Agency Theory & Small Businesses

Background:
Agency theory (Jensen & Meckling 1976) has provided useful insight into the financial dealings between an enterprise (principal) and its stakeholders (agents). It is unlikely that the economic interests of these parties will be exactly the same because it is human nature to maximise one’s own benefit even at the expense of others. (Peacock, p278) Question:
Explain how agency theory may be applied in explaining the relationship between small business and a financial institution. Include, as part of the discussion, an explanation of the costs and benefits of the relationship that may be attributable to the existence of an agency relationship. (2500 words).

Around 96% of businesses in Australia are small businesses. The funds needed to run a small business are typically provided by large financial institutions, which are involved in the supplementation of business loans. By borrowing money from a financial institution an agency relationship is created between the lender and the borrower. By lending money to a small business, the financial institution assumes the role of the principal, authorizing the owner of the small business to act on behalf of the bank, and thus taking on the role of the agent. This however can lead to conflicts between the two parties as often the economic interests between the bank and the owner-manager often differ.

Agency Theory can be applied to such a relationship, to help understand and potentially resolve conflicts of issue that may arise. A small business is defined by its size, that fact that it is independently owned and controlled by the owner, and where the owner-manager is the decision maker for all critical management decisions, who also takes the responsibility to carry the risk involved in the venture (Peacock, 2004). Small businesses range from individual- or family-owned retail outlets to specialised technical consultancies (ABS, 2013), and account for around 96% of all business in Australia (ABS, 2006).

Agency Theory describes the relationship between two parties: the principal, and the agent. The relationship is a contract where the principal engages the agent to perform a service on their behalf. The relationship comes into being when the agent is authorized to act on behalf of the principal, in the creation of a legal agreement (Peacock, 2004).

Discrepancies often arise in such relationships, where both parties may disagree on how their mutual endeavor is to be conducted, and Agency Theory can be a useful way to identify and resolve problems. Principals that afford their agents with a certain degree of autonomy can become frustrated when the agent appears to be serving their own interests. Problems can also arise when the principal and agent have different attitudes towards risk taking. This becomes an important issue when the principal is unable to confirm what the agent is doing. To limit such conflicts, the principal can offer incentives designed to limit irregular or unusual activities of the agent (Jensen & Meckling, 1976). However, incentives can be counterproductive if the agent is not averse to risk. In such cases, incentives may encourage agents to engage in unnecessary risks (Holmstrom & Milgrom, 1991).

Applying Agency Theory to describe the relationship between a financial institution and small business would cast the financial institution as the principal and the small business as the agent. Where the financial institution has lent the money to the small business, the small business represents the bank in the use of its funds, as the financial institution still owns the money. The bank has authorized the small business to use their money on their behalf, on the understanding that it will be used in the both parties’ best interests.

Problems may now arise between these two parties, as it is unlikely that both have exactly the same economic interests, as it is human nature to maximize one’s own benefit (Peacock, 2004). This may be exacerbated due to the lack of timely information the financial institution receives to monitor their investment (Peacock, 2004). In order to avoid conflict, the principal enforces legally binding contracts to guide the agent and ensure that the agent’s actions are in line with the principal’s requirements.

Bank loans to small businesses have been steadily decreasing over the last decade (Small Business Trends). This is due to the fact that the banks make more profit lending to large corporations, as there is a general trend that indicates that as loan size increases company revenue tends to increase faster than costs (Small Business Trends). Financial institutions also see lending money to small businesses as a risky undertaking. Not only is there less reliability in the information flow, as small business are under no obligation to provide financial statements to outside entities, but small businesses tend to have high failure rates due to mismanagement, or operating in an uncertain environment that they have little control over, or a lack of resources (Peacock 2004).

As the economic interests of the principal and the agent may not be exactly in line with one another, the principal may be inclined to regard investment in a small business as more risky, and may charge higher interest rates (Thompson, 2012). Banks are primarily concerned with the proposition of the business enterprise; a clear reason for requiring funds must be given by the agent. As the lending to a small business is based on future revenue and a return on the investment, a clear and realistic business plan is required. The principals protect themselves by insisting on collateral security, such as assets or mortgages. But as the small business is an extension of the people owning the business, the business is free to act in their own best interest, which may not necessarily match the principal’s best interests. (Peacock, 2004).

Due to these risks, interest on loans and bank fees are often much higher for small businesses than for medium to large businesses (OECD). Financial institutions prefer to lend money to small business on a short-term basis. This is due to the fact that the longer the loan, the greater the risk for the bank, as over time businesses change and develop, and the opportunity for the borrower to take more risks increases. To protect themselves, banks have standardized lending contracts that limit the scope and direction of the small businesses (Peacock, 2004).

Building a good relationship with the financial institution is vital, as they are able to help small business owner-managers in times of hardship (NWI times). To ensure a good and close relationship between the financial institution and a successful small business operation, the availability of information from the owner-manager is crucial. It is necessary that the financial institution is provided with accurate and timely financial information, such as financial statement (Sidorenko, 1998). Mitchell & Rajan (1994) suggest that if information given to the financial institution were more accurate and economies of scale exist in the production of information that is not easily transferred, firms with close ties to their financial institution should have lower costs and more availability of capital than small businesses without such ties.

As the financial institution is the principal of the small business, it has a vested interested in the success of the small business. Therefore, many financial institutions offer services, such as free ‘Start-up Guides’, business support, and training seminars, that will help the owner-manager to understand marketing, credit control, profitability, online trading and the recruitment of staff (Barclays Bank). These are all benefits the small business could receive from a close tie to their bank, which help the small business to grow and minimize the risk of failure.

The relationship between the financial institution and the small business can be beneficial for both sides. The small business owner fulfills his dream by owning a small business that may have the potential of high-growth. Owner-Managers of high-growth businesses tend to have prime managerial resources, such as prior experience, education, training and managerial skills, in addition to being highly motivated. Positive motivation and the desire to make money and perceive new ideas or developing new products are key indicators of growth (Barkham 1992)

However high interest rates and additional financial cost to obtain a business loan can put a strain on small businesses, but there are alternatives such as credit unions that are not-for profit, that offer lower interest rates and are more willing to lend to small businesses (Jones, 2012).

As small businesses account for a large majority of business enterprises, the benefits for society as a whole are in the creation of jobs (Picot & Dupuy, 1996). In the UK, the government is very concerned with the restricted lending to small businesses, as this hampers economic growth following the global financial crisis of 2008. The government has implemented the Funding for Lending Scheme, which allows banks to borrow from the Bank of England at cheaper-than-market-rates for up to four years, as an incentive to provide loans to small businesses. With this scheme the government is trying to help small businesses get easier access to loans at lower interest rates (UK Government).

One cause of divergence between the principal and the agent is rooted in the personality of the individual people involved in the relationship. Large financial institutions are governed by a board of directors, whose job is to maintain a maximum return to their shareholders. The board of directors relies on consensus between a number of people, protecting the organization from the influence of dominant personalities. Small businesses, on the other hand, are usually owner controlled. Where large organisations are essentially personality-less, small businesses may be driven by individual personalities. There are two groups of personalities that become owner-managers. The first one is motivated by the incentive of a better lifestyle, independence to be ‘one’s own boss’ and flexibility, where financial success is not the driving motivator (Peacock, 2004). The second group is the entrepreneurs who measure their success in terms of income and business growth. This group has a high need to achieve.

Unlike large corporations, where specialized staff is employed in all business areas and crucial decisions are being made on the level of executive management that are controlled by the board of directors, the small business owner-manager has to fulfill all theses roles by himself. If the owner-manager lacks general management skills and other crucial knowledge, such as accounting and finance, and is not seeking for help to get support in theses areas, it makes it very difficult for the financial institution to build up a sound relationship. This is where financial institutions have to compensate their risk, as timely accurate information may not be given.

The entrepreneur, however, has the urge for the need to achieve, and a strong desire to be successful. Theses traits alone, however, are not sufficient to guarantee the owner will be a successful manager – traits such as managerial competency, financial and communications skills are still needed (Chell & Haworth, 1992). Taking into account these personality traits, it is still risky for financial institution to give out loans. However the entrepreneur is much more likely to have most of his financial resources in the new venture, which would mean he likely has more collateral security than non-entrepreneurial owner-managers (Peacock, 2004). Should the entrepreneur be involved with a high-growth project that is risky but has the potential of high rewards, there may be alternative funding possible such as venture capital.

It might be possible to change the way banks and small businesses interact in terms of risk. The small business owner needs to be more abreast with financial knowledge and give the banks more adequate and timely inside information about the standing of the firm (Peacock, 2004). The small business owner needs to realize that information such as a business plan is needed and should be abreast with latest technology as well as being aware of tax implementation on new products. There should be a close relationship with the accountant and the small business owner to be able to provide the necessary documents banks need to make an adequate decision about financing the small business. On the other hand, banks could be more open to prospect-based lending. This means that the lending would be based mainly on the cash-flow forecast from the small business. However, banks would need to monitor the activities of the small business much more closely in order to protect their investment (Peacock, 2004).

In conclusion, the agency relationship between the financial institution and the small business owner could be potentially beneficial for both sides. Lending money to small businesses can be risky for banks as the flow of information is often not timely or accurate. There is also the risk of business failure due to incompetency or an uncertain environment that the small business owner has little or no influence on. Due to these risks, banks charge higher interest and bank fees than to medium to large corporations.

But not only the risk of uncertainty contributes to possible conflicts but also the characteristics of the small business owner could potentially become a problem within the relationship. Given that the small business owner is more accurate and timely with providing financial statement and information and therefor is building up a trustworthy relation ship with the financial institution. On the other hand the banks need to be less conservative and rethink their lending policy and not only build upon collateral security but perhaps on prospect-based lending. As the small business sector is so large in Australia the economy of scale should make lending money to small businesses be a viable option for banks.

REFERENCES
Australian Bureau of Statistics (ABS) 2006, Australian Industry, cat. no. 8155.0, ABS, Canberra. Australian Bureau of Statistics (ABS) 2013, Australian Industry, cat. no. 8165.0, ABS, Canberra. Barcleys Bank (2013). ‘Starting your own business’. Viewed 16 November 2013. < http://www.barclays.co.uk/BusinessBankAccounts/Startingyourownbusiness/P1242558528795>. Barkham, R. (1992). ‘Entrepreneurial Characteristics and the Size of the New Firm: A Model and an Econometric Test’, Small Business Economics, Vol. 6, pp.117-125. Chell, E. and J. Haworth (1992). ‘The Development of a Research Paradigm for the Investigation of Entrepreneurship: some methodological issues’. Discussion Paper No. 92-26, School of Business Management, University of Newcastle upon Tyne. Earnshaw, R (2013), ‘Bankers offer advice for small-business clients’. NWI Times.

Peacock, RW 2004, Understanding Small Business: Practice, Theory and Research, 2nd edition.

Jones R (2012). What are your experiences of credit unions? The Guardian, viewed 20 November 2013, .

Holmstrom, B and Milgrom, P (1991). “Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design.” Journal of Law, Economics, & Organization, Vol.7, Special Issue: pp 24-52.

Jensen, MC and Meckling, WH,(1976). “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics, Vol.3, No. 4.

Mitchell, AP, Rajan, RG (1994) ‘The Benefits of Lending Relationships: Evidence from Small Business Data’. The Journal of Finance, Vol.49, No.1, pp.3-37.

OECD ‘Small Business, Job Creation and Growth: Facts, Obstacles and Best Practice’.

Picot, G, Dupuy, R (1996).’Job Creation by Company Size Class: Concentration and Persistence of Job Gain and Losses in Canadian Companies’. Business and Labour Market Analysis Division, Statistics Canada.

Shane, S (Feb 4, 2013) Are Banks Losing Interest in Small Business? Small Business Trends, viewed 14 November 2013 .

Sidorenko, A (1998). ‘Agency Theory and Corporate Collapse: The Girvan Case’. University of Technology, Sydney. Viewed 17 November 2013. .

Thompson, M (May 15, 2012) Small Businesses Pay Higher Interest Rates than Larger Companies, Business Monitor, viewed 18 November 2013 .

UK Government (2013). ‘Making it easier to set up and grow business’. Department for Business, Innovation & Skills and HM Treasury.