Agency Theory & Small Businesses
Word count: 2251
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
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
References: Australian Bureau of Statistics (ABS) 2006, Australian Industry, cat. no. 8155.0, ABS, Canberra. Australian Bureau of Statistics (ABS) 2013, Australian Industry, cat 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. 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. 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.