree have been coded as ‘0’. The value per board has been calculated by using the mean of all directors on the board.

The (3) board experience is measured as the percentage of the directors with prior board experience. This is calculated by dividing the amount of directors with prior experience by the total directors on the board.

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The (4) board age indicates the average age of all the board members in the year the foreign direct investment was made. The average age is calculated by using the mean of all directors on the board.

The (5) director ownership indicates what proportion of the outstanding shares of the company is owned by directors of the board. It is measures as the total proportion of shareholdings by all directors on the board.

The board compensation is measured by the (6) fixed pay and the (7) variable pay. The fixed pay represents the base salary that directors receive for their service, regardless of performance in the year the foreign direct investment was made and the variable pay represents all other forms of compensation (e.g. bonus, stock value, long-term incentives) earned by directors based on their performance in the year the foreign direct investment was made. Both are calculated by using the mean of all directors on the board.

Control variable

This study has three control variables: board size, firm size and industry. Board size is included following the approach of other studies on the effect of board characteristics and strategic decision-making as a larger size can increase diversity within the board (e.g. Erhardt et al., 2003; Adams & Ferreira, 2009). Board size is measured as the total number of directors in the board. Firm size has been shown to affect entry mode (Brouthers & Hennart, 2007) as, depending on the industry, bigger firms pursue more aggressive expansion strategies (Buckley & Pearce, 1979). To control for that effect, firm size is used as a control variable. Industry affects the entry mode due to differences in the degree of competition and the existence of present or future excess capacity (Brouthers & Hennart, 2007) and should therefore be controlled. The sample contains companies that operate in 9 different industries, thus, 8 dummy variables for industry were included in the analysis. Companies are coded as ‘1’ if they operate in an industry and as ‘0’ when they operate in another industry.

3.3 Data analysis

The hypothesis, as mentioned in chapter two, will be tested via a regression analysis. The regression analysis is a technique that examines the relationship between one or more independent variable and

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one dependent variable. In this research it is used in a predictive manner to identify a linear combination of the independent variable to predict the value of dependent variable in the best way.

A multiple regression is used to test the relationship between the independent variables and the dependent variable while controlling for the variables that were elaborated on above. In order to do this eight regression models, which are illustrated in table 3.1, are tested. The eight models were built in a hierarchical way. The first model is composed of the control variables board size, firm size and industry. In the subsequent seven models ownership structure, board education, board experience, board age, director ownership and board compensation were added. The eight, and final, model includes all the variables.

Table 3.1: Stepwise regression for Entry Mode

Model Control variable Ownership Board characteristics Compensation

Board size

Firm size

Industry Concentration Education Experience Age Director ownership

Fixed pay Variable pay

Model 1 X X X Model 2 X X X X Model 3 X X X X X Model 4 X X X X X X Model 5 X X X X X X X Model 6 X X X X X X X X Model 7 X X X X X X X X X Model 8 X X X X X X X X X X

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4. Results

The results of the analysis will start with an overview of the descriptive analytics, followed by the statistical analysis.

4.1 Descriptive analysis

The descriptive analysis of the variables provides the following results. In table 1.1 the mean and standard deviation of all the variables are presented and table 1.2 shows how the database is built up in terms of industry. Characteristics of the companies in the sample will be given first to give a clear overview. The sample consisted of 34,33% financials firms, 27% technology firms, 13% customer products and services firms, 6,67% industrials firms, 5% materials firms, 4,33% energy and power firms, 3,67% real estate firms, 3,33% media and entertainment firms and 2,67% healthcare firms. The financial industry includes banks, insurance companies and investment corporations. That both financial and technological firms are the vast majority of the sample is no surprise, due to the big amount of investment corporations and the current nature of the technology industry, which relies partial on buying new corporations for innovation.

The firm size varies from 8 employees, due to small investment corporations, to 307.000 employees, with a mean of 28646. The average stake acquired by the acquirer is 85.96%, which shows a plurality of the firms choose the wholly owned subsidiary entry mode. In the majority of the firms in the sample the five largest shareholders hold more than 50% of the company, as the mean of ownership structure is 60%. The average board has 6 directors, whereas the smallest board has 2 directors and the largest board 12 directors. The board’s education has a mean of 0.79, which implies that the average education levels on boards tends to be a master education or higher, as directors with a bachelor degree or lower were coded as zero and directors with a master degree or higher were coded as one. On average the age was 52, boards members hold two (prior) committee roles and one (0.79) prior board role. This shows that the vast majority is experienced in the role of board member and the accompanying tasks.

The compensation is built-up off a fixed and a variable pay. The fixed pay, salary, has a mean of $528.000, but shows tremendous variation with $119.000 as a minimum salary and $1.880.000 as the

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Industry

N

Percentage

Financials

103

34,33%

Technology

81

27,00%

Customer products and service

39

13,00%

Industrials

20

6,67%

Materials

15

5,00%

Energy and Pow er

13

4,33%

Real Estate

11

3,67%

Media and Entertainment

10

3,33%

Healthcare

8

2,67%

maximum salary. The variable pay has a mean of $5.349.070, but shows tremendous variation, as well with $0 as the minimum variable pay and $52.343.000 as the maximum variable pay. Only 13% of the total compensation is accounted for by fixed pay, the remainder 87% consists of different kinds of variable pay. A form of this variable pay is shares that are rewarded, which are displayed in the variable ‘percentage of total shares owned’. The mean shows that on average boards own 0.77% of the total shares, with some outliers like Facebook and Google that go up to 13%.

Variables

N

Minimum

Maximum

Mean

Stand. Dev.

Board Size

300

2

12

5,59

1,25

Firm Size

300

8

307000

28645,77

49995,251

Equity percentage

300

4,85%

100%

85,96

26,83

Ow nership structure

300

18,07%

100%

59,73

27,19

Education

300

0

1

0,79

0,41

Experience

300

0,00%

100,00%

26,69%

31,51%

Age

300

37,25

70

51,88

5,14

Director shares

300

0,00%

13,15%

0,87%

1,58%

Fixed pay

300

118,74

1880

527,8

224,54

Variable pay

300

0

52342,86

5349,07

7796,68

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4.2 Statistical analysis

Correlation analysis

In table 4.3 the strength of the relationship between the dependent and the independent variables is illustrated in a correlation matrix. The correlation matrix shows that almost all the independent variables except education and age have a significant correlation with the dependent variable, both positive and negative. Education (-.40) and age both have a very small insignificant relationship with the dependent variable. A significant positive relationship is found between equity stake acquired and the following independent variables: ownership structure (.171), experience (.175) and director shares (.182). The positive relationship between ownership structure and equity stake acquired is supported by the negative relationship between firm size and equity stake acquired (-.312), because when firm size increases, ownership gets more dispersed. A significant negative relationship is found between equity stake acquired and the following independent variables: fixed compensation (-.157) and variable compensation (-.173). A negative relationship between equity stake and variable pay was not expected, as both compensation variables show a negative relationship, it would imply that compensation as a whole does not affect entry mode selection. There is a strong relationship between the control variable firm size (-.312), but board size (-.055) has a very small effect and is not significant.

A correlation between the predictor variables of .80 or higher can imply multicollinearity. Multicollinearity poses a problem for multiple regression, because regression requires only one predictor. The correlation matrix shows no correlation higher than .80. In order to rule out multicollinearity further, two collinearity diagnostics are reviewed: the tolerance statistic and the variance inflation factor (VIF). These are presented in table 4.3. Both a tolerance score close to zero, as well as a VIF score close to ten are indicators of multicollinearity problems. Neither of the reported statistics comes close to these scores, so multicollinearity is ruled out.