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, 30 th September 2010 by Professor Gavin C Reid CRIEFF, 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 coalition Each 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 = 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 These levels were the highest since 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 Sales of SMEs were £1,500 billion which is 4.2% higher than in 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 employees 172,055 With 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 Time Stationarity t1t1 Growth O Consolidation Growth t2t2 t3t3 Trajectories if equity is cheap Output Capital Debt Dividend Output

Capital Debt Dividend Time Stationarity t1t1 Growth O Output Capital Debt Dividend Figure 9.1Trajectories 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

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

Figure 8.3Trajectories of debt and interest rates

Figure 8.4Trajectories 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

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!