Production is necessary before goods can be sold to generate revenue. The lag between incurring production costs and receiving revenue means that some great ideas for a business are never put into action.
Few families have sufficient wealth to launch fledgling enterprises on even a moderate scale without some external financing. Economic growth in a healthy economy requires financial intermediation.
Financial intermediaries channel people’s savings to investors in economic capital.
Financial intermediaries include commercial banks, insurance companies, and stockbrokers. This process of moving private saving through markets for financial capital to investors in economic capital is shown in a circular flow model in Figure 2, which illustrates that the ultimate capital suppliers in our economy are savers.
The relatively small amount that individual families save precludes them from devoting sufficient resources to secure information to ensure wise financial investment decisions. High transaction costs are incurred in identifying which financial investments are likely to be reasonably secure and capable of generating solid returns to savers. Consequently, although owners of unincorporated firms often sink all their savings into their firms, only a minority of other families buys stocks and bonds directly.
Most families’ saving takes the form of after-tax deposits in financial institutions such as banks, mutual funds, or other firms that specialize in trimming transaction costs and exploiting economies of scale while executing financial contracts and processing financial information. Thus, external financing for business operations flows primarily through these huge financial intermediaries.
Self-Financing and Retained Earnings
We have indicated that the initial size of a sole proprietorship or partnership is limited by the personal credit ratings and resources of the owners. Many small corporations are similarly limited to the resources of those who start them. Most proprietorships or partnerships that succeed build up slowly because growth depends on income from the business. Corporate growth may also be financed by retained earnings, that is, after-tax income that is not distributed as dividends to stockholders. Unless an established and prosperous firm aggressively tries to absorb substantial numbers of other firms through merger, much of its growth tends to be internally financed.
The prospect that internal financing may be adequate for growth at some future time is cold comfort for aggressive entrepreneurs in the throes of launching an enterprise. Some small firms are able to grow rapidly by preparing persuasive business plans that improve access to financial capital. The right to issue stocks and bonds facilitates this access if a firm is incorporated.
Issuing common stock is one way corporations may secure financing for economic capital.
Common stock provides holders with shares of ownership in a corporation.
The shares of corporate profits distributed to stockholders are called dividends; stockholders may also realize capital gains (or losses) if the market values of their stocks rise (or fall).
The initial offering of a stock raises funds for business firms, but most stock transactions occur in the secondary market, in which stockholders rather than firms transfer stocks to other financial investors. Although the total value of common stock in nonfinancial corporations is about $6 trillion today, less than 0.2% of this value is for stock in companies in business less than five years.
Financial investors require adequate returns to compensate them for risk. The probability that a new firm will fail in its first year is high. While there exists a flourishing market for new stock offerings with high potential rewards, high risks keep most relatively uninformed investors from purchasing these issues.
Small savers know that small stockholders have much less control than a firm’s officers have. But those who establish and control a new corporation have less incentive to perform diligently than they would if they owned the corporation outright. Small savers tend to opt for more security and lower returns than they are likely to get from stock ownership; the prospects of high returns from new stocks are very speculative.
Bonds (corporate IOUs) are assets for their holders but liabilities for the corporations that issue them. Bonds are also transacted primarily in secondary markets. Only the initial sale of a bond generates funds for the firm that issues it.
Bondholders have legal rights to receive interest payments as long as the firm operates. High probabilities of default (nonpayment) by start-up companies, however, leave only large, well-established corporations with much access to funding through bond sales.
Loans from Financial Intermediaries
Most people keep the bulk of their savings in commercial banks, which dominate financial intermediation processes in the United States. Although venture capital firms do specialize in funding new firms that develop promising business plans, most loans are made to huge, well-established firms. Even financial specialists tend to be amazed when they actually look at the numbers and discover that highly publicized sales of stocks and bonds account for only 1/25th as much of the recent financing of corporate activities as bank loans, which receive relatively little attention.2
You now have some notions about how firms are legally organized and financed and why society relies primarily on firms for production. We need to address the other side of explanations for the existence of firms—their purposes from the vantage points of those who own and operate them.