Entrepreneurs with little capital are most successful
Too much wealth makes entrepreneurs fat and content. In a new study of Norwegian entrepreneurs, researchers find that profits increase most for the entrepreneurs with least capital.
Wealth can do more harm than good. This is demonstrated by Professor Jarle Møen of the Department of Finance and Management Science (NHH) and Professor Hans K Hvide of the University of Aberdeen in the article 'Lean and Hungry or Fat And Content? Entrepreneurs' Wealth and Start-up Performance' (2010).
The researchers' article about Norwegian entrepreneurs was published inManagement Science six months ago, triggering NHH's publication bonus for Professor Møen.
'You quote Shakespeare in the introduction, where you already imply that large assets make entrepreneurs fat and content?'
'Yes, our findings point in that direction, so Shakespeare has a point.'
According to economic theory, entrepreneurs with large private wealth should do better than those with fewer assets. Others warn that too much liquidity can lead to over-investment or be detrimental to the entrepreneur's motivation and vigilance. In their article, the researchers write that the idea that more liquidity can have a negative effect on results can be traced back to Plato, who wrote inThe Republic that 'wealth is the parent of luxury and indolence'.
Professors Møen and Hvide test their theories by studying data from a large number of business start-ups in Norway.
'We are studying the connection between wealth and business start-ups, measured in terms of profit. Entrepreneurs are ranked by wealth and, to put it briefly, we see that profits increase in the first three wealth quartiles, while profits drop sharply in the top wealth quartile. For the richest, profitability drops by 11 percentage points in the sample we have studied - and that is a lot. Our study thus indicates that great wealth can do more harm than good for entrepreneurs.'
Lack of constraints
The researchers' data set is made up of the annual accounting information from Dun & Bradstreet's database and individual data from Statistics Norway. This makes it possible for the researchers to take account of variables such as gender, age, education, wealth and income. In addition, they use data from the Brønnøysund Register Centre, where information about owners and assets is available.
'What is the reason for the drop in profits in the group with the greatest wealth?'
'It could be due to the lack of any limit on liquidity,' Professor Møen believes.
Møen and Hvide are unable to pinpoint the underlying mechanisms that drive the negative relationship between a founder's wealth and the financial performance of the start-up business.
'But there are some mechanisms that provide reasonable explanations for the negative connection between wealth and profits. Two mechanisms are particularly useful for understanding this: organisational slack and personal advantages. These are not mutually exclusive,' says Professor Møen.
The fact that a new business owner has financial freedom results in slack, and many people have argued that this creates an effective buffer against external shocks or makes it possible to experiment and develop the business. On the other hand, too much slack could lower the bar for what constitutes acceptable financial performance, as Møen and Hvide describe in their article.
Entrepreneurship as a luxury good
'The other factor is the personal motivation of the entrepreneur. For some people, entrepreneurship can be a sort of luxury good. Rich people may therefore be very motivated to start up a business and be willing to forgo income in order to enjoy the personal advantages this brings.'
'What do you mean by saying that entrepreneurship is a luxury good?'
'It is both about status and about being one's own master. Some people think it is okay to be wage earners, while others like to run their own business. For former top executives, for example, there can be more prestige in running their own business than in starting in a less prestigious job than the one they left.'
If entrepreneurship is regarded as a luxury good, this means that the wealthier you are, the more of this good you can afford.
Professor Møen says that if you have great wealth the result is not critical, and you let your guard down. The bank is not looking over your shoulder and does not contribute its expertise to quality assuring the project in advance. It might not be a conscious wish, but you are less disciplined because of external causes.
'Normally, banks and co-investors will serve as a corrective, and the more risk you take, the more critical they will be. If you finance the whole thing yourself, you can simply start up - and are often a bit too optimistic,' Professor Møen says.
'What can we learn from your research findings?'
'It has been normal to see a lack of capital as an obstacle to entrepreneurship and innovation. Our findings nuance this picture. If new businesses are not disciplined by a certain scarcity of capital, both the entrepreneur and investors should be very much on the alert,' says Professor Møen.