This article explores how to finance small businesses with debt and equity markets. The view of firms is based on the lens of a growth model for financials that explains how different capital structures are suitable at various points of the cycle. We explore the causes of small business financing and how capital structure changes about the size of the firm and its age. The interconnectedness of small-scale firm finance is explored, as well as the effect of macroeconomic factors. We also examine various policy and research issues, review the literature, and suggest possible topics for further research.

 

1. Introduction

The significance of the entrepreneurial business as a catalyst for economic growth attracted much public attention during the 1990s. Much of this attention stems from the idea that innovation largely depends on an active entrepreneurial industry, especially in high-tech biotechnology, information, and biotechnology areas. The incredible successes of companies like Microsoft, Genentech, and Federal Express embody the sense that the creation of new ventures is the keystone of future gains in productivity. Other recent events have raised public attention and concern about small businesses, such as the essential role of entrepreneurialism in the rise in Eastern Europe, financial crises which have posed a threat to credit access for small businesses in Asia and across the world, as well as the increasing usage of entrepreneurial alternatives for those who were forced out by corporate restructuring across the U.S.

Alongside this increased fascination with the overall field of small-scale business has been a rising interest from policymakers, regulators, academics, and policymakers in the structure and behavior the markets use to fund small-sized enterprises. The central issue in this debate questions the types of financing that businesses require and get at different stages of growth, the character of private credit and equity contracts associated with this type of financing, and the connection and substitutability of the different funding sources. Beyond this, the micro-foundations of small business financing are growing concern about the macroeconomic consequences of small business financing. For instance, the effects of the U.S. “credit crunch” of the 1990s and the impact of the growth of the banking sector on access to small business loans are also the subject of extensive analysis over the last few years. In the same way, research into monetary policy’s “credit channels” – the mechanisms that shock monetary policy could cause significant effects on small-business funding – has resulted in much discussion and analysis. Other important issues are the connection to the first public offering (IPO) marketplace and venture capital flow. Prudent man’s guidelines for institutions’ investment in venture capital and the importance of small-firm finance in the financial system are only beginning to garner interest from researchers.

The private markets that fund small-scale enterprises are fascinating due to their distinct nature from the traditional public market, which finances large companies. The private demand for debt and equity provides highly structured, complex contracts to small companies, which are typically extremely inaccessible. This differs from the bond and public stock markets, which fund fairly transparent large corporations through contracts that are usually more general.

Financial intermediaries play an essential part in the private markets as information producers that can evaluate the small-business quality and solve information issues by conducting screening, contracting, and controlling. Intermediaries evaluate potential clients through due diligence, which includes gathering data about the company, the market in which it operates, any collateral that could be pledged, and the start-up or entrepreneur’s team. This could include using information obtained from relationships between intermediaries with the business owner, the business owner, and other stakeholders. The intermediary uses the information regarding the quality of the initial small business to establish conditions for the contract when it was first created (price and ownership percentage, the collateral, restrictive covenants, maturities, and more.). The design of the contract and the payoff structure are determined following the financial capabilities of the company and the entrepreneur, along with the business’s potential and the related information issues. High-risk, high-growth companies with primarily intangible assets are more likely to receive external equity, while low-risk, low-growth companies with predominantly tangible assets are more likely to receive external debt for the reasons discussed below. To prevent the company from engaging in exploitative methods or practices, the intermediary is in charge of monitoring the business throughout the partnership to check the financial and compliance of the firm and exercises control through the use of direct participation in the making of managerial decisions by venture capitalists, or negotiating waivers of loan covenants made by commercial banks.

The articles in this special issue were gathered from an event held at New York University in May 1997, organized by both the Berkley Center for Entrepreneurial Studies and the New York University Salomon Center. They comprise long research papers, discussion panels commenting on these articles, as well as smaller contributions that are which are based upon panel discussion. The topics cover a broad array of issues, including venture capital, going public (Trester, 1998; Thakor, 1998; Bergemann & Hege, 1998; Lerner, 1998b; Benveniste and others. 1998 Flannery 1998), Angel finance (Lerner, 1998a; Prowse et al., 1998 Acs and Tarpley, 1998) and the effect of consolidation by financial institutions on lending to small businesses (Peek & Rosengren, 1998; Strahan & Weston, 1998; Rosen, 1998b; Goldberg & White, 1998; DeYoung & White, 1998) Relationship and lending (Berlin & Mester, 1998; Houston & James, 1998; Pagano, 1998; Angelini and others. 1998 Kashyap 1998; Cole 1998 Duca 1998) problems in the availability of credit (Hancock & Wilcox, 1998; Eisenbeis 1998 Avery and others. 1998 Mann et al., 1998) The availability of data sources that are new to study small-business (Wolken, 1998; Fenn & Liang, 1998; Dunkelberg, 1998) as well as the future for small-business finance (Gompers, 1998; Rosen, 1998a; Meyer, 1998).

The special issue and the conference it is based on have several motives. The first goal is to present as comprehensive a description as feasible of the character of the private credit and equity markets through which small companies are financed by utilizing current research and evidence. The second goal is to establish connections between different strands of empirical and theoretical literature that have been focusing on particular aspects of small-firm finance but have often not adequately reflected the complexity of small-business finance and the different sources of financing accessible to small businesses. The third objective is to broaden research in critical areas related to contracts, markets, and other institutions supporting small-scale firm finance. We also want to identify critical issues for future research and the new data sources available to address these concerns.

Section 2with an explanation of the peculiar nature of small-business finance and market structures that offer this financing and an overview of significant research questions. In 3, The importance that private equity market markets play in small-scale financial needs for business, 4, The significance of private markets for debt in the finance of small businesses and 5, The role of private debt markets in small business finance, we look more thoroughly the literature on the private equity market and the private debt market, respectively. Section 5 discusses the risk of small business finance to macroeconomic conditions. 6. draws some preliminary conclusions and offers suggestions for future research.

1. A brief overview of small-business finances and research topics

The most significant characteristic that distinguishes small business finance is the lack of informational transparency. In contrast to large companies, smaller ones cannot have contracts that are widely and frequently reported in the media, and agreements with their labor staff, suppliers, and customers are usually kept secret. Small businesses also do not issue securities priced continuously on the public market (in the U.S.) and cannot be registered by the Securities and Exchange Commission (SEC). Additionally, many smaller firms need to have audited financial statements available to any other financial institution. This means that small companies need to be able to communicate their high quality. In addition, small companies cannot establish reputations to indicate high-quality or non-spy behavior that can overcome the opacity of information.

The private credit and equity markets we analyze here offer specific ways to deal with these problems. As mentioned above, financial intermediaries operating within these markets are actively screened and contract with and oversee the small businesses they invest in. They also monitor their relationship to resolve these issues of information. It is claimed that the contemporary concept of intermediation in finance that encourages intermediaries to act to act as delegated monitors on behalf of their investors (e.g., Diamond, 1984; Ramakrishnan & Thakor, 1984; Boyd & Prescott, 1986) is generally an idea that applies to the provision of intermediary financing in the private market to more minor, inaccessible businesses.

2.1. Data on small business financing

The aspect of small-business financial management that has made it the most exciting field to study is informational opacity makes this one of the more difficult areas that you can do empirical research up until the last few years. Smaller businesses are not listed on the stock exchanges and are not required to publish financial data on 10K forms. Additionally, their financial data is not gathered from CRSP tapes or similar data sets commonly used in research on corporate finance. Some data are collected on the lending of regulated financial institutions, such as commercial banks and thrifts; however, these data typically need to be categorized by the lender’s size. While a few studies were done on small companies, the data were not widely distributed to researchers. There needs to be comprehensive micro data about small-sized businesses and the money they borrow from private equity and in the debt market is most likely to be the main reason. Until recently, small-business finance was one of the least researched areas of finance.

However, the situation is changing quickly since various data sets have recently been made available, making it much simpler to explain the current state of small-business finance and test current concepts of financial intermediaries and transparency of information. Data sets that contain information about U.S. small businesses comprise these: the National Survey of Small Business Finances (NSSBF) as well as the National Federation of Independent Business Survey (NFIB), both of which examine small firms for financial statements and income figures, and the recourse to financial intermediaries, trade credit and other sources of financing. The data can be used to test the validity of research questions concerning the cost and availability of various kinds of external funding and how the prices and availability differ according to the characteristics of small businesses. This Survey of Consumer Finances (SCF) provides detailed financial data from household members, including ownership of small-sized businesses and whether they provide loans to these companies or support them through the pledge of collateral from their loans or guarantees. This data permits the examination of the role of private wealth and other unique traits in financing small-scale enterprises. It is the Survey of Terms of Bank Lending (STBL) offers extensive information on the terms of contracts for certain individual loans provided by a selection of banks, including the most significant banking institutions within the U.S. Since 1997; the STBL contains credit ratings of banks for their loans, as well as information on loans offered through branches and agencies that are affiliated with the international bank ( Brady et al., 1998). Reports on bank calls (CALL) since 1993 included data on the total dollars of loans granted to small-sized businesses of credit from banks. Community Reinvestment Act (CRA) data first reported in 1997 add to these numbers by providing additional details on the number of creditors (annual earnings above $1 million) as well as their location according to census tracts ( Bostic & Canner, 1998). Data from the STBL, CALL, and CRA sources permit researchers to examine the empirical relationships between the characteristics of banks and the availability of small-business credit. The details of public equity markets are smaller than those regarding private credit markets; however, some improvements are also making progress here. Venture Economics and VentureOne provide information on the need for venture capital as well as data on venture capital and angel financing could be gleaned from NSSBF, and some info on angel finance can be obtained from the SCF as well as the Small Business Administration (SBA) offers a few details on Small Business Investment Companies (SBICs). More information about these sets of data and their use in research, and the methods to access these data sets are offered in panel discussions on particular issues with Wolken (NSSBF, SCF, STBL, CALL, CRA, and other), Dunkelberg (NFIB) and Fenn along with Liang (Venture et al. as well as other).

Information on small-sized firms and their sources of external financing has been compiled in recent times in different countries and utilized in current research projects. This includes information from Eastern Europe (Karsai et al., 1997), Germany (Elsas & Krahnen, 1997; Harhoff & Korting, 1997), Italy (Angelini et al., 1998), Norway (Ongena & Smith, 1997), Russia (Cook, 1997), Trinidad/Tobago (Storey, 1997) along with Trinidad/Tobago (Storey, 1997) and the U.K. (Cressy & Toivanen, 1997; Wright et al., 1997). The challenges of small-scale businesses’ finances will likely apply the same force to small enterprises in developing countries. However, only a few details are available from these countries ( White, 1995).

2.2. U.S. small-business finance at an enumeration

Next, we will review U.S. data. Table 1 depicts the distribution of U.S. small-business finance across different types of debt and equity. The figures in Table 1 are derived primarily from the NSSBF of 1993. NSSBF is based on book value weighted to reflect the entirety of nonfinancial, nonfarm, other than real estate U.S. companies, using an SBA classification of companies with less than 500 equivalent full-time employees. It is important to note that these figures are not 100% accurate nor reliable and are approximate estimates only intended to provide an idea of the areas where small companies receive their funds.