small enterprise: finance, ownership and control

September 1999

Patrick Hutchinson is fromthe School of Accounting,Finance andEntrepreneurship,University of NewEngland, Armidale, NSW2350, Australia.

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Small enterprise: finance,ownership and controlPatrick Hutchinson

Finance, ownership and control issues have received a great deal of attention in recentyears as centres of interest in the `new institutional economics'.Much of the debatehas been fuelled by the inability of neoclassical economics to explain the continuedexistence, and increasing importance, of small enterprises. Developments in agencytheory, information asymmetry and signalling theory, and transaction cost economicsare identified as contributing to a new approach. The concepts distilled from a reviewof these developments are then used in the analyses of well-known phenomenainvolving small enterprises. These include capital structure and access to capital marketsfeaturing the finance gap, the underpricing of new issues and the small firm effect. Inaddition, going private, bymeans ofmanagement buy-outs, and franchising areexamined. It is seen that the economic literature on finance, ownership and controlhelps to explain both the advantages and disadvantages of small enterprises. Theircontinued existence is seen as being due to a trade-off of various costs and benefits.

Introduction

This article reviews developments ineconomics and finance from a smallenterprise perspective. In doing so, it ishoped that some answers will be providedto the questions: what is so special aboutsmall enterprises and, indeed, why do theyexist? Extensive reference will be made todevelopments over the past few decades ineconomic and financial theory to explainthe role of small enterprises and theirfinance, ownership and control. Thereview starts, therefore, with an analysis ofrelevant developments in economic andfinancial theory. It then considers

anomalies that highlight problems thatsmall enterprises appear to face in raisingfinance, namely: the finance ‘gap’, the‘underpricing’ of new issues and the ‘smallfirm effect’. These anomalies suggest thatlife is very hard for small enterprises andthis, along with other problems that theyface, such as lack of economies of scale,would make them uncompetitive withlarge enterprises. The sections that thenfollow consider aspects of ownership andcontrol that indicate that small enterprisesmust have something going for them toexplain why they have not only survivedbut also have increased in importance overthe last few decades. The phenomena

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chosen to illustrate this are those of thegrowth in the number of enterprises ‘goingprivate’ and those involved in franchiseoperations. Finally, the questions of whatis so special about small enterprises andwhy small enterprises exist are returned toin the conclusions section with a view toproviding explanations based on theresearch reviewed.

Economic and Financial Theory andSmall Enterprises

The starting point in this section will be areview of neoclassical economics andfinance theory. This will be followed by aconsideration of the role of smallenterprises, and the challenges that theirpersistence and increasing importance haveposed to traditional theory. The sectionwill conclude by charting theoreticaldevelopments that help to explainvariations in the size and nature oforganizations.

Neoclassical Economics and FinanceTheory

Neoclassical economic theory wasdeveloped from the application of theconcept of marginal change. This waspioneered by economists such as Jevons(1957), Walras (1954), and Marshall (1961).Neoclassical economics uses a number ofassumptions to develop a series ofconditions which give the optimumequilibrium in which all economic agentsare operating with maximum efficiency.These assumptions include: perfectlycompetitive markets with many participants,none of whom can individually influenceprices; information being freely andinstantaneously available to all economic

agents; all economic agents being profitmaximisers and utility maximisers; and alleconomic agents using their complete andperfect knowledge to implement optimisingactions instantaneously. Whilst theseassumptions may not always apply, theyconstitute the basis of a very powerful setof theories that have been argued to havegreat predictive ability (Friedman 1957).

Finance has a well-developed body oftheory based on neoclassical economicprinciples. There are three main elementsto financial theory and they are intuitivelywell known as ‘time is money’, ‘don’t putall your eggs in one basket’ and ‘you can’tfool all of the people all of the time’.‘Time is money’ gives rise to the conceptof the time value of money, which can bemathematically represented in terms ofcompound interest and discount rates thatcan then be incorporated into techniquesused for project appraisal (Fisher 1954;Hirshleifer 1958). ‘Not putting all of one’seggs in one basket’ is the basis ofdiversification (Markowitz 1952), whichcan be generalized into the Capital AssetPricing Model (Sharpe 1964). The conceptof ‘not being able to fool all of the peopleall of the time’ is central to notions ofmarket efficiency and arbitrage(Modigliani and Miller 1958; Ball andBrown 1968; Famaet al. 1969; Black andScholes 1973).

Neoclassical economics and financetheory do not specifically consider theissue of size of enterprise and assume thatall enterprises have access to the capitalmarket on the same terms. Nor do they tellus much about the firm or individualswithin the firm. According to Jensen andMeckling (1976) the neoclassical theory ofthe firm is, in fact, a theory of markets inwhich firms operate:

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The firm is a ‘black box’ operated so as tomeet the relevant marginal conditions withrespect to inputs and outputs, therebymaximizing profits, or more accurately,present value. Except for a few recent andtentative steps, however, we have no theorywhich explains how the conflictingobjectives of the individual participants arebrought into equilibrium so as to yield thisresult.

Small Enterprises

A major problem encountered in adiscussion of small enterprises is that of asuitable definition. Both quantitativedefinitions, such as number of employees,capital invested, or sales turnover andqualitative definitions, such as beingowner-managed, independent and lackingstock market quotation, are used (Agarwal1979). The extent of the contribution ofsmall enterprise to the economy can bedebated, but it is considerable and inrecent years has been growing (Acs andAudretsch 1990). Galbraith (1957)summarizes both the definitional aspectsand the contribution of small enterprisessuccinctly:

No agreed level of assets or sales dividesthe millions of small firms which are half ofthe private economy from the handful ofgiant corporations which are the other half.There is (however) a sharp conceptualdifference between the enterprise which isfully under the command of an individualand owes its success to this and the firmwhich, without entirely excluding theinfluence of individuals, could not existwithout organization.

A key feature of Galbraith’s observation isthe reliance of the small enterprise on

individuals and their lack of formalorganizational structure and managementspecialization.

Ang (1991) argued that small enterprisesface special problems because they haveno publicly traded securities and thereforeno objective basis for valuation, theirowner-managers have undiversifiedportfolios, they have no or ineffectivelimited liability, they experience a higherpropensity for risk taking by firstgeneration owner-managers, they sufferfrom ‘resource poverty’ in terms ofmanagerial skills, they incur higher costsdue to capital market imperfections suchas fixed transaction costs and divergencebetween borrowing and lending rates, theyhave a higher degree of integration ofpersonal and business affairs leading togreater flexibility and more informalrelationships (particularly with family andfriends), they have greater flexibility interms of remuneration, and the distinctionbetween equity and debt can be blurred insmall enterprises.

In addition to the above problems,economies of scale also disadvantage smallenterprises. Significant cost penalties areborne by plants which operate at less thanthe minimum optimum scale. For example,in cement production, the minimumoptimum scale is likely to be in billions ofkilograms per year and firms operating inmere hundreds of millions are likely toincur a penalty of around 25% (Johnset al.1989). There are similar cost penaltiesattached to many other manufacturingprocesses. Even where there are nosignificant production economies of scale, itis not clear why larger firms should notpredominate, given their advantages inmanagerial skills and ability to raise capital.As Williamson (1996) puts it:

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Large firms will be able to do everythingthat a collection of small firms can do andmore.

The fundamental question thereforearises of the reason for the existence ofany small enterprises. Several tributariesflow into the river of theory development.Agency theory, information asymmetryand signalling theory, and transaction costeconomics help provide the answers.

Agency Theory

Berle and Means (1932) observed thatownership and control in largecorporations were often separated andinquired whether this had organizationaland public policy ramifications. Thisseparation of ownership and controlresults, according to Jensen and Meckling(1976), in a classic principal–agentrelationship between shareholders and non-owner managers. Jensen and Meckling(1976) defined an agency relationship asone in which principals delegate decision-making power to others (agents) who arecharged with acting on their behalf. Theagency problem is that agents will nothave exactly the same objectives andmotivation as principals, will not alwaysact in the interests of principals and willbe tempted to divert resources away fromtheir principals to themselves. Followingon from the work of Alchian and Demsetz(1972) clear manifestations of agency costsin large organizations are shirking and theconsumption of perquisites: ‘shirks’ and‘perks’. According to Jensen and Meckling(1976) these arise whenever managershave less than a 100% stake in theenterprise at which point 100% of an extradollar of shirk or perk is worth more than

their share in an extra dollar of profit.In order to minimise the divergence

between principals and agents, costs willbe incurred in the form of monitoring andbonding. Monitoring and bonding areunlikely to be entirely effective leaving aresidual loss in agency relationships(Jensen and Meckling 1976). The use ofmanagement, stock option plans has beenadvocated in order to align managers’interests with those of shareholders andalso to reduce the need for, and costs of,monitoring (Haugen and Senbet 1981).Whilst some studies do show benefits fromsuch schemes (Brickleyet al. 1985), othersraise concerns particularly with regard torisk-taking behaviour and cost (De Fuscoet al. 1990; Beatty and Zajac 1994).

Jensen and Meckling (1976) also arguedthat whilst the agency problem arose in its‘pure’ form between stockholders andmanagers it also applied more generally inother relationships such as those betweenmanagers at different levels in theenterprise. They demonstrated that agencycosts increase as the fraction of outsidefunding increases and as the size of theenterprise increases.

In an elaboration of agency concepts,Fama and Jensen (1985) pointed out thatdifferent organizational forms aredistinguished by the characteristics of theirresidual claims on net cash flows. Theyconcluded that decision-agents in opencorporations, financial mutuals and non-profit organizations are generallyprofessionals whose interests are notidentical to those of residual claimants. Inthese organizations, resulting agencyproblems are controlled by decisionsystems that separate management in theform of initiation and implementation fromcontrol in the form of ratification and



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monitoring. The role of Boards ofDirectors is vital in such situations.

In the case of small enterprises in theform of sole proprietorships, partnershipsand close corporations, a more directapproach is taken to controlling agencyproblems in the decision process (Famaand Jensen 1985). In these organizationsthe residual claims are restricted todecision-agents. This restriction avoidscosts of controlling agency problemsbetween decision-agents and residualclaimants, but at the cost of inefficiencyin residual risk bearing and a tendencytoward under-investment. The limitedpersonal wealth of the residual claimantsin small enterprises can cause theseorganizations to invest less than opencorporations with the same investmentopportunity schedule. In order thatresidual claims and decision making canbe combined in a small number ofagents, residual claimants in smallenterprises are unable to take advantageof optimal portfolio diversification. Theexplanation as to why small enterprisessurvive whilst engaging in sub-optimalbehaviour is that, in many cases, thebenefit of the avoided agency costsresulting from restricting residual claimsto decision agents is greater than the costof the inefficiencies.

There have been criticisms of agencytheory on the grounds that it mayexaggerate the extent to which there isdivergence between the goals of principalsand agents (Waterman and Meier 1998).Another criticism has been that agencycosts are difficult to measure and may notbe very great (Leland 1998). Nevertheless,agency theory provides plausibleexplanations for a variety of differentorganizational structures.

Information Asymmetry and SignallingTheory

The concept of information asymmetryhelps to explain problems faced by bothlarge and small enterprises. In the case oflarge organizations, managers may wellhave information that shareholders do notand may use this to their advantage,although it may not always be the casethat agents know more than principals(Waterman and Meier 1998).

In the case of small enterprises,information asymmetry is likely to beparticularly great in dealing with outsidersin general and lenders in particular(Goswamiet al. 1995). According toLeland and Pyle (1977):

Borrowers typically know their collateral,industriousness and moral rectitude betterthan do lenders; entrepreneurs possess‘inside’ information about their ownprojects for which they seek financing.

Leland and Pyle then considered howentrepreneurs could convincingly signaltheir good intentions to lenders and capitalmarkets in a cost-effective way. Sinceactions speak louder than words, one wayis for entrepreneurs to invest in their ownprojects and firms. They concluded thatthe value of the firm increases as theproportion owned by the entrepreneurincreases.

Myers and Majluf (1984) argued thatinformation asymmetry is so severe in thecapital market that firms may refuse toissue stock and thereby pass up valuableinvestment opportunities because of thehigh cost. Myers (1984) went on to use theconcept of information asymmetry to‘breathe new life’ into what he called the‘pecking order theory’ in order to explain

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why firms’ capital structures in practicediffered from that predicted by theory.

Asymmetric information is an importantconcept in agency theory and transactioncost economics. In agency theory, thecombination of information asymmetry anddifferences in the utility functions ofprincipals and agents leads to moralhazard. In transaction cost economics,information asymmetry combinedparticularly with asset specificity leads toopportunism.

Transaction Cost Economics

A variation of the question ‘Why do smallfirms exist?’ is ‘Why isn’t all economicactivity undertaken by one huge firm?’ Atleast part of the answer to this can befound in transaction cost economics. Theclassic transaction cost problem was posedby Coase in 1937:

When do firms produce to their own needs(integrate backwards, forwards or laterally?)and when do they procure in the market?

Coase (1937) argued that transaction costdifferences between markets andhierarchies were principally responsiblefor the decision to use markets for sometransactions and hierarchal forms oforganization for others. Coase sawactivities within the enterprise as beingcoordinated by direct authority. Alchianand Demsetz (1972) argued that activitieswithin the enterprise were coordinated bycontractual relationships, a viewreiterated and expanded upon by Jensenand Meckling (1976). The ideas of Coasehave been built upon by Williamson(1979, 1985), who analysed transactionsin terms of their asset specificity,

frequency and uncertainty. Thecombination of these factors largelydetermines the scope for opportunisticbehaviour and whether hierarchical formsare optimal.

Williamson (1996), in a recent review,sees transaction cost economics ascombining the study of economics andorganizations. He acknowledges theinfluence of the work of Simon (1955,1959) in its emphasis on decisionprocesses and coalitions. He sees theintroduction of the behavioural dimensionsof opportunism and bounded rationality asleading to better explanations oforganizational structure than theneoclassical explanations involvingtechnology and monopolistic tendencies.Different organizational structures are aresult of economizing on transaction costswhich, depending on the circumstances,may be achieved either by the use ofhierarchical organizations or markettransactions. The implications of thisanalysis for small enterprises are thathierarchies have costs in the forms ofreduced incentive and bureaucracy that canbe avoided in smaller enterprises.

Pratten (1997) identified Williamson’smajor contribution to transaction costeconomics as being in operationalizing theconcept of transaction costs by focusing onthe nature of transactions. Ghoshal andMoran (1996) criticize what they see asWilliamson’s overemphasis onopportunism and claim that transactioncost economics embodies a hiddenideology. Nevertheless, transaction costeconomics has had a major impact on thestudy of economics, business and law withan increasing emphasis being placed ongovernance issues in recent years.



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New Institutional Economics and SmallEnterprises

Both transaction cost economics andagency theory are similar in their emphasison the dangers in large organizations,particularly involving managerialdiscretion, contractual relationships and therole of the board of directors. The maindifference between the two approaches isin the unit of analysis, where transactioncost economics focuses on the transaction,whereas agency theory focuses on theindividual agent. The ideas of varioustheorists have tended to feed off andaugment each other in a way that hasgiven rise to what is described as the ‘newinstitutional economics’. According toKeasey and Watson (1993), the term ‘new’is used to differentiate this approach froman earlier institutional school associatedwith the work of Commons (1934).

Notions of information asymmetry,uncertainty, shirking, consumption ofperks, asset specificity, and frequency oftransactions, come together in terms ofexantecontractual problems, in the form ofadverse selection (where partiesmisrepresents their skills), andex postinthe form of moral hazard arising fromopportunism after contracts have beenentered into. Motivations for such actionsrange from differences in objectivefunction (Jensen and Meckling 1976)through ‘self-seeking with guile’(Williamson 1985) to deliberatewithholding or misrepresentation of insideinformation (Leland and Pyle 1977).

Agency costs of bonding and monitoringand costs of information asymmetry areseen as arising not only in the ‘pure’context of shareholders versus managersbut also in a variety of contractual settings.

It has been argued (Handet al. 1982;Pettit and Singer 1985) that because of the‘close’ nature of small enterprises, thesecosts are particularly high for them in theirdealings with outsiders such as lenders,creditors and capital markets. To theextent to which this is true this representsanother set of reasons which question theexistence of small enterprises. On the otherhand, ‘pure’ agency costs and costs ofhierarchy put large enterprises at adisadvantage compared with small ones.The developments in the ‘new institutionaleconomics’ suggest that there is a trade-off, between different costs, which resultsin the persistence of a variety oforganizational forms and sizes. In thefollowing sections, these ideas aredeveloped by looking at specific examplesof organizational ownership, finance andcontrol. In doing so, attention will be paidto summarizing the state of play from asmall enterprise perspective and assessinghow far developments in economic theoryprovide explanations.

Capital Structure and Access to CapitalMarkets

A great deal of attention has been paid todifferences in the capital structures of, andaccess to capital markets by, large andsmall enterprises. These have often beenattributed to ‘gaps’ in the supply offinance for small enterprises. Another viewhas been that small enterprise owner-managers lack understanding of thevarious sources of finance available andskills in accessing them, a ‘knowledgegap’. More recently, attention has shiftedto explaining differences in terms of thedemand for various sources of financebased on the costs involved that may vary

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between large and small enterprises.Variations could be due to agency,information asymmetry, signalling andtransaction costs.

Capital Structure and the Finance `Gap'

Capital structure, that is the use ofvarious sources of funds, and particularlythe debt to equity mix, to finance anenterprise, has proved to be a perennialpuzzle in finance (Myers 1984). Theoriginal Modigliani and Millerproposition (1958 and 1963) highlightedthe important issues involved in capitalstructure decisions. These are the cheapercost of debt compared with equity, theincrease in risk and in the cost of equityas debt increases, and the benefit of thetax deductibility of debt. They arguedthat, in the absence of taxes, the cost ofcapital remained constant as the benefitof using cheaper debt was exactly offsetby the increase in the cost of equity thatwas due to the increase in risk. Taxationresulted in a tax shield advantage to debtthat suggests that firms should use asmuch debt as possible. Further extensionof the Modigliani and Miller approach toinclude the cost of bankruptcy results inthe ‘static trade-off’ model where thebenefit of cheaper debt is traded-offagainst bankruptcy costs (Myers 1984).This results in the conclusion that firmsshould use some, but not too much, debt.

In practice the variation in the use ofdebt is greater than predicted. The lack ofuse of debt is particularly apparent insmall enterprises, with survey results (Rayand Hutchinson 1983) showing that manysmall firms do not use any debt.

In the UK, work by Bates (1971)revealed differences in financial structure

between large and small enterprises. Hefound that small enterprises, comparedwith large, tended to be more self-financing, had lower liquidity, rarelyissued stock, had lower leverage, reliedmore on bank financing and used moretrade credit and directors’ loans. Bates’sempirical observations tended to confirmthe concern held by policy makers thatsmall enterprises were indeed differentfrom large in terms of their access tofinance. The MacMillan Committee (1931)had coined the term finance ‘gap’ todescribe the situation in which anenterprise had grown to a size where ithad made maximum use of short-termfinance but was not yet big enough toapproach the capital market for longer-term finance, particularly equity.

The variation in the use of debt and thelack of use of equity were addressed byMyers (1984) who explained both in termsof a pecking order theory. Myers (1984)extended the work of Donaldson (1961) byapplying the term ‘pecking order’ toDonaldson’s description of firms’preferences for finance and by providing atheoretical underpinning. The argumentwas that, because of the costs caused byinformation asymmetry, signalling andagency problems, firms would prefer touse internal finance first, followed by debtand would only issue equity as a lastresort. According to Cosh and Hughes(1994), this view can readily be applied tosmaller unquoted companies. Indeed,unquoted small enterprises seem to face amore extreme version of the pecking order(Holmes and Kent 1991; Ang 1991). Inthese scenarios, raising external equity isnot possible, even as a last resort, forsmall enterprises because of their lack ofaccess to the capital market.



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The pecking order theory predictionshave been largely confirmed in severalempirical studies of small enterprises(Holmes and Kent 1991; Van der Wijstand Thurik 1993; Chittendenet al. 1996;Jordanet al. 1998). It emerges as a goodexplanation of small, unlisted enterprises’capital structure with a heavy reliance oninternally generated funds being the keyfeature. The use of collateral, especiallyfor unlisted small enterprises, has beenfound to be widespread and is consistentwith its being used as a way of dealingwith agency and information asymmetryproblems in lending to small firms.

Chittendenet al. (1996) found thataccess to the capital market itself appearedto be a major factor determining thecapital structure of small enterprises. Oncea flotation had been achieved, long-termdebt became available and collateral,which up to that point was crucial, becameless important.

Access to capital markets is animportant concept in finance, and theacquisition of a stock market flotation is awatershed for many small enterprises. Oneof the main problems in acquiring a stockmarket flotation is the cost involved. Costsof flotation include various, non-trivial,administrative costs, but two costs whichhave received a lot of attention in theacademic literature are the underpricing ofinitial public offerings of equity and thesmall firm effect.

Underpricing of Initial Public Offerings

Initial public offerings are likely to be ofparticular importance to small enterprisesbecause not only do they provide access tothe capital market but also they enableentrepreneurs to ‘harvest’ their investment

(Prasadet al. 1995). In the case of the‘underpricing’ of initial public offerings,the price that the enterprise receives for itsshares from subscribers to the issue is lessthan the value of the shares in the marketon commencement of market tradingfollowing the issue. This represents a nettransfer of wealth from the enterprise tothe shareholders that take up the newissue. Underpricing seems to beparticularly severe for smaller firms(Buckland and Davis 1990) and in marketsspecifically set up to cater for smallenterprises such as the US ‘over-thecounter’ market (Prasadet al. 1995). Theamount of underpricing varies over timeand from country to country, but can be ashigh as 30% (Finn and Higham 1988).

The finance literature has generallyviewed the underpricing of initial publicofferings as being the corollary ofoverpricing in the new issue market on thefirst day of trading, which leads to lowerreturns on new issues. Loughran and Ritter(1995) add underpricing to the list of‘puzzles’ in finance and show that initialpublic offerings were poor investments, ifbought on the first day of trading, duringthe 1970s and 1980s. McConaughyet al.(1995) attributed the lower returns tooverpayment rather than increased agencycosts or poor performance of the firmsinvolved. McConaughyet al. (1995) putthe willingness to overpay down toextrapolation of past trends, which Teohetal. (1998) claimed was at least partly dueto the use of accruals. Various othertheories have been put forward in order toexplain underpricing of initial publicofferings. Tinic (1988) groups them asfollows: risk-averse underwriterhypothesis; monopsony power hypothesis;speculative bubble hypothesis; insurance

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hypothesis and asymmetric informationhypothesis.

Saadouniet al.(1996) describe threesources of information asymmetry ininitial public offerings: between the issuerand underwriter, between informed anduniformed investors and between theissuer and underwriter and the market. Inthe case of underwriters and issuers,underwriters are viewed as havingsuperior information that in turn providesthem with a reputation which, in effect,issuing enterprises are buying by meansof the discount on the share price (Baron1982). A study by Muscarella andVetsuypens (1989) tests Baron’s (1982)model by examining self-marketed initialpublic offerings, where informationasymmetry does not exist between theissuing enterprise and the underwriter,and comparing them with those marketedby underwriters. They found that,contrary to expectations, self-marketedofferings were also subject to significantunderpricing.

Rock (1986) saw underpricing as adevice to encourage uninformed investorsto subscribe to new issues. A test ofRock’s hypothesis by Koh and Walters(1989) did not, however, confirm this.

In the case where there may beasymmetry between the issuing enterpriseand its underwriters, and the market, it hasbeen shown (Prasadet al. 1995; Espenlauband Tonks 1998) that, the market viewsfavourably high retentions of equity byentrepreneurs. This provides a good‘signal’ to the market. Other good signalscan be sent by appropriate choice offinancial institutions (Booth and Smith1986; Carteret al.. 1998; Slovin andYoung 1990) and auditors (Balverset al.1988; Firth and Liau-Tan 1998). The use

of prestigious institutions is thought toreassure potential investors that the firminvolved is not over-valued as a result ofthe overestimate of future cash flows byinsiders exploiting information asymmetrybetween managers and potentialshareholders.

Underpricing remains problematic forsmall enterprises and may discouragethem from flotation. The implications ofthe above studies are that smallenterprises could reduce the extent ofunderpricing in a number of ways. Theycould delay their flotation until they wereof larger size and could use a ‘mainboard’ rather than one specially cateringfor small enterprises. They could useprestigious financial institutions andauditors. Entrepreneurs involved in initialpublic offerings could retain a high levelof ownership in their firms until afterflotation. These strategies may help toreduce agency and informationasymmetry costs and send good signals tothe market. However, such actions arelikely to incur costs that offset, at least tosome extent, the benefit of reducedunderpricing. Prestigious institutionsusually charge more than less prestigiousones and entrepreneurs may not wish toretain large shareholdings. Also, evenwhen a stock market flotation isachieved, the newly floated smallenterprise may find itself subject to the‘small firm effect’.

The `Small Firm Effect'

The work of Reinganum (1981) and Banz(1981) has shown a ‘small firm effect’,such that the returns to the investors insmall firms are higher than for large firmsin the same risk class. A related



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phenomenon to the small firm effect is thefinding that most of the excess returninvolved, up to 50%, accrues in Januarygiving rise to the ‘January effect’ (Keim1983). These phenomena appearconsistently over time and throughout theworld (Dimson and Marsh 1989). Thesmall firm and January effects have majorimplications for small enterprises andfinance theory. As far as small enterprisesare concerned, the increased return toshareholders represents a higher cost ofequity and therefore a higher weightedaverage cost of capital than would beexpected for their (beta) risk (Beedles1991). Other things being equal, thiswould result in less investment by smallenterprises.

As far as finance theory is concerned,the small firm effect is a challenge bothfor the Capital Asset Pricing Model andthe Efficient Markets Hypothesis(Dimson and Marsh 1989). The smallfirm effect has been attributed to theimproper measurement of risk of smallfirms because of less frequent trading intheir stocks and subsequent auto-correlation in returns. The small firmeffect has also been attributed totransaction costs although Sinquefield(1991) claimed that superior returns couldbe made from small enterprises even afterallowing for transaction costs. Theinadequacy of beta as a risk measurementhas also been suggested (Friend and Lang1988). The January effect has beenexplained as being due to year endportfolio revision and tax loss selling(Miller 1990). Refinements in methodsand models have been used with somesuccess in explaining the small firmeffect (Sweeneyet al. 1996; Chapman1997).

It has been argued that the capital assetpricing model needs to be modified toinclude a specific allowance for smallenterprise risk (Collins and Barry 1988).Levy (1990) proposed a solution thattakes into account the specialcircumstances of small enterprises in theform of a generalized capital asset pricingmodel. He assumed market segmentationand lack of diversification such that smallenterprise owner-managers’ financial andhuman capital is restricted to a particularfirm or segment. Market segmentationcould arise because of the greaterinformation asymmetry and consequentincrease in potential for opportunisticbehaviour. Although the approachsuggested by Levy (1990) mightreconcile the CAPM with thecircumstances of small enterprises andexplain the small firm effect, it does soon the basis that small enterprises do infact face higher transaction andinformation asymmetry costs than largeenterprises.

Faced with the costs of underpricing andthe small firm effect, it is not surprisingthat many small enterprises do not seekstock market flotation. What may seemmore surprising is that many enterprisesthat have incurred the costs of flotationshould then choose to ‘go private’.

`Going Private'

‘Going private’ is of great interest becauseit represents a reversion in terms ofownership and control, by public quotedenterprises, to those associated withsmaller, private, unquoted enterprises.Fama and Jensen (1985) argued that thevalue of the business is maximized forsome enterprises by being publicly held,

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but maximized for others by beingprivately held. Agency considerations arelikely to play a large part in determiningwhether businesses are better off beingpublic or private.

The `Buy-out' Phenomenon

Going private usually takes the form of a‘buy-out’ by managers or other employeesusing a high degree of debt, and hence thealternative descriptions of leveraged buy-out or management buy-out. It is alsopossible to have a ‘buy-in’ by an externalgroup of managers but the combination ofsimultaneous changes in ownership andmanagement can be problematic (Robbieand Wright 1995).

Buy-outs have been particularly popularin the UK and USA. The phenomenon ofgoing private by means of buy-outs aroseon a large scale in the 1980s. Buy-outactivity in the USA increased from $US1.4billion in 1979 to $US77 billion in 1988(Kaplan 1991). Buy-outs accounted forapproximately 20% of all takeover activityin the United States between 1985 and1987 (Kaplan 1989). It could be thatAnglo-American enterprises are differentfrom those in other advanced marketeconomies because of their legal andinstitutional environment, which may resultin their having a more ‘arm’s length’relationship with outsiders. Enterprises inother countries such as Japan are reputedto work more closely with outsideinstitutions, particularly banks, in a waywhich may reduce information asymmetryand agency costs (Dewenter and Warther1998). Indeed, Thompson and Wright(1995) argued that buy-outs were aresponse to Anglo-American governanceproblems.

The concept of ‘free cash flow’ iscrucial in understanding buy-outs. Jensen(1986) defines free cash flow as beingcash flow in excess of that required tofund all projects that have positive netpresent values discounted at the relevantcost of capital. He argues that conflicts ofinterest could then arise betweenshareholders and managers over the payout of these free cash flows. The tendencyof management could be to retain the cashflows in the form of perquisiteconsumption, shirking or otherinefficiencies. The usual sanction againstthis behaviour by management is a fallingshare price that can lead to a takeover. Amanagement buy-out can be viewed as apre-emptive strike by managers to avoid atakeover. In this situation, managers maybe willing to buy shares from existingshareholders at a premium to avoid thedisadvantages of a hostile takeover. Thetypical buy-out involved managers’ payingpre-buy-out shareholders a premium ofmore than 40% above prevailing marketprice according to De Angeloet al.(1984).

Rationale for Buy-outs

Why should managers be prepared to paya large premium to existing shareholdersto acquire their stock, especially in view ofthe increased level of debt that is incurredin order to finance this share purchase?Whilst management buy-out can be viewedas an internal takeover by managers whowish to avoid an external takeover,evidence of value creation is still needed.Jensen (1986, 1988) argues that large debtinterest payments act as a powerfulincentive to managers to manage theresources of the business more efficiently.



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A large equity stake gives managers anincentive to find ways to pay off the debtwhilst increasing value. Consequently, inaddition to the reduced agency cost thereis the new incentive benefit. Other reasonssuggested for buy-outs include: taxbenefits from the increased leverage of thefirm; the reduced costs of financialdisclosure for private as opposed to publiccompanies; the exploitation of insideinformation by managers; and theopportunity to reduce labour costs byreducing wages or ‘downsizing’ theworkforce.

Lehn and Poulsen (1989) considered theissue of free cash flow and stockholdergains in going-private transactions.Specifically, they considered whether firmsthat go private have significantly greaterfree cash flows than businesses that do notand the extent to which undistributed freecash flows are an important factor in anypremium paid in going private. They foundthat the likelihood of going private wasdirectly related to the ratio of undistributedcash flow to equity value and inverselyrelated to the growth rate in sales. Theyalso found that the premiums paid toshareholders in management buy-outs werepositively related to undistributed cashflow measures. Kim and Lin (1991) foundthat buy-outs were concentrated inindustries with stable cash flows.

The research on the role of informationasymmetry in buy-outs has beeninconclusive. Kim and Lin (1991) foundthat businesses that went private weregenerally smaller than those that remainedpublic. They reviewed the work byVerrechia (1983) and Buzby (1975) whichindicated that the extent of financialinformation disclosure was positivelyassociated with enterprise size. Kim and

Lin (1991) concluded that the amount ofinformation asymmetry between theenterprise and its owners was likely to beassociated with the size of the enterprise.This would provide more scope formanagers of smaller enterprises to exploitinside information. Kaplan (1989),however, found no strong evidence for aninformation advantage on the part ofmanagers leading to underpricing of amanagement buy-out. In fact, the projectedfigures produced at the time of themanagement buy-out tended to be higherthan the actual figures turned out to be.Lee (1992) looked at the consequencesarising when a buy-out, having beenannounced, did not go ahead. Lee’s resultsindicated that information asymmetry didnot seem to be the main motive for buy-outs. However, information asymmetrybetween the firm and the market could bereduced in the case of firms that had beensubject to buy-outs and then returned tothe stock market. Saadouniet al. (1996)demonstrated that such firms experiencedless underpricing than other issues whichwas put down to their having previouslybeen quoted and therefore being betterknown to the market.

Performance of Buy-outs

Kaplan (1989) tested various hypothesesconcerning management buy-outs. Hefound that companies involved inmanagement buy-outs experiencedincreases in operating income and netcash flow and a reduction in capitalexpenditure. The increase in net cashflow was considerable, averaging 22%,43% and 80% more in the first threeyears after buy-out than in the last yearbefore the buy-out. Kaplan concluded

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that management buy-outs are associatedwith valuable operating improvements.He also considered various explanationsfor the improvement in performance,including the employee wealth transferhypothesis and the reduced agency costhypothesis. He found no significantevidence of buy-outs being accompaniedby decreases in labour costs. In terms ofreduced agency cost, he found that theequity holding of the management teamincreased from a median of 6% to 23%,indicating a reduction in agencyproblems. Wrightet al. (1996) found thatevidence from failed buy-outs showed theimportance of incentives to reduceagency problems and the need to avoiddelays in restructuring.

In a subsequent study, Kaplan (1991)considers the staying power of buy-outsand whether they were inherently transitoryorganizations. Kaplan described thetransitory view as being consistent with thenotion of ‘shock therapy’. After the initialbenefits had been reaped, the owner-managers involved in a buy-out would findthemselves bearing a high level ofundiversified risk which eventually wouldlead them back to public ownership. Thehigh level of debt incurred in most buy-outs may bring irksome restrictions on thescope of management who may wish to gopublic in order to reduce reliance on debt.Kaplan’s (1991) results were mixed,indicating that some buy-outs are short-lived, but that others are not. Debt levelsremained high even in the case of buy-outsreverting to public status. Kaplan (1991)concluded that the typical buy-out is likelyto last around 15 years. Similar conclusionswere reached by Wrightet al. (1995).

Kaplan and Stein (1993) reviewed theevolution of buy-outs during the 1980s.

They found that: the price to cash flowratio rose; bank principal repayment rose;private subordination and bank debt werereplaced by public junk debt; and thatmanagement teams and deal makers tookmore money out ‘up front’. Theyconcluded that these phenomena wereconsistent with ‘overheating’ in the buy-out market. Wrightet al. (1994) confirmedthe downturn in buy-out activity in the1990s and pointed out that in the early1990s, unlike earlier times, more buy-outsfailed than were refloated.

Whether buy-outs continue to be aspopular in the future or not, thephenomenon does provide confirmation ofthe notion that there are problemsassociated with public ownership and theconsequent separation of ownership andcontrol. Going private provides a usefulcontrast to going public and suggests thatorganizational ownership and control arenot only important factors but dynamicones as well and that enterprises mayswitch between public and privateownership.

Franchising

Franchising represents an interestinghybrid in terms of ownership and controlissues, especially since franchiseorganizations often include managed andowned outlets. Franchising can be definedas an agreement between a buyer and aseller that permits the buyer (franchisee) tosell the product or the service of the seller(franchiser). It involves a continuingrelationship between the franchiser and thefranchisee in which the sum total of thefranchiser’s knowledge, image, success,manufacturing and marketing techniquesare supplied to the franchisee for a



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consideration. Franchising is regarded asrelevant to small enterprise issues since,although franchising chains may be verylarge, manager-owned outlets would satisfymost definitions of smallness.

According to Dyl (1991), franchising isparticularly well suited to businesses thathave three basic characteristics. The first isthe existence of a trademark signifyingconsistent quality, the second is the abilityto decentralise the product or servicethrough many small units without anysignificant diseconomies of scale, and thethird is that the product or service is bestsupplied to consumers at or near the siteof consumption.

Studies of franchising have includedconsideration of: its economic rationale(Arrow 1985; Kaufman and Lafontaine1994), its organizational form (Norton1988), decisions as to whether to enter intoa franchising arrangement (Chan and Justis1993) and case studies (Dnes 1992).Contractual arrangements have received agreat deal of attention (Agrawal and Lal1995; Klein and Saft 1985; Rubin 1978;Sen 1993). Transaction cost economics,information asymmetry and signallingtheory, and agency theory have beeninvoked in understanding franchising(Brickley et al. 1991; Contractor andKundu 1998; Gupta and Srabana 1998;Klein 1980; Lafontaine 1992, 1993; Shane1998; Wimmer and Garen 1997).

Franchisee and Franchiser Perspectives

Advantages of franchising, from the pointof view of the franchisee, are thoseassociated with having a ready-madebusiness with tried operating methods andwell-developed training and supportfacilities. Another major advantage of

franchising comes in the form of atrademark and a national image whichfacilitate national advertising. Although inmost cases franchisees are required toprovide their own funds, being associatedwith a nationally known franchiseoperation may facilitate fund-raising byproviding a good ‘signal’ because ofassociation with a reputable franchiser. Itcould also be that, since most franchiserssubject potential franchisees to a screeningprocess, failure rates are lower than forother small enterprises. Results of a surveyof the benefits perceived by franchiseesreported in Johnset al. (1989) indicate thatadvertising, followed by quantitydiscounts, and advice and assistance werethe major benefits associated withfranchising. These are benefits typicallyenjoyed by large enterprises. Marketexclusivity and financial aspects were notregarded as major advantages for franchiseoperations.

Disadvantages of franchising from thepoint of view of the franchisee can take anumber of forms. The financialdisadvantage comes in the form of costsinvolved in initial charges and percentagefees on sales charged by the franchiser. Afranchise operation also restricts thefreedom of the franchisees to determinetheir own business arrangements. This isnecessary to ensure uniformity in theprovision of franchise services in order tomaintain the trademark and national imagefor advertising purposes. So, for example,individual franchisees would have toconform with requirements in terms ofopening hours, pricing, packaging, colourschemes and so on. These arrangementscan be justified in terms of ensuring thecontinued value of the franchise, providinga return to franchisers and reducing the

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potential for moral hazard (Agrawal andLal 1995; Wimmer and Garen 1997).

Perhaps the major disadvantage for afranchisee is the limit on expansioninvolved in franchising. This means that itcan be very difficult for individualfranchisees to benefit from the goodwillthey have built up. This is particularly thecase where there are buy-back clauses infranchise agreements. Expansion may belimited in that the franchisee might onlybe allowed to operate one outlet, althoughin some franchise arrangements multipleoutlets are allowed or even encouraged.The issue of the legal relationship betweenfranchisee and franchiser is a matter ofconcern and in most countries there islegislation regulating the contractualarrangements in order to avoid exploitationof franchisees by franchisers (Klein 1980).

From the point of view of the franchiser,the main benefits of franchising are that itallows expansion beyond the franchiser’sown capital resources. It also shifts risk tothe franchisee, especially in the case ofnew outlets that may be of marginaleconomic benefit. Franchising alsoprovides some of the benefits of large sizebut avoids some of the disadvantagesinvolved in monitoring employeesespecially where they are located ondifferent sites. It also takes advantage ofthe greater motivation of self-employedpeople who have an incentive to workhard on the basis that they will retain anyincreased profit generated by their outlet.The main disadvantage of franchising fromthe franchiser’s point of view is thedependence on the activities ofindependent franchisees for themaintenance of the franchise’s image andreputation. As Wimmer and Garen (1997)describe it, franchising involves a two-

sided moral hazard that is amenable toanalysis using agency theory.

Control Mechanisms in Franchising

Brickley and Dark (1987) viewedfranchising as a hybrid between twomethods of controlling agency costs,namely contractual devices and residualownership. Contractual devices couldinclude provisions for multiple ownership,term of contract, renegotiation provision,leasing of assets, standard of quality,minimum level of input use and continuingfranchising fee.

Multiple ownership could be regarded asa device to reduce free-riding by thefranchisee, since the franchisee has agreater stake in the total business. Shorterterms of contract may be desirable on thepart of a franchiser, but may reduce theincentive effect on the part of thefranchisee. Short-term contracts wouldappear desirable where the value of thetrademark is high. Leasing of assets maybe useful in franchising, given the firm-specific assets involved and the consequentpotential for post-contractual opportunisticbehaviour. Wimmer and Garen (1997),however, point out that the use of leasingmay have a trade-off cost in the form ofincreased franchise fee. Contractualarrangements with regard to quality are anobvious way to minimise free-riding onthe part of the franchisee. Requirementsmay be numerous and detailed, and failureto comply with them may result intermination of the franchise agreement.Similarly, stipulation about the minimumlevel of input use can reduce free-riding,for example, in the area of advertising,where the individual franchisee may seekto free-ride on the advertising efforts of



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others. It would be expected that highfranchising fees would be associated withthe maintenance on the part of thefranchiser of the value of the trademark.

Brickley et al. (1991) observed thatfranchising appears to be contrary to theconcept of risk pooling since individualfranchisees are residual claimants on theirown residual outlet. This implies that theremust be offsetting benefits associated withfranchising in the form of an incentive effectand the reduction of monitoring costs.Where ownership and management areseparate, there is always the possibility ofreduced incentive to work and increasedincentive to shirk and consume perquisites.These costs are minimized in mostorganizations by a management structurethat ensures constant monitoring ofemployees. In some circumstances, however,this may not be feasible or cost effective andfranchising may be more effective.

If a unit is owned by the franchiser andoperated by a manager, there are obviouslycosts involved in monitoring theperformance of that manager. If a unit isfranchised and therefore operated by anowner-manager, there is less need formonitoring in order to reduce shirking andperquisite consumption. However, theremay still need to be some monitoring inorder to ensure that the owner-managerdoes not free-ride on the trademark. Inextreme cases this may involve the retailunit being directly managed by thefranchiser. This could occur especially inthe case of non-repeat business. In thesecircumstances, an owner-manager mayhave an incentive to provide less than fullvalue to customers who were not expectedto revisit that particular location.

Franchising can, therefore, be contrastedwith two alternatives: independent, small,

owner-managed enterprises and large,professionally managed, hierarchicalorganizations. In some circumstances,franchising may combine the best featuresof both in a way that can largely beexplained using the perspective providedby the new institutional economics.

Summary and Conclusions

The persistence of a variety oforganizational forms, including smallenterprises, and the failure of neoclassicaleconomics to explain this have acted asthe sand in the oyster of theorydevelopments. The developments that areof particular relevance are those involvingagency theory, information asymmetry andsignalling theory, and transaction costeconomics that are collectively referred toas the new institutional economics.

The new institutional economics is notwithout its critics, nevertheless it doesprovide plausible theories that seem tohold up in empirical studies despiteproblems in measuring the costs involved.It does not seek to favour one type oforganization structure over another butsees a range of structures determined byagency, information asymmetry andsignalling, and transaction costs. The tradeoff between these costs and other costssuch as those involving economies of scaledetermine the optimum organizationalstructure and influence the financing of it.

In some cases the new approach points toeven more problems for small enterprises,for example, when it comes to capitalstructure and access to capital markets. The‘close’ nature of small enterprises, whichconcentrates ownership and control in thesame hands, can be seen as maximizinginformation asymmetry and scope for

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opportunistic behaviour when dealing withoutsiders. This makes small enterprises verydubious customers when it comes tolending money to them and explains theextensive use of collateral. The sameproblem applies to investing in the sharesof small enterprise, hence the finance gap.Also it may explain some of theunderpricing of initial public offerings bysmall enterprises and the small firm effect.It therefore seems likely that the variety offinancial structures observed in practice andthe lack of use of capital market reflectrational trade-offs of various economiccosts by small enterprise owner-managers.Other things being equal, this outcomewould lead to under-investment by smallenterprises and lack of diversification fortheir owner-managers. To survive, smallenterprises need countervailing benefits tooffset these inefficiencies.

The study of buy-outs and franchisingprovides examples of the benefits ofbringing together ownership and controlthat can outweigh the costs of doing so.The combination of ownership and control,along with high levels of debt, seems todramatically improve the performance ofmany enterprises that experience buy-outs.In this case, fusing ownership and controltogether results in the reduction ofinformation asymmetry and agencyconflicts between managers andshareholders and in an increase inincentive. Franchising also seems toconfirm the benefits of the owner-managedform whilst, in addition, reaping thebenefits of large organizations.

It is apt to conclude with the quotationfrom the Wealth of Nations by AdamSmith about managers in largeorganizations, which prefaced the seminalarticle by Jensen and Meckling (1976):

The directors of such (joint stock) companies,however, being the managers of otherpeople’s money than of their own, it cannotwell be expected, that they should watch overit with the same anxious vigilance with whichthe partners in a private copartnery frequentlywatch over their own. Like the stewards of arich man, they are apt to consider attention tosmall matters as not for their master’s honourand very easily give themselves adispensation from having it. Negligence andprofusion, therefore, must always prevail,more or less, in the management of theaffairs of such a company.

In other words, no one looks after yourbusiness as well as you do! Wherepersonal control by the owner is notpossible there have to be other benefits,such as economies of scale, and controlmechanisms, such as effective boards ofdirectors, which overcome the costs ofrelying on others.

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