What do we know about enterprise? The roles of theory and evidence Gavin C Reid, Professor of Economics, Founder/Director CRIEFF, School of Economics &

What do we know about enterprise?

The roles of theory and evidence

Gavin C Reid, Professor of Economics, Founder/Director CRIEFF, School of Economics

& Finance, University of St Andrews

What do we know about enterprise? The roles of theory and evidence

Presentation to ‘Solutions in Enterprise’, University of

Aberdeen, 30th September 2010by

Professor Gavin C ReidCRIEFF, University of St

Andrews

Plan of Presentation

• Defining Enterprise

• Theory of Enterprise

• Evidence on Enterprise

• Confronting Theory with Evidence– Financial Structure; Attitudes to Risk

• Conclusion

What is Enterprise?

Enterprise as an activity e.g. being entrepreneurial, being resourceful

Enterprise as an institution e.g. a type of business, like a small entrepreneurial firm, a co-operative, a social enterprise

Enterprise as a polity e.g. free enterprise

An Economist’s Views on Enterprise

John Maynard Keynes ‘If Enterprise is afoot, wealth accumulates. If Enterprise is asleep, wealth decays’ – note subtle use of Enterprise as activity, polity and institution! A Treatise on Money (1930)

‘The situation is serious when enterprise becomes the bubble on a whirlpool of speculation’ – note relevance to today’s ‘credit crunched’ world. The General Theory (1936)

Theory and Evidence on Enterprise

Theory here is conceived as creating a ‘model’ (i.e. an internally consistent mental construct) of enterprise – this helps us to get to essentials of the phenomenon, and to develop testable propositions

Evidence here refers to fact, opinion, number, image, speech etc all of which tell you something about an enterprise

Testing Theories of Enterprise

Testing a theory of enterprise (e.g. that larger firms pay, on average, higher wage rates than smaller firms) requires confronting a theory with evidence.

Methods of testing can vary greatly – they can use quantitative data (e.g. accounting data of the firm), qualitative data (e.g. opinions expressed by entrepreneurs in interviews), experimental data (e.g. human subjects playing roles, like boss and worker).

Theory of Enterprise

Firms as Coalitions

A General Theory of Enterprise

An enterprise can be considered as a coalition

Such a coalition is made up of distinct individuals all of whom have something to gain from being in the coalition

Such a coalition is stable if no member has an incentive to leave the coalition i.e. nowhere else offers a better deal to any member

The Entrepreneurial Firm as a Coalition

Consider one member of a coalition as being the entrepreneur

S/he ‘signs up’ people to join the coalitionEach person who joins gets a payoff – this

can be psychic (feeling good about belonging in the firm) or pecuniary (pounds and pence)

What does the entrepreneur get? The residual

The Entrepreneur as Residual Claimant

The residual claim is what the entrepreneur gets after satisfying firm members with their payoffs.

This residual is equal to the difference between what value the coalition (i.e. firm) can generate by all working together, and the sum total of rewards that must be given to members of the firm by agreeing to do their work

All Working Together

What is the advantage of all working together, rather than each member being a solo contractor?

The answer is synergy (or more technically, super-additivity): colloquially the 2 + 2 = 6 principle!

The basis of all firms, as coalitions, is that what can be done together is greater than the sum of what can be done independently

The Appearance (and Dis-Appearance) of Profit

The residual claim of an entrepreneurial firm can be identified with profit:

Profit = Total Revenue – Total Cost

As Keynes has also said, it is this, profit, which drives enterprise, not thrift

But does all enterprise require profit? Indeed is all enterprise motivated by just pecuniary goals?

Alternatives to the Entrepreneurial Firm

The firm, as a coalition need not have a leader (e.g. an entrepreneur who ‘calls the shots’) – it may work as a co-operative. In one variant of this, tasks are rotated, and all workers have the same reward.

The firm may not have to generate a surplus, it may only need to break-even. It can be a not-for-profit enterprise, aiming to generate maximum welfare, rather than maximum profit.

From Mind Sights by RN Shepard (1990)

Enterprise Outside the Entrepreneurial Firm

Enterprising behaviour may not be confined to the small entrepreneurial firm, it can occur within a big firm: this is, to use a term of Gifford Pinchot (1978), the act of intrapreneuring (e.g. semi-autonomous units in Lockheed-Martin, 3M, Intel)

This may allow big firms to be adaptive, flexible and innovative – it may allow ‘elephants to dance’, (cf. Moss Kanter, 1990)

Evidence

Facts, figures, opinions, images

The Statistics of Enterprise

• About half a million people are employed in the third sector (charities, social enterprise etc) in the UK

• About a quarter of a million employed in co-operatives in the UK

• About thirteen and a half million (60% of private sector work force) are employed in small and medium sized firms in the UK

Statistical Snapshot of SMEs: Population of Enterprises

• Estimated 4.81 million private sector enterprises in the UK at the start of 2008, an increase of 104,0003 (2.2 per cent) since the start of 2007. These levels were the highest since 1994.

• These enterprises employed an estimated 23.1 million people, and had an estimated combined annual turnover of £3,000 billion.

Source: Statistical Press Release, Department of Business Innovation and Skills, July 2010

Statistical Snapshot of SMEs: Size of Enterprises (start of 2008)

• SMEs made up 99.9 per cent of all enterprises, which is 59.4% of private sector employment

• Employment in SMEs were 13.7 million which is 2.1% higher than in 2007.

• Sales of SMEs were £1,500 billion which is 4.2% higher than in 2007.

Source: Statistical Press Release, Department of Business Innovation and Skills, July 2010

Size Distribution of Enterprises in the UK, 2008

• With no employees 3,545,720 • With 1-9 employees 1,032,775• With 10-49 employees 172,055• With 50-249 employees 26,710 • With 250 or more employees 6,020

TOTAL 4,783,280

Note: ‘no employees’ means sole proprietor, single-person partnership or company (e.g. sole employee director)

Source: Statistical Press Release, Department of Business Innovation and Skills, July 2010

Conclusion on Enterprise Size (start of 2008)

Almost all enterprises (99.3 per cent) are small (0 to 49 employees).

Only 27,000 (0.6 per cent) are medium-sized (50 to 249 employees)

Just 6, 000 (0.1 per cent) are large (250 or more employees)

Source: Statistical Press Release, Department of Business Innovation and Skills, July 2010

Confronting Theory with Evidence

Two Examples: Financial Structure; Attitudes to Risk

Example 1: Financial Structure

The model assumed that the entrepreneur aims to maximise the value of the firm

The focus is on trajectories of debt (e.g. business bank loan) and equity (e.g. entrepreneur’s personal financial injections) over time

The ratio of debt to equity is called gearing

Reference: The Foundations of Small Business Enterprise, Gavin C Reid, Routledge, 2007, Chapter 9

Capital

Debt Dividend

TimeStationarityt1GrowthO Consolidation Growtht2

t3

Trajectories if equity is cheap

*EQ

OutputCapitalDebtDividend

Output

*DQ

Output

Capital

Debt

Dividend

TimeStationarityt1GrowthO

OutputCapitalDebtDividend

Figure 9.1 Trajectories if debt is cheap

Data

150 small firms in Scotland over a three year period, 1994 to 1997 all visited individually and interviewed on all aspects of operations

Source: The Foundations of Small Business Enterprise, Gavin C Reid, Routledge, 2007, Chapter 2

Scatter Diagram of Gearing over Time

0

200

400

600

800

1000

1200

1400

1994-95 1995-96 1996-97

Gea

rin

g

Debt/Equity Ratio

Note:Three high gearing ratios are omitted for presentational purposes, but were used to compute averages.Figure 8.1 Scatter diagram of gearing over time

Trajectories of Actual and Expected Gearing

0

20

40

60

80

100

120

140

160

180

200

0 1 2 3 4 5 6

Time Period

Gea

rin

g

Actual Gearing

Expected Gearing

Trajectories of Debt and Interest Rates

0

5000

10000

15000

20000

25000

30000

1 2 3

Time Period

Deb

t

0

2

4

6

8

10

12

Inte

rest

Long-Term Debt

Bank Base Rate

Interest Rate on Long-TermDebt

Figure 8.3 Trajectories of debt and interest rates

Trajectories of Equity and Interest Rates

0

100

200

300

400

500

600

700

800

1 2 3

Time Period

Eq

uit

y

0

2

4

6

8

10

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Inte

rest

Equity

Bank Base Rate

Interest Rate on Long TermDebt

Figure 8.4 Trajectories of equity and interest rates

Conclusion on Financial Structure

We find that the predictions of the model are confirmed in practice:

• Close to inception, gearing rises

• If the relative price of debt to equity rises, so the gearing falls

• If the relative price of debt to equity falls, so the gearing rises

Example 2: Attitudes to Risk of Investor and Entrepreneur

Risk is analysed in three categories:

• Agency risk• Innovation risk• Business Risk

A principal-agent model is adopted, with investor as principal and entrepreneur as agent

Reference: Risk Appraisal and Venture Capital in High Technology New Ventures, Gavin C Reid and Julia A Smith, Routledge, 2008

Data

Fieldwork created primary source data from leading UK investors and a sample of the high tech firms in which they had invested

Reference: Risk Appraisal and Venture Capital in High Technology New Ventures, Gavin C Reid and Julia A Smith, Routledge, 2008

Importance of Factors in Appraising Risk

0 1 2 3 4 5

local environment

commitment to bring in others

comparable investments

scale of the business

global environment

information system capabilities

funding structure

type of exit

sales model

compelling nature of proposition

business model

employee capabilities

extent of motivation & empowerment

market opportunities

management team

Degree of Importance (0=irrelevant, 5 = high)

Figure 4.3 Most important factors in risk appraisal (venture capitalists)

Figure 4.4 Most important factors in risk appraisal (entrepreneurs)

Conclusion: Differences Between Investors and Entrepreneurs

• Investors focus more on management team, motivation, empowerment, and employee capabilities i.e. what make the relationship tick

• Entrepreneurs focus more on exit, sales, business model, local environment i.e. what results from the relationship

• They both have similar ratings for market opportunities

Conclusion

• A general theory of enterprise exists, and a specific one can model any firm type (entrepreneurial firm, co-operative etc)

• Evidence indicates the central importance of small business enterprise to the UK economy: it is the typical firm type

• Theories of enterprise (e.g. of financial structure, of risk) can be tested successfully on UK data – and (with more effort!) on the Scottish economy

Any Questions?

Thank you for your attention!