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Once an entrepreneur is aware of the financing options available it is time to consider capital structure.  Capital structure is an important consideration for any business.  It refers to the “right hand side” of the balance sheet, or the combination of debt and equity used to finance the firm’s assets (Scott, 1975).  The ratio of debt to equity is carefully controlled in large firms in order to minimize the cost of capital and maximize the value of the firm.

Franco Modigliani and Merton Miller established the static theory of capital structure (Ross, Westerfield & Jordan, 2008, p.  558-573).  In this theory, the value of a firm is not affected by the capital structure of the firm, if the firm existed in perfect world without tax considerations.  These changes do however affect the firms cost of capital.  Increasing the amount of a firm’s debt increases the firm’s riskiness and corresponds to an increase on the required return on equity investment.  But without tax effects, this has zero net effect on the firm’s cost of capital.

With the effect of taxes included, the tax shield for interest payments on debt must be considered.  When these are considered it becomes clear that the value of the firm increases by the present value of the tax shield, or the firms tax rate multiplied by the amount of debt.  In this situation it would make sense for all firms to borrow the maximum amount possible.

However, increasing the proportion of debt financing has a corresponding increase in the cost of equity capital due to the increased likelihood of bankruptcy.  When a firm’s debt is equal to its total value it often defaults on its debt payments.  This usually causes bankruptcy, and thereby, to debt holders assuming control of the firm.

The cost and risk of bankruptcy must be balanced with the benefits from the debt tax shield, which theoretically leads to an optimal financial structure.  In the greater financial literature, which mainly concerns the financing of large corporations, the optimal capital structure of a firm is the combination of debt and equity financing sources that minimize the cost of capital to the firm (Ross, Westerfield & Jordan, 2008).

In his 1975 work “Financial Structure Planning for the Small Firm,” David Scott outlined a method for small firms to arrive at an estimation of their optimal capital structure, assuming that the underlying principles for capital structure were the same for both small and large firms.  Scott recommended four steps, emphasizing that the financial structure should also reflect the goals of the firm.  These steps are: calculating the firm’s key leverage ratios, on both historical data and future projections and comparing them with industry standards; preparing a range of earnings table for all of the financial alternatives; preparing a formal cash budget; and evaluating information obtained in this process.

Scott’s process is similar to that used in large corporations.  For application by entrepreneurs he proposed shortcuts which compensate for the lack of information available to small firms and the lack of staff and equipment resources available.  He also emphasized the importance of the effect of proper financial structuring in maximizing cash flow and the dangers of improper arrangements eating away at cash flow and liquidity, making efficient operations difficult or impossible.

Nevertheless, there are significant differences between large firm and small firm finance and strategy which have profound effects on the capital structure of small or entrepreneurial firms.  These factors, which are small firm specific, have been increasingly examined in the entrepreneurial finance literature.  In their 1998 study of small business financing practices Berger and Udell found that large corporations and small businesses alike depend on similar amounts of equity and debt on average, but that the specific sources of them were different.  They found over two-thirds of the equity funding in small firms was from the principal owner.  Further, more than over 70 percent of the total funding of the firm came from three sources – the principal owner, commercial banks, and trade creditors.

Another large/small business difference is the fundamental theory under which small firm finance seems to operate.  While Modigliani and Miller’s static theory of capital structure is best at explaining large corporate financing strategies, Stewart Myers and Nicolas Majluf’s pecking order theory, with some modifications, seems to apply to small businesses (Hall, Hutchinson and Michaelas, 2000).  Pecking order theory explains capital structure by examining firms’ preferences among financing methods.  Firms generally prefer internal financing over debt, short-term over long-term debt, and debt over outside equity (Cassar, 2002).  However, this preference order may be strongly influenced by various aspects of the small firm, which are numerous and range from credit and equity market access to the owner’s preferences.

A salient difference between a nascent venture or small firm and larger companies is the influence of the entrepreneur on business decisions (Berger & Udell, 1998).  An entrepreneur can make strategic and policy decisions for his venture, with little or no input or control from outside sources.  An owner’s preferences about taking on debt or equity often becomes the firm’s policy and is influenced by the entrepreneur’s perception of the external economic and financial environment (Romano, Tanewski & Smyrnios, 2000).  The choices an entrepreneur makes and his preferences regarding risk and control, his network resources, and the financial discrimination he may be subjected to all influence the capital structure of the business (Cassar, 2002).

The ownership structure and ownership concentration of a new or small business may also impact its financing decisions and preferences.  The decision to incorporate relates to greater use of bank financing, as the incorporation of a small firm may be a signal to banks of higher credibility, formality of operations, or indicate future growth (Cassar, 2002).  Family involvement in the firm is also associated with a higher use of debt financing (Romano, Tanewski, & Smyrnios, 2000).  This is probably due to the desire of the owners to maintain control of their firm.  Traditional financial theory would indicate that lower diversification increases an entrepreneur’s risk and should indicate a preference for lower debt exposure.  To the contrary, firms with high ownership concentration are found typically to use higher levels of debt financing (Ghaddar, 2003).  In these cases it is clear that debt is being used to avoid dilution of ownership and control.

Agency issues are pronounced in small and new firms.  Agency costs for external credit are perceived as high in relation to equity, because little is known about the firm and owners will certainly act in their own interest.  Agency costs to the firm are perceived as higher for outside equity options, than for debt.   The preference of small firms is internal financing, which has the lowest agency costs.  The competing interests of a firm and its financiers may lead to the appearance of a Pecking Order Theory situation .  However, it is also possibile that the observed debt ratios are simply the sum of past financing events (Heyman, Deloof, & Ooghe, 2006).  Furthermore, the preferences of an entrepreneur may override the use of capital structure for addressing issues of corporate governance and agency issues (Romano, Tanewski, & Smyrnios, 2000).

Market access affects the availability of financing options to small firms.  The reliance on internal sources of financing may be a reflection of the lack of access to external sources (Hall, Hutchinson & Michaelas, 2000).  The ability of firms to access different capital markets is linked closely to their life cycle stage.  As explained by Allen Berger and Gregory Udell, the lack of transparent and audited information and an established operating history of a firm creates reliance on insider financing (1998).  As a firm grows, develops operating history, and improves its ability to project future performance, other capital markets become available, such as external credit and equity markets.  The firm’s access to instruments within these markets also improves with external credit offerings – first short-term loans, then longer term loans, and equity markets moving from angel financing to more formal venture capital financing.  Finally, if a firm continues to survive and grow it can eventually benefit from the public debt and equity markets through an initial public offering.

The size of a firm also is linked to greater access to external financing.   This is possibly related to the high fixed costs involved in eliminating informational asymmetries, which create economies of scale in accessing the markets (Cassar, 2002).  Larger firms are better able to cover the costs of audited financial statements and other validating measures which many creditors favor.

Firms that are ready to start growing or those currently growing typically increase their use of short-term debt financing (Hall, Hutchinson & Michaelas, 2000).  This is related to the firm’s need for assets with which to grow and the measures banks use to reduce their risk exposure in a small firm, namely shorter term maturities (Cassar, 2002).  In contrast to the normal preferences of avoiding debt in family run firms, family firms in growth industries or that are experiencing a phase of growth are often willing to take on external debt (Romano, Tanewski, & Smyrnios, 2000).

An entrepreneur’s preferences regarding risk have a significant impact on the capital structure of the firm.  Entrepreneurs that are more risk averse tend to use lesser amounts of leverage, decreasing the volatility of the firm, and seek to use internal financing measures (Ghaddar, 2003).  There are competing forces at work in small firms, because an aversion to risk must be balanced against the idiosyncratic nature of that risk.  Small firm owners frequently have a significant amount of their personal portfolio invested in their firm, and so are not well diversified.  This leads to an inherently greater level of risk, for which the owner may expect a larger return on their investment.  This increased marginal cost of equity leads the firm owner to prefer debt financing, due to lower costs and the increased returns possible using financial leverage (Mueller, 2007).

The lack of information about small firms also severely limits their ability to attract external financing.  First, small firms rely on internal financing which eliminates asymmetrical information problems.  The tools that large firms use to eliminate informational asymmetries are not often available to small firms (Cassar, 2002).  Asymmetrical information and the associated agency costs of debt are major determinants of the financial structure of small firms (Heyman, Deloof, & Ooghe, 2006).  Firms with high levels of information asymmetry tend to make greater use of debt financing than large, established businesses (Ghaddar, 2003).  Decreasing levels of informational asymmetry may produce a progression to different types of financing as the firm matures (Berger & Udell, 1998).  As the firm continues operating, it accumulates operational and credit history and increases its ability to project future operations, thus reducing potential creditors’ or investors’ informational problems.

A firm’s industry is a key factor in influencing the capital structure of all firms, but especially those of small firms.  This effect is visible when considering hard goods manufacturing small firms and technology firms (Berger & Udell, 1998).  In hard goods manufacturing firms there is a predominant use of debt as the primary external financing source.   This is due to the availability of production inputs and inventory as collateral.  In firms in the technology sector, outside equity sources are the predominant form of external financing.  Technology and other knowledge based firms have high levels of intangible assets which are difficult to use as collateral for loans.  They also tend to be in the high growth and high risk markets that attract angel investors and venture capital.  High levels of intangible assets are directly linked with higher uses of outside equity, while tangible assets are correlated with debt (Heyman, Deloof, & Ooghe, 2006).

The effects of industry may also be linked to the use of industry averages as targets when doing ratio analysis of a firm’s capital structure (Hall, Hutchinson & Michaelas, 2000).  The use of averages is important to small firms, because of their lack of management ability and cost effective solutions.  These formulas may be difficult to match, however, because the way debt and equity are recorded on the balance sheet may be different from the methods used in a large corporation.  “What may appear as a loan could be an easy-to-retrieve equity investment” by the owner of the firm (Levin & Travis, 1987).

High use of outside equity in the technology industry may not be solely due to the intangibility of firm’s assets, but also reflects the preferences of the entrepreneur.  The lack of debt on technology firms’ balance sheets are not wholly explained by the level of information asymmetries.  The use of equity may be a projection of the entrepreneur’s focus on innovation and maximization of the firm’s future selling value, at the expense of the entrepreneur’s ability to control the firm (Hogan & Hutson, 2004).

Intermingling the personal assets of the entrepreneur with the assets of the firm further complicates the evaluation of small and nascent firm’s capital structures.  The entrepreneur’s network, as a personal asset, may have a significant impact on the availability of certain types of financing and the extent to which internal financing may be used in funding the business (Cassar, 2002).  Banks rarely focus solely on the firm when evaluating the credit worthiness of a small business.  Instead they examine the entrepreneur’s personal assets, as well as the business’ assets, often requiring some of the entrepreneur’s personal assets as collateral (Berger & Udell, 1998).  The entrepreneur’s personal assets may be used for other business purposes as well, such as working from home or using personal equipment for business purposes (Levin & Travis, 1987).  Alternatively, a firm may hold some personal assets of the entrepreneur on the balance sheet, although they are not used for operations.   Both of these situations serve to further cloud the actual capital structure of small firms.

Finally, profitability in a business generally produces a decrease in its use of debt (Heyman, Deloof & Ooghe, 2006).  This generally holds true, but not when short and long-term debt are differentiated.  Short-term debt use decreases with profitability, but not long-term debt use (Hall, Hutchinson, & Michaelas, 2000).  Also, debt held by the owner and often individuals declines as the firm grows, becomes profitable and pays off its insider loans (Berger & Udell, 1998).  Berger and Udell found that during the first seven or eight years of a firm’s life debt use for financing decreases and then begins increasing again.  This may be partly due to the maturity of the firm, less information asymmetries providing for greater financing alternatives, and an increasing use of long-term debt as it becomes available.

The financial structure of a nascent or small firm is extremely variable as it is subjected to the preferences of the entrepreneur and the resources available.  Information asymmetries, lack of operating history and inability to project future performance all contribute to the difficulties faced by small businesses in their capital structure planning.  While static exchange theory seems to explain the capital structuring decisions of large corporations, in small firms pecking order theory seems a better fit.  Regardless of theory, entrepreneurs who undertake planning and regularly conduct strategic planning achieve better results than those who neglect planning exercises.  Given the influence of planning on the success of small business capital structure decision making, an entrepreneur would be well served by undertaking capital structure planning.