Economics of Small Business

Sixth Week

1. Some Theoretical Background

Introductory

• We will be concerned with some influences on the startups of small businesses and their continuation through the succession to new ownership and management

• Some theoretical topics we will need come from Human capital theory and learning by doingTransaction cost economics

andGame theory

Transaction Cost Economics

• This approach was developed roughly 1966-2009. • Oliver Williamson was honored by the 2009

Nobel for his contributions. • The key idea is that it may cost something to carry

out a transaction. • For example, the lawyers’ fees for writing up a

contract are one instance of transaction costs. • As a result, contracts are usually incomplete.

Opportunism

• Incomplete contracts may leave openings for opportunistic behavior by some parties to the contract.

• According to transaction cost economics, contracts and decisions are often shaped to avoid losses due to opportunism.

• Other instances of opportunism arise because of a certain kind of human capital.

• (We will clarify the meaning of “opportunism” a little later.)

Specific Human Capital

• Human capital is a familiar concept to any college student in economics!

• Some kinds of human capital cannot be transferred to another job or another company or another industry.

• This is specific human capital: job-specific, firm-specific, or industry-specific, as the case may be.

• Firm-specific or job-specific human capital may lead to opportunism.

Learning by Doing

• We know that human capital can be formed by studying.

• It can also be a by-product of working. • This is called learning-by-doing, and plays a big

part in determining labor productivity. • We will be concerned with firm-specific human

capital that is a product of learning-by-doing.

Game Theory

• The concept of opportunism in Transaction Cost Economics is a little vague.

• We can make it clearer by using game theory. • Noncooperative game theory discusses rational

choices by rational, self-interested agents who may be opportunistic.

An Example• Here is a simple example (not necessarily to do with small

or family business) just to illustrate the idea.

• It will be a game between a landlord and the tenant.

• The apartment needs painting.

• The tenant is a skilled painter.

• The landlord could put up the money and the tenant do the painting; and they would both be better off.

• However, the tenant might then take the money to Atlantic City and leave the apartment unpainted.

• It is easy to see that this would be opportunistic.

Tree Diagram• In game theory we

could express this as a “game in extensive form,”

• That is, as a decision tree.

• At 1 the landlord makes the decision to advance money or not.

• At 2 the tenant makes his decision.

The first payoff is to the landlord, the second to the tenant, on an arbitrary scale up to 10 for both.

Method• We have a method

for solving this sort of game to determine the “rational” equilibrium.

• It is called “backward induction.”

• First, solve the last stage.

• Then work backward.

Assume both players are ruthlessly self-interested.

Last Stage• At the last stage

(assuming the tenant is ruthlessly self-interested) the tenant will choose Atlantic City for 8 rather than 5.

• Thus the landlord expects a payoff of -5 if he advances the money.

Reduced Game• Thus, in effect, the

landlord is playing the one-person reduced game to the right.

• His best choice is: don’t advance the money.

• By this decision he avoids being a victim of opportunism.

Subgame Perfect

• The solution we have obtained is called a “subgame perfect Nash equilibrium.”

• It is a particular kind of Nash equilibrium – and there are other kinds.

• It is different, for example, from the more familiar “Prisoner’s Dilemma.”

• It does seem to capture the idea of opportunism.

2. Succession

The Succession Problem

• Many small businesses are family businesses – • Even when they are not, they often depend on a

single strong proprietor-manager –• A key problem for such a business is succession.• When the proprietor-manager retires or passes

away, who will succeed him, and how? • If this question cannot be answered, a useful and

successful business may be terminated.

Three Aspects

• There are three major aspects of succession that have been studied:1. Transition of management

2. Transition of ownership

3. Succession planning

• Succession of management may precede ownership succession.

• There may or may not be planning.

Example of Succession Planning

• (From the reading)• The owner-manager buys an insurance policy that

provides funds for a family foundation. • The foundation lends money to a successor owner-

manager. • Interest on the loan provides an income to the

owner-manager’s spouse or other survivor.

Impact of Planning

• “Common Sense” suggests that a succession plan is likely to give rise to a more satisfactory succession and may improve firm performance before the succession, since it provides certainty.

• The research literature is inconclusive on this conjecture.

Management Succession

• The reading focuses on transition of ownership. • We will first explore the management transition.• The two need not take place at the same time. • Transition of ownership may be delayed. • There may be a number of heirs who succeed to

ownership.• They may not agree on the new manager!

“Nepotism”

• Family members are often chosen as the successor.

• This is often attributed to non-pecuniary motives – or, to use a word with more negative associations, nepotism.

• (That negative word is usually not really appropriate for a family business).

• However, there is another important reason to appoint a family member.

Appropriation Risk

• The jargon term for this second reason is “appropriation risk.”

• We will illustrate it with a fictitious example.

Appropriation Risk Example 1

• Here is a fictitious example:– Smythe and Co. is a B2B business services company

that was managed for decades by the late Uncle Laszlo, but is now owned by a family-held corporation.

– The main asset of the company is “goodwill” in the form of a rolodex of the company’s past and probable future clients.

Appropriation Risk Example 2

– The family are considering whether to appoint Cousin James or Kevin, who is not related.

– Cousin James has a BBA degree from Podunk U, with a C- average, and is only a fair manager.

– Kevin has a Drexel BSBA with straight A’s and an excellent record in his previous job.

– Kevin’s outside option is a payoff of 10 (on an arbitrary scale.)

Appropriation Risk Example 3

– if Cousin James is appointed, the gross profits of Smythe and Co. will be 80, but if Kevin is appointed and manages the company for the foreseeable future, the gross profits will be 100.

– However, if Kevin acts opportunistically, he can steal the rolodex, set up his own company, and take away half of their business.

Decision Tree

Thinking it Through

• The payoffs are first for the family and second for Kevin, s is Kevin’s salary, and Kevin will not accept the position if his salary is less than10.

• Thus, the best the family can do is a payoff of 90, if Kevin accepts and does not act opportunistically.

• But once he has been appointed to the position, Kevin is better off to steal the rolodex if his salary is less than 50.

• In a world of capable opportunists, this is what the Kovaks family will expect that Kevin will do, so they appoint James for a family payoff of 80.

Economics of Organization, again

• If Kevin actually steals the rolodex, Kevin is appropriating it. That is the origin of the term appropriation risk.

• It is a central idea of the economics of organization that many business practices and contract forms are adopted in order to avoid or minimize the risk of losses due to opportunism.

• The worldwide practice of family management seems to be a case in point.

Game Theory Again

• As we saw, the decision tree would be known in game theory as a game in extensive form.

• The farsighted but pessimistic decision we just described is an instance of a subgame perfect Nash equilibrium in such a game.

Succession and Finance 1

• The reading “Succession financing in family firms” assumes that the objective is to transfer both management and ownership within the family.

• This (especially ownership transition) can impose financial costs that require some outside finance.

• For a variety of reasons, a small family firm is likely to prefer loans to equity issue.

Succession and Finance 2

• The reading explores this decision largely from an organization behavior perspective, but there are some important economic aspects considered as well.

• A questionnaire method is used, and the questionnaire responses are analyzed by a regression.

• The dependent variable is the proprietor’s intent to use debt to finance succession.

Succession and Finance 3

• This is a yes-or-no variable, so the study uses a logistic regression.– This is a regression that predicts the probability of a

yes.

• The predictor variables are– Personal factors of the proprietor

– Process factors of the transition itself

– Firm factors that may influence the raising of capital or the transition itself.

Personal Characteristics

• These are indicated by the proprietor’s answers to some of the questions in the questionnaire1. Attitude toward debt +

2. Risk aversion - (propensity +)

3. Financial knowledge +4. Experience with debt + (positive experiences)

Process Factors

• Indices developed from questionnaire responses:1. Need for family control -

2. Succession planning +

3. Prior experience with succession -

Firm Factors

• These are also self-reported on the questionnaire.1. Profitability -

2. Size

3. Growth +

4. Advisory board

5. Ownership dispersion

• Growth is + because a rapidly growing firm will have little capital available relative to current size.

Other Controls

• They also asked about the intention to use financial sources other than debt in the succession.

1. Family wealth

2. Retained earnings

3. Equity• The first two would have negative impacts, and

the third positive, according to the “pecking order hypothesis.”

Sample

• A sample of German firms with sales over 700,000 Euros was contacted.

• Of 2200 questionnaires sent out, 187 were returned and were usable. (This is quite common in this sort of research.)

• There are some possibilities of bias, arising (e.g.) from the fact that some questionnaire responses may be more accurate than others.

• Diagnostic tests indicated no problem.

Results

• The most important impacts seem to come from previous experience and the profitability and growth of the firm.

• Intention to use retained earnings was also an important predictor.

• All in all, the study predicts that the firm’s resources, both human and financial capital, have great impact on the financing decision.

3. “Cloning”

Startups

• The founders of many small businesses have experience as employees, and may draw on this experience as they found new businesses.

• (This needs not be opportunistic – no stolen rolodexes in this section!)

• What sorts of businesses are most likely to give rise to new foundations by their ex-employees?

• How does the previous experience influence the success of the start-up?

The Reading

• The reading used data from the Netherlands. • This data is very unusual in that it allows

employees to be linked to the firm they work for, year by year.

• Thus, it is possible to extract a sample in which an employee or employees of firm A have founded firm Z a year or two or three later.

Questions

1. Do larger or smaller firms spawn more startups?– Large firms may be bureaucratic and create

dissatisfaction among creative employees.

– Employees of small firms may get a wider range of experience.

– Overall, smaller firms don’t pay as well.

2. Do more successful firms spawn more startups?

3. Are firms spawned by successful firms themselves more successful?

Some Data

• Of about 300,000 firms just 20,000 “spawned.”• The study found that almost 20,000 firms had

“spawned” startups, and 24,000 startups were “spawned,” 1999-2004.

• Many more firms did not spawn startups. Accordingly, they chose as a control group a sample of 10% of non-spawning firms, comprising 28000 firms.

Variables

• Firm size was measured by the logarithm of total assets.

• Success was measured by sales growth and by return on assets.

• “Control” variables included the average wage as a proxy for the “quality” of the labor input.

• Other controls: “focus” on one industry, company age, and region region

Method

• Since the number of startups spawned cannot be a fraction, the study used a model that estimates the probability of 0, 1, … positives.

• It is the probability that varies according to the independent variables.

• The probability was assumed to be distributed as a “negative binomial” product.

We see how the average number of successes varies with r

Adjustment

• So the question is, how does r change as the independent variables change?

• Since the data include a very large number of zeros, that would imply a very small r.

• That might be right, but hard to estimate. • To adjust, we add one to every count of startups

spawned. • This is a “zero-inflated” estimate. • It works better.

Results

1. Bigger companies spawn more startups.

2. Financially unsuccessful firms spawn more startups. But this has relatively small impact.

3. Younger companies spawn more startups.

4. Firms that pay high average wages spawn more startups.

5. The tendency to spawn varies in a complicated way from industry to industry and region to region.

The Third Question• The study also ran regressions with the profitability of the

startup as a dependent variable and the profitability of the spawning firm among the independent variables.

• The study relied on corporate tax data to measure financial success.

• Thus, the study is limited to companies that paid corporate tax.

• This did not limit the study of the characteristics of spawning firms – presumably all paid corporate taxes – but the second part of the study was limited to startups that were successful enough to owe corporate taxes.

Result

• The study indicated that more profitable spawning firms were more likely to spawn financially successful startups.

• This is consistent with the idea that the employees of the financially successful startup firms learned more there, though it is possible that the spawning firm was more successful because it had better employees.

Summary• The founders of a small business will often draw on their

experience as employees in other firms. • Large, unprofitable firms give rise to more such foundations

than others. • However, the experience of working for a more profitable firm

seems to increase the chance of success. • The choice of a successor will often be within the family, in

the hope of avoiding opportunism. • This often implies a need for finance. • Here, too, learning by experience seems to play an important

role.