Debt

About forty percent of initial startup capital in a newly founded business is debt that originates from banks. Research finds that forging strong relationships with banks improves entrepreneurs’ access to credit along multiple dimensions.

Introduction

Banks are a primary source of capital for potential entrepreneurs and young firms, eclipsing all other sources of financing (Petersen and Rajan 1994). About 40 percent of the initial startup capital in a newly founded business is debt that originates from banks (Robb and Robinson 2010).

Typically, lending to fledgling firms is carried out by smaller banks because they specialize in learning "soft" information about potential entrepreneurs who lack audited financial statements.

Researchers have consistently found that forging strong relationships with banks improves entrepreneurs' access to credit along multiple dimensions. Early work in the field also shows that proximity between firms and banks matters in small business lending (Petersen and Rajan 1994), but we would like to know more about how banking relationships affect new business formation.

Because of data limitations, we know little about the effect of bank loans on the firms' real outcomes, such as investment and growth in employment.

Discussion

We've understood for a long time that the banking sector was important for small firms, but small firms are not necessarily entrepreneurial firms. Until recently, a variety of data constraints kept us from understanding the importance of distinguishing small businesses from young businesses. Most young businesses start small, even if they grow rapidly, but most small businesses do not grow; they remain small their entire lives (Haltiwanger, Jarmin, and Miranda 2013).

As a result, we are increasingly beginning to understand the importance of bank debt for young businesses, not just small businesses.

Conventional wisdom suggested that firms follow a life-cycle model of financing (Berger and Udell 1998). This held that for the youngest firms, limited liability and the inherent opaqueness of startups meant that they were screened out of lending markets. As startups develop a track record, they gain access to debt markets. In the words of Berger and Udell (1998):

"Small business may be thought of as having a financial growth cycle in which financial needs and options change as the business grows, gains further experience, and becomes less informationally opaque."

Recent evidence from the Kauffman Firm Survey (KFS) suggests that the financing picture for startups is a good deal more complicated than would be suggested by the financial growth cycle. The KFS shows that about 40 percent of the initial startup capital in a newly founded business is debt that originates from banks (Robb and Robinson 2010).

Other forms of financing are similarly less common for startups than is perceived, as entrepreneurs face greater obstacles to raising external funds than do established companies. Since young firms typically do not have an informative record, they are unable to access public equity or bond markets. In addition to being insufficiently informed, arm's length investors are usually too distant and dispersed to monitor the entrepreneur's use of funds. As a result, banks have emerged as intermediaries that specifically screen and monitor firms in order to bridge the divide between entrepreneurs with ideas and investors with capital.

With the exception of high-tech startups that usually require venture-capital financing, banks are traditionally the most important providers of capital for small, entrepreneurial firms. In sum, surveys of small business owners reveal that banks eclipse all other sources of financing, including the owner's personal funds, family and friends, and other non-bank financial institutions (Petersen and Rajan 1994).

One prominent feature of bank lending to entrepreneurs is that it is typically carried out by smaller banks. Banks vary in the type of information they use to evaluate borrowers. Large banks specialize in transaction lending that depends on "hard" information, such as audited financial statements. Fledgling businesses often do not have verified statements or, in the earliest stages, even realized cash flows to report. Consequently, determining these firms' creditworthiness requires producing "soft" information about the firm, including assessments of management quality, borrower character, and other risk factors that are difficult to quantify. This type of lending is the comparative advantage of smaller banks for at least two reasons. First, smaller banks have the proximity to engage in close, repeated interaction with the entrepreneur. In particular, early work by Peterson and Rajan (1994) shows that proximity between firm and bank matters in small business lending. Second, smaller banks have a relatively flat organizational structure that can better accommodate soft information as an input because there are fewer layers of hierarchy across which the subjective information has to be credibly communicated (Petersen and Rajan 1994) (Petersen 2004) (Berger, Miller, Petersen, Rajan, and Stein 2005) (Berger and Udell 2012).

A second prominent feature of bank-financing for entrepreneurial activity is that relationships matter (Boot 2000). Small-business borrowers with longer relationships who buy additional services such as checking accounts and who concentrate their borrowing in fewer banks enjoy benefits including greater access to credit, lower loan rates, and a lower likelihood of pledging collateral (Petersen and Raghuram 1994) (Berger and Udell 1995). The benefits of bank relationships also increase in the extent to which the entrepreneur generates additional profit for the bank by buying non-credit services (e.g., cash management, asset management) and/or referring additional clients to the bank. Conditional on risk profile, borrowers who generate more non-credit profit through cross-selling or referrals get access to more credit at a lower price (Santikian 2014).

A third important factor that affects bank lending to entrepreneurs is competition. Here, the evidence is more mixed. Conventional wisdom would suggest that more competition in a market would lead to reduced prices and make customers better off; however, this market-power reasoning does not account for the critical role relationships play in the market for bank loans to potential entrepreneurs. Petersen and Rajan (1995) argue that market power can help new businesses by facilitating long-term relationships where banks effectively subsidize them in their infancy and extract rents later on. In competitive markets where firms face alternative sources of credit, banks would not be able to offer low prices to entrepreneurs because they would lack the market power to recover their investment by charging higher prices in the future. In a cross-sectional analysis, they show that interest rates on bank loans fall more slowly with the age of the relationship in concentrated markets than in more competitive markets. Other evidence suggests that entrepreneurs could benefit from competitive credit markets instead. For example, an increase in competition following deregulation of branching restrictions was found to lead to an increase in the rate of new incorporations (Black and Strahan 2002) and lower interest rates for small firms (Rice and Strahan 2010).

There are many important questions moving forward. Bank financing seems to be important for startups during their first few years of existence, as founders go back to banks to raise additional capital as they continue to grow. This suggests that many startups are initially constrained in the amount they can borrow. Understanding the nature of these constraints and their ultimate impact on the success of startups remains an important open question in the field (Kerr and Nanda 2009) (Hurst and Annamaria 2004).

Future Research

  • Convincing a bank of credit quality absent audited financials requires close, repeated interaction. If the firm were to switch banks, it would have to start from scratch with a new bank and might suffer in the process. This is an area where empirical evidence is lacking. Do entrepreneurs face switching costs in banking relationships, and if so, what is the magnitude of these costs?
  • The role of collateral and personal assets in bank lending to entrepreneurs.
  • The role of banking relationships for startup activity.
  • Understanding entrepreneurial lending from the bank's perspective: how do banks use hard and soft information to determine which entrepreneurs should receive funding?
  • Innovative contract design for facilitating bank lending to entrepreneurs.

Data Sources

  • The National Survey of Small Business Finances: Has been the primary data source for research on bank lending to small businesses, especially in the United States; publicly available from the Federal Reserve Board.
  • Kauffman Firm Survey (KFS): Follows a panel of roughly 4,500 firms from birth for 8 years from 2004-2012; public-use and confidential versions available.
  • Proprietary Bank Data: Some recent papers have obtained such data, mostly from banks in other countries but a few in the United States as well; proprietary.
  • Census Bureau's Longitudinal Business Database (LBD): Papers that have tied banking deregulation to firm outcomes have used the LBD; requires special access.
  • Dun & Bradstreet: Cost-dependent.
  • Survey of Small Business Finances: No longer conducted but contains important information on small and young firms' access to bank debt; publicly available.
  • Survey of Consumer Finances: While not specifically targeted towards understanding startup activity per se, still has a lot of important household information for many individuals who are business owners; publicly available.
  • Panel Study of Income Dynamics (PSID): Provides a detailed look at individuals, many of whom enter into self-employment. The detail with which it tracks their life-cycle behavior allows for many great insights into the entrepreneurial process; publicly available.
  • Panel Study of Entrepreneurial Dynamics (PSED): Is a large-scale longitudinal data set patterned after the PSID in many respects. It allows researchers to study the transition into self-employment beginning before the transition is made, and identify many factors that influence this transition.

References

Berger, Allen N., Nathan H. Miller, Mitchell A. Petersen, Raghuram G. Rajan, and Jeremy C. Stein. 2005. "Does function follow organizational form? Evidence from the lending practices of large and small banks." Journal of Financial Economics 76(2): 237-269. doi:10.1016/j.jfineco.2004.06.003 

Berger, Allen N., and Gregory F. Udell. 1995. "Relationship lending and lines of credit in small firm finance." Journal of Business 68(3): 351–381. doi:10.1086/296668

Berger, Allen N., and Gregory F. Udell. 2002. "Small business credit availability and relationship lending: The importance of bank organizational structure." The Economic Journal 112(477): F32-F53. doi:10.1111/1468-0297.00682

Berger, Alan N., and Gregory F. Udell. 19998. "The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle." Journal of Banking & Finance 22(6–8): 613-673. doi:10.1016/s0378-4266(98)00038-7

Black, Sandra, and Philip Strahan. 2007. "Entrepreneurship and Bank Credit Availability." The Journal of Finance 57(6): 2807-2833. doi:10.1111/1540-6261.00513

Boot, Arnoud W.A. 2000. "Relationship banking: What do we know?" Journal of Financial Intermediation 9(1): 7-25. doi:10.1006/jfin.2000.0282

Haltiwanger, John, Ron S. Jarmin, and Javier Miranda, Javier. 2013. "Who Creates Jobs? Small vs. Large vs. Young." The Review of Economic and Statistics 95(2): 347-361. doi:10.1162/rest_a_00288

Hurst, Erik, and Annamaria Lusardi. 2004. "Liquidity Constraints, Household Wealth and Entrepreneurship." Journal of Political Economy 112(2): 319-347. doi:10.1086/381478 

Kerr, William R., and Ramana Nanda. 2009. "Democratizing Entry: Banking Deregulations, Financing Constraints, and Entrepreneurship." Journal of Financial Economics 94(1): 124–149. doi:10.1016/j.jfineco.2008.12.003

Petersen, Mitchell A. 2004. "Information: Hard and Soft." Working paper

Petersen, Mitchell A., and Raghuram G. Rajan. 1994. "The Benefits of Lending Relationships: Evidence from Small Business Data." The Journal of Finance 49(1): 3-37. doi:10.1111/j.1540-6261.1994.tb04418.x

Petersen, Mitchell A., and Raghuram G. Rajan. 1995. "The effect of credit market competition on lending relationships." The Quarterly Journal of Economics 110(2): 407-443. doi:10.2307/2118445

Rice, Tara, and Philip E. Strahan. 2010. "Does credit competition affect small-firm finance?" Journal of Finance 65(3): 861-889. doi:10.1111/j.1540-6261.2010.01555.x

Robb, Alicia, and David T. Robinson. 2010. "The Capital Structure Decisions of New Firms." Review of Financial Studies 27(1):153-179. doi:10.1093/rfs/hhs072

Santikian, Lori. 2014. "The Ties That Bind: Bank Relationships and Small Business Lending." Journal of Financial Intermediation 23(2): 177-213. 

Page last edited 14 June 2016