Strat. Change 19: 928 (2010) Published online in Wiley Interscience (interscience.wiley.com) DOI: 10.1002/jsc.

855

RESEARCH ARTICLE

The ModiglianiMiller Proposition After Fifty Years and Its Relation to Entrepreneurial Finance1
Ciarn mac an Bhaird
Dublin City University, Ireland

Many studies emphasize the significance of two theoretical approaches based on information asymmetry and agency theory. Empirical evidence suggests that financial capital structures of entrepreneurial firms are determined by cost-based considerations, firm-specific characteristics, and ownerspecific factors, such as desire for control and managerial independence. Whilst firm owner preferences are paramount in determining capital structure, the common underlying factor in accessing external finance is the alleviation of information asymmetries, which is relatively easier for firms with a high level of fixed assets accessing debt markets.

mpirical evidence suggests that cost-based considerations, firmspecific characteristics, and owner-specific factors such as desire

for control and managerial independence are important determinants of capital structures of entrepreneurial firms. Keywords: capital structure, entrepreneurial nance, agency theory, information

asymmetry, nancial life cycle, protability, collateral, rm characteristics, owner preferences

Introduction
Most research on capital structure has focussed on public nonnancial corporations with access to U.S. or international capital markets . . . Yet even 40 years after the Modigliani and Miller research, our understanding of rms nancing choices is limited (Myers, 2001: 82) Early studies of small venture nancing frequently remarked that it was a much ignored subject of research (Zignales, 2000). A belated realization of the signicant economic contribution of SMEs has resulted in increased attention focused on the sector from policy-makers and academics. The earliest studies investigating SME nancing predominantly comprised government-sponsored surveys and reports, concentrating largely on potential deciencies and obstacles to the sustainability and development of the sector. These reports repeatedly addressed the provision of nance, and were instrumental in shaping and inuencing policy. Academic research on SME nancing is a relatively more recent topic of investigation, and articles that rst emerged were largely descriptive, primarily considering dierences between SMEs and large rms (Walker and Petty, 1978; Bates and Hally, 1982; Ang, 1991). These papers described general dierences between small and large rms, including ownership and management structures, nancing, and access to capital markets, and were not concerned with theory generation or theory testing per se. Subsequent studies addressed this deciency, employing theories developed in corporate nance
1

JEL classication codes: G32, G35.

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as the basis for empirical studies of small venture nancing (Daskalakis and Psillaki, 2008; Heyman et al., 2008; Mac an Bhaird and Lucey, 2010). Results from these studies conrm the relevance of capital structure theories for SME nancing, albeit employing a dierent rationale than their corporate nance counterparts. Expansion in research activity on the subject in the past two decades has resulted in a burgeoning corpus of material. Emerging initially from the UK (Chittenden et al., 1996) and the USA (Balakrishnan and Fox, 1993), studies have also been conducted in Portugal (Esperanca et al., 2003), Belgium (Manigart and Struyf, 1997; Heyman et al., 2008), Spain (Sogorb Mira, 2005; GarciaTeruel and Martinez-Solano, 2007), Italy (Giudici and Paleari, 2000), Sweden (Cressy and Olofsson, 1997; Berggren et al., 2000), Taiwan (Fu et al., 2002), India (Ghosh, 2007), Germany (Audretsch and Elston, 1997; Elsas and Krahnen, 1998), Australia (Cassar and Holmes, 2003; Fitzsimmons and Douglas, 2006), Greece (Daskalakis and Psillaki, 2008), and Ireland (Mac an Bhaird and Lucey, 2010). In light of the signicant body of accumulated research, it seems timely to analyze and evaluate previous studies and consider the state-of-the-art of the literature. This paper is organized around theoretical perspectives of rm nancing, commencing with the origin of capital structure theory; the irrelevance propositions of Modigliani and Miller (1958). The objectives of this paper are threefold: to evaluate the relevance of capital structure theories to SME nancing; to synthesize and summarize empirical studies on the subject; and to present a number of practical implications of previous conceptual and empirical studies. This paper examines universal theoretical concepts that are relevant to all SMEs, such as agency and information asymmetries, and focuses on the SME nancing literature. (A comprehensive overview of the venture capital literature is provided by Wright and Robbie, 1998 and Landstrom, 2008.) The paper proceeds as follows: fundamental issues pertaining to SME nancing are explained by outlining the relevance of theoretical propositions to the subject. Empirical evidence from pre-

vious research is then presented, categorized by two approaches: the rm characteristic approach and the owner characteristic approach. Practical implications of previous conceptual and empirical studies are then proposed. The paper concludes with a brief synopsis of results of previous studies.

The trade-off theory and SME financing

Capital structure theory originates in the irrelevance propositions of Modigliani and Miller (1958) (often referred to as the seminal work of Modigliani and Miller). In examining the eect of capital structure on the cost of capital, and therefore the market value of the rm, Modigliani and Miller (1958) demonstrate that under a number of assumptions the source of nancing employed has no eect on rm value. Modigliani and Miller conclude that rm value is determined by the protability and riskiness of its real assets, and not by its capital structure. These propositions were based on a number of unrealistic assumptions, most notably the absence of corporate taxes, which Modigliani and Miller introduced into the model in 1963. Within the tax system, interest payments on debt are allowable against corporate tax, and so a rm with debt faces a lower corporate tax bill than a similar all-equity nanced rm ceteris paribus. There is, however, a trade-o between the tax benets of debt and potential costs of nancial distress. A theoretical optimum is reached when the present value of tax savings due to further borrowing is just oset by increases in the present value of costs of distress. In accordance with the trade-o theory, rms have an optimal debt ratio which they attempt to maintain. Applicability of the trade-o theory to the SME sector has been the focus of a number of studies (Heyman et al., 2008; Lpez-Gracia and Sogorb Mira, 2008), although the debt tax shield is as relevant for SMEs as it is for publicly quoted rms. This is explained by consideration of two factors central to trade-o theory: protability and nancial distress. Research indicates that smaller rms are not as protable as larger rms (Pettit and Singer, 1985; Vos and Forlong, 1996; Michaelas

Copyright 2010 John Wiley & Sons, Ltd.

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et al., 1999), and thus have less use for debt tax shields ceteris paribus. Additionally, Day et al. (1983) argue that the tax shield is less valuable to small rms as they are generally less capital-intensive. This is because smaller rms adapt exible production technologies in order to compete with larger companies operating with lower average costs, maintaining an ability to respond swiftly to changes in demand (Mills and Schumann, 1985). This relatively lower capital expenditure means that the debt tax shield is of lesser value to smaller rms. A second component of the trade-o theory is risk of nancial distress. The ultimate consequence of nancial distress is bankruptcy, and it is well established in the literature that . . . young rms are more failure prone than older ones (Cressy, 2006b: 103). Higher bankruptcy rates in younger rms are indicative of the relatively higher business risk that smaller rms face, which is attributed to a number of factors. Firstly, smaller businesses may be overly dependent on a small number of customers (Hudson et al., 2001). This is exacerbated by dependence of many SMEs on a single product or service (Cambridge Small Business Research Centre, 1992). These rms are particularly vulnerable to nancial distress, as loss of their principal customer(s) would severely aect their chances of survival. Secondly, nascent and early-stage rms are vulnerable to problems of undercapitalization. This is aggravated by reduced access to external nance due to information opacity, and lack of a trading history. Thirdly, smaller rms are exposed to economic shocks and adverse macroeconomic conditions, which are intensied by the absence of hedging instruments in their nancial portfolio. Poorly diversied undercapitalized rms are particularly vulnerable under adverse macroeconomic conditions. The heightened business risk faced by younger, smaller rms indicates a lower threshold of nancial distress and bankruptcy costs. The impact of bankruptcy costs for the SME owner has farther-reaching and more severe personal eects than in the case of a publicly owned company. This is due to the well-documented integration of SME owners

personal nances with the nancing of the rm (Ang, 1992; Avery et al., 1998). Adverse eects of bankruptcy may thus have implications for the personal aairs of the owner, particularly in rms with unlimited liability. In this case, . . . consequences of business bankruptcy very often leads to personal bankruptcy, and the impact of provisions for the transfer of management and ownership to succeeding generations in a family enterprise (McMahon et al., 1993: 77). An additional onerous burden is the considerable negative eects on the owners reputation and self-esteem (Vos and Forlong, 1996). Empirical evidence for the eect of bankruptcy costs in SMEs is inconclusive; Michaelas et al. (1999) state that bankruptcy costs are not signicant enough to prove a negative relationship between risk and gearing, although Esperanca et al. (2003) nd that bankruptcy costs are a signicant determinant of debt ratios. A caveat of these studies is use of the coecient of variation in protability as a proxy for economic risk. This measure does not encompass all aspects of risk for the SME owner, particularly the proportion of personal wealth invested in the rm. Results of previous studies indicate that debt tax shields are not a rst-order concern for rms opting for debt nance. Jordan et al. (1998) and Sogorb Mira (2005) report a relationship contrary to predictions of trade-o theory. This is explained by the eect of the amount of tax paid on retained earnings, and consequently on the level of debt employed. Studies by Michaelas et al. (1999) and Bartholdy and Mateus (2008) nd that tax rates do not signicantly inuence the level of debt in SMEs. Collective evidence suggests that rm owners are more concerned with the potential negative eects of assuming more debt than the tax shield it confers.

Asymmetric information and signaling theories and SME financing

The Modigliani and Miller (1958) propositions were based on the assumption that corporate insiders and

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outside investors were privy to symmetric information. An alternative approach to capital structure theory is based on the assumption of asymmetry of information, i.e. that rm managers or insiders possess private information about the rm that outside uninformed investors do not. Thus, managers may use nancial policy decisions to reveal information about rms revenue streams and risk. Myers (1984) and Myers and Majluf (1984) present a pecking order model based on two primary assumptions: that a rms managers know more about revenue streams and investment opportunities than outside investors, and that managers act in the interests of existing shareholders. Therefore, announcement of an equity issue to new investors will be viewed as a bad signal, as investors perceive that managers will only issue stock if they believe it to be overvalued by the market. Underinvestment can be avoided by funding investment projects with internal funds. When internal funds are exhausted, debt is preferred to external equity as it is less susceptible to undervaluation due to information asymmetries. When internal cash ow and safe debt are exhausted, the rm issues risky debt or convertibles before common stock (Myers, 1984). There are two contrasting views in the literature on the source of information asymmetries in SME nance markets. One school of thought contends that external suppliers of nance have superior information on the value of a rms investment projects and prospects for survival, and therefore the SME bears the cost of information asymmetries (Garmaise, 2001). This view is supported by studies detailing the entrepreneurs excessive optimism about business prospects (Cooper et al., 1988), and the high non-survival rate among new rms (Audretsch, 1991; Cressy, 2006b). Additionally, survival rates among bank-nanced rms are higher than those among owner-nanced rms (Reid, 1991), indicating that nancial institutions are more skilled than insiders in appraising a rms chances of survival, particularly in nascent and start-up rms. The contrasting view is that insiders have greater knowledge about a rms investment projects, and may

take advantage of this superior information to the detriment of outsiders. This view emphasizes the lack of opacity in the small rm sector, which is exacerbated by the relatively high cost of compiling information on individual rms, the limited and fragmented market for this information, and diculties in signaling to nancial markets. Because of increased information opacity, investments are funded primarily by inside equity, including the rm owners funds, as he has superior information on the rm. Small rm owners thus try to meet their nance needs from a pecking order of: rst, their own money (personal savings and retained earnings); second, short-term borrowings; third, longer-term debt; and, least preferred of all, from the introduction of new equity investors (Cosh and Hughes, 1994). Firms debt ratios comprise the cumulative need for external nance over time (Myers, 1984; Myers and Majluf, 1984), and reect variations in factors such as initial capitalization, asset structure, protability, and rates of reinvestment. Garmaise (2001) states that this view of information asymmetries is more appropriate for established rms. Numerous studies report SME nancing patterns consistent with the pecking order theory, including Chittenden et al. (1996), Hall et al. (2004), Voulgaris et al. (2004), Baeyens and Manigart (2005), Gregory et al. (2005), Johnsen and McMahon (2005), Sogorb Mira (2005), Ou and Haynes (2006), Daskalakis and Psillaki (2008), and Mac an Bhaird and Lucey (2010). These studies emphasize that rms rely on internal equity and external borrowing to nance operations and growth, and only a very small number of rms employ external equity. Certain rms operate under a constrained pecking order, and do not even consider raising external equity (Holmes and Kent, 1991; Howorth, 2001). Other studies indicate that the nancing preferences of SMEs adhere to a modied pecking order, such as the High Technology Pecking Order Hypothesis (HTPOH) (Oakey, 1984; Brierley, 2001; Hogan and Hutson, 2005). This theory propounds that rms with a particular prole (high-technology rms with potential for high growth rates) prefer to nance

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Strategic Change DOI: 10.1002/jsc

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investment from internal equity, followed by external equity, and nally debt, and is supported by empirical evidence. In seeking to explain the apparent adherence of rms in the SME sector to the pecking order theory, the primary question is whether it is imposed by supply-side factors, or if it is due to demand-side choices. One of the most frequently examined issues in SME nancing addresses the supply of nance to the sector, and enquires whether there is a nancing gap. Holmes and Kent (1991) describe the nancing gap as having two components: a knowledge gap, whereby the rm owner has limited awareness of the appropriate sources of nance and the relative advantages and disadvantages of each source; and a supply gap, whereby funds are either unavailable to small rms, or the cost of debt to small rms exceeds the cost of debt to large rms. Authors in the eld of economics and SME nance have concentrated on the latter, with two polarized views emerging. Stiglitz and Weiss (1981) present a model of credit rationing in markets with imperfect information in which good projects are denied funding because of credit rationing. This is viewed as an underinvestment problem, where equity clears the market. The opposing theory of De Meza and Webb (1987, 2000) proposes that inability to discover risk characteristics of borrowers results in socially excessive levels of lending. Thus, the pooling of good projects with poor projects results in a lower interest rate charged to poor projects and credit rationing of good projects. The central issue concerns market eciency. Many papers empirically investigate the subject of a nancing constraint in SMEs, both supporting (Fazzari et al., 1988, 2000) and refuting (Levenson and Willard, 2000) the phenomenon. Intervention to alleviate funding gaps due to market ineciencies, if they exist, or if intervention is the proper response, is a question that has been comprehensively discussed by academics, policy-makers, and practitioners. Although evidence for a persistent equity gap is inconclusive, Cressy (2002) opines that governments across the globe will continue to intervene in SME capital markets because of political considerations.

An alternative approach to explaining the apparent adherence of SMEs to the pecking order theory concerns preferences of the rm owner, or demand-side issues. One reason for the observed hierarchy in nancing patterns is the relatively higher cost of external equity for smaller rms. The process of raising capital through an Initial Public Oering of common stock (IPO) is more expensive per share for SMEs due to the xed costs of due diligence, distribution, and securities registration (Berger and Udell, 1998). Despite the reduced cost and lesser diligence requirements of obtaining a listing on markets specically oriented towards smaller rms, such as the Alternative Investment Market (AIM), it remains a very costly process. Additionally, empirical evidence suggests that the eect of underpricing is signicantly more severe for smaller rms (Buckland and Davis, 1990; Ibbotson et al., 2001). Whilst the combination of these costs is an impediment to stock market otation, perhaps the greatest disincentive is the resultant loss of control due to wider equity ownership. The latter factor, along with the interrelated issue of managerial independence, is commonly cited as the primary reason for adherence of SMEs to the pecking order theory (Bolton, 1971; Chittenden et al., 1996; Jordan et al., 1998). In some cases, desire for independence is so great that SME owners eschew growth opportunities rather than relinquish control (Cressy and Olofsson, 1997; Michaelas et al., 1998). This also applies to debt nancing; Cressy (2006a) argues that the psychological costs of borrowing outweigh the benets, as the small rm owner dislikes interference from debt providers. In Cressys (2006a) model, as rms get larger and less personal, aversion to bank interference diminishes, whereas in micro rms control aversion restricts the amount borrowed. Desire to retain control and maintain managerial independence varies with ownership structure and rm prole. Previous studies have shown that desire for control is greater in family rms, primarily for reasons of intergenerational transfer (Poutziouris, 2002; LpezGracia and Sanchez-Andujar, 2007). The aspiration of retaining control may not be constant over the life cycle

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of the rm, however, and may change for reasons such as change of lifestyle or lack of a successor, for example. Fitzsimmons and Douglas (2006: 79) state that . . . there may come a point where the stress and responsibility of decision making, coupled with the entrepreneurs realisation that he/she lacks critical market, industry or management information, causes the entrepreneur to switch from autonomy preference to autonomy aversion. Further studies report that reluctance to employ external equity from new investors is dependent on sector, nding that owners of rms in the high-technology sector are willing to cede control in return for equity capital (Hogan and Hutson, 2005). Moreover, willingness to employ external equity may be contingent on added capabilities of the equity provider. For example, rm owners are willing to employ external equity from new investors in return for managerial input and non-nancial competencies (Giudici and Paleari, 2000; De Bettignies and Brander, 2007). Researchers in the corporate nance literature propose that rms overcome potential information asymmetry problems by signaling to the nancial markets through issuing debt or equity. Notwithstanding fundamental differences in the nature of public and private debt and equity markets, researchers assert that SMEs overcome information opacity by signaling to funders. Bester (1985) and Besanko and Thakor (1987) state that provision of personal assets by the rm owner as collateral for business loans may be interpreted as having a signaling function. Conversely, Coco (2000) and Manove et al. (2001) state that collateral is used by nancial institutions to protect against credit exposure, rather than as a signaling mechanism. This view is supported by Hanley and Crook (2005: 417), nding that . . . the menu approach that underpins signalling models as lacking in realism. This evidence does not completely reject the role of signaling in SME nancing, however. A number of studies nd that funders willingness to provide nance to SMEs is positively related to the nancial commitment of the rm owner to the venture, particularly the amount of personal nance invested (Storey, 1994a; Blumberg and

Letterie, 2008). These studies report that the amount of equity invested by the rm owner in a venture is a signal of the owners belief that the venture will succeed, and reduces the likelihood of incurring increased risk ex post, as: Willingness to put your own money into a venture is a pretty eective test of its worth and a high personal stake is a powerful incentive to good stewardship (Black et al., 1996: 73)

Agency theory and SME financing

Integrating theories of nance, agency, and property rights, Jensen and Meckling (1976) outline a nexus of relationships in publicly listed companies which could be characterized as principalagent relationships. Firms security holders (debtholders and equityholders) are seen as principals, and rms management as agent, managing the principals assets. The principalagent relation may be costly, because if both are utility maximizers . . . there is a possibility that the agent will not always conduct business in a way that is consistent with the best interest of the principals (Jensen and Meckling, 1976: 308). Conicts between debtholders and equityholders arise because of the uneven nature of payos in debt contracts. Once debtholders have advanced capital to equityholders, the latter have an incentive to take on riskier projects than intended by the debtholders, an eect known as the asset substitution eect. The eect of agency costs is more pronounced if businesses are small because information asymmetries are greater (Hand et al., 1982). Unique characteristics of SMEs increase the potential for agency costs, including alternative organisational forms, absence of publicly traded shares, risk taking tendency of entrepreneurs, limited personal wealth of rm owners and shortened expected duration for the rm (Ang, 1991: 4), conicts in perception regarding the intentions of the entrepreneur, the heightened probability of failure, and credibility of

Copyright 2010 John Wiley & Sons, Ltd.

Strategic Change DOI: 10.1002/jsc

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commitments and signals made by owners with limited wealth holdings (Keasey and Watson, 1993: 41). Agency costs are not constant across all rms; potential agency costs increase with intangibility of assets, as growth options increase and asset specicity rises (Gompers, 1995). Furthermore, incentives and opportunities for the ownermanager to gamble with outside investors claims are greatly enhanced when the rm becomes nancially distressed (Keasey and Watson, 1993). Application of agency theory to the SME sector focuses on the relationship between rm owners and suppliers of external capital. Suppliers of private equity seek to minimize agency costs by employing a number of techniques at frequent stages in the investment process. At the outset, venture capitalists conduct extensive due diligence (Manigart et al., 1997). Throughout the investment process further control mechanisms are employed, including: use of convertible securities, syndication of investment, and staging capital investment (Gompers, 1995), which is the most eective mechanism a venture capitalist can employ (Sahlman, 1990). Shorter duration between funding rounds increases the eectiveness in monitoring the rm. Intensity of monitoring is negatively related to expected agency costs, and the venture capitalist always retains the ultimate answer to agency problems: . . . abandonment of the project (Gompers, 1995: 1462). Whilst venture capital is an important source of nance for a limited number of SMEs, debt is by far the most commonly used source of external capital (Binks and Ennew, 1998; Cole, 2008). Potential agency costs are greater in the SME sector than in the corporate sector (Vos and Forlong, 1996), partly because reliable information on SMEs is rare and costly to obtain for nancial intermediaries (Baas and Schrooten, 2006). Potential problems arising from agency relationships with debt providers consist of moral hazard, and adverse selection. Adverse selection arises at loan origination when providers of debt have diculty in discriminating between good and bad investment projects, resulting in nancing constraints for small businesses (Stiglitz and Weiss, 1981;

Hyytinen and Vaananen, 2006). A demand-side consequence of adverse selection is that borrowers may be reluctant to apply for loans in the belief that their application will be rejected (Kon and Storey, 2003). Debt providers seek to minimize potential agency costs arising from moral hazard by employing a number of lending techniques. Baas and Schrooten (2006) propose a classication of four methods: asset-based lending, nancial statement lending, small business credit scoring (transactions-based or hard techniques), and relationship lending (a soft technique). Lending to SMEs by nancial institutions is frequently collateral-based (Kon and Storey, 2003: 45), and rms report that lack of security oered is the primary reason cited for refusal of a term loan (Basu and Parker, 2001; Ayadi, 2008). Empirical evidence from a number of countries indicates the pervasiveness in use of asset-based techniques to advance debt. For example, Black et al. (1996) nd that the ratio of loan size to collateral exceeds unity for 85% of small business loans in the UK, and Berger and Udell (1990) report that over 70% of all loans to SMEs are collateralized. Provision of collateral fullls a number of roles for nancial institutions: it provides an asset for the bank in the event of project failure (Bartholdy and Mateus, 2008); it provides an incentive for commitment to the entrepreneur and attenuates moral hazard (Boot et al., 1991); it provides a signal to the bank that the entrepreneur believes the project will succeed (Storey, 1994a); it mitigates information asymmetries, and thus reduces credit rationing (Besanko and Thakor, 1987); it may also help in the renegotiation of loans under nancial distress (Gorton and Kahn, 2000). A unique feature of SME debt markets is the personal commitment of the rm owner. Personal guarantees and provision of personal assets as collateral are important for rms seeking to secure business loans (Ang et al., 1995; Avery et al., 1998). These commitments are akin to quasi-equity, but as they are not recorded in the business nancial statement, the owners contribution to the rm is underestimated (Ang, 1992). Pledging outside collateral is even more eective in countering problems of

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moral hazard, as the rm owner may place a greater value on the asset than the market valuation. The borrowers risk preference incentives are limited as the likelihood increases that he will feel the loss personally (Mann, 1997), even if personal commitments represent . . . only a small fraction of the value of the loan (Berger and Udell, 1998: 639). An important aspect of the collateral-based lending technique is enforceability of the lenders collateral claims in the event of default, as the power of collateral ultimately depends on whether the priority rights of lenders are upheld in bankruptcy (Berger and Udell, 2006). Problems in enforcing collateral rights are more prevalent in countries with underdeveloped nancial infrastructures, compelling SMEs to rely on leasing, supplier credit, and development banks (Beck and Demirguc-Kunt, 2006). The greatest disadvantage of asset-based lending techniques is that they do not fully overcome problems of moral hazard and adverse selection, because not all rm owners have equal access to collateral (Storey, 1994b). This is especially true for high-technology start-ups and capital-intensive projects where the loans required are typically large (Storey, 1994b; Ullah and Taylor, 2005). Another disadvantage of this lending technique lies in the monitoring and legal costs (Chan and Kanatas, 1985), which may be passed on to SMEs in the form of higher lending charges. Because of these drawbacks, Baas and Schrooten (2006) contend that the asset-based lending technique is generally used as a substitute for relationship lending if the term of the relationship is short. Relationship lending is based on soft information generated by a banks experience with a lender through continuous contact with the rm and the rm owner in the provision of nancial services (Berger and Udell, 1998: 645). As a rm becomes established and develops a trading and credit history, reputation eects alleviate the problem of moral hazard (Diamond, 1989), facilitating borrowing capacity. Studies emphasize the importance of relationship lending in funding SMEs (Berger and Udell, 1995; Cole, 1998), and Hanley and Crook (2005) state that a pre-existing reputation is the single most important

determinant in inducing a bank to extend a loan. Empirical evidence suggests additional benets of relationship lending, including lower interest rates (Berger and Udell, 1995; Keasey and Watson, 2000), lower collateral requirements (Elsas and Krahnen, 1998), access to increased amounts of nance, and protection against credit crunches (Berger and Udell, 1998). The importance of lending relationships for provision of nance to the sector is emphasized by studies highlighting the destructive eects on relationship lending of the consolidation of the banking sector through mergers (Cole, 1998; Berger and Udell, 2002), making it too costly for banks to provide relationship-based services (Berger and Udell, 1998); and by resultant changing practices within banks, such as making lending decisions centrally (Berger and Udell, 2006). Additional techniques employed by nancial institutions to advance debt include nancial statement lending and credit scoring. The former technique entails basing the lending decision on nancial statements of the rm, and is thus dependent on the strength of the balance sheet and income statements of applicants (Baas and Schrooten, 2006). Credit scoring lending techniques augment data provided in nancial statements with additional information, such as the creditworthiness and nancial history of the rm owner, to predict probability of repayment (Frame et al., 2001). The eectiveness of this technique is based on the quality of available data (Baas and Schrooten, 2006). These latter approaches require more analytical skills and monitoring than asset-based lending approaches (Berger and Udell, 1998), and are more costly to administer. Berry et al. (2004: 118) conclude that the approach adopted by lending institutions . . . varies from case to case, and ultimately depends on the availability and cost of acquiring information. Recent developments in recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision (the Basel II Accord) may have implications for lending to the SME sector (Ayadi, 2008). The agreement proposes adoption of more risk-sensitive minimum capital requirements for banks. Financial

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Strategic Change DOI: 10.1002/jsc

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institutions may therefore assign more importance to the relative riskiness of borrowers, and will require more information than heretofore. This will place greater reporting and disclosure requirements on SMEs, although safer rms may benet from lower interest rates and greater access to loans. Smaller, riskier SMEs may face greater diculty in sourcing debt nance, higher interest rates, and greater collateral requirements (Tanaka, 2003).

The financial growth life cycle approach

More recently, SME researchers have considered rm nancing through a stage model or life cycle approach, viewing development of the rm as a linear sequential process through a number of stages. This approach originates in economics literature (Penrose, 1952, 1959; Rostow, 1960), and is commonly used to describe progression of the successful rm through growth phases. Adopted by researchers in corporate nance, and presented as a descriptive concept in early textbooks (Weston and Brigham, 1970), it outlines sources of nance typically available at various growth stages of the rm, along with potential nancing problems that may arise at each stage. Applying this model to SME nancing, Berger and Udell (1998) present rms on a size/age/information continuum, and describe the increasing array of nancing options available to the rm as it grows. Their nancial growth life cycle model incorporates changes in availability of information and collateral in describing sources of nance available to rms over time. Berger and Udell (1998) thus conceptualize the sequencing of funding over the life cycle of the rm centered on information opacity and following a nancial pecking order. Smaller, more informationally opaque rms are depicted to the left side of the continuum, relying on . . . initial insider nance, trade credit, and/or angel nance (Berger and Udell, 1998: 622). As rms advance along the continuum, they gain access to increased sources of external debt and equity. Ultimately, rms may access greater amounts of capital in public debt and equity markets. Empirical tests

of nancial life cycle models include studies by Fluck et al. (1998) and Gregory et al. (2005). The former study nds that, contrary to predictions of the nancial growth life cycle model, external sources of nance exceed internal sources for the youngest rms. Furthermore, Fluck et al. (1998) nd that the contribution of the rm owner increases initially and then decreases in rms over 12 years old. The initial increase in use of insider nancing is explained by rm owners employing retained earnings for investment because of potential diculties in raising external nance explained by the monopoly-lender theory (Rajan, 1992). The subsequent decrease in use of internal sources is explained by older rms sourcing increasing amounts of external debt due to reputation eects (Diamond, 1989). Results from a study by Gregory et al. (2005) partially support the model, although they conclude that the nancial growth life cycle cannot be encompassed in a one size ts all universally applicable model.

Empirical evidence of determinants of SME financing

Previous empirical studies on SME nancing can generally be categorized as rm characteristic or owner characteristic studies, depending on the level of analysis. A number of studies employ a multi-level approach, combining rm and owner characteristics. These approaches dier substantially with respect to the means of data collection, methods of analysis employed, and presentation of ndings. Firm characteristic studies The majority of rm characteristic studies adopt the positivist approach applied in corporate nance, developing and testing multivariate regression models utilizing panel data (Daskalakis and Psillaki, 2008; Heyman et al., 2008; Lpez-Gracia and Sogorb Mira, 2008). Data is generally sourced from secondary sources, such as the Dun and Bradstreet database (Hall et al., 2004). These studies investigate the extent to which debt ratios are

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determined by rm characteristics, commonly employing short-term, long-term, and total debt ratios as dependent variables (Lpez-Gracia and Sogorb-Mira, 2008). Despite being the most important source of investment nance for SMEs, studies employing internal equity as the dependent variable are rare (Ou and Haynes, 2006; Mac an Bhaird and Lucey, 2010). Firm characteristic studies are commonly representative of a broad range of sectors, and sample sizes are typically large (Sogorb Mira, 2005). Notwithstanding signicant inter- and intra-industry dierences, a number of consistent results have emerged. Firm size: Results from previous studies indicate a positive relationship between long-term debt and size (Daskalakis and Psillaki, 2008; Heyman et al., 2008; Lpez-Gracia and Sogorb-Mira, 2008; Mac an Bhaird and Lucey, 2010), which is consistent with the view that smaller rms are oered, and employ, less long-term debt due to scale eects (Cassar and Holmes, 2003). This positive relationship may also be accounted for by collateral eects, as the natural logarithm of total assets is commonly employed as a proxy variable for size. Firms with a greater amount of collateralizable assets have capacity for higher long-term debt ratios ceteris paribus, and tend to match maturity of debt with that of assets (Bartholdy and Mateus, 2008). In contrast, results from previous studies indicate a negative relationship between use of short-term debt and size (Esperanca et al., 2003; Hall et al., 2004). This nding is consistent with the view that smaller rms are heavily reliant on short-term debt (Garcia-Teruel and MartinezSolano, 2007), and may result from rms being unwilling or unable to employ long-term debt because of relatively higher transaction costs. Firm age: Empirical evidence from previous studies indicates that debt (both short-term and long-term) is negatively related with age (Bartholdy and Mateus, 2008; Lpez-Gracia and Sogorb-Mira, 2008; Mac an Bhaird and Lucey, 2010). This suggests a pattern of nancing consistent with the pecking order theory, as rms become less reliant on external funding over time as debt is retired and

rms become increasingly reliant on retained prots. Furthermore, a number of researchers emphasize that the relationship between source of nance and age is more complex, in particular that patterns of nancing over time are not necessarily linear (Fluck et al., 1998). This constitutes a more sophisticated investigation of rm nancing, surmounting the assumption of linearity in nancial growth life cycle models. Protability: Coecients for the relationship between debt and protability in previous studies are typically negative (Bartholdy and Mateus, 2008; Daskalakis and Psillaki, 2008; Heyman et al., 2008), indicating that rms employ debt nance when retained prots are insucient for investment requirements. These results are consistent with the pecking order theory, and emphasize the importance of protability in nancing the sector, as retained prots are the most important source of nance for SMEs (Ou and Haynes, 2006; Cole, 2008). Asset structure: Empirical evidence from previous studies indicates a positive relationship between use of long-term debt and asset structure (Daskalakis and Psillaki, 2008; Heyman et al., 2008; Mac an Bhaird and Lucey, 2010), supporting the proposition that asset structure is the principal determinant of access to external nance for SMEs (Bartholdy and Mateus, 2008). Results reveal a negative relationship between short-term debt and xed assets (Hall et al., 2004; Johnsen and McMahon, 2005; Sogorb Mira, 2005), suggesting that rms shortterm debt is secured on other (short-term) collateral, or unsecured. These results suggest inter-industry dierences in capital structures, as rms in industries typied by greater levels of collateralizable assets have the capacity for, and may employ, greater levels of debt than rms with a higher concentration of intangible assets (Brierley and Kearns, 2001). Indeed, intra-industry capital structures may be more comparable than inter-industry capital structures (Harris and Raviv, 1991). Empirical evidence of sectoral eects is mixed, with studies both supporting (Michaelas et al., 1999; Hall et al., 2000) and failing to support this hypothesis. Examples of the latter include

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Balakrishnan and Fox (1993), who conclude that rmspecic characteristics are more important than structural characteristics of industry, and Jordan et al. (1998), who nd that nancial and strategy variables have greater explanatory power than industry-specic eects. Growth: Consistent with the observation that highgrowth rms typically have a large external nancing requirement (Gompers and Lerner, 2003), results of previous studies indicate a positive relationship between growth and debt ratios (Sogorb Mira, 2005; Daskalakis and Psillaki, 2008). Evidence suggests that the nature of funding for growth (short-term or long-term) is dependent on asset structure. Firms investing in rm-specic or intangible assets are typically nanced by external equity (Brierley and Kearns, 2001). They have diculty accessing long-term debt, and may resort to short-term debt as an alternative (Hall et al., 2000; Johnsen and McMahon, 2005). Non-debt tax shields: Lack of empirical evidence indicating the relevance of tax advantages of debt may be partly explained by the signicant negative relationships between debt and non-debt tax shields (Michaelas et al., 1999; Sogorb Mira, 2005; Lpez-Gracia and SogorbMira, 2008). Use of non-debt tax shields lessens the importance of the debt tax shield, and consequently the level of debt employed. By employing non-debt tax shields such as investment credits or accelerated depreciation costs, rms seek to avoid distress costs or other adjustment costs which . . . may be more important in particular instances (Lpez-Gracia and Sogorb-Mira, 2008: 119). These results imply that rms with higher levels of tangible assets can maintain higher levels of debt, supporting the secured-debt view propounded by Smart et al. (2007) and Bartholdy and Mateus (2008). Operating risk: Given the importance of retained prots as a source of investment nance in SMEs (Cole, 2008), it is hardly surprising that the coecient of variation in protability is commonly used as a proxy for operating risk. Results from previous studies indicate that the level of debt employed by SMEs is positively related

to operating risk as measured by volatility in earnings (Michaelas et al., 1999; Esperanca et al., 2003). This indicates that bankruptcy costs are not suciently large to deter risky SMEs from employing additional debt, particularly short-term debt. Furthermore, these results may indicate distress borrowing, particularly in adverse macroeconomic conditions (Jordan et al., 1998). A notable feature of these studies is the diculty in calculating an appropriate variable for bankruptcy costs. In summary, empirical investigations of rm characteristic determinants of SME capital structures reveal a number of consistent results; for example, positive relationships between debt nance and growth; and between long-term debt and tangible assets; and negative relationships between debt nance and protability; and between debt and rm age. There are also a number of conicting results, however, such as relationships between short-term debt and rm size, and short-term debt and tangible assets. Notable features of previous studies are the lack of statistical signicance, and the low explanatory power of a number of models, especially in models employing short-term debt as a dependent variable. These shortcomings prompt researchers to seek further explanations for SME nancing, employing alternative methodologies and analysis techniques. Owner characteristic studies The inuence of rm owners business goals, objectives, and preferences on SME nancing is understated, as witnessed by the relative paucity of published papers employing this approach. Variables examined in previous studies investigating the inuence of owner characteristics on a rms capital structure may be delineated by two approaches: (1) a rm owners personal characteristics, such as age, gender, race, education, and previous business experience, and (2) a rm owners preferences, business goals, and motivations. Data for studies adopting these approaches are typically sourced from interviews and postal questionnaires, and are commonly analyzed employing descriptive and non-parametric techniques. Sample

Copyright 2010 John Wiley & Sons, Ltd.

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sizes are generally smaller than those in quantitative studies employing panel data, resulting in limitations to the generalizability of results. Personal characteristics investigated in owner characteristic studies include race (Scherr et al., 1993; Hussain and Matlay, 2007; Salazar, 2007), gender (Brush, 1992; Carter and Rosa, 1998; Boden and Nucci, 2000; Coleman and Cohn, 2000), tertiary education (Cassar, 2004), age (Romano et al., 2001), and years of business experience (Coleman and Cohn, 2000; Cassar, 2004), amongst others. Whilst researchers generally do not nd signicant empirical evidence supporting the proposition that rm owners personal characteristics determine the source of nancing employed (Cassar, 2004), a number of signicant results have emerged. For example, Chaganti et al. (1995) nd that women are more likely to employ internal than external equity; Romano et al. (2001) discover that older business owners are less likely to employ external equity; Scherr et al. (1993) nd that owners age is negatively related with debt, and also that more debt is obtained if the owner is married and less if he is black. Coleman and Cohn (2000) test if rm owners age, education, years of experience, prior experience in a family-owned business, and gender inuence the capital structure decision, and nd education of the rm owner to be the sole signicant variable. In summary, although evidence suggests that personal characteristics of the rm owner may inuence nancing choice in SMEs, the bulk of empirical evidence indicates that these variables are not of primary importance (Carter and Rosa, 1998). Perhaps the single most important owner characteristic variable directly related to SME nancing is personal wealth of the rm owner. Personal wealth of the entrepreneur inuences the rate of business start-ups (Evans and Jovanovic, 1989; Fairlie, 1999), and its use is dependent on the rm owners: (a) propensity for risk, (b) wealth relative to the capital requirements of the rm, and (c) availability of external sources of nance. The latter may, in turn, be dependent on the amount of personal equity

the rm owner is willing to invest in the venture (Bruns and Fletcher, 2008). This is most important in the startup and nascent stages (Berger and Udell, 1998; Fluck et al., 1998; Ullah and Taylor, 2007), when wealth constraints may contribute to the commonly experienced problem of undercapitalization. Despite the importance of personal wealth of the rm owner to SME nancing, empirical studies on the relative inuence of this variable on the capital structure of SMEs are rare due to the sensitive nature of the data. A further approach adopted in owner characteristic studies is to examine the inuence of rm owners preferences, motivations, and business goals on rm nancing. These studies seek to explain SME capital structures with reference to non-nancial factors, including desire for control, managerial independence, motivation for being in business, business goals, nancial objective function, and propensity for risk (Jordan et al., 1998; Michaelas et al., 1998; Romano et al., 2001). Evidence indicates that these factors may be more important than rm characteristic factors in explaining SME nancing (Barton and Matthews, 1989; Norton, 1990; Jordan et al., 1998), particularly the desire to retain managerial control and independence. Furthermore, the primary nancial objective of small rm owners is maximization of net income (LeCornu et al., 1996), which is consistent with the goal of maintaining control of the rm.

Conclusion
Whilst authors have expressed the view that the ModiglianiMiller theorem is empirically incorrect (Jensen, 1993) and perhaps unsuitable for application to the SME sector, empirical evidence indicates the importance of two theoretical approaches adopted from the corporate nance literature: agency theory, and theories based on information asymmetries. Over half a century after the ModiglianiMiller proposition, and following almost two decades of academic research on SME nancing, a number of consistent results suggest the following conclusions:

Copyright 2010 John Wiley & Sons, Ltd.

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1. SMEs are generally funded in a manner consistent with the pecking order theory, i.e. in the order of: rst, internal funding (rm owners funds and retained earnings); second, debt nance; third, external equity from new investors, which is the least desired form of nancing. The primary rationale for this preference is the rm owners desire to retain control of the rm and maintain managerial independence. A second consideration is cost, as debt nance is generally less expensive than external equity from new investors. 2. SMEs applying for debt nance must typically satisfy funders requirements to overcome potential agencyrelated costs of moral hazard. Financial institutions commonly employ asset-based lending techniques. Although funders also employ alternative techniques, such as relationship lending, and seeking personal guarantees, rms that do not have access to lien-free collateralizable assets have greater diculty in accessing debt nance ceteris paribus. 3. Resourcing of SMEs generally follows a nancial growth life cycle. This model incorporates elements of agency and information-asymmetry theories, and models nancing across a life cycle continuum (Berger and Udell, 1998). Employing this approach, rm nancing generally follows the following trajectory. At start-up, access to nance is typically limited, and is largely dependent on the resources of the rm owner, friends, and family. This includes equity and quasiequity, as debt nance for the rm is often secured on the personal assets of the rm owner. As the rm grows and matures, nance is increasingly sourced from retained prots, as reliance on the personal funds of the rm owner, friends, and family diminishes. As rms progress along the later stages of the life cycle continuum, increased amounts and sources of funding are typically available. Progression along the life cycle continuum is dependent on the rm owners growth objectives, and desire to retain control of the rm. Notwithstanding the signicant increase in academic research of SME nancing over the past two decades,

there are a number of outstanding issues that are unresolved. (Whilst a number of scholars suggest that venture capital rather than nancial aspects oer a more promising avenue of research (Blackburn, 2009), a number of issues are pertinent for all rms, regardless of the means of nancing employed.) A signicant impediment to researching these and other issues is the lack of comprehensive databases containing complete data. Databases, such as exist, are either incomplete, or are not representative of the total population. The paucity of comprehensive, reliable data on small ventures will be exacerbated with the introduction of the EU Administrative Burdens Exercise, which is likely to reduce the availability of published accounting data in countries where such information is presently readily available. This issue may be overcome by employing methodologies such as questionnaire and interview data collection. These methods facilitate examination of issues such as the process of raising nance and how it is inuenced by factors such as past experience with nanciers, pledging of personal guarantees to secure debt nance, percentage of the rm owners wealth invested in the rm, issues of succession in family rms, and a number of other potentially important factors. This approach also enables a more in-depth examination of how incremental nancing decisions of SME owners change through successive developmental stages of the rm, and facilitates development of more sophisticated nancial growth life cycle models.

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Ciarn mac an Bhaird

BIOGRAPHICAL NOTE

Ciarn mac an Bhaird is a lecturer of Business and Management, and Chair of the undergraduate degree programs at Fiontar, Dublin City University, Ireland.
Correspondence to: Ciarn mac an Bhaird Fiontar, Dublin City University Dublin 9, Ireland email: ciaran.macanbhaird@dcu.ie

Copyright 2010 John Wiley & Sons, Ltd.

Strategic Change DOI: 10.1002/jsc

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