How Are Small Firms Financed? Evidence from Small Business Investment Companies

Article excerpt

How do firms and financial intermediaries decide how to finance investment projects undertaken by a firm? Some firms fund projects by issuing equity, others by borrowing from investors and/or financial intermediaries. This issue interests researchers and practitioners in corporate finance, as well as public officials whose policies influence the availability of capital and the terms on which capital is provided to firms. Since Modiagliani and Miller's (1958) seminal work demonstrating the conditions under which a firm's value is not affected by the choice between debt and equity to finance its activities (capital structure), research has focused on establishing the analytical and empirical determinants of a firm's capital structure. Three hypotheses, which are not mutually exclusive, are offered to explain the relevance of capital structure. The asymmetric information hypothesis holds that managers and other insiders of a firm are better informed about the current and future prospects of the firm than outside providers of capital. The firm's capital structure, or financing policy, is designed to convey this private information to the capital markets and to minimize any underpricing of the firm's financial instruments due to investors' uncertainty about the quality of the firm. The second hypothesis is based on the differential tax treatment of equity and debt and implies that firms design their financial policy to minimize taxes. In this article, we focus on the third hypothesis, which stems from work in contracting theory. Contracting theory views a firm as a nexus of contracts among its various stakeholders, such as management, shareholders, creditors, suppliers, and customers. From this perspective, the financing policy of a firm is designed to minimize total contracting costs, including potential conflicts of interest among the parties (agency conflicts).(1) All of these hypotheses offer predictions about which types of firms should issue which types of securities. Although numerous studies test these predictions, the evidence is not conclusive.(2)

We examine the implications of contracting theory, using a unique, transactions-level dataset on the investment activities of small business investment companies (SBICs), which are private venture capital firms licensed and regulated by the U.S. Small Business Administration (SBA). The SBIC program was established by Congress in 1958 to encourage the provision of long-term private sector capital, both debt and equity, to the nation's small businesses. SBICs are private firms but, in return for accepting some restrictions on the types of investments they undertake, they are eligible to receive government subsidies by issuing SBA-guaranteed debentures (SBA leverage). Our data contain information about every financing transaction conducted by SBICs between 1983 and 1992, including characteristics of the small firm receiving funds, the type of security used (debt, equity, or some hybrid), and other characteristics of the project and transaction agreement. Thus, instead of using stock data to examine the capital structure question, we use flow data to consider each financing transaction separately. This permits us to separate the influence of firm, industry, and project characteristics on the decision of whether to use debt in a particular transaction. Furthermore, the data allow us to examine the relationship between the characteristics of investors (SBICs) and the types of securities they purchase. Hence, we can offer evidence on how the agency relationships of SBICs with others affect their investment policy with small firms.

Overall, our results are consistent with the predictions of contracting theory. Our main finding is that business projects that generate tangible assets and allow little management discretion tend to be funded with debt rather than equity. This result is consistent with the view that projects that generate tangible assets minimize the ability of owner/managers to shift funds to riskier projects. …