Directory UMM :Data Elmu:jurnal:I:International Journal of Entrepreneurial Behaviour & Research:Vol4.Issue3.1998:
The financing preferences of
small firm owners
Financing
preferences
Robert T. Hamilton
University of Canterbury, Christchurch, New Zealand, and
239
Mark A . Fox
Lincoln University, Canterbury, New Zealand
Introduction
Most small firms will never be able to raise all the funding they would like from
banks and other institutions. In this crude sense there w ill alw ay s be a
deficiency in the funding of the sector equal to the difference between the total
demand for funding and that part of this demand which qualifies for funding
suppo rt. T his paper focuses mo re narrow ly on the debt versus equity
preferences revealed in the initial and ongoing financing of small firms drawn
from a cross-section of the New Zealand economy[1]. W hile pointing to a gap in
the supply of funds, particularly institutional equity capital, previous local
research (Coopers and Lybrand, 1993) attributed most failings in the capital
market to small firm owners rather than the suppliers of funds. Owners were
portrayed as unable to understand the appropriate form of capital (debt versus
equity) and to have unrealistic expectations of deals involving the introduction
of new equity. It is the consequent restriction of choice that leads small firms to
become burdened with excessive levels of debt. We begin the paper by outlining
our research objective and the methodology used to pursue this. The sample of
small firms used in the study is then profiled. T his sets the scene for a
discussion of the initial and ongoing financing preferences revealed by small
firm owners. The paper concludes that supposed gaps in the supply of finance
to small firms might be in part the consequence rather than the cause of
financing decisions of the business owners.
Research objectives
T here is some debate in the literature over the extent to which leverage levels
vary with the size of firm and the reasons for this. International comparative
studies by Remmers et al. (1974) and Peterson and Schulman (1987) reach
different conclusions. The first of these studies found the debt/total assets ratio
to be independent of firm size. In contrast Peterson and Schulman reported
debt/total assets ratio to first rise and then fall with size of firm. W hile much
depends on the precise definition of what is to be treated as debt, it is accepted
that small owner-managed companies operate with higher levels of debt than
do larger firms (Holmes and Kent, 1991) and have a particularly high reliance on
short-term debt.
International Journal of
Entrepreneurial Behaviour &
Research, Vol. 4 No. 3, 1998,
pp. 239-248. © MCB University
Press, 1355-2554
IJEBR
4,3
240
One possible explanation for this resort to debt is that it is externally
imposed, reflecting a persistent gap in the capital market, which denies small
firms access to more appropriate forms of finance (e.g. equity and long-term
debt). Such a gap was first identified in 1931 (MacMillan Committee, 1931) and
has been rediscovered in many subsequent inquiries (e.g. Bolton Committee
Report, 1971; Stanworth and Gray, 1991, pp. 112-50; Tamari, 1980; University of
Cambridge, 1992). A n alternative explanation comes from the extension of the
work of Myers (1984) to the small firm sector (Holmes and Kent, 1991; Scherr et
al., 1990). T his suggests that small firm owners operate without targeting an
optimal debt:equity ratio and reveal a strong preference for those financing
options that minimise intrusion into their business. Following Myers (1984, p.
589), observed debt ratios will reflect the cumulative need for external finance
over an extended period and these will vary both between industries and among
firms in the same industry. The inter-industry differences will reflect differences
in asset type and intensity. Intra-industry variation reflects firm-level differences
in initial capitalisation and the ongoing capacity to retain earnings. Small firm
owners will try to meet their finance needs from a pecking order of, first, their
“own” money (p ersonal savings; retained earnings); second, sho rt-term
bo rrowings; third, longer term debt; and, least preferred of all, from the
introduction of new equity investors, which represents the maximum intrusion
(Cosh and Hughes, 1994). If small firm owners in different countries reveal such
a preference ordering, then perhaps the nature of the long-standing finance gap
needs to be reconsidered.
Methodology
The method adopted here was to investigate directly the financing preferences of
small firm owners using a postal questionnaire administered in September 1995.
We also sought to incorporate age and size effects, two related variables that
have been associated with financial structure. To deal with the first of these
dimensions we surveyed 185 “new” businesses, all less than four years old (i.e.
founded in 1992 or later) and 370 “established” businesses more than five years
of age (i.e. founded in 1989 or earlier). Businesses were also selected on the basis
of size: all employed fewer than 100 people in 1995. Samples of different ages
provided us with a basis of identifying any changes over time in the funding
preferences of small business owners.
The scope for growth does vary from industry to industry and this too will
have a bearing on financing preferences, i.e. the greater prospects for growth are
perceived to be, the g reater the need for external finance and vice versa. We
gauged growth potential in terms of the export intensity (the ratio of export
sales to total sales) for each firm’s main industry. T he higher the industry’s
export intensity, the g reater the g rowth prospects for small firms in that
industry. The use of export intensity appears reasonable on two grounds. First it
provided an ex ante measure of growth potential which is likely to be perceived
as such by all firms, small and large, involved in an industry (Frater et al., 1995,
p. 70). Second, the small size of the New Zealand market means that significant
growth ambitions tend to involve exporting[2]. This procedure based on export
intensity could only be applied to manufacturing industries and we sought a
wider cross-section. To this end we also brought into the survey small nonmanufacturing firms operating in areas which appeared to be experiencing
some g rowth. T hese areas were computer software development; inbound
tourism-related; and advertising agencies. A further reason for adding these
businesses is that they will generally have principal assets, which are both
intang ible and po rtable in contrast to the tang ible and fix ed nature of
manufacturing assets.
The survey reached a total of 555 firms spread among the range of industry
sectors described above. The composition of the survey and the response rates
are in the Appendix. T he names, addresses and number of employees were
obtained from the 1995 edition of T he New Zealand Business W ho’s W ho . The
overall response rate of 34 per cent was in line with expectations based on
comparable surveys which have been reported in the literature and sufficient for
the statistical analyses undertaken.
Financing
preferences
241
A ge and size profiles
The evidence on age and size (number of full-time employees) is set out in Table
I. Note the age range of the sample (the oldest firm having been founded in 1905)
and the relationship between age and size (full-time employees).
For ease of reference we henceforth refer to these three groups of firms as
“new” (founded 1992-1994); “established” (founded 1980-1989); and “mature”
(founded before 1980). Not only were the new businesses significantly smaller
than their older counterparts, they also had less ambition in terms of future size.
The intended maximum size of the new and established firms was 13 employees
while that for the mature group was 22, a size already attained by many of the
oldest firms. However, that more recently founded firms currently intend to be
smaller than older firms may reflect the possibility that future size is positively
related to current size. It is also the case that our measure of size (number of fulltime employees) may understate g rowth intentions where these involve
increased efficiency or greater use of outsourcing. However, these caveats are
unlikely to apply to more than a few of the firms. The profiles in Table I also have
a bearing on the targeting of publicly funded job creation schemes. T he stark
policy choice has been between funding start-ups with high rates of failure and
supporting further g rowth in established firms where the failure rates are
reduced. Here the new firms have created on average eight jobs in their first two
Period
founded
Number of
firmsa
Average age
(in years)
Current fulltime employees
Intended
maximum size
Prior to 1980
45
31
17
22
1980-1989
52
10
13
13
1992-1994
77
2
8
13
Note:
a
12 firms did not provide full data
Table I.
A ge and size profiles
IJEBR
4,3
years and, bearing in mind their intended maximum siz e, most of the
employment potential of small firms may already have been realised within
these first two years[3]. However, mature firms, though larger but less numerous
and more slowly growing, also offer the prospect of further job creation. T his
supports the view that resource allocation should be determined by the growth
potential rather than age of business (Smallbone and North, 1995).
242
Initial financing
Initial funding preferences have been the subject of international research and
are a useful focus in part because firm age has not yet become a variable capable
of influencing this decision. Peterson and Schulman (1987) provide a general
model relating the financial structure of the small firm to its age (or size). Here
the ownership ratio (i.e. shareholders’ funds as a proportion of total assets) is at
its highest in new firms; then falls for a time with age/size, before rising again in
larger mature businesses. This general pattern established by these authors in
12 countries has been explained in terms of information asymmetry and agency
problems. The problem of information asymmetry is endemic to small business
lending and it compounds concerns about the principal (bank)-agent (small
business) relationship (see Storey, 1994, pp. 204-52). The issue here is the ability
of the lender to control the borrower. Indeed the borrower may adopt high risk,
high reward strategies secure in the knowledge that their risk is fixed and that
all capital gains will accrue to them as owners. T he lender remains with the
downside risk of writing-off the loan that is not compensated by the prospect of
gain if the business performs well. Monitoring is possible to some extent but its
costs are largely independent of loan size, i.e. the agency costs are highest for the
smaller loans that we would expect in the new business area. Consequently, we
would expect the bulk of the initial financing to have come from the founder. The
findings are contained in Table II that reports the percentages of firms reliant on
the different sources as their main source of initial funding.
W hile the savings of the founders continue to be the dominant source of initial
capital[4], the proportion of businesses dependent on such funding fell from 76
per cent of the oldest firms to 60 per cent of the newest group; a difference in
proportions which is significant at the 10 per cent level. T he recent increased
involvement of financial institutions (mainly banks) in funding new businesses
may indicate an improved ability on their part to monitor and control new
Before 1980
Period founded
1980-1989
1992-1994
76
73
60
4
8
8
Financial institutions
11
13
24
Other main sourcesa
9
6
8
Main source of initial funding
Founder’s own savings
Founder’s immediate family
Table II.
Sources of initial
financing of small
firms (per cent)
Note:
a
These included friends of the founder, large companies and small local firms
enterprise lending. It may also point to a realisation by the banks that for new
firms, information asymmetry may now operate in their favour. This would be
so if bank staff were better able than the founder to assess the prospects of the
proposed business (Storey, 1994, p. 206). But a more likely explanation is that
there are just more new firms around who are willing and able to provide the
collateral on the basis of which limited loan funds can be allocated (Cowling and
Westhead, 1996). Interviews conducted with senior bankers confirmed that this
greater availability of collateral was indeed a key factor in the change[5].
Two other supply-side developments appear to have contributed to this
apparent increase in institutional involvement with new business. First, the
banks were discovering that their original customers’ financing needs were
changing. Many of those who had become customers to obtain housing loans
were now seeking new loans for business purposes, a development seen as
positive by the banks. Second, most banks did not distinguish between housing
and business loans. T he loans would be secured against the borrower’s house
but their purpose was to support the financial requirements of a new business.
Capital adequacy rules adopted by the Reserve Bank of New Zealand, as a
signatory to the Basle Accord, classify housing mortgages more favourably than
business loans for the purpose of determining a bank’s capital adequacy ratios.
T his translates into a lower cost of borrowing for businesses that could be
funded in this manner. The banks, by meeting their customers’ requirements in
this way, established not only a profitable small business lending base but also
the diversified income stream favoured by the international rating agencies.
Financing
preferences
243
Ongoing financing
If we follow the theory of Peterson and Schulman (1987), we would expect that
as time passes firms become more acceptable to lenders, i.e. debt levels will rise
causing ownership ratios to fall. Our information on financial structure is
confined to measures of the ownership ratio that we asked our respondents to
compute from their most recent balance sheet. We confined the measure of
financial structure in this way because, measured as shareholders funds/total
assets, it is among the easier ratios to compute and did not require us or the
respondent to judge what is debt and how to distinguish among short, medium
and long -term debt. T he ow nership ratio is also v ital from the lender’s
perspective, a matter we return to later in this paper.
T he survey evidence relating to the ongoing financing preferences of these
small firm owners is set out in Table III.
Period
founded
Ownership ratio
(per cent)
Percentage of profit retained
(intended)
Percentage of firms able
to retain intended share
Prior to 1980
44.0
44.6
73
1980-1989
45.6
40.9
79
1992-1994
44.3
53.1
60
Table III.
Ongoing financing
preferences of small
firms
IJEBR
4,3
244
In fact the average ownership ratios between our samples of different ages are
not significantly different, contrary to expectations based on the findings of
Peterson and Schulman (1987). T his then opens up the question of how small
firm owners do provide for the ongoing financing needs of their businesses.
Our first approach to this w as to discover the immediate financing
preferences of these owners and here we found no significant differences among
new, established and mature firms. If they had to raise more ongoing funding in
the next three months, the preferences expressed were indeed unaffected by
time in business. Of the new group, 41 per cent would seek only debt, as would
41 per cent of the established g roup. T he mature firms appeared the most
wedded to debt with 54 per cent confining any new funding to this form of
finance. However, as we indicated, the difference in these proportions (54 per
cent versus 41 per cent) is not significant. T he issue of ownership and control
was, as expected, central to the attitude towards introducing new equity. On
average 41 per cent of the owners would consider a new equity investor if this
did not affect their control of the business but, if new equity meant some
weakening or sharing of control, then only 22 per cent of owners would be
interested. Further scrutiny of these responses also suggested that many who
would be prepared to share or lose control were those who were keen to find a
way to realise their investment in the business, i.e. they saw new equity as their
way out of the business.
T he picture that emerges here is consistent with the pecking order theory
proposed by Myers (1984). T he financing preferences at the outset are
constrained towards owners’ equity (personal savings) but then establish a
preference for external debt over equity which is independent of the age of the
small firm. Within this set of preferences, we would expect retained earnings to
feature as a prominent source of internal funding, particularly so for new
businesses that have fewer financing options available to them. However, while
new firms may desire to retain a higher share of earnings, the economics of
business start-up are such as to militate against high retention ratios. In other
words, we might expect to observe more difficulty in attaining the higher
desired rates of retention in new firms. These expectations are borne out by the
data presented in Table III above. T he new firms were aiming to retain most
profit (averaging 53.1 per cent), higher than either of the other groups and
significantly higher (5 per cent level) than the 40.9 per cent of the established
group of firms. These intended retention rates have also to be considered in the
light of the rather modest growth intentions of these firms that we commented
on above. This points to a preference to internalise the financing of these firms.
However, at the time of the survey, only 60 per cent of the new firms were able
to achieve their intended rate of retention, less than either of the older groupings
and significantly below (5 per cent level) the 79 per cent reported for established
firms.
This suggests an over-emphasis on retained earnings, one that exceeds both
the intended growth rates of the business and their ability to attain their desired
retention rate. W hen additional funding must come from beyond the firm, we
have seen that debt is much preferred over new equity partners. A s noted
previously, some have interpreted this preference for debt to be due to the
knowledge g ap on the part of small firm owners, i.e. that owners fail to
comprehend the differing cash flow implications of debt versus equity. We do
not support this contention. Debt is the strongly preferred form of external
funding despite carrying with it the more onerous and complex cashflow
implications, e.g. regular scheduling of interest payments as a prior charge and
scheduling the loan repayment over the term of the loan. The real issue here is
how these small single-manager businesses go about framing their funding
decisions. T hey tend not to operate with much forward planning and so most
funding decisions end up presenting themselves as cash problems. W hen the
need is to raise cash quickly the dominant preference ordering puts the most
easily accessed debt at the head of all external sources (but behind internal
sources). A predilection towards debt is therefore manifest but this can be
explained without resort to gaps in either knowledge or in supply of particular
types of funds. These small firm owners simply prefer to have all of debt-laden
business rather than merely a share in the control of a relatively debt-free
operation.
T his draws attention to the attitude of small business owners to their
ownership ratios, i.e. the extent to which their shareholder funds account for the
total assets of the business. This ratio, or correlates of it, feature prominently in
financial theory and in any discussion of small business lending seen from the
lender’s perspective. Lenders are influenced by knowing how much the owners
have actually been able to fund the assets of the business. If this share is less
than say 50 per cent, then a lender will begin to question the commitment of the
owners to the business and hence be reluctant to lend without some increase in
equity. But if financing preferences were such as to rank internal ahead of
external sources, and new equity as the least preferred of all external sources,
then we would expect small firm owners to be much less concerned than
lenders with their ownership ratios. We obtained ownership ratios from 120
businesses who also gave their opinion on the number they had just computed.
These data are in Table IV.
Opinions of owners
Too high
A bout right
Up to 25%
Number in each ownership range
26-50%
51-75%
76-100%
Financing
preferences
245
Total
0
1
4
3
8
6
19
12
4
41
Too low
14
13
2
0
29
Not concerned
11
8
10
13
42
Total
31
41
28
20
120
Table IV.
Business owners’
opinions on their
ownership ratios
IJEBR
4,3
246
The first point to note is that 35 per cent of the owners said they were simply
“not concerned” with the ownership ratio even though this was no greater than
50 per cent in 19 of the 42 businesses. In other words, this key ratio is unlikely
to influence their financial preferences. To put this another way, of the 72
owners with ratios less than 50 per cent, only 27 (or 38 per cent) expressed the
opinion that their ratio was “too low”. However, while 45 per cent of owners (14
out of 31) do concede that their ownership ratios of 25 per cent or less are indeed
“too low”, if owners in this group had to raise new ongoing funding in the next
three months, only five of the 31 (16 per cent) would seek equity only: 13 (42 per
cent) would attempt to raise more debt. Here again it seems that the financial
preferences of many owners are more pervasive than the consequences of these
for the ongoing funding and indeed stability of their businesses.
Conclusions
We are not suggesting here that all new and small firms either could or should
be funded. Bank lending, for example, must be subject to rationing. W hat we do
propose is that debt levels in small firms do reflect a demand-side preference
ordering and are not just the manifestation of supply-side deficiencies. In
drawing this discussion to its end, there is an apt statement of small firm
financing decisions in Norton (1991, p. 174) as follows:
In small business and entrepreneurial firms, managerial beliefs and desires will play an
especially important role in determining capital structure ... [and] models must include the role
of management preferences, beliefs, and expectations if we are to better understand capital
structure policy.
Our evidence g ained directly from small business owners from a range of
industry sectors in New Zealand lends support to this view. T hese owners do
appear to have a set of preferences over funding sources which, for the most
part, are independent of age (or size) and have little to do with the consequent
financial structures of their balance sheets. Internal funding sources
commencing with the cash savings of the founders and then extending to
retained earnings are the most preferred since these do least to inhibit the
independence of the owner. T his view of how the financing preferences of
owners are established enables one to explain small firm financial structures
without resort to any shortcomings or gaps in the supply of finance. Indeed one
may even argue that any apparent gap is in part a consequence rather than a
cause of the financing preferences of small firm owners.
Notes
1. T he research was commissioned by the New Zealand Ministry of Commerce and we are
particularly grateful to Richard Dore and Matt Roy for their support. The views expressed
here are those of the authors alone.
2. Small firms (less than 100 employees) were selected into the survey from a range of
manufacturing industries representing either end of the range of the spectrum of export
intensity, e.g. medical and surgical equipment with an export intensity of 0.655 and general
printing and publishing (0.004).
3. It also seems that most new businesses will survive two years. Of the 22,946 businesses
created in New Zealand in 1988, 69 per cent were still operating in 1990. Source: Business
A ctivity 1992-93.
Financing
preferences
4. It is interesting to note that our combined data for New Zealand are almost identical to the
percentages reported for a sample of Australian firms in Scott and Kent (1991).
5. T his recent greater involvement of financial institutions may also be one reason why 54
per cent of the newer group were operating with a written business plan compared with
only 29 per cent of the older firms (a difference significant at the 5 per cent level).
References
Bolton Committee Report (1971), Report of the Committee of Inquiry on Small Firms, HMSO,
London.
Business A ctivity 1992-93 , (1994), Statistics New Zealand, Wellington.
Coopers and Lybrand (1993), Factors A ffecting the Supply of Capital for Small Company Growth,
New Zealand Ministry of Commerce, Wellington.
Cosh, A .D. and Hughes, A . (1994), “Size, financial structure and profitability”, in Hughes, A . and
Storey, D.J. (Eds), Finance and the Small Firm, Routledge, London.
Cowling, M. and Westhead, P. (1996), “Bank lending decisions and small firms: does size
matter?”, International Journal of Entrepreneurial and Behavioural Research, Vol. 2 No. 2,
pp. 52-68.
Frater, P., Stuart, G., Rose, D. and A ndrews, G. (1995), T he New Zealand Innovation Environment,
The Berl Foundation, Wellington.
Holmes, S. and Kent, P. (1991), “A n empirical analysis of the financial structure of small and large
Australian manufacturing enterprises”, Journal of Small Business Finance, Vol. 1 No. 2, pp.
141-54.
MacMillan Committee (1931), Report of the Committee on Finance and Industry, HMSO, London.
Myers, S. (1984), “The capital structure puzzle”, Journal of Finance, July, pp. 595-62.
New Zealand Business W ho’s W ho (1995), Financial Press, Wellington.
Norton, E. (1991), “Capital structure and small growth firms”, Journal of Small Business Finance,
Vol. 1 No. 2, pp. 161-77.
Peterson, R. and Shulman, J. (1987), “Capital structure of g rowing small firms: a twelve
country study on becoming bankable”, International Small Business Journal, Vol. 5 No. 4,
pp. 10-22.
Remmers, L., Stonehill, A ., Wright, R. and Beekhuisen, T. (1974), “Industry and size as debt ratio
determinants in manufacturing internationally”, Financial Management, Vol. 36 No. 3,
pp. 879-88.
Scherr, F., Sugrue, T. and Ward, J. (April 1990), “Financing the small firm startup: determinants
of debt use”, Proceedings Second A nnual Small Firm Finance Research Symposium.
Smallbone, D. and North, D. (1995), “Targeting established SMEs: does their age matter?”,
International Small Business Journal, Vol. 13 No. 3, pp. 47-64.
Stanworth, J. and Gray, C. (1991), Bolton 20 Years On: T he Small Firm in the 1990s, Paul
Chapman, London.
Storey, D.J. (1994), Understanding the Small Business Sector, Routledge, London.
Tamari, M. (1980), “T he financial structure of the small firm – an international comparison of
corporate accounts in the USA , France, UK, Israel and Japan”, A merican Journal of Small
Business, April-June, pp. 20-34.
University of Cambridge (1992), T he State of British Enterprise: Growth, Innovation &
Competitive A dvantage in Small and Medium-sized Firms, Small Business Research Centre,
Cambridge.
247
IJEBR
4,3
248
Table A I.
Survey design and
response rates
A ppendix
Industry type
Export
intensity
A ge of
firms
Manufacturing
Manufacturing
Manufacturing
Manufacturing
Non-manufacturing
Non-manufacturing
High
Low
High
Low
–
–
New
New
Established
Established
New
Established
Totals
Number
sent
Usable
replies
Response
rate (% )
54
56
108
112
75
150
21
23
27
30
33
52
39
41
25
27
44
35
555
186
34
small firm owners
Financing
preferences
Robert T. Hamilton
University of Canterbury, Christchurch, New Zealand, and
239
Mark A . Fox
Lincoln University, Canterbury, New Zealand
Introduction
Most small firms will never be able to raise all the funding they would like from
banks and other institutions. In this crude sense there w ill alw ay s be a
deficiency in the funding of the sector equal to the difference between the total
demand for funding and that part of this demand which qualifies for funding
suppo rt. T his paper focuses mo re narrow ly on the debt versus equity
preferences revealed in the initial and ongoing financing of small firms drawn
from a cross-section of the New Zealand economy[1]. W hile pointing to a gap in
the supply of funds, particularly institutional equity capital, previous local
research (Coopers and Lybrand, 1993) attributed most failings in the capital
market to small firm owners rather than the suppliers of funds. Owners were
portrayed as unable to understand the appropriate form of capital (debt versus
equity) and to have unrealistic expectations of deals involving the introduction
of new equity. It is the consequent restriction of choice that leads small firms to
become burdened with excessive levels of debt. We begin the paper by outlining
our research objective and the methodology used to pursue this. The sample of
small firms used in the study is then profiled. T his sets the scene for a
discussion of the initial and ongoing financing preferences revealed by small
firm owners. The paper concludes that supposed gaps in the supply of finance
to small firms might be in part the consequence rather than the cause of
financing decisions of the business owners.
Research objectives
T here is some debate in the literature over the extent to which leverage levels
vary with the size of firm and the reasons for this. International comparative
studies by Remmers et al. (1974) and Peterson and Schulman (1987) reach
different conclusions. The first of these studies found the debt/total assets ratio
to be independent of firm size. In contrast Peterson and Schulman reported
debt/total assets ratio to first rise and then fall with size of firm. W hile much
depends on the precise definition of what is to be treated as debt, it is accepted
that small owner-managed companies operate with higher levels of debt than
do larger firms (Holmes and Kent, 1991) and have a particularly high reliance on
short-term debt.
International Journal of
Entrepreneurial Behaviour &
Research, Vol. 4 No. 3, 1998,
pp. 239-248. © MCB University
Press, 1355-2554
IJEBR
4,3
240
One possible explanation for this resort to debt is that it is externally
imposed, reflecting a persistent gap in the capital market, which denies small
firms access to more appropriate forms of finance (e.g. equity and long-term
debt). Such a gap was first identified in 1931 (MacMillan Committee, 1931) and
has been rediscovered in many subsequent inquiries (e.g. Bolton Committee
Report, 1971; Stanworth and Gray, 1991, pp. 112-50; Tamari, 1980; University of
Cambridge, 1992). A n alternative explanation comes from the extension of the
work of Myers (1984) to the small firm sector (Holmes and Kent, 1991; Scherr et
al., 1990). T his suggests that small firm owners operate without targeting an
optimal debt:equity ratio and reveal a strong preference for those financing
options that minimise intrusion into their business. Following Myers (1984, p.
589), observed debt ratios will reflect the cumulative need for external finance
over an extended period and these will vary both between industries and among
firms in the same industry. The inter-industry differences will reflect differences
in asset type and intensity. Intra-industry variation reflects firm-level differences
in initial capitalisation and the ongoing capacity to retain earnings. Small firm
owners will try to meet their finance needs from a pecking order of, first, their
“own” money (p ersonal savings; retained earnings); second, sho rt-term
bo rrowings; third, longer term debt; and, least preferred of all, from the
introduction of new equity investors, which represents the maximum intrusion
(Cosh and Hughes, 1994). If small firm owners in different countries reveal such
a preference ordering, then perhaps the nature of the long-standing finance gap
needs to be reconsidered.
Methodology
The method adopted here was to investigate directly the financing preferences of
small firm owners using a postal questionnaire administered in September 1995.
We also sought to incorporate age and size effects, two related variables that
have been associated with financial structure. To deal with the first of these
dimensions we surveyed 185 “new” businesses, all less than four years old (i.e.
founded in 1992 or later) and 370 “established” businesses more than five years
of age (i.e. founded in 1989 or earlier). Businesses were also selected on the basis
of size: all employed fewer than 100 people in 1995. Samples of different ages
provided us with a basis of identifying any changes over time in the funding
preferences of small business owners.
The scope for growth does vary from industry to industry and this too will
have a bearing on financing preferences, i.e. the greater prospects for growth are
perceived to be, the g reater the need for external finance and vice versa. We
gauged growth potential in terms of the export intensity (the ratio of export
sales to total sales) for each firm’s main industry. T he higher the industry’s
export intensity, the g reater the g rowth prospects for small firms in that
industry. The use of export intensity appears reasonable on two grounds. First it
provided an ex ante measure of growth potential which is likely to be perceived
as such by all firms, small and large, involved in an industry (Frater et al., 1995,
p. 70). Second, the small size of the New Zealand market means that significant
growth ambitions tend to involve exporting[2]. This procedure based on export
intensity could only be applied to manufacturing industries and we sought a
wider cross-section. To this end we also brought into the survey small nonmanufacturing firms operating in areas which appeared to be experiencing
some g rowth. T hese areas were computer software development; inbound
tourism-related; and advertising agencies. A further reason for adding these
businesses is that they will generally have principal assets, which are both
intang ible and po rtable in contrast to the tang ible and fix ed nature of
manufacturing assets.
The survey reached a total of 555 firms spread among the range of industry
sectors described above. The composition of the survey and the response rates
are in the Appendix. T he names, addresses and number of employees were
obtained from the 1995 edition of T he New Zealand Business W ho’s W ho . The
overall response rate of 34 per cent was in line with expectations based on
comparable surveys which have been reported in the literature and sufficient for
the statistical analyses undertaken.
Financing
preferences
241
A ge and size profiles
The evidence on age and size (number of full-time employees) is set out in Table
I. Note the age range of the sample (the oldest firm having been founded in 1905)
and the relationship between age and size (full-time employees).
For ease of reference we henceforth refer to these three groups of firms as
“new” (founded 1992-1994); “established” (founded 1980-1989); and “mature”
(founded before 1980). Not only were the new businesses significantly smaller
than their older counterparts, they also had less ambition in terms of future size.
The intended maximum size of the new and established firms was 13 employees
while that for the mature group was 22, a size already attained by many of the
oldest firms. However, that more recently founded firms currently intend to be
smaller than older firms may reflect the possibility that future size is positively
related to current size. It is also the case that our measure of size (number of fulltime employees) may understate g rowth intentions where these involve
increased efficiency or greater use of outsourcing. However, these caveats are
unlikely to apply to more than a few of the firms. The profiles in Table I also have
a bearing on the targeting of publicly funded job creation schemes. T he stark
policy choice has been between funding start-ups with high rates of failure and
supporting further g rowth in established firms where the failure rates are
reduced. Here the new firms have created on average eight jobs in their first two
Period
founded
Number of
firmsa
Average age
(in years)
Current fulltime employees
Intended
maximum size
Prior to 1980
45
31
17
22
1980-1989
52
10
13
13
1992-1994
77
2
8
13
Note:
a
12 firms did not provide full data
Table I.
A ge and size profiles
IJEBR
4,3
years and, bearing in mind their intended maximum siz e, most of the
employment potential of small firms may already have been realised within
these first two years[3]. However, mature firms, though larger but less numerous
and more slowly growing, also offer the prospect of further job creation. T his
supports the view that resource allocation should be determined by the growth
potential rather than age of business (Smallbone and North, 1995).
242
Initial financing
Initial funding preferences have been the subject of international research and
are a useful focus in part because firm age has not yet become a variable capable
of influencing this decision. Peterson and Schulman (1987) provide a general
model relating the financial structure of the small firm to its age (or size). Here
the ownership ratio (i.e. shareholders’ funds as a proportion of total assets) is at
its highest in new firms; then falls for a time with age/size, before rising again in
larger mature businesses. This general pattern established by these authors in
12 countries has been explained in terms of information asymmetry and agency
problems. The problem of information asymmetry is endemic to small business
lending and it compounds concerns about the principal (bank)-agent (small
business) relationship (see Storey, 1994, pp. 204-52). The issue here is the ability
of the lender to control the borrower. Indeed the borrower may adopt high risk,
high reward strategies secure in the knowledge that their risk is fixed and that
all capital gains will accrue to them as owners. T he lender remains with the
downside risk of writing-off the loan that is not compensated by the prospect of
gain if the business performs well. Monitoring is possible to some extent but its
costs are largely independent of loan size, i.e. the agency costs are highest for the
smaller loans that we would expect in the new business area. Consequently, we
would expect the bulk of the initial financing to have come from the founder. The
findings are contained in Table II that reports the percentages of firms reliant on
the different sources as their main source of initial funding.
W hile the savings of the founders continue to be the dominant source of initial
capital[4], the proportion of businesses dependent on such funding fell from 76
per cent of the oldest firms to 60 per cent of the newest group; a difference in
proportions which is significant at the 10 per cent level. T he recent increased
involvement of financial institutions (mainly banks) in funding new businesses
may indicate an improved ability on their part to monitor and control new
Before 1980
Period founded
1980-1989
1992-1994
76
73
60
4
8
8
Financial institutions
11
13
24
Other main sourcesa
9
6
8
Main source of initial funding
Founder’s own savings
Founder’s immediate family
Table II.
Sources of initial
financing of small
firms (per cent)
Note:
a
These included friends of the founder, large companies and small local firms
enterprise lending. It may also point to a realisation by the banks that for new
firms, information asymmetry may now operate in their favour. This would be
so if bank staff were better able than the founder to assess the prospects of the
proposed business (Storey, 1994, p. 206). But a more likely explanation is that
there are just more new firms around who are willing and able to provide the
collateral on the basis of which limited loan funds can be allocated (Cowling and
Westhead, 1996). Interviews conducted with senior bankers confirmed that this
greater availability of collateral was indeed a key factor in the change[5].
Two other supply-side developments appear to have contributed to this
apparent increase in institutional involvement with new business. First, the
banks were discovering that their original customers’ financing needs were
changing. Many of those who had become customers to obtain housing loans
were now seeking new loans for business purposes, a development seen as
positive by the banks. Second, most banks did not distinguish between housing
and business loans. T he loans would be secured against the borrower’s house
but their purpose was to support the financial requirements of a new business.
Capital adequacy rules adopted by the Reserve Bank of New Zealand, as a
signatory to the Basle Accord, classify housing mortgages more favourably than
business loans for the purpose of determining a bank’s capital adequacy ratios.
T his translates into a lower cost of borrowing for businesses that could be
funded in this manner. The banks, by meeting their customers’ requirements in
this way, established not only a profitable small business lending base but also
the diversified income stream favoured by the international rating agencies.
Financing
preferences
243
Ongoing financing
If we follow the theory of Peterson and Schulman (1987), we would expect that
as time passes firms become more acceptable to lenders, i.e. debt levels will rise
causing ownership ratios to fall. Our information on financial structure is
confined to measures of the ownership ratio that we asked our respondents to
compute from their most recent balance sheet. We confined the measure of
financial structure in this way because, measured as shareholders funds/total
assets, it is among the easier ratios to compute and did not require us or the
respondent to judge what is debt and how to distinguish among short, medium
and long -term debt. T he ow nership ratio is also v ital from the lender’s
perspective, a matter we return to later in this paper.
T he survey evidence relating to the ongoing financing preferences of these
small firm owners is set out in Table III.
Period
founded
Ownership ratio
(per cent)
Percentage of profit retained
(intended)
Percentage of firms able
to retain intended share
Prior to 1980
44.0
44.6
73
1980-1989
45.6
40.9
79
1992-1994
44.3
53.1
60
Table III.
Ongoing financing
preferences of small
firms
IJEBR
4,3
244
In fact the average ownership ratios between our samples of different ages are
not significantly different, contrary to expectations based on the findings of
Peterson and Schulman (1987). T his then opens up the question of how small
firm owners do provide for the ongoing financing needs of their businesses.
Our first approach to this w as to discover the immediate financing
preferences of these owners and here we found no significant differences among
new, established and mature firms. If they had to raise more ongoing funding in
the next three months, the preferences expressed were indeed unaffected by
time in business. Of the new group, 41 per cent would seek only debt, as would
41 per cent of the established g roup. T he mature firms appeared the most
wedded to debt with 54 per cent confining any new funding to this form of
finance. However, as we indicated, the difference in these proportions (54 per
cent versus 41 per cent) is not significant. T he issue of ownership and control
was, as expected, central to the attitude towards introducing new equity. On
average 41 per cent of the owners would consider a new equity investor if this
did not affect their control of the business but, if new equity meant some
weakening or sharing of control, then only 22 per cent of owners would be
interested. Further scrutiny of these responses also suggested that many who
would be prepared to share or lose control were those who were keen to find a
way to realise their investment in the business, i.e. they saw new equity as their
way out of the business.
T he picture that emerges here is consistent with the pecking order theory
proposed by Myers (1984). T he financing preferences at the outset are
constrained towards owners’ equity (personal savings) but then establish a
preference for external debt over equity which is independent of the age of the
small firm. Within this set of preferences, we would expect retained earnings to
feature as a prominent source of internal funding, particularly so for new
businesses that have fewer financing options available to them. However, while
new firms may desire to retain a higher share of earnings, the economics of
business start-up are such as to militate against high retention ratios. In other
words, we might expect to observe more difficulty in attaining the higher
desired rates of retention in new firms. These expectations are borne out by the
data presented in Table III above. T he new firms were aiming to retain most
profit (averaging 53.1 per cent), higher than either of the other groups and
significantly higher (5 per cent level) than the 40.9 per cent of the established
group of firms. These intended retention rates have also to be considered in the
light of the rather modest growth intentions of these firms that we commented
on above. This points to a preference to internalise the financing of these firms.
However, at the time of the survey, only 60 per cent of the new firms were able
to achieve their intended rate of retention, less than either of the older groupings
and significantly below (5 per cent level) the 79 per cent reported for established
firms.
This suggests an over-emphasis on retained earnings, one that exceeds both
the intended growth rates of the business and their ability to attain their desired
retention rate. W hen additional funding must come from beyond the firm, we
have seen that debt is much preferred over new equity partners. A s noted
previously, some have interpreted this preference for debt to be due to the
knowledge g ap on the part of small firm owners, i.e. that owners fail to
comprehend the differing cash flow implications of debt versus equity. We do
not support this contention. Debt is the strongly preferred form of external
funding despite carrying with it the more onerous and complex cashflow
implications, e.g. regular scheduling of interest payments as a prior charge and
scheduling the loan repayment over the term of the loan. The real issue here is
how these small single-manager businesses go about framing their funding
decisions. T hey tend not to operate with much forward planning and so most
funding decisions end up presenting themselves as cash problems. W hen the
need is to raise cash quickly the dominant preference ordering puts the most
easily accessed debt at the head of all external sources (but behind internal
sources). A predilection towards debt is therefore manifest but this can be
explained without resort to gaps in either knowledge or in supply of particular
types of funds. These small firm owners simply prefer to have all of debt-laden
business rather than merely a share in the control of a relatively debt-free
operation.
T his draws attention to the attitude of small business owners to their
ownership ratios, i.e. the extent to which their shareholder funds account for the
total assets of the business. This ratio, or correlates of it, feature prominently in
financial theory and in any discussion of small business lending seen from the
lender’s perspective. Lenders are influenced by knowing how much the owners
have actually been able to fund the assets of the business. If this share is less
than say 50 per cent, then a lender will begin to question the commitment of the
owners to the business and hence be reluctant to lend without some increase in
equity. But if financing preferences were such as to rank internal ahead of
external sources, and new equity as the least preferred of all external sources,
then we would expect small firm owners to be much less concerned than
lenders with their ownership ratios. We obtained ownership ratios from 120
businesses who also gave their opinion on the number they had just computed.
These data are in Table IV.
Opinions of owners
Too high
A bout right
Up to 25%
Number in each ownership range
26-50%
51-75%
76-100%
Financing
preferences
245
Total
0
1
4
3
8
6
19
12
4
41
Too low
14
13
2
0
29
Not concerned
11
8
10
13
42
Total
31
41
28
20
120
Table IV.
Business owners’
opinions on their
ownership ratios
IJEBR
4,3
246
The first point to note is that 35 per cent of the owners said they were simply
“not concerned” with the ownership ratio even though this was no greater than
50 per cent in 19 of the 42 businesses. In other words, this key ratio is unlikely
to influence their financial preferences. To put this another way, of the 72
owners with ratios less than 50 per cent, only 27 (or 38 per cent) expressed the
opinion that their ratio was “too low”. However, while 45 per cent of owners (14
out of 31) do concede that their ownership ratios of 25 per cent or less are indeed
“too low”, if owners in this group had to raise new ongoing funding in the next
three months, only five of the 31 (16 per cent) would seek equity only: 13 (42 per
cent) would attempt to raise more debt. Here again it seems that the financial
preferences of many owners are more pervasive than the consequences of these
for the ongoing funding and indeed stability of their businesses.
Conclusions
We are not suggesting here that all new and small firms either could or should
be funded. Bank lending, for example, must be subject to rationing. W hat we do
propose is that debt levels in small firms do reflect a demand-side preference
ordering and are not just the manifestation of supply-side deficiencies. In
drawing this discussion to its end, there is an apt statement of small firm
financing decisions in Norton (1991, p. 174) as follows:
In small business and entrepreneurial firms, managerial beliefs and desires will play an
especially important role in determining capital structure ... [and] models must include the role
of management preferences, beliefs, and expectations if we are to better understand capital
structure policy.
Our evidence g ained directly from small business owners from a range of
industry sectors in New Zealand lends support to this view. T hese owners do
appear to have a set of preferences over funding sources which, for the most
part, are independent of age (or size) and have little to do with the consequent
financial structures of their balance sheets. Internal funding sources
commencing with the cash savings of the founders and then extending to
retained earnings are the most preferred since these do least to inhibit the
independence of the owner. T his view of how the financing preferences of
owners are established enables one to explain small firm financial structures
without resort to any shortcomings or gaps in the supply of finance. Indeed one
may even argue that any apparent gap is in part a consequence rather than a
cause of the financing preferences of small firm owners.
Notes
1. T he research was commissioned by the New Zealand Ministry of Commerce and we are
particularly grateful to Richard Dore and Matt Roy for their support. The views expressed
here are those of the authors alone.
2. Small firms (less than 100 employees) were selected into the survey from a range of
manufacturing industries representing either end of the range of the spectrum of export
intensity, e.g. medical and surgical equipment with an export intensity of 0.655 and general
printing and publishing (0.004).
3. It also seems that most new businesses will survive two years. Of the 22,946 businesses
created in New Zealand in 1988, 69 per cent were still operating in 1990. Source: Business
A ctivity 1992-93.
Financing
preferences
4. It is interesting to note that our combined data for New Zealand are almost identical to the
percentages reported for a sample of Australian firms in Scott and Kent (1991).
5. T his recent greater involvement of financial institutions may also be one reason why 54
per cent of the newer group were operating with a written business plan compared with
only 29 per cent of the older firms (a difference significant at the 5 per cent level).
References
Bolton Committee Report (1971), Report of the Committee of Inquiry on Small Firms, HMSO,
London.
Business A ctivity 1992-93 , (1994), Statistics New Zealand, Wellington.
Coopers and Lybrand (1993), Factors A ffecting the Supply of Capital for Small Company Growth,
New Zealand Ministry of Commerce, Wellington.
Cosh, A .D. and Hughes, A . (1994), “Size, financial structure and profitability”, in Hughes, A . and
Storey, D.J. (Eds), Finance and the Small Firm, Routledge, London.
Cowling, M. and Westhead, P. (1996), “Bank lending decisions and small firms: does size
matter?”, International Journal of Entrepreneurial and Behavioural Research, Vol. 2 No. 2,
pp. 52-68.
Frater, P., Stuart, G., Rose, D. and A ndrews, G. (1995), T he New Zealand Innovation Environment,
The Berl Foundation, Wellington.
Holmes, S. and Kent, P. (1991), “A n empirical analysis of the financial structure of small and large
Australian manufacturing enterprises”, Journal of Small Business Finance, Vol. 1 No. 2, pp.
141-54.
MacMillan Committee (1931), Report of the Committee on Finance and Industry, HMSO, London.
Myers, S. (1984), “The capital structure puzzle”, Journal of Finance, July, pp. 595-62.
New Zealand Business W ho’s W ho (1995), Financial Press, Wellington.
Norton, E. (1991), “Capital structure and small growth firms”, Journal of Small Business Finance,
Vol. 1 No. 2, pp. 161-77.
Peterson, R. and Shulman, J. (1987), “Capital structure of g rowing small firms: a twelve
country study on becoming bankable”, International Small Business Journal, Vol. 5 No. 4,
pp. 10-22.
Remmers, L., Stonehill, A ., Wright, R. and Beekhuisen, T. (1974), “Industry and size as debt ratio
determinants in manufacturing internationally”, Financial Management, Vol. 36 No. 3,
pp. 879-88.
Scherr, F., Sugrue, T. and Ward, J. (April 1990), “Financing the small firm startup: determinants
of debt use”, Proceedings Second A nnual Small Firm Finance Research Symposium.
Smallbone, D. and North, D. (1995), “Targeting established SMEs: does their age matter?”,
International Small Business Journal, Vol. 13 No. 3, pp. 47-64.
Stanworth, J. and Gray, C. (1991), Bolton 20 Years On: T he Small Firm in the 1990s, Paul
Chapman, London.
Storey, D.J. (1994), Understanding the Small Business Sector, Routledge, London.
Tamari, M. (1980), “T he financial structure of the small firm – an international comparison of
corporate accounts in the USA , France, UK, Israel and Japan”, A merican Journal of Small
Business, April-June, pp. 20-34.
University of Cambridge (1992), T he State of British Enterprise: Growth, Innovation &
Competitive A dvantage in Small and Medium-sized Firms, Small Business Research Centre,
Cambridge.
247
IJEBR
4,3
248
Table A I.
Survey design and
response rates
A ppendix
Industry type
Export
intensity
A ge of
firms
Manufacturing
Manufacturing
Manufacturing
Manufacturing
Non-manufacturing
Non-manufacturing
High
Low
High
Low
–
–
New
New
Established
Established
New
Established
Totals
Number
sent
Usable
replies
Response
rate (% )
54
56
108
112
75
150
21
23
27
30
33
52
39
41
25
27
44
35
555
186
34