Contracting strategies in entrepreneurial and established firms.

A central thrust of research about entrepreneurs is that they are somehow different from established firms' managers. This belief has led to numerous studies comparing the inherent characteristics of entrepreneurs with those of established firms' managers (e.g., Brockhaus & Horwitz, 1986;

Dunkelberg & Cooper, 1982; McGrath & MacMillan, 1992; Greiner, 1972; Kaish & Gilad, 1991; Kets de Vries & Miller, 1986; Lamont, 1972; McClelland, 1967; Niederkofler, 1991; Sexton & Bowman, 1985; Vesper, 1980). We continue the tradition of studying differences between entrepreneurs and established firms' managers by examining how each engages in contracting. Contracting is essential to all firms. Both entrepreneurs and established firms' managers obtain raw materials and resources, and distribute products by contracting with other firms. In this paper we show how differences in environments, contracting context, and conditions lead entrepreneurs and established firms' managers to use different kinds of contracting strategies. In addition, we illustrate and hypothesize how successful contracting leads to overall firm success.

Contracting can take many forms, encompassing both formal written arrangements and undocumented exchanges. Some contracts begin formally, with both sides signing a document that specifies nearly all the terms that will govern the exchange. In many cases the terms change as the relationship between the parties evolves and the new terms may be explained in a formal amendment, through an exchange of letters, or simply through an undocumented understanding. Many contracts between trading partners are less formal, such as those governed through letters of understanding. Most exchanges are completed without a negotiated formal document (Macauley, 1963), for example, when a supplier receives a purchase order explaining the purchaser's terms, and the supplier then accompanies the filled order with an invoice listing a different set of terms. Although the terms listed by the buyer and seller do not agree, the transaction is typically completed without difficulty because the areas of disagreement do not become relevant. Contracting, as used in this paper, refers to the entire range of formal and informal methods for regulating exchanges, not just to the legal documents prepared by lawyers and signed by buyers and sellers.

WHY DIFFERENT STRATEGIES ARE NECESSARY

Different contracting strategies are necessary because entrepreneurial and established firms operate in different environments. These differences are apparent in the economic theories that are applied to the two types of firms. As Kaish and Gilad (1991) pointed out, the implicit economic model employed in most studies of established firms assumes free and full flow of information. According to equilibrium theory, competitive markets drive risk-adjusted profit-making opportunities to zero. There are no informational advantages available to established firms' managers, or if informational advantages exist, they are overcome by the quick action of another firm's managers. An equilibrium model is appropriate for established firms because products are relatively well developed, markets and distribution channels are established, and production technology is standardized. Firms attempt and sometimes gain a short-term advantage through product innovation, process innovation, and new marketing strategies. However, the conditions that lead to extraordinary profits are quickly dissipated and markets return to equilibrium until the next round of innovation nudges them into short-term disequilibrium. While advances may be made in one or a few markets, products, or processes, the majority of the established firms' endeavors remain stable. In an overall sense, established firms' markets are in or approaching equilibrium. As a result, established firms' long-term success is explained either through an advantageous cost structure or superior adherence to customer needs.

Entrepreneurial firms' environments are explained by a different economic theory. As Israel Kirzner (1973, 1979) pointed out, the entrepreneurial firm's environment is predominantly one of disequilibrium. Success and failure result from recognizing informational gaps and market niches in which disequilibrium exists and can be maintained. In this situation, either products, processes, or markets, or all three provide a speculative opportunity to the entrepreneur. If the entrepreneur proves the opportunity is profitable, established firms will attempt to take advantage of the opportunity created by disequilibrium. The entrepreneur maintains the lead by continually searching out new opportunities that established firms' managers can not or choose not to pursue.

Just as success has many fathers and failure none, entrepreneurs are seen as great visionaries when they succeed and wild-eyed, impractical dreamers when they fail. The very fact that established firms have not pursued the entrepreneur's business opportunity is enough to convince many that the opportunity is illusionary. Because the perceived likelihood of success is low, potential contracting partners prefer doing business with established firms over doing business with entrepreneurial firms. Even contracting partners who have confidence in the entrepreneur will see a prospective venture as risky until history proves the entrepreneur right or wrong. As a result, established firms have advantages over entrepreneurial firms. On the input side of the business, established firms will have easier access and better terms from suppliers of capital, materials, equipment, technology, facilities, and labor than will entrepreneurial firms. On the output side of the business, established firms will have better terms and access to distribution channels and customers than will entrepreneurial firms. Another advantage held by established firms results from their relationships with contracting partners and membership in an extended network of potential contracting partners. Most contracting in established firms is a replication of previous contracts with relatively long-term contracting partners. One bonus of repeat contracting is that many of the contract terms and conditions need not be renegotiated. Those that are reconsidered may require only incremental changes. The parties know each other through long association and trust each other to behave honestly. This advantage extends to established firms even when they contract with new partners. Because established firms are part of the broader network of successful and well-known firms, even as first-time contracting partners they already know quite a lot about each other. For example, the firms' positions in their respective industries and the managers' reputations for integrity are common knowledge. As a result, established firms find it easier to identify potential contracting partners and reach agreements because of the firms' and the firms' managers' reputations.

Entrepreneurial firms suffer a distinct "liability of newness" (Stinchcombe, 1965) that makes it more costly for them to identify potential contracting partners and to negotiate contracts. Much of the entrepreneurial firm's contracting is conducted with new partners because many entrepreneurs are not members of networks. In the worst case, each contract begins de novo and requires countless hours of negotiation. Each attempt to expand the base of contracting partners requires extensive search for appropriate partners followed by protracted negotiation. The entrepreneur must devise contracting strategies to overcome the greater perceived risks and uncertainty inherent in exchanges with entrepreneurial firms. Also, to efficiently allocate their time and other scarce resources, the entrepreneur must reduce the amount of time and transaction costs required to identify and negotiate with new contracting partners. The entrepreneur has fundamentally different problems from established firms because of the contracting risk and the contracting context, and must develop fundamentally different contracting strategies to overcome these problems.

GENERAL CONTRACTING MODEL

In the following section we build on the contracting models developed by Coase (1952) and Williamson (1975, 1985). The general contracting model varies from previous models in two important aspects. First, the model pertains only to inter-firm transactions rather than whether markets or hierarchies will prevail. Entrepreneurial firms typically suffer severe resource constraints that produce a bias for inter-firm transactions over internalized contracting (Jarillo, 1989; Spann, 1990). Even though entrepreneurs may believe a hierarchy would result in lower transaction costs than the market, insufficient resources are a more pressing problem than economizing on transaction costs. In addition, by examining only the market transactions of entrepreneurial and established firms, more direct comparisons are possible. A second divergence from traditional models is that the contracting context is more fully developed. Contracting between finns is affected by the contracting partners' reputations, the degree of trust between contracting partners, network membership, and the legal and economic systems in which the firms operate.

Coase (1952) described a firm as a nexus of contractual relationships between the firm and its suppliers, customers, and creditors and within the firm between its owners, managers, and workers. The contracts govern the exchange of property rights between contracting partners. If the exchanges have a net positive value, wealth increases and a firm can prosper. If the exchanges have a net negative value, wealth decreases and a firm eventually fails.

As shown in Figure 1, a contractual relationship is formalized in a governance structure consisting of fundamental contractual terms and a set of negotiated endogenous safeguards. Additional exogenous safeguards are automatically provided by the legal system in which contracts are embedded. All contracting entails some risk but the risks can be offset, at least partially, by the contracting context, for example, trust between the contracting partners and dyad and network membership. Contracting efficiency through lower transaction costs is required to meet the demands of market competition. Transaction justice or equitable outcomes are required because all people pursue self-interest and will not willingly engage in inequitable relationships. On a more practical note, a firm cannot survive for long in inequitable relationships.

Contractual Governance Structures

A contractual governance structure includes basic terms specifying who are the contracting parties, what property rights are being exchanged, when and where the exchange will take place, and how the exchange will occur. These terms allocate risks and responsibilities among the contracting partners. In a typical retail setting, specifying terms is easy even though the agreement is implicit rather than the result of explicit bargaining. The contracting partners are the retailer and customer and their property rights are the purchase price on the one hand and the product and any guarantees it carries on the other. The checkout process specifies when, where, and how the exchange is executed. Specifying the terms governing a more complex contract is obviously more difficult. For example, construction of a shopping mall involves more parties, complicated exchanges of property rights, and the when, where, and how expands from a single event into a timetable for completion of the project. As deals and projects become more complex, the contractual governance structure supporting them becomes more complex.

In addition to basic terms, a contractual governance structure may include ancillary terms designed to safeguard against undesirable behaviors and unintended events. Endogenous safeguards are used to enumerate more precisely each party's rights and responsibilities. As Ring and Van de Ven (1989) pointed out, these endogenous safeguards are either structural or procedural. Structural endogenous safeguards include requiting collateral, membership on the other firm's board of directors, contingent claims, and other performance specifications (Williamson, 1985). Procedural endogenous safeguards include auditing rights or open book rights, monitoring tights, and agreeing to use arbitration or mediation to resolve disputes.

At one extreme, the contractual governance structure can be a simple device for regulating straightforward exchange, such as a spot market purchase, a short-term agreement between supplier and customer, or a lender and borrower arrangement. Yet even simple transactions can require considerable investigation, negotiation, and monitoring. At an intermediate level of exchange, such as a franchise, or a licenser and licensee agreement, the contractual governance structures become increasingly complex. Extensive endogenous safeguards are used because of the uncertainty surrounding future events. At the other extreme, such as a R&D partnership, a cooperative marketing agreement, or a joint venture (Badaracco, 1991; Contractor & Lorange, 1988; Harrigan, 1985), negotiating, executing, and monitoring a contract becomes nearly overwhelming. The parties will find it impossible to deal with all contractual risks, uncertainty, and unexpected consequences (Macneil, 1978). Under these circumstances, the parties negotiate a contract, recognizing they cannot cover all future events and that ongoing negotiation will be required.

Contracting Risk

Risk is associated with the uncertainty of predicting outcomes (March, 1978; Vlek & Stallen, 1980). As Williamson (1985) pointed out, uncertainty due to bounded rationality is an ubiquitous problem in contracting. Future predictions are difficult, but when the transaction involves entrepreneurial firms this difficulty is magnified. Entrepreneurial firms do not have a performance history and potential contracting partners are skeptical about the entrepreneur's capabilities to resolve the technical, financial, logistic, and human problems required to complete the transaction. At the same time, entrepreneurs may fear that established firms are simply using them to acquire their innovative technologies and new products, or that this is just the first step towards an acquisition (Doz, 1988). These questions, assumptions, and fears heighten the uncertainty surrounding transactions and increase perceived contracting risks for both established firms' managers and entrepreneurs.

Information asymmetry between an entrepreneur and an established firm's manager can increase contracting risk because each enters the contract with substantially different information. Managers of established firms may not share their long-term plans. Entrepreneurs may not share how dependent they are on the contract, the precariousness of their financial position, or how uncertain they are about their ability to perform.

The possibility of opportunistic behavior or "self-interest seeking with guile" (Williamson, 1975, p. 26) increases contracting risks and forces contracting partners to negotiate terms that protect them from unscrupulous behavior. Even though a contracting partner may believe that the vast majority of managers are trustworthy, there is still a possibility that the other contracting partner will seek unfair advantage or behave unethically.

Contracting risk increases if asset-specific investments that cannot be redeployed are required to complete a contract. There are three forms of asset-specific investments: physical, site, and knowledge (Teece, 1985). Physical asset-specific investments refers to equipment that has only one purpose. For example, a manufacturer builds special equipment for creating products for one customer, but the equipment has no value in creating products for other customers. Site asset-specific investments are based on proximity. For example, a container manufacturer locates adjacent to a bottling plant, but shipping and inventory costs render it economically inviable for serving more distant customers. Knowledge asset-specific investments refers to knowledge that is situation specific. For example, a supplier's computer programmers develop skill and knowledge that is critical when transacting with one customer but has no value when transacting with other customers (Hudson, 1990).

Contracting Context

Each contract is affected by the context in which it is negotiated and executed. Context can be examined at multiple levels: dyad, network, and system. At the dyad level, trust between partners is essential to contracting longevity and contracting success. Once an entrepreneur establishes a successful dyad and gains a reputation for trustworthiness, network membership may be possible. Dyads and networks are embedded in legal, economic, and social systems. The context can either reinforce the risks and make contracting less efficient or offset the risk and make contracting more efficient.

Trust refers to the belief that contracting partners will honor the contractual terms and will not take advantage even when the opportunity is available (Bromiley & Cummings, 1989; Gore, 1983). Williamson (1974, 1985) argued that because identifying untrustworthy parties is difficult, given the potential for opportunistic behavior, individuals are forced to act as if others are untrustworthy. Yet, this contradicts theory, experience, and common sense. Arrow (1973, p. 24) argued that ". . . ethical elements enter in some measure into every contract: without them, no market could function. There is an element of trust in every transaction." Fried (1981) argued that people want to trust one another so much that they pursue trust for its own sake, and that people prefer working cooperatively to working alone.

There are two explanations for the existence of trust. The first is based on the belief that people want to do the right thing because it is right. The second is based on the belief that people will do the right thing because it is in their self-interest. The first explanation for trust is based on norms of equity. Equity or fairness has two components, one based on ends and the other based on the means used to achieve the ends (Greenberg, 1987). The former is derived from equity theory (Adams, 1965). This approach conceptualized equitable or distributively just relations as ones in which the outcomes are proportional to the contribution made. The latter is based on procedural justice (Thibaut & Walker, 1975). This approach focuses on the fairness of the procedures used to allocate outcomes. Trust results from contracting parties having successfully completed transactions and perceiving one another as following the norms of equity (Van de Ven & Walker, 1984).

Another explanation for the emergence of trust is based on utilitarian or calculative reasoning; there are many non-legal sanctions that make it expedient for individuals and organizations to fulfill commitments (Macaulay, 1963) and forsake opportunism. At the personal level, repeated personal interaction encourages courtesy and consideration, and the prospect of ostracism among peers attenuates individual aggressiveness. More important, the prospect of repeat business discourages managers from opportunism (Larson, 1992; Maitland, Bryson, & Van de Ven, 1985).

Trust is closely related to reputation. If managers violate trust with their contracting partners it can quickly lead to a negative reputation. Organizational reputation is a valuable business asset (Weigelt & Camerer, 1988), and once a reputation is lost it is difficult to regain. The payoff from a good reputation includes attracting and retaining talented workers and customers, opening doors to potential stakeholders, and efficient marketing of products (Caminiti, 1992). Fortune magazine provides rating of firms' reputations (Ballen, 1992), which attests to its importance.

Absence of trustworthiness and reputation are major problems for entrepreneurs. Entrepreneurs need start-up money but banks will not lend without a customer order, customers will not place orders without evidence that the product can be supplied, suppliers will not give credit, the landlord requires a deposit and a lease, and skilled workers are reluctant to leave guaranteed employment. Birley and Norburn (1985) described this cycle as the credibility merry-go-round. The entrepreneur may be locked out of existing channels, labor pools, and sources of financial resources. Assuming the entrepreneur is able to break this cycle, there are still other obstacles to overcome. Contracts with customers may be small, suppliers may grant only limited credit, key employees are offered modest salaries for long hours of work and may join only if promised ownership benefits (Greiner, 1972), and lines of credit may be inadequate.

The trust that can evolve in successful dyads enhances personal and firm reputation, and serves as the entry price for network membership. The dyad relationship is built through an accumulation of incremental and cautious transactions that creates a social system that transcends narrow self-interest and includes moral as well as economic motives (Etzioni, 1988). Trust, prior personal relationships, individual reputation, and firm reputation are critical to the development of dyad relationships (Coser, Kadushin, & Powell, 1982; Jarillo, 1988; Larson, 1992; Niederkofler, 1991). These preconditions offset uncertainty, establish expectations and obligations, enhance early cooperation, and provide implicit control over contracting relationships. Because they are present, these moral controls prevent unethical acts. For example, word travels quickly within the network, and deviation from the accepted norms could cause an individual's or a firms reputation to be tarnished.

Once the entrepreneur has built a relationship with one network member, access to the broader network becomes more readily available (Larson, 1992). Affiliation with any one of the network members enhances the entrepreneur's reputation through legitimacy and credibility. An entrepreneur's positive reputation improves the likelihood of not only current short-term economic rewards, but the possibility of increasing business volume and returns by acquiring new contracting partners in the future (Larson, 1992). A network simplifies the entrepreneur's search for contracting partners by providing a broad range of contacts that could open opportunities for exchange. A network is used to gain access to new distribution channels and markets that might have otherwise been closed to the entrepreneur. For example, Larson (1992) argues that a key strategy for the resource-poor entrepreneur is building network exchange structures with critical resource suppliers. These relationships, based on strategic fit, trust, and reciprocity, allow the entrepreneur to gain resources, expertise, and competitive advantages without incurring great financial burdens. However, there are inherent risks associated with this strategy, such as over-dependency and environmental and strategic change, that could make an entrepreneurial firm vulnerable if its managers fail to develop the firm's capacities (Hull, Slowinski, Wharton, & Azumi, 1988; Larson, 1992; Doz, 1988; Niederkofler, 1991).

Written contracts with highly specific terms and endogenous safeguards become necessary when one party has not established a reputation, there is no prior personal relationship, or there is no reason to trust the other party. But under effective networking conditions, the use of safeguards can be reduced because trust, reciprocity, reputation, and obligation offset risky contracting conditions and contract specificity.

Dyads and networks are embedded in and constrained by a legal system. These exogenous safeguards, or legal systems, are created through constitutions, legislation, and regulations that establish the limits within which contracting must be conducted. Although most contracts are executed without resorting to legal enforcement (Macaulay, 1963), exogenous safeguards provide a last resort for resolving contract disputes. Exogenous safeguards vary depending upon the particular governments that are involved.

Finally, the culture in which contracting occurs can conceivably affect willingness to accept the risk, the manner in which trust is formed and reputation communicated, the specificity of contractual terms, and the use of endogenous safeguards. Yet, two cross-cultural studies of entrepreneurs report that entrepreneurs in different cultures share a number of core values (McGrath, MacMillan, & Scheinberg, 1992) and share a belief that entrepreneurs are different from others in their societies (McGrath & MacMillan, 1992).

Transaction Costs

Transaction costs represent the expenses incurred in contract negotiation and execution. That is, the actual cost of negotiating an agreement, of subsequent renegotiation, and compliance monitoring. Even simple transactions result in a small cost for the participants. Time is required to communicate the nature of the property rights to be exchanged and the timing of the exchange. More complicated contracts require more complex and specific negotiation terms about, for example, prices, product specification, quantities, delivery schedules, and inspection rights. Some transaction costs are obvious, such as legal expenses, monitoring costs, and the time required for negotiation and clarification of unresolved issues. Other costs are less obvious, such as the cost of training inspectors. In addition, the type and timing of transaction costs vary. For example, market transactions may entail greater ex ante costs than hierarchical transactions due to the difficulty of reaching agreement on complex issues, and more modest ex post costs due to the relatively greater ease of judging performance and compliance.

Contracts involving an entrepreneurial firm may require greater transaction costs than contracts between established firms. Entrepreneurs have little basis for accurate performance projections, have product ideas rather than established products, and have cost estimates rather than cost accounting records. Under such circumstances, potential lenders, suppliers, customers, investors, and managers must spend considerably more time collecting and analyzing information about the entrepreneurial firm. Negotiations are drawn out and monitoring requires more time and attention.

Transaction Justice

The contracting partners enter into an exchange relationship to accomplish personal and organizational objectives. Although costs are an important criterion for evaluating the success or failure of transaction outcomes, transaction justice or fairness is another fundamental evaluation criterion. In any exchange relationship each contracting partner contributes and expects to receive a fair return proportional to its contribution. When this occurs the transaction outcomes are seen as just, trust between the transaction partners increases, future contracts become more likely, and future negotiations between the parties become easier. When transaction outcomes are perceived as unjust, trust is diminished or extinguished, and future contracting is unlikely.

Adams (1965) proposed that whenever two parties exchange anything, one or both parties may perceive the exchange as inequitable. In exchange relationships the parties' contributions-to-outcomes ratios are compared. Equity exists when both parties perceive the ratios to be equal, but this is often not the case. One party's contributions and outcomes may not be recognized or considered relevant by the other party. Differences in perceptions lead to feelings of inequity.

People are assumed to engage in self-interest seeking behavior. They negotiate terms that allow them to achieve their self-interest. This is not a simple process because sellers always prefer selling less for more, whereas buyers always prefer buying more for less. Bargaining is required because of conflicting interests that must be resolved in an equitable manner. Two issues are involved in applying equity theory. Equity is affected by the extent to which each contracting partner lives up to the terms of the negotiated contract. If one contracting partner fails to comply with the terms, the other contracting partner will likely perceive the transaction as unfair. If both contracting partners' performance match the terms, the contract is likely to be perceived as equitable. However, the participants may perceive a transaction as unfair even though all the terms are satisfied. This happens because they believe, in retrospect, that the agreed upon terms were unfair due to ignorance about current and future conditions, because of poor bargaining position, or because they lack good bargaining skills. Thus, perceived transaction justice is a function of the degree to which contractual terms are met and the degree to which the outcomes represent a fair and reasonable exchange between the contracting partners.

Injustice in transaction outcomes can result in three ways. Perhaps the most obvious form of injustice occurs when one or more of the contracting partners does not live up to the terms of the agreement. Violations of the spirit or letter of the terms seriously damage the trust between the contracting partners and make future contracting between them highly unlikely because those who break their word are held in contempt. However, if the offender can convince the offended that events beyond personal control forced the violation, and if amends that demonstrate good faith can be provided, future contracting may be possible, albeit with diminished trust and more difficult negotiations.

A subtle but no less serious form of injustice occurs when outcomes are perceived as inequitable even though terms are upheld. Based on equity theory each participant expects to receive outcomes proportional to contributions and the contracting partners undoubtedly desire fair outcomes. However, uncertainty may make it impossible to know exactly what each contracting partner's outcomes will be, or even exactly what each contracting partner's contributions will be. When the contract reaches completion, one or more of the partners may perceive their outcomes as inequitable when compared to those of the other contracting partner and react with dissatisfaction. The dissatisfaction may be reduced by one contracting partner unilaterally sharing some of the outcomes with the other partner, by renegotiating the terms of the contract, or by making up for the inequality of past outcomes when negotiating future contracts. It is important to note that no blame need be attached to the more successful contracting partner for the other partner to perceive inequity. Events are difficult to predict and unexpected consequences are common. Yet long-term or repeated inequity and dissatisfaction will begin to erode trust between the contracting partners and make future contracts less likely and more difficult to negotiate.

Finally, injustice may occur because of the procedures used to bring about outcomes (Folger, 1977). For example, one contracting partner may behave opportunistically when negotiating the contract. Even if the terms of the contract are strictly upheld and contributions and outcomes are exactly as negotiated, the contracting partner will perceive inequity and a grave procedural injustice. While inequity produces a perception of dissatisfaction, procedural injustice produces a feeling of moral outrage (Folger, 1986). Trust between the contracting partners will be extinguished and future contracting will be highly unlikely.

It is important to note that transaction injustice usually, but not inevitably, leads to a loss of trust and reduces the likelihood of future contracting. The determining factor is the cause of the injustice and the feeling of the aggrieved contracting partner. Behaving opportunistically or in bad faith will almost certainly strain the bonds of any relationship to the breaking point. The sense of moral outrage felt by the offended contracting partner will be permanent. Similarly, willfully breaking one's word typically produces a feeling of contempt and has a permanent effect on contracting relationships. The dissatisfaction felt due to a perceived inequity can be overcome, but only if the dissatisfied party believes the inequity is temporary.

Several researchers have recognized the importance of equity, trust, and reciprocity as control mechanisms in both formal and informal exchange relationships (Aldrich & Zimmer, 1986; Birley, 1985; Jarillo, 1988; Larson, 1992; Lorenzoni & Ornati, 1988; MacMillan, 1983). These factors are also critical in understanding long-term relationships because fair outcomes and processes, and the trust which results, will be the most beneficial to all concerned parties in the long run (Leventhal, 1976) and for maintaining long-term social harmony (Deutsch, 1975).

Contract and Firm Success or Failure

Business success requires a succession of successful contracts. Successful contracting requires that contracting partners achieve efficiency by minimizing transaction costs and achieve effectiveness by creating just outcomes. Without contracting efficiency firms will consume potential profits with excessive overhead. Without contracting justice, firms will not be able to obtain repeat business and will tarnish their reputation as a fair contractor. This in turn increases subsequent transaction costs because new contracting partners must be identified and because a firm with a tarnished reputation will be forced to negotiate more specific contract terms and offer more safeguards.

CONTRACTING STRATEGIES

Entrepreneurial and established firms need different contracting strategies to be successful because there is a quantum difference in their environments, not a difference of degree (Miller & Friesen, 1984). Minimizing transaction costs begins with an efficient strategy for identifying potential contracting partners, and also requires efficient contract negotiation and execution. Negotiation and execution efficiency are particularly important because the inefficiencies of one contracting partner often result in greater transaction costs to the other partner. For example, if one of the contracting partners uses a ponderous negotiation approach, the other contracting partner becomes bogged down as well.

In more specific terms, contracting strategies achieve three objectives. First, a firm needs strategies to efficiently identify and attract potential contracting partners. Second, a firm needs strategies to efficiently complete the negotiation and execution of exchanges with contracting partners. Third, a firm needs strategies to gain membership in networks to lower transaction costs (Jarillo, 1988). Entrepreneurs and established firms' managers have different strategies for achieving these goals.

Because newly formed entrepreneurial firms are often not members of networks, they can not follow the strategies of established firms' managers who use network contracts to identify potential contracting partners. Consequently, the entrepreneur's search for potential contracting partners is less focused and has a lower likelihood of success. Both join groups and associations, but for different reasons. In addition, entrepreneurs have less uncommitted time and will join groups selectively.

H1: Entrepreneurs join business-oriented civic organizations to identify and earn the trust of potential contracting partners. Established firms' managers join social-oriented civic organizations to enhance personal and firm prestige in the community.

H2: Established firms' managers are more likely than entrepreneurs to join a larger number of trade groups and industry associations as a way of establishing a personal relationship with representatives of potential contracting partners.

Once a potential contracting partner is identified, the entrepreneur must have strategies for overcoming the skepticism and hesitancy held by established firms' managers. It is risky for an entrepreneur to develop or acquire contract-specific assets without a long-term relationship or commitment, but such investments demonstrate good faith and willingness to commit on the part of the entrepreneur. If contracting relationships involving entrepreneurs start small, the entrepreneur can minimize the size of the initial asset-specific investments. The investments can increase when justified by larger orders and when a more solid relationship is built between the contracting partners. The modest scale also provides the entrepreneur with an opportunity to learn how to perform the tasks required for contract completion. In addition, small initial orders provide advantages to both contracting partners. Both have a chance to learn the styles, capabilities, and needs of the other without a great deal of risk (Van de Ven, Hudson, & Schroeder, 1984). If the contracting partners see the initial relationship as equitable or likely to be equitable in the long run, their ongoing exchanges and interaction will increase the level of trust between them.

H3: Entrepreneurs are more likely to commit asset-specific investments in a contractual relationship than established firms' managers.

H4: Entrepreneurs are more likely to accept small, modest contracts with new contracting partners than established firms' managers.

If the entrepreneur feels it is necessary to accept an inequitable outcome in order to land the first contract, the small scale minimizes the size of the loss. An established firm's manager may at times want to accept an inequitable initial contract, but the manager may have difficulty getting approval from superiors. The superiors may believe that there are too many other attractive potential contracting partners to necessitate an inequitable one.

H5: Entrepreneurs are more likely to accept an inequitable contract with new partners than established firms' managers.

Another way that entrepreneurs can overcome doubts and skepticism about their integrity or their firm's capabilities is to provide safeguards, such as board seats, collateral, or monitoring rights to contracting partners. Banks may ask for more collateral from an entrepreneurial firm than from an established firm, and may even require personal collateral from the entrepreneur. Important customers, lenders, and equity participants may ask for a board seat or monitoring rights as a safeguard for their investment. While safeguards can offset some of the risk inherent in contracting with entrepreneurial firms, entrepreneurs will resist granting safeguards because they increase the entrepreneurial firm's transaction costs and because they infringe on the entrepreneur's authority and independence.

H6: Entrepreneurs are more likely to grant safeguards to important contracting partners than are established firms' managers.

One of the few advantages entrepreneurs bring to the bargaining table is that they negotiate as principals rather than agents. They can be more flexible and imaginative than their counterparts in established firms because they need not sell the terms of the exchange twice, once to the contracting partner and a second time to skeptical supervisors. However, understanding the needs of contracting partners and proposing terms that simultaneously advance the interests of both partners is probably critical to breaking the negotiating log-jam. This suggests that entrepreneurs who have worked for established firms, and who understand the needs, bureaucratic impediments, and negotiation styles of the managers in established firms will be more successful in negotiations with managers in established firms.

H7: Entrepreneurs are more flexible and creative negotiators than established firms' managers.

If the costs involved in identifying and negotiating with contracting partners are to provide a long-term payoff for the entrepreneur, the contract must be repeated or the relationship must provide access to a larger network. For either to occur, the entrepreneur must earn the contracting partner's trust and ensure that the outcomes are perceived as just. One-time contracting requires substantially higher investments because managers are forced to continually seek out new contracting partners. In addition, initial contract negotiations take longer than repeat contract negotiations because of the time spent negotiating terms and safeguards, and because trust between the parties is low. Conversely, membership in a network reduces search time and fewer safeguards will be necessary because network norms, concern for reputation, and trust between the contracting partners will be higher.

H8: Entrepreneurs are more likely to renegotiate and remedy inequitable outcomes with a contracting partner than are established firms' managers.

H9: Entrepreneurial firms with repeat contracts will be more successful than entrepreneurial firms with a succession of one-time-only contracts.

H10: Entrepreneurs that pursue network contracting partners will be more successful than entrepreneurs that do not.

Entrepreneurs who launch a business after gaining industry experience and contacts have a distinct advantage over entrepreneurs who do not. Experienced entrepreneurs are generally able to build their new firm around a small set of customers with whom they have previously established a relationship based on trust and reputation. Transaction costs will be substantially lower for experienced entrepreneurs than for inexperienced entrepreneurs. Experienced entrepreneurs launch their firm after identifying potential contracting partners, after earning the trust of potential contracting partners, and after establishing a reputation and gaining access to networks. As a result, their search costs will be lower, the time spent in negotiation will be lower, and the level of monitoring will be lower. Because the experienced entrepreneur is more likely to understand the needs of contracting partners and have a clearer understanding of the capabilities of the entrepreneurial firm, negotiations can be completed more quickly and contract outcomes are more likely to be just. Because transaction costs will be lower and transaction justice higher for the experienced entrepreneur, contract success and overall firm success is more likely.

H11: There will be little difference in contracting strategies between experienced entrepreneurs and established firms' managers.

H12: New ventures launched by experienced entrepreneurs are more likely to be successful than new ventures launched by inexperienced entrepreneurs.

Although a central thrust of this paper is the comparison of entrepreneurial and established firms operating under similar economic, legal, and cultural conditions, the general contracting model presented can be used for cross-cultural comparisons.

H13: In countries where property rights, torts, and contract laws are well developed and the judicial process is fair, exogenous contractual safeguards provide better protection for contractors and as a result, transaction costs are lower, contracting success is greater, and a larger percentage of entrepreneurial firms are successful.

H14: In countries where property rights, torts, and contract laws are not well developed, or where the judicial process is perceived as biased, transaction costs are greater, transaction success is lower, and entrepreneurial efforts are smaller scale, evolve more slowly, use fewer asset-specific investments, and are less successful.

If substantiated, these hypotheses suggest that the first steps governments must take in order to encourage large-scale entrepreneurial efforts is to provide a stable, well-documented legal and economic system. While network norms can control behavior to a great extent, they are insufficient by themselves. Without a well-developed and fair legal system contracting risk is great and contract terms and endogenous safeguards are unenforceable.

CONCLUSIONS

In the preceding sections we have shown that the environments of established and entrepreneurial firms are fundamentally different and that different contracting strategies are required to achieve contract and firm success. While the general contracting model draws heavily from transaction cost theory, it also recognizes that trust and reputation play an equally important role. The model provides a general framework for comparing the different situations and contracting strategies for established and entrepreneurial firms.

Future research can proceed at two levels; the explicit hypotheses about contracting strategies and the implicit hypotheses of the general contracting model need to be tested. Although many researchers believe that all transaction cost models are tautological, this is true primarily of those that focus on the selection of markets versus hierarchies. When transaction costs and transaction justice are the primary outcome measurements, and contract mode is limited to market transactions, comparisons are more straightforward. For example, transaction costs can be compared in terms of the number of work hours invested in identifying potential contracting partners, preparing for negotiation, conducting negotiations, and monitoring contract execution. Legal expenses, for contracts that require them, can be reported by the firms paying the bills. Less direct, but important, measures of transaction costs include the number of employees involved and the number of meetings held both during and subsequent to negotiations. Transaction justice is a perception on the part of each contracting partner and must be collected from the managers involved.

Firms must exchange with other firms to obtain input resources and sell their products. Planning and managing the exchange function is arguably as important as planning and managing a firm's production function. Certainly, neither function is sufficient to yield firm success without the other. Just as firms have strategies, often implicit, to direct the transformation of input resources to deliverable products, firms have strategies to direct contracting with suppliers and customers. An understanding of contracting strategies in the two types of firms can help explain why so many entrepreneurial firms fail, and can provide guidance to entrepreneurs who wish to increase the likelihood of their success.

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Roger L. Hudson is an Associate Professor at the University of Wisconsin-Parkside.

Angeline W. McArthur is an Associate Professor at the University of Wisconsin-Parkside.