Cases of start-up financing An analysis of new venture capitalisation
structures and patterns Andrew Atherton
Enterprise Research and Development Unit, University of Lincoln, Lincoln, UK
Abstract Purpose – This paper seeks to understand the dynamics of new venture financing across 20 business start-ups. Design/methodology/approach – A total of 20 cases were explored, via initial discussions with the founder(s), and follow-up contact to confirm sources of financing acquired during new venture creation. This approach was adopted because of the challenges associated with acquiring full details of start-up financing, and in particular informal forms of new venture financing. Findings – Significant variation in, and scale of, new venture financing was identified. In multiple cases, funding patterns did not tally with established explanations of small business financing. Research limitations/implications – The primary limitation of the analysis is the focus on a small number of individual cases. Although this allowed for more detailed analysis, it does not make the findings applicable across the small business population as a whole. New ventures acquired very different forms of finance, and in different configurations or “bundles”, so creating a wide range of start-up financing patterns and overall levels of capitalisation. This suggests that multiple factors influence founder decisions on start-up funding acquisition. It also indicates the wide divergence between highly capitalised and under-capitalised start-ups. Practical implications – Many of the new ventures were started with low levels of capitalisation, which as the literature suggests is a strong determinant of reduced prospects for survival. This suggests a possible “financing deficit”, rather than gap, for a proportion of business start-ups. Originality/value – The paper provides an alternative methodology for considering new venture financing, and as a result concludes that standard, rational theories of small business financing may not always hold for new ventures.
Keywords New venture, Business start-up, Business formation, Financing, Entrepreneurship
Paper type Research paper
Introduction From a policy maker’s perspective, a lack of funding discourages people from starting businesses (Bank of England, 2003, 2004; EC, 2003; OECD, 1998). There is empirical support for the policy assertion that small businesses can face difficulties in acquiring finance that constrain their prospects for venture creation, survival and growth (Binks and Ennew, 1996; Harding and Cowling, 2006; Holmes and Kent, 1991; Hughes and Storey, 1994; Landstrom andWinborg, 1995; Lopez-Gracia andAybar-Arias, 2000; Reid, 2003), although there are studies that question the existence of funding gaps (Uusitalo, 2001). Theoretically-basedarguments for andagainst fundinggapsmostly conclude that small firms face finance constraints (Ang, 1992a, b; Binks et al., 1992) or are discouraged (KonandStorey, 2003), although somepropose that such issues are trivial or non-existent (Cressy, 1996; Parker, 2002). Access to external equity, in particular, has long been identified as a development constraint for many small firms (Binks and Ennew, 1996; Bolton Report, 1971; Harrison et al., 2004; Mason and Harrison, 1996).
The current issue and full text archive of this journal is available at
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Received 21 November 2010 Accepted 22 November 2010
International Journal of Entrepreneurial Behaviour & Research Vol. 18 No. 1, 2012 pp. 28-47 q Emerald Group Publishing Limited 1355-2554 DOI 10.1108/13552551211201367
Financing constraints are likely to be particularly acute for start-ups, given their lack of trading history and the risks associated with funding a new venture (Verheul and Thurik, 2001). Bhide (1992) argued that funding is a central concern for new ventures, even though most do not pursue “big money” models of start-up financing. Insufficient financing of new firms leads to a greater likelihood of failure (Basu and Parker, 2001; Cassar, 2004; Chaganti et al., 1995; van Auken and Neeley, 1996). Conversely, sufficient capitalisation at the outset improves future prospects for growth (Alsos et al., 2006; Chandler and Hanks, 1998). Initial capitalisation structures therefore offer insight into the entrepreneurial process of business formation and future prospects for both survival and growth (Smallbone et al., 2003; Storey, 1994).
The aim of this paper is to examine the relevance and applicability of established explanations of capitalisation structures of small businesses to business start-ups. Whereas the majority of studies of capitalisation structures have used large-scale surveys or publicly-available financial information, this paper uses in-depth analysis of a small sample of new ventures. The reasons for this are two-fold. Firstly, direct and ongoing engagement with the founders of these businesses is more likely to lead to full divulgence of all financing sources than less engaged methods of data acquisition. And, secondly, case approaches are a useful means of exploring theoretical propositions (Yin, 1989). An initial review of pecking order and debt-equity trade-off considerations of small firm funding suggests that these approaches may not provide a comprehensive or sufficient explanation of start-up financing (Atherton, 2009). The findings in this paper indicate that new ventures do not always or necessarily follow these established explanations of financing structures and patterns.
Research questions Accounts of the financial structures of firms have been particularly influenced by two alternative explanations of capitalisation patterns; namely debt-equity trade-offs (Modigliani and Miller, 1958) and pecking order theorisations (Myers, 1984; Myers and Majluf, 1984). When applied to small firms, the former proposes a trade-off between the tax advantages of debt financing over equity and increased risk of possible bankruptcy arising from financial stress if debt levels become too high (Verheul and Thurik, 2001). Peckingorder theorisations, on theotherhand,posit apreference for internally-generated retained earnings over externally acquired finance, and for debt over equity when externalfinance is sought out.Bothapproacheshave sincebeenused to examineandseek to understand the financing structures of small firms, and in particular whether such explanations hold for smaller enterprises, with varying results (e.g. Berggren et al., 2000; Chaganti et al., 1995; Hamilton and Fox, 1998; Holmes andKent, 1991; Jordan et al., 1998). However, the results have been variable; with some studies supporting these explanations of funding patterns (e.g. Norton, 1991, when examining high growth firms), whereas others have found either no corroborating evidence (e.g. Chittenden et al., 1996), or limitedsupport;generallybecause fundingfornewventures is “constrained”due to a lack of access to one or more forms of financing (Howorth, 2001).
A key feature of pecking order explanations of firm financing that is lacking in debt-equity trade-off considerations is the existence of information asymmetries due to varying levels of information about the venture held by the founder and by prospective funders. Supporting this, some studies have established evidence of pecking order patterns, but not of static debt-equity trade-off explanations of choice of financing by
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small businesses (Watson and Wilson, 2002). Information asymmetries-based explanations of firm financing seem to be highly relevant to new ventures, because they are more likely to be “opaque” due to a lack of trading history and the practical barriers to undertaking due diligence on new and unproven ventures (Cassar, 2004; Verheul and Thurik, 2001). Information asymmetries are likely to increase the cost for new ventures of raising external finance, as lenders seek higher interest rates and greater equity shares to compensate for the additional risk of funding an unproven new venture. Despite the apparent relevance of information asymmetries to the new venture, and the extensive literature on small business financing that adopts this perspective, it has been noted that there is a relatively small literature focusing on the effects of such asymmetries on new ventures (Paul et al., 2007).
There is also a growing body of work that that has identified additional factors that affect small business capitalisation structures, such as: national differences in institutional frameworks (Hall et al., 2004); sensitivity to cost of debt, and to an extent equity (Reid, 1996, 2003); personal preferences of the entrepreneur (Gibson, 1992; Kuratko et al., 1997; Petty and Bygrave, 1993); and the particular characteristics of the new venture (Cassar, 2004). Some of these additional explanatory factors have a cognitive dimension, such as personal propensity to take on different levels of risk and the experientially-framed preferences of owner-managers, so suggesting subjectivised influences on patterns of new venture financing. Others, such as different institutional frameworks from country-to-country, are contextual. This has led to an emerging view that the determinants of new venture financing patterns will be affected by a wide variety of factors, only some of which are related to financial markets and rational economic decision-making consideration (Atherton, 2009):
RQ1. To what extent do either debt-equity trade-offs or pecking order approaches explain patterns and structures of start-up financing?
There are indications that new firms are more likely to rely on debt, and in particular short-term debt, than equity financing during start-up and in their early years of operation (Hughes, 1997; Titman and Wessels, 1988; Dwyer and Lynn, 1989). Reluctance to lose control over their own business is seen as a reason why many founders of firms do not seek out external equity finance (Howorth, 2001). Capital markets and other forms of larger-scale equity investment typically are not available to new firms (Ang, 1992b; van Auken and Neeley, 1996; Coleman and Cohn, 1999). New firms are likely as a result to be pushed towards debt capital when founding a new venture, generating a “large debt service” requirement (van Auken and Neeley, 1996) and increasing the likelihood of liquidity problems during the early trading period following on from start-up (van Auken and Carter, 1989):
RQ2. Is there evidence of greater use of debt than equity amongst new firms?
Start-ups and new ventures, unlike established small businesses, have no substantive trading history and so are unlikely to have generated sufficient levels of retained profit to fund development internally (Sjogren and Zackrisson, 2005). Even when trading for an initial period, new ventures will have to cover establishment costs through revenue generation and so are unlikely to generate retained earnings that can be re-invested in the new venture:
RQ3. Is internal finance generated from retained earnings a source of funding for new ventures?
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Constraints to internal as well as external finance suggest that the funding options for new ventures are limited. Founders of new ventures are likely, as a result, to seek out alternative financing mechanisms, in the form of bootstrap or “supplementary” financing (van Auken, 2005; Hughes, 1997). Bootstrap finance, i.e. funding other than that acquired from personal savings or external debt and equity, has been found to be an important source of start-up finance in many successive studies (Bhide, 1992; Carter and van Auken, 2005; Ebben, 2007; Ebben and Johnson, 2006; Lam, 2010; van Auken, 2005; van Auken and Neeley, 1996). This paper follows on from Carter and van Auken (2005, p. 135) in defining bootstrap financing as funding other than personal funds from non-formal sources, including: personal loans applied to the venture; credit card debt; delaying payments; minimising accounts receivable; sharing resources. It allows the new ventures to secure “resources at little or no cost” (Harrison et al., 2004), and so may be preferred during start-up when access to funding is likely to be constrained:
RQ4. To what extent do start-ups acquire and deploy “supplementary” bootstrap funding as an alternative to formal debt and equity or internally generated funds?
The predominant form of financing for many, if not most, new ventures is the founder or founding team (Berger and Udell, 1998; Carter and van Auken, 2005; Cassar, 2004). Personal investment “signals” to investors and lenders that the founder or founding team are committed to and confident about the future development of the venture, and so provides a basis for justifying external financing of a new venture (Myers and Majluf, 1984; Prasad et al., 2000). Insider finance is likely, as a result, to account for a significant proportion of start-up funding and can help the founder(s) to acquire financing from sources outside the new venture:
RQ5. Are personal funds a significant proportion of start-up capitalisation, and are they associated with external funding by other actors?
Methodology A case-based approach to data collection and analysis is suitable for examining a particular issue or phenomenon (Chetty, 1996). Detailed analysis of specific cases via direct interaction with new venture founders will be particularly important for understanding the “opaque” capitalisation structures of new ventures (Cassar, 2004), as well as the evolving and often improvised structures of business start-up funding (Atherton, 2009). The data presented are financial in nature, given the specific research propositions and questions that are the focus of this paper. Although not consonant with current approaches in the small business literature, which tend to view case-based data analysis as qualitative (Chetty, 1996; Perren and Ram, 2004; Romano, 1989), Eisenhardt (1989) noted that case approaches relate to the ways in which the data are extracted, rather than to a particular types of data:
[. . .] evidence may be qualitative (e.g. words), quantitative (e.g. numbers), or both (Eisenhardt, 1989, pp. 534-535).
Many case-based approaches in the small business and entrepreneurship literature have concerned themselves with one or a small number of ventures (e.g. Atherton and Hannon, 2000; Rod, 2006; Vinnell and Hamilton, 1999). A larger sample of cases was used for this study in order to provide for sufficient variation in the scale, sector and
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nature of the start-up and the possible diversity of types of start-up financing postulated in this paper’s review of the literature. A wide range of industries and types of new venture were included in the study, as can be seen in Table I. This provided a stronger base on which to draw conclusions from the analysis, as the sample although not statistically relevant, was sufficiently broad to encompass different industries and experiences of new venture creation. This follows a previous analysis of small firm demand for finance, which used 13 case studies (Howorth, 2001), and is based on the tenet that a greater number of cases allow for improved pattern recognition during data analysis (Eisenhardt, 1989; Yin, 1989). A total of 20 new businesses that had been operating for less than two years at the time of interview were identified through recommendations from publicly-funded agencies based in the North of England that offered counselling, advisory and training services to new business start-ups (Table I). These businesses varied in terms of sector and also size. Amongst the sample were: sole traders (ventures 8, 13, 15, and 16); micro-enterprises (ventures 6 and 18), some of which were family-owned and run (ventures 3 and 20); new ventures that grew rapidly to become established small businesses with between 20 and 30 employees (ventures 7, 8 and 14); and one large-scale start-up that rapidly grew to over 50 employees, and continued to grow beyond the initial start-up period (venture 2). Referrals from professional advisers were seen as likely to identify new venture founders who will be more disposed to seek out assistance and resources when establishing a new business, and so would be likely to acquire multiple forms of finance from different formal and informal sources. It is recognised, however, that this sample is more likely to have taken up publicly-funded sources, such as the small firms loan guarantee scheme (now enterprise guarantee fund), and responses as a result will show a tendency towards such subsidised forms of public support for business start-up. Initial contact and interviews predated the current economic downturn, and consequent constraints on
Venture Nature of business Key characteristics
1 Car dealership Franchise 2 Branded snack foods Team start limited company 3 Pharmacy Co-owned by husband and wife 4 Engineering 3rd business started by founder 5 Water management 3rd business started by owner-manager 6 Scaffolding Two directors, limited company 7 Industrial flooring Owner-manager acquired company 8 Organic chemicals Started as sole trader 9 Media post production Directors started venture following redundancy
10 Communications Prototype product developed over four years 11 Glass design Started as sole trader 12 Industrial components Limited company set up following redundancy 13 Hairdresser Started as sole trader 14 High tech composites High tech applications developed with university 15 Modelling agency Started as sole trader 16 Retail Started as sole trader 17 Engineering Launched business to sell new paint product 18 Electrical contractor Limited company set up by two partners 19 Nursing agency Franchise 20 Lighting supplier Co-owned by husband and wife
Table I. Summary profiles of new ventures
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credit from banks and other sources that characterise current financial markets. These ventures, in other words, enjoyed superior prospects of acquiring finance to those available to new venture founders today. For each venture, data collection involved:
. an initial interview, lasting between 112 to 2 hours;
. at least one, and typically two to three, follow-up telephone and email contacts to confirm the analysis; and
. integration of secondary data, including company reports acquired during or after the initial interview.
The focus throughout was on identifying the types of funding they acquired and used to start their ventures.
Results Types and sources of start-up finance Start-up financing can be considered in terms of type, i.e. form, as well as source (Chaganti et al., 1995; Bank of England, 2004). Seven types, and ten sources, of start-up finance were identified amongst the interviewed businesses (see Tables II and III). External equity was the most valuable type of finance, totalling £2 million or 48.1 per cent of all funding secured. Almost all of the external equity came in the form of venture capital investment and most of it was acquired by one business, reflecting the frequently reported tendency for low levels of venture capital investment in all but a small proportion of start-ups (Bank of England, 2003; Mason and Harrison, 1996; Reid, 1996). Two of the businesses received venture capital equity investments of £100,000 each. Formal loans (debt) came primarily from banks, although other sources of loans, mostly offered at subsidised rates and on special terms, were also evident as was widespread use of the Small Firms Loan Guarantee Scheme. The total value of formal loans greatly exceeded the value and frequency of start-up financing by bank overdraft, and more long-term debt was acquired than short-term debt.
Informal debt and equity, including the founder’s own savings and funding provided by family and friends, accounted for around one-seventh of the total value of all start-up funding acquired, but was used widely by three-quarters of the sample. Fourteen businesses had invested their own savings and one had taken out a personal loan to help finance start-up. In most cases, the investments were relatively low, with ten founders investing between £1,000 and £10,000. The take-up and use of grants was common in the sample. Local government grants were small, ranging from £750 to £5,000. Central government grants ranged from £15,000 to £40,000, and mostly were for innovation or R&D purposes. Hire purchase, leasing and factoring accounted for £48,000 of all financing acquired by the start-ups, and were only used by two of the businesses, both of which had a relatively high capitalisation value.
Although significant in value terms, external equity was an uncommon form of funding for most new ventures. In contrast, loans and informal finance were common across the sample. None of the respondents indicated that they had started trading prior to formal launch of the venture, and so were not able to use retained profits to finance the business. Tables II and III therefore indicate a propensity to fund business start-up through informal finance and debt funding, rather than through external equity and retained profits, with a very small proportion acquiring equity investment from venture capitalists.
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33
F in an ce
ty pe
T ot al
P er ce nt
of to ta l
F re qu
en cy
% N o. bu
si ne ss es
% M ea n/ ty pe
M ea n/ bu
si ne ss
M in im
um M ax im
um
F or m al
eq ui ty
£ 2, 00 0, 00 0
48 .1
4 5. 6
3 15
£ 50 0, 00 0
£ 66 6, 66 7
£ 10 0, 00 0
£ 90 0, 00 0
F or m al
lo an
£ 1, 13 1, 50 0
27 .2
18 25
15 75
£ 62 ,8 61
£ 75 ,4 33
£ 1, 00 0
£ 22 0, 00 0
In fo rm
al in ve st m en t
£ 67 0, 00 0
16 .1
18 25
16 80
£ 37 ,2 22
£ 41 ,8 75
£ 50 0
£ 50 0, 00 0
O ve rd ra ft
£ 14 2, 00 0
3. 4
5 6. 9
4 20
£ 28 ,4 00
£ 35 ,5 00
£ 10 ,0 00
£ 50 ,0 00
H P L F
£ 48 ,0 00
1. 2
3 4. 2
2 10
£ 16 ,0 00
£ 24 ,0 00
£ 8, 00 0
£ 25 ,0 00
G ra nt
£ 15 6, 45 0
3. 8
18 25
12 60
£ 8, 69 2
£ 13 ,0 38
£ 75 0
£ 50 ,0 00
E A S
£ 10 ,3 00
0. 2
6 8. 3
6 30
£ 1, 71 7
£ 1, 71 7
£ 1, 00 0
£ 2, 00 0
T ot al /a ve ra ge
£ 4, 15 8, 25 0
10 0
72 10 0
8. 3
£ 93 ,5 56
£ 12 2, 60 4
£ 17 ,3 21
£ 24 9, 57 1
Table II. Types of start-up finance acquired
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Capitalisation values The capitalisation values of each start-up are summarised in Table IV. The total capitalisation value varied significantly across the cases, from a high of £2.2 million to a low of £3,050. The majority of capitalisation values at start-up were below £50,000 (12/20), and only one was above £550,000. The mean capitalisation value was £207,912.50, reflecting start-up number 2, which had a total capitalisation of £2.2 million. Without this outlier, the mean fell to £97,912.50. The median was between £43,200 and £33,000, indicating that total capitalisation across the group was dominated by a small number of highly capitalised start-ups, and that total start-up
Co. Total Number of funding transactions Average per transaction
2 £2,200,000 5 £440,000 1 £550,000 3 £183,333 3 £370,000 2 £185,000 6 £305,000 4 £76,250
10 £182,000 7 £26,000 4 £153,000 7 £21,857
14 £106,750 5 £21,350 5 £80,000 3 £26,667 9 £46,750 4 £11,688 7 £43,200 3 £14,400 8 £33,000 4 £8,250
19 £22,000 2 £11,000 18 £20,000 3 £6,667 20 £10,000 1 £10,000 16 £10,000 3 £3,333 11 £10,000 5 £2,000 15 £5,000 3 £1,667 12 £4,500 4 £1,125 13 £4,000 2 £2,000 17 £3,050 3 £1,017
£4,158,250 3.65 £56,962
Table IV. Total and average
funding for each business
Source Total Frequency Transaction average
Venture capitalist £2,000,000 4 £500,000 Own funds £517,500 15 £34,500 Business partner £525,000 1 £525,000 SFLGS £276,000 6 £46,000 Other loan guarantee £220,000 1 £220,000 Bank £208,000 9 £23,111 Family/friends £152,500 3 £50,833 Central government grant £135,000 5 £27,000 Non-bank loan £44,500 6 £7,417 Local government grant £17,200 10 £1,720 Other £62,550 12 £5,213 Total £4,158,250 72 £57,753
Table III. Sources of start-up financing acquired
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capitalisation for most cases was below the mean. The variation in total capitalisation values at start-up therefore was very wide; ranging from large-scale new ventures with significant funding to micro-enterprises and sole traders with very low levels of start-up capital.
The four start-ups with the highest capitalisation values (businesses 2, 1, 3 and 6) accounted for 82.4 per cent of all capitalisation across the 20 new ventures, pointing to high levels of concentration of funding in a small number of new ventures. Conversely, the remaining sixteen new ventures accounted for around one-sixth of the sample’s total capitalisation value only – highlighting low levels of capitalisation for these new ventures. This indicates that a small number of new ventures were highly-capitalised, but the majority had low levels of capitalisation below both the mean and median for the sample.
“Bundling” patterns in start-up financing Most of the new ventures acquired multiple forms of finance, so creating “bundles” of new venture finance. All but three new ventures secured their start-up capitalisation from between two and five different sources, with the mean number of sources being 3.65 and the median and mode both 3. Only one new venture started with funding from one source only (perhaps not surprisingly founder’s savings), and only four of the 20 secured finance from fewer than three sources, whereas almost half (9/20) secured start-up funding through four or more transactions. On the whole, start-ups with higher capitalisation acquired finance from more sources than those with low capitalisation.
Table V indicates that overdrafts, venture capital investment and other forms of finance (hire purchase and leasing) were evident almost exclusively in higher capitalised new ventures. This suggests a greater awareness of (case 2), or willingness
No. Personal O/D Loan VC HPL Grant Total No. sources Mean/source
2 * * * * £2,200,000 5 £440,000 1 * * £550,000 3 £183,333 3 * * £370,000 2 £185,000 6 * * * £305,000 4 £76,250
10 * * * * * £182,000 7 £26,000 4 * * * * £153,000 7 £21,857
14 * * * * £106,750 5 £21,350 5 * * * £80,000 3 £26,667 9 * * £46,750 4 £11,688 7 * * * £43,200 3 £14,400 8 * * * £33,000 4 £8,250
19 * * £22,000 2 £11,000 18 * * * £20,000 3 £6,667 11 * * * £10,000 5 £2,000 16 * * * £10,000 3 £3,333 20 * £10,000 1 £10,000 15 * * £5,000 3 £1,667 12 * * * £4,500 4 £1,125 13 * £4,000 2 £2,000 17 * * £3,050 3 £1,017
Table V. Patterns in “bundling” of start-up financing
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to explore (cases 4, 6 and 10), funding options by founders of more capitalised new ventures. The founders of seven of the eight most capitalised new firms also had clear growth plans for their businesses (cases 1, 2, 3, 4, 5, 10, 14).
Debt-equity distributions across the cases Table VI lists debt and equity funding for each of the 20 new ventures, in order to compare patterns of debt-equity distributions across the 20 cases. The total values of grants and other forms of public subsidy obtained by the start-ups are also included because they cannot be categorised as either debt or equity. Grants are defined as non-repayable provisions of, typically public, finance to new ventures that do not result in an equity stake or other claim over the business and its profits and value by the funding provider. Grants have been included because they are a distinctive form of finance with different characteristics and terms than debt and equity, and because of their extensive use by most of the businesses included in the sample. Of the 20 businesses, 15 acquired grant funding during start-up ranging in value from £50,000 to £1,000. Grants accounted for a large proportion of total financing amongst new ventures with a low overall capitalisation value. However, they were also evident amongst businesses with higher start-up capitalisation values, indicating that they are not acquired only by new ventures that have difficulties in acquiring other forms of start-up funding.
The debt, equity and grant distributions summarised in Table VI indicate that propositions of debt-equity trade-offs, or businesses funded solely by debt, as optimum financing structures do not hold across the cases (Modigliani and Miller, 1958, p. 294; equations 32 and 33). Indeed, no clear patterns on debt-equity funding are evident across the ventures. Instead, many patterns can be identified, including funded solely
Company Debt Equity Grant Total
2 £50,000 £2,100,000 £50,000 £2,200,000 1 £550,000 0 0 £550,000 3 £370,000 0 0 £370,000 6 £220,000 £85,000 0 £305,000
10 £55,000 £107,000 £20,000 £182,000 4 £98,000 £30,000 £25,000 £153,000
14 0 £102,000 £4,750 £106,750 5 £15,000 £40,000 £25,000 £80,000 9 £31,000 0 £15,750 £46,750 7 £35,000 £6,000 £2,200 £43,200 8 £5,000 £21,000 £7,000 £33,000
19 £20,000 0 £2,000 £22,000 18 £10,000 £8,000 £2,000 £20,000 11 £1,500 £4,000 £4,500 £10,000 16 £5,000 £4,000 £1,000 £10,000 20 0 £10,000 0 £10,000 15 £2,500 £500 £2,000 £5,000 12 £1,000 0 £3,500 £4,500 13 £2,500 £1,500 0 £4,000 17 0 £1,000 £2,050 £3,050 Total £1,471,500 £2,520,000 £166,750 £4,158,250
Table VI. Debt-equity-grant
distributions across the cases
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by debt (1, 3); funded solely by equity (20); funded by debt and grant (9, 19, 12); funded by equity and grant (17); funded predominantly with equity (2, 5, 14, 8); funded predominantly by debt (4, 6, 9, 19, 13). Overall, half the new ventures were funded with a combination of debt, equity and grant, and 60 per cent with both equity and debt. The very different distributions of debt and equity demonstrate that stable patterns of debt-equity trade-offs are not evident across the sample. There is, in other words, no indication of a common pattern of debt-equity distributions across the 20 new ventures.
Bootstrap, informal and intermediary financing The literature suggested that bootstrap, informal and intermediary funding may be important to business start-ups, particularly when not successful in or discouraged from acquiring formal finance (Kon and Storey, 2003) or when strong social ties provide access to bootstrap finance ( Jones and Jayawarna, 2010). Table VII indicates, however, that only two of the firms used non-business personal funding, in these cases personally secured loans, as a form of bootstrap finance during business start-up (although the majority invested their own savings as capital to secure equity in their own ventures). When financing options were discussed with the founders, both in the initial interview and when feeding back and discussing the results, the author asked each respondent about which, if any of the following forms of bootstrap finance had been used (following Carter and van Auken, 2005): personal loans applied to the venture; credit card debt; delaying payments; minimising accounts receivable; sharing resources. Informal funding from family and friends was particularly significant for business number 3, accounting for almost half of the capitalisation secured for this new venture. Overall, however, informal finance was only found in three of the
Bootstrap Informal Intermediary Co. Personal loan Family/friend HP/leasing Factoring Total capitalisation
2 £2,200,000 1 £25,000 £550,000 3 £50,000 £100,000 £370,000 6 £305,000
10 £2,000 £182,000 4 £20,000 £15,000 £8,000 £153,000
14 £106,750 5 £80,000 9 £46,750 7 £43,200 8 £33,000
19 £22,000 18 £20,000 11 £10,000 16 £10,000 20 £10,000 15 £500 £5,000 12 £4,500 13 £4,000 17 £3,050 Totals £70,000 £102,500 £40,000 £8,000 £4,158,250
Table VII. Bootstrap, informal and intermediary financing by business
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20 businesses. Moreover, only three of the new ventures secured intermediary funding in the forms of hire purchase, leasing and factoring.
These forms of financing were particularly evident in the cases where total capitalisation values were high (over £100,000). Of the ventures with the six highest capitalisation values, four used these forms of financing when starting up. In three of these cases, informal and intermediary funding mechanisms accounted for only a small proportion of total capitalisation. Business 4 was funded by one form of bootstrap financing – a personal loan taken out by the founder – and by both leasing and factoring agreements with funders. There is also little evidence of bootstrap financing as a recourse should formal sources of funding not be acquired. For lower capitalised ventures, other forms of funding were acquired instead; in particular own funds and formal loans (i.e. external debt).
Signalling effects Myers and Majluf (1984) argued that the use of own funds in a start-up is a “signal” of commitment to and confidence in the new venture. Money invested by the founder in the new venture provides external funders with a degree of reassurance that the starter is committed to, and confident about, the prospects of, the business (Prasad et al., 2000). Signalling as a result helps to convince funders that the new venture is a viable prospect for financing, in part because the risk is shared with the founder who is committing their own capital. For the business founder, commitment of own funds therefore has the potential to leverage in external funding and so creates opportunities to increase the capitalisation value of the start-up. Table VIII identifies possible signalling effects, based on the premise that where businesses are funded by both own funds and either external debt or equity (formal debt, formal equity) then signalling effects may have occurred and checking this against the individual cases for corroborating evidence. Individual cases were reviewed to determine whether founders were deploying personal investment to attract or secure other forms of financing. In each case where signalling was corroborated, the founder indicated that they sought to “match” their own funding with bank lending, in particular, in order to maximise the value of start-up capitalisation and, significantly, to persuade lenders to offer larger loans. In the cases where venture capital was secured, founders deliberately invested a larger sum to attract the desired amount of external equity investment (case 2) or committed all their available savings, even though meagre, to “signal” commitment (cases 10 and 14).
Clear evidence of signalling could only be found in nine of the 20 cases. In some cases, external funding was used to capitalise the new venture without personal investment by the funders (businesses 1, 3, 9, 12, 19). In cases 1 and 3, formal debt values are high (£525,000 and £220,000 respectively). Debt was sourced from a “sleeping” business partner in the case of new venture 1, with whom the founder had a long-standing personal as well as business relationship. The loan guarantee acquired by the founder of new venture 3 was secured against an equity investment by members of the founder’s family, suggesting a leverage effect (rather than signalling) if the notion of own funds is extended from the founder to the founder’s family. Signalling can also be seen not to occur where own funds are invested, but external debt and equity are not (cases 17 and 20). These two businesses had low start-up capitalisation values, of £10,000 and £3,050 respectively, and were cautious about the scale of the
Cases of start-up financing
39
C o.
O w n fu nd
s F or m al
de bt
F or m al
eq ui ty
Si gn
al lin
g? C or ro bo ra ti ng
ca se
ev id en ce
1
£ 0
£ 55 0, 00 0
£ 0
£
F ou nd
er di d no t ha ve
pe rs on al
fu nd
s to
in ve st ,a nd
re lie d on
“s le ep in g”
pa rt ne r to
fi na nc e fr an ch is e
st ar t- up
2
£ 30 0, 00 0
£ 50 ,0 00
£ 1, 80 0, 00 0
U
F ou nd
er s in ve st ed
su ffi ci en t pe rs on al
eq ui ty
to de m on st ra te
to ex te rn al
in ve st or s th ey
w er e
co m m it te d to
th e ne w
ve nt ur e
3
£ 0
£ 22 0, 00 0
£ 0
£
P ar en ts in ve st ed
in th e ne w ve nt ur e, an d th is he lp ed
se cu re
a ba nk
lo an
– a fo rm
of “p ro xy
” si gn
al lin
g th ro ug
h th e w id er
ki ns hi p gr ou p?
4 £ 30 ,0 00
£ 98 ,0 00
£ 0
U F ou nd
er ’s in ve st m en t se cu re d in
in it ia lr ou nd
of lo an
fi na nc in g
5 £ 40 ,0 00
£ 15 ,0 00
£ 0
U L ar ge r pe rs on al
in ve st m en t se cu re d sm
al le r ba nk
lo an
6
£ 85 ,0 00
£ 22 0, 00 0
£ 0
£
In it ia l ba nk
re lu ct an ce
to le nd
de sp it e fo un
de r
in ve st m en t le d to
ov er dr af t th at
w as
th en
au gm
en te d/ pa rt -c on ve rt ed
in to
a lo an
7 £ 6, 00 0
£ 35 ,0 00
£ 0
£ In ve st ed
ow n fu nd
s, bu
t on ly
a sm
al la m ou nt
an d so
w as
no ta bl e to se cu re a ba nk
lo an
w it ho ut
gu ar an te e
8 £ 21 ,0 00
£ 5, 00 0
£ 0
U O w n fu nd
s le ve ra ge d ba nk
lo an
9 £ 0
£ 31 ,0 00
£ 0
£ N o pe rs on al
fu nd
s in ve st ed
10 £ 5, 00 0
£ 55 ,0 00
£ 10 0, 00 0
U O w n fu nd
s le ve ra ge d ba nk
lo an ,w
hi ch
th en
w as
au gm
en te d w it h ve nt ur e ca pi ta l
11 £ 4, 00 0
£ 1, 50 0
£ 0
U O w n fu nd
s “t op pe d up
” w it h no n- ba nk
lo an
12 £ 0
£ 1, 00 0
£ 0
£ N o pe rs on al
fu nd
s in ve st ed ,s m al l lo an
13 £ 1, 50 0
£ 2, 50 0
£ 0
U O w n fu nd
s co m bi ne d w it h no n- ba nk
lo an
14 £ 2, 00 0
£ 0
£ 10 0, 00 0
U F ou nd
er in ve st ed ,a nd
IP ,a tt ra ct ed
U S V C
15 £ 0
£ 2, 50 0
£ 0
£ N o pe rs on al
fu nd
s in ve st ed
16 £ 4, 00 0
£ 5, 00 0
£ 0
U O w n fu nd
s “m
at ch ed ” ag ai ns t ba nk
lo an
17 £ 1, 00 0
£ 0
£ 0
£ N o ex te rn al
fu nd
in g
18 £ 8, 00 0
£ 10 ,0 00
£ 0
£ B an k no t w ill in g to
pr ov id e lo an ,a nd
so of fe re d
ov er dr af t in st ea d
19 £ 0
£ 20 ,0 00
£ 0
£ N o pe rs on al
fu nd
s in ve st ed
20 £ 10 ,0 00
£ 0
£ 0
£ N o ex te rn al
fu nd
in g
Table VIII. Likely signalling effects
IJEBR 18,1
40
new venture and in particular the potential future risk of repayment and liability that external borrowing and investment may produce. Business 17 relied solely on their own funds as the only source of start-up funding, and business 20 combined a small personal investment with a small grant and funding from a matching government grant (Enterprise Allowance Scheme). These two founders could be characterised as averse to securing external funding that they may need to repay in the future even if the new venture does not succeed, which can in turn be taken as a “signal” of a lack of confidence in the ventures they were starting.
Data discussion The three most common forms of finance across the 20 cases were grants, external debt and informal finance, with all three being used extensively by most new ventures within the sample. Overdraft facilities were less common than loans, indicating greater levels of acquisition of longer-term lending than shorter-term credit. Grants were used most extensively (24 times across 15 of the 20 cases). However, their total value was low and their overall significance to total capitalisation was high in only two cases (12 and 17, both of which had amongst the lowest total capitalisation values in the sample). Although venture capital investment (equity) accounted for almost half the total start-up capitalisation value for all 20 businesses, this form of finance was acquired by only three businesses. Almost all ventures acquired “bundles” of multiple forms of start-up financing from different sources, and there was some indication that more capitalised new ventures used a wider range of financing options that extended beyond loans and grants to include overdraft credit, formal venture capital investment, hire purchasing and leasing. Across the sample, therefore, the most significant forms of start-up funding, when value and frequency of acquisition were both considered, were externally acquired debt and personal funds.
Research question 1 explored the extent to which new venture financing patterns confirmed either debt-equity trade-offs or pecking order sequences. Across the sample, there was no clear or definitive alignment of financing patterns with either debt-equity trade-off configurations or pecking order sequences; even though some new ventures did follow these patterns. Instead, the key observation arising from the analysis is that patterns of start-up financing varied widely from new venture to new venture, in terms of multiple parameters including: total capitalisation value at start-up; types and sources of finance acquired; numbers of financing transactions undertaken; numbers of financing sources used; average values of each transaction; nature and structure of financing “bundles” acquired.
As per research question 2, there was greater use of external debt than equity across the sample, even though the value of equity was particularly significant for a small number of start-ups. Internal finance was not used (research question 3), as the firms were not yet trading, and there was little use of informal, bootstrap and intermediary funding (research question 4). This latter finding is somewhat surprising, given the incidence of bootstrap finance cited in many studies, and this may reflect the nature of this sample of new ventures, which were referred by business support agencies and so can be assumed to be more likely to use formal sources of finance as well as their own funds. This supports research question 5, which suggests the importance of own savings and funds from close family and friends as a starting point for funding business start-up.
Cases of start-up financing
41
Conclusions and implications These findings indicate that the underpinning assumptions of debt-equity trade-off theorisations of financing do not apply universally to the new ventures examined in this paper. Instead, this paper has found multiple cases where new ventures are funded by equity alone, or by a combination of equity and grants, i.e. instances where there is no evidence of debt-equity trade-offs because no debt has been acquired to finance business start-up. Pecking order theorisations do not appear to apply fully to the sample either. Firstly, none of the cases used internal funds, i.e. retained earnings, to finance new venture creation, reflecting their lack of trading history. This indicated that pecking order approaches are internally, as well as externally “constrained” or “truncated” (Howorth, 2001). In other words, even though new firm founders may prefer internal finance in the first instance, their lack of trading history removes this funding option. Secondly, shorter-term debt in the form of bank overdraft was used less than longer-term loan debt: only five instances of bank credit through overdraft were reported, compared with ten instances of commercial lending and seven guaranteed loans. A preference for short-term over long-term debt (Howorth, 2001, p. 79) was not evident in this sample. The extensive use of loan guarantee debt funding suggests that public intervention, particularly through the Small Firms Loan Guarantee Scheme, has provided access to external debt on quasi-commercial terms that may not have been available on a commercial basis.
Overall, therefore, there were no common or clear debt-equity distributions across the sample. Instead, there was noticeable variation in financing patterns within the sample. The scale and nature of start-up funding was also highly variable, with significantly different capitalisation structures and values evident across the sample. These variations in new venture capitalisation highlight two important themes that may inform our thinking on how founders finance their new ventures. The first is the extent to which many of the new ventures were started with low levels of capital, and so with the prospect that they are likely to be under-capitalised and, as a result, vulnerable to pressures such as lack of investment funding for staff, equipment and business development as well as a greater risk of cash flow problems once trading. This suggests that many new ventures are started without sufficient capitalisation and so will be more likely to grow more slowly as well as being more vulnerable to closure.
Conversely, a greater propensity to use more and a wider variety of types of finance can be seen in new ventures with higher capitalisation. This appears to be influenced by the founder’s understanding of funding options, i.e. their overall “financial literacy” in relation to resourcing business start-up, and their aspirations for the new venture; with more “financially literate” and more ambitious founders generating higher levels of start-up funding from a wider range of sources and types of finance. This suggests in turn that prospects for survival and growth once a new venture is created are influenced by the capability of the founder to start a well-resourced new venture with future growth ambitions, i.e. to establish larger-scale, more growth-focused new ventures (as measured by capitalisation).
However, the financial “literacy” of the founder in gauging the funding needs of a new venture and that founder’s ability to secure these resources and apply them to growing the business did not provide a definitive account of the drivers for securing new venture finance across the sample. A pattern of incremental “bundling” of various forms of finance across all but one case attests to this in several ways. For many of the
IJEBR 18,1
42
new ventures, a single source of finance did not provide all the funding the founder was seeking, so forcing them to either start the venture under-capitalised – as happened in several cases – or to seek the outstanding financing need from other sources. In some cases, such as business 6, an external funder was reluctant to lend the full amount sought by the founder because the start-up was informationally “opaque” as a result of it being unproven and having no track record in trading profitably. In addition, funding was secured in bouts, or waves, initially as the founder was planning the new venture’s future establishment and was still exploring how this would be achieved and seeking to understand how the new venture would operate. As the founder moved through planning to launch of the new venture, unanticipated additional costs were often identified or discovered, so demanding more funding and a need to seek out additional sources of start-up finance. This was particularly the case for technologically-focused new ventures seeking to mass produce or commercialise proprietary knowledge or technology (cases 5, 8, 10, 14). An additional reason for incremental raising of start-up finance was a desire by the founder to not become overly dependent upon a single source of funding. In these cases, multiple forms of finance were sought from different providers (venture 2 acquired funding from two different venture capitalists when either would have funded the full value sought). Incremental acquisition of start-up finance also occurred because of what could be termed “cumulative incrementalism”, where personal funding was used initially to secure or “match” against other forms of finance. Over time, several new venture founders accumulated larger financing “bundles”, and deployed these enhanced capitalisation values to secure further external finance (businesses 10 and 14 acquired loans against founder equity initially, and then approached venture capitalists to secure further funding once a first “bundle” of funding was in place).
Combined, these various factors suggest that start-up capitalisation values and structures are influenced by a variety of factors, as follows:
(1) The overall ability of the founder(s) in terms of their: . financial literacy; . success in negotiating to acquire funding; and . expertise in planning business start-up and launch effectively.
(2) The financial constraints experienced by most new ventures, in particular how funders respond to and deal with: . the opacity of a new and as yet unproven new venture; and . the additional risk associated with funding new and unproven ventures.
(3) The incremental and unpredictable dynamics of starting a new business, in particular the: . uncertainty generated by iterative development of the new venture; and . experiential learning of the founder as he/she deals with this iterative
uncertainty in business start-up.
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About the author Andrew Atherton is Professor of Enterprise and Entrepreneurship and Senior Deputy Vice Chancellor at the University of Lincoln. At Lincoln, he established the Enterprise Research and Development Unit (ERDU), which has undertaken more than 30 commissioned policy studies since 2003. Before joining Lincoln, he was Director of the Foundation for SME Development at the University of Durham, the successor department to the Small Business Centre, a leading international centre for enterprise and SME development. While at Durham, he established the Policy Research Unit, which undertook commissioned research and policy analysis on enterprise development and entrepreneurship. He has degrees in Chinese and Economics from the School of Oriental and African Studies, University of London, and Yale University. His current research is concerned with enterprise policy, entrepreneurship in China, and new venture creation. Andrew Atherton can be contacted at: [email protected]
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