Capital structure and funding small businesses

 An analysis of the international literature on capital structure, as one of the main elements in
determining value, shows that a main research priorities is the attempt to apply capital-structure theory
to small firms (Berger and Udell 1998, Michaelas et al. 1999, Romano et al. 2001, Gregory et al.
2005)2
. Small and medium-sized firms play an essential role in the European economy. They account
for more than 95% of the total number of operating firms and for around two-thirds of jobs and half of
the turnover in the non-agricultural business sector (European Commission and Eurostat 2001). Given
their economic relevance, the role of the small and medium-sized firms and their ability to growth and
have success is essential for the economic development. The ability of firms to grow is important,
because it has been suggested that firms with low or negative growth rates are more likely to fail
(Phillips and Kirchhoff, 1989). 

Due to their prominent role in the economy, the source of finance to
support their growth is a crucial topic. In particular, Storey (1994) suggests that firm growth is affected
by the availability and cost of funding; the availability of finance for investment is vital to the
sustainability and viability of a small and medium-sized firm. Their growth, both considering start-up
and existing companies, significantly depends on access to external finance. Small businesses are likely
to suffer most from information and incentive problems and thus are particularly constrained in their
capacity to obtain external finances (Berger and Udell 1998). 

Carpenter and Petersen (2002) show
empirically that the growth of small firms is constrained by the source of finance. Therefore, much of
the attention surrounding the growth of small and medium-sized firms is affected by capital-structure
decisions (Gregory et al. 2005).
The issues that are most important for capital structure decisions of small and medium-sized
firms differ from those of large corporations and, correspondingly, this gives rise to different financial
behaviors. Among several aspects that distinguish small from large companies3
, one of the most
important is informational opacity (Berger and Udell 1998). This informational opacity, in the form of
costly verification, adverse selection, and moral hazard, typically affects the financial policy of small
firms, specifically in terms of debt and external equity sources4
. Costly verification and adverse 

 2
Zingales (2000) also has emphasized the fact that “…the attention shown towards large firms tends to partially obscures
(and often ignore) firms (of small and medium size) that do not have access to the (public) financial markets…”.
3
Large firms use a variety of financing instruments, public and private, while small firms typically use bank loans and
private equity, mainly based on the financial support of the entrepreneur and his or her family. Moreover, small businesses
do not issue securities that are priced in public markets.
4
According to Berger e Udell (1998), the opportunities to invest in positive net present value projects may be blocked if
potential providers of external finance cannot readily verify that the firm has access to a quality project (adverse selection
3
selection problems tend to favor debt contracts, whereas moral hazard problems tend to favor external
equity contracts (Berger and Udell 1998).

 The lack of external finance, and in particular of debt or
equity, may reflect an entrepreneurial choice but it can also be due to inefficient local financial
institutions. Specifically, the effects of financial institutions on the various types of external finance
differ such that the relative amount of debt may strictly depend on the abilities of these institutions to
solve information problems, e.g., by engaging in screening, contracting, and monitoring activities
(Beck et al. 2002)5
.
In one of the most interesting studies of capital structuring, Berger and Udell (1998) asserted that
general financial theory is not applicable to all businesses; instead, the particular phase of a business’s
life cycle determines the nature of its financial needs, the availability of financial resources, and the
related cost of capital. This approach supports financial behaviors that are life-cycle-specific. As
argued by Kaplan and Stromberg (2003), the changing degree of informational opacity that confronts a
firm drives its financial growth cycle. From its inception until maturity, the financial needs of a firm
change according to its ability to generate cash, its growth opportunities, and the risk in realizing them.
This will be reflected by evolving financing preferences and the nature of the specific financial choices
that a firm makes during its life cycles. As a consequence, firms at the earlier stages of their life cycles,
that arguably tend to have larger levels of asymmetric information, more growth opportunities, and
reduced size, should have specific capital structure drivers and applying specific financing strategies as
they advance through the different phases of their life cycles.
Despite recent attention to this topic, data on their financing structure during the course of their
life cycles are rather limited and the results are inconclusive (Gregory et al. 2005). Thus, we still need
to enhance our understanding of firms’ financial choices in this area, in particular verifying the
existence of a pro-tempore optimal capital structure and the drivers that are potentially relevant to
explain capital structure decisions as they progress along the different phases of their life cycle6
. 

In
some contexts, equity (specifically, venture capital) has been shown to play a role in the early stages,
while debt becomes relevant only in the late stages. In other contexts, the support of a financial
intermediary (bank) is fundamental in early stages, whereas the capital structure is rebalanced in later
problem), ensure that the funds will not be diverted to an alternative project (moral hazard problem), or costlessly monitor
use of the revenue by the firm they invest in (costly state verification).
5
Beck, Demirguc-Kunt, and Maksivmovic (2002) showed that small firms are the most credit-constrained by
underdeveloped institutions.
6
Moreover, this topic is of particular interest also in the valuation of the firm, considering that capital structure decisions,
differing along the stages of the life cycle of the firm, directly affect the opportunity cost of capital and the market value of
the firm.
4
stages. A common consensus is the importance of the institutional environment in which a small firm is
based (Beck et al. 2002 and 2005).

 To operate in the USA or in Italy, small businesses must have
access to a different variety of financial solutions in order to sustain growth in light of asymmetric
information. Thus, the financing preferences of these firms are complex and the appropriateness of the
available options deserves further research.
The present study contributes to this area of research in that it seeks to verify whether life-cycle is
relevant factor in a firms financing behavior. An empirical analysis is used to evaluate the role of the
life-cycle and the differences in the determinants of the debt/equity ratio throughout the life cycles of
Italian small businesses. Specifically, the following questions are addressed: Do Italian firms have
different financial structures during different stages of their life cycles? How do Italian capital-structure
determinants change in the course of a firm’s life cycle?
The paper is structured as follows. The first part examines the strategic financing choices of firms
through formal research hypothesis. In the second part, the sample is introduced, the variables and the
model are applied, and the results are shown. The third part consists of the conclusions and a discussion
of the implications for management and for future research.
2. Capital Structure and Financial Life Cycle
The notion that firms evolve through a financial growth or life cycle is well-established in the
literature. However, there is disagreement concerning sequential financing choices and the debt/equity
ratio. Moreover, the growth-cycle paradigm does not fit all small businesses (Berger and Udell 1998),
and differences exist not only for management determination but also regarding different industry
affiliation and institutional environment in which firms operate (Harris and Raviv 1991, Beck et al.
2002, Rajan and Zingales 2004, Utrero-González 2007).

 In their review of the capital structure
literature, Harris and Raviv (1991) noted that it is generally accepted that firms in a given industry will
have similar leverage ratios, which overtime are relatively stable, while leverage ratios vary across
industries. Specifically, industry is a significant determinant of leverage, that alone has been found to
explain up to 25% of within-country leverage variation (Bradley, Jarrell and Kim1984). Moreover, the
institutional environment has also a crucial influence on capital-structure decisions, as recently
documented by Titman et al. (2003) for large companies and by Gaud et al. (2005) for small firms.
More than the type of financial system (market-based or bank-based), it is the efficiency of the
financial system (Rajan and Zingales 1995, Wald 1999, Booth et al. 2001, Zingales et al. 2004) and of
the general institutional context (Petersen and Rajan 1994 and 1995, Berger and Udell 1995) that
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determine the financial growth of firms affecting capital structure decisions. Therefore, hypotheses on
capital-structure determinants must take into account industry affiliation and the institutional
environments. This is particularly the case for firms that are opaque and affected by asymmetric
information.