On Governance and Agency Issues in Small Firms

The study of small businesses has received limited attention by financial economists. This volume makes important strides in redressing this oversight. I believe that small businesses offer important research opportunities but also present substantial challenges. In this note, I discuss aspects of each. Small businesses are intrinsically interesting and important. They account for almost half the overall employment in the United States; moreover, over the last decade this sector has been responsible for two-thirds of new jobs. The juxtaposition of these two statistics highlights the important role that these firms play in terms of the dynamics of the larger economy. They are responsible for a disproportionate number of innovations--both in terms of new products and new processes. Someone with an innovative idea can capitalize on it by starting a small business to exploit the idea. And the more robust this sector, the larger the pool of experiments being undertaken and the more rapid the overall rate of innovation within the economy. Small businesses provide an important set of research opportunities for financial economists. It is useful to think of identifying those factors that are important determinants of corporate policy decisions as running a regression. The precision of economists' estimate of the impact of a factor such as operating risk on a decision like target leverage depends on the observed variation in the right-hand-side variable. This sector includes extreme examples of factors that are common to a broad range of companies. An obvious example is firm size. Although at some level, size is endogenous, researchers regularly treat it as predetermined; it frequently is important in explaining leverage, risk management, payout, board structure, and compensation policy decisions. This sector also includes firms that have high operating risk, that own assets that are quite firm specific, and that have low transparency. Small businesses frequently are closely held. By eschewing public capital markets, entrepreneurs maintain control and avoid regulatory burdens. These firms thus offer extreme observations on ownership concentration, and on the overlap between ownership and management. As a result, these firms tend to exploit leasing and risk-management opportunities more extensively than otherwise similar public firms. Finally, this sector includes richer variation in the choice of organizational form--corporation, limited liability corporations, partnerships--than is reflected in the firm populations that are more regularly studied. This variation provides potentially useful texture in our understanding of important firm policy choices. For all these reasons, data from small businesses substantially expand our range of observations and thus the power of our tests. Voordeckers, Van Gils, and Van den Heuvel (2007) offer a good example; they examine data that differs materially from that typically reported. They analyze 211 small and medium-sized Belgian firms. They examine the effects of firm size, firm age, life-cycle stage, and various characteristics of the CEOs and their families, in explaining the firms' board composition. Because this analysis employs Belgian data, it has the potential to make substantial contributions to our understanding of the role that the business environment plays in governance systems. To identify the impact of the legal system or the tax code, one must be able to observe decisions across legal and tax environments. The U.S. legal system evolved from the British common law; the Belgian legal system evolved from the Napoleonic Code. Tax law also plays a potentially important role in explaining observed board composition. For instance, in a U.S. family-owned corporation, family members would receive two checks--compensation as a return to labor services plus dividends as a return to capital ownership. Before the recent change in the taxation of dividends, both checks would be treated as ordinary income to the individuals but only compensation would be deductible to the corporation. …