Corporate Ownership and Vertical Integration Into Selling, 1857-1883

Preliminary draft – comments welcome

Corporate Ownership and Vertical Integration into Selling, 1857-1883

Eric Hilt Department of Economics Wellesley College and NBER

November, 2016

I. Introduction

American manufacturing enterprises began the ninteenth century as uncomplicated organizations.

With few exceptions, their operations did not encompass multiple divisions and were not vertically integrated, either backward into raw materials or forward into marketing and distribution. They were simply focused on the manufacture of a single good or a few closely related goods, and contracted with other firms to obtain inputs and for the sales and distribution of their products. During the second half of the nineteenth century, this began to change. Some manufactuing firms developed the organizational capacity to integrate forward into marketing, opening their own sales offices with a salaried staff, and advertising their products. These marketing efforts were initially quite limited in scope and did not extend into retailing or even wholseale distribution. Instead, they were aimed at wholesale buyers— jobbers—who would then re-sell the goods to retailers. But this constituted an important change in the structure of some manufacturing enterprises, and often represented the first step in a long structural evolution that culmintated in the emergence of vertically integrated, multi-divisional manufacturing firms at the end of the nineteenth century.

These developments were analyzed in Alfred Chandler’s The Visible Hand (1977). Drawing on the work of Porter and Livesay (1971) and others, Chandler argued that improvements in domestic transportation and communication networks, which integrated American markets, and the development of new technologies and new goods, which enabled firms to benefit from economies of scale, were the impetus behind the shift toward vertical integration. Operating at a much greater scale, firms could no longer rely on traditional selling houses, and had to assume control of the marketing and distribution of their own products. And selling some of the innovative new goods they produced, such as sewing machines or electrical equipment, required specialized marketing and training efforts that were best undertaken by their producers, rather than third parties. These insights have become influential well beyond the field of business history, as they were formalized in Williamson’s (1981) transactions cost

1 analysis which, in turn, has been among the major inspirations for a large theoretical and empirical literature on vertical integration in economics.1

All of this analysis of vertical integration, from Chandler’s interpretation of American business history to the theoretical economic models it helped inspire, proceeds from the assumption that firms choose between market transactions, or internal management. In the case of selling, firms either contract at arm’s length with wholesalers for marketing services, in which case market transactions coodinate the distribution of goods, or direct those functions internally, in which case their own management coordinates distribution. This sharp distinction makes the conceptual analysis clearer, and also characterizes the choices modern businesses face relatively well. Yet the contracting for marketing services with wholesalers among nineteenth century manufacturers was often anything but an arm’s length market transaction. The merchants who operated wholesale commission firms were among the most influential figures in American business, and often founded or invested in relatively large numbers of manufacturing corporations. They were also frequently directors or executives in those manufacturing corporations, and were in a position to steer contracts for marketing services to their own commission firms—and often did exactly that. By contracting with themselves, these merchants were in a position to personally gain at the expense of the other shareholders in the corporation, for example by charging excessive commissions. The conflicts of interest created by the dual roles of merchant-directors sometimes posed serious problems for manufacturing corporations, and provoked rancorous debates among shareholders when their malign effects were discovered.

The role of corporate insiders in contracting for selling services has mostly been ignored in the business history literature. This is likely due to the difficulty in observing internal conflicts among nineteenth century firms. Indeed, just documenting the mechanisms by which nineteenth century firms sold their goods is difficult, and most of the literature has focused on the experiences of a relatively small number of prominent firms. Yet cases of conflicts between shareholders and selling agents have been

1 This literature is too large and complex to summarize here. Valuable reviews include Lafontaine and Slade (2007), Gibbons (2005), and Whinston (2003).

2 documented even among those prominent firms, and dismissed as unimportant. This likely reflects the emphasis in the work of Chandler and others on the advantages that were gained from changes in firms’ organizational structure, rather than conflicts and governance problems within those organizations.

This paper analyzes the role of selling agents in the governance of nineteenth century manufacturing firms, and explores how that role may have influenced the transition to vertical integration into selling. I present newly collected data on the sales mechanism (internal selling office vs. external sales agent) chosen by more than a thousand manufacturing corporations from 1857 until 1883, and, where external sales agents were chosen, I document any directorships or other offices held by the agents.

I also document the many differences between firms that vertically integrated into sales and those that did not, and I empirically analyze the determinants of the decision of firms that contracted with sales agents to switch into operating a sales office.

My analysis of the data supports several conclusions. First, most manufacturers contracted with selling agents until the 1870s, when a major shift into vertical integration began. Second, the firms that contracted with selling agents tended to have very large numbers of shareholders, and also frequently had partners of their selling agent firms on their boards of directors, suggesting that they faced a distinct set of governance problems such as conflicts of interest among their merchant-directors. Third, the growth in the use of sales offices in the 1870s and 1880s was not driven by widespread transitions from external to internal sales efforts, but was instead driven by the emergence of large numbers of new firms choosing to be vertically integrated into sales from their inception. Fourth, the very small number of firms that actually did make the transition from contracting for sales into vertical integration had very different ownership structures compared to those that did not: they had far fewer shareholders, and much larger ownership stakes held by their directors. This suggests an important role for ownership structures and governance mechanisms in the decision to vertically integrate. Finally, consistent with the insights of earlier scholarship, firms producing the innovative or “high-tech” products of the time were much more likely to choose vertical integration, and firms producing relatively standard products such as cotton textiles were considerably less likely to make that choice.

The data collected for this paper represent the only systematic documentation of the choice of sales mechanism for the nineteenth century that I am aware of. Whereas previous contributions have focused on just a handful of firms, these data encompass a broad cross-section of manufacturing enterprises, from firms making paper or glass or rubber products, to makers locomotives, steam engines, textiles, or electrical equipment. The data were collected from successive editions of a comprehensive directory of manufacturing corporations, and matched to corporate balance sheets and the directors and owners of the corporations. But they are limited to the firms of only of one state, Massachusetts. This is by necessity: in the 1870s, Massachusetts was the only American state that required its manufacturing corporations to produce annual reports that included detailed information on their directors and shareholders.2 These manuscript reports, which have been preserved as microfilm at the Massachusetts

State Archives, were scanned and transcribed. The focus on Massachusetts is in some respects advantageous. The state was the home of many pioneering manufacturing enterprises in the nineteenth century, and in particular its textile corporations have been the focus of much of the analysis of how manufacturing firms operated and sold their goods (Ware, 1931; Gregory, 1975; Chandler, 1977). But it naturally also raises questions about the extent to which the firms were representative of the nation as a whole. It is quite likely that the firms analyzed in this paper were typical of those of New England—

Massachusetts entrepreneurs often founded or invested in firms in neighboring states—but firms in other regions may have evolved differently.

The analysis of this paper contributes to a growing literature that emphasizes governance problems within firms, and the legal mechansims employed to address those problems. The work of

Chander often conceptualized firms as unitary entities that developed new managerial capacities in response to their economic environments. The work that built on Chandler, such as Williamson (1981), has viewed firms as “governance structures,” but in the sense of determining the allocation of resources in production and distribution, rather than in the sense of determining the allocation of control rights or

2 Hilt (2015) presents a comparative analysis of the content of the general incorporation statutes adopted by the American states up to 1860.

4 profits among different owners or claimants on the firm. In contrast, this newer literature has explored the conflicting interests within firms, for example between controlling shareholders and small investors (Hilt,

2008; Lamoreaux and Rosenthal, 2006), and how such conflicts may influence the choice of legal organizational form (Guinnane et al, 2007). Although its emphasis is somewhat different, this new work draws on an older literature on governance problems in corporations (Berle and Means, 1932; Baumol,

1959; Jensen and Meckling, 1976) which achieved somewhat greater influence among economists than within the business history literature that followed the work of Chandler.

Finally, the analysis of this paper also illustrates the value of the construction of large samples of firms for the analysis of issuses in American business history. The approach of earlier scholars in the field, who have tended to rely on detailed studies of particular firms from archival records, has produced some extrarodinary insights, but it also has serious limitations. For example, previous scholars have characterized the process leading to the emergence of large numbers of firms that were vertically integrated into selling as one of longstanding firms transitioning away from the old mechanisms of selling through third parties and opening up their own sales offices.3 In fact, the growth in the use of sales offices was driven by the emergence of large numbers of new firms choosing to be vertically integrated into sales from their inception, whereas older firms were unwilling or unable to make this transition. This insight was only made visible by creating repeated samples of firms and matching them over time. A full and accurate analysis of the history of American business can only be produced by the use of both approaches: the traditional one focused on specific firms, and the more social-scientific one focused on the collection of large samples of firms.

II. The Role of Selling Agents in Manufacturing Companies

The annual meetings of the shareholders of the major Massachusetts textile producers in 1863 were apparently filled with rancor. Groups of angry shareholders agitated for changes in the composition

3 See, for example, Porter and Livesay (1971: 146) or Chandler (1977: 248).

5 of boards of directors and in business practices in response to their perception of major problems in the governance of those firms. As memorialized in the pamphlet Some of the Usages and Abuses in our

Manufacturing Companies by Lowell resident J.C. Ayer, the shareholders of the Lowell Manufacturing company argued that “management was paying…an exorbitant sum of money to Messrs. A & A.

Lawrence & Co. for selling their goods.” Likewise the shareholders of the Merrimack Manufacturing

Company claimed that “the selling agents J.W. Paige & Co., [were paid] about $36,000 per annum commissions, besides charges … of about $18,000 per annum [for expenses]” and that Paige & Co. had possessed “very large amounts of the Company’s assets, cash, negotiable paper &c., at one time as high as $870,000…without any security for the same.” And the shareholders of the Hamilton Manufacturing company argued that their selling agents were attempting to shut down their company’s print works, since those same selling agents worked on behalf of other firms that also made prints—which made their motives “sufficiently apparent.” The pamphlet goes on to detail similar problems identified by the shareholders of many other companies.

These allegations are somewhat puzzling. One wonders how it is that selling agents, a third-party firm tasked with wholesaling the companies’ goods, could have had such influence over managerial decisions, or came into posession the financial assets of the firms that hired them. And the apparently exorbitant fees they charged make little sense—why had the corporations not negotiated fees more diligently, or simply moved to different selling agents in response to excessive charges, if they were indeed excessive? The resolution of this puzzle is found in the powerful role selling agents held in the management of many large manufacturing corporations. In each of the above cases, one or more partners from the selling agent firm held directorships with the manufacturing coporations, and sometimes held the position of treasurer as well.4 This gave them significant influence over the firm’s management, and, of course, the choice of selling agent and the terms of the relationship with the selling agent. In principle,

4 At the time, company presidents were sometimes more figure heads than active managers; day-to-day management was generally delegated to the treasurer, who also maintained the company’s accounts (although another set of accounts may also have been maintained by the company’s resident agent.) See McGouldrick (1968) and Chandler (1977).

6 the participation of the selling agents in the management of the firm could have been efficient. It would have facilitated the flow of information between the two firms, for example on market conditions or buyers’ preferences for particular goods, which would have been quite valuable. And it may also have represented a form of delegation of managerial decisions by the shareholders to extremely knowledgeable and capable experts.5

But it also created conflicts of interest. Since the ownership stake these merchants held in the corporation was relatively small, they had a strong incentive to tunnel resources out of the manufacturing corporation and into their wholesale commission firms—the selling agents—where they were the major owners.6 And they were uniquely positioned to do so, since they held a board seat with the manufacturer, and effectively negotiated with themselves over fees and services. The corporations often had hundreds of small shareholders, with none holding a block of even five percent of the shares, which meant that each of the shareholders individually lacked any incentive to carefully monitor management, and that coordination among the shareholders to investigate or replace the directors was difficult. This insulated directors engaging in self-dealing from accountability.7 And finally, major selling-agent firms often served in that role for many manufacturing corporations, rather than just one. This may have brought their interests into conflict with those of particular client firms in some respects. Selling agents sought to maximize total commissions, rather than the commissions they earned from a particular client, which may have led them to shift buyers away from some of their clients’ products and toward those of others, or to shift some clients away from the production of particular goods that competed with those of their other clients.

5 An exploration of the costs and benefits of such relationships is presented in Frydman and Hilt (2016). 6 This is not to suggest that the dollar value of selling agents’ stakes in firms was small, but rather that the fraction of all of the stock that they held was small. And it is the latter figure that determines the incentives of merchant- directors to shift profits or resources out of the company. 7 Ayer notes that in many cases, the directors persuaded large numbers of the small, passive shareholders to sign over their proxy votes to them. And at the annual meeting of the Hamilton Company, in response to the complaints of dissident shareholders, “Mr. J.W. Paige, the selling agent of that Company … rose and stated that he had a majority of the proxies of the company in his hand…”

Business historians who have noted the existence of these conflits have mostly minimized their significance.8 Gregory’s (1975) laudatory account of the business affairs of Nathan Appleton, the founder of the selling agent firm Paige & Company, does mention Ayer’s pamphlet, but charaterizes the allegations described in it as the result of “confusion,” irrationality, and the fact that Ayer was “not well informed” and of “lesser economic ability” (p. 245-46).9 Citing Gregory, Chandler (1977: 72) notes that there were “conflicts” arising in selling agent relationships, but mischaracterizes them as occuring

“between the mill agents, treasurers, and selling agents,” when in fact those positions were often held by the same people, or different people who together acted in ways that were contrary to the interests of the investors. The lack of centralized management among early manufacturers represents a source of communication and coordination problems in Chandler’s framework. He therefore emphasizes the greater coordination that could be achieved when selling agent partners held board seats with their clients, and fails to note the conflicts of interests that could also result. Chandler’s misreading of the problem arises from his focus on managerial structures, rather than on business organizations with different owners and managers whose interests sometimes diverged.

Over the first half of the nineteenth century, selling agent firms became increasingly important as marketers of the products of American manufacturing firms. Eighteenth century manufacturers, which typicaly operated at a relatively small scale, frequently handled the marketing and distribution of their products in-house. For example the earliest cotton spinning mills in New England sold directly to local storekeepers and weavers, sometimes accepting “cotton, dyestuffs and flour as payment.”10 Yet as the scale of that industry’s firms began to grow, particularly with the innovation of the integrated mill, textile producers sought to reach more distant customers, and turned to specialized wholesale commission houses in major cities—selling agents—to do so. The institution of the wholesale “selling house” became

8 McGouldrick (1968) finds the claims of Ayer credible, but suggests that the large and successful textile corporations he studies were unlikely to have suffered serious decreases in profitability as a result. 9 Gregory even presents evidence of “irregularities in Paige’s cloth account,” and notes that “with the decline in ownership” by the Paige partners in their client firms, “went an increase in commissions,” yet he mostly dismisses the complaints of the shareholders. 10 Porter and Livesay (1971: 24).

8 the dominant mode by which cotton cloth was sold.11 Manufacturers in other industries generally relied on selling agents as well (Porter and Livesay, 1971).

Selling agent firms typically specialized in the marketing of a particular class of goods. They developed highly specialized knowledge of the market for their goods, such as the attributes of the goods that were particularly valued or disliked by customers, and any trends or changes in the level of demand or in the preferences of important classes of customers. The fact that some selling agents handled the products of upwards of 20 different manufacturers suggests that the costs of aquiring this information were significant, and the efficient scale of a selling firm was therefore greater than the efficient scale of a manufacturer, at least in some industries.12 Given the specialized knowledge held by the selling agents, manufacturers typically delegated a wide range of decisions to them, and gave them discretion over the prices to be charged, and the quantities of different products to be produced. Some product innovations were developed in response to the suggestions of selling agents.13

Selling agents typically operated on a commission basis, which meant that they did not take title to their clients’ goods but instead charged a fee for their services in the form of a commission on the company’s sales. Some selling agency contracts apparently provided for reimbursement for certain kinds of expenses as well. The selling agents typically did not sell the goods for cash, but instead advanced the goods to jobbers on credit, and bore the credit risk of these advances (in exchange for a fee). Selling agents therefore also invested in obtaining knowledge of the creditworhthiness of particular buyers.

The services provided by these firms often extended well beyond selling functions, however. The wholesale commission merchants who acted as selling agents for manufacturers were among the elite of the world of commerce, and used their connections and reputations to help their clients gain access to much-needed credit and working capital. Commercial banks often required the endorsement of a

11 The role of selling agents in the textile industry is very well documented. See, in particular, Ware (1931) and Knowlton (1948). 12 It should be emphasized that this analysis of the efficient scale of a selling agent does not imply that it was actually optimal for manufacturers to use those selling agents; costs to the firm from conflicts of interest in their relationship with their selling agents could easily overwhelm those efficiencies. 13 Bagnall (1908) provides several examples.

9 merchant in order to discount the commercial paper of a manufacturer, and the selling agents generally served that role. Selling agents themselves offered advances to manufacturers as well when they took goods on consignment.14 An exploration of all of the different functions provided by selling agents in the textile industry, and the corresponding fees charged, is presented in Siegenthaler (1967).

Over the course of the nineteenth century, the role of selling agents in the economy declined, and growing numbers of manufacturers emerged that were vertically integrated into selling. This process began with the establishment of a sales office in a major city (or perhaps offices in several major cities) operated by a professional staff. This office would perform most of the that had been provided by the selling agent firm: an in-house staff replaced the third-party firm. Opening a sales office clearly presented tradeoffs: the company would need to make significant investments in obtaining knowledge of markets and customers; would need to cover the fixed costs of a new office or offices; and would have to forego the credit services provided by selling agents, and find some other way to obtain access to working capital. On the other hand, it could tailor its marketing efforts to its own products, and make specialized investments in training and sales materials that might help expand its customer base.

Figure 1 presents advertisements that illustrate the way firms utilizing different sales mechanisms presented themselves in advertisements. The ads for firms that utilized selling agents typically stated the company’s name and gave a description of the company’s products, but then presented the name and address of the selling agents. The selling agents sometimes also advertized separately; those ads contain far less detail on the products sold, and typically only listed the products they carried, along with the names of their manufacturers. In contrast, firms with their own sales offices clearly stated the address of their “salesrooms” in their ads, and make no mention of any third-party sellers.

14 Comprehensive evidence is difficult to obtain, but the surviving records of some textile manufacturers suggest that selling houses were intimately involved in their clients’ interactions with credit markets. For example, in the 1870s, nearly all of the notes payable of the Warren Cotton Mills were issued to their selling agents, Bliss Fabyan & Co., who then took the notes to banks for discounting and gave the proceeds to the firm. Volume 98, Notes Payable, and volume 92, Journal, Warren Cotton Mills, Baker Library, Harvard Business School.

A. Firms using selling agents

B. Firms with sales offices

Figure 1: Advertisements of firms utilizing different sales mechanisms Note: The upper panel presents ads from two companies that utilized selling aent, and the lower panel presents ads from two companies that operated their own sales offices. Red arrows mark the information about sales in the ads. Source: Massachusetts Register and Directory, 1867.

The business history literature has advanced at least two distinct explanations for the emergence of these sales offices (Porter, 2006; Chandler, 1977). First, for some firms, the existing network of selling agents and jobbers was not well suited to the marketing or distribution of their goods. This was the case

11 with manufacturers of some new goods, such as electrical equipment, dressed meat and, to a somewhat lesser extent, sewing machines. Some of these products required specialized distribution infrastructure, or significant marketing and training efforts to get consumers to accept or successfully use them—and thus required the investment of major firms that could internalize the benefits of doing so.15 But in other cases the existing network proved inadequate because of the volume rather than the nature of the goods produced. Manufacturers using new production technologies and operating at a dramatically greater scale in some cases could not rely on selling agents and jobbers to market the volume of output they produced.

The second explanation offered in the literature for the emergence of vertically integrated firms is that structural and institutional changes in the economy lowered the cost of handling sales internally for some firms. For example, improvements in transportation and communication technologies led to the consolidation of the jobbers in some markets into a small number of very large wholesale firms, and these firms made and received payments in cash (Chandler, 1977: 217-18). This contracted the number of customers of some firms, and reduced their need for credit and working capital. Both of these developments lowered the cost of vertically integrating into sales.

On the other hand, a large number of manufacturers continued to distribute their goods through selling agents. Some of the variation in the choice of sales mechanism was clearly related to firms’ products and industries. But within particular industries, some firms were vertically integrated and some were not, which suggests that the particular characteristics of individual firms also may have come into play. For example, some selling agents may have had stronger relationships with their clients, and provided a broad range of services that some manufacturers may have grown to depend on or would have struggled to replace.16 Alternatively, in cases where one of the partners of the sales house held a

15 Williamson (1981) formalizes these dynamics as the “asset specificity principle” and “externality principle.” Asset specificity arises when durable assets are specialized to a specific user, and create transactions cost problems in market transactions. They therefore contribute to vertical integration. Externalities arise when one seller’s poor service in installing or repairing or maintaining a good affects a product’s reputation. This also supports vertical integration. For an analytical review of the vast literature that followed, see Lafontaine and Slade (2007). 16 Siegenthaler (1967: 40) notes that the wide range of services offered by selling agents “could introduce a monopolistic element” into their relationships with manufacturers: by offering a wide variety of services that the manufacturer depended on, the selling agent could “attach a mill to itself” and “influence the demand for its services, pushing up the price for this package.”

12 directorship with a manufacturer, they may have been positioned to resist any proposal to change that manufacturer’s approach to sales. Some partners in selling houses were not only directors but were among the founders of manufacturing firms, which likely made them quite influential in the governance of manufacturers.17

In addition, some firms may have lacked the entrepreneurial intiative or organizational capacity to launch a sales office and handle sales internally. Many older, well-established manufacturing firms were owned by hundreds of completely passive shareholders, who delegated management to conservative executives who followed routine procedures and produced consistent earnings which they paid out in a steady stream of dividends (McGouldrick, 1968). Within such firms, the use of selling agents was quite attractive: it was conservative, it was safe, it was passive, it did not require a major outlay of resources, and it did not require any innovation in the way business was conducted. These manufacturers may have simply persisted in traditional methods until they were driven out of business by more efficient, newer firms.

The major hypothesis I wish to investigate in this paper is that the degree to which firm ownership was dispersed in the hands of small, passive shareholders—or instead highly concentrated— influenced whether or not firms were vertically integrated into sales. In particular, some firms may have persisted in relationships with the selling agents that were not in the best interests of the firm’s shareholders. These relationships may have benefitted the directors at the expense of the shareholders (if the directors were the selling agents), or they may have represented a suboptimal mode of doing business.

But if the company was owned by large numbers of passive shareholders, it is unlikely that they would have been able to discover the problem or organize an effort to force a change. On the other hand, a firm with concentrated shareholdings would have been more likely to take the potentially risky step of opening a sales office.

17 Few records of the early origins of relationships between manufacturers and selling agents survive, so it is difficult to know how common it was for selling agents to found companies. One important example is Nathan Appleton, who was among the founders of many of the great textile producers in Massachusetts, and who also helped to found the commercial partnership that acted as selling agent for his companies, J.W. Paige & Company (Gregory, 1975).

III. Sources, Data and Sample Characteristics

The data utilized in the analysis that follows were all hand-collected for this paper. The mode of selling for business corporations in Massachusetts was obtained from the Massachusetts Register and

Business Directory, an annual publication that began including a table of “Manufacturing Companies” in its 1857 volume. This table presents the companies’ location and paid-in capital, along with the names of the president and selling agents, and a short description of the items it produced.

Under selling agents, there were four categories of entries. First, there were partnership firms, which were coded as selling agent firms (eg, “A & A Lawrence & Co.”). Second, there were were company offices (eg, “Office, 131 Devonshire, Boston”), which were coded as indications that the firm had vertically integrated into selling. Third, there were individual names (“Geo. D. Atkins, Boston”).

This third category is difficult to interpret—the individuals were often officers of the company, and may represent something equivalent to a company sales office. Yet they may also be individuals acting as selling agents for the company and for other companies, who are simply operating alone rather than with partners. The difficulties presented in discerning the full nature of the relationship between these individuals and their firms has led me to treat these as a separate case—neither a third-party sales agent, nor an internal sales division of the firm. (The main arguments of this paper are not changed if these individuals are treated as selling agent firms.) Finally, for a fourth category of firms, no information about selling agents at all is presented—the line in the table is left blank. These are regarded as cases where information on the sales mechansim chosen by the firm is unavailable, and are excluded from the analysis.18 The directory data was collected for the years 1857, 59, 65, 67, 72, 78 and 1883. The total number of manufacturing corporations listed in the directories rose from 212 in 1857 to 699 in 1883, and

18 It is possible that these firms chose not to use any sales agent or representative or office, and instead interacted with customers through their treasurer’s office or at their factory.

Table 1: Industrial composition of sample firms, 1872 and 1883

1872 1883 (%) (%) Apparel 2.20 2.86 Brick and stone products 2.20 3.58 Chemicals 2.20 2.15 Coal and petroleum products 1.10 1.00 Fabricated metals 17.84 19.03 Food and tobacco products 1.32 2.29 Glass products 1.32 1.14 Instruments 1.32 2.43 Leather and leather goods 1.10 1.72 Lumber and wood products 3.08 2.72 Machinery and engines 11.23 11.16 Paper and paper products 5.73 7.73 Primary metals 2.20 1.57 Rubber products 1.76 2.72 Shoes 1.32 1.00 Telephone, telegraph, electrical equipment - 1.29 Textiles 39.87 29.61 All others 4.19 6.01

on average the directories provided information on the sales mechanisms chosen by 61.1 percent of the corporations.

The description of the products sold by each corporation provided in the directory was coded into a categorical variable for the firm’s industry. Table 1 presents the industrial composition of the firms listed in the directory for the years 1872 and 1883, which will become the focus of much of the subsequent analysis. As one might expect, textiles were the most important industry, although their relative importance declined over time. Other major industries included fabricated metals, and machinery and engines. The only completely new industries that appeared in 1883 that was not present in 1872 were producers of telephones and electrical equipment.

The firms listed in the directory were then matched to the certificates of condition submitted to the Secretary of the Commonwealth. These certificates were required of all manufacturing companies

15 beginning in 1870, and survive as microfilm in the Massachusetts Archives. The certificates present some minimal accounting data, as well as the names of officers and directors, and the identities of all shareholders, together with the number of shares they held. All available certificates for the years 1872 and 1880 were scanned and transcribed. The names of all directors were recorded, and their shareholdings were obtained from the shareholder list. The total number of shareholders was also recorded.

The accounting data presnted in the certificates were intended for the use of the firms’ creditors, and provide information on the resources available for the repayment of debts, as well as the level of indebtedness. No information about revenues, operating costs, or profits, which would have been of interest primarily to the firms’ shareholders, was provided. The certificates therefore do not provide the information necessary for the computation of any of the usual accounting ratios, such as return on assets, or measures of productive efficiency, such as total factor productivity, which are commonly used to evaluate firm performance. The impact of different sales mechanisms on firms’ profitability therefore cannot be observed. The certificates do, however, provide detailed information about the firms’ ownership and assets, and became somewhat more detailed over time so that by 1880 particular types of assets such as patents were specifically identified.

IV. Vertical Integration into Sales, 1857-1883

Figure 2 presents the rate at which Massachusetts manufacturing firms contracted with selling agents, or vertically integrated into sales by operating their own sales office, as computed from the data from business directories. The rate at which manufacturers contracted with selling agents rose consistently over the 1850s and 1860s, and peaked in 1872 at about 63 percent. Over those same years, the fraction of firms operating their own sales office also rose from essentially zero to about 13 percent.19

19 The reason both lines can be rising is that a third category of corporations, those listing an individual rather than a firm as their “selling agent,” are not presented in the table. As discussed above, it is unclear whether those firms are

0.7 Firms Contracting with Selling Agents

0.6

0.5

0.4

0.3

0.2

Firms with Selling Offices 0.1

0 1855 1860 1865 1870 1875 1880 1885

Figure 2: The share of firms contracting with selling agents, and the share with selling offices, 1857-83 Note: Data calculated from business directories from the years (as indicated by the markers along the lines) of 1857, 59, 65, 67, 72, 78 and 83. Firms that listed the name of an individual, rather than a firm, as their “selling agent” are the excluded category.

But beginning in 1872, the rate at which firms contracted with selling agents fell significantly, from 63 percent down to 41 percent in 1878 and 32 percent in 1883. At the same time, the rate at which the firms operate selling office rose from 13 percent to 25 percent in 1878 and 47 percent in 1883. The manufacturers of 1883 were quite different from those of the late 1850s, and far more likely to be vertically integrated into selling.

patterns are explored further in Figure 3, which shows the rate at which firms in three major industries—textiles, machinery and engines, and fabricated metals—contracted with selling agents or operated their own selling offices over the same period. The data in the figure indicate that there were very strong differences across industries, with the textile firms being much more likely to contract with selling agents, and much less likely to operate a selling office, than the others. In addition, textile manufacturers exhibited little change over time, whereas firms in the other industries showed a significant contracting for selling services or vertically integrated into selling. Among the firms in that category, there is evidence for both.

A. Firms Contracting with Selling Agents 0.9

0.8

0.7 Textiles

0.6

0.5 Fabricated Metals 0.4

0.3

0.2 Machinery and Engines

0.1

0 1855 1860 1865 1870 1875 1880 1885

B. Firms with Selling Offices 0.9

0.8 Fabricated Metals 0.7

0.6

0.5

0.4

0.3 Machinery and Engines 0.2

0.1 Textiles 0 1855 1860 1865 1870 1875 1880 1885

Figure 3: The share of firms contracting with selling agents, and with selling offices, by industry Note: Panel A of the figure presents the rate at which firms in three major industries, textiles, fabricated metals, and machinery and engines, contracted with selling agents over the 1857-83 period. Panel B shows the rate which the firms in those same industries operated selling offices over the same period.

18 decline in their propensities to contract with selling agents in the 1870s, and an even more significant increase in their propensities to operate sales offices during those years.

Although this is the first documentation of the rate at which a large sample of firms opened their own sales offices, previous scholarship has noted a decline in the role of selling agents beginning in the

1870s, and the data presented in figures 2 and 3 corroborates those findings.20 However, earlier work has characterized the transition as a progression through different sales and distribution mechanisms among particular firms. For example, Porter and Livesay (1971:146) state that within the iron and steel industry,

“as a large manufacturer’s sales in a city rose, he turned from several local brokers to only one—the authorized agent or manufacturer’s representative…When area demand increased still more, the manufacturer turned to his own sales office.” In their account, manufacturers progressed from the use of multiple selling agents, to an exclusive selling agent, to the creation of a sales office, as the demand for their products rose. It is tempting to interpret the post-1872 changes in figure 2 as depicting such transitions, with many firms ending their relationships with sales agents and opening their own sales offices, perhaps in response to rising demand.

Yet investigating the patterns in the data in greater depth reveals that this was not the case.

Changes in the approaches of individual firms to selling were quite rare. Instead, the decrease in the rate at which the firms contracted with selling agent firms, and the increase in the rate at which the firms distributed their goods through a sales office, were caused by the appearance of large numbers of new firms that chose overwhelmingly to be vertically integrated into sales. Older firms that had previously contracted with selling agents opened up their own sales office only very rarely. Figure 4 provides some insight into these patterns. Panel A of the figure presents the relative share of existing firms and new

20 Referring to iron and steel producers, Porter and Livesay (1971: 132) state that “from 1870 to 1900, the importance of these middlemen declined…manufacturers came increasingly to assume the functions of wholesalers.”

A. Overall Share of New Firms vs. Existing Firms 1 Existing Firms 0.8 New Firms

0.6

0.4

0.2

0 1859 1865 1872 1878 1883

B. Firms Contracting with Selling Agents 0.8 Existing Firms 0.6 New Firms

0.4

0.2

0 1859 1865 1872 1878 1883

C. Firms with a Selling Office 0.8 Existing Firms 0.6 New Firms

0.4

0.2

0 1859 1865 1872 1878 1883

Figure 4: Differences Between New Firms and Existing Firms Note: Panel A presents the share of existing firms and new firms, measured as those that had and had not appeared in the previous sampled directory. Panel B presents the rate at which existing and new firms contracted with selling agents over time. And Panel C presents the rate at which existing and new firms operated their own selling office over time

20 firms (measured as those that had and had not appeared in the previous directory in the sample) over time, and shows that new firms accounted for around 46 percent of all firms in 1883.21 As Panels B and C of figure show, those new firms became increasingly less likely to contract with selling agent firms, and more likely to operate their own sales offices. These patterns are mirrored among the existing firms, which did become more likely to operate sales offices, and somewhat less likely to contract with selling agent firms over time. Yet the existing firms in 1883 exhibited a far stronger propensity to contract with selling agents, and a far weaker propensity to operate a selling office, relative to the new firms.

A precise decomposition of the change in the use of selling agents between 1872 and 1883—the large drop evident in figure 2—is presented in Table 2. 22 Between 1872 and 1883, the rate at which manufacturers contracted with selling agents fell from 63.2 percent to 31.9 percent. Those years saw tremendous churn among manufacturing firms, with significant numbers disappearing, and much larger numbers of new firms appearing. In 1883, 69 percent of existing firms had not existed in 1872, and those new firms contracted with selling agents only 20.5 percent of the time. The 31 percent of 1883 firms that had survived since 1872 continued to rely on selling agents at rates very similar to the rate at which they had done so in 1872 (57 percent of the time). As the data in the table make clear, of the 31.2 percentage point decline in the use of selling agents between 1872 and 1883, only 1.9 percentage points were due to

21 The relative share of new and old firms was largely determined by economic conditions. In periods of strong economic growth, many new firms appeared, and in periods of economic contraction, the rate at which new firms appeared declined. Whereas the years 1865-72 and 1878-83 were periods of strong economic growth, the years of 1873-78 was a prolonged recession following the Panic of 1873. The decline in the relative share of new firms in The number of new firms appearing in the directory in 1878, 181, was far lower than the number of new firms appearing in 1872, which was 262, or in 1883, which was 342. 22 The calculations are as follows. Define and as the fraction of firms in 1883 that were survivors from 1872, and were new firms that had not existed in 1872, respectively. Further, define as the overall rate at which firms 1 2 contracted with selling agents in 1872, and푓 and푓 as the rate at which survivors from 1872 contracted with selling agents, and new firms that had not existed in 1872 contracted with selling agents,푆 respectively. Then the total 1 2 change in the rate at which firms contracted푠 with selling푠 agents between 1872 and 1883 is: ( ) + ( ). The fraction of this total change accounted for by the change in the rate at which surviving firms utilized selling ( ) 푓1 푆 − 푠1 푓2 푆 − 푠2 agents is ( ) ( ). 푓1 푆−푠1

푓1 푆−푠1 +푓2 푆−푠2 21

Table 2: Decomposition of Changes in The Use of Selling Agents, 1872-1883

Share Absolute of Change Total Total -0.312 1.000

Due to change in rate surviving firms contracted with selling agents -0.019 0.060

Due to rate new firms contracted with selling agents -0.294 0.940

Note: the rate at which manufacturers contracted with selling agents fell from 63.2 percent to 31.9 percent from 1872 to 1883, a total of 31.2 percentage points. The data presented in this table decompose that change into its components, the effect of changes in the rate at which existing firms contracted with selling agents, and the effect of the emergence of new firms that contracted with selling agents at a different rate.

changes in the use of selling agents by surviving firms, whereas 29.4 percentage points (or 94 percent of the change) was due to new firms using selling agents at lower rates.

Aside from being younger, how did firms that operated their own sales office differ from those that did not? Table 3 presents comparisons for 1883, for a broad range of firm characteristics. Column

(1) presents means and standard deviations for firms with no sales office—that is, firms that had not vertically integrated into sales—and column (2) presents data for firms that had their own sales office.

Perhaps contrary to expections, the two categories of firms were not different in their average size, as measured by paid-in capital. Porter and Livesay (1971) argue that the decision to integrate into marketing depended on firms reaching a minimum threshold of revenues: enough to cover the fixed costs of a sales office. If paid-in capital was correlated with revenues, then this reasoning implies that firms with sales offices should have had higher levels of paid-in capital. Yet they did not, which is an indication that the decision to integrate vertically was influenced by a broader range of factors than sales volumes.

Table 3: Differences between firms that had and had not vertically integrated into sales, 1883

Means, 1883 Firms without Firms with Their own Their own Sales office Sales office Difference s (1) (2) (3) A. Firm characteristics: Paid-in capital 275,199 232,498 42,700 [395,761] [250,591] (33,671) Age, years 20.440 11.327 9.113** [17.776] [14.194] (1.545) Firm owns a patent 0.180 0.388 -0.208** [0.386] [0.490] (0.054) Total shareholders 70.029 29.850 40.182** [119.891] [52.439] (12.761) Management share 0.426 0.505 -0.079* [0.230] [0.315] (0.039) Selling agent holds board seat 0.422 0 0.422** [0.495] [0] (0.084) Location in Boston 0.072 0.665 -0.593** [0.259] [0.473] (0.036) B. Industries: Textiles 0.563 0.090 0.473** [0.497] [0.286] (0.039) Fabricated metals 0.119 0.250 -0.132** [0.324] [0.434] (0.036) Machinery and engines 0.043 0.165 -0.123** [0.202] [0.372] (0.028) Paper and paper products 0.038 0.042 -0.004 [0.191] [0.202] (0.019) Rubber products 0.021 0.056 -0.035+ [0.144] [0.232] (0.018) Apparel 0.042 0.028 0.014 [0.202] [0.166] (0.176) Chemicals and fuels 0.013 0.042 -0.030+ [0.112] [0.202] (0.015) Telephone, telegraph, electrical 0 0.236 -0.0236* [0] [0.152] (0.010) Note: Standard deviations are presented in brackets [ ] and standard errors in parentheses ( ). Column (1) presents the mean values, and standard deviations, for various characteristics of firms that had not integrated vertically into selling, which is measured by the presence of a sales office for the firm. Column (2) presents means and standard deviations for firms that had not vertically integrated into selling. Column (3) presents the difference, and the standard error of the difference. **, *, and + denote statistical significance at 1%, 5% and 10%, respectively.

The firms that vertically integrated into sales were quite different along other dimensions, however. Firms with their own sales offices were far younger, more than twice as likely to report owning a patent23 on their balance sheets, and were an order of magnitude more likely to be located in Boston.

Each of these differences is highly statistically significant. This suggests that vertically integrated firms were newer, high-tech enterprises, a characterization that finds additional support in Panel B of the figure, where the rates at which the firms operated in different industries are compared. The firms that vertically integrated into selling were far more likely to be manufacturers of fabricated metal products or machinery or engines, and somewhat more likely to be manufacturers of rubber products or chemicals or fuels, although there were few firms within the latter categories. And all of the handful of telephone, telegraph, and electrical equipment companies operating in 1883 were vertically integrated into selling. The vertically integrated firms were far less likely to be textile manufacturers, and about equally as likely to manufacture paper or apparel.

In addition to manufacturing high-tech products, however, the vertically integrated firms had very different ownership structures. They had only half as many shareholders on average—about 30—and the ownership of their shares was more concentrated among their managers. Whereas many of the firms relying on selling agents had extremely dispersed shareholdings among large numbers of relatively small investors, the vertically integrated firms had much more concentrated share ownership. As with start-up technology firms today, this arrangement likely created powerful incentives for management, which may have been particularly important if developing and operating a network of sales offices made the decisions and efforts of managers more important.

Finally, firms that were not vertically integrated were quite likely to have their selling agents on their boards. In more than 42 percent of firms that did not have their own sales office, a partner of the

23 The reported balance sheets from 1880 state the value of patents owned. However, given the difficulties in correctly valuing intangible assets, and the possibility that companies with “aggressive” approaches to their accounts may have ascribed extremely ambitious values to their patents, I instead construct an indicator value that simply reflects whether or not a firm reports owning any patents, regardless of their value.

24 selling agent firm held a board seat. This would have given them a strong voice in the governance of the firm, and in its choice of sales mechanism.

Many of these firm characteristics would have been related to firm age. For example, newer firms were probably more likely to own a patent relative to their older counterparts, and more likely to have concetrated ownership, rather than divided among the decendants of the founders through inheritance. Newer firms would also have been more likely to be located in Boston: over the course of the nineteenth century, American manufacturing became increasingly urbanized.24 And locating in

Boston may have lowered the cost of opening a sales office. For manufacturers whose factories were located near Boston’s commercial districts, a sales office could be opened at their factory site, making it less costly to operate and simpler to manage. The question raised by Table 3 is: do the differences between firms with and without sales offices simply indicate that new firms were different from older firms, or do any of the specific characteristics actually matter?

To address this question, we can estimate regressions in which we control for the age of firms, and see if the other firm characteristics matter in firms’ decisions to integrate vertically. We can also control for industry fixed effects into the analysis, and ask whether firms in the same industry with different charaterstics were more or less likely integrate vertically. (To the uninitiated: this is important for the following reason. Suppose that rubber manufacturers tend to have large numbers of shareholders, and tend to be vertically integrated. Then the rubber manufacturers in the sample will create a positive correlation between numbers of shareholders, and vertical integration. But it could be the case that rubber manufacturers have large numbers of shareholders and are vertically integrated for completely unrelated reasons. Incorporating industry fixed effects regressions means looking at relationships within industries.

That is, among the rubber manufacturers, do those with more shareholders also tend to be vertically integrated?)

24 See, for example, Kim (2005) and the references cited therein.

Using the 1880 data, I will estimate regressions of the following form:

= + + + + + +

푖푖 � 1 푖 2 푖 3 푖 4 푖 5 푖 푖 where is푣 an indicator훿 훽 for표표표표표 whether�ℎ푖푖 or not훽 � a푝푝 firm𝑝푝 is vertically훽 �푎� integrated훽 푐𝑐𝑐� into푐 sales훽 퐵,𝐵𝐵� is an industry휀 fixed

푖푖 � effect, 푣 is a measure of firm ownership such as the log of the total number훿 of shareholders,

푖 and 표표표표표, �ℎ푖푖 , , and are the firm age and paid-in capital and indicators for whether a firm�푎 owned�푖 푐𝑐𝑐� a patent푐푖 �푝푝 or𝑝 was푝푖 located퐵𝐵𝐵� in Boston,푖 respectively. The estimated coefficients will show the effect of each of the included firm charateristics on the propensity to vertically integrate into sales, holding constant all the others.

Table 4 presents the results. In column (1), the indicator for vertical integration is simply regressed on a basic set of firm characteristics: age, captial, and indicators for owning a patent and locating in Boston. Industry fixed effects are not included. The results indicate that, even controlling for firm age, both size and owneship of a patent are strongly positively correlated with vertical integration.

This implies that the relationships exhibited in Table 4 are not simply a mechanical consequence of firms of different ages having different characteristics. But the strongest result in column (1) is that a Boston location is very strongly correlated with vertical integration—all else equal, firms located in the city were

57 percent more likely to operate their own sales office.

In column (2), a measure of firm ownership, the log of the total number of shareholders, is included. This is negatively correlated with vertical integration, and the estimated coefficient implys that a one-standard-deviation increase in the log of total shareholders produces a seven percent decrease in the likelihood that firm will operate its own sales office. This is a substantial effect, equivalent in magnitude to about 14 percent of the mean rate of vertical integration in the sample. But it is far smaller than the effect of a location in Boston.

In column (3), industry fixed effects are added, so that the estimated effects are all obtained only from the within-industry variation in vertical integration. Most of the coefficients do not change substantially, and the effect of the number of shareholders even increases in magnitude. The one effect

Table 4 Regressions: Vertical integration into sales, 1880 (The dependent variable is an indicator =1 if the firm has its own sales office)

(1) (2) (3) (4)

Log(total shareholders, 1880) -0.052* -0.068** (0.021) (0.020) Percent of shares owned by directors, 1880 0.1 18 (0.084) Firm age, 1880 -0.00 3+ -0.00 2 -0.00 2+ -0.003* (0.002) (0.002) (0.001) (0.001) Log(paid-in capital, 1880) 0.037+ 0.065** 0.118** 0.091** (0.022) (0.025) (0.028) (0.025) Firm owns a patent 0.122* 0.122* 0.028 0.045 (0.060) (0.060) (0.058) (0.059) Location in Boston 0.569** 0.549** 0.458** 0.484** (0.060) (0.061) (0.074) (0.072) Constant -0.182 -0.368 -0.610* -0.572+ (0.255) (0.260) (0.280) (0.307) Observations 269 269 269 267 R-squared 0.306 0.318 0.429 0.417 Industry FE NO NO YES YES Robust standard errors in parentheses ** p<0.01, * p<0.05, + p<0.1

that does change is that of ownership of a patent: the estimated coefficent falls dramatically in magnitude.

This implies that the strong correlation between patent ownership and vertical integration observed in

Table 3 and in columns (1) and (2) of Table 4 is simply due to the fact that some industries tend to both report owning patents and vertically integrate, but within those industries, firms that owned patents were not more likely to be veritcally integrated.

Finally, in column (4), the log of total shareholders is replaced by the share of stock owned by the corporations’ directors. This is positively correlated with vertical integration, as expected, but the effect is not statistically distinguishable from zero.

The above results establish that certain firm characteristics—having a location in Boston, having a large capital, having fewer shareholders, and being established more recently—were all correlated with vertical integration. But a more powerful test of the effects of these characteristics would investigate whether they influenced the decisions of firms to make the transition from the use of a selling agent to the

Table 5 Regressions: Transitions into vertical integration, 1872-83 (The dependent variable is an indicator =1 if the firm opened its own sales office)

(1) (2)

Log(total shareholders, 1872) -0.048* (0.024) Percent of shares owned by directors, 1872 0.263* (0.111) Log(paid -in capital, 1872) 0.083* 0.073* (0.038) (0.028) Firm age, 1872 0.002 0.002 (0.001) (0.001) Location in Boston 0.387+ 0.366+ (0.230) (0.202) Constant -0.965* -1.040* (0.446) (0.401) Observations 84 84 R-squared 0.546 0.570 Industry FE YES YES Robust standard errors in parentheses ** p<0.01, * p<0.05, + p<0.1

establishment of their own sales office. These transitions occurred quite rarely, and we can only use data for surviving firms, which limits the sample even futher. But among those 84 firms in 1872 that contracted with a sales office and survived until 1883, were those with fewer shareholders, larger capitals, or a Boston location more likely to be among the nine that actually opened their own sales office?

Table 5 presents results of regressions of a similar form as those presented in Table 4, but with a dependent variable that is an indicator for whether or not a firm transitioned from contracting with a selling agent to operating its own sales office in the years between 1872 and 1883. Most of the same firm characteristics are included as controls, although their 1872 values are used.25 These regressions thus estimate the effects of different firm characteristics on the propensity to vertically integrate, in the context of a model with industry fixed effects. The results in column (1) indicate that firms with larger capitals and locations in Boston were more likely to be among those that made the transition, whereas the effect of

25 No information on patent ownership is reported on the firms’ 1872 balance sheets, so the patent variable cannot be included in the regressions reported in Table 5.

28 firm age in 1872 was relatively less important. But the ownership structure of the firms also mattered.

Those with large numbers of shareholders were less likely to make the transition, and those in which the directors held large ownership stakes were considerably more likely to make the transition. A one- standard-deviation increase in the fraction of the shares held by the directors was in fact associated with a seven percentage point increase in the probability of making the transition—a transition that occurred only among 10 percent of the firms.

These results need to be interpreted cautiously. They have been obtained from a very small sample of firms, for example. And subtle differences in the nature of the products produced by different firms, which would not be captured in the broad industry variables included in the regression, may have influenced the choice of sales mechansim. If those product characteristics were also correlated with the ownership structure of the firms, this could account for the observed correlations (althoug this would not diminish the importance of ownership in influencing the choice of sales mechanism.) Finally, the results cannot definitively establish causation. The owners of firms may have chosen to retain large stakes in anticipation that their enterprises would later open a sales office, for example. Yet the relationship between corporate ownership and vertical integration is strong enough to suggest that the two were clearly related. Firms that actually made the transition to operating a sales office had far fewer shareholders than those that did not, and were managed by directors that owned far larger stakes in their firms.

Established firms were very unlikely to transition into operating their own sales office. The growth in the rates at which firms were vertically integrated was due overwhelmingly to the appearance of new firms, which were much more likely to operate sales offices. This may reflect the fact that they had no existing relationships with selling agents to sever, and were not yet owned by passive shareholders with little interest in their firms’ strategies. Among existing firms, the few that made the transitions had ownership structures that resembled those of newer firms, again suggesting an important role for conflicting interests within firms in determining the choice of sales mechanism.

V. Conclusion

The emergence of manufacturers that were vertically integrated into sales marked an important step in the evolution of American business. A substantial literature in business history has analyzed the transition into vertical integration as an optimal response to changes in institutions and markets, and new technologies that made traditional mercantile networks unsuitable for marketing and distribution. Using new data, this paper has identified some previously unknown elements of the transition.

In particular, the growth in the use of sales offices in the 1870s and 1880s was not driven by widespread transitions from external to internal sales efforts, but was instead driven by the emergence of large numbers of new firms choosing to be vertically integrated into sales from their inception. Most existing firms chose to remain with their selling agents. That these firms often had large numbers of passive shareholders, and selling agents holding seats on their board of directors, suggests that they may not have been organizationally capable of making the transition. Their directors may have benefitted from their choice of sales mechanism at the expense of the other shareholders, but the shareholders may not have been capable of forcing a change. Moreover, the small number of firms that actually did make the transition from contracting for sales into vertical integration had very different ownership structures compared to those that did not: they had far fewer shareholders, and much larger ownership stakes held by their directors.

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