The financing preferences of small firm owners

Robert T. Hamilton
University of Canterbury, Christchurch, New Zealand, and

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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 will always 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 support. This paper focuses more narrowly 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]. While 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. This 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 There 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. While 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

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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). An 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). This 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 (personal savings; retained earnings); second, short-term borrowings; 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 greater 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 firms main industry. The higher the industrys export intensity, the greater the growth 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 growth. These 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 intangible and portable in contrast to the tangible and fixed 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. The names, addresses and number of employees were obtained from the 1995 edition of The New Zealand Business Whos Who. 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. Age 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 growth 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. The stark policy choice has been between funding start-ups with high rates of failure and supporting further growth in established firms where the failure rates are reduced. Here the new firms have created on average eight jobs in their first two

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Period founded Prior to 1980 1980-1989 1992-1994 Note:

a

Number of firmsa 45 52 77

Average age (in years) 31 10 2

Current fulltime employees 17 13 8

Intended maximum size 22 13 13

12 firms did not provide full data

Table I. Age and size profiles

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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. This supports the view that resource allocation should be determined by the growth potential rather than age of business (Smallbone and North, 1995). 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. The 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. While 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. The 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

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Main source of initial funding Founders own savings Founders immediate family Financial institutions Other main sourcesa Note:
a

Before 1980 76 4 11 9

Period founded 1980-1989 73 8 13 6

1992-1994 60 8 24 8

Table II. Sources of initial financing of small firms (per cent)

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. The loans would be secured against the borrowers 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 banks capital adequacy ratios. This 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. 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. The ownership ratio is also vital from the lenders perspective, a matter we return to later in this paper. The survey evidence relating to the ongoing financing preferences of these small firm owners is set out in Table III.
Period founded Prior to 1980 1980-1989 1992-1994 Ownership ratio (per cent) 44.0 45.6 44.3 Percentage of profit retained (intended) 44.6 40.9 53.1 Percentage of firms able to retain intended share 73 79 60

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Table III. Ongoing financing preferences of small firms

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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). This 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 was 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 group. The 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. The 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. The picture that emerges here is consistent with the pecking order theory proposed by Myers (1984). The 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. The 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. When additional funding must come from beyond the firm, we have seen that debt is much preferred over new equity partners. As noted previously, some have interpreted this preference for debt to be due to the knowledge gap 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. They tend not to operate with much forward planning and so most funding decisions end up presenting themselves as cash problems. When 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. This 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 lenders 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.

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Opinions of owners Too high About right Too low Not concerned Total

Up to 25% 0 6 14 11 31

Number in each ownership range 26-50% 51-75% 76-100% 1 19 13 8 41 4 12 2 10 28 3 4 0 13 20

Total 8 41 29 42 120

Table IV. Business owners opinions on their ownership ratios

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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. What 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 gained directly from small business owners from a range of industry sectors in New Zealand lends support to this view. These 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. This 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. The 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 Activity 1992-93. 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. This 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 Activity 1992-93, (1994), Statistics New Zealand, Wellington. Coopers and Lybrand (1993), Factors Affecting 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 Andrews, G. (1995), The New Zealand Innovation Environment, The Berl Foundation, Wellington. Holmes, S. and Kent, P. (1991), An 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 Whos Who (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 growing 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 Annual 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: The Small Firm in the 1990s, Paul Chapman, London. Storey, D.J. (1994), Understanding the Small Business Sector, Routledge, London. Tamari, M. (1980), The financial structure of the small firm an international comparison of corporate accounts in the USA, France, UK, Israel and Japan, American Journal of Small Business, April-June, pp. 20-34. University of Cambridge (1992), The State of British Enterprise: Growth, Innovation & Competitive Advantage in Small and Medium-sized Firms, Small Business Research Centre, Cambridge.

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Appendix Export intensity High Low High Low Age of firms New New Established Established New Established Number sent 54 56 108 112 75 150 555 Usable replies 21 23 27 30 33 52 186 Response rate (%) 39 41 25 27 44 35 34

Industry type Manufacturing Manufacturing Manufacturing Manufacturing Non-manufacturing Non-manufacturing Totals

248
Table AI. Survey design and response rates