Hypothesis 3.b (certification hypothesis): Young firms seek to obtain certification of their
quality by submitting themselves to monitoring by banks. This action supports the credibility and the
quality of the business with regards other stakeholders. Thus, in the initial stage of its life cycle a firm
will allow itself to be monitored by a bank in order to overcome the handicap of its lack of reputation,
credibility, and reliability, as well as its difficulties in acquiring customers and interacting with
stakeholders (Diamond 1989 and 1991). This reputation-based capital can be used to reinforce the
quality perception of the business by other stakeholders in the product market (Berger and Udell 1998).
Vice versa, monitoring becomes of secondary importance in the maturity stage, when the firm grows to
the point that it becomes self-sufficient in providing signals as to its quality and reliability, based on its
cumulative history.
Therefore, according to Diamond (1991), the role of the growth cycle in the use of
debt is linked to a firm’s ability to gain a reputation in the market. In this regard, monitoring is
important for reducing information asymmetries and screening moral hazard problems. Young firms
lack credibility and thus a positive reputation that is advantageous when interacting with stakeholders
(customers, suppliers, employees, etc.). For this reason, financial intermediaries play a critical role in
private markets as producers of information on the borrower. They can assess small-business quality
and address information problems, through the activities of screening, contracting, and monitoring,
before granting credit. Intermediaries screen potential customers (firms) by conducting due diligence,
including collecting information about the business, the market in which it operates, any collateral that
may be pledged, and the entrepreneur or start-up team. Diamond (1991) argued that the lack of a track
record and of creditworthiness can be balanced by the firm through its decision to submit itself to bank
monitoring, which can confirm the quality of the business and supports its competitiveness. Monitoring
of private information is more efficiently delegated to a financial intermediary rather than to numerous
equity investors (Diamond 1984)10.
To sum-up, hypothesis 1 suggests the existence of an order of preferences in the financing
choices of small and medium-sized firms that face asymmetric information problems. The financial
growth cycle suggests the possible existence of different order of preferences among the use of debt
along the life cycle of the firm. According to hypotheses 2.a and 2.b, in the absence of family financial
resources, early-stage firms start by using equity sources of finance and then rebalance their capital
structure in later years using debt. Conversely, according to hypotheses 3.a and 3.b, in the absence of
10 In a second scenario Diamond (1989), observed that the institutional environment, in which incentive and informational
problems can be more or less severe, influences the use of debt funds; if moral hazard is sufficiently widespread, then firms
will build their reputation by being monitored by a financial intermediary.
10
family financial resources, firms start by using debt as the source of finance and rebalance their capital
structure in later years reducing the use of debt. In general, financial preferences along a firm’s life
cycle can be heterogeneous by industry affiliation and varies according to the institutional
environment; thus, our analysis has to control for these factors.
2.2 Role of Industry Affiliation and Institutional Context
Galbraith (1983) states that industry is the primary determinant of all aspects of firm performance
and behavior. Industry affiliation may have a relevant influence upon financing choices (Lopez-Garcia
and Aybar-Arias 2000); firms within a particular industry, facing similar prevailing circumstances, tend
to adopt an analogous financing pattern (Holmes et al. 2003). A review of the literature (Harris and
Raviv, 1991) suggested a strong relationship between industry classification and average firm leverage
ratio,
highlighting the existence of differences across industries but consistency within industries. Hall
et al. (2000) point out that also agency costs may vary across industries and lead to inter-industry
differences in financial structure. In general, the life cycle of the firm is affected by the kind of industry
a firm operates. The effect of industry affiliation on the life cycle was suggested already in the 1981 by
Weston and Brigham. They claimed that life-cycle differs between high-growth and low-growth
industries, or between emerging and traditional industries. Industry-specific features affect the role of
tangible asset, business risk and growth opportunity influencing their debt ratios. For example, firms
operating in high-growth industries carry less leverage, because they have stronger incentives to signal
that they do not engage in adverse selection and moral hazard costs in the form of underinvestment and
asset substitution. By contrast, firms operating in low-growth industries should use debt because of its
disciplinary function in signalling the lack of misuse of free cash flows.
However, small and mediumsized firms in high-growth industries have, as stated by Michaelas et al. (1999), a greater demand for
funds and, ceteris paribus, a greater preference for external financing through debt. Young firms, and
especially those that operate in fast growing sectors, tend to have greater external financing
requirements than firms in low-growth sectors. Empirical findings provide strong support for the
hypothesis that industry has an influence on the capital structure of small and medium-sized firms. Hall
et al. (2000) and Michaelas et al. (1999), for UK small and medium-sized firms, Lopez-Garcia and
Aybar-Arias (2000) for Spanish small and medium-sized firms, and Van der Wijst and Thurik (1993)
for West German small and medium-sized firms observed that leverage ratios vary across industries.
Therefore, the role of industry affiliation seems to be relevant but the effect on capital structure of
small and medium-sized firms needs to be controlled for.
11
Moreover, previous studies have highlighted the existence of systematic differences in the
capital structure claims issued by companies operating in different institutional contexts (Rajan and
Zingales 1995, Chittenden et al. 1996, Demirgüç-Kunt and Maksimovic 1998, Hall et al. 2001, LopezIturriaga and Rodriguez-Sanz 2007, Utrero-González 2007). The efficiency of the institutional context
can reduce problems of opportunism and asymmetric information,
with significant effect on the relative
magnitude of the costs and benefits associated to debt. The prevalent research has examined companies
that face a wide range of institutional environments and has been based on cross-country studies
(Chittenden et al. 1996, Levine 1997, Demirgüç-Kunt and Maksimovic 1998, Booth et al. 2001, Titman
et al. 2003, Hall et al. 2001). However, a recent literature focused on differences in institutional setting
at local level (Guiso et al. 2004). In a single country institutional differences can exist at a local level,
playing a crucial role in determining corporate financial decisions. Petersen and Rajan (2002)
documented the importance of distance in the provision of bank credit to small firms, especially in a
country where the problems of asymmetric information are substantial.
This argument is close to
contemporary debates in Economic Geography, interested in the understanding of firm financing across
different regional contexts (Martin 1999, Pollard 2003), and in Regional Economic (Dow and
Montagnoli 2007). Specifically, the research into the relationship between law and finance (La Porta et
al. 1998) takes into account the role of institutional factors, such as the efficiency of financial and
enforcement systems. According to Titman et al. (2003) a principal source of the wedge influencing
capital-structure choices may be asymmetric information and the cost of contracting between
companies and potential providers of external financing; this wedge is particularly high in presence of a
poorly developed financial system11. A well-developed financial system can facilitate the ability of a
company to gain access to external financing, providing cheaper financing to worthy companies (Guiso
et al. 2004). Moreover, differences in financial development also reflect differences in credit protection
(Demirgüç-Kunt and Maksimovic 1999, Cheng and Shiu 2007)12. Due to the risk of default and the
difficulty to get back the liquidation value of the collateral, judicial enforcement affects the ex-ante
availability of agents to provide finance. Although the legal system applies all over a country the court
efficiency does not equally work among different areas. Therefore, among different geographical
areas, more developed and efficient local institutions should allow for a higher use of debt.
The
11 It appears that firms can raise finance more easily as the financial system develops because physical collateral becomes
less important, while intangible assets and future cash flows can be financed. As the financial system develops, it should be
able to easily appreciate the soundness of the firm’s projects and of its managerial behaviors (Rajan and Zingales 1998).
12 The judicial enforcement is important because the financial system and the regulations governing it work in the interest of
investors, protecting creditors only to the extent that the rules are actually enforced.
12
influence of local institutional factors on capital structure decisions is particularly relevant for small
and medium-size firms; these firms face different menus of choices, opportunities and constraints
according to the geographic context where they are based (Pollard 2003). While large companies that
can operate multinationally are affected by country institutional factors, smaller companies are instead
influenced by local institutional factors, that seems to be still important despite the international
phenomenon of market integration (Guiso et al 2004).
