In a recent paper conducted on behalf of the Office of Advocacy of the U.S. Small Business Administration entitled, What do we Know about the Capital Structure of Privately Held Firms? Evidence from the Surveys of Small Business Finances, Rebel Cole examines Federal Reserve data to figure out why some small businesses rely more on leverage than others.
Leverage is the amount of debt that a company uses to finance its assets. According to the pecking order theory of finance, companies first use internally-generated capital, then borrow money, and finally obtain outside equity.
Professor Cole’s study confirms that the pecking order theory applies to the financing of small businesses. Leverage decreases as firms get older, larger, and more profitable, and increase their liquidity and credit quality.
Stated differently, new, small, unprofitable start-ups are more reliant on debt than older, larger, more profitable established companies. Once they have exhausted their own funds, entrepreneurs are more likely to turn to lenders than to equity providers.
This pattern is consistent with the evidence that banks and trade creditors are the number one and number two source of non-founder capital for young companies, but it is inconsistent with the efforts of many entrepreneurs to seed outside equity when they found their companies.
Professor Cole found that businesses with a lot of intangible assets are less highly leveraged than those with a lot of tangible assets, indicating that knowledge-based technology companies might be exceptions to this approach to financing. But outside of a small number of high-tech start-ups, the data suggest that entrepreneurs finance their companies by first using their own money and then by borrowing.
In short, obtaining outside equity isn’t something most entrepreneurs do successfully when they first start their companies. If you’re starting a business, you should think about that when formulating your financing strategy.
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About the Author: Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool’s Gold: The Truth Behind Angel Investing in America; Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By; Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures; Technology Strategy for Managers and Entrepreneurs; and From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company.