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Transcript of What do we know about enterprise? The roles of theory and evidence Gavin C Reid, Professor of...
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
12
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!