2.1 Financial Life Cycle: Theory and Hypothesis
Several hypothesis, as synthesized in table 1, can be proposed to consider the life-cycle in
explaining firms financing behavior.
Table 1 – Main hypothesis
Hypothesis Description of the hypothesis
H.1 (pecking-order theory): Myers
(1984), Holmes and Kent (1991),
Chittenden et al. (1996), Michaelas et
al. (1999).
Financial managerial preferences depends on the costs of information asymmetries and of transaction costs,
pushing for the utilize at first place of retained earnings, then debt and at last equity. The level of debt in a
firm’s capital structure is adjusted in response to difference sensitivity to financial needs of the firm over its
growth cycle. More-profitable firms will retain earnings and become less leveraged.
H.2.a (financial life cycle): Fluck
(2000), Kaplan and Stromberg 2003,
Carey et al. (1993), Helwege and Liang
(1996)
A life-cycle pattern of firm financing assumes that small firms, that are particularly sensitive to asymmetric
information problems, will use outside equity first (such as venture capital finance) and retained earnings,
issuing debt at last to satisfy their subsequent financing needs.
H.2.b (reputational effect): Fluck,
Holtz-Eakin and Rosen (1998),
Diamond (1989)
Young firms, without past experience and a track record, have a low debt capacity. A reputation argument
supports the convenient use of debt only in the maturity stage.
H.3.a (reverse financial life cycle):
Petersen and Rajan (1994), Hamilton
and Fox 1998
Young firms rely on the closest sources of financing, i.e., family capital and bank capital based on family
pledges. Firms rebalance their capital structure at the maturity stage.
As the firm grows, internal selfgenerated financial resources substitute debt and the fraction of borrowing declines as the firm matures.
H.3.b (reputational searching effect):
Diamond (1991)
Young firms seek to obtain certification of their quality and acquire credibility in the product market by
submitting themselves to monitoring by banks. In an actively growing firm and, especially, in a mature one,
monitoring becomes secondary, as the track record signals both quality and reliability, the debt level declines.
The use of internal resources as a substitute for external finance must be acknowledged, as in the
pecking-order theory, as these reflect the severity of asymmetric information problems. Accordingly, in
this study, hypothesis 1 deals with the role of profitability and the preferences regarding internal
resources vs. debt. Hypotheses 2 and 3, each of which is further divided into two formulations, address
the different theoretical financial preferences during the life cycle of a firm. Hypothesis 2.a attempts to
describe the financial life cycle with respect to the age of a firm, while hypothesis 3.a is the reverse
formulation. Hypothesis 2.b attempts to describe the financial life cycle with respect to the role of a
firm’s reputation, while hypothesis 3.b is the reverse formulation. Finally, due to the fact that the
previous mentioned effects can be heterogeneous for different industries and for firms operating in
different institutional context, we explicitly take into account for industries affiliation and for the
context of analysis.
Hypothesis 1 (pecking-order theory): The main approach to interpret capital-structure choices
from the asymmetric information point of view is the pecking-order hypothesis (Myers 1984), which
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suggests that firms finance their needs in a hierarchical fashion. Myers (1984) and Myers and Majluf
(1984) pointed out the role of managerial preferences in the choice of financing resources. These
choices are made by considering the relative costs of the various sources of finance due to information
asymmetries and of transaction costs. The pecking-order theory proposes that firms prefer to use
internal sources of capital, relying on external sources only when the internal ones are exhausted. As a
result, firms prefer to use less information-sensitive securities, with retained earnings being the most
preferred financing source, followed by debt, and then equity capital7
. This implies that more-profitable
firms will retain earnings and become less leveraged, while less-profitable firms will become more
leveraged, thus demonstrating an inverse relation between profitability and financial leverage. The
pecking-order theory seems particularly relevant for small and medium-sized firms due to their typical
features and limited access to external finance (Holmes and Kent 1991). In particular, the pecking order
hypothesis provides an instrumental tool to analyze the strategic financing problem of firms along the
life cycle (Rocha Teixeira and Coutinho dos Santos 2005). It states that no optimal level of debt
becomes “objectively” evident; instead it becomes apparent as a firm’s situation changes over time.
Thus, the proportion of debt in a firm’s capital structure is adjusted in response to the impending
financial needs of the firm over its growth cycle. Empirical evidence from previous studies that
examined small and medium-sized firms (Chittenden et al. 1996, Michaelas et al. 1999) was consistent
with the pecking-order argument, since leverage was found to be negatively related to profitability.
Therefore, the empirical model employed here included profitability, defined as earnings before
interest, taxes, depreciation, and amortization (Ebitda) to capital (Sogorb-Mira 2005, Fama and French,
2002, Michaelas et al. 1999).
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
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Pinegar and Wilbricht (1989), in their survey, observed that external debt is strongly preferred over external equity as a
way to raising funds.
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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
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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.
Hypothesis 3.a (reverse financial life cycle): Entrepreneurs’ financial resources and those of their
families are, by definition, limited; thus, for a young firm insider financial resources are usually not
sufficient to allow start-up and growth. The role of debt funds in providing needed financial support
beginning at the start-up phase and continuing thereafter can be explained by the entrepreneur’s aim to
sustain growth and retain the control of the business (Hamilton and Fox 1998)8
. Berger and Udell
(1998) observed that young firms may be heavily financed by external debt from financial institutions,
because this funding is not entirely external9
. When loaning money to small businesses, most financial
institutions require that the owners personally guarantee the loan.
These guarantees give the institution
recourse to the personal wealth of the small-business owner in the event of default. Similarly, Petersen
and Rajan (1994) found that young firms (less than 2 years old) rely most heavily on loans from the
owner and his or her family and then on bank loans. Moreover, in their initial years of this business, the
largest incremental source of funds is from banks, with the dependence on personal funds gradually
decreasing.
As the firm grows, a devoted entrepreneur will remain inclined to place self-generated
financial resources into the firm. These funds provide further capital and thus the fraction of borrowing
from banks declines as the firm matures. Therefore, firms rebalance their capital structure at the
maturity stage. Empirically, Robb (2002) reports, in contrast to Fluck, Holtz-Eakin and Rosen (1998),
that younger firms use relatively more debt than older firms. Moreover, according to Petersen and
Rajan (1994), leverage decreases with the age of the firm, as young firms are externally financed while
mature ones mainly use retained earnings and equity. These authors suggested that firms follow a
“pecking order” of borrowing over time, starting with the closest sources, i.e., family capital and bank
capital based on family pledges, and then progressing to more external sources.
