(This interview appeared in SAFE Newsletter Q1 2018)
It is often claimed that one of the main barriers to the development of young firms is the lack of financing. However, there is rather little empirical research of such firms. In this interview, Uwe Walz, Professor of Management and Microeconomics at Goethe University and Director of SAFE, elaborates on the dynamics of financing of newly founded firms and on the effect of shocks on their financing and investment behavior. Uwe Walz’ research mainly focuses on private equity, entrepreneurial finance and contract theory as well as on the industrial organization of financial markets.
Despite the fact that young firms are considered to be important for the dynamics and development of the overall economy, very little is known about their financing structure. In two recent studies you investigate the financing dynamics and financial constraints of newly founded firms. What does their initial financing structure look like?
The question of whether newly founded firms often face financing gaps is a frequently discussed issue in politics. However, because of the lack of data there is only little empirical research on this topic. One has to bear in mind that the fast-growing start-ups, that usually attract much attention in the public and academic debate, are only a very small minority of the group of newly founded firms. By examining a sample of 2,620 French firms, founded in the years 2004 to 2006, we aim to contribute to filling this gap. As opposed to start-up companies, which usually emerge from the digital industries and grow quite fast, we focus on companies mainly from the manufacturing sector, which grow much more slowly. To the best of our knowledge our sample, which stems from the ALTARES database, is quite representative for the overall French population of newly founded firms in this period and in these industries. We found a clear-cut picture of the initial financing structure of these newly founded firms: They rely to an astonishing extent on external financing sources that include trade credit from their suppliers as well as formal bank credit. In the first year, more than a quarter of their funds, on average, come from bank lending (see figure). The amount of bank credit we found speaks against the often-claimed difficulty of young entrepreneurial firms to access formal bank loans.
To what extent is the future financing structure of those firms determined by the initial financing pattern?
This question is highly relevant because, if the initial financing pattern is persistent and has an impact on the development of the company, then, obviously, initial financing matters a lot. If initial financing converges in the medium term to a unique equilibrium, however, then the starting point is much less of importance. Our empirical analysis comes to mixed results on this question: We find, on the one hand, huge differences across firms in the first place which, however, slowly but surely tend to converge such that firms with a lower initial level of debt accumulate more debt over time whereas firms which are initially more leveraged accumulate less debt. On the other hand, we find that the dispersion of financing structures becomes even greater over time. Since our data display patterns of hysteresis in this latter sense, for example in the aftermath of temporary firm-specific shocks, we conclude that those shocks have permanent effects and cause the dispersion of financing structures.
Financing is usually considered a major factor for growth of young companies. Have you found evidence for this hypothesis?
We find in our 2016 SAFE working paper that initial share capital has a significant positive effect on the growth both of total assets and of sales, meaning that firms which initially finance with equity seem to grow significantly faster than their debt-financed counterparts. These effects are identical for firms with low and high profitability, which implies that access to equity financing is crucial for all newly founded firms in order to steepen their growth path. However, we find opposite effects for these two types of firms in the debt financing case: For highly profitable firms, debt financing has a significant negative effect, meaning that highly profitable firms which are initially mainly financed by debt grow more slowly while the opposite is true for firms with low profitability. A possible explanation is that low profitability firms are potentially more financially constrained in the first years so that access to external financing might alleviate the negative growth effect that stems from a lack of capital.
Your sample period includes the years of the financial crisis 2008/2009. As newly founded firms are likely to be affected by shocks, how did they react on the crisis in terms of financing decisions?
We show in our 2017 SAFE working paper that the financial crisis reduced overall debt financing as well as the different types of specific sources of debt, such as long-term debt as well as trade-credit financing. The crisis also imposed a shock on the investments of newly founded firms. Interestingly, we found that it was more the demand shock (resulting from the shock on the firms’ product market) than a lack of credit supply which led them to reduce investments and bank lending. Of course, there was also a supply shock because banks reduced lending overall. However, according to our data on French newly founded firms, the demand shock was significantly stronger.
Did the financial crisis affect all newly founded firms to the same extent?
Interestingly, the financially constrained firms in our sample were affected to a smaller degree than financially non-constrained firms. This holds for all different financing sources. With respect to the effect of the crisis on investment decisions we do not find any differences between financially and non-financially constrained firms; the financial crisis reduced the investment levels of all companies in our sample. Both findings suggest that the demand channel seems to have played a bigger role than the supply shock.
The financial crisis was a special environment for newly founded firms. Do financial constraints matter in general?
We find that financially constrained firms use less external debt financing than their counterparts, which clearly shows their limited access to this form of financing. They can also rely less on trade credit. When it comes to repayment of debt, it turns out that financially constrained firms repay less than their non-financially constrained counterparts. Regarding investments we find that financially constrained firms invest less than non-financially constrained firms. This leads us to the conclusion that financial constraints stemming from informational asymmetries are an impediment for growth for young companies.
Hirsch, J. and U. Walz (2017), “Financial Constraints, Newly Founded Firms and the Financial Crisis”, SAFE Working Paper No. 191.
Hirsch, J. and U. Walz (2016), “The Financing Dynamics of Newly Founded Firms”, SAFE Working Paper No. 153.