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FEDERAL RESERVE BANK OF CLEVELAND pd papers NUMBER 28 By Timothy Dunne, Scott Shane, and James B. Thomson POLICY DISCUSSION PAPER Workshop on Entrepreneurial Finance: A Summary NOVEMBER 2009 POLICY DISCUSSION PAPERS FEDERAL RESERVE BANK OF CLEVELAND Workshop on Entrepreneurial Finance: A Summary By Timothy Dunne, Scott Shane, and James B. Thomson This Policy Discussion Paper summarizes papers that were presented at the Workshop on Entrepreneurial Finance, which was held March 12–13, 2009, at the Federal Reserve Bank of Cleveland. Researchers presented new empirical research that exploits data sets on entrepreneurial activity that are based on broad and representative data samples. Papers in the workshop focused primarily on analyses of the sources and structure of start-up ﬁnance, including the importance of bank lending, venture capital, angel investors, and owner equity. Timothy Dunne is the Chong K Liew Professor of Economics at the University of Oklahoma. Scott Shane is the A. Malachi Mixon, III, Professor of Entrepreneurial Studies at the Weatherhead School of Management at Case Western Reserve University. James B. Thomson is a vice president in the Ofﬁce of Policy Analysis at the Federal Reserve Bank of Cleveland. Materials may be reprinted, provided that the source is credited. Please send copies of reprinted materials to the editor. POLICY DISCUSSION PAPERS Policy Discussion Papers are published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or to be placed on the mailing list, e-mail your request to firstname.lastname@example.org or fax it to 216-579-3050. Please send your questions comments, and suggestions to us at email@example.com. Policy Discussion Papers are available on the Cleveland Fed’s site on the World Wide Web: www. clevelandfed.org/Research. Views stated in Policy Discussion Papers are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. ISSN 1528-4344 FEDERAL RESERVE BANK OF CLEVELAND Introduction In March of 2009, the Federal Reserve Bank of Cleveland and the Kauﬀman Foundation jointly hosted a workshop on entrepreneurial ﬁnance that brought together scholars in the ﬁeld. The goal of the workshop was to present new empirical research that exploits data sets on entrepreneurial activity that are based on broad and representative data samples. The research presented employed data from relatively new survey instruments, such as the Kauﬀman Firm Survey, as well as data from well-established programs, such as the Survey of Small Business Finances. Additionally, some of the data sets highlighted are in the public domain, while others are available to researchers only through restricted access. It was clear from the workshop presentations that both privately and publicly sponsored data are valuable sources of information on entrepreneurial activity. Papers in the workshop focused primarily on analyses of the sources and structure of start-up ﬁnance, including the importance of bank lending, venture capital, angel investors, and owner equity. While many of the studies focused on the analysis of U.S. data, several papers oﬀered international perspectives. In addition, several papers emphasized diﬀerences in the ﬁnancing structure of new ﬁrms across demographic groups. This Policy Discussion Paper provides a brief summary from each paper presented at the workshop. The overview is organized broadly into ﬁve themes: bank ﬁnancing; topics in international entrepreneurial ﬁnance; demographics and entrepreneurial ﬁnancing; industry and institutional settings; and angel investors. Bank Financing Alicia M. Robb and David T. Robinson investigate the capital structure choices that ﬁrms make in their initial year of operation in their paper “The Capital Structure Decisions of New Firms.” Using restricted-access data from the Kauﬀman Firm Survey, they ﬁnd that, contrary to many accounts of start-up activity, ﬁrms rely heavily on external debt sources such as bank ﬁnancing and less extensively on friends- and family-based funding sources. This ﬁnding is robust to controls for credit quality, industry, and business owner characteristics. It is a feature both of the cross-section of ﬁrms at their founding date and of the time-series of ﬁrm ﬁnancing decisions. Formal credit complements other sources of funding, rather than substituting for it. The heavy reliance on external debt underscores the importance of well-functioning credit markets for the success of nascent business activity. The paper “Information Asymmetries between Lenders and the Availability of Competitive Outside Oﬀers” by Lamont K. Black examines the eﬀect of information asymmetries between lenders on the availability of competitive outside loan oﬀers. Existing lenders to ﬁrms tend to have private information about ﬁrms that is not available to other potential lenders, which creates an information asymmetry between “inside” lenders (those with more information about a ﬁrm) and “outside” lenders (those with less). Due to this information disadvantage, outside lenders face 1 POLICY DISCUSSION PAPERS NUMBER 28, NOVEMBER 2009 an adverse selection problem. The paper solves a benchmark model of information asymmetries in lending and ﬁnds that an increase in ﬁrm transparency causes the outsider to win more “good” ﬁrms. This reﬂects the eﬀect of better public information. The outsider also wins fewer bad ﬁrms because it faces less of a “winner’s curse.” The total eﬀect on outside lending depends on the net of these two eﬀects. An analytical solution shows that an increase in ﬁrm transparency leads to a decrease in the likelihood of a ﬁrm receiving a competitive outside loan oﬀer. The model’s main prediction is tested using a sample of small business ﬁrms that borrow either from an existing lender or a new lender. The evidence generally suggests that transparent ﬁrms are less likely to borrow from a new lender. In “Small and Medium-Sized Enterprises, Bank Relationship Strength, and the Use of Venture Capital,” Allen N. Berger and Klaus Schaeck use data on small and medium-sized enterprises in Italy, Germany, and the United Kingdom to analyze bank–ﬁrm relationships and how these relationships inﬂuence a ﬁrm’s use of venture capital. They examine whether ﬁrms substitute venture capital for multiple bank relationships to avoid the rent-extracting behavior of the main bank. The empirical results are consistent with this hypothesis and robust to changes in speciﬁcation, estimation method, and sample. The paper uses matching methods to explore whether ﬁrm performance diﬀers between ﬁrms that use venture capital and those ﬁrms that rely on multiple banking relationships. They report that the use of venture capital positively aﬀects ﬁrm performance in terms of growth and R&D spending; however, such performance eﬀects do not arise from multiple banking relationships. Topics in International Entrepreneurial Finance Larry W. Chavis, Leora F. Klapper, and Inessa Love study the use of diﬀerent ﬁnancing sources for new and young ﬁrms in the paper “Entrepreneurial Finance around the World: The Impact of the Business Environment on Financing Constraints.” They use a unique data set of over 70,000 ﬁrms (most of which are small) in over 100 countries from the World Bank Enterprise Surveys. The authors ﬁnd that, in all countries, younger ﬁrms rely less on bank ﬁnancing and more on informal ﬁnancing. Moreover, younger ﬁrms have better access to bank ﬁnance in countries with stronger rule of law and better credit information, and that the reliance of young ﬁrms on informal ﬁnance decreases with the availability of credit information. Overall, the results suggest that improvements to the legal environment and availability of credit information are disproportionately beneﬁcial for promoting access to formal ﬁnance by young ﬁrms. In the “Determinants of Start-up Firm External Financing Worldwide,” John R. Nofsinger and Weicheng Wang report on the determinants of the initial start-up ﬁnancing of entrepreneurial ﬁrms in 27 countries. Their study looks at how institutional investors and informal investors respond to product type (new vs. existing product), production technology (new vs. existing technology), and entrepreneur experience when providing ﬁnance to start-up ﬁrms. Using data from the Global Entrepreneurship Monitor survey, the authors’ ﬁndings suggest that informal 2 FEDERAL RESERVE BANK OF CLEVELAND investors prefer ﬁnancing new ﬁrms that have new products, whereas institutional investors are more willing to provide ﬁnance to ﬁrms with existing products and to more-experienced entrepreneurs. Demographics and Entrepreneurial Financing Alicia M. Robb, Robert W. Fairlie, and David T. Robinson use a new panel data set from the Kauﬀman Firm Survey to examine racial diﬀerences in the incidence and determinants of ﬁnancial capital use among young ﬁrms in their paper “Financial Capital Injections among New Black and White Business Ventures: Evidence from the Kauﬀman Firm Survey.” Looking across all ﬁrms, the authors ﬁnd a heavy reliance on owner’s equity at startup that declines substantially in subsequent years. Reliance on external debt, however, does not decline as the startup ages. The authors report that black-owned businesses face persistent diﬃculty in accessing external capital markets. These businesses rely much more on owner equity than do white-owned ones, indicating that blackowned businesses face more diﬃculty in raising external capital. Direct evidence on average levels of external capital reveals large diﬀerences between blacks and whites. Regression analyses indicate that racial disparities in the amounts and types of early ﬁnancing between blacks and whites do not entirely disappear after controlling for diﬀerences in credit quality, human capital, and ﬁrm characteristics. Blinder-Oaxaca decomposition estimates identify several factors contributing to lower average capital injections for black-owned businesses. The most important factor contributing to racial diﬀerences in ﬁnancing levels are credit scores, especially for ﬁnancial injections in the years following startup. Lower levels of start-up capital and initial sales are also found to be associated with lower levels of capital use in the two years after startup for black-owned businesses. In “Gender and the Availability of Credit to Privately Held Firms: Evidence from the Surveys of Small Business Finances,” Rebel A. Cole and Hamid Mehran analyze diﬀerences in the availability of credit between male- and female-owned ﬁrms. Using data from the nationally representative Surveys of Small Business Finances, which span a period of 16 years, the authors ﬁrst document a series of empirical regularities in diﬀerences between male-owned and female-owned ﬁrms. Female-owned ﬁrms are signiﬁcantly smaller as measured by sales, assets, and employment; younger as measured by ﬁrm age; more likely to be organized as proprietorship and less likely to be organized as corporations; and have fewer and shorter banking relationships. Female owners are younger, less experienced, and less educated. Comparing across groups, there appears to be some diﬀerence in the availability of credit to male-and female-owned ﬁrms. Female-owned ﬁrms are more likely to be credit-constrained because they are more likely to be discouraged from applying for credit but not more likely to be denied credit when they apply. However, these differences are not statistically signiﬁcant in a multivariate setting, when controls for additional ﬁrm and owner characteristics are included in the statistical model. 3 POLICY DISCUSSION PAPERS NUMBER 28, NOVEMBER 2009 Industry and Institutional Settings The paper “Does Debtor Protection Really Protect Debtors? Evidence from the Small Business Credit Market” by Allen N. Berger, Geraldo Cerqueiro , and María Fabiana Penas studies how different levels of debtor protection across U.S. states aﬀect small ﬁrms’ access to credit, as well as the price and non-price terms of their loans. The research uses data from the Survey of Small Business Finance. They ﬁnd that unlimited liability small businesses (sole proprietorships and most partnerships) have lower access to credit in states with more debtor-friendly bankruptcy laws. In addition, these businesses face harsher loan terms—they are more likely to pledge business collateral, have shorter maturities, and borrow smaller amounts. For limited liability small businesses (corporations and limited liability partnerships), the authors report a reduction in credit availability, but of smaller magnitude, together with an increase in the loan rate. The results also suggest that the personal bankruptcy law disproportionately aﬀects ﬁrm owners with low home equity values. Entrepreneurs rely on a spectrum of ﬁnancing options for new companies, including informal sources of capital, bank loans, and venture capital. Sheryl Winston Smith looks at the relationship between the type and source of ﬁnancing and success in high-tech entrepreneurial ventures in “Capital Structure and Entrepreneurial Performance: New Firm Innovation and Survival.” Nascent high-technology ventures are often highly information opaque for outside investors, with consequent implications for the availability of ﬁnancing in the earliest, riskiest phase. The author uses the Kauﬀman Firm Survey data set to analyze entrepreneurial performance in relationship to ﬁnancing and ownership over time, drawing on the data from the baseline survey of new businesses started in 2004 and subsequent follow-up surveys. The paper ﬁnds that nascent high-technology ﬁrms are more likely to have outside equity than ﬁrms in non-high-technology industries. However, with regard to bank loans, high-technology ﬁrms do not appear to be more likely to utilize this method of ﬁnancing than non-high-technology ﬁrms. In “Informal and Early Formal Financial Support in the Business Creation Process: Exploration with PSED II Data Set,” Paul D. Reynolds describes the patterns of ﬁnancing for a cohort of nascent enterprises in the earliest stages of the business creation process, The data come from the second U.S. Panel Study of Entrepreneurial Dynamics [PSED II]. Firms in the sample are identiﬁed after their ﬁrst eﬀorts to create a business have been initiated but before the new venture has an initial period of proﬁtability. The amount of informal ﬁnancial support provided to these new ventures before they have been registered as a legal entity is separated from formal equity and debt provided after this event. The author reports that the average amount of informal support is $48,000, but the distribution is highly skewed with the median amount of informal support being only $4,300. The average amount of formal ﬁnancial support is about $200,000, but again the distribution is highly skewed with the median amount of formal support being $0. There are some diﬀerences related to the sources of informal and formal ﬁnancial support and the status of 4 FEDERAL RESERVE BANK OF CLEVELAND the new ventures in the 12- and 24-month follow-up interviews, but no clear relationship to the amounts of support. Angel Investors In “Expected Returns of Angel Investors,” Ramon P. DeGennaro and Gerald P. Dwyer Jr. estimate the expected rate of return to angel investors. The authors note that previous research has calculated realized internal rates of return on angel investments but that internal rates of return are subject to misinterpretation due to nonlinearities and statistical biases. Perhaps more importantly, though, realized internal rates of return do not drive ﬁnancial decisions. Rather, expected returns drive ﬁnancial decisions. The authors utilize data from the Angel Investor Performance Project to estimate expected returns. The estimate of an equally weighted average of expected returns is about 58 percent annually. This is comparable to the expected return on venture capital investments. Jess H. Chua and Zhenyu Wu analyze post-investment involvement of angel investors in the paper “Value Added by Angel Investors through Post-Investment Involvement: Empirical Evidence and Ownership Implications.” While the post-investment involvement for venture capital is well studied, little is known about this activity for angel investors. Using data from the Angel Investor Performance Project, the authors estimate the impact of post-investor involvement of internal rates of return. The ﬁndings suggest the post-investment involvement increases the internal rate of return, and the authors posit this is because of mentoring channels versus monitoring channels. The authors recognize, however, that the data contain some important limitations with regard to low response rates and sample selection issues. Conclusion The conference covered a broad range of papers in terms of techniques used, questions addressed, data sets queried, and sources of ﬁnancing investigated. Perhaps the broad message of these papers is that a deeper understanding of the sources and structure of start-up ﬁnance is needed. 5 POLICY DISCUSSION PAPERS NUMBER 28, NOVEMBER 2009 Papers Presented at the Conference The Capital Structure Decisions of New Firms Alicia Robb, UC Santa Cruz David T. Robinson, Duke University Information Asymmetries between Lenders and the Availability of Competitive Outside Offers Lamont Black, Board of Governors, Federal Reserve Small and Medium-Sized Enterprises, Bank Relationship Strength, and the Use of Venture Capital Allen S. Berger, University of South Carolina, Wharton Financial Institutions Center and Center, Tilburg University Klaus Schaeck, University of Wales at Bangor Entrepreneurial Finance around the World: The Impact of the Business Environment on Financing Constraints Larry W. Chavis, University of North Carolina at Chapel Hill Leora F. Klapper, World Bank Inessa Love, World Bank Determinants of Start-up Firm External Financing Worldwide John R. Nofsinger, Washington State University Weicheng Wang, Washington State University Financial Capital Injections among New Black and White Business Ventures: Evidence from the Kauﬀman Survey Alicia Robb, UC Santa Cruz Robert W. Fairlie, UC Santa Cruz David T. Robinson, Duke University Gender and the Availability of Credit to Privately Held Firms: Evidence from the Surveys of Small Business Finances Rebel A. Cole, DePaul University Hamid Mehran, Federal Reserve Bank of New York Does Debtor Protection Really Protect Debtors? Evidence from the Small Business Credit Market Allen S. Berger, University of South Carolina, Wharton Financial Institutions Center and Center, Tilburg University Geraldo Cerqueiro, CentER, Tilburg University Fabian Penas, CentER, Tilburg University Capital Structure and Entrepreneurial Performance: New Firm Innovation and Survival Sheryl Winston Smith, Temple University 6 FEDERAL RESERVE BANK OF CLEVELAND Informal and Early Formal Financial Support in the Business Creation Process: Exploration with the PSED II Data Set Paul Reynolds, George Mason University Expected Returns of Angel Investors Ramon P. DeGennaro, University of Tennessee Gerald P. Dwyer, Federal Reserve Bank of Atlanta Value Added by Angel Investors through Post-Investment Involvement: Empirical Evidence and Ownership Implications Jess H. Chua, University of Calgary Zhenyu Wu, University of Saskatchewan 7 pd papers Presorted Standard FEDERAL RESERVE BANK OF CLEVELAND RESEARCH DEPARTMENT P.O. 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