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ABSTRACT
Small-cap firms provide a significant nexus for entrepreneurship and innovation in the U.S., and hence might be viewed as less prone to governance problems than large firms. This paper tests this assertion, allowing for interactions between internal and external governance mechanisms and performance. Significant interactions between board independence, firm leverage, CEO ownership, and pay-performance sensitivity are observed. The results support the paradigm of entrepreneurial CEO's whose ownership in such firms is optimally aligned with performance. Some suboptimal deployment of governance mechanisms is observed for the sample as a whole. In particular, excess leverage which significantly reduces firm value is observed. This is consistent with the view that debt reduces the entrepreneurial capacity of firms, by hindering the firm's ability or willingness to compete aggressively, particularly against well-financed competitors. Larger board sizes are detrimental to performance. Pay-for performance compensation for CEOs, on the other hand is beneficial for small-cap firm performance. While Sarbanes-Oxley Act compliance may be difficult for many of these firms, its passage does not adversely affect their performance.
JEL Classification: G32, G34
Keywords: Corporate governance mechanisms; US small-cap firms; Entrepreneurship; performance
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I. INTRODUCTION
This paper looks at the impact of governance mechanisms on small-cap firm performance in the US. Much of the extant research on the effects of governance mechanisms on performance focuses exclusively on large-cap firms, leaving a hiatus on our empirical knowledge about the corporate governance of small companies. In the U.S., small firms have been the nexus of entrepreneurship and innovation, and at the same time, account for a sizable portion of economic activity.1 While the returns of small-cap companies have been studied extensively since Banz (1981) and Reinganum (1981) documented the "small-cap anomaly,"2 little attention has been devoted to the governance of such firms. One could argue that small-cap firms may be less prone to governance problems relative to large firms, particularly if they are closely controlled. This could be due to alignment of incentives of entrepreneur-managers, who have significant ownership stakes, with those of outside shareholders. The entrepreneurial imperative for such firms may also be conducive to operational efficiencies resulting in easier coordination of resources.
Ang et al. (2000) find that for non-publicly listed small firms, agency costs (as measured...