Agency Conflicts and the Small Firm Investment Decision

Transcription

1 Agency Conflicts and the Small Firm Investment Decision Morris G. Danielson * St. Joseph s University Jonathan A. Scott Temple University Abstract This paper explains how agency conflicts and potential agency conflicts can influence the investment decisions of small firms, and provides evidence of these effects using data from a recent survey of small firm investment practices. The survey asks business owners to identify their most important investment concern over-investment or under-investment. We find that underinvestment concerns are more prevalent in growing firms, and those with concentrated ownership and control structures. Over-investment concerns increase as firms adopt less-concentrated ownership and control structures. These results suggest that the management challenges facing small firms shift as the degree of separation between ownership and control becomes greater. Keywords: small business, agency costs, capital budgeting We thank Clifford Smith, David Reeb, and participants at the 2005 Office Depot Small Business Research Forum for comments on previous versions of this paper. * Corresponding author: Erivan K. Haub School of Business, Saint Joseph s University, Philadelphia, PA 19131; Phone: (610) ; mdaniels@sju.edu.

2 Agency Conflicts and the Small Firm Investment Decision Introduction Agency conflicts can distort a firm s investment decisions if all ownership and control interests do not reside in one person (Jensen and Meckling, 1976). Although agency costs can affect both large and small firms, the initial separation between ownership and control typically occurs when a firm is still small. It is the owner of a closely-held small firm who will assess whether the benefits of expansion outweigh the agency costs growth might create. Then, once ownership and control are separate, the entrepreneur must establish planning and control systems, to reduce the costs of agency conflicts. In this paper, we use data from the 2003 National Federation of Independent Business Reinvesting in the Business Survey (NFIB survey) to explain how the management challenges facing small firms change as the degree of separation between ownership and control increases. Although the participants in the NFIB survey are all small privately-held companies, the survey includes firms with varying degrees of separation between ownership and control. The median number of employees for sample firms is 4, the mean is 9, and the maximum is 250. Thus, the survey includes firms where ownership and operating decisions are tightly linked, and others in which some operating decisions must be delegated. Almost 50 percent of the firms are proprietorships (or S corporations), almost 20 percent are partnerships (or LLCs), and over 30 percent are corporations. Therefore, approximately half of the firms have organizational structures in which more than one individual holds an ownership interest, creating potential agency conflicts. The NFIB survey asked business owners to identify their most important investment concern: under-investment, over-investment, or investing in the wrong projects. The empirical analysis in this paper focuses on those firms where the owner reports under-investment or over- 1

3 investment as the primary concern when reinvesting in the business. Our objective is to determine if business owner perceptions of these two potential problems shift as the degree of separation between ownership and control increases. We find that under-investment concerns are more frequent in firms with the mostconcentrated management and control structures, suggesting that potential agency costs contribute to the (real or perceived) capital constraints facing these firms. For example, banks may be hesitant to approve a loan before a firm has adequate planning and control systems in place. Under-investment concerns are also more common in firms pursuing growth strategies. In contrast, over-investment concerns tend to be more important in firms with lessconcentrated ownership and control structures. These firms are also more likely to use planning tools, such as written business plans. Thus, small-business owners recognize that the separation of ownership and control can lead to free cash flow problems. To control these agency costs, and to maintain financial flexibility, firms establish internal planning and monitoring systems. Two caveats must be kept in mind when interpreting the results. First, survey questions measure beliefs, rather than outcomes. For example, the firms identifying over-investment as a potential problem in this survey may not actually over-invest. Instead, concerns about overinvestment could lead to the implementation of planning and control systems designed to prevent the problem. 1 Second, the survey does not include financial statement information for participating firms. Thus, we cannot comment on how the over- and under-investment concerns we identify are related to the firms operating performance and investment activity. In addition, we cannot measure leverage without financial statement data, and therefore cannot discuss how underand over-investment concerns are related to conflicts between debt-holders and equity-holders. 1 Similarly, a driver concerned about speeding might pay attention to speed limits, reducing the likelihood of receiving a ticket. 2

4 Although data limitations constrain the scope of our analysis, the results nonetheless suggest that agency conflicts and potential agency conflicts affect a firm s investment decisions in different ways before and after the separation of ownership and control. This finding can motivate additional research into the question of how a small-business owner can best manage the transition from a concentrated to a less-concentrated ownership and control structure while pursuing growth strategies. Under- and Over-Investment by Small Firms It is well-known that agency conflicts can distort a firm s investment decisions, leading to either under- or over-investment. Typically, under-investment is said to occur if a firm does not invest in a positive net present value (NPV) project. Over-investment describes a scenario in which a firm not only selects all positive NPV projects, but also makes additional negative NPV investments. In this section, we develop hypotheses predicting when agency conflicts, and potential agency conflicts, will cause a small-business owner to be concerned about potential under- or over-investment. In each case, we motivate the discussion by focusing on unique characteristics of small businesses that may cause their behavior to differ from that of larger firms. The Degree of Separation between Ownership and Control The initial separation between ownership and control usually takes place when a firm is small. Thus, the risk of under- and over-investment by small firms could depend on the degree of separation between ownership and control. At its inception, the ownership and control of a firm are likely to be closely linked. Indeed, for some firms, all ownership and control interests are held by one person, mirroring the zero-agency-cost base case from Jensen and Meckling (1976). If a firm has a closely-held own- 3

5 ership structure and few employees (approximating the Jensen and Meckling base case), each new investment has the potential to create separation between ownership and control. For example, an entrepreneur must delegate decision-making authority as a firm expands, even though employees may not always act in the owner s best interests (Demsetz, 1983). Growth can also require external financing, bringing in new stakeholders (e.g., shareholders, partners, or lenders) who will have little control over day-to-day operating decisions. To minimize the costs of sub-optimal investment decisions, a firm must invest in decision hierarchies following the separation of ownership and control (Fama and Jensen, 1983). A decision hierarchy includes accounting, budgeting, and evaluation systems to monitor and constrain the behavior of the decision agents (i.e., the non-owner employees). Decision hierarchies can play an especially important role in controlling agency problems if the external market for corporate control cannot effectively monitor the firm, as is often the case for small, privatelyheld firms (Jensen and Ruback, 1983). Although decision hierarchies can be necessary to align manager and shareholder interests, these systems cannot eliminate all agency problems (Jensen, 1993), and they impose substantial administrative costs on a firm. Ang, Cole, and Lin (2000) find that such costs increase with the degree of separation between ownership and control. If ownership and control are closely-linked, and if the costs required to control agency conflicts are sufficiently high, a firm may forego projects that would introduce agency conflicts into the firm. The desire to avoid agency costs will be especially strong in firms where wealth maximization is not the owner s primary goal. As Keasey and Watson (1993, p. 228) observe, an entrepreneur may establish a firm as an alternative to unemployment, as a way to avoid employment boredom, or as a vehicle to develop, manufacture, and market inventions. Such firms may voluntarily limit their investments and growth because agency conflicts would reduce the 4

6 entrepreneurs ability to pursue these life-style goals. Indeed, McMahon (2003) concludes that under-investment is most frequent in life-style businesses. Even if profit maximization is the owner s primary goal, the potential benefits from expansion may not exceed the agency costs growth might create for the firm. Thus, potential agency costs could encourage a firm with a concentrated ownership and control structure to bypass a promising project, and lead to underinvestment. This possibility is hypothesis H.1. H.1. Small business owner concerns about under-investment will increase as a firm s ownership and control structure becomes more concentrated. If a firm decides to expand, it can benefit from better operating and investment decisions by delegating decision-making authority to agents with decision-specific knowledge (Fama and Jensen, 1983, p. 322). However, this separation between ownership and control can create agency conflicts between a firm s managers and owners. For example, non-owners with decision-making authority could promote excessively optimistic projections of a project s benefits (because the decision-agent s personal wealth is not at stake), perhaps leading to over-investment (Jensen, 1986, and Ang, 1991). To reduce the risk of over-investment, the firm will establish internal budgeting and monitoring systems. These ideas are hypotheses H.2. and H.3. H.2. Small-business owner concerns about over-investment will increase as a firm s ownership and control structure becomes less concentrated. H.3. Small-business owner concerns about over-investment will be positively related to the use of planning tools. Capital Constraints and Financial Flexibility Two recent studies suggest that financial slack can influence a firm s investment and financing decisions. Graham (2000) shows that firms often use financial slack to fund future expansion. Using survey data, Graham and Harvey (2001) find that the most important factor af- 5

7 fecting the use of debt is the desire to preserve financial flexibility. Because many small firms face capital constraints (e.g., Peterson and Rajan, 1994 and 1995; Cole, 1998; and Danielson and Scott, 2004), the desire to preserve financial flexibility can be especially important to small business owners. The capital constraints facing small businesses arise, to a large extent, from the firms information-opaqueness. For example, some small firms have limited operating histories while others lack formal planning and reporting systems. In each case, it can be difficult for a bank to evaluate the business owner s management skills, and to assess the owner s representations about future plans. Unless a bank can obtain sufficient information to evaluate the risk of a loan, it may limit the amount of credit extended to a firm. In the immediate period, capital constraints make it difficult for a small business to finance all available projects. If a firm cannot raise sufficient capital to make essential investments, it could incur the costs created by under-investment, such as the loss of key customers or market share. However, even if a business can raise capital currently, most small firms cannot raise an unlimited amount of capital. Therefore, the entrepreneur should not make investment decisions today without also considering the financing requirements of potential future projects (Hawawini and Viallet, 2002). If future projects could be more profitable than the ones available today, the firm may want to limit the amount invested today (i.e., avoid over-investment), so as to preserve financial slack. Depending on when the firms most important investments must be made, one capital-constrained firm might be more concerned about under-investment (if these investments must be made currently), while another capital-constrained firm might be more concerned about over-investment (if the most important investments will be made in future years, making it essential for the firm to preserve financial slack). Thus, concerns about both under- 6

8 and over-investment could decrease (increase) as the firm becomes more (less) creditworthy. These ideas are summarized in hypotheses H.4. and H.5. H.4. Small business owner concerns about under-investment will decrease as the creditworthiness of the firm increases. H.5. Small business owner concerns about over-investment will decrease as the creditworthiness of the firm increases. Growth Opportunities The under- and over-investment concerns of a small-business owner could also be related to the composition of the firm s assets. In Myers (1977), the presence of debt could cause a firm to bypass positive NPV projects in certain future outcomes. Because the NFIB survey does not contain information about a firm s use of leverage, we cannot directly test Myers hypothesis linking under-investment, growth, and leverage. However, if lenders believe that the use of debt could distort a firm s future investment decisions (as in Myers, 1977), this factor could increase the cost of debt for small firms pursuing growth strategies. If so, small firms with growth opportunities may be unsure of their ability to obtain sufficient funds at a reasonable cost, leading to under-investment concerns. This is hypothesis H.6. H.6. Small business owner concerns about under-investment will be most frequent in firms with growth opportunities. If a firm does not have growth opportunities, business owners may focus on preventing over-investment. In Jensen (1986), non-owner managers use free cash flows (defined as cash flows in excess of the amount necessary to fund all positive NPV investments) to fund negative NPV projects that fulfill the managers personal agenda, but do not necessarily promote shareholder wealth maximization. Thus, firms without growth opportunities will be more concerned about over-investment, as stated in hypothesis H.7. 7

9 H.7. Small business owner concerns about over-investment will be most frequent in firms without growth opportunities. Data The NFIB survey was collected by the executive interviewing group of The Gallup Organization. The interviews for this survey were conducted between April 3 and May 27, 2003 from a sample of small employers, defined as a business employing at least one individual in addition to the owner(s), but no more than 250. The sampling frame used for the survey was drawn from the files of the Dun & Bradstreet Corporation (an imperfect file, but the best currently available for public use). Because the distribution of small businesses is highly skewed when ranked by the number of employees, interview quotas were used to increase the number of larger firms in the sample. Once the data were compiled, the responses were weighted to reflect the population proportions in U.S. Census data, yielding a sample of 792 observations. Description of Sample Firms The demographic characteristics of the sample industry, sales growth, business age, employment, form of business, owner education, and owner age are summarized in Table 1. As shown in Table 1, the sample firms have a wide range of ownership and control structures. Almost 50 percent of the sample firms are proprietorships or sub-s corporations, where conflicts between ownership groups should be rare. However, almost 20 percent of the sample firms are partnerships (or LLC corporations), and over 30 percent are corporations. Thus, conflicts between ownership groups could arise in many sample firms. Although all sample firms are small, the size of firms (in terms of employees) is spread over a wide range. Forty-five percent of the sample firms have three or less employees, but 18 8

10 percent have 10 or more employees. Because it is more difficult for owners to monitor employees in larger firms, agency conflicts between owners and employees could arise in a sizeable portion of the sample. Key Survey Questions In addition to the firm characteristics listed in Table 1, the NFIB survey contains several other questions we use in this study. To measure owner concerns about over- and underinvestment, we use responses to the question Is the greatest long-term concern about reinvesting in your business possible over-investment, possible under-investment, or possible investment in the wrong things? One limitation of this survey is that it did not specifically define under-investment and over-investment. Thus, these terms may not have been defined in the same way by all survey respondents when answering this question. For example, some participants may have defined under-investment as bypassing a positive NPV project. Others may have defined it as simply being unable to make desired investments. Similarly, some of the business owners may have defined over-investment as the selection of a negative NPV project, while others could have defined it in a less technical manner. For instance, some business owners might define overinvestment as the selection of a project that reduces a firm s available capital, making it difficult for the firm to make future investments. Because less than 15 percent of the firms in this survey use discounted cash flow methods to evaluate new projects (Danielson and Scott, 2005), it is unlikely that many of these business owners defined under- and over-investment in terms of project NPV. Thus, we adopt the less technical definitions of under- and over-investment when interpreting the results. 9

11 Because the firms in the survey are not publicly traded, we cannot use market prices to estimate the value of a firm s growth opportunities. 2 However, the historical growth rates listed in Table 1 provide some insight about whether a firm is following a growth strategy. In addition, survey participants reveal... the purpose of the largest share of the investments made in the business over the last 12 months. Responses to this question included replacement and maintenance, extension of existing product line or service lines, expansion into new business areas, and safety or environmental improvement. We classify firms answering extension or expansion as growth firms. To measure the sophistication of a firm s planning environment, we use answers to the following questions. Do you typically make cash flow projections prior to making MAJOR investments in your business? And, Do you have a written business plan projecting the MAJOR investments you plan to make in your business over the next few years? For these questions, a MAJOR investment was defined as... an investment or series of investments where the total purchase price amounts to around 5 percent or more of your annual gross receipts. We use responses to two questions to identify owners who are averse to borrowing. We classify a firm as being averse to borrowing if the owner answered not appropriate to borrow for business investment to the question Which BEST describes when it is appropriate to borrow to make a business investment? Similarly, an owner is averse to borrowing if the answer wait until you accumulate enough cash was chosen in response to Suppose you had the opportunity to make an investment in your business that would allow earnings to rise 25 percent within the next two years. The project had minimal risk, but you did not have the cash right then to make the investment. What would you most likely have done? 2 In studies using large publicly traded firms, the value of a firm s growth opportunities is often estimated using the firm s market value to book value ratio. This proxy cannot be used in studies covering small, privately-held firms. 10

12 Data Limitations The NFIB survey was designed to identify a broad set of factors that affect small firm investment decisions, and includes questions about the owners attitudes toward borrowing, the firms planning environment, and the goal of the firms recent investments (e.g., replacement versus expansion). Although a number of these questions are related to agency conflicts and their potential affect on small firm investment decisions, the survey was not designed around this issue. Thus, data limitations constrain the scope of our analysis, as discussed in this section. For example, the NFIB survey does not ask participants for financial statement data. 3 Without financial statement data, we cannot identify the relations between the business owners under- and over-investment concerns and the firms operating performance and capital expenditures. The absence of financial statement data also makes it impossible to measure the firms use of leverage. Thus, we cannot comment on how the business owners under- and over-investment concerns are related to potential agency conflicts between debt-holders and equity-holders. The NFIB survey also does not include the firms credit ratings. Without this information, we cannot directly measure creditworthiness when evaluating hypotheses H.4 and H.5. Instead, we use firm size (number of employees) and age as proxies for creditworthiness, where younger and smaller firms face the tightest credit constraints (see Cole, 1998, and Cole, Goldberg, and White, 2004). By doing so, we create an artificial conflict between hypotheses H.2 and H.5. When size is used to measure creditworthiness, H.5 predicts over-investment concerns will be lower in large firms because these firms do face less stringent capital constraints. In contrast, 3 Small privately-held firms are generally reluctant to provide income statement and balance sheet information, and often do not have audited financial statements to support their answers. In other surveys conducted by the NFIB, limited financial information is requested (e.g., annual revenues), but the number of no answer responses can be quite high. The Board of Governors of the Federal Reserve System has a similar problem with their periodic Survey of Small Business Finance. Although extensive financial information is solicited in the telephone surveys, there are many non-responses, and inconsistent (or missing) data are interpolated using an internal algorithm. 11

13 H.2 implies that over-investment concerns will be greatest in larger firms because these firms have more severe agency problems. However, H.2 and H.5 do not inherently conflict, and the acceptance of one hypothesis should not necessarily lead to the rejection of the other. Although the empirical relation between firm size and over-investment concerns provides information about which effect might be stronger, it cannot fully discriminate between the two hypotheses. Because of these limitations, our study is best viewed as an exploratory analysis. Nonetheless, the data include information about small business owner perceptions not available elsewhere. Thus, our results highlight owner attitudes and motivations that help shape the firms investment and financing decisions. Empirical Analysis to H.7. This section reports the results of empirical procedures we use to evaluate hypotheses H.1 Descriptive Statistics In Table 2, we compare the characteristics of firms reporting under-investment as the primary investment concern, to the characteristics of those selecting over-investment. Panel A shows how under- and over-investment concerns are related to five dimensions of the ownership and control structure: organizational form, size (number of employees), owner education, owner age, and a variable measuring the degree of separation between ownership and control. A more concentrated ownership and control structure is defined as a proprietorship or Sub-S corporation with three or less employees; a less concentrated ownership and control structures is defined as a corporation with ten or more employees; the other concentrated ownership and control group includes firms with more than three employees organized as proprietorships or S- 12

14 corporations, and firms with fewer than 10 employees organized as corporations. Panel B describes the firms planning environment, Panel C identifies the percent of these firms reporting borrowing aversion, and Panel D includes information about the firms industry, sales growth, and years in business. The majority of small business owners are not concerned about either under- or overinvestment. As reported in Table 2, 19 percent of survey participants selected under-investment as their most important investment concern, while 23 percent chose over-investment. Thus, 58 percent of the small business owners are most concerned about simply selecting the correct projects. This result suggests that most of the owners are confident in their ability to fund worthwhile projects when available, and can separate the investment and financing decisions. Under-investment concerns are less frequent in corporations, larger firms (10 or more employees), older firms, and firms with less-concentrated ownership and control structures. Because of their size, age, and organizational form (limited liability for shareholders makes it easier for corporations to raise capital), these firms are less likely to face immediate capital constraints that would force under-investment. In contrast, concerns about under-investment are most prevalent in smaller firms, partnerships, younger firms, and firms with recent investments to expand or extend product lines (i.e., firms following a growth strategy). The organizational form with the highest frequency of under-investment concerns is partnership. Because each partner shares joint liability for the actions of other partners, it may be difficult for these firms to gain internal approval for capital expenditures and borrowing agreements, potentially leading to under-investment. Not surprisingly, under-investment concerns are much lower in LLCs, as partners in LLCs do not share joint unlimited liability. 13

15 As agency theory suggests, over-investment concerns are most frequent in corporations, larger firms, and firms with less concentrated ownership and control structures. In some of these firms, it may be possible for an employee to advocate projects that increase the employee s human capital, but do not increase shareholder wealth. This is the traditional over-investment problem explained in Jensen and Meckling (1976). For small firms though, the possibility of future capital constraints creates a second type of over-investment the firm must guard against. In particular, the firm must avoid spending all of its resources on marginal projects in one period, if better opportunities might develop in the future. Thus, it is not surprising to find that the firms most concerned about over-investment are also most likely to use business plans, as planning and control systems can help prevent this type of over-investment. Over-investment concerns are also strongly related to the owner s education level; owners with less (more) formal education report over-investment concerns more (less) frequently. Owners with more formal education (especially if this education includes courses in business planning or accounting) may be better prepared to handle the multi-period budgeting problem capital constrained small firms face, reducing the risk of over-investment. Firms reporting over-investment concerns are more likely than other firms to say that they would wait for cash before making an investment. If the firm wants to maintain financial flexibility in case more promising opportunities emerge in the future (i.e., it wants to avoid overinvestment), it may wait for cash before investing in a less promising project today. Multivariate Analysis In Tables 3 and 4, we identify the characteristics of firms selecting under- and overinvestment as the primary investment concern using logistic regressions. In Table 3, we define the dependent variable as those firms identifying under-investment as the primary investment 14

16 concern (this variable is equal to 1 if the firm is concerned about under-investment, and is equal to 0 otherwise). In Table 4, we define the dependent variable as those firms identifying overinvestment as the primary investment concern (this variable is equal to 1 if the firm is concerned about over-investment, and is equal to 0 otherwise). In each case, the explanatory variables include firm characteristics listed in the rows of Table 2 (for categorical variables using dummy variables, we omit one category in the regressions). In columns (1) and (2) of both tables, we include form of business and number of employees as explanatory variables, and omit the variables measuring the concentration of ownership and control. In columns (3) and (4), we replace form of business and number of employees with the variables measuring concentration of ownership and control. More concentrated ownership and control structure takes a value of 1 if the firm is a proprietorship or Sub-S corporation and has 3 or less employees, and is 0 otherwise. Less concentrated ownership and control structure takes a value of 1 if the firm is a corporation with 10 or more employees, and is 0 otherwise. Other concentrated includes firms with more than three employees organized as proprietorships or S-corporations, and firms with fewer than 10 employees organized as corporations. Because partnerships can face a unique set of agency problems (Fama and Jensen, 1983), we exclude firms organized as partnerships and LLCs from the regressions in columns (3) and (4). In columns (1) and (3), we measure growth using the firm s sales growth rate over the past two years. In columns (2) and (4), we identify the firm as a growth firm using a binary variable that takes the value 1 if the firm has made recent investments to expand or extend product lines. The estimates in Table 3, columns (1) and (2), suggest that concerns about underinvestment tend to be isolated in partnerships and smaller firms. The coefficient for partnerships in these columns is positive and significant. The category for 3 or less employees is omitted in 15

17 these columns, but the coefficients for the two larger size groups are negative and significant. Thus, concerns about under-investment decrease as firm size increases. Because small firms may be less likely to be approved for bank loans (Cole, 1998), it is not surprising that many of these firms are concerned about under-investment. This result supports hypothesis H.4. The estimates in columns (3) and (4) of Table 3 show that under-investment concerns are more frequent in firms pursuing growth strategies. The coefficients for both growth variables are positive and significant, providing support for H.6. The owner of a firm pursuing a growth strategy is likely to be concerned about the firm s ability to make critical investments on a timely basis, and this contributes to the under-investment concerns identified in the NFIB survey. 4 Under-investment concerns are slightly more common in firms with concentrated ownership and control structures, but the coefficient is only significant in column (4). This result provides weak support for hypothesis H.1. Table 4 reveals that over-investment concerns are most prevalent in corporations, larger firms, and those with less concentrated ownership and control systems. The coefficients for proprietorships, partnerships, and LLCs are all negative (and the coefficients for proprietorships and partnerships are significant), implying that over-investment is positively related to the omitted category, corporations. The coefficient for large firms (11 or more employees) is positive and significant in columns (1) and (2). In columns (3) and (4), the coefficients for the more concen- 4 The omission of a control variable for leverage could cause the growth coefficients to be understated (less positive), as it is the interaction between growth and leverage that creates under-investment (Myers, 1977), not growth opportunities alone. Wooldridge (Chapter 4, 2002) shows that the direction of the bias created by an omitted variable will have the same sign as the product of two correlations: 1) the correlation between the omitted variable (in this case leverage) and the dependent variable (under-investment concerns); and 2) the correlation between the omitted variable (leverage) and an included variable that is correlated with the omitted variable (in this case, growth opportunities). The correlation between the omitted variable, leverage, and under-investment concerns is likely to be positive (because firms with outstanding debt may not have sufficient financial flexibility to fund available projects), while the correlation between growth opportunities and leverage is likely to be negative (Myers, 1977). The product of these two correlations is negative, indicating that the coefficient for growth opportunities in regressions explaining under-investment may be biased downward if a control variable for leverage is omitted. 16

18 trated ownership and other ownership categories are both negative. This implies a positive relation between the less concentrated ownership category and concerns about over-investment. These results show that concerns about over-investment do not decrease as creditworthiness increases (as measured by firm size), in conflict with H.5. Instead, overinvestment concerns appear to become more prevalent in firms with less concentrated ownership and control structures (e.g., corporations and larger firms), as predicted by hypothesis H.2. As in Table 2, the Table 4 results show that firms concerned about over-investment are more likely to use a business plan, in support of hypothesis H.3. In each column, the coefficient for this variable is positive and significant. Over-investment concerns are negatively related to the growth variables in columns (3) and (4), as expected. Thus, over-investment concerns are slightly more likely to arise when a firm does not have growth opportunities, making free cash flow problems possible. However, these coefficients are not significantly different from zero. Thus, the results do not provide support for H.7. 5 Several of the control variables in the Table 4 regressions are significant, confirming results suggested by the descriptive statistics in Table 2. The coefficient for wait for cash is positive (and significant) in each column; the coefficient for will not borrow is negative in each column and is significant in column (2). Over-investment concerns are concentrated in firms with the lowest education level (the coefficients for college and grad school are both negative 5 The omission of a control variable for leverage may cause the growth coefficients to be overstated (the coefficients should be more negative). Firms without growth opportunities are most likely to over-invest when the firm has free cash flows (i.e., it does not have debt outstanding). Thus, it is the interaction between (the absence of) growth and leverage that creates over-investment, not (the absence of) growth opportunities alone. To view this potential bias another way (following footnote 4), the correlation between leverage and over-investment is likely to be negative (because firms with outstanding debt will have lower free cash flows; Jensen, 1986), as is the correlation between growth opportunities and leverage (Myers, 1977). The product of these terms is positive, indicating that the coefficient for growth opportunities in regressions explaining over-investment is likely to be biased upward when a control variable for leverage is omitted. However, without data on leverage, we cannot determine whether this potential bias is large enough for us to have incorrectly rejected H.7. 17

19 and significant) and older owners (the coefficients for the three listed categories are all negative and significant). Table 5 summarizes the empirical results for each of the hypotheses. Conclusions When the ownership and control of a small firm are closely linked, each new investment has the potential to introduce agency conflicts into the firm. For example, the expansion of a firm s operations can require decision-making authority to be delegated to employees, creating agency conflicts between employees and owners. Or, new investments can require external financing from third parties. If so, agency problems can develop between the entrepreneur and other equity-holders, or between debt- and equity-holders.. These agency conflicts or the desire to avoid the costs of such conflicts can complicate the investment decisions of small firms. If a firm has a closely-held ownership and control structure, potential agency conflicts can raise the direct and indirect costs of external funds, increasing the risk of under-investment. Once growth has created a separation between ownership and control, the entrepreneur must establish planning, approval, and monitoring systems, to guard against the possibility that employees will advocate inappropriate (or unnecessary) projects. Thus, many small firms must choose between accepting more stringent (voluntary or involuntary) capital constraints perhaps leading to under-investment and incurring the costs necessary to control agency costs. Our results suggest that many small business owners implicitly understand this trade-off. As a firm s ownership and control structure becomes less concentrated, the importance of overinvestment (relative to under-investment) increases as a management concern. In addition, firms are more likely to use business plans in this circumstance. 18

20 However, because of data limitations, our results also leave a number of important questions unanswered. For example, Table 2 reveals that over 70 percent of the business owners with less-concentrated ownership and control structures are not concerned about over-investment. It is possible that these firms have adequate internal controls in place, and have sufficient financial resources for the immediate future. But, it is also possible that some small business owners do not appreciate the problems that can arise when ownership and control are separate. Information about the firms operating performance and their use of leverage would be necessary to distinguish between these possibilities. In addition, we cannot comment on how under- and overinvestment concerns are related to agency conflicts between debt- and equity-holders because the data do not include information about the firms use of leverage. Nonetheless, our results suggest that agency conflicts and potential agency conflicts affect a firm s investment decisions in different ways before and after the separation of ownership and control. Once a small firm crosses the threshold, and adopts a less-concentrated ownership and control structure, direct and indirect agency costs complicate the policy choices the firm must make. For example, what should an internal planning and control structure look like for a firm with 10 or 20 employees? What tools should entrepreneurs use to weigh the (direct and indirect) costs and benefits of growth? What is the optimal mix of debt and external equity for small, growing firms? Finally, if a firm issues debt, what maturity structure will minimize agency conflicts and maximize the firm s financial flexibility? Although the existing literature provides business owners with some guidance about each of these questions, future research could tailor these prescriptions to more directly address the unique challenges a small firm faces as it makes the transition from a concentrated to a less-concentrated ownership and control structure. 19

21 References Ang, J., On the theory of finance for privately held firms, The Journal of Small Business Finance 1 : Ang, J., R. Cole, and J. Lin, Agency costs and ownership structure, Journal of Finance 55, Cole, R., The importance of relationships to the availability of credit, Journal of Banking and Finance 22, Cole, R., L. Goldberg, and L. White, Cookie cutter vs.character: The micro structure of small business lending by large and small banks, Journal of Financial and Quantitative Analysis 39, Danielson, M. and J. Scott, Bank loan availability and trade credit demand, Financial Review 39, Danielson, M. and J. Scott, The capital budgeting decisions of small businesses, working paper. Demsetz, H., The structure of ownership and the theory of the firm, Journal of Law and Economics 26, Fama, E. and M. Jensen, Separation of ownership and control, Journal of Law and Economics 26, Graham J., How big are the tax benefits of debt? Journal of Finance 55, Graham J. and C. Harvey, The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics 60, Hawawini G. and C. Viallet, Finance for Executives, Southwestern. Jensen, M Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review 76, Jensen, M The modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance 48, Jensen, M. and W. Meckling, Theory of the firm: managerial behavior, agency costs, and capital structure. Journal of Financial Economics 3,

22 Jensen, M. and R. Ruback, The market for corporate control. Journal of Financial Economics 11, Keasey K. and R. Watson, Small Firm Management: Ownership, Finance and Performance, Oxford: Blackwell. McMahon, R., An exploratory study of under- and over-investment amongst manufacturing SMEs from Australia s business longitudinal survey, International Small Business Journal 21, Myers, S., Determinants of corporate borrowing. Journal of Financial Economics 5, Petersen, M. and R. Rajan, The benefits of firm-creditor relationships: Evidence from small business data, Journal of Finance, 49, Petersen, M. and R. Rajan, The effect of credit market competition on lending relationships, Quarterly Journal of Economics, 60, Wooldridge, J.M. 2002, Econometric Analysis of Cross Section and Panel Data, MIT Press, Cambridge MA. 21

23 Table 1: NFIB Investing in the Business Survey - Sample Description The data are compiled from the Reinvesting in the Business Survey sponsored by the National Federation of Independent Business. There were 792 respondents to the survey. DK/NA denotes "Don't Know/No Answer". No. of % of No. of % of Obs Total Obs Total Industry Form of business Service Proprietorship Construction Sub-S corporation Retail/Wholesale Partnership 67 8 Other, DK/NA 65 8 LLC Corporation Real sales growth (2 yr) DK/NA percent percent Owner education level +/- 10 percent Less than college degree Fell 10+ percent College degree DK/NA 32 4 Advanced/prof. Degree DK/NA 12 2 Business age < 6 years Owner age 6-10 years < 35 years years years years years DK/NA years DK/NA 17 2 Employment

24 Table 2 Under- and Over-investment Concerns The column labeled "Under-investment Concern" consists of the 150 respondents (19 percent of the total) who reported that under-investment was their greatest long-term investment concern while "Over-investment Concern" consists of the 181 respondents (23 percent of the total) who reported that over-investment was their greatest longterm investment concern. The percentages reported in each column are the percent of the total responses for that characteristic that report under- or over-investment. For example, 22.2 percent of all firms that reported 1-3 employees said that under-investment was the greatest concern. Panel A presents the independent variables that are proxies for ownership and control; Panel B the proxies for planning sophistication; Panel C the proxies for borrowing aversion; and Panel D other firm characteristics. Underinvestment Over- Investment Underinvestment Over- Investment Concern Concern Concern Concern Panel A: Ownership and Control Organizational Form Proprietorship/Sub-S corp Panel B: Planning Sophistication Use Business Plan Partnership Make Cash Flow Forecasts LLC Corporation Panel C: Borrowing Aversion Wait for cash Employment Will not borrow Panel D: Other Firm Characteristics Industry (NAICS) Concentration Service More (Prop/S-corp <=3 FTE) Construction/Manufacturing Less (Corporation >=10 FTE) Retail/Wholesale Other* Other Owner education level Growth Opportunities Less than college degree Real sales growth > 20% College degree Expand/extend CAPX Advanced/prof. Degree Business age Owner age < 10 years <35 years Over 10 years years years years * Proprietorship and S-corporations with more than 3 employees or corporations with fewer than 10 employees

25 Table 3 Multivariate Results: Under-investment Concern The dependent variable takes a value of 1 if the owner reports under-investment is the greatest long-term investment concern and 0 otherwise. Logistic regression is used to estimate the equations. Equations (3) and (4) replace form of business and number of employees with a combined variable that is a proxy for concentration of ownership. 'More concentrated' takes a value of 1 if the firm is organized as a proprietorship or S-corporation and has under three employees; 'less concentrated' takes a value of 1 if the firm is organized as a corporation and has 10 or more employees. 'Other concentrated' includes firms organized as a proprietorship or S-corporation with more than three employees, or organized as a corporation with fewer than 10 employees. Firms organized as partnerships and LLCs are excluded from Equations (3) and (4). In each case where there is a set of 1/0 variables for the independent variable, the omitted variable is identified and significance should be interpreted relative to this omitted variable. *** indicates significance the.01 level, ** significance at the.05 level and * significance at the.10 level. (1) (2) (3) (4) Coeff Std Err Coeff Std Err Coeff Std Err Coeff Std Err Proprietorship/S-corp Partnership *** *** LLC Corporation (omitted) Employees:1-3 (omitted) Employees: Employees: *** *** More concentrated * Other concentrated Less concentrated (omitted) High real sales growth * *** Expansion CAPX * Cash flow projection made Business plan prepared Will not borrow Wait for cash Years in business: <=10 (omitted) Years in business: >10 years College graduate Graduate school Less than college (omitted) Owner age: under 35 yrs Owner age: yrs ** ** * ** Owner age: yrs Owner age: 55+ (omitted) Industry: manufacture/const ** ** Industry: retail/wholesale Industry: other (omitted) Constant *** *** *** *** No. of observations Pseudo r-squared

26 Table 4 Multivariate Results: Over-investment Concern The dependent variable takes a value of 1 if the owner reports over-investment is the greatest long-term investment concern and 0 otherwise. Logistic regression is used to estimate the equations. Equations (3) and (4) replace form of business and number of employees with a combined variable that is a proxy for concentration of ownership. 'More concentrated' takes a value of 1 if the firm is organized as a proprietorship or S-corporation and has under three employees; 'less concentrated' takes a value of 1 if the firm is organized as a corporation and has 10 or more employees. 'Other concentrated' includes firms organized as a proprietorship or S-corporation with more than three employees, or organized as a corporation with fewer than 10 employees. Firms organized as partnerships and LLCs are excluded from Equations (3) and (4). In each case where there is a set of 1/0 variables for the independent variable, the omitted variable is identified and significance should be interpreted relative to this omitted variable. *** indicates significance at the.01 level, ** significance at the.05 level and * significance at the.10 level. (1) (2) (3) (4) Coeff Std Err Coeff Std Err Coeff Std Err Coeff Std Err Proprietorship/S-corp * * Partnership ** ** LLC Corporation (omitted) Employees:1-3 (omitted) Employees: Employees: More concentrated * * Other concentrated Less concentrated (omitted) High real sales growth Expansion CAPX Cash flow projection made * Business plan prepared *** *** *** *** Will not borrow * * Wait for cash * ** * ** Years in business: <= 10 (omitted) Years in business: >10 years ** ** ** ** College graduate *** *** * * Graduate school *** *** *** *** Less than college (omitted) Owner age: under 35 yrs ** ** ** ** Owner age: yrs ** *** *** *** Owner age: yrs * ** ** ** Owner age: 55+ (omitted) Industry: manufacture/const Industry: retail/wholesale Industry: other (omitted) Constant No. of observations Pseudo r-squared