Academic journal article
By Schmid, Frank A.
Federal Reserve Bank of St. Louis Review , Vol. 83, No. 6
An entrepreneur is an individual with a project blueprint and limited wealth. If launching the project requires expenses that exceed the entrepreneur's initial wealth, he needs outside financing. Entrepreneurs differ from "hired management" in that they are indispensable for the firm's day-to-day operations. This is because entrepreneurs add value to companies perpetually, rather than by handing over the project blueprints.
Outside financing is fraught with the problem of asymmetric information between the entrepreneur (who is a firm insider) and the (outside) investor. Asymmetric information between management and investor is considered the most significant problem in corporate finance. (1) Typically, the problem of asymmetric information is modeled in finance literature as one that pertains to the use of free cash flow by management or to management's project choice. (2) Asymmetric information about the use of free cash flow can take on a variety of forms. First, cash flow might be unobservable. In this case, the diversion of free cash flow for personal use by management goes unnoticed by the investor. If cash flows are unobservable, the outside equity holder has no bargaining power over the allocation of free cash flow to dividend payments. Second, management's use of free cash flow might be observable, but not verifiable. This is when the outsider can observe management directing free cash flow to its own benefit, but canno t verify these actions in court. Third, management's actions might be observable and verifiable, but compliance might not be enforceable. Examples of non-enforceability are cases where it is prohibitively costly for investors to go to court, or where court rulings are rendered worthless because the culprit is subject to limited liability or has limited wealth. (3)
In spite of the problems of asymmetric information outlined above, outside equity financing of the entrepreneurial firm has achieved a rapid increase over the past decade (see Figure 1). Venture capital funds, which finance privately held start-ups, raised a record $92.3 billion in 2000. This is a thirty-fold increase relative to 1990. At Nasdaq, initial public offerings raised an all-time high of $53.6 billion in 2000, which is 24 times as much as in 1990.
This article analyzes equity financing of the entrepreneurial firm against the background of observable but non-verifiable cash flow. The study covers three organizational forms: the limited partnership, the private corporation, and the public corporation. The legal type of the firm determines the outside equity financing options that are available to the entrepreneur. By definition, initial public offerings are available to the (henceforth) public corporation only, whereas venture capital is possible for both the limited partnership and the privately held corporation.
The analysis shows that venture capital financing is superior to public offerings when the entrepreneur has low initial wealth relative to the size of the project and is equivalent otherwise. This result highlights the importance of private equity in financing entrepreneurial enterprises. The GrammLeach-Bliley Act of 1999 allows banks to expand the scope of their activities in this arena. The law allows financial holding companies to provide equity financing to non financial firms for up to ten years. In particular, the act defines a framework in which financial holding companies can sponsor private equity funds that provide venture capital to entrepreneurial firms. While it is not the purpose of this article to study the consequences of the GrammLeach-Bliley Act on venture capital financing, the analysis suggests that venture capital is a significant financing instrument. The Gramm-Leach-Bliley Act helps improve the supply side in the venture capital market by broadening the spectrum of institutions that ar e allowed to provide private equity to firms that do not (or not at this stage) seek to raise capital in an initial public offering. …