Journal of Small Business Management 2002 40(4), pp.

273–286

Do Banks Price Owner–Manager Agency Costs?

An Examination of Small Business Borrowing*
by James C. Brau

Ang, Cole, and Lin (2000) provide evidence that supports the theoretical work of Jensen
and Meckling (1976) on agency costs. As a further examination, I conduct a test to
determine the economic significance of owner–manager agency conflicts. Using the same
data source and empirical framework as Ang, Cole, and Lin (2000), I test to determine if
banks charge a premium when extending loans to firms with various ownership structures.
In empirical tests, I find that banks do not require an owner–manager agency premium
either through increased interest rates or through the requirement of collateral. Instead, I
find that the interest rate is significantly affected by the length of the longest banking
relationship, the number of banking relationships, firm age, and firm size. Additionally,
the requirement of collateral is significantly affected by the number of banking relation-
ships, the debt position of the firm, and firm size.

In a recent article, Ang, Cole, and Lin
(2000) (hereafter ACL) find empirical evi-
dence of the owner–manager agency costs
theorized by Jensen and Meckling (1976).1
ACL use two proxies for owner–manager
agency costs: the expense ratio (that is,
operating expenses/sales) and the total as-
set turnover ratio (that is, sales/assets).
These two ratios measure how efficient the
manager operates and are intended to
proxy for the owner–manager agency costs
suffered by the firm. Using a sample drawn
from the Federal Reserve Board’s National
Survey of Small Business Finances
(NSSBF), the authors compare the base
Jensen and Meckling (1976) zero agency
cost firm (that is, a firm with a single
owner–manager) to firms with different
ownership structures.
ACL find that agency costs (as measured
by the expense and turnover ratios) are
significantly higher when an outsider man-

Jim Brau is assistant professor of finance at the Marriott School, Brigham Young University. His
current research interests include initial public offerings and entrepreneurial finance.
*The author thanks Rebel Cole, Hal Heaton, Andrew Holmes, Grant McQueen, Mike Pinegar,
Steve Thorley, Brent Wilson, three anonymous referees, and the editor (Patrick Mann) for helpful
comments.
1For this study, I use the term “owner–manager agency” to refer to the principal-agent conflicts
that occur when the incentives of owners and management are imperfectly aligned. This specific
type of agency cost is modeled by Jensen and Meckling (1976) and is a subset of all possible
agency conflicts.

BRAU 273
ages the firm and are significantly lower
with greater monitoring by banks. Addi-
tionally, they report that agency costs are
related inversely to the manager’s owner-
ship share and are related directly to the
number of nonmanager shareholders. The
authors conclude that the ownership
structure of a firm significantly impacts the
degree of agency costs.
In this paper, I extend the work of ACL
by testing to determine if banks price
owner–manager agency costs within bor-
rowing firms. The bank pricing issue is
important because it allows for the mea-
surement of the impact of owner–manager
agency costs on firm value. Ideally, a re-
searcher would like to test the impact of
the various ownership structures (that is,
the owner–manager agency costs) on firm
stock prices to determine if the costs are
priced. Unfortunately the firms included
in the NSSBF survey generally are not pub-
licly traded, and the survey neither identi-
fies nor provides market price data for
those that are publicly traded. Without the
stock market data, ACL cannot relate
agency costs to firm value but rather can
only show that agency costs as measured
by the two performance ratios are related
to ownership structure and to the degree
of monitoring. This paper differs from ACL
in that I construct an alternate methodol-
ogy to determine if the owner–manager
agency costs impact firm value.
If owner–manager agency costs de-
crease firm value and therefore increase
the probability of loan default, banks
should price these costs in one of two
ways: Banks should increase the interest
rate (referred to as the interest rate agency
premium); and/or banks should require
collateral (referred to as the collateral
agency premium).2
If the interest rate and collateral premi-
ums exist, then one can infer that owner-
management agency conflicts impact firm
2For discussions pertaining to secured debt that are consistent with this argument, see Smith and
Warner (1979a and 1979b), Stulz and Johnson (1985), and Leeth and Scott (1989).
274 JOURNAL OF SMALL BUSINESS MANAGEMENT
value. Banks specialize in gathering data
and making loans, so they can be thought
of as highly informed investors. Showing
that these informed investors not only de-
tect potential agency problems but also
deem them important enough to price
would provide evidence that agency costs
are both statistically and economically sig-
nificant. If, however, banks do not charge
an interest rate or collateral agency pre-
mium, this indicates that bankers do not
consider owner–manager agency conflicts
important enough to price (that is, impor-
tant enough to affect firm value).
I employ the same data source as in the
ACL article. The NSSBF survey was con-
ducted in 1994 and 1995 for the Board of
Governors of the Federal Reserve System
and the U.S. Small Business Administration.
The survey consists of 4,637 firms that em-
ployed less than 500 employees at year-end
1992. My sample, however, differs from the
ACL sample in that I include only those
corporations that answered “yes” to the sur-
vey question that asked if they had applied
for a loan within the past three years. By
doing so, I am able to obtain the interest rate
associated with the loan.
In empirical tests, I find that banks do not
charge either interest rate or collateral
agency premiums. The same owner–man-
ager agency variables that are significantly
related to the performance ratios in the ACL
study have no impact on either the interest
rate charged in the loan or the requirement
of collateral. These findings suggest that, at
least as viewed by the banking industry in
extending loans to small businesses,
owner–manager agency costs are not eco-
nomically significant. Instead, several other
variables do significantly impact the interest
rate and the incidence of collateral.
Specifically, firms with longer banking
relationships, older firms, and larger firms
each pay a significantly lower interest rate,
whereas firms with numerous banking
relationships pay a greater rate. Addition-
ally, firms with numerous banking relation-
ships, firms with relatively more debt in
their capital structures, and larger firms
pledge collateral more often than their
counterparts.
Theoretical Discussion
In their seminal work on agency theory,
Jensen and Meckling (1976) begin with the
case of a manager-owner who owns 100
percent of the firm. The manager may in-
crease utility through money wages, the mar-
ket value of the firm, and perquisites. In this
framework, money wages are assumed con-
stant and perquisites are assumed to be in-
separable from the firm. Given these three
avenues to increase utility, the manager-
owner constructs the optimal combination
of wages, firm appreciation, and perquisites
to maximize his/her utility. Because the man-
ager bears all of the costs associated with the
perquisites taken, the costs are factored into
the optimal consumption mix and no agency
conflicts exist.
As the ownership structure varies from
the 100 percent owner–manager, poten-
tial agency conflicts emerge. For example,
when a part of the company is sold to
outside investors but the manager-owner
retains control of the firm, the three ave-
nues for increasing utility remain. How-
ever, the cost of perquisite consumption
now is shared by the outside investors.
Thus, incentives to consume perquisites
are increased for the manager-owner while
continuing to reap the full benefit but not
having to bear the full cost. This type of
owner–manager agency cost is hypothe-
sized to reduce firm value by impairing
operating efficiencies. Whether firm value
actually is harmed by the owner–manager
agency conflicts is an empirical matter and
is the motivation for this study.3 The pur-
pose of this paper is to determine if inter-
est rate and collateral agency premiums
exist. The two questions asked in this pa-
per are (1) Is there a relationship between
the potential owner–manager agency con-
flict in a firm due to its ownership structure
and the interest rate required to obtain a
loan; and (2) Is there a relationship be-
tween the potential owner–manager
agency conflict in a firm and the incidence
of pledged collateral required for a loan?
If potential agency conflicts are consid-
ered important economic factors by banks,
either one or both of these questions should
be answered in the affirmative. Agency the-
ory predicts that a direct relationship will be
observed between the agency premium and
the potential agency conflicts. If banks do
not view owner–manager agency conflicts
within borrowing firms as important eco-
nomic factors, the questions should be an-
swered in the negative.4
Data and Empirical
Methodology
Data
The data sample for this study is gathered
from the Federal Reserve Board’s National
Survey of Small Business Finances (NSSBF)
1995 survey. The target population for the
survey is the population of all for-profit,
nonfinancial, nonfarm businesses with
fewer than 500 employees that were in op-
eration as of year-end 1992. The sample was
drawn from the November 1993 Dun’s Mar-
ket Identifier file.

3Another example of an ownership structure that may induce agency conflicts is when the
ownership is retained but the management is relinquished. In this case, if the manager acts in
his/her own interest and not in the owner’s best interest, the agency costs will be realized by the
owner to the detriment of the firm. Again, this potential of conflict may decrease firm value and
increase the risk of default associated with the bank loan.
4These arguments assume that banks are sophisticated enough to recognize potential agency
conflicts within borrowing firms. Given the time, energy, and assets banks employ to obtain and
analyze information on potential borrowers, this assumption seems plausible.

BRAU 275
 For a firm to be included in this study,
it must meet the following criteria: (1) The
firm must be organized as a C-corpora-
tion; and (2) The firm must have received
a loan that is indexed to the prime rate in
the three years prior to the survey. Interest
rate data is available only for the most
recent loan; hence, it is the choice of the
three-year window.5 There are 903 such
firms indexed to prime in the survey of
which 479 are C-corporations. Finally, firms
with less than 200 shareholders are in-
cluded to create a homogeneous sample.6
These selection criteria result in a sample
of 463 firms. The final sample represents
approximately 27 percent of the 1,708 firm
ACL sample.
Methodology
The methodology used to answer the
two questions asked above is an adapta-
tion of the ACL article. Specifically, a series
of difference tests are employed (that is,
means and medians), Ordinary Least
Squares (OLS) regressions and logit re-
gressions. Tables 1, 2, and 3 coincide with
the same tables in the ACL study. The iden-
tical independent variables are used to
measure the potential for owner–manager
agency costs and to control other relevant
factors because these are identified as sig-
nificant factors by ACL. In order to deter-
mine the existence of an interest rate
agency premium, I examine the number of
points above the prime rate that the firm
paid for the loan. In order to determine
the existence of a collateral agency pre-
mium, I create a binary variable that equals
one if collateral secures the loan and zero
if collateral is not required.
Limitations of the Research
It is possible that the nature of the sam-
ple may impose biases upon the sub-
sequent results of the paper, which may
appear for several reasons. First, I study
exclusively C-corporations, in order to ex-
tend the ACL study by using the same
organizational structure of firms. In unre-
ported tests, however, all of the forms of
ownership are included (that is, proprie-
torship, partnership, and S-corporations).
Although I cannot perform all of the tests
reported due to the limitation of share-
holder ownership data, qualitatively the
results of the reported tests are robust.
A second possible source of bias is that
only firms that successfully received a loan
are included. Thus, the data sample ex-
cludes those firms that (1) applied for a
loan and were rejected, (2) rejected bank
financing as too expensive, and/or (3) used
personal assets to finance corporate pro-
jects. To the extent that this bias exists, the
conclusions of the study are limited only
to those firms that choose to seek bank
loans and who successfully obtain them.
A third possible source of bias is the
requirement that loans be indexed to
prime. This mandate excludes firms that
were financed with fixed-rate loans or
loans indexed to other interest-rate data.
Again, if this requirement does introduce
bias, then the conclusions of this study are
limited only to those firms that receive
prime-based loans.
A fourth possible source of bias is the
absence of the amount of financial lever-
age in the firm before the newly collateral-
ized loan is received. Although the
debt-to-asset ratio of the firm is used in

5Although the survey question asks if the firm has applied for a loan within the past three years
and the survey was conducted from 1994–1995, the actual breakdown of the sample is one loan
in 1990, nine loans in 1991, 32 loans in 1992, 167 loans in 1993, and 254 loans in 1994.
6Two hundred shareholders represents a truncation at the 97 percent upper tail of the distribution.
I truncate to remove the top three percent of firms that may be viewed as outliers of the sample.
If the top three percent of the firms are not removed, the results are qualitatively similar in that
there is no evidence that banks price owner–manager agency.

276 JOURNAL OF SMALL BUSINESS MANAGEMENT

subsequent tests, the data on financial lev-
erage prior to the loan are not available.
Inasmuch as the debt-to-asset ratio serves
as a proxy for this pre-loan debt, the factor
is controlled in the tests that follow. How-
ever, if the debt-to-asset ratio does not
serve as a good proxy for this financial
leverage risk at the time of the loan appli-
cation, then this is a limitation of the study.
Because financial theory would suggest
that loan officers are concerned with the
default risk of total financial leverage (in-
cluding the new loan), it seems plausible
to argue that the post-loan debt-to-asset
ratio may control for the pre-loan leverage
(that is the risk of default).
A final limitation may be that the rich-
ness of the loan interest rate question is
not considered completely by the data. It
is possible that other factors may exist that
are not captured by the data set employed
in subsequent tests. For example, personal
relationships between the banker and a
member of the borrowing firm or the ex-
istence of other business relations be-
tween the banker and a member of the
borrowing firm may not be captured by the
data. In these cases, the firm may be
charged a lower interest rate or there may
be less of a requirement for collateral due
to the (unobserved) relationship between
the banker and the lending firm. Because
the banking relationship variables (and
other variables) employed in subsequent
tests do not include these types of unob-
served factors, this is a limitation of the
study.
Empirical Results
Interest Rate Agency Premiums
Table 1 reports the results of a series of
difference tests. The sample is partitioned
based upon the manager type. Firms that
have an owner–manager are listed in the
second and third columns. Firms that have
an outside manager are listed in the fourth
and fifth colum ns. ACL show that
owner–manager firms have significantly
lower agency costs than outside-manager
BRAU
firms; that is, ACL provide compelling evi-
dence that ownership structure impacts
agency costs as measured by the expense
ratio and asset turnover. If banks feel that
these agency costs are significant enough
to price, then it follows that owner–
manager firms will pay a lower rate on
average for their loan.
The first column describes the sample
that is being tested. When the entire sample
is employed, the difference in means is three
basis points and is not significant. The differ-
ence in medians is 25 basis points in the
predicted direction; however, this difference
is not statistically significant.
The next subsample analyzed is the case
in which the primary owner owns 100
percent of the firm. For the owner–man-
ager partition, this sample represents the
Jensen and Meckling (1976) zero-agency
cost case. In this case, the difference of
means is two basis points and is not signifi-
cant. The difference of medians is12 basis
points; however, it is in the opposite direc-
tion predicted by agency theory and is not
significant.
The final three samples represent other
ownership structures. They include the
cases in which (1) the primary owner owns
more than half of the firm, (2) a single family
owns more than half of the firm, and (3) no
owner or family owns more than half of the
firm. In cases (1) and (2) the differences of
means and medians are all in the opposite
direction as predicted by agency theory.
None of these differences are significant. In
case (3) the difference of means is not sig-
nificant; however, the difference of medians
is significant at the 10 percent level. This final
finding is the only evidence that supports the
notion that banks price agency. Specifically,
the case in which no owner or family owns
a majority stake represents the scenario of
less intense monitoring. Agency theory pre-
dicts that greater monitoring is associated
with decreased agency costs and vice versa.
In this scenario, the outside manager is able
to shirk more or to consume additional per-
quisites with the decreased monitoring.
Banks may recognize these potential agency
277
 Table 1
Difference in Interest Rate Tests Based
on Ownership Structure
Type of Manager
Owner–manager Outside Manager Difference
Mean Mean
(Median) (Median)
Number Points above Number Points above In Means
of firms Prime of firms Prime (In Medians)

All firms 338 1.29 125 1.32 0.03

(1.00) (1.25) (–0.25)
Primary Owner 84 1.45 26 1.47 0.02
Owns 100 Percent (1.50) (1.38) (0.12)
of the Firm
Primary Owner 244 1.40 71 1.22 –0.18
Owns >50 Percent (1.50) (1.05) (0.45)
of the Firm
A Single Family 242 1.37 77 1.27 –0.10
Owns >50 Percent (1.50) (1.20) (0.30)
of the Firm
No Owner or 79 1.05 43 1.38 0.33
Family Owns >50 (1.00) (1.50) (0.50)*
Percent of the Firm

* indicates statistical significance at the 10 percent level.

conflicts and may charge a higher rate to
firms that display this type of ownership
structure.
In an attempt to further analyze this
issue, I conduct an additional series of
difference tests in Table 2. The first column
lists the variable that is being tested. The
second and third columns report the mean
and median of the variable calculated using
the full sample. The fourth and fifth columns
report the mean for the two subsamples
obtained from partitioning the sample into
those firms that enjoyed rates below the
sample median and those that paid rates
higher than the sample median. The last
column reports the difference in means.
As in the ACL study, four variables are
used to identify varying ownership struc-
tures. These variables are (1) an indicator
for firms in which the firm manager is a
shareholder; (2) an indicator for firms in
which one family owns more than half of
the firm; (3) the ownership share of the
primary owner; and (4) the number of non-
manager shareholders. As discussed in ACL,
agency theory predicts that agency costs
should be inversely related to (1), (2), and
(3) and should directly related to (4).
In sharp contrast to the ACL results,
none of the ownership variables have sig-
nificantly different group means. In fact,
the latter three variables have the opposite

278 JOURNAL OF SMALL BUSINESS MANAGEMENT

 Table 2
Descriptive Statistics and Difference Tests
for Predicted Explanatory Variables
Low- High-
Interest Interest
Mean Median Rate Firms Rate Firms Difference

Ownership Variables
Firm Manager is 0.73 1.00 0.75 0.71 0.04
a Shareholder
One Family Owns 0.69 1.00 0.66 0.72 –0.06
>50 Percent of the Firm
Ownership Share of 0.59 0.51 0.57 0.62 –0.05
Primary Owner
Number of Nonmanager 8.02 2.00 8.20 7.90 0.30
Shareholders
External Monitoring Variables
Length of the Longest 12.37 10.0 13.6 11.3 2.30***
Banking Relationship
(Years)
Number of Banking 3.20 3.0 2.96 3.47 –0.51***
Relationships
Debt-to-Asset Ratio 0.72 0.62 0.68 0.76 –0.08
Control Variables
Annual Sales 8.70 4.30 10.1 7.40 2.70**
($Million)
Firm Age 18.9 15.0 20.4 17.6 –2.80*
(Years)

*indicates significance at the 10-percent level.

**indicates significance at the five-percent level.
***indicates significance at the one-percent level.

signs that are predicted by agency theory.
These results suggest that banks do not
consider potential owner–manager
agency conflicts caused by various owner-
ship characteristics important enough to
price directly through increased rates.
Continuing to follow ACL, the next
three variables represent external moni-
toring variables. Specifically, these vari-
ables are (1) the length of the longest
banking relationship in years, (2) the
number of banking relationships, and (3)
the debt-to-asset ratio. ACL argue that the
first variable proxies for the ability of the
bank to effectively monitor, the second
variable proxies for the bank’s cost of
monitoring, and the third variable proxies
for the incentive to monitor. Table 2 re-

BRAU 279
ports that the first two external monitoring
variable group means are significantly dif-
ferent beyond the one percent level. This
finding is consistent with the relationship
lending results of Berger and Udell (1995),
Petersen and Rajan (1994), and Cole
(1998). Finally, the two control variables
have significantly different means in the
expected direction.
Table 3 reports the results of a series of
OLS regressions designed to further deter-
mine if banks charge an implicit agency
premium. The dependent variable for
each model is the number of points above
(or below) prime required on the loan.
The independent variables for each OLS
model are reported in the first column.
The format for this table is similar to that
of Tables III and IV in ACL. Again, in sharp
contrast to ACL, none of the ownership
agency variable coefficients are signifi-
cantly different from zero. Once again
these results suggest that banks do not
price the agency considerations associated
with firm-ownership characteristics. The
external monitoring and control variables
confirm the results of the Table 2 differ-
ence tests and provide additional evidence
that banking relationships and size
(proxied by log of annual sales) are impor-
tant factors in determining loan rates.
As a whole, the analysis of interest rate
agency premiums indicates that banks do
not charge higher rates for loans issued
to firms that display high-agency cost
ownership structures. This finding is im-
portant because it questions the eco-
nomic importance of agency costs at
least as interpreted by banks. To draw the
conclusion that banks do not price
agency at this point would be premature.
As discussed above, banks have an addi-
tional avenue to hedge from potential
owner–manager agency conflicts in the
form of collateral. In the next section, I
examine the incidence of collateral in
association with the agency ownership
structure variables to determine if banks
choose this alternative course to price
owner–manager agency.
280 JOURNAL OF SMALL BUSINESS MANAGEMENT
Collateral Agency Premiums
Tables 4 and 5 replicate Tables 2 and 3
using the collateral indicator variable in-
stead of the number of points above
prime. The second column of Table 4 re-
ports the group means of the firms that
pledged no collateral, and the third col-
umn reports the group means of those
firms that did pledge collateral. As re-
ported in the fourth column, none of the
ownership variable group means are sig-
nificantly different. Two of the external
monitoring variables (that is, the number
of banking relationships and the debt-to-
asset ratio) have significantly different
means in support of the lending relation-
ship literature. Finally, the proxy for firm
size (log of annual sales) indicates that
larger firms offer collateral more fre-
quently than smaller firms.
The final tests are reported in Table 5.
The first column lists the independent vari-
ables used in a series of logit regressions.
The dependent variable in each model is
the binary choice variable equal to one
when collateral is used to secure the loan
and zero when no collateral is pledged.
The results of these multivariate models
support the findings reported in Table 4.
Specifically, none of the agency conflict
ownership variables significantly impact
the use of collateral. Additional results in-
dicate that firms with a greater number of
banking relationships and firms with a
high-debt ratio must pledge collateral
more often.
Robustness Tests
A series of robustness tests were per-
formed but were not reported in the form of
tables. The areas of robustness are using
lines of credit instead of loans, controlling
for industry effects, and numerous alterna-
tive specifications of the empirical models.
Berger and Udell (1995) make an argu-
ment for including only lines of credit
when analyzing the value of relationship
lending between banks and borrowers.
The data source for their study is the 1987
NSSBF survey. Each of the tests here is
 Table 3
OLS Regressions To Determine if Banks Price Agency through Interest Rates
Intercept 3.79*** 3.56*** 3.51*** 3.67*** 3.71*** 3.9*** 3.6*** 3.79***
(9.5) (8.9) (8.3) (9.2) (9.7) (10.1) (9.4) (8.8)
Ownership Variables
Firm Manager is –0.09 –0.10
a Shareholder (–1.1) (–1.1)
One Family Owns 0.09 0.13
>50 Percent of the Firm (1.1) (1.3)
Ownership Share of 0.001 0.001
Primary Owner (1.0) (0.74)
Log of the Number –0.003 0.05
of Nonmanager (–0.1) (–0.90)
Stockholders
External Monitoring Variables
BRAU

Length of the Longest –0.01** –0.01**

Banking Relationship (Years) (–2.4) (–2.5)
Number of Banking 0.07*** 0.07***
Relationships (3.5) (3.5)
Debt-to-Asset Ratio 0.05 0.04
(1.1) (0.9)
Control Variables
Log of –0.16*** –0.15*** –0.15*** –0.16*** –.16*** –0.19*** –0.16*** –0.19***
Annual Sales (–6.3) (–6.0) (–5.8) (–5.8) (–6.0) (–7.1) (–6.2) (–6.6)
Firm Age 0.004 0.003
(1.4) (1.1)
Regression Summary
Statistics
Adjusted R2 0.076 0.076 0.080 0.074 0.083 0.098 0.080 0.106
F-stat 19.99*** 19.99*** 19.87*** 19.38*** 14.99*** 25.97*** 19.97*** 7.06***
a
Estimated coefficients are listed first; t-statistics are below in parentheses.
*indicates significance at the 10-percent level.
281

**indicates significance at the five-percent level.

*** indicates significance at the one-percent level.
 Table 4
Difference Tests on the Requirement of Collateral
No Yes
Collateral Collateral Difference

Ownership Variables
Firm Manager is 0.77 0.72 0.05
a Shareholder
One Family Owns 0.68 0.69 –0.01
>50 Percent of the Firm
Ownership Share of 0.60 0.59 0.01
Primary Owner
Number of Nonmanager 7.6 8.2 –0.6
Shareholders
External Monitoring Variables
Length of the Longest 13.4 12.0 1.4
Banking Relationship (Years)
Number of Banking 2.6 3.4 –0.8***
Relationships
Debt-to-Asset Ratio 0.61 0.76 –0.15**
Control Variables
Annual Sales 6.9 9.3 –2.4**
($ Million)
Firm age 19.5 18.6 0.90
(Years)

** and *** indicate significance at the five and one percent levels, respectively.

conducted on a sample of 359 firms that
received a line of credit in the three years
prior to the survey. The qualitative results
and conclusions reported (that is, the all
loan-type sample) are the same as this line
of credit subsample. Incidentally, this study
serves as an out-of-sample test and robust-
ness check for the earlier Berger and Udell
(1995) study pertaining to the relationship
variables included in both studies.
ACL include 35 two-digit Standard indus-
trial code (SIC) code dummy variables to con-
trol for industry effects in their regressions.
In robustness tests, industry does not
significantly impact either the interest rate
charged on the loan or the requirement of
collateral. Specifically, not one of the two-
digit SIC code dummy variables is signifi-
cant if included in the regression models.
Alternative robustness tests and specifi-
cations include analyzing collateral in a
framework similar to the Table 1 difference
testing; rerunning each of the collateral
tests using personal collateral as the binary
choice variable; employing the data
weights provided in the survey; and using
alternative multivariate model specifica-
tions. These alternative specifications in-
clude the explanatory variables: interaction
ownership variables formed by taking the
product of the various ownership vari-
ables; firm profit; term of the loan; size of

282 JOURNAL OF SMALL BUSINESS MANAGEMENT

 Table 5
Logit Regressions to Determine If Banks Price Agency through Collateral
Intercept –2.1** –2.6*** –2.7** –2.7*** –2.5** –1.9*** –2.7*** –2.3*
(0.0502) (0.0169) (0.0199) (0.0142) (0.0196) (0.0695) (0.0104) (0.0615)
Ownership Variables
Firm Manager is –0.21 –0.32
a Shareholder (0.3993) (0.2254)
One Family Owns 0.18 0.35
>50 Percent of the Firm (0.4473) (0.2091)
Ownership Share of 0.003 –0.003
Primary Owner (0.5099) (0.5859)
Log of the Number of –0.11 –0.09
Nonmanager Stockholders (0.3171) (0.5513)
External Monitoring Variables
BRAU

Length of the Longest –0.02 –0.02

Banking Relationship (Years) (0.1108) (0.1281)
Number of Banking 0.19*** 0.19***
Relationships (0.0066) (0.0081)
Debt-to-Asset Ratio 0.51* 0.37
(0.0510) (0.1354)
Control Variables
Log of 0.22*** 0.24*** 0.24*** 0.26*** 0.26*** 0.16** 0.23*** 0.21***
Annual Sales (0.0015) (0.0008) (0.0008) (0.0007) (0.0004) (0.0271) (0.0011) (0.0099)
Firm Age 0.00 –0.001
(0.9608) (0.8496)
Regression Summary Statistics
–2 Log Likelihood 11.7*** 11.5*** 11.4*** 11.9*** 15.2*** 19.2*** 16.3*** 30.2***
(0.0029) (0.0031) (0.0034) (0.0025) (0.0016) (0.0001) (0.0003) (0.0004)

a
Estimated coefficients are listed first; p-values below in parentheses.
*indicates significance at the 10-percent level.
**indicates significance at the five-percent level.
283

*** indicates significance at the one-percent level.

the loan; the log of total assets; the firm’s
quick ratio; the firm’s accounts receivable
turnover ratio; an indicator variable that
equals one if the firm has been denied
credit within the past three years; and a
personal collateral/guarantee indicator
variable that equals one if personal
collateral or guarantees are pledged.
None of these additional tests suggest that
banks price manager-owner agency costs.
Summary and Discussion
Summary
The purpose of this paper has been to
determine if banks price owner–manager
agency conflicts in the firms to which they
extend loans. Whether banks price this
type of agency cost is important to analyze
because it directly tests the economic sig-
nificance of owner–manager agency con-
flicts on firm value. Due to their expertise
in collecting information and monitoring
borrowers, banks can be considered very
sophisticated investors. If potential agency
conflicts are to be detected, we expect
them to be noticed by sophisticated inves-
tors. Thus, if potential agency costs are
economically important and impact firm
value, then banks should price them. I
argue that this agency premium can come
in the form of a rate increase or through
the requirement of collateral.
Ang, Cole, and Lin (2000) provide evi-
dence that agency costs do exist in small
businesses based upon varying ownership
structures. I employ the same data source
and similar methodology as Ang, Cole, and
Lin (2000) to determine if banks charge a
premium when extending loans to firms
with varying ownership structures indica-
tive of varying levels of owner–manager
agency costs. Subject to any limitations
discussed in the paper, a series of empiri-
cal tests indicate that banks do not price
agency as it pertains to firm ownership
structure. Thus, the academic implication
of this study is that when lending to small
businesses, banks are not concerned with
Jensen and Meckling (1976)-type owner-
284 JOURNAL OF SMALL BUSINESS MANAGEMENT
manager agency costs. Empirical tests do
indicate that when lending to small busi-
nesses, banks are more concerned with
banking relationships, the debt position of
the borrowing firm, the size of the firm,
and the age of the firm.
Implications for Management
Who cares about this and why should
they care? This study should be of inherent
interest to any finance researcher who is
interested in principle-agent theory, so the
implications as they relate to a nonfinan-
cial audience are discussed here.
As well as addressing the finance litera-
ture as discussed primarily in the introduc-
tion and theory sections, this paper speaks
to at least two areas of the management
literature—organizational behavior and
strategic management. The two funda-
mental research questions explored deal
with the structure of the firm and its rela-
tionship to firm value. Inasmuch as re-
searchers in the field of organization
behavior study the impact of firm structure
on firm value, the results of this paper should
be of interest. Specifically, this study docu-
ments the impacts of relationships between
the manager and owner, the impact of family
ownership, and the impact of shareholder
ownership structure on the value of the firm
through bank loan costs.
Those who study organizational behav-
ior theory may find the specific results of
this study interesting, as they are pre-
sented from a financial background. Al-
though the paper is framed from a
financial researcher’s viewpoint, the topics
of organizational structure and organiza-
tional behavior surely overlap. Conflicts in
organizations are a central theme in the
organizational behavior literature. These
conflicts are at the heart of principle-agent
conflicts and agency theory. An interesting
question in the field of organizational be-
havior is “What are the costs of these con-
flicts as they relate to firm value?” This
paper has attempted to answer this ques-
tion (at least in part) by analyzing the
agency conflict impact on firm value as
determined by bank loans.
Researchers in the field of strategic
management may be interested in the
strategy of developing banking relation-
ships to decrease the cost of bank loans,
thus increasing the value of the firm. One
key research issue in this field may be the
optimal strategy for minimizing the cost of
bank debt. Is there an optimal number of
banks with whom to establish relation-
ships? For example, is it optimal to deal
exclusively with one bank or with several
banks? Although the results of my study
suggest fewer banking relationships in-
crease firm value, I do not attempt to find
the optimal number of relationships. Fu-
ture research may be profitable by explor-
ing the implications of this paper from
either of these two management perspec-
tives. Below, I shift the implications of the
study from those of a researcher to those
of a practicing manager by discussing four
specific practical implications.
The first implication of the results for
small business managers is that by consid-
ering these factors that impact (and do not
impact) the interest rate and collateral re-
quirements as they pertain to their own
businesses, managers may be able to more
accurately calculate their cost of capital. A
more precise cost of capital will increase
the accuracy of the firm’s capital budgeting
decisions when using techniques that re-
quire a discount rate (such as the net pre-
s e n t v a l u e , p r o fi t a b i l ity in d ex, or
discounted payback) or a hurdle rate (such
as the internal rate of return). The adop-
tion and rejection of projects is at the heart
of financial management. With more pre-
cise capital budgeting decisions, firms
have a greater probability of adopting
wealth-increasing projects and rejecting
wealth-destroying projects.
Second, the results of this paper sug-
gest that managers who interface with the
bank have incentives to build strong rela-
tionships with the bank officials with
whom they work. Managers should pur-
posely attempt to build lasting banking
BRAU
relationships of trust with a few banks. Firms
with longer banking relationships enjoy
lower interest rates and firms with a large
number of banking relationships have to pay
higher rates. Thus it may be inferred that
these relationships build firm value.
Third, the results in this study indicate
that banks do not significantly reward or
punish borrowers through either interest
rates or collateral requirements for various
agency-cost management and ownership
structures. An implication of this finding may
be illustrated by an example. Suppose a
manager is considering a hiring decision.
She has narrowed her selection to two po-
tential candidates. Candidate A seems to be
marginally superior to Candidate B; how-
ever, Candidate B happens to be an insider
(for example, a family member or a share-
holder). The manager currently is searching
for various margins to compare the two can-
didates. The manager may reason that if she
hires the insider, the bank may believe that
the potential for agency costs is decreased
and as such may give more favorable loan
terms. These favorable loan terms essentially
increase the value of the firm.
The results of this study indicate that
the cost of bank loans (either through inter-
est rates or collateral) should not be part of
this decision. Whether an insider or outsider
is hired as a manager of the firm, this study
indicates that the bank is not concerned
enough to price the decision. The implica-
tion of this finding suggests that (at least as
it pertains to the cost of bank loans) the
manager should hire the best qualified per-
son for the job and should not attempt to
use a strategy for obtaining less expensive
bank financing by hiring an insider. Although
the previous example may seem too hypo-
thetical, an important extension of this im-
plication is the impact of ownership-based
compensation programs. Many firms at-
tempt to enhance employee work effort by
providing compensation programs that in-
clude stock options or other forms of own-
ership rewards. Although these types of
compensation may enhance firm value else-
where, the results of this study suggest that
285
this form of bonding does not impact the
value of the firms as determined by the cost
of bank loans.
The final implication considers the
ownership structure of the firm. The con-
clusions of the paper may be of interest to
managers who are considering a restruc-
turing of ownership. If the firm is currently
structured as a C-corporation, whether a
family owns more than 50 percent of the
firm, the ownership share of the primary
owner, or the number of nonmanager
stockholders does not seem to impact the
value of the firm as reflected in the cost of
bank loans. Although the agency cost im-
plications of the restructuring may be rele-
vant in other areas of firm operations (a
potential topic for future research), the
manager should not weigh the cost of bank
loans too heavily in the decision.
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