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Understanding the small enterprise financial objective function.

Small enterprises that are independently owner-managed, are not dominant in their sphere of activities, and are physically modest when measured by the usual indicators of business size such as sales revenues, assets, and number of employees, are increasingly becoming a focus of scholarly attention. Specifically, the last few years have seen a burgeoning of research into the specific institutions, principles, practices, and problems of small enterprise financial management. However, much of this research has focused on the functioning of financial markets from the perspective of small enterprises and the financing of such concerns. While these are undeniably important matters, the inquiry to date seems to have overlooked more fundamental aspects of small enterprise financial management such as the financial objective function. Attention to the pivotal issue of what financial objectives should be and are aspired to in small enterprises would seem to be a logical first step in coming to understand financial decision making in this context.

Financial management is concerned with understanding factors that determine the value of a business enterprise's uncertain cash-flows over time, and with management of these factors in a normative sense. Thus, the basic dimensions of business activity on which the theory and practice of financial management focus are cash, time, and risk. The temporal patterns of cash-flow and risk encountered are the outcome of purposeful decision making on the part of persons charged with financial management of an enterprise's affairs. The broad purpose is to serve the best interests of those who have provided the enterprise with capital to finance its assets and activities, and who ultimately bear the risk that stems from an uncertain future. The essential task is to secure, through sound investment, financing, and profit-distribution decisions, returns sufficient in both amount and timing to reward providers of capital for their initial and continuing support. Strictly speaking, this should apply to all suppliers of finance. However, at the risk of introducing conflicts of interest between stakeholders, those who provide equity finance are usually accorded preferential concern on the not-unreasonable grounds that their risk is greatest, since their stake is strictly residual, and also that they are legal owners of the enterprise. Hence, it is argued that the normative goal of financial management should be to maximize the value of an enterprise to its owners, which is believed to be a function of the amount, timing, and risk of the cash-flows they ultimately receive. This goal is held to embrace two parameters only - expected return and perceived systematic risk. The question to be addressed is whether this is a valid and useful objective function for small enterprise financial management.

In search of a sound conceptual understanding of small enterprise financial objectives, this paper proceeds by first identifying terms that should be included in the small enterprise financial objective function in order to embrace enterprise-specific sources of risk typically encountered in such concerns. A conceptualization of the small enterprise financial objective function is subsequently presented by extension of fundamental utility theory, which underlies much of existing financial thought. Consideration is then given to alternative asset pricing models, which consequently might be used in small enterprise financial management. A review follows of the limited empirical evidence available on small enterprise financial objectives. Finally, a research agenda is proposed for further empirical inquiry into the nature of the small enterprise financial objective function.


Three important messages appear to emerge from available empirical evidence on the broad motivations of small enterprise owner-managers:

1. Owner-managers of small enterprises are unlikely to have a single overriding aim in establishing and running their own businesses. Their intentions are apt to be numerous and complex.

2. Many of the motives owner-managers have for being in small enterprise, and also the satisfactions they derive from this occupation, are unequivocally non-pecuniary.

3. Owner-managers of small enterprises have considerable freedom to indulge their many and varied objectives, be they pecuniary or otherwise. Any specification of a goal for small enterprise financial management obviously needs to be viewed in the broader context thus portrayed.

A serious complication to the problem of specifying the financial objective function of small enterprises is that this sector of the economy is far from homogeneous in many respects. Based on the small enterprise research literature, there is good reason to believe that the following typologies of small enterprise could have important implications for the nature of the financial objective function encountered in such concerns:

1. Traditional small enterprises versus growth or entrepreneurial enterprises.

2. Small enterprises of various legal structures (sole proprietorships, partnerships, private companies, public companies listed on stock exchange second boards, trusts, cooperatives, etc.).

3. Small manufacturing enterprises versus small trading enterprises versus small service enterprises.

4. Various other distinctive types of small enterprise such as informal enterprises, minority enterprises (based on the ethnicity or gender of their owner-managers), family enterprises, franchised enterprises, and entrepreneurial enterprises funded by venture capital organizations.

By way of example, consider the first of these typologies. Support for the proposition that financial objectives of business concerns in the traditional small enterprise may vary from those of growth or entrepreneurial enterprises is provided by Petty and Bygrave (1993, p. 131) who assert that "The firm's financial objective . . . [is] largely dependent on the stage of development of the small business." Petty and Bygrave (1993, p. 130) point out that for traditional small enterprises (styled micro-ventures or lifestyle firms):

The concept of wealth maximization has reduced meaning, since there are so many exogenous considerations influencing the decisions, besides that of economics. Utility maximization becomes the rule, rather than the conventional wisdom of wealth maximization. The objective is not so much to create value, but to provide a "preferred" life style within the community. Even for the "successful" lifestyle firms, there is little in the way of value created beyond providing a living for the owner and his or her family.

Petty and Bygrave (1993, p. 135) encourage owner-managers of growth enterprises (styled entrepreneurial firms) "to think value, and not accounting profits, in making economic decisions." It would therefore seem that any specification of the financial objective function for small enterprises must be able to accommodate significant differences between small enterprise types.

In view of the foregoing discussion, it seems possible that the financial objective function conventionally specified in the financial literature is an oversimplified and inaccurate statement of the real purpose of owner-managers of small enterprises. Ang (1992, p. 190) expresses the view that "depending on the organizational types and circumstances, there are several admissible forms of objective function for small businesses." He points out that a profitable small enterprise that does not depend to any significant extent on outside funding may tend to ignore current performance and focus resolutely on maximizing long-term value. However, for a small enterprise that does employ external financing and is subject to monitoring by financiers, Ang (1992, pp. 190-191) argues that:

Current performance, albeit a rather noisy measure, may no longer be unimportant. Thus, a good number of small businesses would have a weighted average objective function consisting of current profit and long term value. Weight for current profit is expected to be higher for small businesses approaching loan renegotiation, initial public offering, potential sale to an acquirer, signing long term contracts with suppliers or customers and possible dissolution of a partnership. On the other hand, its weight will be smaller when the business is due to pay estate taxes, renegotiate employee contract, discourage a nonmanaging family member from selling their shares, and avoid tax on excess accumulation.

Ang (1992, p. 191) believes these considerations - the fact that small enterprises typically function as extensions of their owner-managers, and the widely recognized importance attached to independence by owner-managers - mean that "the complete formulation of the small business objective function could be quite involved."

Based on the literature, it appears that the financial objective function of small enterprise owner-managers might include the following dimensions of financial management, which are all likely to influence enterprise value to some degree.


It is a fundamental axiom of financial thought that expected return is a major parameter in financial decisions of all types. The only issues that require consideration here are how return is conceived and measured by small enterprise owner-managers, whether they in fact attempt to maximize return, and over what time horizon return is assessed. After reviewing empirical evidence on these issues, McMahon and Holmes (1989) form a general impression that small enterprise owner-managers typically seek to achieve a satisfactory level of short-term accounting profit. As Ray and Hutchinson (1983) report, the exception seems to be growth or entrepreneurial enterprises in which liquidity and maximizing profit and sales growth are primary concerns. Ang's (1992) views on the issues identified have already been presented.

Kao (1985) questions the usefulness and validity of profit maximization as a financial goal in small enterprises and argues that, conceptually, profitability of such concerns should be measured as residual income after deducting non-pecuniary personal sacrifices made by owner-managers. In their research, Boyer and Roth (1978) discovered that owner-managers are willing to sacrifice rate of return on their investment for non-pecuniary rewards such as control over their income and job security, pride in their achievements, self-actualization, and esteem in the community. On the basis of this finding, the researchers go on to develop a model for determining the cost of equity capital that reflects the mix of pecuniary and non-pecuniary rewards owner-managers enjoy.


No justification for considering perceived risk in financial decisions is required here since this is accepted financial thought. However, there is a need to comment on the nature of risk from the viewpoint of small enterprise owner-managers. Contrary to precepts of existing financial thought, there is good reason for believing both systematic and unsystematic risk are important to owner-managers of small enterprises. The nature, sources, and significance of systematic risk are well documented in the finance literature. The principal sources of unsystematic or enterprise-specific risk, which appear to require attention, and which should be made explicit in the financial objective function of a small enterprise, are briefly reviewed in the points below.


The importance of cash-flow in a small enterprise is emphasized by Welsh and White (1981, p. 29) as follows:

A small business can survive a surprisingly long time without a profit. It fails the day it can't meet a critical payment. In a small company, the cash flow is more important than the magnitude of the profit or the ROI. Liquidity is a matter of life or death for the small business.

Here, liquidity refers to the overall level of cash and near-cash assets (such as debtors and stock) held, and to cash inflows and outflows that add to and subtract from the sum of these assets.

As pointed out by Walker and Petty (1986, p. 7), existing financial thought with its focus mainly on large business enterprises holds that in a perfect capital market "the level of a firm's liquidity should be of no intrinsic value to the investor, thereby becoming a passive variable for the firm's decision makers." However, it has to be conceded that the existence of capital market imperfections introduces the possibility that investors might not be indifferent to decisions made concerning liquidity management. Perceptions of the wisdom or otherwise of these decisions could therefore affect the value attached to an ownership stake in a business enterprise.

In a manner and to an extent not contemplated by existing financial thought, the soundness of liquidity management has emerged as arguably the most critical influence on survival and financial well-being in small enterprises. Walker and Petty (1986, pp. 10-11) identify two principal reasons why this should be the case, one of which is exogenous to the enterprise and the other endogenous:

The apparent difference in liquidity between . . . large and small firms lends further support to the existing belief that working capital shortages are a common problem for small firms. The difference could be the result of at least two factors. First, the small firm's limited access to the capital markets may impose the need for more economy in the use of working capital. Second, the basic nature of the "entrepreneur" could have a beating upon the working capital decisions within the small corporation. If the managers of small firms are willing to assume greater risk, as experience would suggest, their attitude may well be reflected in the small firm's liquidity position.

In his speculations on liquidity and small enterprise financial management, Ang (1991, 1992) focuses on endogenous influences. He points out that working capital management typically occupies a major proportion of a small enterprise owner-manager's time, and that part of this is devoted to management of slacks or excess liquid funds. Ang (1992) identifies a number of factors likely to lead to greater or lesser slacks in a small enterprise.

Thus, it would seem liquidity should be a matter of concern in the present context because cash is such a critically scarce resource in a small enterprise as a result of supply constraints, which do not exist to nearly the same extent for a large enterprise. The cause for concern is reinforced by the knowledge that small enterprise owner-managers are inclined towards risk-taking in an inherently risky environment, and are less constrained and expert in their decision making than managers of large enterprises. Finally, from a small enterprise owner-manager's perspective, there seem to be multiple motivations for what amounts to gaming in agency relationships which inevitably impinge on liquidity management.


The undiversified nature of a typical small enterprise owner-manager's investment of financial and human capital and its implications for financial management are considered later in the paper. An owner-manager's consciousness of the risk this circumstance poses may cause him or her to be disposed towards capital investment opportunities that provide some potential for diversification of the enterprise's activities. Contrary to the "independent project evaluation rule" of financial theory, the owner-manager may weigh this consideration quite favorably when evaluating a proposal and might be prepared to sacrifice return in order to achieve a degree of diversification.


The undoubted risk posed to an owner-manager by the immobility of financial and human capital invested in his or her small enterprise, and its implications for financial management, are also addressed later in the paper. The inability of an owner-manager to quit an enterprise may predispose him or her to actions that could alleviate this constraint, such as "going public" by listing the enterprise on a stock exchange second board. The transferability of financial and human capital is likely to be a major preoccupation in family enterprises where succession by the subsequent generation demands attention. As far as financial decision making is concerned, the immobility of financial and human capital invested in a small enterprise may, ceteris paribus, cause the owner-manager to favor outcomes promising higher returns and/or lower risks.


Focusing particularly on the issue of liquidity, Sahlman (1983, p. 38) asserts unequivocally that financial flexibility has value, but he recognizes this is not without its costs:

The fact that keeping financial reserves on hand, whether in the form of excess cash, unused debt capacity or lines of credit, is costly precludes all firms from maintaining unlimited flexibility.

On asset investment and divestment in small enterprises, Pettit and Singer (1985, p. 52) indicate that:

. . . the flexibility of a smaller firm's operations may allow the manager to control and maintain firm risk more easily by moving resources from one productive process to another with changes in technology or economic conditions.

Thus, flexibility can be most important in allowing investment decisions to be reversed should they prove to be mistaken or inappropriate to changed circumstances. Flexibility is similarly valuable in making financing and profit-distribution decisions. For each type of decision, the benefits of flexibility are particularly apparent when the decision maker has limited expertise, as is often the case in small enterprise.


The dependence of small enterprise value upon financial objectives pursued, decision-making, practices and control issues is addressed by Rader (1987). In the following quotation, Rader (1987, p. 43) is concerned especially with control contests between owners and managers:

Increasing value while maintaining control of the firm is the main task facing business owners. This is a difficult goal to achieve because managers and owners often perceive conflicting objectives and therefore use different methods and motivations for choosing various business strategies.

Rader (1987) argues that incompatibility of financial objectives between owners and managers can be ameliorated through suitably designed compensation schemes for managers.

Focusing on the relationship between financing decisions and control, Brigham (1992, p. 29) points out that:

. . . there is value to being in control, and that value is not easily measurable. As a result, we often observe small businesses taking actions, such as refusing to bring in new stockholders even when they badly need new capital, that do not make sense when judged on the basis of value maximization but that do make sense when seen in the light of the personal objectives of the owner.

The potential significance of control to owner-managers of growth or entrepreneurial enterprises and neglect of this matter in the finance literature are highlighted by Brophy and Shulman (1992, p. 66) as follows:

. . . the conflict between growth and expected wealth maximization may be compounded by the issue of survival and the desire among entrepreneurial founders to remain in control of their corporate enterprise. The basic finance premise of maximizing shareholder wealth explains only some entrepreneurial behavior. Those firms unwilling to sacrifice control or maximize corporate growth are often ignored in the finance literature.


The considerable importance of owner-manager independence as a motivation for entering small enterprise has been discovered by many researchers. Most notably, the Bolton Committee of Inquiry on Small Firms (1971) in the United Kingdom found that the need to attain and preserve independence is the most fundamental objective in the majority of small enterprises. An owner-manager is therefore unlikely to be indifferent to decision outcomes that would impose some degree of financial accountability to other stakeholders in his or her enterprise, especially when they are outside parties such as suppliers, customers, and financiers.

External financing almost inevitably brings with it some form of monitoring arrangement intended to overcome difficulties posed by asymmetric access to financial information between those within the enterprise and the financiers concerned. Pace and Collins (1976) and Stanga and Tiller (1983) report that the information a small enterprise might be required to provide in support of an application for debt financing is considerable. Stanga and Tiller (1983, p. 69) conclude that "the informational needs of bank loan officers do not differ substantially between large public companies and small private companies." Financing and profit-distribution decisions made in small enterprises might be strongly influenced by a desire to avoid such accountability.

To summarize, this section of the paper has argued that the small enterprise financial objective function should reflect not only customary expected return and perceived systematic risk considerations, but also exposure to sources of unsystematic or enterprise-specific risk that typically exist in small enterprises arising from liquidity, diversification, transferability, flexibility, control and accountability considerations. Some tentative empirical support for the proposed significance of enterprise-specific sources of risk in financial management of small enterprises is provided by recent work by Everett and Watson (1993). In their study of systematic and unsystematic sources of risk in small enterprises located in managed shopping centres in Australia, Everett and Watson (1993, p. 13) conclude:

Regression models of failure against real trading bank interest rates have been constructed and reported to provide some indication of the likely effect of both systematic and unsystematic risk factors on small business failure rates in managed shopping centres. On average unsystematic factors appear responsible for approximately 80 percent of businesses that either "fail to make a go of it" or cease to "avoid further losses."

Conceptualization of the Small Enterprise Financial Objective Function

A sound approach to conceptualizing the small enterprise financial objective function is to return to the basic tenets of utility theory that underlie existing financial thought, and to develop an extension of utility theory that contemplates more fully the circumstances typically prevailing in small enterprises. A useful starting point for this endeavor is provided by Copeland and Weston (1988, p. 82) in explaining the behavior of rational investors who, in a world of uncertainty, seek to maximize the expected utility of their wealth:

In general, e can write the expected utility of wealth as follows:

E[U(W)] = [summation over i] [p.sub.i] U([W.sub.i])

Given the . . . axioms of rational investor behavior and the additional assumption that all investors always prefer more wealth to less, we can say that investors will always seek to maximize their expected utility of wealth. In fact, the above equation is exactly what we mean by the theory of choice. All investors will use it as their objective function. In other words, they will seem to calculate the expected utility of wealth for all possible alternative choices and then choose the outcome that maximizes their expected utility of wealth.

In the equation given, E is the expectations operator, U is utility, W is wealth and pi is the proportion of wealth held as asset i. In this context, wealth is construed as consumption possibilities, where consumption is considered to be command over goods and services. Formally, wealth is the present value of all future consumption opportunities available to an investor.

The next step is to reconsider what is meant by 'utility' and 'consumption.' Basically, utility arises from anything which yields an investor satisfaction. This mostly comes from consumption of goods and services. However, consumption can be defined more widely to include access to non-pecuniary (sometimes referred to as psychological or psychic) benefits, which might provide satisfaction to a particular investor. Such benefits can include:

* Non-pecuniary satisfactions that are nevertheless in the financial domain, such as security derived from an adequate liquidity buffer, security derived from having a diversified wealth holding, owning an investment that is easily transferable to others, having flexibility to change circumstances should this become necessary, sole retention of control, and avoidance of accountability to others.

* Non-pecuniary satisfactions that, strictly speaking, are outside the financial domain, such as having a preferred lifestyle, being secure in self-employment, being able to offer secure employment to family and friends, maintaining good or benevolent relations with employees, having self-esteem or esteem of others, contributing to the wider community, and being philanthropic.

The value of these non-pecuniary benefits could be measured by the amount of any pecuniary rewards that are given up in order to enjoy them, should this be necessary.

Consider now a rational investor who has a proportion of his or her diversified wealth tied up in equity shares of a business that is a publicly traded company. If, as is common, the company is run by professional managers who are not holders of equity shares, there will be separation of ownership and control of the company. In these circumstances, financial theory argues the objective of management should be to maximize shareholder wealth, which can be achieved by maximizing the market price of the equity shares - that is, a function of two variables only: expected pecuniary return and perceived systematic risk of the shares. The relationship between these two variables may be captured by the conventional Capital Asset Pricing Model (CAPM) as follows:

E([R.sub.j]) = [R.sub.f] + [[Beta].sub.j] [E([R.sub.m]) - [R.sub.f]]

where [R.sub.j] = Expected rate of return on investment j.

[R.sub.f] = Risk-free rate of return.

[R.sub.m] = Expected rate of return on the market portfolio.

[[Beta].sub.j] = Systematic risk of investment j.

It is important to note that the investor can use the maximized pecuniary return provided to acquire whatever non-pecuniary benefits he or she might desire. That is to say, pecuniary returns are traded for non-pecuniary benefits after the pecuniary returns have been received.

Agency theory warns that, in circumstances of separation of ownership and control, there is a chance that maximization of shareholder wealth could be frustrated to a degree by self-seeking behavior on the part of professional managers who are not also owners of the business. Such behavior might include granting themselves exorbitant salaries, excessive consumption of perquisites, shirking, entrenching the position of managers, etc. It is argued that such behavior is partially ameliorated by existence of a competitive market for managerial positions, and by threat of takeover (with subsequent loss of some managerial positions) if share price is not maximized. Nevertheless, some risk of self-seeking behavior by managers could remain and shareholders may have to engage in monitoring and bonding measures which are inevitably costly. Ultimately, the cost of such measures is borne by the shareholders and this represents a diminution of their wealth. These costly activities will be undertaken to the point that their marginal cost just equals the marginal benefit of a reduction in self-seeking behavior on the part of managers.

Now consider the circumstances of an owner-managed business enterprise in which, by definition, there is no separation of ownership and control. The existence of an agency relationship between an owner and a professional manager is less likely and, where such a relationship does exist, the cost of monitoring and bonding measures tends to be less onerous since the owner can often directly observe the behavior of an employed manager on a daily basis. In principle, the precepts of financial theory are no different from those applying to a public company. The objective should still be maximization of the owner's wealth, again a function of expected pecuniary return and perceived risk. However, there are complications in such a business, making achievement of this objective less straightforward. For reasons of taxation, an owner-manager might accept an apparently low return on his or her invested capital while taking what by normal standards would be considered an excessive salary. For reasons of convenience and/or taxation, an owner-manager may personally enjoy excessive consumption of perquisites, and thus diminish the apparent pecuniary return on his or her capital.

In an owner-managed enterprise, non-pecuniary benefits can be, and often are, taken in place of pecuniary returns. For example, an owner-manager may sacrifice pecuniary return in exchange for a preferred lifestyle. Or pecuniary return might be lowered by an owner-manager's insistence on employing family and/or friends on overly generous terms, or when such employment is not justified by real labor requirements. The point is that an owner-manager is perfectly entitled and able to do such things since he or she owns and has sole control over the business. Most importantly, these non-pecuniary benefits are taken before pecuniary returns are ascertained. The tradeoff between pecuniary returns and non-pecuniary benefits may be taking place more or less continuously in day-to-day work life.

For the circumstances of an owner-managed business enterprise, Osteryoung, Best, and Nast (1992) have proposed an investor utility function as follows:

U = U (I, P, L, A)

where I = Income from the business enabling personal consumption by the owner manager.

P = Premium consumption, meaning the consumption of perquisites in the business by the owner-manager.

L = Leisure time which may be increased by the owner-manager shirking in the business

A = Achievement needs of the owner-manager interpreted as his or her desire to succeed.

Osteryoung, Best, and Nast (1992, p. 5) go on to indicate that:

Both income and premium consumption are quantitative measures and are financial in nature. Thus, these factors can be thought of as the single financial factor (F) of utility. . . . leisure time desire and need for achievement cannot be measured quantitatively. They are, in essence, nonfinancial factors. Thus, these two factors can be considered corporately as nonfinancial factors (N) of utility.

Hence, the investor utility function posited reduces to:

U = U (F, N)

Considering also a priori beliefs of owner-managers and financial constraints typically applying in small enterprises, in particular limited access to capital, Osteryoung, Best, and Nast et al. (1992) use this investor utility function to provide an explanation of why some small enterprises grow and why others do not. Hence, they account for the usually observed size distribution of business enterprises.

An alternative specification of the investor utility function for circumstances of an owner-managed business enterprise, based on ideas presented in this paper, would appear as follows:

U = U (P, [N.sub.f], [N.sub.n], [null set])

Where P = Pecuniary returns from the business including a return on invested capital, a reasonable salary for owner-manager expertise, experience, time and effort, any excess in owner-manager salary above a reasonable reward, and also the value of perquisites consumed.

[N.sub.f] = Non-pecuniary satisfactions from the business that are nevertheless in the financial domain, as specified earlier in the paper.

[N.sub.n] = Non-pecuniary satisfactions from the business that, strictly speaking, are outside the financial domain, as specified earlier in the paper.

[null set] = Total risk associated with owner-manager investment of financial and human capital in the business, which is the sum of the systematic risk faced and the unsystematic or enterprise-specific risk faced.

In the formulation of a small enterprise owner-manager's utility function presented above, the term P corresponds to pecuniary return as normally contemplated by modem finance theory. Thus, the level of P is expected to depend primarily upon the level of systematic risk faced. The term [N.sub.f] captures the liquidity, diversification, transferability, flexibility, control, and accountability considerations, which it is believed should be made explicit in the small enterprise financial objective function. As indicated earlier, their inclusion is justified on the basis of their association with sources of enterprise-specific or unsystematic risk. The terms P, [N.sub.f], and [null set], together constitute the main elements of the small enterprise financial objective function.

Inclusion of the term [N.sub.n] in the small enterprise owner-manager's utility function allows for the fact that an owner-manager may choose not to maximize financial return from his or her business, instead trading off financial return for non-pecuniary benefits such as preferred lifestyle, security of employment, etc. In a traditional or lifestyle small enterprise, the term [N.sub.n] can be expected to be a significant influence on owner-manager decision behavior. This being the case, the growth prospects of the enterprise are inevitably limited. In a growth or entrepreneurial small enterprise, the term [N.sub.n] can be expected to have a negligible influence on owner-manager decisions. Thus, the growth prospects of the enterprise are likely to be enhanced. Whether such a concern is likely to become a large, publicly traded company is dependent upon the relative importance of the two return terms that make up the business's financial objective function.

The more important the term [N.sub.f] is as an influence on owner-manager decisions, the more likely the enterprise will cease to grow at some intermediate stage of development. For example, preoccupation with retaining control and avoiding accountability to others may cause an owner-manager to minimize dependence of his or her enterprise upon external sources of finance, thus limiting growth potential. This behavior is often evident at the stage in the enterprise lifecycle at which public listing of the concern is the only avenue to further growth. Where the term P is the dominant influence on owner-manager behavior, public listing is far more likely. Where the term [N.sub.f] is influential, the owner-manager may arrest development of the enterprise by rejecting the opportunity of public listing on a stock exchange.


The purpose of the discussion in the previous section of the paper was to present a conceptualization of the small enterprise financial objective function that is sympathetic to existing financial thought, but that nevertheless captures complexities arising in a small enterprise from the absence of separation of ownership and control. It is believed that the resulting utility function holds promise as an explanatory framework for financial behavior in small enterprises in that it provides valuable insights into owner-manager decision making and small enterprise development. The next logical step in this conceptual development would involve formulation of a new asset pricing model for small enterprise incorporating the additional terms that have been included in the utility function. This, of course, would be a non-trivial undertaking because of the mathematics likely to be involved.

Conventional Capital Asset Pricing Model

More pragmatic researchers in the field might be inclined to make do with the conventional CAPM, and to recognize likely influences of the additional terms in the utility function in a more or less ad hoc fashion. The rationale for doing this is that, notwithstanding its obvious shortcomings as a representation of financial reality, it is still widely used in teaching and research in the academic domain of financial management. The work of McMahon, Holmes, Hutchinson, and Forsaith (1993) includes consideration of the relevance and applicability of the CAPM to the circumstances typically encountered in small enterprises. After reviewing the small enterprise literature, their conclusion is that, in its conventional form, the CAPM is not a good description of the basic relationship between return and risk operative in small enterprises. In recognition of this, a modification to the CAPM is proposed as follows:

Required rate of return = Risk-free rate of return + Premium for systematic risk + Small enterprise premium

It is suggested that the small enterprise premium would reflect exposure to sources of unsystematic or enterprise-specific risk typically arising in small enterprises identified earlier in the paper.

An important question at this stage is whether there are grounds for believing a small enterprise premium might exist. The only available empirical evidence on this is provided by the extensive literature on the so-called Osmall firm effectO for smaller publicly listed enterprises. This literature suggests that, on average, smaller enterprises listed on stock exchanges experience significantly higher risk-adjusted returns than listed larger enterprises. In other words, investors in shares of listed smaller enterprises can earn excess returns above those that would be predicted by the CAPM given the systematic risks of these shares. After reviewing the relevant literature on the small firm effect, McMahon rom. (1993, p. 114) conclude as follows:

In summary, the available empirical evidence on the small firm effect suggests that it exists and persists on stock exchanges around the world, and that this is so for main boards and second boards. There is some evidence which is not conclusive that the cause of the small firm effect may be related to the limited availability of information on listed small enterprises, and to a lack of marketability of their shares. Hence, it is argued that ignorance and illiquidity confront investors in small enterprises with greater unique or unsystematic risk, and that they therefore expect to receive higher returns than would be predicted from the CAPM which prices only systematic risk. It is probable that the existence of transaction costs which bear more heavily on small enterprises, and which the CAPM assumes away, also play a part in accounting for the small firm effect.

It should be noted that the terms "lack of marketability" and "illiquidity" in the quotation above correspond to one of the sources of unsystematic or enterprise-specific risk in small enterprises identified earlier, namely transferability. Thus, the small firm effect provides some limited evidence, albeit for smaller publicly listed enterprises, for existence of a small enterprise premium - possibly related, inter alia, to limited transferability of ownership stakes in smaller enterprises arising from thin markets, information asymmetries, and neglect of small enterprise investment opportunities on the part of investors.

Because there is by no means universal agreement on the validity of the CAPM for large business enterprises, let alone for small enterprises, it might be considered that such an ad hoc extension to the CAPM as is described above is not an appropriate means for making explicit the proposed liquidity, diversification, transferability, flexibility, control, and accountability considerations in the financial objective function of small enterprises. McMahon rom. (1993, p. 115) provide further justification for not using the CAPM framework in the present context:

It is difficult to disregard the mounting evidence that as far as small enterprises are concerned, the CAPM seems to be missing some vital explanatory factors which would account for the relationship between return and risk in such concerns. The existence of the small firm effect lends support for the possibility that these might include information, marketability and transaction cost considerations. However, it does not shed light on the other important deficiency of the CAPM in the context of small enterprise financial management - that contrary to the underlying assumptions of the CAPM the typical small enterprise owner-manager does not hold a diversified wealth portfolio.

Generalized Capital Asset Pricing Model

Another possibility for an asset pricing model appropriate to the context of small enterprise is provided by Levy (1990) who proposes a Generalized Capital Asset Pricing Model (GCAPM) which purportedly applies in a world where there is market segmentation, and investors do not hold diversified portfolios. This model not only reflects the influences of some of the additional terms in the small enterprise utility function proposed in this paper, but also deals with the apparent existence of the small-firm effect. In the world contemplated by Levy (1990), an investor in a particular market segment would only acquire investments available in that segment and would necessarily hold an undiversified portfolio, which is not efficient in the sense of representing the highest expected return for the level of risk faced or the lowest risk for the level of expected return. As far as small enterprise is concerned, this world would be one in which an owner-manager's undiversified investment of financial and human capital would be confined to whatever is appropriate to his or her industry or business activity (that is, market segment). On the basis of what is known about small enterprise, this does not appear to be an unreasonable representation of reality.

The GCAPM suggested by Levy (1990) may be expressed as follows:

[R.sub.jk] = [R.sub.f] + [[Beta].sub.jk] ([] - [R.sub.f])

where [R.sub.jk] = Expected rate of return on investment j in market segment k.

[R.sub.f] = Risk-free rate of return.

[] = Expected rate of return on market portfolio of market segment k.

[[Beta].sub.jk] = Systematic risk of investment j in market segment k.

This model is of the same form as the conventional CAPM but confines the measurement of return and risk to a particular market segment. Instead of having a single market portfolio represented by one broad-based index, there would be a separate market portfolio for each market segment represented by an index for that segment only.

Levy (1990) argues that the number of investments included in an optimal portfolio would vary between investors because of the existence of transaction costs. In other words, non-trivial transaction costs of moving between segments are what maintain those segments. In the absence of transaction costs, the GCAPM collapses to become the single segment, conventional CAPM, and the latter is therefore a special case of the former. Incomplete information and the heterogeneous expectations that result could also explain market segmentation. If full information is available without cost to all investors, the GCAPM again reduces to the special case represented by the CAPM.

The potential relevance of Levy's (1990) model to the circumstances of small enterprise is apparent. Unlike the CAPM, the GCAPM can address and accommodate the immobility of financial and human capital invested in a typical small enterprise. The GCAPM would acknowledge that the owner-manager of an unprofitable small enterprise may not be easily able to escape from it and enter another pursuit due to the transaction costs involved, such as sale of the enterprise at a distress price, brokering and legal fees, and relocation expenses. The GCAPM would also recognize the possible existence and influence of incomplete information such as not knowing the whereabouts of a buyer, not being aware of other opportunities available, and not having the expertise required to become established in another field.

In his paper, Levy (1990) proves mathematically that the relationships between key elements of the conventional CAPM and those of the GCAPM are as follows:

* For small enterprises [[Beta].sub.j] [less than] [[Beta].sub.jk], and for large enterprises [[Beta].sub.j] [greater than] [[Beta].sub.jk].

* For segments of portfolios composed of small enterprises [] [greater than] [R.sub.m], and in segments of portfolios composed of large enterprises [] [less than] [R.sub.m].

Levy (1990) then shows mathematically and empirically that if the CAPM is used as the benchmark for testing, either of these conditions would make the small-firm effect appear to exist. He also indicates that empirical research has shown that the two conditions actually enhance each other, making the small-firm effect even more pronounced. In Levy's (1990, pp. 236-237) own words:

In equilibrium with segmented markets, we expect small firms to have abnormal returns if risk is measured in the CAPM context. We . . . show that if markets are indeed segmented, then the use of a risk index derived from a non-segmented market equilibrium model induces the [small firm effect], as documented in the literature. The measured abnormal returns, however, are illusory and result from employing a misspecified model and not from statistical measurement errors. In general, when one employs a 'wrong' model, biases are not expected in one direction. We . . . prove . . . that employing the CAPM when the markets are in fact segmented includes a systematic bias which is erroneously identified as the [small firm effect].

Thus, Levy's (1990) GCAPM not only accommodates the lack of diversification that is common amongst small enterprise owner-managers and the immobility of their financial and human capital, but also provides an explanation for the puzzle of the small-firm effect. Moreover, it accomplishes these most desirable ends as far as small enterprise financial management is concerned without seriously compromising the simplicity and elegance that has made the CAPM a cornerstone of existing financial theory.


Attention should first be given to the basic issue of whether owner-managers of small enterprises actually have and use explicitly stated objectives. This matter is addressed by Hornaday and Wheatley (1986), who indicate that some research reveals small enterprises do not formally set goals because they perceive little benefit from doing so. On the reliability of such evidence, Hornaday and Wheatley (1986, p. 2) comment as follows:

Perhaps small firms do plan and do set goals, but because they cannot afford and do not use the planning processes found in large organizations, researchers find little evidence of goal-setting and planning.

D'Amboise and Gasse (1980) contend owner-managers in their research had goals, predominantly relating to profitability and growth; however, only 10 percent stated them in writing. In their review of empirical evidence on small enterprise financial management practices, McMahon and Holmes (1989) note considerable emphasis in small enterprise upon mere survival - an aspiration that hardly requires written expression. Hornaday and Wheatley (1986, p. 2) found objectives were specified using terms of survival, growth, and internal efficiency, and they conclude that "Managers of successful small firms set goals and, at least in the case of survival and growth goals, achieve these goals."

Consider now the available empirical evidence on the nature of financial objectives pursued in small enterprises. In his study of the investment behavior of 65 small manufacturing enterprises in the Plymouth area of England between 1970 and 1975, Hankinson (1977) produced evidence presented in Table 1 on the primary objective of those businesses.

The strategic planning practices of 46 small and medium-sized enterprises from a range of industries located in the New England region of the United States are reported by Shuman (1975). Approximately 52 percent of respondents reported their primary objective to be "profits." Growth was the primary objective of under 4 percent of respondents. In the province of Quebec in Canada, D'Amboise and Gasse (1980) found that 16 percent of a sample of small shoe manufacturers and approximately 20 percent of a sample of small plastics manufacturers reported "profits" as their primary objective. Growth was the primary objective of just over 30 percent of respondents in both industries.

The English "supergrowth" enterprises in the research of Ray and Hutchinson (1983) were primarily motivated to maximize profits or increase sales. Reflecting the inevitable financial pressures of their circumstances, the key control variables for these enterprises were cash-flow and sales growth. The objectives and key control variables of a matched sample of non-growth enterprises were more consistent with the Bolton [TABULAR DATA FOR TABLE 1 OMITTED] (1971) findings in the United Kingdom, which underscored the importance of owner-manager independence. In a study of the pricing behavior of a sample of 60 small engineering businesses in the East Dorset and West Hampshire regions of England during the period 1983 to 1985, Hankinson (1985) found that 32 percent of respondents indicated their conception of success to be "survival." "Good profit record" and "sales growth" were the nearest alternatives, each coming from 12 percent of respondents.

The most comprehensive empirical study of financial objectives in small enterprises found in the literature is reported by Cooley and Edwards (1983). The researchers asked a sample of 97 small enterprise owner-managers engaged in distribution of petroleum products in the United States to rank in order of importance six specific financial goals. A summary of responses is provided in Table 2.

These results suggest maximizing accounting profit was the most popular financial objective amongst respondents to the survey, with growth in this measure of performance being the next most highly ranked. From the viewpoint of financial theory, the low ranking accorded enterprise selling value is obviously most disturbing. Cooley and Edwards (1983, p. 31) explain their findings as follows:

For owner-managers of small firms, net income is a readily identifiable and measurable quantity obtained from the income statement. In contrast, selling value of the firm is not so readily identifiable, there being no active trading in the stock of the company. The obscureness of selling value and difficulty in its estimation probably account for the little emphasis placed on value maximization.

The implication here is that enterprise value may have been important to the owner-managers surveyed (it is difficult to imagine this would be otherwise), but problematic for them to operationalize as a focus for their financial decision making. Consequently, accounting profit appears to have served as a surrogate measure of financial achievement. The concern with this practice for financial theory is how well accounting profit [TABULAR DATA FOR TABLE 2 OMITTED] proxies for enterprise value in a financial decision context, given that it fails to adequately capture the amount, timing, and risk of cash-flows.


The purpose of this paper has been to improve the conceptual understanding of the small enterprise financial objective function as a theoretical foundation for future empirical inquiry. The paper has presented a conceptualization of the small enterprise financial objective function that captures complexities arising in small enterprise that receive minimal attention in financial theory, such as non-separation of ownership and control. While every attempt has been made to ground the conceptualization of the small enterprise financial objective function in existing theoretical and empirical knowledge in the academic fields of financial management and small enterprise, it remains largely conjectural and in need of rigorous empirical validation (or, indeed, refutation). The value in undertaking this task will obviously lie in providing a sounder basis for understanding the theory and practice of small enterprise financial management.

In the broadest terms, a research agenda for an empirical inquiry into the small enterprise financial objective function might appear as follows:

1. Discovery of the extent to which small enterprise owner-managers actually pursue explicit (written or unwritten) financial objectives; what these objectives are likely to be, how they are expressed, and how their attainment is measured; what influences are apt to bear on establishment of financial objectives; and the extent to which specified financial objectives are short-term (tactical) or long-term (strategic) in nature, and whether temporal trade-offs in financial objectives might take place. It would also be necessary to catalogue from a fairly sizable literature all non-pecuniary objectives likely to be encountered in small enterprises.

2. Identification and specification of the key elements of the financial objective function of small enterprises in general (if this should prove possible). Based on research to date, this paper has proposed that these may include return, systematic risk, liquidity, diversification, transferability, flexibility, control, and accountability considerations. There could be other important elements; and some of those suggested might be redundant. The central proposition made in this paper that begs empirical scrutiny is that the small enterprise financial objective function should reflect exposure to the enterprise-specific sources of risk identified.

3. Examination of the extent to which the financial objective function varies between small enterprises of different kinds. Existing knowledge establishes a prima facie case for believing there are likely to be significant variations in financial objectives pursued by diverse small enterprises, and also that there will be contrasts in the major influences on these objectives. In this regard, possible differences between traditional or lifestyle small enterprises and growth or entrepreneurial enterprises could be most important for financial theory. Again, there is presently little, if any, empirical evidence to support or refute this belief.

4. Determination of the extent to which pecuniary returns are traded off in small enterprises for what have been variously called non-pecuniary, non-monetary, non-financial, lifestyle, psychological, or psychic returns. The bulk of evidence currently available gives every reason to expect such trade-offs can and do take place in small enterprises. Any theory of small enterprise financial management that overlooks these will necessarily be ill-founded and lacking in explanatory power.

The proposed inquiry will be inherently problematic in that it will focus on matters that most small enterprise owner-managers would consider to be privileged to themselves and their advisers, and sensitive to external scrutiny. Meeting this challenge, however, seems more than justified by the potential contribution of the inquiry to scholarship in the emerging academic field of small enterprise financial management.


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Richard G. P. McMahon is Associate Professor of Accounting and Finance at the Flinders University of South Australia.

Anthony M. J. Stanger is Lecturer in Accounting and Finance at The Flinders University of South Australia.

Earlier versions of this paper were presented to the 5th Small Firm Financial Research Symposium in Long Beach, California, April 1993, and to the 38th World Conference of the International Council for Small Business in Las Vegas, Nevada, June 1993. Parts of the paper have been presented to the 6th Small Finn Financial Research Symposium in Edwardsville, Illinois, April 1994, and to the 39th World Conference of the International Council for Small Business in Strasbourg, France, June 1994. The authors acknowledge advice from Professor A.L. Riding of Carleton University, Professor F.C. Scherr of West Virginia University, and Dr. K. Brown of the University of Otago, Dunedin, which has contributed significantly to the paper. The authors' thanks are also due to Professor J.S. Osteryoung, Florida State University, for access to his work, and to four anonymous reviewers for comments on earlier drafts.
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Author:McMahon, Richard G.P.; Stanger, Anthony M.J.
Publication:Entrepreneurship: Theory and Practice
Date:Jun 22, 1995
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