HOW DO START-UP FIRMS FINANCE THEIR ASSETS:

EVIDENCE FROM THE KAUFFMAN FIRM SURVEYS

Rebel A. ColeDePaul University

Tatyana SokolykBrock University

Searle Center Conference on Innovation and Entrepreneurship

June 2013

Introduction:

• How do start-up firms finance their assets and why does it matter?

• The capital-structure decision is one of the most important decisions facing a financial manager..

• Yet, we know very little about how the manager of start-up decides on the capital stack of various types of debt and equity.

• We analyze the use of credit by entrepreneurial firms at the time of their establishment, utilizing Kauffman Firm Surveys (KFS) of start-up firms.

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Study Overview:

• We provide important new evidence on why the capital structure decision of a start-up firm matters.

• First, we find that firms using debt in their capital structure are significantly more likely to survive than are firms using no debt; and firms using business debt, as opposed to personal debt, are more likely to survive.

• Second, we find that firms using debt in their capital structure grow faster than do firms using no debt; and firms using business debt, as opposed to personal debt, grow faster.

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Study Overview (continued):

• We then turn to how start-up firms finance their assets.

• We find that the majority (55%) of firms rely upon personal credit, and also a sizable fraction of firms use business credit (44%) and trade credit (24%), but that a significant portion (24%) use no credit at start-up.

• Finally, we analyze what factors explain a start-up’s decision to use credit and its decision as to what type of credit to use (business or personal).

• We find that both firm and owner characteristics explain the use of credit.

• We find that both firm and owner characteristics explain the use of credit.

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Related Literature:Capital Structure of Privately Held Firms:• Berger and Udell (JBF 1998), SSBF data: Posit a “financial growth-cycle

paradigm” where different capital structures are optimal as the firm grows, ages and becomes less informationally opaque. Show how the capital structure of small firms varies by firm size and age.

• Cole (2009), SSBF data: Examines “who needs credit and who gets credit.” Splits firms into four groups: no-need, discouraged, applied (approved/denied). No-need accounts for majority in all 3 periods.

• Cole (FM 2012), SSBF data: Identifies factors that are important in determining capital structure at privately held firms (firm age, minority ownership, industry median leverage, corporate form of organization, and the number of banking relationships).

• Cole (2010), SSBF data: Examines factors that explain whether the firms use bank credit, trade credit, or no credit. Finds that 25% of all firms use no credit; 20% use trade credit/bank credit only.

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Related Literature:Capital Structure of Privately Held Firms:

• Robb and Robinson (RFS 2012):

– Use KFS data to analyze the amounts of capital obtained from formal and informal sources.

– Documents the surprising importance of formal sources at the firm’s start-up: bank loans and lines of credit.

– Finds that trade credit is much less important than bank credit: average firm uses twice as much outside debt as trade credit.

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Differences from Robb and Robinson (2012):

• We focus on the incidence of use, whereas RR focus on the amounts of credit used.

• This is important because of mass points at 0, and highly skewed distributions for non-zero use of credit, especially sub-types.

• The median amount can be zero while the mean amount is large and positive, as it is for trade credit, business credit, and personal credit.

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Differences from Robb and Robinson (2012):

• RR combine owner and business credit, whereas we analyze them as separate, distinct categories.

• RR justify their classification because “research has shown that personal guarantees and personal collateral must often be posted to secure financing for startups.” As evidence, they cite a paper on the subject by Avery et al., JBF 1998. – A closer reading of Avery et al. shows that it reports 60% of SBLs

are not personally guaranteed.

– In addition, Avery et al. exclude credit card loans, which account for large portion of KFS business loans. Business credit cards typically are an unsecured form of credit.

– Finally, Cole (2012) finds that privately held corporations use significantly more leverage than proprietorships. This should not be true if most business loans are personally guaranteed.

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Data: Kauffman Firm Surveys (KFS)

• The KFS is the largest and most comprehensive dataset on U.S. start-up firms, providing information on firms’ use of credit, as well as various firm and owner characteristics.

• It tracks a panel of 4,928 U.S. businesses established during 2004: data available for the initial year and for seven follow-up years (2004-2011).

• Firms are a stratified random sample of all U.S. start-ups in 2004.

Credit Categories:• Business Credit: includes either of the following categories:

business bank loan, business credit line, business loan from nonbank institutions, business credit card, business credit card issued on owner’s name, business loan from the government, business loan from other businesses, business loan from other sources.

• Personal Credit: includes either of the following categories: personal bank loan by the primary owner, personal bank loan by other owners, the primary owner’s personal credit card used for business purposes, and the other owners’ personal credit cards used for business purposes.

• Any Credit: Firm reported that it used any trade credit, business credit, or personal credit

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Table 3: Survival Analysis (credit and firm characteristics; hazard ratios) Variables 1 2 5

Credit 0.851**

Business Credit 0.848** 0.783***

Personal Credit 1.043 1.026

Firm Characteristics:

Ln (Revenue 2004 +1) 0.996

Corp 1.200*

Multiown 0.943

Credit Risk 1.093

Intell Property 0.833*

Comp Advantage 0.952

Product 1.261*

Product & Service 0.688***

Rural 0.986

Table 3: Survival Analysis (continued)(owner characteristics, other capital; hazard ratios) Variables 5Female 1.146Hours Worked 0.997*Prior Experience 0.985***Prior Start-Ups 1.032**Owner Age 0.959*Owner Age2 1.000*Asian 0.525**Black 1.077Hispanic 1.162Other 1.212College Education 0.723***Graduate Degree 0.632***Trade Credit 1.066Owners' Equity/Totcap 1.022Outsiders' Debt/Totcap 1.038Insider Equity 1.273Insider Debt 1.196Outsider Equity 0.967

Table 4: Revenue Analysis (continued)(credit and firm characteristics; hazard ratios)

Variable 1 2 5Credit 1.674***Business Credit 1.441*** 0.682**Personal Credit -0.153 -0.549**Firm Characteristics:Ln (Revenue 2004 +1) 0.209***Corp 1.392***Multiown 0.109Credit Risk -0.149Intell Property -0.161Comp Advantage 0.484*Product -0.139Product & Service 0.724*Rural -0.263

Table 4: Revenue Analysis (continued)(owner characteristics, other types of capital) Variable 5Female -0.769***Hours Worked 0.027***Prior Experience 0.008Prior Start-Ups 0.027Owner Age -0.022Owner Age2 0.000Asian -1.101Black -1.556***Hispanic -1.16*Other -1.383College Education -0.147Graduate Degree 0.128Trade Credit 0.786***Owners' Equity/Totcap 0.404Outsiders' Debt/Totcap 0.497Insider Equity -1.189*Insider Debt 0.191Outsider Equity 1.376***

Tables 3 &4: Credit Use and Corp, interactions

Survival Analysis (hazard ratios) 6Corp 1.094Business Credit*Corp 0.875Business Credit*Non-Corp 0.639***Personal Credit*Corp 1.01Personal Credit*Non-Corp 1.046Firm, Owner, Other Capital Controls Yes

Revenue Analysis 6Corp 0.98**Business Credit*Corp 1.03***Business Credit*Non-Corp 0.186Personal Credit*Corp -0.539*Personal Credit*Non-Corp -0.571Firm, Owner, Other Capital Controls Yes

Table 5: Credit Use at Start-Up

Credit Category Full Sample Corps Non-Corps z-statistic

Credit (any type) 76.10 79.60 71.00 6.31***Trade Credit 23.80 26.70 19.70 6.10***Business Credit 44.40 51.20 34.80 10.91*** Business Credit Card Owner Name 28.70 33.10 22.50 7.42*** Business Credit Card 24.30 27.80 19.30 6.94*** Business Credit Line 8.60 11.00 5.30 7.27*** Business Bank Loan 6.80 9.00 3.70 7.46***Personal Credit 54.90 55.80 53.70 0.70

Personal Bank Loan by Primary Owner 17.30 19.40 14.40 4.30***

Personal Bank Loan by Other Owners 2.60 4.10 0.50 1.80*

Primary Owner's Credit Card 46.20% 45.10 47.60 2.00** Other Owner's Credit Card 5.70 8.10 2.30 2.72***Number of Observations 4,928 3,038 1,890

Table 7: Factors Explaining Credit Use at Start-Up(biprobit model; odds ratios) 1st stage: 2nd Stage: 2nd Stage:

Credit Business Credit Personal Credit

Firm Characteristics:

Ln (Revenue 2004 +1) 1.043*** 1.030*** 0.977*

Ln (Total Assets+1) 1.058*** 1.077*** 0.969

Corp 1.155** 1.344*** 0.973

Multiown 0.953 1.101 0.828**

Credit Risk 0.886*** 0.890*** 1.104**

Intell Property 0.904 1.102 1.051

Comp Advantage 1.151** 0.992 0.927

Product 1.385*** 1.000 0.976

Product & Service 0.809* 1.012 0.971

Rural 0.952 0.979 0.993

Table 7: Factors Explaining Credit Use at Start-Up(biprobit model; odds ratios) 1st stage: 2nd Stage: 2nd Stage: Credit Business Credit Personal Credit Female 0.941 0.917 1.175**Hours Worked 1.004** 1.003** 1.001Prior Experience 0.991*** 0.996 0.991*Prior Start-Ups 0.996 0.986 0.984Owner Age 1.006 1.018 0.987Asian 1.003 1.123 1.038Black 0.568*** 0.685*** 0.832Hispanic 0.972 0.885 0.970Other 1.068 1.279 1.235College Education 1.196** 1.081 1.096Graduate Degree 1.582*** 1.202* 1.018Log(Owners' Equity +1) 1.014* 1.006 1.010Insider Equity 1.609*** 1.214 0.956Insider Debt 0.980 0.837** 1.26**Outsider Equity 0.909 0.925 1.049

Summary:• We use Kauffman Firm Survey data to analyze how U.S. start-ups

finance their assets. Our study contributes to entrepreneurship and finance literatures.

• First, we establish that the initial capital structure decision is important because it predicts future outcomes – survival and growth.

• Second, we document the initial capital structure that these firms choose for financing their start-up assets. More than one in five firms reports 100% equity financing; the majority (55%) rely upon personal credit, a large percentage (44%) on business credit, and almost a quarter (24%) on trade credit.

• Third, we analyze what factors explain whether a firm uses credit in its initial capital structure; and, if so, what type of credit (business or personal).

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Conclusions:• Firms are more likely to use credit at start-up when they are larger in

terms of revenues and assets, are organized as corporations, have lower credit risk, competitive advantage, provide product, and have more educated primary owner.

• Firms are less likely to use credit at start-up when they provide product and service , and the primary owner is Black.

• Among firms that use credit, larger firms are more likely to use business credit but less likely to use personal credit; firms with better credit scores are more likely to use business credit but less likely to use personal credit; corporations are more likely to use business credit; firms with multiple owners are less likely to use personal credit; black owners are less likely to use business credit; and firms with owners who work more hours in the firm are more likely to use business credit.

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