Julien Cadot Conference Small business banking and financing: a global perspective

1. A model of adaptive relationship between the entrepreneur and the bankThe case of french vineyards entrepreneurs Julien Cadot Conference Small business banking and financing: a global perspective May 25th-26th, 2007, Cagliari

2. Introduction • A demand from the Crédit Agricole (main agricultural bank) • Changes in the wine business/ Changes in the bank practices • A new relationship between the bank and the vineyards entrepreneurs ?

3. Financial specificities • Small Family Business (capital limited) • Capital-intensive • Natural risk, risk of prices • Non depreciable assets (land) • High leverage, good solvency but… … a risk of chronic liquidity crisis (Barry, 2001)

4. Bank relationship specificities(Barry, 2001) • Close-ties relationship • US banks but also Crédit Agricole: « local community entrenchment » • An alignment of preferences instead of « pure » credit rationing • Investment flexibility • An adaptive relationship

5. A long phase of very high leverage 1000€ Sales Debt 2-3 years 4-5 years 6-7 years Years after business start-up

6. The research question • What is the influence of the bank financing on the investment process? • Information asymmetry and underinvestment (initiated by Myers (1977)) • Liquidity risks and reputation (Diamond (1991)) • A role of debt maturity on the investment process

7. The modelHypothesis • Entrepreneur limited in capital • Project of different scales (« prudent » and « ambitious » project) • Value/Investment and Risk are constant along project scale • Access to long term finance depends on the initial demand and bank rating • The spread between investment and long term finance can be filled by short term debt • Liquidity risks

8. θ: project scale V(θ): value I(θ): investment p: probability of success : bank rating : long term debt γ: Short term interest rate S(D;I): Short term debt Φ(S): Cost of a liquidity crisis C(S): Total expected costs of short term debt VR: Readjusted value (value less expected costs of short term debt) The modelDefinition

9. The modelEquation • The entrepreneur decides to undertake θ • Balance sheet at t=0 • Profit at t=1 • Expected profit: In case of success : p In case of failure : (1-p)

10. The modelEquation • Readjusted Value

11. Optimal project scale under long term finance limitations $ V I VR S D θ* θ

12. A dynamic setting

13. Optimal projects in a two-period setting $ V Vr2 I D2 Vr1 D1 θ θ1* θ2*

14. The entrepreneur dilemmawhen he has the choice between two projects • The « prudent » project • Optimal at the first period • No renegotiation of short term debt • No bank rating revision when state realized • The « ambitious » project • Optimal at the second period • Reputation due to renegotiation of short term debt • Bank rating revision when state realized

15. The entrepreneur dilemmawhen he has the choice between two projectsThe decision tree Second-period entrepreneur’s profit Entrepreneur’s choice First-period entrepreneur’s profit p Bank’s rating 1-p p 1-p

16. The solution Is it profitable to be ambitious and take liquidity risks? Yes, if… First period loss < Time preference*Quality*Second-period gain

17. The solutionThe second-period expected gain - “Absolute” Value Differential Total expected costs of the short term debt surplus >0 <0 The trade-off between liquidity risk and reputation building

18. Managerial implicationsDifferent trajectories • Role of renegotiation as a condition of « growth » • Information sharing (in the course of the bank relationship or at the time of short term debt revolving or conversion in long term debt) : a necessary condition for renegotiation • Three trajectories : • The “prudent” trajectory • The “growth” trajectory • The “go-back ” trajectory

19. Managerial ImplicationsThe determinants of the “growth”trajectory • The liquidity crisis costs • The time preference • The entrepreneur’s quality • The information shared in the interim period • The ability of the bank to revise its rating

20. Value and debt for youngest business (2-4 years after start-up) V D+S D Part of short term debt linearity test: significant at 0,015%

21. Value and debt for oldest business (5-7 years after start-up) V D+S D Part of short term debt linearity test: significant at 0,012%

22. Evolution of the part of short term debt in total debt

23. …work-in-progress… …variables specification and further quantitative or qualitative evidences have to come… Thanks for your attention!