An Empirical Analysis of the Relationship between Capital Acquisition and Bankruptcy Laws

Auken, Howard Van, Kaufmann, Jeffrey, Herrmann, Pol, Journal of Small Business Management

Ineffective capital acquisition decisions at start up may lead to business failure and bankruptcy; a result which is both costly and disruptive to the owners and other stakeholders of the firm. To cope with the risk of failure, owners embark on a variety of risk-reducing activities whereas the U.S. government attempts to moderate the downside effects of such failures through the rules surrounding bankruptcy. Previous studies imply that as owners become more aware of the protections offered through the government regulation of bankruptcy, they should become less concerned with the effects of failure and be willing to raise higher levels of initial capital. Raising higher levels of initial capital, in turn, leads owners to take actions intended to reduce firm risk and to minimize the threat to their personal financial security. Data from a sample of small firms confirm our hypothesis by showing that as the level of initial capital acquisition increases, owners embark o activities intended to reduce firm risk. However, capital acquisition is not associated with the owner's familiarity with bankruptcy regulations. As a result, governmental objectives in establishing these regulations may not be achieved. Our findings have implications for firms' owners, consultants, and policymakers, in terms of the relationship between an entrepreneur's knowledge of bankruptcy laws and the financing of their enterprises.

Introduction

Acquisition of start-up capital is one of the most important challenges facing the owners of small firms (Black and Strahan 2002). Financial theory suggests that firms should seek an optimal capital structure to minimize the cost of capital and thus maximize firm value. However it is believed that owners of small firms often lack the skills necessary to deal with the start-up capital acquisition process. Common errors associated with inappropriate start-up capital acquisition include undercapitalization, excessive use of debt, disproportionate levels of short-term debt, and payment of relatively high rates of interest. Furthermore, inappropriate capitalization at business launch may lead to a variety of financial problems, including and inability to fund operations, successfully market products, attract qualified personal, and repay loans (Timmons and Spinelli 2004). As such, poor financial decisions at start-up have been cited as a reason for the high failure rate among small firms (van Praag 2003; Gaskill, Van Auken, and Manning 1993).

Finance theory presumes that initial financing decisions are made within the context of wealth maximization (Kuratko, Hornsby, and Naffiziger 1997; McMahon and Stanger 1995; Petty and Bygrave 1993; Gibson 1992). However. the quality of these business financial decisions is directly linked to the quality and availability of relevant information (Arthurs and Busenitz 2003). Holmes and Kent (1991) referred to the relationship between information and financing decisions as a potential "knowledge gap" that may be overcome through external assistance designed to promote a better understanding of financing alternatives and risk assessment. Poor information can lead to ineffective business financial decisions and, ultimately, to bankruptcy.

Bankruptcy is thought to have a disproportionate impact on small business somewhat muting its important contributions to economic vitality. The small business sector is often viewed as a primary incubator of employment, innovation, and growth (Craig, Jackson, and Thomson 2003), but entrepreneurial activities are inherently risky and entrepreneurs may face severe consequences if the efforts fail and the firm goes bankrupt. Although bankruptcy among firms is been as part of the creative self destruction phenomenon that contributes to the dynamics of innovation and economic renewal (Timmons and Spinelli 2004), bankruptcy is both costly and disruptive to a variety of firm stakeholders including owners, investors, and communities.

Current government policies on bankruptcy are based on the principle that failure is, at lest in part, a risk of the market so that its consequences for the entrepreneur should be limited (Lawless and Warren 2005). Increased risk at start-up also can be due both financial (e.g., financial and operating leverage) and nonfinancial (e.g., lack of experience and information) factors, either of which may expose the firm to higher chances of bankruptcy (Black and Strahan 2002). Owners manage this risk by taking on risk assessment and management activities as an integral part of the start-up decision-making and capital acquisition process. Examples of these activities may include the hiring of consultants, obtaining additional training, and formulating new or improved business plans.

Although governments try to reduce the severe impact of bankruptcy through regulations and owners though risk-reducing activities, the literature has overlooked the association and has ignored whether and how they affect each other. Despite the importance of small business to the U.S. economy and the effects of bankruptcy on levels of entrepreneurship, few studies have investigated the impact of these policy variables on small business success (Berkowitz and White 2004). Consequently, we do not fully understand whether such policies attain their intended outcomes or how these policies affect entrepreneurs. This gap in our understanding is important to investigate given that entrepreneurial activity and financially healthy firms have a "ripple effect" on a variety of constituents ranging from community economic vitality to the entrepreneur's own family dynamics.

We focus on capital acquisition (both debt and equity) by small firms because issues related to capitalization continue to be an important reason for the financial distress and failure faced by small firms (Carter and Van Auken 2006). An understanding of the extent to which issues related to bankruptcy and associated measures to mitigate risk exposure impact capital acquisition can provide insight into potential financial strategies and the development of government policy. We argue that as owners increase the level of their initial capital acquisition, they will take actions intended to reduce firm risk and consequently decrease the possibility of losing their homes, personal capital, or guarantees. Based on the idea that familiarity with the protections provided by bankruptcy law should give owners the confidence to acquire higher levels of capital without risking their own personal financial security, we also argue that the amount of start-up capital acquisition should be associated with the owners' familiarity with such laws.

In this article, we examine the relationship between new business owners' acquisition of start-up capital and both the activities they undertake to reduce risk and their familiarity with bankruptcy laws. Our findings offer a variety of implications for firms' owners, consultants, and policymakers, in terms of entrepreneurs' knowledge of bankruptcy laws and the financing of their enterprises. Our analysis can help us to better understand the relationship between the acquisition of start-up capital, legal familiarity, risk management, and other issues related to bankruptcy.

Small Firm Capital Acquisition and Risk

Timeliness and accuracy of information are required for sound financing decisions (Lang, Calantone, and Gudmundson 1997; Gibson 1992). …

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Publication information: Article title: An Empirical Analysis of the Relationship between Capital Acquisition and Bankruptcy Laws. Contributors: Auken, Howard Van - Author, Kaufmann, Jeffrey - Author, Herrmann, Pol - Author. Journal title: Journal of Small Business Management. Volume: 47. Issue: 1 Publication date: January 2009. Page number: 23+. © 2002 Journal of Small Business Management. COPYRIGHT 2009 Gale Group.

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