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TheEconomicsofSmallBusinessFinance:TheRolesofPrivateEquityandDebtMarketsintheFinancialGrowthCycle
AllenN.BergerBoardofGovernorsoftheFederalReserveSystemWashington,DC20551U.S.A.andWhartonFinancialInstitutionsCenterPhiladelphia,PA19104U.S.A.GregoryF.UdellStemSchoolofBusiness,NewYorkUniversityNewYork,NY10012U.S.A.Forthcoming,
JournalofBankingandFinance
Volume22,1998
Abstract
Weexaminetheeconomicsoffinancingsmallbusinessinprivateequityanddebtmarkets.Firmsareviewedthroughafinancialgrowthcycleparadigminwhichdifferentcapitalstructuresareoptimalatdifferentpointsinthecycle.Weshowthesourcesofsmallbusinessfinance,andhowcapitalstructurevarieswithfirmsizeandage.Theinterconnectednessofsmallfirmfinanceisdiscussedalongwiththeimpactofthemacroeconomicenvironment.Wealsoanalyzeanumberofresearchandpolicyissues,reviewtheliterature,andsuggesttopicsforfutureresearch.JELclassificationcodes:G21,G28,G34,E58,L89Keywords:VentureCapital,SmallBusinessLending,Bank,MergersTheopinionsexpresseddonotnecessarilyreflectthoseoftheBoardofGovernorsoritsstaff.TheauthorsthankZoltanAcs,MitchBerlin,EmiliaBonaccorsi,SethBonime,MarkCarey,DanCovitz,MariaFilson,HesnaGenay,GibiGeorge,MarkGertler,JereGlover,DianaHancock,AnilKashyap,NellieLiang,ZacharyMagaw,NicoleMeleney,LorettaMester,DonMorgan,PatriciaMiller-Edwards,CharlesOu,LindaPitts,LorettaPoole,PhilStrahan,LarryWhite,andJohnWolkenforhelpwiththearticle.PleaseaddresscorrespondencetoAllenN.Berger,MailStop153,FederalReserveBoard,20thandCSts.NW,Washington,DC20551,call202-452-2903,fax202-452-5295,oremailaberger@frb.gov.
 
I.Introduction
Theroleoftheentrepreneurialenterpriseasanengineofeconomicgrowthhasgarneredconsiderablepublicattentioninthe1990s.Muchofthisfocusstemsfromthebeliefthatinnovation--particularlyinthehightech,information,andbio-technologyareas--isvitallydependentonaflourishingentrepreneurialsector.ThespectacularsuccessstoriesofcompaniessuchasMicrosoft,Genentech,andFederalExpressembodythesensethatnewventurecreationisthesinequanonoffutureproductivitygains.Otherrecent“phenomenahavefurtherfocusedpublicconcernandawarenessonsmallbusiness,includingthecentralroleofentrepreneurshiptotheemergenceofEasternEurope,financialcrisesthathavethreatenedcreditavailabilitytosmallbusinessinAsiaandelsewhere,andthegrowinguseoftheentrepreneurialalternativeforthosewhohavebeendisplacedbycorporaterestructuringintheU.S.Accompanyingthisheightenedpopularinterestinthegeneralareaofsmallbusinesshasbeenanincreasedinterestbypolicymakers,regulators,andacademicsinthenatureandbehaviorofthefinancialmarketsthatfundsmallbusinesses.Atthecoreofthisissuearequestionsaboutthetypeoffinancinggrowingcompaniesneedandreceiveatvariousstagesoftheirgrowth,thenatureoftheprivateequityanddebtcontractsassociatedwiththisfinancing,andtheconnectionsandsubstitutabilityamongthesealternativesourcesoffinance.Beyondthisinterestinthemicro-foundationsofsmallbusinessfinanceisagrowinginterestinthemacroeconomicimplicationsofsmallbusinessfinance.Forexample,theimpactoftheU.S.“creditcrunch”oftheearly1990sandtheeffectoftheconsolidationofthebankingindustryontheavailabilityofcredittosmallbusinesshavealsobeenthesubjectofmuchresearchoverthepastseveralyears.Similarly,the“creditchannels”ofmonetarypolicy--mechanismsthroughwhichmonetarypolicyshocksmayhavedisproportionatelylargeeffectsonsmallbusinessfunding--hasgeneratedconsiderableanalysisanddebate.Otherkeyissues,suchasthelinkbetweentheinitialpublicoffering(IPO)marketandventurecapitalflows,prudentmanrulesregardinginstitutionalinvestinginventurecapital,andtheroleofsmallfirmfinanceinfinancialsystemarchitecturearejustbeginningtoattractresearchattention.Theprivatemarketsthatfinancesmallbusinessesareparticularlyinterestingbecausetheyaresodifferentfromthepublicmarketsthatfundlargebusinesses.Theprivateequityanddebtmarketsofferhighlystructured,complexcontractstosmallbusinessesthatareoftenacutelyinformationallyopaque.Thisisincontrasttothepublicstockandbondmarketsthatfundrelativelyinformationallytransparentlarge
 
2businessesundercontractsthataremoreoftenrelativelygeneric.Financialintermediariesplayacriticalroleintheprivatemarketsasinformationproducerswhocanassesssmallbusinessqualityandaddressinformationproblemsthroughtheactivitiesof
screening,contracting,
and
monitoring.
Intermediariesscreenpotentialcustomersbyconductingduediligence,includingthecollectionofinformationaboutthebusiness,themarketinwhichitoperates,anycollateralthatmaybepledged,andtheentrepreneurorstart-upteam.Thismayinvolvetheuseofinformationgarneredfromexistingrelationshipsoftheintermediarywiththebusiness,thebusinessowner,orotherinvolvedparties.Theintermediarythenusesthisinformationabouttheinitialqualityofthesmallbusinesstosetcontracttermsatorigination(price,fractionofownership,collateral,restrictivecovenants,maturity,etc.).Acontractdesignandpayoffstructureischosenonthebasisofthefinancialcharacteristicsofthefirmandtheentrepreneuraswellasthefirm’sprospectsandtheassociatedinformationproblems.Highrisk-highgrowthenterpriseswhoseassetsaremostlyintangiblemoreoftenobtainexternalequity,whereasrelativelylowrisk-lowgrowthfirmswhoseassetsaremostlytangiblemoreoftenreceiveexternaldebtforreasonsexploredbelow.Finally,inordertokeepthefirmfromengaginginexploitiveactivitiesorstrategies,theintermediarymonitorsthefirmoverthecourseoftherelationshiptoaswwscomplianceandfinancialcondition,andexertscontrolthroughsuchmeansasdirectlyparticipatinginmanagerialdecisionmakingbyventurecapitalistsorrenegotiatingwaiversonloancovenantsbycommercialbanks.Thispaperhasseveralmotivations.Thefirstistoprovideascompleteapictureaspossibleofthenatureoftheprivateequityanddebtmarketsinwhichsmallbusinessesarefinancedbasedoncurrentlyavailableresearchanddata.Thesecondistodrawconnectionsbetweenvariousstrandsofthetheoreticalandempiricalliteraturethathaveinthepastfocusedonspecificaspectsofsmallfirmfinancebutoftenhavenotcapturedthecomplexityofsmallbusinessfinanceandthealternativesourcesoffundingavailabletothesefirms.Thethirdgoalistosuggestextensionstotheresearchinkeyareasrelatedtothemarkets,contracts,andinstitutionsassociatedwithsmallfirmfinanceandtohighlighttherelativelynewdatasourcesavailabletoaddresstheseissues.Weproceedinthenextsectionwithadiscussionoftheidiosyncraticnatureofsmallfinance,theprivatemarketsthatprovidethisfinance,andanoverviewofkeyresearchissues.InbusinessSections
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