The study reported here examines the financing choices of small and medium-sized firms, i.e., those most vulnerable to information and incentive problems, through the lens of the business life cycle. We argue that the controversy in the empirical literature regarding the determinants of capital structure decisions is based on a failure to take into account the different degrees of information opacity, and, consequently, firms' characteristics and needs at specific stages of their life cycles. The results show that, in a bank-oriented country, firms tend to adopt specific financing strategies and a different hierarchy of financial decision-making as they progress through the phases of their business life cycle. Contrary to conventional wisdom, debt is shown to be fundamental to business activities in the early stages, representing the first choice. By contrast, in the maturity stage, firms re-balance their capital structure, gradually substituting debt for internal capital, and for firms that have consolidated their business, the pecking-order theory shows a high degree of application. This financial life-cycle pattern seems to be homogeneous for different industries and consistent over time.
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Zingales (2000) also has emphasized the fact that “…the attention shown towards large firms tends partially to obscure (and often ignore) firms (of small and medium size) that do not have access to the (public) financial markets…”.
Large firms use a variety of financing instruments, both public and private, while small firms typically use bank loans and private equity, mainly based on the financial support of the entrepreneur and his or her family. Moreover, small businesses do not issue securities that are priced in public markets.
According to Berger and Udell (1998), the opportunities to invest in positive net present value projects may be blocked if potential providers of external finance cannot readily verify that the firm has access to a quality project (adverse selection problem), ensure that the funds will not be diverted to an alternative project (moral hazard problem), or costlessly monitor use of the revenue by the firm they invest in (costly state verification).
Beck et al. (2002) showed that small firms are the most credit-constrained by underdeveloped institutions.
Moreover, this topic is also of particular interest in the valuation of the firm, considering that capital structure decisions, which differ throughout the stages of the life cycle of the firm, directly affect the opportunity cost of capital and the market value of the firm.
Pinegar and Wilbricht (1989), in their survey, observed that external debt is strongly preferred over external equity as an approach for raising funds.
Furthermore, since small businesses are usually owner-managed, the owner/managers often have strong incentives to issue external debt rather than external equity in order to retain ownership and control of their firms (Berger and Udell 1998); indeed, venture capitalists seek to take part in corporate decisions.
The availability of external finance to small business is likely to be highly dependent upon the institutional environment (Demirgüç-Kunt and Maksimovic 1996). An information-poor environment, characterized by a weak system of investor protection and poorly developed mechanisms for information sharing, will lack venture-capital markets and has only a limited ability to sustain small business without collaterals.
In a second scenario, Diamond (1989) observed that the institutional environment, in which incentive and informational problems can be more or less severe, influences the use of debt funds; if moral hazard is sufficiently widespread, then firms will build their reputation by being monitored by a financial intermediary.
It appears that firms can raise finance more easily as the financial system develops because physical collateral becomes less important, while intangible assets and future cash flows can be financed. As the financial system develops, it should be possible to easily appreciate the soundness of the firm’s projects and of its managerial behaviors (Rajan and Zingales 1995).
Judicial enforcement is important because the financial system and the regulations governing it work in the interests of investors, protecting creditors only to the extent that the rules are actually enforced.
Several outliers were deleted from the dataset in order to reduce their impact on the results. All firm-year observations for which variables used in the estimation were below the 1st percentile or above the 99th percentile were deleted.
With regard to the variable Age, which was used to proxy reputation, we would like to comment that we followed what was indicated by Diamond (1989), who considers reputation to mean the good name a firm has built up over the years, and Petersen and Rajan (1994), who found that older firms, which ought to be of higher quality, have higher debt ratios. In particular, Diamond (1989) suggests that the “reputation of the enterprise” may be measured as a function of variables such as age and/or length of service.
In the empirical analysis, other functional forms were tested, but they did not add relevant significance to the model.
Overall, we examined the values for adjusted R 2, F test, T tests and Durbin–Watson test to assess the statistical significance of the model. The regression models were always statistically significant (p value of the F test < 0.01) with a relevant adjusted R 2, indicating that the variables accounted for a substantial part of the variation in leverage across companies. From the Durbin–Watson value, which was generally close to 2, an absence of autocorrelation was observed.
Although young firms do not have as many tangible assets that can be easily evaluated or pledged as collateral and have little repayment history or record of profitability upon which external suppliers of funds can rely, they resulted in being directly in need of debt to grow.
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La Rocca, M., La Rocca, T. & Cariola, A. Capital Structure Decisions During a Firm's Life Cycle. Small Bus Econ 37, 107–130 (2011). https://doi.org/10.1007/s11187-009-9229-z
- Capital structure
- Financial growth cycle
- Financing decisions
- Small and medium-sized firms
- Source of finance