Financial life cycle for start up business - informationally opaque


Hypothesis 2.a (financial life cycle): For start-ups, which are “the most informationally opaque”
type of business, it is difficult to obtain external funding (Berger and Udell 1998). Information opacity
prevents investors in small firms from distinguishing between high-quality and low-quality companies.
Consequently, Berger and Udell (1998) argued that debt, due to the higher interest rate applied by
lenders to hedge against the higher default probability, is costly for young firms. Due to asymmetric
information, young, informationally opaque firms are less leveraged. 

This phenomenon can inhibit
small firms from using external funding at all (Weinberg 1994), in addition to the fact that cash-flows
are needed to service interest payments, and small and young business are typically not able to generate
positive cash-flows in the early stages. Consequently, according to Fluck (2000), and to the empirical results of Carey et al. (1993) and Helwege and Liang (1996), young firms are financed mainly by
insiders, business angels, and venture capital. Equity as a source of funds allows the soundness of an
investment to be monitored, while “patient” capital can wait for long-term economic returns on
investments and thereby meet the longer financial needs of a young firm. Especially given an imperfect
market, the venture capitalist professionally supports a young firm with his or her financial resources
and skills (Kaplan and Stromberg 2003).

 In regards, Carey et al. (1993) and Helwege and Liang (1996)
showed that small entrepreneurial firms frequently issue outside equity before they issue debt. Bank
debt is typically more readily available after a firm has achieved significant tangible assets that might
be collateralized. The use of debt increases over time and becomes particularly important in the
maturity stage of a business (Berger and Udell 1998). As a firm becomes larger and more mature, and
less informationally opaque, its financing choices change, including better access to the debt market
(Chittenden et al. 1996). Therefore, leverage increases with age, as young firms are financially
constrained while old firms have convenient access to external finance. Therefore, this life-cycle
pattern of firm financing assumed that small firms will use outside equity first (such as venture capital
finance) and retained earnings, issuing debt at last to satisfy their subsequent financing needs. This
approach contrasts with that described in the pecking-order model mainly with respect to the financing
choices of start-up firms.
Hypothesis 2.b (reputational effect): Also a reputation argument supports the convenient use of
debt only in the maturity stage. Young firms, without past experience and a track record, have a low
debt capacity.

 Vice versa, firms that have consolidated their business, with past history, past
profitability, track record, and credibility and reliability in the product market, are not constrained in
the credit market and can obtain finance under good economic terms. These firms have typically
developed a positive reputation to be spend the financial market (Diamond 1989). Therefore, early in
the growth cycle, small businesses have little repayment history or record of profitability upon which
external suppliers of funds can rely. For such firms, internal resources (by entrepreneur or his family)
are fundamental, and when these are exhausted, venture capital becomes the primary choice. After a
period of sufficient profits as well as reliability and credibility in the market, firms gain a positive
reputation and are thus able to readily obtaining the required financing, including debt (Hirshleifer and
Thankor 1992). As the firm matures, outside stakeholders can examine the firm’s track record and its
creditworthiness over time. A firm’s reputation attenuates the problem of asymmetric information and
improves its access to external sources of funding, such as trade credit and bank debt (Diamond 1989).
Thus, gaining a reputation in the market over time, reducing moral hazard problems,

 provides to older firms better conditions for using debt as source of finance. As stated by Diamond (1989) older firms
will be able to increase their use of debt. Empirically, Fluck, Holtz-Eakin and Rosen (1998) find that
the proportion of funds from insiders increases during the early stages of firm’s life cycle, while the
proportion of outsider finance declines. However at some point this relationship reverses. They
interpret this result as a consequence of the development of a positive reputation in credit markets
which allow the firm to obtain cheaper sources of external financing.

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