Ebook The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle
The role of the entrepreneurial enterprise as an engine of economic growth has garnered considerable public attention in the 1990s. Much of this focus stems from the belief that innovation particularly in the high tech, information, and biotechnology areas is vitally dependent on a flourishing entrepreneurial sector. The spectacular success stories of companies such as Microsoft, Genentech, and Federal Express embody the sense that new venture creation is the sine qua non of future productivity gains. Other recent phenomena have further focused public concern and awareness on small business, including the central role of entrepreneurship to the emergence of Eastern Europe, financial crises that have threatened credit availability to small business in Asia and elsewhere, and the growing use of the entrepreneurial alternative for those who have been displaced by corporate restructuring in the U.S.
Accompanying this heightened popular interest in the general area of small business has been an increased interest by policy makers, regulators, and academics in the nature and behavior of the financial markets that fund small businesses. At the core of this issue are questions about the type of financing growing companies need and receive at various stages of their growth, the nature of the private equity and debt contracts associated with this financing, and the connections and substitutability among these alternative sources of finance. Beyond this interest in the micro foundations of small business finance is a growing interest in the macroeconomic implications of small business finance. For example, the impact of the U.S. “credit crunch” of the early 1990s and the effect of the consolidation of the banking industry on the availability of credit to small business have also been the subject of much research over the past several years. Similarly, the “credit channels” of monetary policy mechanisms through which monetary policy shocks may have disproportionately large effects on small business funding has generated considerable analysis and debate. Other key issues, such as the link between the initial public offering (IPO) market and venture capital flows, prudent man rules regarding institutional investing in venture capital, and the role of small firm finance in financial system architecture are just beginning to attract research attention.
The private markets that finance small businesses are particularly interesting because they are so different from the public markets that fund large businesses. The private equity and debt markets offer highly structured, complex contracts to small businesses that are often acutely informationally opaque. This is in contrast to the public stock and bond markets that fund relatively informationally transparent large businesses under contracts that are more often relatively generic.
Financial intermediaries play a critical role in the private markets as information producers who can assess small business quality and address information problems through the activities of screening, contracting , and monitoring. Intermediaries screen potential customers by conducting due diligence, including the collection of information about the business, the market in which it operates, any collateral that may be pledged, and the entrepreneur or start up team. This may involve the use of information garnered from existing relationships of the intermediary with the business, the business owner, or other involved parties. The intermediary then uses this information about the initial quality of the small business to set contract terms at origination (price, fraction of ownership, collateral, restrictive covenants, maturity, etc.). A contract design and payoff structure is chosen on the basis of the financial characteristics of the firm and the entrepreneur as well as the firm’s prospects and the associated information problems. High risk-high growth enterprises whose assets are mostly intangible more often obtain external equity, whereas relatively low risk-low growth firms whose assets are mostly tangible more often receive external debt for reasons explored below. Finally, in order to keep the firm from engaging in exploitive activities or strategies, the intermediary monitors the firm over the course of the relationship to aswws compliance and financial condition, and exerts control through such means as directly participating in managerial decision making by venture capitalists or renegotiating waivers on loan covenants by commercial banks.
This paper has several motivations. The first is to provide as complete a picture as possible of the nature of the private equity and debt markets in which small businesses are financed based on currently available research and data. The second is to draw connections between various strands of the theoretical and empirical literature that have in the past focused on specific aspects of small firm finance but often have not captured the complexity of small business finance and the alternative sources of funding available to these firms. The third goal is to suggest extensions to the research in key areas related to the markets, contracts, and institutions associated with small firm finance and to highlight the relatively new data sources available to address these issues.
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