The Capital Structure Decisions of New Firms

Alicia M. Robb, University of California, Santa Cruz & Kauffman FoundationDavid T. Robinson, Duke University, Fuqua School of Business

Il finanziamento delle piccole e medie imprese: uno strumento per superare la crisi economica

URBINO, Martedì 21, Mercoledì 22 Aprile 2009

Outline

Motivation & Theoretical Background Data Findings Conclusion

Motivation There is a widely held view that startup

firms face credit constraints The inability to access formal credit

markets drives many firms to pursue financing from informal channels to finance their startup activity Relationship lending (Peterson and Rajan,

1994, 2000; Berger and Udell, 1998)

Motivation, continued

What theories best describe the capital structure decisions of new firms? Pecking Order of Myers and Majluf (1984) Life-Cycle theory by Berger and Udell (1998) Other theories?

We investigate the capital structure choices that firms make in the first year of operation, using new longitudinal data on firm startups in the United States.

Kauffman Firm SurveyKauffman Firm Survey Longitudinal survey of new businesses in the United

States Collected information on nearly 5,000 firms that began

operations in 2004 and surveys them annually Detailed information on firm characteristics, owner

characteristics, financing at startup and over time Original project was a 4 year panel---it was recently

extended to be an 8 year panel (collecting data for calendar years 2004 through 2011). Currently there are four years of data available (2004-2007).

Detailed Data: Baseline & Over Time

Firm characteristicsIndustry, Legal Form, # of Owners, # of Employees (PT/FT),

Types of Customers, Location Firm strategy and innovation

Product/Service Offerings, Intellectual Property, Licensing In, Licensing Out, R&D

Detailed financial informationEquity & Debt Financing, Income Statement Info (Revenue,

Expenses, Profits), Balance Sheet Info (Assets, Liabilities) Employees

Types of Benefits Offered, Task/Work Structure Owner characteristics and work behaviors

(Information on up to 10 owners)Education, Age, Race, Ethnicity, Gender, Citizenship,

Immigrant Status, Hours Worked, Previous Years of Work Experience, Previous Start-up Experience (same/different industry as this firm)

Classification Scheme

Debt Owner Financing Informal Financing Formal Financing

Equity Owner Financing Informal Financing Formal Financing

Security DesignIdentity & Relationship of the investor to the firm

Lines between business and personal finance are often blurred for new and small firms

2004Equity

Internal Equity (Owner(s)) 79.3%Insider (spouse, parent) 4.9%Outsider (informal investors, businesses 4.6% government, venture capital, etc.)

DebtOwner 31.0%Insider (family, employee, etc.) 13.7%Outsider (bank, credit line, credit cards) 36.5%

New Firm FinancingKauffman Firm Survey (KFS)

Mean (all) Mean (just>0) n > 0

Total Financial Capital 80,359$

Owner Equity 28,541$ 36,134$ 3,125

Informal Equity 1,700$ 36,367$ 177Spouse Equity 491$ 30,732$ 62Parent Equity 1,209$ 35,310$ 126

Formal Equity 6,901$ 153,608$ 205Other Informal Investors 2,793$ 107,685$ 110Other Business Equity 1,841$ 162,369$ 56Government Equity 466$ 85,664$ 27Venture Capital Equity 1,454$ 352,111$ 26Other Equity 347$ 189,561$ 9

Sources of Financing for 2004 Startups

Mean (all) Mean (just>0) n > 0

Owner Debt 3,487$ 11,322$ 1,194Personal Credit Card -Owner 3,175$ 10,587$ 1,159Personal Credit Card-Other Owners 288$ 8,995$ 132Other Personal Owner Loan 25$ 15,853$ 5

Informal Debt 7,633$ 52,048$ 542Personal Family Loan 2,670$ 28,398$ 327Personal Family Loan-other owners 286$ 34,681$ 29Business Loan from family 1,350$ 43,909$ 115Business Loan from Owner 1,887$ 117,804$ 67Business Loan from Employee(s) 69$ 19,349$ 9Other Personal Loan 559$ 29,457$ 73Other Personal Funding 812$ 64,514$ 50

Formal Debt 32,097$ 86,374$ 1,439Personal Bank Loan 10,476$ 61,086$ 641Business Credit Card 1,394$ 9,828$ 543Other Bank Loan 1,498$ 65,010$ 92Business Credit Card-other owners 167$ 9,694$ 62Business Credit Cards 859$ 7,383$ 452Bank Business Loan 10,060$ 154,043$ 243Credit Line 3,798$ 71,429$ 210Other Non-Bank Loan 2,040$ 120,950$ 72Government Business Loan 725$ 84,303$ 34Other Business Loan 187$ 63,305$ 19Other Individual Loan 259$ 49,512$ 22Other Business Debt 634$ 120,971$ 22

Sources of Financing for 2004 Startups

Mean %Formal Debt 32,097$ 39.9%

Owner Equity 28,541$ 35.5%Informal Debt 7,633$ 9.5%Formal Equity 6,901$ 8.6%Owner Debt 3,487$ 4.3%Informal Equity 1,700$ 2.1%

Total Financial Capital 80,359$ 100.0%

Sources of Financing for 2004 Startups

Home Based Non-employer Pre-Revenue Pre-ProfitsOwner Equity 14,730$ 18,712$ 25,579$ 23,316$ Informal Equity 761$ 898$ 2,021$ 799$ Formal Equity 1,440$ 2,250$ 6,005$ 3,072$ Owner Debt 2,290$ 2,647$ 2,558$ 1,236$ Informal Debt 2,751$ 3,250$ 7,582$ 5,713$ Formal Debt 12,919$ 17,836$ 28,972$ 26,189$

Total Financial Capital 34,890$ 45,593$ 72,718$ 60,325$

Home Based Non-employer Pre-Revenue Pre-ProfitsOwner Equity 42.2% 41.0% 35.2% 38.7%Informal Equity 2.2% 2.0% 2.8% 1.3%Formal Equity 4.1% 4.9% 8.3% 5.1%Owner Debt 6.6% 5.8% 3.5% 2.0%Informal Debt 7.9% 7.1% 10.4% 9.5%Formal Debt 37.0% 39.1% 39.8% 43.4%

Source of Financing for 2004 Startups by Firm Type

All Sole Prop Partnership LLC S & C CorpsOwner Equity 28,541$ 12,146$ 40,319$ 34,731$ 40,601$ Informal Equity 1,700$ -$ 2,787$ 3,074$ 2,169$ Formal Equity 6,901$ -$ 13,329$ 9,275$ 11,932$ Owner Debt 3,487$ 2,370$ 1,899$ 4,240$ 4,432$ Informal Debt 7,633$ 3,506$ 13,490$ 9,105$ 10,171$ Formal Debt 32,097$ 12,106$ 49,453$ 44,695$ 40,621$ Total Financial 80,359$ 30,128$ 121,277$ 105,121$ 109,926$

Owner Equity 35.5% 40.3% 33.2% 33.0% 36.9%Informal Equity 2.1% 0.0% 2.3% 2.9% 2.0%Formal Equity 8.6% 0.0% 11.0% 8.8% 10.9%Owner Debt 4.3% 7.9% 1.6% 4.0% 4.0%Informal Debt 9.5% 11.6% 11.1% 8.7% 9.3%Formal Debt 39.9% 40.2% 40.8% 42.5% 37.0%

Initial Capital Structure by Legal Form of Organization

Angel/Informal VC Corporate Govt-Other

Owner Equity 104,335$ 64,469$ 98,738$ 47,341$ Insider Equity 11,205$ 6,367$ 4,904$ 5,425$ Outsider Equity 150,594$ 488,911$ 212,672$ 123,189$ Owner Debt 7,462$ 2,697$ 9,878$ 6,655$ Insider Debt 25,811$ 28,731$ 12,447$ 4,430$ Outsider Debt 106,962$ 307,871$ 61,727$ 58,073$

Total Financial Capital 406,368$ 899,046$ 400,366$ 245,112$

Owner Equity 25.7% 7.2% 24.7% 19.3%Insider Equity 2.8% 0.7% 1.2% 2.2%Outsider Equitiy 37.1% 54.4% 53.1% 50.3%Owner Debt 1.8% 0.3% 2.5% 2.7%Insider Debt 6.4% 3.2% 3.1% 1.8%Outsider Debt 26.3% 34.2% 15.4% 23.7%

Equity Backed Firms

High Low All Credit Score Credit Score

Owner Equity 28,541$ 45,227$ 19,866$ Owner Debt 3,487$ 3,344$ 3,336$

Informal Equity 1,700$ 3,548$ 1,100$ Informal Debt 7,633$ 17,606$ 4,543$

Formal Equity 6,901$ 13,998$ 3,561$ Formal Debt 32,097$ 66,899$ 19,209$

Total Financial Capital 80,359$ 150,621$ 51,615$

Owner Equity 35.5% 30.0% 38.5%Owner Debt 4.3% 2.2% 6.5%Informal Equity 2.1% 2.4% 2.1%Informal Debt 9.5% 11.7% 8.8%Formal Equity 8.6% 9.3% 6.9%Formal Debt 39.9% 44.4% 37.2%

Credit Worthiness & Capital Structure

High Low All Credit Score Credit Score

Owner Equity 44,493$ 64,151$ 28,601$ Owner Debt 4,368$ 3,321$ 6,064$

Informal Equity 2,374$ 3,844$ 2,819$ Informal Debt 10,871$ 22,922$ 12,843$

Formal Equity 32,466$ 115,099$ 17,586$ Formal Debt 42,776$ 85,406$ 30,292$

Total Financial Capital 137,347$ 294,741$ 98,205$

Owner Equity 32.4% 21.8% 29.1%Owner Debt 3.2% 1.1% 6.2%Informal Equity 1.7% 1.3% 2.9%Informal Debt 7.9% 7.8% 13.1%Formal Equity 23.6% 39.1% 17.9%Formal Debt 31.1% 29.0% 30.8%

High Tech Firms Only

Technology, Creditworthiness, and Access to Capital

Separating Credit Supply from Credit Demand

We regress the firms credit score on variables that proxy for demand-side factors that would influence credit ratings. We consider two models. First, we run the following regression:

scoreij = α + βj + ϵi (1) where scoreij is the credit score of firm i in industry j, βj are industry fixed effects.

The first estimation simply includes a set of 60 industry dummies.

For the second specification, we run the following regression:

scoreij = α + βj + γFij + ŋKij + ϵi (2) where scoreij is the credit score of firm i in industry j, βj are industry fixed effects, F is a vector of owner characteristics and K is a vector of firm characteristics

Pecking Order Differences by High and Low Access Firms

Top Quintile Bottom QuintileOwner Equity 41,802$ 22,964$ Insider Equity 3,484$ 1,967$ Outsider Equity 14,018$ 5,598$ Owner Debt 3,930$ 3,133$ Insider Debt 14,133$ 6,772$ Outsider Debt 53,804$ 27,780$ Total Financial Capital 131,171$ 68,213$

Top Quintile Bottom QuintileOwner Equity 35,395$ 29,552$ Insider Equity 2,566$ 2,086$ Outsider Equity 9,722$ 7,394$ Owner Debt 3,610$ 4,194$ Insider Debt 12,943$ 7,855$ Outsider Debt 50,216$ 32,413$ Total Financial Capital 114,452$ 83,493$

Model 1

Full Model

All Firm has Inc./Employees Home basedFirms Outside Equity Asset-Backed Nonemployers

2004Owner Equity 28,541$ 83,785$ 64,019$ 12,848$ Insider Equity 1,700$ 8,292$ 5,053$ 706$ Outsider Equity 6,901$ 153,608$ 23,636$ 1,401$ Owner Debt 3,487$ 7,400$ 6,708$ 1,985$ Insider Debt 7,633$ 18,564$ 19,419$ 2,313$ Outsider Debt 32,097$ 109,483$ 82,330$ 13,598$ Total Financial Capital 80,359$ 381,132$ 201,164$ 32,851$

2005Owner Equity 13,015$ 29,936$ 22,461$ 5,661$ Insider Equity 1,433$ 1,099$ 3,542$ 354$ Outsider Equity 6,468$ 74,212$ 22,390$ 901$ Owner Debt 3,346$ 6,958$ 5,547$ 1,854$ Insider Debt 4,717$ 11,458$ 7,862$ 1,906$ Outsider Debt 27,733$ 74,898$ 63,185$ 14,339$ Total Financial Capital 56,712$ 198,560$ 124,985$ 25,015$

2006Owner Equity 10,248$ 28,308$ 20,623$ 4,602$ Insider Equity 647$ 956$ 2,120$ 89$ Outsider Equity 3,949$ 22,797$ 13,249$ 1,622$ Owner Debt 3,243$ 5,526$ 5,004$ 1,838$ Insider Debt 3,910$ 13,349$ 8,619$ 738$ Outsider Debt 27,096$ 85,193$ 64,169$ 12,488$ Total Financial Capital 49,092$ 156,128$ 113,785$ 21,376$

2007Owner Equity 7,933$ 16,923$ 13,484$ 3,988$ Insider Equity 850$ 1,960$ 2,715$ 116$ Outsider Equity 2,984$ 33,419$ 9,191$ 401$ Owner Debt 3,628$ 8,257$ 6,694$ 1,675$ Insider Debt 3,604$ 18,215$ 9,492$ 686$ Outsider Debt 31,701$ 87,775$ 77,838$ 12,910$ Total Financial Capital 50,700$ 166,549$ 119,416$ 19,776$

Time Series Evidence on the Importance of Formal Debt

All Firm has Inc./Employees Home basedFirms Outside Equity Asset-Backed Nonemployers

2004Outsider Debt 39.9% 28.7% 40.9% 41.4%

2005Outsider Debt 48.9% 37.7% 50.6% 57.3%

2006Outsider Debt 55.2% 54.6% 56.4% 58.4%

2007Outsider Debt 62.5% 52.7% 65.2% 65.3%

Time Series Evidence on the Importance of Formal Debt

Does Financial Access Affect Firm Performance? Probit Analysis 2007 Outcomes: Revenue 100K+, Profits

50K+, Assets 50K+, Employment Key explanatory variables

Ratio of outside debtLevel of 2004 sales

Revenue Assets Profits Employer COEFFICIENT 100K+ 50K+ 50K+ 2007

Log of 2004 Revenue 0.0187*** 0.00690** 0.00850*** 0.00647**(0.00274) (0.00270) (0.00226) (0.00265)

Outside Debt Ratio 0.107*** 0.290*** 0.0297 0.0654(0.0408) (0.0438) (0.0330) (0.0410)

Black -0.0870* -0.0900* -0.114*** 0.125***(0.0467) (0.0481) (0.0307) (0.0448)

Hispanic -0.112** -0.0920 -0.0120 0.0452(0.0519) (0.0608) (0.0489) (0.0637)

Female -0.140*** -0.143*** -0.0548** -0.0634**(0.0285) (0.0303) (0.0244) (0.0294)

Hours Worked 0.00333*** 0.00352*** 0.00259*** 0.00281***(0.000586) (0.000564) (0.000463) (0.000582)

Industry Experience 0.00422*** 0.00322** 0.00352*** 0.00426***(0.00138) (0.00133) (0.00109) (0.00133)

Team Ownership 0.112*** 0.157*** 0.0331 0.0570**(0.0288) (0.0259) (0.0236) (0.0273)

Credit Score 0.00317*** 0.00225*** 0.00204*** 0.00303***(0.000585) (0.000590) (0.000474) (0.000581)

Home based -0.244*** -0.178*** -0.0367 -0.224***(0.0270) (0.0268) (0.0240) (0.0268)

Capital Structure Choices and Firm Outcomes

Conclusions New firms rely to a surprising degree on debt

provided through formal credit channels Notion of friends, family, and fools seems misleading

given our findings Informal investors are important for the handful of

firms that rely on outside equity, but most firms turn elsewhere

Roughly 80% of firms’ start up capital is made up in equal parts of owner equity and bank debt

Equity and debt are complements, not substitutes Findings underscore the importance of liquid credit

markets for the formation and success of young firms.

Thank you!

arobb@ucsc.edu

davidr@duke.edu