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Pecking order and debt capacity considerations for high-growth companies seeking financing

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Abstract

This paper examines incremental financing decisions within high-growth businesses. A large longitudinal dataset, free of survivorship bias, to cover financing events of high-growth businesses for up to 8 years is analyzed. The empirical evidence shows that profitable businesses prefer to finance investments with retained earnings, even if they have unused debt capacity. External equity is particularly important for unprofitable businesses with high debt levels, limited cash flows, high risk of failure or significant investments in intangible assets. These findings are consistent with the extended pecking order theory controlling for constraints imposed by debt capacity. It suggests that new equity issues are particularly important to allow high-growth businesses to grow beyond their debt capacity.

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Notes

  1. We acknowledge that information asymmetries do not necessarily lead to a financing hierarchy (Halov and Heider 2004), and the existence of asymmetric information may not be the only reason why a financing hierarchy exists. First, transaction costs may also contribute to the wedge between the costs of internal and outside financing (Myers 1984). Second, there is a potential cost of losing control over the business when resorting to outside financing. These factors may further inhibit business managers from issuing outside financing and even constrain company growth (Manigart and Struyf 1997). Finally, the existence of a knowledge gap from the entrepreneur’s perspective may cause a financing hierarchy, as business owners are typically most familiar with traditional sources of funding, such as inside financing and debt, but less familiar with capital commonly used to fund growth, such as venture capital and business angel financing (Van Auken 2001).

  2. Other examples of so-called bank-oriented countries are Germany, Japan and France, as opposed to market-oriented countries like the UK, US and Canada. Rajan and Zingales (1995) show that the difference between the two types of financial systems is not so much present in the level of leverage, but is more likely to be reflected in the choice between public (e.g., stocks and bonds) and private financing (e.g., bank loans and venture capital financing).

  3. We use a 3-year moving average of the growth rate and require a company to be at least twice among the first percentile of companies in order to exclude erratic or one-shot growth businesses.

  4. We are mainly studying unquoted high-growth companies. Consequently, market values are not available. Second, previous research argues that managers have book value rather than market value targets (Hovakimian et al. 2001).

  5. In the entire sample less than 9% of all financing events were related to companies that had negative shareholders’ equity in the previous year.

  6. This is in line with prior studies on capital structure, such as that of Cassar (2004), who reports a pseudo R² of 0.049, 0.122 and 0.092 in respectively the leverage, outside financing and bank financing regression. It is also in line with studies focusing on incremental financing decisions, such as that of Ou and Haynes (2006), who report a pseudo R² of 0.113 and 0.158 in respectively the combined internal equity and external equity logit models.

  7. The mean ratio of cash and cash equivalents on total assets is lower for debt issuers compared to companies resorting to equity financing (Table 6). The difference in the mean ratio of cash and cash equivalents on total assets for debt issuers compared to equity issuers is more pronounced when excluding these cases where data on financial risk are not available (not reported). This indicates that the change in sign may be due to a relatively larger number of businesses with higher cash and cash equivalents issuing debt financing that are dropped because of missing values when including the financial risk measure.

  8. We included mean centered values of the financial debt ratio and cash flow ratio in our models and used these values to calculate the interaction term. This is done in order to reduce potential multicollinearity problems as advised by Neter et al. (1996).

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Acknowledgements

The authors appreciate helpful comments and suggestions from Rajesh Aggarwal, Gavin Cassar, Wouter De Maeseneire, Miguel Meuleman, Hans Landström, Harry Sapienza, anonymous referees and participants from the 2008 Academy of Management Meeting, the 2006 Babson College Entrepreneurship Research Conference and the Finance Seminars at Ghent University and the Katholieke Universiteit Leuven. A preliminary version of this research was published in the 2006 Frontiers of Entrepreneurship Research. We are indebted to Bart Clarysse and Caroline Van Eeckhout for help in constructing the high-growth company database. The financial support of the Intercollegiate Center for Management Science (I.C.M.) and “Steunpunt Ondernemingen, Ondernemerschap en Innovatie” is gratefully acknowledged.

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  1. Ghent University, Ghent, Belgium

    Tom R. Vanacker

  2. Ghent University and Vlerick Leuven Gent Management School, Ghent, Belgium

    Sophie Manigart

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  1. Tom R. Vanacker
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Correspondence to Tom R. Vanacker.

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Vanacker, T.R., Manigart, S. Pecking order and debt capacity considerations for high-growth companies seeking financing. Small Bus Econ 35, 53–69 (2010). https://doi.org/10.1007/s11187-008-9150-x

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