Managing internal corporate entrepreneurship: an agency theory perspective
Gareth R. Jones
Recent research reflects entrepreneurship’s increasingly important role in the strategic management process (e.g., Gartner, 1985; Schendel & Hofer, 1979; Sexton, 1982; Sexton & Smilor, 1986). Explanations of corporate growth and development (e.g., Burgelman, 1985; Burgelman & Sayles, 1986; Pinchot, 1985), and of the firm’s ability to maximize profitability over time have increasingly relied on the entrepreneurial function (e.g., Greiner, 1972; Kamien & Schwartz, 1983). However, the internal dynamics of entrepreneurship (e.g., Kanter, 1989a, 1989b; Miller, 1983; Stewart 1990), and the complex motivational and organizational forces that affect individual entrepreneurs’ actions and behaviors (e.g., Kanter, North, Richardson, Ingols, & Zolner, 1991; MacMillian, Block & Subbanarashima, 1984) needs additional research attention. In particular, the effect of motivational and organization factors on the level of entrepreneurship over time needs to be more fully explored (e.g., Kazanjian, 1988; Kazanjian & Drazin, 1989).
In this article, we develop a model of corporate entrepreneurial behavior using information and agency theory. This theoretical framework identifies the agency problems affecting the level of internal corporate entrepreneurship. In addition, when examining the dynamics of entrepreneurship, this framework allows a distinction to be made between internal corporate entrepreneurship and outside or entry affecting entrepreneurship. Internal corporate entrepreneurship refers to entrepreneurial behavior within one firm, or the level of entrepreneurial behavior. Outside entrepreneurship refers to the entrepreneurial behavior of other industry firms or of firms that through entry become industry players. The ways in which agency and organizational forces affect the level of internal corporate entrepreneurship and how these problems subsequently affect the level of outside entrepreneurship are a major theme of the article.
First, the meaning of entrepreneurship and profit are developed using a view of uncertainty developed from Knight (1921) and Schumpeter (1934), and of information and action developed by Kirzner (1973). Next, the specific meaning of entrepreneurship, as used in this article, is defined. Then, the foundations of agency theory (Jensen & Meckling, 1976) are discussed. It is also shown how the tools of agency theory provide a useful vehicle for discussing corporate entrepreneurship. These include the motivational and organizational factors that cause agency problems and reduce the level of internal corporate entrepreneurial behavior as well as problems relating to the maintenance of high levels of internal corporate entrepreneurship. The article then turns to a discussion of how agency problems that reduce the level of internal corporate entrepreneurship can indirectly cause an increase in the level of outside entrepreneurship. Finally, we examine the organizational level factors that contribute to agency problems and focus on how firms can solve agency problems to maintain a high level of inside entrepreneurship.
It should be noted that though the rational economic approach of agency theory is adopted in this article, the intention is not to obviate the importance of behavioral and motivational factors that are outside the confines of a strict agency model. In developing our framework, we recognize how many of our arguments would be tempered by the inclusion of other behavioral factors such as desire for prestige, will to succeed, or need for achievement. We recognize the limitations of our arguments here rather than qualify all our statements below.
Agency Theory and Entrepreneurship
The meaning of entrepreneurship is intimately bound up with the concept of uncertainty. In this article, we follow the approach of Knight (1921) and Schumpeter (1934), defining uncertainty as a situation that exists when there is imperfect foresight or human inability to find the best solution to complex problems. Entrepreneurs create value by acting in the context of uncertainty. As Knight (1921) puts it, the entrepreneur is the “organizer of uncertainties,” which means he or she possesses the ability to creatively reorganize the relationship between factors of production and market opportunities in ways that create value that would not otherwise have been generated. A successful new combination of factors produces a surplus over and above that paid for the factors of production involved. The surplus value created by entrepreneurs results because “the new combination or innovation allows an existing producer to operate at a lower cost than previously, or it allows him to sell a new product at a price higher than the long term equilibrium price” (Manne, 1966:119).
Uncertainty should be distinguished from risk. Although uncertainty exists when, “the probabilities of alternative outcomes cannot be determined by a priori reasoning or statistical inference” (Casson, 1982:371), risk refers to the knowledge of the probable distribution of potential outcomes (Alchian, 1950). Thus, risk refers to a state of future affairs that is in some degree, even if only probablistically, predictable. Uncertainty precludes the setting of objective probabilities. The distinction between uncertainty and risk is important because only the presence of uncertainty leads to the existence of entrepreneurial profits. The assumption of risk does not give rise to entrepreneurial profit (Knight, 1921; Schumpeter, 1934). Rather, the compensation for risk is determined, as with any other factor of production, by the forces of supply and demand and its reward is normal rent or salary. Bearers of risk are obtaining a competitive return for their services in proportion to the degree of risk they are undertaking. This situation is totally different from actions providing true entrepreneurial profits, which are the above normal returns from acting upon unique uncertainties or opportunities for which objective probabilities cannot be calculated. The importance of this distinction is developed below.
The ability to organize wealth-generating relationships between factors of production presupposes that a market opportunity exists for the entrepreneur to capture. It is here that Kirzner’s (1973) concept of the entrepreneur as the “noticer of opportunity” and entrepreneurial behavior as “action taken on noticed opportunities,” becomes important. Markets are almost always in disequilibrium because no one knows all the prices that are available, and knowing about market prices is one of the costs of using a market. Buyers and sellers must search for information and the degree of price dispersion in the market is a measure of market ignorance (Stigler, 1961). Uncertainty causes
information fragmentation (Hayek, 1937, 1945), and the resultant prohibitively high costs of search allow market disequilibrium to be exploited as a source of entrepreneurial advantage. The existence of uncertainty about prices means that entrepreneurial profits, in the form of arbitrage, are available to those capable of noticing discrepancies. Entrepreneurs are more adept noticers.
This implies that there are two related sources of entrepreneurial profits available for entrepreneurs to capture: (a) those accruing to the noticer of opportunities and (b) those to the organizer of uncertainties. Value, as entrepreneurial profit, is created by both these means. Thus, in this article, entrepreneurship is defined as the process by which firms notice opportunities and act to creatively organize transactions between factors of production so as to create surplus value.
In this “classical” view of entrepreneurship, entrepreneurs notice opportunities, act, and create new hierarchies or ventures to organize transactions. If successful, they reap the profits from their actions. However, once an opportunity has been acted upon, a series of internal forces begin to take place in the entrepreneurial process that change the entrepreneurial context. First, at the level of a new hierarchy a distinction arises between entrepreneurship and management in the firm. The rounding entrepreneur, having creatively organized and implemented factors of production, has now superseded his or her role as entrepreneur. The actual act of management of the firm, the cost of monitoring and rewarding of functions or factors of production inside the firm, is not part of entrepreneurial behavior. The reward for these managerial activities, as noted above, is normal rent or salary, not entrepreneurial profit. If the entrepreneur becomes the firm’s manager, or the management function becomes separate from the entrepreneurial function, agency problems arise in the new hierarchy.
Agency problems arise whenever a division of labor results in one party (the principal) delegating decision-making authority or control over resources to another (the agent). The agency problem occurs whenever (a) it is difficult or expensive for one party to evaluate the performance of the other, and (b) the motives of the parties to an exchange may be different, such that each has an incentive to act in a different or incompatible way. The factors that make it difficult or expensive to evaluate the performance of the other party are due to the existence of uncertainty in environmental, organizational, or task conditions. The parties have incentives to act differently because they have different risk preferences, or because they may have different propensities to act opportunistically. Both risk and opportunism are only problems because uncertainty exists. Thus, in an agency theory context, risk preferences and opportunism are a function of the parties’ estimation of the chances of success in achieving a desired goal in the context of uncertainty. It is here that the basic agency problem in entrepreneurship arises, because, by definition, entrepreneurial behavior is action in the context of uncertainty so that it is impossible or prohibitively expensive to evaluate the effectiveness of an agent’s behavior. Thus, the risk or opportunistic preferences of the parties to the exchange become the salient issue. Each of these agency problems is considered below.
Effects of Risk Preferences
Risk preferences cause an agency problem in the entrepreneurial context because the principal and agent have different risk preferences. Agency theory assumes that agents are risk averse because though they have to bear the uncertainty of entrepreneurial activities (the principal’s job), many of which will fail, they are only rewarded on the basic of undertaking risk–normal salary (the agent’s reward). The principal is the residual claimant: that is, the person who claims all revenues net of payments to factors of production (in other words, profit). The reward to the principal is the entrepreneurial profit for undertaking uncertainty; the reward to the agent is the salary for normal risk taking. Thus, given this reward structure, agents have no incentive to behave entrepreneurial, other things being equal.
Agents face an additional problem if they have made a specialized investment in the firm because their entrepreneurial skills will have less value elsewhere. If the firm engages in highly uncertain ventures that may lead to bankruptcy, they face nontrivial costs because equivalent alternative employment will be difficult to secure. Consequently, they have no incentive to undertake highly uncertain (entrepreneurial) projects and will prefer those with a low level of risk. Although less profitable, such projects will keep them employed. These two forces cause a misalignment of the interests of principals or entrepreneurs and agents or managers and result in a loss in a firm’s entrepreneurial ability.
Thus, from an agency theory perspective, the central issue is to define and control who is the principal and who is the agent in the entrepreneurial context in order to provide the set of incentives for engaging in entrepreneurship. Solving the agency problem involves aligning the interests between the principal and agent when the entrepreneur is the agent, not the principal. Fundamentally, the problem of maintaining a productive entrepreneurial context is that the identity of principal and agent changes as the entrepreneurial context changes so that the problem of aligning their rewards with uncertainty/risk preferences changes. This change in the entrepreneurial context can be depicted in terms of a series of stages.
The first stage is when an entrepreneur establishes a new venture to organize transactions more efficiently. At this point she or he is both principal and agent and there is no agency problem because the entrepreneur is the residual claimant for all profit obtained. However, as the firm grows, the entrepreneur is increasingly forced into the role of manager, as noted above, and the principal/agent relationship changes.
In the second stage, when the entrepreneur assumes the management of the firm, his or her risk preferences change because of the future returns associated with business activity. Although still the residual claimant, when the entrepreneur functions as an agent, not a principal, “it is generally rational for the residual claimant-decision maker to assign lower values to uncertain cash flows than residual claimants would in organizations where residual claims are unrestricted and risk bearing can be freely diversified across organizations…|leading~ to less investment in risky (entrepreneurial) projects that lower the costs of the outputs” (Fama & Jensen, 1983:306). The result of mixing the entrepreneurial and management functions is the decision to make fewer entrepreneurial choices because the “entrepreneur is never the risk taker” (Schumpeter, 1934:137). The result is the substitution of projects providing entrepreneurial profits with those providing normal returns. Consequently, the firm’s ability to notice opportunities and act upon them declines as the entrepreneur becomes the manager or, in other words, starts to function as an agent rather than as a principal. The result is a decline in the level of internal corporate entrepreneurship.
The third stage in the entrepreneurial process, when the potential profits from entrepreneurship are dissipated because of agency problems, occurs when firms become large and complex. By this stage, the function of entrepreneurship has become separate from management. The issue here is that principal/agent relationships have changed again because in large firms a new category of principals has arisen–that of shareholders. Now shareholders, as principals, delegate responsibility to top management for entrepreneurship. However, a central issue is how are rewards linked to this new structure? Shareholders are the new residual claimants and expect the returns from bearing uncertainty. Top managers as agents are expected to organize entrepreneurship but they typically receive an agent’s salary instead of being residual claimants. This means that the agency problems noted above still arise. Moreover, the situation is even more complicated in a large corporation because entrepreneurship is often delegated to a lower tier of management. Now top management, who are agents with respect to shareholders, become the principals with respect to the new corporate entrepreneurs who are their agents. These corporate entrepreneurs are also rewarded in the form of straight salary and bonuses that are tied to the overall performance of the firm. Thus, management at both levels do not receive the profit contribution that their entrepreneurial activity would receive if they were to establish their own hierarchies. Rather, they receive managerial salaries for bearing risk.
Thus, agency problems increase geometrically as new levels of the hierarchy take on the entrepreneurial role because in this new entrepreneurial context, the incentive is for managers to find ways of behaving that either maximizes their personal financial returns or provides new challenges (Cooper & Dunkelberg, 1986), improved changes for advancement (Feeger & Dugan, 1989) or increased prestige (Carland, et. al., 1984). Hence, problems associated with the separation of ownership from control arise, such as sales goals coming to replace profit goals (e.g., Baumol, 1967; Jensen & Meckling, 1976), and such problems continue down the hierarchy. Consequently, the level of entrepreneurship falls again, other things being equal. This is not to say that innovation cannot take place. It just means that there are complex internal dynamics associated with the development and growth of corporate entrepreneurship that are exposed when entrepreneurship is treated through the lens of agency theory.
Effects of opportunism
As noted earlier, agent opportunism is also a function of the agent’s beliefs that he or she will achieve, in the context of uncertainty, a desired goal. The causes and effects of opportunism and the form it takes are very subtle in an entrepreneurial context. Risk aversion encourages managers to select safe projects that provide normal rates of return. The managerial behavior that results is in the interests of the organization, but it in no way optimizes long-run profitability. Opportunism, or moral hazard as it is sometimes called in the entrepreneurial context, causes managers to actively shirk their responsibilities and put forth below normal effort that does not result in even normal returns, but sub-optimal performance. The problem stems from the inability of principals to monitor the behavior of agents because it is impossible or prohibitively expensive to monitor entrepreneurial behaviors, (i.e., actions that will lead to above normal returns). The value of entrepreneurial behaviors can only be evaluated in the long run when the effects of changes in a firm’s strategy and structure become manifested in changes in long run profitability. In the short run, which may be several years, no such estimation is possible.
When it is impossible to evaluate agents, they have the incentive to pursue their own interests. This shirking problem is made worse by the reward structure discussed above and by the fact that entrepreneurship normally is the result of the joint product of the actions of many entrepreneurs in the large corporation (Burgelman, 1983). Thus, any one person’s contribution is difficult to evaluate in a group setting. If agents are not rewarded for their entrepreneurial efforts in the form of profits rather than salary, they will have less incentive to perform entrepreneurially and will have a positive incentive to shirk, reduce their performance, and pursue their own interests. In a situation where the effects of individual inputs are indistinguishable, or monitoring costs are prohibitive because of uncertainty, each individual has a negative incentive to control or minimize production costs (called free riding here) and a positive incentive to supply less effort (Jones, 1984). Although individuals will receive only a part of their own contribution to the organization from exerting normal or extra effort they will still receive unearned a part of every other person’s contribution regardless of the level of their own performance (Latane, Williams, & Harkins, 1979).
Thus, the intrinsic nature of the entrepreneurial process makes it risky, or unprofitable, for individuals to display supra-normal or entrepreneurial behavior designed to produce above average returns. The import of this discussion is that agency problems that arise when the entrepreneurial role is difficult to distinguish from the managerial role also make it difficult for a firm to maintain high levels of internal corporate entrepreneurship. As a firm’s incentive structure changes, so do agent-entrepreneurs’ risk preferences and opportunistic inclinations. Such a change alters their perceptions of the level of uncertainty in the environment and leads to decision-making inertia, an inability to notice opportunities, and a lowering of entrepreneurial behavior.
Having identified the agency problem in entrepreneurship, we can now consider solutions to the agency problem. We will look first at the effects of this reduced level of corporate entrepreneurship on the emergence of outside entrepreneurship, (i.e., entrepreneurship outside the firm’s boundaries). We will then turn to ways in which firms can alter the internal organizational context to maintain a high level of entrepreneurial behavior, which will indirectly lessen the development of outside entrepreneurship.
An Increase in Outside Entrepreneurship
With the lowering of corporate entrepreneurial behavior, new forces are set in motion. As argued above, problems of maintaining the entrepreneurial spirit emerge when entrepreneurs become managers because their risk preferences change or because it becomes rational to act opportunistically. Bureaucratization tends to occur as firms become large and established (Peterson, 1981). Problems of coordinating the hierarchy help to cause the split between entrepreneurship and management as entrepreneurs become too involved in the day-to-day management of the firm, Bureaucracy also reduces the visibility of the agent’s performance because people begin to work in structured teams, which are subject to rules and procedures. The effect of this increase in bureaucratization is a lowering of agent motivation. Agent-entrepreneurs inside the firm begin to feel frustrated when their performance contributions are not recognized or not rewarded, and when the firm subsequently fails to act on noticed opportunities (Brockhaus, 1980; Hornaday & Tieken, 1983). For instance, in high technology industries technical-entrepreneurs cite frustration as one of the reasons they leave to start their own firm (Cooper, 1985, 1986; Thorne & Ball, 1981). The issue is that employee entrepreneurs often see better prospects lot securing profit and wealth outside of the large corporation because of the difficulty that large firms have in aligning rewards while engaging in internal corporate entrepreneurship.
Moreover, in agency theory terms, entrepreneurs have gained capital that is specific to a new area of innovation, but not to a specific firm. Thus, it is transferable to a new firm. Although the original firm has incurred the sunk costs associated with being the incubator, it may gain none of the benefits if the agent-entrepreneur leaves to become a principal, often in close geographic proximity (Cooper, 1985, 1986).
Thus, one result of agency problems may be the departure of employee entrepreneurs to found their own firms. This action reduces the ability of the original founding firm to notice opportunities, while creating new entry into the industry by entrepreneurs who now function as principals, not agents. As a result (while the new hierarchy stays small) risk and opportunism problems disappear. With the departure of agent entrepreneurs, the balance of noticing opportunities may have changed in favor of the new firms. Thus, the original firm faces the prospect of a decline in its ability to earn entrepreneurial profits as it moves from being the entrepreneurial initiator to being the imitator. The first “unanticipated” solution to the agency problem in entrepreneurship is the founding of new hierarchies in competition with existing ones.
Thus, an inverse relationship between internal corporate and outside entrepreneurship seems to occur. If internal corporate entrepreneurship falls in the original firm because of agency problems, more outside entrepreneurship occurs to overcome the problems. More internal corporate entrepreneurship, (i.e., because the firm solves internal agency problems) reduces the incentives for employee entrepreneurs to depart and propels the firm up the “innovation slope,” which may put potential imitators and competitors at a disadvantage. So long as the entrepreneurial firms continue to innovate, imitators will always be one step behind. How can firms solve internal agency problems to allow them to maintain a high level of internal corporate entrepreneurship?
Increasing the Level of Internal Corporate Entrepreneurship
If the founding of new firms is a primary way in which agency problems are solved, altering the existing entrepreneurial context to align interests between principals and agents is the second. The problem becomes one of providing the incentive structure for (entrepreneurial) agents to act as principals, or more generally the incentives for managers to act as entrepreneurs. To solve agency problems, however, firms must first identify the organizational factors that promote the agency problems identified above.
Organizational Factors and Agency Problems
Three distinct, but highly correlated, organizational level factors–organizational size, age, and complexity–promote agency problems and curtail inside entrepreneurship.
Organizational size. Organizational size causes agency problems in several ways. First, the separation between entrepreneurship and management increases as the firm grows, causing an increase in risk aversion. As a result, agent-entrepreneurs appear to reallocate resources from income producing to control functions, which introduces increased rigidity into organizational transactions and makes entrepreneurial action more difficult (Abernathy, Clark, & Kantrow, 1983;
Ettlie, 1983; Metcalfe, 1981). Essentially, to reduce risk, managers control the choice of new ventures by developing bureaucratic procedures, where levels of hierarchy and rules and procedures replace ad hoc methods of operation, making creative or innovative choices less likely. Those individuals best capable of noticing entrepreneurial opportunities may leave a firm because controls are stifling their ability to take action on opportunities: hence, outside entrepreneurship increases.
Increased size also increases the opportunism problem because as the number of agents involved in the entrepreneurial process increases, so does the likelihood for shirking. Each individual agent is also provided with less opportunity to demonstrate his or her discrete performance contributions. Thus, agents have less motivation to take responsibility for uncertain ventures where they will receive only blame if they fail and some predetermined salary if they succeed.
Another issue connected to the growth in firm size comes from the increased use of group-based entrepreneurial projects. For instance, as firms grow, there is an increased use of teams in research and development and product development (e.g., Hounshell & Smith, 1988). Although this should lead to better problem-solving capability for the organization, the effect on entrepreneurship is that it becomes harder for the individual or employee entrepreneur to demonstrate his or her discrete role in the innovation process and to claim the rewards of entrepreneurial behavior. The result can be free riding, which takes the form of the withholding of ideas, or departure from the organization to set up a new company to compete with the founding entrepreneur, as discussed earlier.
Organizational age. Age is also a factor to consider in understanding agency problems. Evidence suggests that there tends to be an age-size correlational relationship such that firms in later stages of their evolution have been found to be less innovative (e.g., Chandler, 1962, 1977; Mintzberg & Waters, 1982; Stopford & Wells, 1972; Strebel, 1987). As Kanter (1983:182) has argued, older, inflexible firms are less likely to notice and take action on entrepreneurial opportunities because of “the inability of many traditional mature firms to anticipate the need for productive change and their resistance to new ideas advanced by creative people.” We can refine these ideas by noting that top managers who have lapsed into the agent role will often resist attempts by subordinate managers to act as principals because this threatens the organizational reward structure and established organizational expectations. As Schumpeter (1934) noted, few individuals are able to sustain the entrepreneurial attitude across their careers, and this can be attributed to the increase in risk aversion and propensity to shirk that occurs as organizational inertia increases.
Organizational complexity. Finally, with growth there is an increase in organizational complexity. Organizational complexity leads to an increase in both vertical and horizontal differentiation, which may contribute to agency problems. The proliferation of hierarchical levels, and the growth in the number of interdependent semi-autonomous operating subunits makes acting on noticed opportunities difficult, and as noted earlier serves to make entrepreneurs act as agents, not principals. An increase in the number of levels in the hierarchy reduces the opportunity for internal corporate entrepreneurs to exercise meaningful authority over projects, and subjects them to the scrutiny of many levels of management who must sign off on projects or plans. Moreover, it allows managers to pass responsibility for entrepreneurial efforts to others in the hierarchy, either up or down–a form of shirking. These factors reduce the level of entrepreneurial responsibility, attenuate entrepreneurial motivation, and increase the possibility that rewards will not accrue to the entrepreneur personally.
Given these problems, inherent with organizational growth due to entrepreneurship, the proposition follows that there may be decreasing returns to entrepreneurship as organizational size, age, and complexity increase. In agency theory terms, tile issue is that, as the firm gets larger, the returns to entrepreneurship decrease because the agency costs of organizing additional transactions inside the firm to create surplus value increase. At some point, the organization of factors of production may be better handled in the market by an entrepreneur who founds a new firm and places factors of production in their most highly valued use. Unless organizational innovations can be put in place to make agents act like principals, the level of inside entrepreneurship may fall.
Solving the Agency Problem
Many of the agency problems caused by organizational factors can be solved through the design of the entrepreneurial context to align interests of principals and agents. In this section, we look at how (a)innovations in organizational structure and (b) innovations in organizational control and reward systems can mitigate the split between the role of principal and agent in the entrepreneurial context and reduce the extent to which entrepreneurs act like managers.
Innovations in Organizational Structure
In terms of the above argument, as firms grow they need to provide the incentives for agents to act as principals. That is, they need to find ways to (a) provide agents with the opportunity to take responsibility for entrepreneurship, (b) recognize individual performance contributions, and (c) reward entrepreneurial performance appropriately. One way of doing this is by finding organizational innovations that raise the visibility of an agent’s performance and increase accountability to reduce shirking and encourage the bearing of uncertainty. One such innovation occurs in the form of the movement of the firm from a functional structure, to a product structure, and eventually to a multidivisional structure as its size and complexity increase (Williamson, 1975). One of the main reasons for the movement from the U-form to the M-form structure is that operating and strategic decisions become confounded in the U-form, making it difficult for the firm to notice new strategic opportunities.
Opportunities can be acted upon more quickly and efficiently in the M-form organization because it has a corporate headquarters devoted solely to noticing opportunities. Essentially, by isolating entrepreneurship at the top of the organization, including top divisional managers, the motivational and agency problems associated with increasing organizational complexity and size are reduced, and internal corporate entrepreneurs are more easily able to be recognized and to claim rewards from their innovative performance. Moreover, the existence of a corporate headquarters makes it easier to monitor activities inside the operating divisions, which reduces the ability of divisional managers to pursue their own interests. Thus a multi-divisional structure can reduce the decline in internal corporate entrepreneurship.
However, though this change in structure may be a necessary condition for promoting entrepreneurship, it is not sufficient to solve agency problems because accelerated control loss problems quickly set in, even with a multidivisional structure. The question remains as to who is the principal and who is the agent in the new structure. As was noted earlier, internal corporate entrepreneurs are often subordinate to top managers, who themselves are agents of shareholders. Thus, it is not clear that establishing a corporate headquarters is sufficient to encourage entrepreneurial behavior. It may be that divisional personnel who are closer to the opportunities are better able to act on new opportunities in the environment, whereas corporate personnel are better able to sense opportunities inside the firms between divisions. Because divisional personnel are still agents, the new structure will not be sufficient to overcome agency problems.
Another subtle problem also arises with a multidivisional structure. As noted above, senior corporate managers are often agents with respect to entrepreneurial subordinates. That is, they are performing a monitoring role not an entrepreneurial one. If divisional managers do act entrepreneurially because they want to become corporate executives, investments in uncertain research and development or new ventures may actually reduce divisional profitability in the short run. How will corporate agents respond when they begin feeling the effects of loss of control? They may respond by increasing the monitoring of divisions, or they may set tough performance standards and impose new bureaucratic controls to reduce the risk they are experiencing. How will divisional principals respond? They will come to believe top management attributes the cause of declining divisional performance to their actions and they will respond by reducing their uncertainty-bearing activities and pursuing actions designed to lead to short term increases in profitability (i.e., ventures that provide normal returns). Thus, internal corporate entrepreneurship suffers at both the corporate and divisional levels.
Another structural innovation that may raise agent visibility and increase accountability may occur if a firm establishes a new venture division to separate the entrepreneurial component of the firm from the operating component. New venture management would have the opportunity for demonstrating their own competency and may lay claim to some of the rewards from the new venture’s success. However, whether or not a new venture does raise visibility and increase accountability seems to depend crucially on the relationship between the new venture division and the parent company. Fast’s research (1977, 1978) showed that the political and strategic relationship between these parties is very fragile, and similar agency problems that occur inside a multidivisional structure often occur between the new venture division and the parent company.
In this connection, it may be that the use of a corporate venture fund, which operates as a separate entity allowing a firm to invest in new ideas by establishing hierarchies totally independent of the parent company’s hierarchy offers a new avenue for growth. Here visibility would be at a maximum, and the advantages of small size could be exploited. The downside of this entrepreneurial mechanism might be a loss in synergies between businesses; however, this could be achieved by an efficient transfer pricing system between divisions, which would also help to establish accountability. Finally, spinoffs of ideas into new businesses is a similar solution to the agency problem from a structural perspective.
Innovations in Organizational Control and Rewards
To ameliorate and solve agency problems, M-form structures, and other structural solutions, must be matched to organizational control and reward systems that overcome the principal-agent division. In agency theory, the issue becomes one of choosing the appropriate monitoring and bonding control mechanisms to align interests and optimize performance. Specifically, this involves choosing either outcome- or behavior-based contracts to govern principal agent relationships (Jensen & Meckling, 1976). In the entrepreneurial context, monitoring entrepreneurial behavior and the outcomes of that behavior to align interests is very expensive, only possible over the long term, and an inefficient solution to making agents act like principals. Thus, behavior-based contract are seldom sufficient. An outcome-based contract is the appropriate contract to promote the bearing of uncertainty and reduction of opportunism: an outcome-based contract aligns the preferences of agents with principals because the rewards for both parties depend on the same actions (Jensen & Meckling, 1976). Essentially, agents are bonded to principals because they share the same rewards as the principal, which in the entrepreneurial context means that they too became residual claimants.
There are many forms that residual claimancy can take. One way is for large organizations to use career paths to reward the activities of internal corporate entrepreneurs so that they match the reward of partnership or residual claimancy (Rumelt, 1987). This is the route from being a divisional manager to a corporate level manager. Essentially, bonding takes place through the assurance that promotion will occur from the divisional to the corporate level. Note the long-term nature of this reward.
More generally, the analysis here suggests that firms should pay large monetary premiums that are directly tied to individual and group actions. As partners, successful innovators should receive an equity stake in the corporation in proportion to the increase in corporate profitability directly attributable to their actions. The size of this proportion is a matter for internal negotiation. However, it is very rare to find any evidence of this form of reward at levels below top executives who receive bonuses or stock options tied to firm performance. Firms are notoriously averse to paying supra-normal rewards for supra-normal performance to lower level agents because of beliefs that it will destroy the equity of the internal reward structure. As noted earlier the failure to pay for entrepreneurial performance is often the source of the increase in outside entrepreneurship. It can also be the source of failure of the M-form structure because not only are divisional executives unrewarded, but theoretically it is not at all clear that top managers as agent entrepreneurs should be rewarded as principals if they perform only a monitoring role.
Practically, the issue becomes one of how much it is necessary to reward agents to bear uncertainty and to overcome risk aversion. Generally, speaking, the wealthier the agent, the relatively less risk averse they are argued to be–a strong rationale for the payment of supra-normal rewards (Harris & Raviv, 1979). Similarly, the higher the equity stake in the venture, the more the agent will bear uncertainty (Jensen & Meckling, 1976; Fama & Jensen, 1983). There is, therefore, a strong rationale for stock options schemes and leveraged buyouts to include employees at all levels in the firm, not just at the corporate level. In essence, organizational rewards and controls need to be matched to structure if internal corporate entrepreneurship, at all levels, is to be promoted.
However, as with any reward system at any level in the firm, there are problems associated with using output reward systems to link reward to performance. For example, one common argument made against stock option plans, even for CEO’s, is that the link between personal performance and firm performance may be tenuous at best, as when a firm’s stock price rises not because of its CEO but because of a bull market. In the entrepreneurial context, linking performance to reward may be difficult because, over the development of an innovation, different people become involved in the innovation process or may drop out depending on the specific problems being resolved, such as market versus technical considerations (Kanter, 1989(a); Angle & Van de Ven, 1989). In this situation, strong functional control and supervision becomes vital for linking performance to reward. It is interesting that a matrix structure, where a member’s team performance is monitored by both functional and project supervisors, provides a vehicle for such a high level of monitoring. Moreover, a matrix structure may be useful in handling another common problem that arises with innovation: that is, when the innovation is the result of noticing related opportunities between different projects or product lines and of organizing factors of production to take advantage of these different opportunities.
In general, establishing equitable reward systems to encourage inside entrepreneurship is a difficult process, and the literature on distributive and procedural justice (e.g., Greenberg, 1982; Greenberg & Folger, 1983) suggests the importance not just of an equitable distribution of rewards, but also of the equity of the procedures for determining rewards in maintaining long term entrepreneurial behavior. For example, given the length of time it takes for many innovations to realize significant profits, which is typically no less than 4 years, and modally between 5 and 10 (Biggadike, 1979), linking performance to rewards is an intrinsically difficult process over time. All the more reason then for considerations of procedural justice to be particularly emphasized by an organization and to prevent perceptions of inequity from emerging over time.
In fact, the time dimension is particularly important in charting out the different reward profiles faced by intrapreneurs who may be considering the external entrepreneur option. Perceptions of long-term equity may be particularly important in the case of those intrapreneurs who are evaluating the gains from leaving the firm to start their own hierarchies against the gains from staying with the organization. Although leaving may earn supra-normal short-term rewards, them is the prospect of a long-term, secured stream of income by staying with the firm, providing there is clear evidence of procedural as well as distributive justice in the firm. Moreover, the firm is likely to protect its successful entrepreneurs and offer long-run rewards as payment for past services, noncontingent on current performance, whereas the outside entrepreneur faces the prospect of an uncertain future.
Clearly, there are numerous problems lacing firms that try to link entrepreneurial performance to reward. The specific strategic circumstances facing each firm, including the nature of the organizational arrangements they use to structure entrepreneurial activities, will affect the actual solutions chosen. The forces behind entrepreneurship are always in some dynamic balance and only the ability of firms to control the principal/agent relationship and align incentives and rewards to changing conditions can prevent the entrepreneurial spirit from lapsing into the practice of management.
Implications and Conclusions
The theoretical framework discussed in this article helps place entrepreneurship and entrepreneurial behavior within the mainstream of strategic management. It illustrates how entrepreneurship is central to the value-creation process and demonstrates that the main issue facing the firm is to manage the entrepreneurship-management link, whereby the firm must solve agency problems so as to achieve entrepreneurial profits through innovation while managing the stream of normal rents that then accrue from the innovation. These two processes are logically distinct and it is important to recognize this distinction, if the venture is to be successfully managed over the long run. This article argues that the two processes of entrepreneurship and management are different and that the firm must employ incentives and rewards that solve delegation problems at the entrepreneurial and management levels.
It is in this connection that the distinction between senior and middle management, or between the corporate staff and divisional headquarters staff, becomes relevant. Essentially, a distinction has to be made between managers creatively organizing transactions and those whose role is to monitor and control their execution. It is not clear in many situations how this division is made and where the real source of entrepreneurship actually lies. Normally, we see the headquarters staff in the role of the arbiter of successful innovation. The image is conjured up of 3M, where a seasoned team of previous entrepreneurs size up the value-creating impact of new projects and ratify the ones to be followed by their organization. If this view is correct, then firms must have clear organization ladders for entrepreneurs to follow if they are to be motivated to perform the entrepreneurial function and reap the rewards of their labors. Some firms have these in place, but in other cases this is a serious problem. For instance, this view is somewhat paradoxical because the implication is that entrepreneurs will normally be in the junior roles in organizations and their superiors are the managers doing the monitoring. This is different from the view normally advanced in the literature. Managing this entrepreneurship-monitoring interface is a thorny process that is deserving of more study.
The model also has several implications for strategy implementation. Successful entrepreneurship and subsequent growth puts pressure on the manager to bureaucratize the organization, but the resulting agency problems suggest limits on the structural adjustment possible for firms that wish to maintain their entrepreneurial capability. Ways must be found to separate entrepreneurs from organizational controls so that the opportunity-noticing capability is maximized.
The expanded notion of what entrepreneurship means, presented in this article, has implications that expand far beyond new venture considerations. The entrepreneur is more than the inventor or the individual capable of implementing a new innovation. Entrepreneurial profit can be obtained across functions and at all levels in the firm, provided a structure is in place to allow rights and responsibilities to match and employees to receive the rewards that accrue from their activities. Creating avenues for entrepreneurial communication and ensuring that vehicles exist for the assignment of rewards and responsibilities is vital if entrepreneurship and competitive position is to be maintained.
Finally, as mentioned earlier, we have not considered the role of behavioral factors such as desire for prestige or intrinsic interest in innovation per se in the model developed above. Obviously, these variables affect the model and there is evidence that many entrepreneurs engage in innovation for its own sake. Similarly, we have not incorporated social variables such as organizational culture into the analysis although these play a role in sustaining the entrepreneurial attitude over and above the economic rewards we have focused on above. For example, organizational cultures that promote the development of norms and values of excellence in innovation and service can play a distinctive role in promoting internal entrepreneurship. Exploring the interplay amongst economic and behavioral factors would be interesting empirically. However, there is no a priori reason to believe that the direction of the relationships outlined in the model above would change; only the strength of the relationships might fall as non-economic rewards come into play.
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