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INTRODUCTION

Entrepreneurial firms are privately-held firms that exhibit the capacity to create economic value for the investors which goes beyond merely providing a comfortable life style for the founders. That is, entrepreneurial firms provide returns that exceed the opportunity cost of their invested capital, thus creating value in the firm which will at some point require harvesting by the entrepreneurial founder. This contrasts with the majority of privately-held firms which support the lifestyle of its owners but create no lasting value.

We know relatively little about the financial attributes of entrepreneurial firms. Reynolds (1993) notes that due to the absence of empirical data on entrepreneurial firms we do not have a basis for comparing them with publicly-held companies. The recently compiled National Center for Entrepreneurship Research (NCER) database provides us with the basis for such comparisons. Specifically, we investigate whether the financial characteristics of entrepreneurial firms is distinctively different from large, publicly-traded firms. In addition we investigate a number of firm attributes that have been hypothesized to influence firm performance including: board composition, continued founder involvement, and the use of performance-based compensation.

SEPARATION OF OWNERSHIP AND CONTROL

Entrepreneurial firms are generally thought to differ from publicly-held firms in ways related to the separation of ownership and control. Entrepreneurial firms are younger and frequently continue to involve a founder, or member of the founder's family, in the firm's management team. This difference suggests that there may exist a closer link between the firm's management and its ownership. Such a relationship should serve to at least partially mitigate the agency problem that characterizes the separation of ownership and control of the large publicly-held corporation. The separation of ownership from control gives rise to actions by a firm's management that are unobservable by the firm's shareholders, thus creating the possibility of opportunistic behavior whenever management's interests come into conflict with those of the owners. Berle and Means (1932) long ago pointed out that where managers hold relatively little equity in their firms and the shareholders are too dispersed to enforce value maximization, the firm may be managed so as to benefit the managers rather than the shareholders. Specifically, the firm's management may engage in shirking and perquisite consumption, but may also pursue such non-value maximizing objectives as sales growth, empire building, and employee welfare (Morck, Shleifer and Vishny, 1988b).

While the greater overlap between management and ownership within a privately-held, entrepreneurial firm may be beneficial for investors, it also gives rise to another class of agency problems between the firm's founders who continue to serve in a management capacity (active equity investors) and other investors who are not directly involved in the firm's management (passive equity investors). Problems arise where owner-managers encounter situations in which their self-interest is in conflict with those of passive equity investors. In these circumstances the active equity investors may seek to maximize their own welfare at the expense of the passive equity investors (Finegan, 1991). In addition, family businesses have to contend disputes involving different generations and sibling rivalries as well as basic business concerns.

Two approaches have been used to resolve the conflict-of-interest problem between owners and managers. The first involves the use of effective managerial oversight by the firm's board of directors. Fama and Jensen (1983) characterized the board's principal responsibilities as the ratification of management decisions and the monitoring of management performance. However, the board does not always use its authority to advance shareholder interests where director interests come into conflict with those of the shareholders. Thus, the degree to which this oversight is effective in controlling opportunistic behavior by the firm's management depends upon the degree to which the board members' own self interests are aligned with those of the shareholders. This alignment problem is generally resolved by assuring that the board members themselves are not members of the management team (i.e., they are independent) nor do they hold any particular allegiance to management (e.g., attorneys, bankers and others who depend upon management favor) and, in addition, the directors hold substantial equity investments in the firm.

A number of studies have found that board composition does influence corporate performance. Rosenstein and Wyatt (1990) report a positive and significant stock price reaction to the announced appointment of an outsider to the board, which indicates that the market expects shareholders to benefit from the appointment. Moreover, Hermalin and Weisbach (1988) observe that the proportion of outsiders increases on the boards of firms that haveexperienced a period of poor performance. Furthermore, the stock price reactions to decisions made by outsider-dominated boards tend to be more favorable. For example, Byrd and Hickman (1992) found that the abnormal bidder returns on the date of a takeover announcement are significantly higher when the decision is likely to have been made by outside directors. Similar results have been found for announcements of management buy-outs (Lee, Rosenstein, Rangan and Davidson, 1992) and the adoption of poison pills (Brickley, Coles and Terry, 1994).

The second approach to aligning management and shareholder interests involves the use of incentive compensation contracts which reward managers for taking actions that are directly beneficial to shareholders. Fundamentally these compensation contracts link pay to firm performance. However, the evidence supporting the connection between the use of performance-based compensation and firm performance is mixed. Jensen and Murphy (1990) found that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth. They note however, that although the incentives generated by stock ownership are large relative to pay and dismissal incentives, most CEOs hold trivial fractions of their firms' stock, and ownership levels have declined over the past 50 years. Gibbons and Murphy (1990) test more directly for relative performance pay and find that after holding constant the rate of return on a firm's common stock, a higher value-weighted industry rate of return lowers the growth of CEO pay. Aggarwal and Samwick (1997) argue that strategic interactions between firms in an oligopoly can explain the puzzling lack of high-powered incentives in managerial compensation contracts. Specifically, these authors argue that pay based on relative performance would give the executive an incentive to price too aggressively which under certain forms of competition is counter to shareholder's objectives to soften competition.

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