This article reviews the literature and applies principal-to-principal (PP) conflict theory to small family based businesses. The lack of accurate measurement and communication of risk leading to issues with innovation, is the primary cause of PP agency costs. Careful analysis of the risk levels reflected in the cost of debt and opportunity cost of equity provides a theoretically robust and empirically estimable process for ascertaining the true PP agency cost. Awareness of the constraining governance structures and the suggested method, based on the cost of capital, to assess small business risk can assist SME owners and financiers to SMEs to promote business efficiency and innovation.

This research examines the risk of failure in small and medium enterprises (SMEs) in Malaysia, using a dataset of 303 individual companies from 2005 to 2014. The study aims to provide a robust framework for quantifying SME risk and understanding the relationship between operational characteristics and risk. The methods available to calculate SME risk are the pure-play beta, accounting beta and probability of survival methods. We then use Gaussian mixture model (GMM) regression framework to examine the relationship between SME risk and firm characteristics. Our results show (1) having a high amount of debt does not necessarily make a SME riskier than its counterparts; (2) profitability significantly affects SME risk; and (3) size, firm age and business ethnicity are not significantly associated with SME’s risk in Malaysia. Our results also show that PP beta works better for risk measurement comparing with other risk measures. The study is important for a range of stakeholders, including government in relation to sustainable economic growth goals and other areas of public policy, as well as investors, customers, suppliers, employees, and society, as it aims to provide a robust framework for quantifying SME risk and avoiding avoidable business churn. The research draws on information from financial statements, owner ethnicity, age and gender, business location, shareholding, and items stored in the database, providing a rich panel of data for businesses over time.