The Capital Structure Decisions of New Firms

The average amount of bank financing [for start-up firms] is seven times greater than the average amount of insider-financed debt.

In The Capital Structure Decisions of New Firms (NBER Working Paper No. 16272), co-authors Alicia Robb and David Robinson investigate the capitalization choices that firms make in their initial year of operation. Using a novel dataset that tracks firms' funding decisions through their early years of operation, they find that these firms rely heavily on external debt sources such as bank financing and less extensively on friends and family-based funding sources.

There is a widely held view that frictions in capital markets prevent startup firms from achieving their optimal size, or indeed, from starting up at all. That view implies that startups are likely to pursue financing from informal channels. But Robb and Robinson find that funding through the use of formal debt dwarfs funding from friends and family: the average amount of bank financing is seven times greater than the average amount of insider-financed debt. Moreover, three times as many firms rely on outside debt as inside debt. This reliance on formal credit channels as opposed to personal credit cards and informal lending even holds true for the smallest firms in the sample at the earliest stages of their founding.

These findings are robust to controls for credit quality, industry, and characteristics of the business owner. Nonetheless, the authors do find that women are somewhat less likely to acquire outside debt. Also, black-owned businesses have a lower ratio of outside-to-inside financing. Businesses started by individuals without a high school degree also rely more on inside financing than others.

Extending their analysis, the authors find that a capital structure that is more heavily tilted towards formal credit channels is associated with a greater likelihood of success for the new firm. Firms that ceased operations within three years not only began smaller but also had considerably smaller proportions of outside debt-to-total capital. Moreover, capital structure decisions are especially important in the initial years: firms that accessed more external debt in the initial stages were nearly 10 percent more likely to be in the top revenue group. Even if credit conditions in 2004 -- the first year of the data set -- were unique, credit market access appears to have had an important impact on firm success.

The authors conclude that the heavy reliance on external debt underscores the importance of well functioning credit markets for the success of nascent business activity. Because startups rely so extensively on outside debt as a source of startup capital, they are especially sensitive to changes in bank lending conditions.

-- Claire Brunel