New research from Texas McCombs shows that when small-business owners see a drop in their personal stock portfolios during a recession, it’s bad news for their companies. The study found a connection between the wealth of these entrepreneurs and how well their businesses do in tough economic times.
When their stock portfolios take a hit, it has a ripple effect on their businesses, leading to less money available and fewer new hires. This begs the question: do these smaller businesses suffer more than the bigger, older ones when faced with the challenges of a recession?
“Entrepreneurial wealth follows the ups and downs of economic cycles,” the researchers explain. “I show that for entrepreneurs whose stock portfolios take a hit, their businesses are adversely affected to a greater extent than established businesses.”
Influencing behavior
The study found that these kinds of business constrictions are especially common among younger firms, not least because older firms tend to have a wider range of financial options.
The researchers analyzed the stock portfolios of entrepreneurs during the 2008 financial crisis. They used Norway as their Petri dish as income and investing data is widely available. They merged this data with the employment registers to understand what impact the fall in share prices had on the businesses of investors, and indeed on their employees.
The results show that when the markets crashed, it had a significant impact on the way entrepreneurs invested in their firms, with newer firms seeing a bigger fall in investment.
Fall in investment
A 10% decline in stock values resulted in a significant 5-percentage-point reduction in employment growth, particularly noticeable from 2007 to 2010. Even five years after the financial crisis initiated, job levels in younger companies had not fully recovered.
The employment shrinkage wasn’t primarily due to layoffs but rather a decrease in hiring. During a recession, investing in new employees tends to take a back seat as a priority.
When an owner’s wealth experienced a 10% dip, it translated into limitations on capital available for business expansion. This led to a 22% reduction in outside equity injections, with younger companies experiencing an 84% decline in the two-year rate of investment in facilities and property.
The sensitivity of younger businesses to their owners’ investment setbacks can be attributed to their reliance on a single source of financing. More mature firms, on the other hand, demonstrated the ability to substitute other funding sources, such as banks.
Other forms of finance
Interestingly, mature companies increased their reliance on bank debt following an owner’s wealth shock, while younger ones witnessed a decrease in bank debt. This divergence raises a crucial policy question: whether diminished business activity is predominantly influenced by financial factors or psychological ones, such as a decline in entrepreneurs’ risk-taking inclination.
The results strongly suggest that financial constraints are a key factor. As a result, the authors argue that government interventions should actively try and counter these constraints so that small businesses are better able to weather recessions.
“Small businesses are important in most economies, and most of these firms rely heavily on their owners for financing,” the researchers conclude. “Owners can be a viable source of financing, but unfortunately, the owner’s personal wealth is likely to be hit at the same time as the firm is experiencing a downturn.”
