Entrepreneurship and Public Policy

Entrepreneurship and Public Policy Lecture 5: Financing Entrepreneurship

Lecture Overview • Overview of small business finance and research issues • The role of private equity market in small business finance • The role of debt market in small business finance • Public policy and small business finance

Financing Options: Firm Capital Structures • Types of outsider finance • Debt • Equity • Firm capital structure: selection of a ratio of debt to equity financing • Capital structure irrelevance theory (Modigliani and Miller, 1958) • The value of a firm is unaffected by how that firm is financed • Pecking-order theory vs. Trade-off theory of firm capital structures • Firm size and age are important determinants of capital structure • Larger firms use less leverage • Older firms use less leverage

U.S. Small Business Finance at a Glance • A national survey of small business finances (1993) provides a touchstone for understanding small business finance • SMEs obtain external finance almost exclusively through private markets • SMEs depend on both equity (49.63%) and debt (50.37%) • The largest sources are the principal owner, commercial banks, and trade creditors • Funds provided by the “principal owner”, family and friends critical at initial stages when information problems are most acute • As the firm grows, retained earnings become more important • Data from Kauffman Firm Survey generally consistent with these findings • 56% of new firms had debt financing in year one: 48 % had personal debt and 24% had business debt • 80% had equity financing ( 90% from owners)

U.S. Start-up Finance at a Glance • 2002 Survey of Business Owners Characteristics of Businesses shows that start-ups rely primarily on personal and family savings and assets • Data from Kauffman Firm Survey • 56% of new firms had debt financing in year one: 48 % had personal debt and 24% had business debt • 80% had equity financing ( 90% from owners)

Characteristics of the Small and Medium Enterprise (SMEs) Finance Market • Information asymmetry is a key characteristic of the market for small business finance • SMEs do not generally issue public information on contracts, business practices, financial conditions and do not provide auditable financial statements • This can lead to inefficiencies in the market for funding • Adverse selection • Moral hazard • Private financial markets partially address this problem through screening, contracting, and monitoring

SMEs Finance: A Life Cycle Framework Firm Size, Firm Age, Information Availability Very small firms, no collateral or track record Small, high-potential firms, limited track record Medium firms, some track record & collateral Large firms, known risk & track record Initial Insider Finance Angel Finance Venture Capital Public Equity Trade Credit Short Term Financial Institution Loans Commercial Paper Intermediate Term Financial Institution Loans Medium Term Notes Mezzanine Funding Private Placements Public Debt Source: Berger & Udell, 1998

Research on SMEs Finance Focuses on Several Key Issues • The type of financing that growing companies need and receive at various stages of their growth • The nature of the private equity and debt contracts associated with this financing • The connections and substitutability among alternative sources of finance • Implications of macroeconomic conditions for small business finance (e.g. the “credit crunch” of the early 1990s)

The Angel Finance Market: Overview • Angels are usually high net worth individuals who offer finance in the range of $50,000 to $1 million • Focus on early stages in firms’ life cycle • Invest very selectively and target small companies with high potential. Typically invest their own funds* • In 1995 estimates, there are roughly 250,000 angels making 30,000 investments per year for an aggregate of $20 billion • Double the total investment levels of venture firms but each investment is much smaller in size Source: Wiltbank & Boeker; Horvath, 2001

The Angel Finance Market: Recent Developments • Angels have begun to organize small investment groups or networks • Recent attempts to formalize the market (e.g. ACE-Net) • Usually operated by a government or non-profit (I.e. university) • Designed to reduce search and information costs • The true value of angel networks is substantially understudied • Informal angel market may be the most effective way of addressing information problems Source: Berger & Udell, 1998

Venture Capital Market: Overview I • Venture capital is defined as independent, professionally managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high growth companies • Venture capital firms take funds from institutional and/or individual investors and invest in startup firms • Seek funds from university endowments, pension funds, insurance companies etc. • Typically invest in small, young firms where there are large information asymmetries between entrepreneurs and investors • VCs spend a lot of time evaluating prospects and monitoring the firms in which they invest • VCs actively participate in strategic planning and managerial assistance in firms Source: Berger & Udell, 1998; Horvath, 2001; Gompers & Lerner, 2001

Venture Capital Market: Overview II • VC firms are typically structured as LLP with a finite life • General partners manage the fund • Make investment decisions • Playing a critical role in screening • Contracting and monitoring • Limited/investing partners contribute funds and receive funds’ profit • Typically put up 98% of funds and receive 80% of profits • General partners typcially receive a management fee plus 20% of profit Source: Berger and Udell, 1998

Exit Strategies for VC Investors • Acquisition or merger • Provides liquidity if the acquiring or merging firm is a publicly traded firm • Difficult to assess whether a failure or success • Initial public offering (IPO) • The most desirable exit strategy • Usually provides lucrative profit to the VC firm • Successful examples include Apple, Cisco, Yahoo, etc. • Liquidation • When the investment is unable to continue operating • All assets are sold off the proceeds are distributed to the investors according to pre-specified contracts Source: Berger & Udell, 1998; Horvath, 2001

Venture Capital and Entrepreneurship • Theorists favor venture capital on the basis that VC • Reduces the asymmetric information because venture capitalists are highly-informed investors • Reduces the moral hazard problem because venture capitalists usually monitor the investment closely and offer managerial assistance • Existing literature (Kortum and Lerner, 2000) show VC activities are positively associated with patent rates

Venture Capital is a Source of Capital for a Small Minority of New Businesses • VC tends to focus only on a few sectors • Minimum size of VC investment is too large for start-ups in some industries • VC sector requires a thick public market in small and new firm stocks (NASDAQ or EASDAQ) in order to provide an exit strategy for early-stage investors • The U.S. so far has provided the most fertile environment for VC Source: Berger & Udell, 1998; Horvath, 2001

Policy Factors that Influence Angel and VC Fundraising • Capital gains tax rates • Regulatory changes • Pension fund regulation • Capital market regulation (e.g., SOX) • Macroeconomic conditions • credit crunch in the early 1990s • dot-com bubble in the late 1990s • 2008 market crisis • Federal R&D expenditures • Taxation of “carried interest”

The Role of Debt Markets in SMEs finance: Trade Credit and Individual Debt • Individual debt • Accounts for a very small proportion of SMEs finance (estimated as 6% of total small business finance) • Primary source is the principal owner himself/herself • Trade credit • Plays an important role (estimated as 16% of total small business assets) • Provides a cushion during credit crunches and other shocks • Expensive for long term use • SMEs tend to reduce the use of long term trade credit once they mature Source: Berger & Udell, 1998

The Role of Debt Markets in SMEs finance: Financial Institution Debt • The most important debt provider for SMEs • SMEs tend to borrow from a single financial institution • Funds are often secured with collateral and guarantees (due to information opacity) • Borrowers are often protected by loan commitments and lines of credit • Relationship lending is very common Source: Berger & Udell, 1998

Bankruptcy Law and SMEs • When a firm is unincorporated, its debts are personal liabilities of the firm’s owner • The owner may file for personal bankruptcy if the firm fails • States have had different regulations that make it easier or harder to file for bankruptcy • Existing research offer evidence on the impact of state bankruptcy policies (varies by state prior to 2005) on • The propensity of individual to own business (Fan and White, 2003) • The decision to start business • Access to credit (Berkowitz & White 2004)

New Federal Bankruptcy Abuse Prevention and Consumer Protection Act • Took effect in October 2005 • Generally regarded as having raised the bar of filing personal bankruptcy, depending on the prior level in a particular state • Offer new research opportunities, especially in view of the financial and credit crisis of 2008-9

Personal Income Tax • It is usually assumed the higher marginal income tax rate, the lower entrepreneurial activity level • Some argue this has not been the case • Higher marginal income tax rates may encourage risk-taking by shifting more risk to the government and indeed encourage entrepreneurship (Domar and Musgrave, 1944) • SMEs offers easy channels for the owner to deduct some personal expenses; higher marginal rates may thus encourage more self-employment (Bruce, 2000) • Gentry and Hubbard (2000) contend that it is the shape of the tax schedule that is more important for entrepreneurs than the actual level of the marginal tax rate

Corporate Income Tax I • The current U.S. corporate income tax structure favors debt finance over equity • Equity finance is double-taxed • Firms can write-off the costs of debt finance • Focused tax relief to promote entrepreneurship or VC appears to be more effective in promoting entrepreneurship than a general reduction in capital gains tax (Keuschnigg & Nielsen (2004)) • General capital gains tax • Narrowly focused tax relief to VC firms • Selective reduction of the capital gains tax on entrepreneurs

Corporate Income Tax II • Poterba (1989) models how corporate income tax affects venture capital • A reduction in the capital gains tax rate would in theory lower the required expected (pre-tax) rate of return on venture investments for taxable investors • However, since most VC investors after 1980 have been tax-exempt institutions, the supply effect may have been very small • Lower capital tax rate makes it relatively more attractive to start one’s own business. Thus the demand for venture capital increases and in turn increases the equilibrium quantity of venture capital

Monetary Policy • Monetary policy changes interest rates and thus affect the real spending preferences of economic agents • Raising bank reserves reduces banks’ supply of loans, disproportionately affecting bank-dependent borrowers with few alternative sources of funds (e.g. SMEs) • Raising interest rates impair collateral values or otherwise reduce the net worth of certain borrowers, making them less creditworthy

Banking Industry Consolidation (M&As) • Larger organizations created by M&As may reduce the availability of credit to small businesses • Small banks devote a bigger share of loans to SMEs than big banks do • Studies compare small business lending by consolidating institutions before and after M&A also tend to support this conclusion • However, previous studies concentrate on the quantities of credit issued, and not the rates charged or other contract terms

Discussion Questions • A combination of information issues and costs associated with public equity issue and debt underwriting create a size threshold below which an IPO is not attractive. Berger and Udell estimated that threshold at 10 mil for public equity and 150-200 mil for public debt. Some argue that SOX has increased that threshold significantly. • If so, why would this be potentially important for entrepreneurship? • What effect might it have on small firm finance? • How would you research this issue? • What outcomes might you look at? • How might you approach an analysis of this question? • What challenges might you run into?

Entrepreneurship and Public Policy