The Low Leverage Decisions of Knowledge based Firms - An empirical study of the impact of employees' risk preferences on the firm's capital structure decisions

Abstract: A distinctive trait of knowledge-based companies is their dependency on the competence and contribution of their employees. They are commonly structured as partnership firms and tend to have a low amount of tangible assets and virtually no debt. Although theories within capital structure state that debt can indeed be beneficial, knowledge-based companies persistently choose to completely avoid the use of long-term debt and hence do not adequately fit the description of any of the dominant theories within the field. The aim of this thesis is to analyse and explain the process behind the capital structure decisions of knowledge-based firms. The main purpose is to see how well these companies align to the major theories within the field and seek further explanations in alternative theories where the former do not suffice. Moreover, due to the nature of the firm’s assets an interesting aspect to investigate further is whether the risk preferences of the firm’s employees affect the firms financing decisions. The emphasis is put on partners’ ability to impact decisions as they have decision-making authority and incentives to maximise profitability, gaining rewards in the form of substantial yearly dividend payments. The study was performed with the use of a qualitative method, which enables a profound understanding of what affects decisions. Primary data was collected through interviews with representatives of four knowledge-based firms operating in the fields of law, consulting and advertising, which were deemed to provide a broad and fair view of the industry. We sought to interview employees that had great insight in the companies’ finances; therefore the interviews were conducted with either the Chief Financial Officer or Chief Executive Officer of the respective firms in order to gain as high reliability as possible. The study showed that the main reason for avoidance of debt was most often referred to the interviewed companies’ low investment needs. Moreover, theories in the area were found not to be actively considered, even though evidence in favour of them can be found. Much of the findings aligned with the implications of the pecking order theory, but even so the extreme policies of knowledge-based need more explaining. In line with the stakeholder co-investment theory the thesis investigates whether the risk preferences of the firms’ employees, in being the most important stakeholder, in any way affect decision-making. It was found that even though not explicitly expressed, many times decisions are made that favour the employees over the overall financial benefit of the firm. Rather than increasing the market value of the company by taking on debt, dividend-payouts create value-enhancing activities on a personal level.