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The role of informal capital on new venture formation and growth in China

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Abstract

This study examines the nature and role of informal capital used by micro-firms in the dynamic emerging market of China. Using a unique source of data for 260 urban entrepreneurs, this study provides empirical evidence that entrepreneurs’ personal savings and family funding are important sources of start-up capital. However, household income was found to be the most important funding source in driving firm growth over time. This research directly addresses the lacuna of studies on entrepreneurship in emerging economies and contributes to our understanding of the critical role informal capital plays in the Chinese entrepreneurial process. Overall findings suggest that informal capital is still predominantly used over formal capital sources for financing firm start-up, underscoring the slow transition in China from an emerging to a modern economy.

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Notes

  1. Their survey of the literature was from 1980 to 2005 of 11 leading English language journals. Of these 68 studies on China’s transition economy, only 13 were either firm-level or micro-level studies.

  2. AQQ (2005) also emphasized the importance of studying micro-firms noting that “firm-level studies are needed to ascertain the sources and importance of other capital used by firms in China, especially high-growth private firms.”

  3. Xiao (2011) reports on the frequency of informal capital sources for 74 small high-technology firms in two Chinese provinces, Guangdong and Guangxi.

  4. Also see Bruton et al. (1999).

  5. For a discussion on the importance of local context for entrepreneurial activity, see Feldman (2014), Tavassoli & Carbonara (2014), among others.

  6. Bhide (2000) and others find that start-up capital can be rather modest in developing countries.

  7. For more details on growth theory foundations and evidence for the USA, see Hall (1987).

  8. For example, historically in Germany, larger firms grew faster until about 1990s, when the growth of high-technology firms was documented as exceeding that of the older manufacturing sector (AE, Audretsch and Elston 2006).

  9. In one study, US high-technology entrepreneurs used earnings from a second job, and loans from either individuals or banks are their most common sources of capital to start a firm (Elston and Audretsch 2010).

  10. Although Daunfeldt and Halvarsson (2015) find empirical evidence that high-growth firms may be “one hit wonders” as high rates of firm growth were often followed by periods of low growth in their Swedish sample. This finding questions the efficacy of using policies to promote consistent high firm growth over time.

  11. Unlike many countries in the West, institutional investors such as pension and mutual funds and insurance companies play a relatively minor role in China (Eun and Resnick 2012). The newly established Shanghai Stock Exchange, Shenzhen Stock Exchange, and the more established Hong Kong Stock Exchange are all growing with newly listed firms from all over China, but are not expected to be the primary funders of micro-firms.

  12. In a study on US entrepreneurial ventures, Becker-Blease and Sohl (2015) find that quality top management teams, advisors, and developed products are viewed more favorably by angel investors and likely have better access to these investors, suggesting that firm quality also impacts access to capital.

  13. AQQ (2005) conclusions are based on data and figures from the Chinese Securities and Futures Statistical Yearbook (2001) and the Chinese Statistical Yearbook (2000).

  14. Noted exceptions include micro-financing from institutions such as the Grameen Bank founded Mohammed Yunis to provide small amounts of credit to uncollateralized entrepreneurs in Bangladesh.

  15. Growth of the firm can be estimated using any of these three proxies for firm size where Growth i,t  = [ln(S i,t )  − ln(S i,t − 1)]/ln(S i,t − 1).

  16. Section 2 of the survey included three sets of questions asking about motives in starting up the business, business operation goals, and perceived barriers to starting and operating a business, which were not utilized in this study.

  17. Initially, we conducted a pilot study with 10 small business owners in a small city located in Hubei Province to refine the clarity and suitability of all survey questions before finalizing the data collection process.

  18. The “Other choices” category was recoded to include not only the “other funding sources” category on the survey, but all other low-frequency categories including funding by: colleagues = 2, banks and financial institutions = 1, employer = 1, and government programs = 0.

  19. Similarly, GROWTH_R is the growth of firm as measured by gross revenues, calculated as [ln(Size_R_2010) − ln(Size_R_2009)/ln(Size_R_2009)]. And GROWTH_P is the growth of the firm as measured by profits calculated as [ln(Size_P_ 2010) − ln(Size_P_ 2009)/ln(Size_P_2009)].

  20. It is also possible that there may be feedback in the model in that when the firm grows, the entrepreneur’s household income grows. Since this depends on how much money is being taken out of the firm, which is unobservable, we are unable to control for this possibility.

  21. While we control for gender in our study, the role of gender in financing is undoubtedly more nuanced, and worthy of future examination. For example, in a related study examining US-based venture capital, Becker-Blease and Sohl (2007) find that US women seek angel financing at rates substantially lower than that of men, but have an equal probability of receiving investment.

  22. In this context, household income or wealth is internal where bank credit, institutional loans, or equity would be external.

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Authors and Affiliations

  1. Oregon State University, 228 Cascades Hall, 2600 NW College Way, Bend, OR, 97701-5998, USA

    Julie Ann Elston

  2. Ohio University, Athens, OH, 45701, USA

    Sandy Chen

  3. Higher Colleges of Technology, Abu Dhabi, UAE

    Alois Weidinger

Authors
  1. Julie Ann Elston
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  2. Sandy Chen
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  3. Alois Weidinger
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Correspondence to Julie Ann Elston.

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Elston, J.A., Chen, S. & Weidinger, A. The role of informal capital on new venture formation and growth in China. Small Bus Econ 46, 79–91 (2016). https://doi.org/10.1007/s11187-015-9674-9

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