Do Banks Price Owner Manager Agency Costs? An Examination of Small Business Borrowing*

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1 Journal of Small Business Management (4), pp Do Banks Price Owner Manager Agency Costs? An Examination of Small Business Borrowing* by James C. Brau Ang, Cole, and Lin (2000) provide evidence that supports the theoretical work of Jensen and Meckling (1976) on agency costs. As a further examination, I conduct a test to determine the economic significance of owner manager agency conflicts. Using the same data source and empirical framework as Ang, Cole, and Lin (2000), I test to determine if banks charge a premium when extending loans to firms with various ownership structures. In empirical tests, I find that banks do not require an owner manager agency premium either through increased interest rates or through the requirement of collateral. Instead, I find that the interest rate is significantly affected by the length of the longest banking relationship, the number of banking relationships, firm age, and firm size. Additionally, the requirement of collateral is significantly affected by the number of banking relationships, the debt position of the firm, and firm size. In a recent article, Ang, Cole, and Lin (2000) (hereafter ACL) find empirical evidence of the owner manager agency costs theorized by Jensen and Meckling (1976). 1 ACL use two proxies for owner manager agency costs: the expense ratio (that is, operating expenses/sales) and the total asset turnover ratio (that is, sales/assets). These two ratios measure how efficient the manager operates and are intended to proxy for the owner manager agency costs suffered by the firm. Using a sample drawn from the Federal Reserve Board s National Survey of Small Business Finances (NSSBF), the authors compare the base Jensen and Meckling (1976) zero agency cost firm (that is, a firm with a single owner manager) to firms with different ownership structures. ACL find that agency costs (as measured by the expense and turnover ratios) are significantly higher when an outsider man- Jim Brau is assistant professor of finance at the Marriott School, Brigham Young University. His current research interests include initial public offerings and entrepreneurial finance. *The author thanks Rebel Cole, Hal Heaton, Andrew Holmes, Grant McQueen, Mike Pinegar, Steve Thorley, Brent Wilson, three anonymous referees, and the editor (Patrick Mann) for helpful comments. 1 For this study, I use the term owner manager agency to refer to the principal-agent conflicts that occur when the incentives of owners and management are imperfectly aligned. This specific type of agency cost is modeled by Jensen and Meckling (1976) and is a subset of all possible agency conflicts. BRAU 273

2 ages the firm and are significantly lower with greater monitoring by banks. Additionally, they report that agency costs are related inversely to the manager s ownership share and are related directly to the number of nonmanager shareholders. The authors conclude that the ownership structure of a firm significantly impacts the degree of agency costs. In this paper, I extend the work of ACL by testing to determine if banks price owner manager agency costs within borrowing firms. The bank pricing issue is important because it allows for the measurement of the impact of owner manager agency costs on firm value. Ideally, a researcher would like to test the impact of the various ownership structures (that is, the owner manager agency costs) on firm stock prices to determine if the costs are priced. Unfortunately the firms included in the NSSBF survey generally are not publicly traded, and the survey neither identifies nor provides market price data for those that are publicly traded. Without the stock market data, ACL cannot relate agency costs to firm value but rather can only show that agency costs as measured by the two performance ratios are related to ownership structure and to the degree of monitoring. This paper differs from ACL in that I construct an alternate methodology to determine if the owner manager agency costs impact firm value. If owner manager agency costs decrease firm value and therefore increase the probability of loan default, banks should price these costs in one of two ways: Banks should increase the interest rate (referred to as the interest rate agency premium); and/or banks should require collateral (referred to as the collateral agency premium). 2 If the interest rate and collateral premiums exist, then one can infer that ownermanagement agency conflicts impact firm value. Banks specialize in gathering data and making loans, so they can be thought of as highly informed investors. Showing that these informed investors not only detect potential agency problems but also deem them important enough to price would provide evidence that agency costs are both statistically and economically significant. If, however, banks do not charge an interest rate or collateral agency premium, this indicates that bankers do not consider owner manager agency conflicts important enough to price (that is, important enough to affect firm value). I employ the same data source as in the ACL article. The NSSBF survey was conducted in 1994 and 1995 for the Board of Governors of the Federal Reserve System and the U.S. Small Business Administration. The survey consists of 4,637 firms that employed less than 500 employees at year-end My sample, however, differs from the ACLsampleinthatIincludeonlythose corporations that answered yes to the survey question that asked if they had applied for a loan within the past three years. By doing so, I am able to obtain the interest rate associated with the loan. In empirical tests, I find that banks do not charge either interest rate or collateral agency premiums. The same owner manager agency variables that are significantly related to the performance ratios in the ACL study have no impact on either the interest rate charged in the loan or the requirement of collateral. These findings suggest that, at least as viewed by the banking industry in extending loans to small businesses, owner manager agency costs are not economically significant. Instead, several other variables do significantly impact the interest rate and the incidence of collateral. Specifically, firms with longer banking relationships, older firms, and larger firms each pay a significantly lower interest rate, whereas firms with numerous banking 2 For discussions pertaining to secured debt that are consistent with this argument, see Smith and Warner (1979a and 1979b), Stulz and Johnson (1985), and Leeth and Scott (1989). 274 JOURNAL OF SMALL BUSINESS MANAGEMENT

3 relationships pay a greater rate. Additionally, firms with numerous banking relationships, firms with relatively more debt in their capital structures, and larger firms pledge collateral more often than their counterparts. Theoretical Discussion In their seminal work on agency theory, Jensen and Meckling (1976) begin with the case of a manager-owner who owns 100 percent of the firm. The manager may increase utility through money wages, the market value of the firm, and perquisites. In this framework, money wages are assumed constant and perquisites are assumed to be inseparable from the firm. Given these three avenues to increase utility, the managerowner constructs the optimal combination of wages, firm appreciation, and perquisites to maximize his/her utility. Because the manager bears all of the costs associated with the perquisites taken, the costs are factored into the optimal consumption mix and no agency conflicts exist. As the ownership structure varies from the 100 percent owner manager, potential agency conflicts emerge. For example, when a part of the company is sold to outside investors but the manager-owner retains control of the firm, the three avenues for increasing utility remain. However, the cost of perquisite consumption now is shared by the outside investors. Thus, incentives to consume perquisites are increased for the manager-owner while continuing to reap the full benefit but not having to bear the full cost. This type of owner manager agency cost is hypothesized to reduce firm value by impairing operating efficiencies. Whether firm value actually is harmed by the owner manager agency conflicts is an empirical matter and is the motivation for this study. 3 The purpose of this paper is to determine if interest rate and collateral agency premiums exist. The two questions asked in this paper are (1) Is there a relationship between the potential owner manager agency conflict in a firm due to its ownership structure and the interest rate required to obtain a loan; and (2) Is there a relationship between the potential owner manager agency conflict in a firm and the incidence of pledged collateral required for a loan? If potential agency conflicts are considered important economic factors by banks, either one or both of these questions should be answered in the affirmative. Agency theory predicts that a direct relationship will be observed between the agency premium and the potential agency conflicts. If banks do not view owner manager agency conflicts within borrowing firms as important economic factors, the questions should be answered in the negative. 4 Data and Empirical Methodology Data The data sample for this study is gathered from the Federal Reserve Board s National Survey of Small Business Finances (NSSBF) 1995 survey. The target population for the survey is the population of all for-profit, nonfinancial, nonfarm businesses with fewer than 500 employees that were in operation as of year-end The sample was drawn from the November 1993 Dun s Market Identifier file. 3 Another example of an ownership structure that may induce agency conflicts is when the ownership is retained but the management is relinquished. In this case, if the manager acts in his/her own interest and not in the owner s best interest, the agency costs will be realized by the owner to the detriment of the firm. Again, this potential of conflict may decrease firm value and increase the risk of default associated with the bank loan. 4 These arguments assume that banks are sophisticated enough to recognize potential agency conflicts within borrowing firms. Given the time, energy, and assets banks employ to obtain and analyze information on potential borrowers, this assumption seems plausible. BRAU 275

4 For a firm to be included in this study, it must meet the following criteria: (1) The firm must be organized as a C-corporation; and (2) The firm must have received a loan that is indexed to the prime rate in the three years prior to the survey. Interest rate data is available only for the most recent loan; hence, it is the choice of the three-year window. 5 There are 903 such firms indexed to prime in the survey of which 479 are C-corporations. Finally, firms with less than 200 shareholders are included to create a homogeneous sample. 6 These selection criteria result in a sample of 463 firms. The final sample represents approximately 27 percent of the 1,708 firm ACL sample. Methodology The methodology used to answer the two questions asked above is an adaptation of the ACL article. Specifically, a series of difference tests are employed (that is, means and medians), Ordinary Least Squares (OLS) regressions and logit regressions. Tables 1, 2, and 3 coincide with the same tables in the ACL study. The identical independent variables are used to measure the potential for owner manager agency costs and to control other relevant factors because these are identified as significant factors by ACL. In order to determine the existence of an interest rate agency premium, I examine the number of points above the prime rate that the firm paid for the loan. In order to determine the existence of a collateral agency premium, I create a binary variable that equals one if collateral secures the loan and zero if collateral is not required. Limitations of the Research It is possible that the nature of the sample may impose biases upon the subsequent results of the paper, which may appear for several reasons. First, I study exclusively C-corporations, in order to extend the ACL study by using the same organizational structure of firms. In unreported tests, however, all of the forms of ownership are included (that is, proprietorship, partnership, and S-corporations). Although I cannot perform all of the tests reported due to the limitation of shareholder ownership data, qualitatively the results of the reported tests are robust. A second possible source of bias is that only firms that successfully received a loan are included. Thus, the data sample excludes those firms that (1) applied for a loan and were rejected, (2) rejected bank financing as too expensive, and/or (3) used personal assets to finance corporate projects. To the extent that this bias exists, the conclusions of the study are limited only to those firms that choose to seek bank loans and who successfully obtain them. A third possible source of bias is the requirement that loans be indexed to prime. This mandate excludes firms that were financed with fixed-rate loans or loans indexed to other interest-rate data. Again, if this requirement does introduce bias, then the conclusions of this study are limited only to those firms that receive prime-based loans. A fourth possible source of bias is the absence of the amount of financial leverage in the firm before the newly collateralized loan is received. Although the debt-to-asset ratio of the firm is used in 5 Although the survey question asks if the firm has applied for a loan within the past three years and the survey was conducted from , the actual breakdown of the sample is one loan in 1990, nine loans in 1991, 32 loans in 1992, 167 loans in 1993, and 254 loans in Two hundred shareholders represents a truncation at the 97 percent upper tail of the distribution. I truncate to remove the top three percent of firms that may be viewed as outliers of the sample. If the top three percent of the firms are not removed, the results are qualitatively similar in that there is no evidence that banks price owner manager agency. 276 JOURNAL OF SMALL BUSINESS MANAGEMENT

5 subsequent tests, the data on financial leverage prior to the loan are not available. Inasmuch as the debt-to-asset ratio serves as a proxy for this pre-loan debt, the factor is controlled in the tests that follow. However, if the debt-to-asset ratio does not serve as a good proxy for this financial leverage risk at the time of the loan application, then this is a limitation of the study. Because financial theory would suggest that loan officers are concerned with the default risk of total financial leverage (including the new loan), it seems plausible to argue that the post-loan debt-to-asset ratio may control for the pre-loan leverage (that is the risk of default). A final limitation may be that the richness of the loan interest rate question is not considered completely by the data. It is possible that other factors may exist that are not captured by the data set employed in subsequent tests. For example, personal relationships between the banker and a member of the borrowing firm or the existence of other business relations between the banker and a member of the borrowing firm may not be captured by the data. In these cases, the firm may be charged a lower interest rate or there may be less of a requirement for collateral due to the (unobserved) relationship between the banker and the lending firm. Because the banking relationship variables (and other variables) employed in subsequent tests do not include these types of unobserved factors, this is a limitation of the study. Empirical Results Interest Rate Agency Premiums Table 1 reports the results of a series of difference tests. The sample is partitioned based upon the manager type. Firms that have an owner manager are listed in the second and third columns. Firms that have an outside manager are listed in the fourth and fifth columns. ACL show that owner manager firms have significantly lower agency costs than outside-manager firms; that is, ACL provide compelling evidence that ownership structure impacts agency costs as measured by the expense ratio and asset turnover. If banks feel that these agency costs are significant enough to price, then it follows that owner manager firms will pay a lower rate on average for their loan. The first column describes the sample that is being tested. When the entire sample is employed, the difference in means is three basis points and is not significant. The difference in medians is 25 basis points in the predicted direction; however, this difference is not statistically significant. The next subsample analyzed is the case in which the primary owner owns 100 percent of the firm. For the owner manager partition, this sample represents the Jensen and Meckling (1976) zero-agency cost case. In this case, the difference of means is two basis points and is not significant. The difference of medians is12 basis points; however, it is in the opposite direction predicted by agency theory and is not significant. The final three samples represent other ownership structures. They include the cases in which (1) the primary owner owns more than half of the firm, (2) a single family owns more than half of the firm, and (3) no owner or family owns more than half of the firm. In cases (1) and (2) the differences of means and medians are all in the opposite direction as predicted by agency theory. None of these differences are significant. In case (3) the difference of means is not significant; however, the difference of medians is significant at the 10 percent level. This final finding is the only evidence that supports the notion that banks price agency. Specifically, thecaseinwhich no ownerorfamilyowns a majority stake represents the scenario of less intense monitoring. Agency theory predicts that greater monitoring is associated with decreased agency costs and vice versa. In this scenario, the outside manager is able to shirk more or to consume additional perquisites with the decreased monitoring. Banks may recognize these potential agency BRAU 277

6 Table 1 Difference in Interest Rate Tests Based on Ownership Structure Type of Manager Owner manager Outside Manager Difference Mean Mean (Median) (Median) Number Points above Number Points above In Means of firms Prime of firms Prime (In Medians) All firms (1.00) (1.25) ( 0.25) Primary Owner Owns 100 Percent (1.50) (1.38) (0.12) of the Firm Primary Owner Owns >50 Percent (1.50) (1.05) (0.45) of the Firm A Single Family Owns >50 Percent (1.50) (1.20) (0.30) of the Firm No Owner or Family Owns >50 (1.00) (1.50) (0.50)* Percent of the Firm * indicates statistical significance at the 10 percent level. conflicts and may charge a higher rate to firms that display this type of ownership structure. In an attempt to further analyze this issue, I conduct an additional series of difference tests in Table 2. The first column lists the variable that is being tested. The second and third columns report the mean and median of the variable calculated using the full sample. The fourth and fifth columns report the mean for the two subsamples obtained from partitioning the sample into those firms that enjoyed rates below the sample median and those that paid rates higher than the sample median. The last column reports the difference in means. As in the ACL study, four variables are used to identify varying ownership structures. These variables are (1) an indicator for firms in which the firm manager is a shareholder; (2) an indicator for firms in which one family owns more than half of the firm; (3) the ownership share of the primary owner; and (4) the number of nonmanager shareholders. As discussed in ACL, agency theory predicts that agency costs should be inversely related to (1), (2), and (3) and should directly related to (4). In sharp contrast to the ACL results, none of the ownership variables have significantly different group means. In fact, the latter three variables have the opposite 278 JOURNAL OF SMALL BUSINESS MANAGEMENT

7 Table 2 Descriptive Statistics and Difference Tests for Predicted Explanatory Variables ables are (1) the length of the longest banking relationship in years, (2) the number of banking relationships, and (3) the debt-to-asset ratio. ACL argue that the first variable proxies for the ability of the bank to effectively monitor, the second variable proxies for the bank s cost of monitoring, and the third variable proxies for the incentive to monitor. Table 2 re- Low- High- Interest Interest Mean Median Rate Firms Rate Firms Difference Ownership Variables Firm Manager is a Shareholder One Family Owns >50 Percent of the Firm Ownership Share of Primary Owner Number of Nonmanager Shareholders External Monitoring Variables Length of the Longest *** Banking Relationship (Years) Number of Banking *** Relationships Debt-to-Asset Ratio Control Variables Annual Sales ** ($Million) Firm Age * (Years) *indicates significance at the 10-percent level. **indicates significance at the five-percent level. ***indicates significance at the one-percent level. signs that are predicted by agency theory. These results suggest that banks do not consider potential owner manager agency conflicts caused by various ownership characteristics important enough to price directly through increased rates. Continuing to follow ACL, the next three variables represent external monitoring variables. Specifically, these vari- BRAU 279

8 ports that the first two external monitoring variable group means are significantly different beyond the one percent level. This finding is consistent with the relationship lending results of Berger and Udell (1995), Petersen and Rajan (1994), and Cole (1998). Finally, the two control variables have significantly different means in the expected direction. Table 3 reports the results of a series of OLS regressions designed to further determine if banks charge an implicit agency premium. The dependent variable for each model is the number of points above (or below) prime required on the loan. The independent variables for each OLS model are reported in the first column. The format for this table is similar to that of Tables III and IV in ACL. Again, in sharp contrast to ACL, none of the ownership agency variable coefficients are significantly different from zero. Once again these results suggest that banks do not price the agency considerations associated with firm-ownership characteristics. The external monitoring and control variables confirm the results of the Table 2 difference tests and provide additional evidence that banking relationships and size (proxied by log of annual sales) are important factors in determining loan rates. As a whole, the analysis of interest rate agency premiums indicates that banks do not charge higher rates for loans issued to firms that display high-agency cost ownership structures. This finding is important because it questions the economic importance of agency costs at least as interpreted by banks. To draw the conclusion that banks do not price agency at this point would be premature. As discussed above, banks have an additional avenue to hedge from potential owner manager agency conflicts in the form of collateral. In the next section, I examine the incidence of collateral in association with the agency ownership structurevariables todetermineif banks choose this alternative course to price owner manager agency. Collateral Agency Premiums Tables 4 and 5 replicate Tables 2 and 3 using the collateral indicator variable instead of the number of points above prime. The second column of Table 4 reports the group means of the firms that pledged no collateral, and the third column reports the group means of those firms that did pledge collateral. As reported in the fourth column, none of the ownership variable group means are significantly different. Two of the external monitoring variables (that is, the number of banking relationships and the debt-toasset ratio) have significantly different means in support of the lending relationship literature. Finally, the proxy for firm size (log of annual sales) indicates that larger firms offer collateral more frequently than smaller firms. The final tests are reported in Table 5. The first column lists the independent variables used in a series of logit regressions. The dependent variable in each model is the binary choice variable equal to one when collateral is used to secure the loan and zero when no collateral is pledged. The results of these multivariate models support the findings reported in Table 4. Specifically, none of the agency conflict ownership variables significantly impact the use of collateral. Additional results indicate that firms with a greater number of banking relationships and firms with a high-debt ratio must pledge collateral more often. Robustness Tests A series of robustness tests were performed but were not reported in the form of tables. The areas of robustness are using lines of credit instead of loans, controlling for industry effects, and numerous alternative specifications of the empirical models. Berger and Udell (1995) make an argument for including only lines of credit when analyzing the value of relationship lending between banks and borrowers. The data source for their study is the 1987 NSSBF survey. Each of the tests here is 280 JOURNAL OF SMALL BUSINESS MANAGEMENT

9 Table 3 OLS Regressions To Determine if Banks Price Agency through Interest Rates Intercept 3.79*** 3.56*** 3.51*** 3.67*** 3.71*** 3.9*** 3.6*** 3.79*** (9.5) (8.9) (8.3) (9.2) (9.7) (10.1) (9.4) (8.8) BRAU 281 Ownership Variables Firm Manager is a Shareholder ( 1.1) ( 1.1) One Family Owns >50 Percent of the Firm (1.1) (1.3) Ownership Share of Primary Owner (1.0) (0.74) Log of the Number of Nonmanager ( 0.1) ( 0.90) Stockholders External Monitoring Variables Length of the Longest 0.01** 0.01** Banking Relationship (Years) ( 2.4) ( 2.5) Number of Banking 0.07*** 0.07*** Relationships (3.5) (3.5) Debt-to-Asset Ratio (1.1) (0.9) Control Variables Log of 0.16*** 0.15*** 0.15*** 0.16***.16*** 0.19*** 0.16*** 0.19*** Annual Sales ( 6.3) ( 6.0) ( 5.8) ( 5.8) ( 6.0) ( 7.1) ( 6.2) ( 6.6) Firm Age (1.4) (1.1) Regression Summary Statistics Adjusted R F-stat 19.99*** 19.99*** 19.87*** 19.38*** 14.99*** 25.97*** 19.97*** 7.06*** a Estimated coefficients are listed first; t-statistics are below in parentheses. *indicates significance at the 10-percent level. **indicates significance at the five-percent level. *** indicates significance at the one-percent level.

10 Table 4 Difference Tests on the Requirement of Collateral No Yes Collateral Collateral Difference Ownership Variables Firm Manager is a Shareholder One Family Owns >50 Percent of the Firm Ownership Share of Primary Owner Number of Nonmanager Shareholders External Monitoring Variables Length of the Longest Banking Relationship (Years) Number of Banking *** Relationships Debt-to-Asset Ratio ** Control Variables Annual Sales ** ($ Million) Firm age (Years) ** and *** indicate significance at the five and one percent levels, respectively. conducted on a sample of 359 firms that received a line of credit in the three years prior to the survey. The qualitative results and conclusions reported (that is, the all loan-type sample) are the same as this line of credit subsample. Incidentally, this study serves as an out-of-sample test and robustness check for the earlier Berger and Udell (1995) study pertaining to the relationship variables included in both studies. ACL include 35 two-digit Standard industrial code (SIC) code dummy variables to control for industry effects in their regressions. In robustness tests, industry does not significantly impact either the interest rate charged on the loan or the requirement of collateral. Specifically, not one of the twodigit SIC code dummy variables is significant if included in the regression models. Alternative robustness tests and specifications include analyzing collateral in a framework similar to the Table 1 difference testing; rerunning each of the collateral tests using personal collateral as the binary choice variable; employing the data weights provided in the survey; and using alternative multivariate model specifications. These alternative specifications include the explanatory variables: interaction ownership variables formed by taking the product of the various ownership variables; firm profit; term of the loan; size of 282 JOURNAL OF SMALL BUSINESS MANAGEMENT

11 Table 5 Logit Regressions to Determine If Banks Price Agency through Collateral Intercept 2.1** 2.6*** 2.7** 2.7*** 2.5** 1.9*** 2.7*** 2.3* (0.0502) (0.0169) (0.0199) (0.0142) (0.0196) (0.0695) (0.0104) (0.0615) BRAU 283 Ownership Variables Firm Manager is a Shareholder (0.3993) (0.2254) One Family Owns >50 Percent of the Firm (0.4473) (0.2091) Ownership Share of Primary Owner (0.5099) (0.5859) Log of the Number of Nonmanager Stockholders (0.3171) (0.5513) External Monitoring Variables Length of the Longest Banking Relationship (Years) (0.1108) (0.1281) Number of Banking 0.19*** 0.19*** Relationships (0.0066) (0.0081) Debt-to-Asset Ratio 0.51* 0.37 (0.0510) (0.1354) Control Variables Log of 0.22*** 0.24*** 0.24*** 0.26*** 0.26*** 0.16** 0.23*** 0.21*** Annual Sales (0.0015) (0.0008) (0.0008) (0.0007) (0.0004) (0.0271) (0.0011) (0.0099) Firm Age (0.9608) (0.8496) Regression Summary Statistics 2 Log Likelihood 11.7*** 11.5*** 11.4*** 11.9*** 15.2*** 19.2*** 16.3*** 30.2*** (0.0029) (0.0031) (0.0034) (0.0025) (0.0016) (0.0001) (0.0003) (0.0004) a Estimated coefficients are listed first; p-values below in parentheses. *indicates significance at the 10-percent level. **indicates significance at the five-percent level. *** indicates significance at the one-percent level.

12 the loan; the log of total assets; the firm s quick ratio; the firm s accounts receivable turnover ratio; an indicator variable that equals one if the firm has been denied credit within the past three years; and a personal collateral/guarantee indicator variable that equals one if personal collateral or guarantees are pledged. None of these additional tests suggest that banks price manager-owner agency costs. Summary and Discussion Summary The purpose of this paper has been to determine if banks price owner manager agency conflicts in the firms to which they extend loans. Whether banks price this type of agency cost is important to analyze because it directly tests the economic significance of owner manager agency conflicts on firm value. Due to their expertise in collecting information and monitoring borrowers, banks can be considered very sophisticated investors. If potential agency conflicts are to be detected, we expect them to be noticed by sophisticated investors. Thus, if potential agency costs are economically important and impact firm value, then banks should price them. I argue that this agency premium can come in the form of a rate increase or through the requirement of collateral. Ang, Cole, and Lin (2000) provide evidence that agency costs do exist in small businesses based upon varying ownership structures. I employ the same data source and similar methodology as Ang, Cole, and Lin (2000) to determine if banks charge a premium when extending loans to firms with varying ownership structures indicative of varying levels of owner manager agency costs. Subject to any limitations discussed in the paper, a series of empirical tests indicate that banks do not price agency as it pertains to firm ownership structure. Thus, the academic implication of this study is that when lending to small businesses, banks are not concerned with Jensen and Meckling (1976)-type ownermanager agency costs. Empirical tests do indicate that when lending to small businesses, banks are more concerned with banking relationships, the debt position of the borrowing firm, the size of the firm, and the age of the firm. Implications for Management Who cares about this and why should they care? This study should be of inherent interest to any finance researcher who is interested in principle-agent theory, so the implications as they relate to a nonfinancial audience are discussed here. As well as addressing the finance literature as discussed primarily in the introduction and theory sections, this paper speaks to at least two areas of the management literature organizational behavior and strategic management. The two fundamental research questions explored deal with the structure of the firm and its relationship to firm value. Inasmuch as researchers in the field of organization behavior study the impact of firm structure on firm value, theresults of this paper should be of interest. Specifically, this study documentstheimpactsofrelationshipsbetween the manager and owner, the impact of family ownership, and the impact of shareholder ownership structure on the value of the firm through bank loan costs. Those who study organizational behavior theory may find the specific results of this study interesting, as they are presented from a financial background. Although the paper is framed from a financial researcher s viewpoint, the topics of organizational structure and organizational behavior surely overlap. Conflicts in organizations are a central theme in the organizational behavior literature. These conflicts are at the heart of principle-agent conflicts and agency theory. An interesting question in the field of organizational behavior is What are the costs of these conflicts as they relate to firm value? This paper has attempted to answer this question (at least in part) by analyzing the 284 JOURNAL OF SMALL BUSINESS MANAGEMENT

13 agency conflict impact on firm value as determined by bank loans. Researchers in the field of strategic management may be interested in the strategy of developing banking relationships to decrease the cost of bank loans, thus increasing the value of the firm. One key research issue in this field may be the optimal strategy for minimizing the cost of bank debt. Is there an optimal number of banks with whom to establish relationships? For example, is it optimal to deal exclusively with one bank or with several banks? Although the results of my study suggest fewer banking relationships increase firm value, I do not attempt to find the optimal number of relationships. Future research may be profitable by exploring the implications of this paper from either of these two management perspectives. Below, I shift the implications of the study from those of a researcher to those of a practicing manager by discussing four specific practical implications. The first implication of the results for small business managers is that by considering these factors that impact (and do not impact) the interest rate and collateral requirements as they pertain to their own businesses, managers may be able to more accurately calculate their cost of capital. A more precise cost of capital will increase the accuracy of the firm s capital budgeting decisions when using techniques that require a discount rate (such as the net present value, profitability index, or discounted payback) or a hurdle rate (such as the internal rate of return). The adoption and rejection of projects is at the heart of financial management. With more precise capital budgeting decisions, firms have a greater probability of adopting wealth-increasing projects and rejecting wealth-destroying projects. Second, the results of this paper suggest that managers who interface with the bank have incentives to build strong relationships with the bank officials with whom they work. Managers should purposely attempt to build lasting banking relationships of trust with a few banks. Firms with longer banking relationships enjoy lower interest rates and firms with a large number of banking relationships have to pay higher rates. Thus it may be inferred that these relationships build firm value. Third, the results in this study indicate that banks do not significantly reward or punish borrowers through either interest rates or collateral requirements for various agency-cost management and ownership structures. An implication of this finding may be illustrated by an example. Suppose a manager is considering a hiring decision. She has narrowed her selection to two potential candidates. Candidate A seems to be marginally superior to Candidate B; however, Candidate B happens to be an insider (for example, a family member or a shareholder). The manager currently is searching for various margins to compare the two candidates. The manager may reason that if she hires the insider, the bank may believe that the potential for agency costs is decreased and as such may give more favorable loan terms. These favorable loan terms essentially increase the value of the firm. The results of this study indicate that the cost of bank loans (either through interest rates or collateral) should not be part of this decision. Whether an insider or outsider is hired as a manager of the firm, this study indicates that the bank is not concerned enough to price the decision. The implication of this finding suggests that (at least as it pertains to the cost of bank loans) the manager should hire the best qualified person for the job and should not attempt to use a strategy for obtaining less expensive bank financing by hiring an insider. Although the previous example may seem too hypothetical, an important extension of this implication is the impact of ownership-based compensation programs. Many firms attempt to enhance employee work effort by providing compensation programs that include stock options or other forms of ownership rewards. Although these types of compensation may enhance firm value elsewhere, the results of this study suggest that BRAU 285

14 this form of bonding does not impact the valueofthefirmsasdeterminedbythecost of bank loans. The final implication considers the ownership structure of the firm. The conclusions of the paper may be of interest to managers who are considering a restructuring of ownership. If the firm is currently structured as a C-corporation, whether a family owns more than 50 percent of the firm, the ownership share of the primary owner, or the number of nonmanager stockholders does not seem to impact the value of the firm as reflected in the cost of bank loans. Although the agency cost implications of the restructuring may be relevant in other areas of firm operations (a potential topic for future research), the manager should not weigh the cost of bank loans too heavily in the decision. References Ang, J.S., R.A. Cole, and J.W. Lin (2000). Agency Costs and Ownership Structure, Journal of Finance 55(1), Berger, A.N., and G.F. Udell (1995). Relationship Lending and Lines of Credit in Small Firm Finance, Journal of Business 68(3), Cole, R.A. (1998). The Importance of Relationships to the Availability of Credit, Journal of Banking and Finance 22(6 8), Federal Reserve Board s National Survey of Small Business Finances (NSSBF) (1995). Board of Governors of the Federal Reserve System and the U.S. Small Business Administration. Jensen, M.C., and W.H. Meckling (1976). Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, Journal of Financial Economics 3(4), Leeth, J.D., and J.A. Scott (1989). The Incidence of Secured Debt: Evidence from the Small Business Community, Journal of Financial and Quantitative Analysis 24(3), Petersen, M.A., and R.G. Rajan (1994). The Benefits of Lending Relationships: Evidence from Small Business Data, Journal of Finance 49(1), Smith, C.W., Jr. and J.B. Warner (1979a). Bankruptcy, Secured Debt, and Optimal Capital Structure: Comment, Journal of Finance 34(1), (1979b). On Financial Contracting: An Analysis of Bond Covenants, Journal of Financial Economics 7(2), Stulz, R.M., and H. Johnson (1985). An Analysis of Secured Debt, Journal of Financial Economics 14(4), JOURNAL OF SMALL BUSINESS MANAGEMENT

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