Business borrowing and control: A theory of entrepreneurial types

Abstract

A formal model of the bank borrowing decision by the small firm is provided to explain why some entrepreneurs borrow and others do not, and why some businesses grow and others remain stationary over long periods. Loan capital is productive and increases the firm's revenue but brings the business under the control of the bank. Profits generated by borrowing are a ‘good’ increasing owner utility whereas control is a ‘bad’, reducing it. The consequent tradeoff between borrowing and control implies that the business' optimum will involve borrowing less than the amount that maximises profits. If owner control-aversion is strong enough equilibrium may involve a corner solution with the business being entirely self-funding. The above result holds under conditions of symmetric information and zero credit rationing. Dynamic analysis distinguishes one group of entrepreneurs (Movers) whose preferences towards control evolve through time and their control-aversion diminishes, from another group (Stayers) whose preferences remain stationary. For the Movers borrowing increases over time up to a profit-maximising optimum whereas for the Stayers independence of control is maintained but at the expense of non-growth.