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Entrepreneurship and Public Policy
Lecture 5: Financing Entrepreneurship
Lecture Overview
• Overview of small business finance and research
issues
• The role of private equity market in small business
finance
• The role of debt market in small business finance
• Public policy and small business finance
Gates EPP_Lecture 5-2 Spring 2009
Financing Options: Firm Capital Structures
• Types of outsider finance
•
•
•
•
– Debt
– Equity
Firm capital structure: selection of a ratio of debt to equity
financing
Capital structure irrelevance theory (Modigliani and Miller,
1958)
– The value of a firm is unaffected by how that firm is
financed
Pecking-order theory vs. Trade-off theory of firm capital
structures
Firm size and age are important determinants of capital
structure
– Larger firms use less leverage
– Older firms use less leverage
Gates EPP_Lecture 5-3 Spring 2009
Financing Options: Firm Capital Structures
• Types of outsider finance
•
•
•
•
– Debt
– Equity
Firm capital structure: selection of a ratio of debt to equity financing
Capital structure irrelevance theory (Modigliani and Miller, 1958)
– The value of a firm is unaffected by how that firm is financed
Pecking-order theory vs. Trade-off theory of firm capital structures
Firm size and age are important determinants of capital structure
– Larger firms use less leverage
– Older firms use less leverage
Gates EPP_Lecture 5-4 Spring 2009
U.S. Small Business Finance at a Glance
• A national survey of small business finances (1993) provides a
touchstone for understanding small business finance
– SMEs obtain external finance almost exclusively through private
markets
– SMEs depend on both equity (49.63%) and debt (50.37%)
– The largest sources are the principal owner, commercial banks,
and trade creditors
– Funds provided by the “principal owner”, family and friends
critical at initial stages when information problems are most
acute
– As the firm grows, retained earnings become more important
• Data from Kauffman Firm Survey generally consistent with these
findings
– 56% of new firms had debt financing in year one: 48 % had
personal debt and 24% had business debt
– 80% had equity financing ( 90% from owners)
Gates EPP_Lecture 5-5 Spring 2009
U.S. Start-up Finance at a Glance
• 2002 Survey of Business Owners Characteristics of Businesses shows that
start-ups rely primarily on personal and family savings and assets
Personal/family savings
54.6%
Other personal/family assets
9.0 %
Personal/ business credit card
8.8%
Government business loan
0.9%
Government-guaranteed bank loan
0.7%
Business loan from bank
11.4%
Outside investor
2.7%
None needed
27.7%
Not reported
3.9%
• Data from Kauffman Firm Survey
– 56% of new firms had debt financing in year one: 48 % had personal
debt and 24% had business debt
– 80% had equity financing ( 90% from owners)
Gates EPP_Lecture 5-6 Spring 2009
Characteristics of the Small and Medium Enterprise
(SMEs) Finance Market
• Information asymmetry is a key characteristic of the market
for small business finance
– SMEs do not generally issue public information on
contracts, business practices, financial conditions and do
not provide auditable financial statements
• This can lead to inefficiencies in the market for funding
– Adverse selection
– Moral hazard
• Private financial markets partially address this problem
through screening, contracting, and monitoring
Gates EPP_Lecture 5-7 Spring 2009
SMEs Finance: A Life Cycle Framework
Firm Size, Firm Age, Information Availability
Very small firms, no
Small, high-potential firms,Medium firms, some track
collateral or track record
limited track record
record & collateral
Large firms, known
risk & track record
Initial Insider
Finance
Angel
Finance
Venture
Capital
Public
Equity
Trade Credit
Short Term Financial
Institution Loans
Commercial Paper
Intermediate Term Financial
Institution Loans
Mezzanine
Funding
Private Placements
Source: Berger & Udell, 1998
Medium Term
Notes
Public
Debt
Gates EPP_Lecture 5-8 Spring 2009
SMEs Finance: A Life Cycle Framework
Firm Size, Firm Age, Information Availability
Very small firms, no
Small, high-potential firms,Medium firms, some track
collateral or track record
limited track record
record & collateral
Large firms, known
risk & track record
Initial Insider
Finance
Angel
Finance
Venture
Capital
Public
Equity
Trade Credit
Short Term Financial
Institution Loans
Commercial Paper
Intermediate Term Financial
Institution Loans
Mezzanine
Funding
Private Placements
Source: Berger & Udell, 1998
Medium Term
Notes
Public
Debt
Gates EPP_Lecture 5-9 Spring 2009
Research on SMEs Finance Focuses on Several Key
Issues
• The type of financing that growing companies need
and receive at various stages of their growth
• The nature of the private equity and debt contracts
associated with this financing
• The connections and substitutability among
alternative sources of finance
• Implications of macroeconomic conditions for
small business finance (e.g. the “credit crunch” of
the early 1990s)
Gates EPP_Lecture 5-10 Spring 2009
Research on SMEs Finance Focuses on Several Key
Issues
• The type of financing that growing companies need
and receive at various stages of their growth
• The nature of the private equity and debt contracts
associated with this financing
• The connections and substitutability among
alternative sources of finance
• Implications of macroeconomic conditions for
small business finance (e.g. the “credit crunch” of
the early 1990s)
Gates EPP_Lecture 5-11 Spring 2009
Lecture Overview
• Overview of small business finance and research
issues
• The role of private equity market in small business
finance
• The role of debt market in small business finance
• Public policy and small business finance
Gates EPP_Lecture 5-12 Spring 2009
The Angel Finance Market: Overview
• Angels are usually high net worth individuals who
offer finance in the range of $50,000 to $1 million
• Focus on early stages in firms’ life cycle
• Invest very selectively and target small companies
with high potential. Typically invest their own
funds*
• In 1995 estimates, there are roughly 250,000 angels
making 30,000 investments per year for an
aggregate of $20 billion
– Double the total investment levels of venture
firms but each investment is much smaller in
size
Source: Wiltbank & Boeker; Horvath, 2001
Gates EPP_Lecture 5-13 Spring 2009
The Angel Finance Market: Recent Developments
• Angels have begun to organize small investment groups or
networks
• Recent attempts to formalize the market (e.g. ACE-Net)
– Usually operated by a government or non-profit (I.e.
university)
– Designed to reduce search and information costs
– The true value of angel networks is substantially
understudied
• Informal angel market may be the most effective way
of addressing information problems
Source: Berger & Udell, 1998
Gates EPP_Lecture 5-14 Spring 2009
Venture Capital Market: Overview I
• Venture capital is defined as independent, professionally
managed, dedicated pools of capital that focus on equity or
equity-linked investments in privately held, high growth
companies
• Venture capital firms take funds from institutional and/or
individual investors and invest in startup firms
– Seek funds from university endowments, pension funds,
insurance companies etc.
– Typically invest in small, young firms where there are
large information asymmetries between entrepreneurs
and investors
• VCs spend a lot of time evaluating prospects and monitoring
the firms in which they invest
• VCs actively participate in strategic planning and managerial
assistance in firms
Source: Berger & Udell, 1998; Horvath, 2001; Gompers & Lerner, 2001
Gates EPP_Lecture 5-15 Spring 2009
Venture Capital Market: Overview II
• VC firms are typically structured as LLP with a finite life
• General partners manage the fund
– Make investment decisions
– Playing a critical role in screening
– Contracting and monitoring
• Limited/investing partners contribute funds and receive funds’
profit
– Typically put up 98% of funds and receive 80% of profits
• General partners typcially receive a management fee plus 20%
of profit
Source: Berger and Udell, 1998
Gates EPP_Lecture 5-16 Spring 2009
Exit Strategies for VC Investors
• Acquisition or merger
– Provides liquidity if the acquiring or merging firm is a
publicly traded firm
– Difficult to assess whether a failure or success
• Initial public offering (IPO)
– The most desirable exit strategy
– Usually provides lucrative profit to the VC firm
– Successful examples include Apple, Cisco, Yahoo, etc.
• Liquidation
– When the investment is unable to continue operating
– All assets are sold off the proceeds are distributed to the
investors according to pre-specified contracts
Source: Berger & Udell, 1998; Horvath, 2001
Gates EPP_Lecture 5-17 Spring 2009
Venture Capital and Entrepreneurship
• Theorists favor venture capital on the basis that VC
– Reduces the asymmetric information because
venture capitalists are highly-informed
investors
– Reduces the moral hazard problem because
venture capitalists usually monitor the
investment closely and offer managerial
assistance
• Existing literature (Kortum and Lerner, 2000) show
VC activities are positively associated with patent
rates
Gates EPP_Lecture 5-18 Spring 2009
Venture Capital is a Source of Capital for a
Small Minority of New Businesses
• VC tends to focus only on a few sectors
• Minimum size of VC investment is too large for
start-ups in some industries
• VC sector requires a thick public market in small
and new firm stocks (NASDAQ or EASDAQ) in order
to provide an exit strategy for early-stage investors
– The U.S. so far has provided the most fertile
environment for VC
Source: Berger & Udell, 1998; Horvath, 2001
Gates EPP_Lecture 5-19 Spring 2009
Policy Factors that Influence Angel and VC
Fundraising
• Capital gains tax rates
• Regulatory changes
– Pension fund regulation
– Capital market regulation (e.g., SOX)
• Macroeconomic conditions
– credit crunch in the early 1990s
– dot-com bubble in the late 1990s
– 2008 market crisis
• Federal R&D expenditures
• Taxation of “carried interest”
Gates EPP_Lecture 5-20 Spring 2009
Lecture Overview
• Overview of small business finance and research
issues
• The role of private equity market in small business
finance
• The role of debt market in small business finance
• Public policy and small business finance
Gates EPP_Lecture 5-21 Spring 2009
The Role of Debt Markets in SMEs finance: Trade
Credit and Individual Debt
• Individual debt
– Accounts for a very small proportion of SMEs finance
(estimated as 6% of total small business finance)
– Primary source is the principal owner himself/herself
• Trade credit
– Plays an important role (estimated as 16% of total small
business assets)
– Provides a cushion during credit crunches and other
shocks
– Expensive for long term use
– SMEs tend to reduce the use of long term trade credit
once they mature
Source: Berger & Udell, 1998
Gates EPP_Lecture 5-22 Spring 2009
The Role of Debt Markets in SMEs finance: Financial
Institution Debt
• The most important debt provider for SMEs
• SMEs tend to borrow from a single financial
institution
• Funds are often secured with collateral and
guarantees (due to information opacity)
• Borrowers are often protected by loan
commitments and lines of credit
• Relationship lending is very common
Source: Berger & Udell, 1998
Gates EPP_Lecture 5-23 Spring 2009
Lecture Overview
• Overview of small business finance and research
issues
• The role of private equity market in small business
finance
• The role of debt market in small business finance
• Public policy and small business finance
Gates EPP_Lecture 5-24 Spring 2009
Bankruptcy Law and SMEs
• When a firm is unincorporated, its debts are personal
liabilities of the firm’s owner
– The owner may file for personal bankruptcy if the firm
fails
– States have had different regulations that make it easier
or harder to file for bankruptcy
• Existing research offer evidence on the impact of state
bankruptcy policies (varies by state prior to 2005) on
– The propensity of individual to own business (Fan and
White, 2003)
– The decision to start business
– Access to credit (Berkowitz & White 2004)
Gates EPP_Lecture 5-25 Spring 2009
New Federal Bankruptcy Abuse Prevention and
Consumer Protection Act
• Took effect in October 2005
• Generally regarded as having raised the bar of filing
personal bankruptcy, depending on the prior level
in a particular state
• Offer new research opportunities, especially in view
of the financial and credit crisis of 2008-9
Gates EPP_Lecture 5-26 Spring 2009
Personal Income Tax
• It is usually assumed the higher marginal income tax rate, the
lower entrepreneurial activity level
• Some argue this has not been the case
– Higher marginal income tax rates may encourage risktaking by shifting more risk to the government and indeed
encourage entrepreneurship (Domar and Musgrave, 1944)
– SMEs offers easy channels for the owner to deduct some
personal expenses; higher marginal rates may thus
encourage more self-employment (Bruce, 2000)
– Gentry and Hubbard (2000) contend that it is the shape of
the tax schedule that is more important for entrepreneurs
than the actual level of the marginal tax rate
Gates EPP_Lecture 5-27 Spring 2009
Corporate Income Tax I
• The current U.S. corporate income tax structure
favors debt finance over equity
– Equity finance is double-taxed
– Firms can write-off the costs of debt finance
• Focused tax relief to promote entrepreneurship or
VC appears to be more effective in promoting
entrepreneurship than a general reduction in capital
gains tax (Keuschnigg & Nielsen (2004))
– General capital gains tax
– Narrowly focused tax relief to VC firms
– Selective reduction of the capital gains tax on
entrepreneurs
Gates EPP_Lecture 5-28 Spring 2009
Corporate Income Tax II
• Poterba (1989) models how corporate income tax affects
venture capital
– A reduction in the capital gains tax rate would in theory
lower the required expected (pre-tax) rate of return on
venture investments for taxable investors
– However, since most VC investors after 1980 have been
tax-exempt institutions, the supply effect may have been
very small
– Lower capital tax rate makes it relatively more attractive
to start one’s own business. Thus the demand for venture
capital increases and in turn increases the equilibrium
quantity of venture capital
Gates EPP_Lecture 5-29 Spring 2009
Monetary Policy
• Monetary policy changes interest rates and thus
affect the real spending preferences of economic
agents
• Raising bank reserves reduces banks’ supply of
loans, disproportionately affecting bank-dependent
borrowers with few alternative sources of funds
(e.g. SMEs)
• Raising interest rates impair collateral values or
otherwise reduce the net worth of certain
borrowers, making them less creditworthy
Gates EPP_Lecture 5-30 Spring 2009
Banking Industry Consolidation (M&As)
• Larger organizations created by M&As may reduce
the availability of credit to small businesses
– Small banks devote a bigger share of loans to
SMEs than big banks do
– Studies compare small business lending by
consolidating institutions before and after M&A
also tend to support this conclusion
• However, previous studies concentrate on the
quantities of credit issued, and not the rates
charged or other contract terms
Gates EPP_Lecture 5-31 Spring 2009
Discussion Questions
• A combination of information issues and costs associated
with public equity issue and debt underwriting create a size
threshold below which an IPO is not attractive. Berger and
Udell estimated that threshold at 10 mil for public equity and
150-200 mil for public debt. Some argue that SOX has
increased that threshold significantly.
– If so, why would this be potentially important for
entrepreneurship?
– What effect might it have on small firm finance?
– How would you research this issue?
– What outcomes might you look at?
– How might you approach an analysis of this question?
– What challenges might you run into?
Gates EPP_Lecture 5-32 Spring 2009