Debt Financing, Survival, and Growth of Start-Up Firms

Transcription

1 Debt Financing, Survival, and Growth of Start-Up Firms Rebel Cole DePaul University Chicago, IL phone: (312) fax: (312) Tatyana Sokolyk Brock University St. Catharines, ON phone: (905) ext fax: (905) Abstract: We analyze how the start-up capital structure of a firm affects subsequent firm outcomes. We find that, after three years, firms using debt at start-up in particular, business debt but not personal debt are significantly more likely to survive, and to achieve higher levels of revenues than are other firms. We attribute this to the incentives and expertise of the lenders, which, for business debt, almost always are banks. We also examine a start-up s decision to use credit; we find that better-quality start-ups are more likely to use credit, and are more likely to use business rather than personal credit. Keywords: banking/financial intermediation, entrepreneurial finance, credit, debt financing, capital structure, Kauffman, KFS, small business, start-up, survival JEL Classifications: G21, G32, J71, L11, M13

2 According to most corporate finance textbooks, the capital-structure decision how to finance a firm s fixed assets is one of the three most important decisions facing a financial manager; second in importance only to the capital-budgeting choice. 1 Yet we know very little about how the owner/manager of a start-up firm decides which of various types of debt and equity to use to finance the firm s fixed assets and whether that decision affects subsequent firm performance. 2 Because of the high degree of uncertainty about the future performance of a start-up firm and large information asymmetry between the provider of capital and the firm s owner, the question of what funding mix improves the performance prospects of a newly founded firm is of great interest to financiers, researchers, and policymakers. We argue that traditional theories of capital structure, such as the pecking-order theory, are largely irrelevant for start-up firms because start-ups have no retained earnings, have no access to public debt or equity markets, and have only extremely limited access to the private equity market. Rather, the sources of capital available to a start-up firm are primarily limited to owner s equity and bank debt. 3 Existing theories on capital markets (see, e.g., Stiglitz and Weiss, 1981; Berger and Udell, 1998) posit that large information asymmetries lead to credit rationing and, thus, limited access to credit financing. Relative to public firms, and even to mature privately held firms, start-ups are the most opaque; consequently, they should find it most difficult to obtain external financing. Yet we document that almost half of all entrepreneurial firms successfully obtain business loans, primarily from banks, at the firm s start-up with no record of the firm s operations to inform their lenders. 1 See, for example, Brealey, Myers, and Allen (2011) and Ross, Westerfield, and Jaffe (2012), two of the leading corporate finance textbooks used in U.S. MBA programs. 2 Most existing empirical studies of capital structure have focused on large publicly traded corporations, for which data are readily available. Four notable exceptions are Brav (2009), who analyzes data on privately held U.K. companies; Ang, Cole, and Lawson (2010) and Cole (2013), who analyze data on privately held U.S. companies from the Federal Reserve s Surveys of Small Business Finances; and Robb and Robinson (2014), who, as we do, analyze data on U.S. start-up companies from the Kauffman Firm Surveys. 3 Conventional wisdom posits that start-up firms rely heavily on financial capital from friends and family, but Robb and Robinson (2014) document that this is not the case.

3 In addition, we find that 55% of all start-ups report using personal loans to the owners to finance the business start-up, but we argue that these types of loans are fundamentally different from loans directly to the business. When evaluating a personal loan application, a lender is evaluating the creditworthiness of the person making the application, with no commitment to monitor the firm should the lender extend credit. In fact, the lender often does not know that the loan proceeds will be funnelled by the borrower into financing the start-up firm. In this respect, personal loans used to finance a start-up are really equity injections by the owner rather than private debt. Consequently, we hypothesize that start-up firms that obtain business loans benefit from the selection and monitoring by bank lenders, whereas start-up firms that obtain financing from personal loans to their owners do not. We further hypothesize that this selection and monitoring leads to superior outcomes for entrepreneurial firms that obtain business loans at the firm s start-up. We test these hypotheses using data from the Kauffman Firm Surveys (KFS) on U.S. start-up firms, and find that (1) better-quality start-ups are more likely to obtain credit, and (2) start-ups who obtain credit during their first year of operation grow faster and survive longer than their counterparts without credit financing. Notably, business debt, as opposed to personal debt, carries positive benefits for a firm s performance and survival. Furthermore, of all credit users, better-quality start-up firms are more likely to obtain business credit and are less likely to obtain personal credit. This new evidence on the differences between business and personal credit is consistent with our reasoning outlined above that personal loans are fundamentally different from loans made directly to the business. The results are robust to controls for the initial firm and owner characteristics, for the sample selection bias, and for the availability of credit financing to small businesses at the state level. Furthermore, our results hold true when we employ propensity-score-matching analysis, again showing that start-up firms that use business debt in their initial capital structures outperform otherwise similar firms that do not. Finally, the result that start-ups who obtain credit, and in particular business credit, show a higher level of revenue is robust when we control for the potential endogeneity between the probability of receiving debt financing and performance outcomes of start-up firms. In the endogeneity - 2 -

4 analysis, we use an exogeneous variable that estimates the probability of obtaining credit, and utilize data from another survey of small businesses, the Federal Reserve s Survey of Small Business Finances (SSBF). Our study expands the capital-structure literature and, in particular, the literature on the special role of financial intermediaries in reducing information asymmetry about a borrowing firm through screening and monitoring (see Diamond, 1984, 1991; Fama, 1985; Ramakrishan and Thakor, 1984). In contrast to the prediction of credit-rationing theory, we document that banks participate quite actively in the most informationally opaque market the credit market for start-up businesses. Furthermore, we show that banks are successful in screening and monitoring brand-new businesses. This evidence complements the existing literature on pre-ipo (initial public offering) firms and newly public firms (Schenone, 2004; Gonzalez and James, 2007; Benzoni and Schenone, 2010) and extends earlier studies examining the special role of banks in public markets (e.g., Billett, Flannery, and Garfinkel, 1995; Slovin, Sushka, and Poloncheck, 1993; Hoshi, Kashyap, and Scharfstein, 1990; James, 1987; James and Wier, 1990; Lummer and McConnell, 1989). Once again, we emphasize that bank lending is unique in the setting of startup firms that have extremely limited access to other sources of funds and are characterized by large information asymmetry. In addition, we contribute to the literature on debt financing of privately held firms (see, e.g., Ang, 1992; Berger and Udell, 1998; Brav, 2009; Ang, Cole, and Lawson, 2010; Robb and Robinson, 2014; Cole, 2013) by documenting that the start-up s decision to obtain credit in particular, business credit has important consequences on subsequent firm outcomes of survival and growth. Furthermore, by documenting the importance of start-up credit financing for subsequent firm outcomes, we contribute to the strand of literature that seeks to determine what initial factors affect the survival and growth of new entrepreneurial firms (Cassar, 2004; Cooper, Gimeno-Gascon, and Woo, 1994; Schwienbacher, 2013). Finally, we contribute to the growing literature that analyzes start-up firms using data from the Kauffman Firm Surveys (see, e.g., Coleman and Robb, 2009; Fairlie and Robb, 2009; Coleman and Robb, 2012; Robb and Watson, 2012; Cassar, 2014; Robb and Robinson, 2014)

5 Our study has several important implications for economic policymakers and investors interested in entrepreneurial start-ups. Without a doubt, small firms are vital to the U.S. and world economies. According to the U.S. Small Business Administration, small firms are responsible for almost two out of three net new private sector jobs, and almost half of both private-sector employment and private sector output. 4 A better understanding of what types of firms obtain credit and the sources of credit finance at the initial stage of business formation can help policymakers take actions to increase the availability of credit to start-up firms that will potentially lead to the creation of more jobs and faster economic growth. 5 Furthermore, a better understanding of the importance of credit use at the firm s start-up stage should provide policymakers with guidance on how to tailor economic and tax policies to help start-up businesses obtain credit when they need credit, thereby increasing both employment and productivity. This information has especially important implications for tax reform proposals that would limit the deductibility of interest on business debt, which would increase the cost of credit to small firms. Additionally, the results of our study provide some guidance to investors considering new entrepreneurial firms. We show that entrepreneurial firms that are able to secure business credit at the firm s start-up tend to outperform other start-up firms. Finally, our results underscore the critical role that banks play in the success of start-up firms. In the United States, the number of banks has plummeted by almost half over the past three decades, primarily by the consolidation of community banks that specialize in lending to small businesses. Policymakers need to rethink burdensome regulations that are driving many bankers to leave the business. Our study provides important new evidence and contributes to the existing literature; however, it has several limitations that we are not able to address. We leave these for future research. For example, the KFS data do not identify start-up firms that apply for business credit and get rejected. With data on loan-application details and outcomes, researchers could analyze 4 See frequently asked questions at 5 Such policies recently have included the Small Business Lending Fund, which provides capital to community banks and community development loan funds as an incentive to increase their lending to small firms, and the 7(a) Loan Program of the U.S. Small Business Administration, which provides loans to qualifying small firms

6 the selection mechanisms and processes used by lenders in the case of start-up firms. Also, the KFS data do not provide information on the terms and structure of the loans or the characteristics of the lenders. That information would enable researchers to better analyze how banks select and monitor start-up firms, the role of relationship lending in start-up financing, and policy implications regarding the types of lenders that are most successful in selecting and nurturing start-up firms. Nevertheless, our study provides new evidence on the importance of bank lending for firms with no record of business operations and very limited access to other types of financing. The remainder of our study is structured as follows. In section I, we review related studies that analyze (A) credit financing of privately held firms; (B) banks roles in screening and monitoring borrowers; and (C) performance of young entrepreneurial firms. In addition, we develop hypotheses in section I. In section II, we describe our data and methodology. In section III, we present our results, followed by a summary and conclusions in section IV. I. Literature Review and Hypotheses A. Credit Financing of Privately Held Firms A large number of articles, dating back almost 70 years to Wendt (1946), have examined the issue of availability of credit to small businesses. Theory on capital rationing due to information asymmetry suggests that even good-quality firms may have limited access to debt financing (Stiglitz and Weiss, 1981). Extending this theory, Berger and Udell (1998) discuss small business financing through a financial growth cycle paradigm in which different capital structures are optimal at different points in the firm s life cycle. They suggest that firms use internal funds in the firm s early years of operation and external funds as they grow older and larger. Petersen and Rajan (1994) find that close ties with creditors lead to greater availability of credit at lower rates of interest and highlight the importance of firm-lender relationships in the allocation of credit. Berger and Udell (1998) extend the findings of Petersen and Rajan (1994) by analyzing the lines of credit, a type of lending where relationships should be especially important. They document that loan rates are lower for firms with longer firm-lender - 5 -

7 relationships. Cole (1998), in contrast, focuses on the lender s decision whether to extend credit and finds that the existence rather than the length of the firm-lender relationship affects the likelihood of a lender extending credit to the firm. Cole (2013) examines the capital structure decisions of small, privately held firms in the United States and documents that leverage is negatively related to firm size, age, profitability and credit quality; and is positively related to tangibility and limited liability. In a related paper, Cole (2009) finds that firms using no credit are significantly smaller, more profitable, more liquid, and of better credit quality than firms using credit, and concludes that this evidence is generally consistent with the pecking-order theory of firm capital structure. 6 Robb and Robinson (2014) examine the capital structure decisions of start-up firms and document that, in contrast to the conventional wisdom and theory implications, young entrepreneurial firms rely heavily on formal debt financing. These authors document that more than 40% of initial capital comes from external debt financing. Several studies analyze whether the business owner s race and gender influence the availability of credit for small businesses and find significant differences in availability of credit by owner s race (Cavalluzzo and Cavalluzzo, 1998; Blanchflower, Levine, and Zimmerman. 2003; Cavalluzzo and Wolken, 2005). Furthermore, Coleman (2002) documents that small businesses with Black owners are more likely to be denied borrowers and are more likely to be discouraged borrowers. Blanchard, Zhao, and Yinger (2008) find that both Black-owned and Hispanic-owned firms are more likely to be denied credit. Robb, Fairlie, and Robinson (2009) document that Black-owned start-up firms face greater difficulty in obtaining financial capital than do White-owned firms. B. Banks Role in Screening and Monitoring Borrowers Theories of financial intermediation posit that banks, through screening and monitoring, play a special role in reducing information asymmetry about the borrowing firm (see Berlin and 6 Harris and Raviv (1991) review the theories of capital structure. The pecking-order theory of financing demonstrates that capital structure is driven by firms' desires to finance new investments, first internally, then with low-risk debt, and finally with equity (Myers, 1984)

8 Loeys, 1988; Diamond 1984, 1991; Fama, 1985; Ramakrishan and Thakor, 1984). Banks identify successful firms ex ante, prior to providing a loan (screening); and influence borrowing firms to achieve better performance ex post, while a loan is outstanding (monitoring). Several empirical studies, that examine publicly traded firms provide evidence of a bank s special role by documenting positive abnormal returns to the announcements of bank loan agreements (e.g., James, 1987; Lummer and McConnell, 1989; Mikkelson and Partch, 1986). These studies conclude that banking relationships generate valuable private information about the financial prospects of the borrowing firms. Several more recent studies, however, have questioned the special role of bank lending. Billett, Flannery, and Garfinkel (2006) document that firms announcing bank loans experience negative abnormal returns over the subsequent three years. Fields, Fraser, Berry, and Byers (2006) argue that the advantages of bank lending have disappeared since the 1980s due to financial system changes and greater availability of (and less costly) financial information. However, recent studies examining pre-ipo and young publicly traded firms present evidence of positive effects of bank lending on the borrowing firm. Schenone (2004) documents that firms with a pre-ipo banking relationships with a prospective underwriter have a lower level of IPO underpricing. Gonzalez and James (2007) find that the existence and size of pre-ipo banking relations positively affect the firm s post-ipo performance and suggest that firms with the best prospects establish banking relationships prior to IPO. Shaffer and Sokolyk (2013) document that bank lending is associated with positive long-term outcomes of newly public firms. Newly public firms that borrow experience significantly smaller decreases in operating performance and better long-term stock performance than non-borrowers. These studies highlight the importance of banks screening and monitoring in an environment characterized by high information asymmetry. C. Performance of Young Entrepreneurial Firms Most studies of firm performance and survival have focused on public firms or on older, more established privately held firms. Our focus on privately held start-up firms provides an important contribution to this literature. From the perspective of economic theory, informational - 7 -

9 asymmetry is an important framework for the analysis of firms financing decisions and outcomes (see Myers, 1984; Jensen and Meckling, 1976). The analysis of privately held start-up firms provides new insights to the literature because start-up firms have extremely high levels of information asymmetry due to the opacity of their operations, their lack of a performance track record, their small size, and the central role of their founders in designing and managing firm operations. Several studies from the entrepreneurship literature analyze the performance prospects of young entrepreneurial firms and argue that decisions made at the initial stage of business formation can have permanent and significant effects on subsequent firm outcomes. Cassar (2004) examines the determinants of initial capital structure, and Schwienbacher (2013) develops a theory of the effects of early stage financing decisions on subsequent firm growth and development. Cooper, Gimeno-Gascon, and Woo (1994) develop a theoretical model of the initial financial capital and entrepreneur s characteristics and their effect on the performance of newly established firms. These authors argue that factors observable at the firm s start-up provide a highly predictive power in firm performance analysis. D. Hypotheses Development Our primary hypotheses relate to the differences between start-up firms that obtain credit ( use-credit firms ) and start-up firms that do not obtain credit ( no-credit firms ). As outlined above, a start-up firm has a high degree of informational asymmetry due to the lack of a performance track record and a high degree of uncertainty about future performance. We hypothesize that new entrepreneurial firms with better performance prospects are more likely to obtain credit financing at the firm s start-up. Formally, our first hypothesis states: H 1 : Lenders are more likely to extend credit to start-up firms with better performance prospects. Whereas our first hypothesis relates to the screening role performed by financial intermediaries when evaluating performance prospects of potential borrowers, our second hypothesis emphasizes the monitoring function performed by credit providers. We hypothesize that firms that obtain credit financing at the firm s initial stage exhibit better future performance - 8 -

10 than do firms that do not obtain credit financing at the firm s start-up. This hypothesis is also consistent with the notion that availability of credit at the initial stage of business formation helps firms grow and develop. Formally, our second hypothesis states: H 2 : Monitoring by lenders enables firms that obtain credit financing at start-up to achieve better subsequent performance. Our second set of hypotheses relate to the differences between firms that, at start-up, obtain business credit versus personal credit. Robb and Robinson (2014) document that debt financing provides an important source of capital for start-up firms. They further argue that it is important to distinguish between insider debt (obtained from the owner, family, and friends) and outsider debt (obtained from sources such as banks, nonbanks, government, and so forth). Robb and Robinson (2014) document that the portion of total capital financed through outsider debt is positively related to firm performance three years after the firm s start-up. They conclude that outsider debt is most important for successful firm outcomes because of the superior enforcement technologies available to outsiders. In so doing, they conflate the effects of personal and business loans, especially those loans from banks. 7 We argue that a much superior taxonomy is based upon the entity (i.e., the firm versus the firm s owner) being evaluated, and subsequently monitored, by the prospective lender. When the entity is the firm s owner, the prospective lender is only tangentially concerned with the firm s creditworthiness, finances, and prospects for success; instead, the lender is focused on the creditworthiness of the firm s owner. In fact, the prospective lender often does not know that the borrowed funds will be used to finance a start-up, as in the case of the firm s owner using proceeds from a home-equity line of credit or personal credit card to finance the start-ups assets. H 3 : The ability of a start-up firm to obtain financing by personal credit is unrelated to the firm's performance prospects. 7 Whereas Robb and Robinson (2014) presume that personal guarantees and personal collateral must often be posted to secure financing for startups, Avery, Bostic, and Samolyk (1998) report that 60% of small business lending is not personally guaranteed. In addition, Avery, Bostic, and Samolyk (1998) exclude from their analysis credit card loans, which account for a large portion of KFS business loans and are typically an unsecured form of credit

11 In contrast, when the entity being evaluated is the firm itself, the prospective lender is highly focused on the firm s creditworthiness, finances, and prospects for success. H 4 : Lenders are more likely to extend business credit to start-up firms with better performance prospects. Moreover, when the firm is successful in obtaining financing, it then benefits from the lender s monitoring throughout the life of the loan. Consequently, our taxonomy categorizes debt based upon the entity being evaluated by the lender the firm or the firm s owner in marked contrast to the categorization by Robb and Robinson (2014). We hypothesize that firms obtaining loans in the name of the firm, rather than in the name of the firm s owner, are more likely to succeed in terms of both survival and revenues because of the banks monitoring. Formally, we formulate our fifth and six hypotheses as follows: H 5 : Monitoring by lenders enables firms that obtain business credit financing at start-up to achieve better subsequent performance. H 6 : Start-up firms that obtain personal credit do not benefit from bank monitoring, so its subsequent performance is unrelated to obtaining personal credit. In the next section, we describe the data and methodology used to test these hypotheses. II. A. Data and Sample Description Data and Methodology We use data from the Kauffman Firm Survey to examine what types of firms use credit at the firm s start-up and the effect of the initial credit use on subsequent firm performance and survival. This annual survey follows 4,928 privately held firms that were established in Currently, the survey results are available for the baseline year (2004) and seven follow-up years ( ), with the final 2012 results to be released during The KFS represents the 8 The KFS identified start-up firms by using a random sample from Dun & Bradstreet s database list of new businesses established during 2004, excluding wholly owned subsidiaries of existing businesses, businesses inherited from someone else, not-for-profit organizations, and firms that had any kind of business activity prior to For more detailed information about the KFS data, see Ballou et al. (2008) and DesRoche et al. (2012)

12 largest and the most comprehensive data on U.S. start-up firms. Along with detailed information on the firm s use of credit, the KFS provides data on various firm and owner characteristics. The richness of the KFS data allows us to identify what types of firms use credit as well as the different types of credit at the firm s start-up and to explore the relation between the use of different types of credit at the firm s start-up and subsequent firm performance. Whereas Robb and Robinson (2014) analyze the amounts of financial capital used by start-up firms, we focus on the incidence of credit use by such firms. The analysis of the incidence of credit use is important because of the mass of points at zero for most of the amounts of capital and highly skewed distributions for those firms with non-zero amounts of capital, especially for credit sub-types. This means that the median amount can be zero while the mean amount is large and positive for many debt categories. Table I provides a summary and definitions of KFS variables used in the study; Table II presents the descriptive statistics for these variables. Table II shows that 76% of firms use some type of credit (either business, personal, or trade) at the firm s start-up. This is quite similar to 80% of closely held U.S. firms of any age documented by Cole (2010) and suggests that entrepreneurial firms try to secure credit financing at the earliest stage of their formation. Furthermore, 55% of firms use personal credit at the firm s start-up, suggesting that more than half of start-ups owners explicitly take on personal liability beyond their equity investment in the firm. This evidence is consistent with the notion that many entrepreneurs hold levered equity stakes in their ventures (see Robb and Robinson, 2014). However, a sizable percentage (44%) of start-up firms secure financing on the name of the business itself. While it is possible that business credit is also backed by personal guarantees and personal collateral, the fact that a majority of start-ups explicitly use personal credit and a large minority use business credit suggests that there are important differences in these firms and in their capital-structure decisions. 9 9 The KFS does not provide data on personal guarantees or personal wealth of the entrepreneurs in 2004 so we cannot directly test this proposition

13 Table II also reports summary statistics on the firm s and primary owner s characteristics. On average, start-up firms generated about $230,000 in revenues, a surprising $486 in net income, and had $347,000 in total assets by the end of the first year of operations. The average level of cash and tangible assets was $38,000 and $187,000, respectively. The financial characteristics of a median firm, however, are quite different from the characteristics of an average firm. The median firm generated only $7,500 in revenues, reported a net loss of $300, had $20,000 in total assets, $2,000 in cash, and $5,000 in tangible assets by the end of the startup year. The 25 th percentile start-up firm had values of zero for revenue, cash, current assets, and tangible assets, and reported a net loss of $10,000. The 75 th percentile start-up firm had values for revenues and assets that are substantially smaller than the sample averages, indicative of the highly skewed distributions for these financial variables. In addition, the standard errors for firm variables are very large. These observations demonstrate that the distribution of start-up firms is highly skewed with the potential presence of significant outliers. To address the skewness of the distributions, we take the natural logarithms of firm financial characteristics variables in our subsequent analysis. Table II also shows that about two in three start-up firms are organized as corporations and one in three has more than one owner. At the firm s start-up, the primary owner, on average, is 45 years old, has almost 13 years of prior experience in the same industry, and has one prior start-up experience. 10 One in four start-up firms has a female as its primary owner. Four out of five firms have a White primary owner; but less than one in ten have a Black primary owner; one in twenty has a primary owner who is Asian; and one in twenty has a primary owner who is 10 Similar to prior studies using the KFS data, we define a firm s primary owner as the firm s owner who has the highest percentage ownership (see, e.g., Ballou et al. 2008; Robb, Fairlie, and Robinson, 2009). In cases where two or more owners have the same percentage ownership, the owner who works the most hours in the firm is defined as the primary owner. In cases where two or more owners report the same ownership and the same number of work hours, a series of other variables (i.e., owner s education, age, work experience, amount of initial equity invested, and other start-up experience) is used to create a ranking of owners in order to define the primary owner

14 Hispanic. With respect to educational attainment, two out of three primary owners have some college education or hold a college (bachelor s) degree, and one in five holds a graduate degree. B. Methodologies In order to test our first hypothesis H 1, we use a multivariate probit model to analyze what types of firms are more likely to use credit at the firm s start-up. To test our third and fourth hypotheses, H 3 and H 4, we examine what types of firms are more likely to use personal credit and what types of firms are more likely to use business credit, conditional on the use of any type of credit; for this analysis, we employ the multivariate bivariate probit model. We describe the methodologies used to test these hypotheses in section II.B.1. To test our second hypothesis H 2, we explore whether the use of credit at the firm s startup is associated with firm outcomes specifically, firm survival and firm growth in terms of revenues. For survival analysis, we use the Cox (1972) proportional hazard model. For growth analysis, we employ Weighted-Least Squares (WLS) regression to examine the effect of credit use on the firm s revenues three years after the start-up. Since this analysis includes only firms that have survived three years from the firm s start-up, we use the Heckman (1979) two-step model to control for sample selection bias. To test hypotheses H 5 and H 6, we use the same two models to examine the relation between the use of business credit and personal credit and the firm s revenue and survival three years after the firm s start-up. 11 The methodologies for testing these hypotheses are described in section II.B.2. In all our analyses, we incorporate the survey sampling weights because the KFS sample is not a random sample, but instead is a stratified random sample where high technology firms are over-represented relative to firms in other industries. B.1. Types of Firms that Use Credit at Start-Up To examine whether better-quality firms are more likely to obtain credit at the firm s start-up (H 1 ) and are more likely to obtain business credit (H 4 ), we estimate a multivariate 11 We analyze revenues for and survival up to 2007, 2008, 2009, and 2010, and find that our results are qualitatively similar across all these years. The results for 2007 are most consistent across various specifications, and we focus on these results in this paper

15 bivariate probit selection model. The first/selection equation estimates the probability of using any credit (test of H 1 ), with the dependent variable equal to one if the firm used business, personal, or trade credit at the firm s start-up. The second/outcome equation estimates the probability of using business credit, conditional upon using any type of credit (test of H 4 ). To test H 3, we use the same bivariate probit selection model with the second/outcome equation estimating the probability of using personal credit. The bivariate probit selection model accounts for a non-random selection mechanism operating on those firms that decide to use credit and choose whether to use business or personal credit. The two equations in the bivariate probit model are as follows: y * = ' X + є, y = sign (y* ) (1) 1 and y * = ' X + є, y = sign (y* ) (2) 2 where: є, є ~ Bivariate Normal (0, 0, 1, 1, ρ) 1 2 In the bivariate probit selection model, (y, x ) are observed only when y is equal to one, so the error terms in eqs. (1) and (2) must be re-specified as є j = exp(γ j, z j) u j, where (u 1, u 2 ) have the bivariate standard normal distribution. The estimated correlation coefficient ρ (the correlation between error terms є 1 and є 2 ) can be used to test for selection bias. If ρ is statistically significant, then we can reject the null hypothesis that selection bias is not present. X 1 and X 2 are the vectors of independent variables (defined in Table I), which include Firm Characteristics, Owner Characteristics, Other Sources of Capital, and Industry Classifications. The probability of using credit is likely to be influenced by the availability of credit, so we include a proxy for the supply of credit, measured as the amount of 2004 state-level small-business bank lending per small business enterprise. 12 To make sure that the amount of state-level small-business bank 12 Data on bank lending to small businesses are from the FFIEC s Consolidated Reports of Condition and Income, which is a quarterly regulatory report filed by all U.S. commercial banks

16 lending is exogenous to the use of credit by start-up firms, we instrument it with the amount of state-level homestead bankruptcy exemption and use the predicted value from that regression as a proxy for the supply of credit to small businesses. 13 Finally, the coefficients and in eqs. (1) 1 2 and (2) are estimated by the Maximum Likelihood Estimation Method. 14 B.2. Does Initial Credit Explain Firm Outcomes? After analyzing what types of start-ups are more likely to use credit, we explore whether the use of credit at the firm s start-up is associated with firm outcomes (test of H 2, H 5, and H 6 ). We first examine the relation between credit use and the probability of survival during the first three critical years of firm operations. For surviving firms, we explore the relation between the use of credit at the firm s start-up and the level of revenues three years after the firm s establishment. With firm s survival and revenue measures, we are capturing both the stability of the firm and its growth during the first critical years of the firm s operations. B.2.1. Survival Analysis We use the Cox (1972) proportional hazard model to estimate the effect of initial credit conditions on the probability of survival of young entrepreneurial firms. The advantage of using a survival model, such as the Cox proportional hazard model, is that the survival functions follow the firm through time and observe at which point in time it experiences an event of (see Part II of Schedule RC-C Loans to Small Businesses and Small Farms ). Business loans with original amounts less than $1 million are reported on this schedule. We then scale the total amount of small business lending by the number of small business enterprises in each state, using the number of enterprises in each state as reported in the 2004 County Business Patterns, which summarizes results from a U.S. Census survey of businesses. Information on the amount of statelevel homestead bankruptcy exemption as of 2003 is taken from Table 1 in Berger et al. (2011). 13 These results, which show that the exemption amount is a valid instrument, are available from the authors upon request. Berkowitz and White (2004) show that small firms are more likely to be turned down for loans if they are located in states that have higher bankruptcy exemptions. We argue that there is no reason for the bankruptcy exemption to be correlated with the use of bank credit by entrepreneurial firms except through its impact on the supply of credit by lenders. 14 We operationalize this methodology by using the heckprobit procedure of the Stata 11 software

17 interest (see Shumway, 2001). Also, survival models incorporate data truncation; that is, if some events are unobserved because they occur beyond the end of the sample period, they are taken into consideration through right censoring. The Cox proportional hazard model is a semiparametric model that employs a maximum partial likelihood estimation method and has the following form (Cox, 1972): h ( t) h ( t)exp( X ), (3) i 0 i where h i (t) is the time-t hazard of firm i (t = in our analysis), which is the probability that firm i will be out of business at the end of year t, conditioning on firm i surviving up to time t; h 0 (t) is the baseline hazard function that is left unspecified and corresponds to the probability of an event when all explanatory variables are zero; X i is a vector of explanatory and control variables, corresponding to firm i; ß is a vector of coefficients to be estimated. 15 Variables are defined in Table I. The explanatory variables are: Credit, which equals one if the firm used business, personal, or trade credit at the firm s start-up, and Business (Personal) Credit, which equals one if the firm used business (personal) credit at the firm s start-up. In some specifications, we also control for Firm Characteristics, Owner Characteristics, Other Sources of Capital, Industry Classifications, and for state-level credit supply to small businesses. B.2.2. Revenue Analysis We then examine whether young entrepreneurial firms that use credit at the firm s startup perform better in terms of revenue growth. We estimate a multivariate Weighted-Least- Squares regression: Revenue i = X i α + µ i (4) where the dependent variable Revenue i is measured as the natural logarithm of one plus the level of revenue of firm i three years after the firm s start-up (2007 KFS); 16 X i is a vector of 15 We operationalize the Cox proportional hazard model using the stcox procedure in the Stata 11 software package. 16 For firms that do not report the amount of 2007 revenues, we use the midpoint value of the reported 2007 revenue range if it is available. Our results do not qualitatively change if we

18 explanatory and control variables, corresponding to firm i; and µ i is a normally distributed error term. Explanatory variables include Credit, which indicates whether the firm used any type of credit at the firm s start-up; in the analysis that differentiates between the use of personal and business credit, Credit is replaced with the indicators Business Credit and Personal Credit. Independent variables also include controls for Firm Characteristics, Owner Characteristics, Other Sources of Capital, Industry Classifications, and a proxy for credit supply. The variables are defined in Table I. Since this analysis includes only firms that have survived three years from the firm s start-up, we use the Heckman (1979) two-step model to control for sample selection bias. This methodology involves first estimating a single-equation multivariate probit model to explain survival through 2007 (rather than the Cox proportional hazard model explained above in section II.B.2.1). y * = X i ' + є, y = sign (y * ) (5) i i i i where y i is equal to one if the firm survives through 2007 and is equal to zero otherwise, є i ~ Normal (0, 1); and corr (µ i; є ) = ρ. In the probit model, we use the same set of regressors X i i as in the Cox proportional hazard model discussed above. We then use the results of this probit estimation to calculate the Inverse Mills Ratio (IMR), and then include IMR as an additional regressor in the WLS model of revenues shown in eq. (4). 17 III. A. Types of Firms that Use Credit at Start-Up Data Analysis and Empirical Results This section presents the analysis on the use of credit by start-up firms. We examine what types of firms are more likely to use credit at the firm s start-up and, conditional upon credit use, what types of firms use business credit and what types of firms use personal credit. Table III exclude these firms from our analysis. We add one to the level of revenue before taking the natural logarithm to avoid creating a missing value for a firm with zero level of revenues. 17 We operationalize the two-step Heckman sample-selection model using the heckman procedure in the Stata 11 software package

19 presents the results of this analysis, utilizing a weighted bivariate probit selection model. In the first selection stage (results reported in column 1 of Table III), the dependent variable takes a value of one if the firm uses any type of credit. The second stage estimates the probability of using business/personal credit, conditional upon using any type of credit estimated in the first stage; the results of this analysis appear in columns 2 and 3 of Table III, respectively. In each of the columns, for ease of economic interpretation, we report odds ratios, which are calculated as e, where is a vector of estimated coefficients. t-statistics are reported in parentheses. As shown in column 1 of Table III, firms that use credit at the firm s start-up are significantly larger, as measured by both revenues and assets, than firms that use no credit. The economic significance of these variables is also large: 4% higher odds of using credit for a 1% increase in revenues, and an almost 6% higher odds of using credit for a 1% increase in assets. 18 In general, corporations are 16% more likely to use credit than other forms of business organizations combined. Furthermore, firms with greater credit risk are less likely to borrow at the firm s start-up. A one-step decrease in the firm s credit category is associated with 10% lower odds of obtaining credit. Firms with a competitive advantage are 16% more likely to use credit. Firms that provide product only are 35% more likely to use credit, and firms that provide product and services are 18% less likely to use credit. Overall, the results provide support for the hypothesis (H 1 ) that better-quality firms are more likely to obtain credit financing at the firm s start-up. These results are different from prior findings on more mature privately held firms (see, e.g., Cole, 2009, 2013) and provide new evidence on the use of credit by start-ups. Furthermore, as shown in columns 2 and 3 of Table III, there are notable differences between firms that use business credit and firms that use personal credit. Firms that are larger in terms of revenue and total assets are more likely to use business credit. In contrast, larger firms are less likely to use personal credit. Corporations are 35% more likely to use business credit, but being incorporated does not affect the probability of personal credit use. Firms that have multiple owners are almost 15% less likely to use personal credit. Firms with lower credit scores are 18 We add one to cash and revenue in order to avoid creation of missing values when we perform logarithmic transformations on those variables

20 significantly less likely to use business credit but are significantly more likely to use personal credit. These findings suggest that, out of all credit users, better-quality firms are more likely to obtain business credit, whereas lesser-quality firms are more likely to obtain personal credit. These results support H 4 that lenders provide business credit to start-ups with better performance prospects. However, we did not expect firm characteristics to affect the probability of obtaining personal credit financing. One possible explanation is that firms with worse performance prospects are either denied or are discouraged from applying for business credit and they apply for personal credit instead. Whereas we do not have data on the loans application process to test this prediction, it is clear from Table III that there are important differences between firms that obtain business credit and firms that obtain personal credit at the firm s start-up. Prior studies examine the effect of owner characteristics on the probability of obtaining credit for privately held firms. Table III demonstrates that several owner characteristics significantly relate to the probability of using credit at the firm s start-up. Firms with owners who are college educated are 18% more likely to borrow, and firms with owners who have a graduate degree are 52% more likely to borrow. However, when differentiating between the use of personal credit and the use of business credit, the results show that owners with graduate degrees are 20% more likely to use business credit, but the owner s education does not affect the probability of personal credit use. Furthermore, consistent with prior studies documenting lower availability of credit to minorities, our results show that firms with Black owners are 45% less likely to use credit at start-up; this result is also negative and significant for business credit use, but not significant for personal credit use. Firms that are owned by females are 17% more likely to use personal credit, but are no less likely to use business credit. Finally, firms with equity contributions by insiders (i.e., friends and family of the owners) are 47% more likely to use credit at the firm s start-up. However, insider equity is not significant in business and personal credit regressions; instead, the insider debt variable is significant, but in opposite ways. Firms with insiders lending money to the firm are less likely to use business credit and are more likely to use personal credit

21 Overall, the results presented in Table III support H 1 and H 4 and suggest that betterquality firms are more likely to obtain credit, specifically business credit, at the firm s start-up. These findings are different from the predictions of the pecking-order theory of financing developed for more mature firms and provide new evidence and contribution to the existing literature on young entrepreneurial firms. We find that better-quality entrepreneurial firms secure credit financing at the earliest stage of business formation. Furthermore, while there is a common notion that entrepreneurs are often personally liable for business debts of the firm and that the distinction between personal and business debt is negligible, the results presented in Table III suggest that it is important to differentiate between the use of business versus personal credit by start-up firms. Our results suggest that, of the credit users, better-quality firms are more likely to use business credit and are less likely to use personal credit. B. Credit Use and Firm Performance In this section, we examine whether the firm s initial capital-structure decisions regarding the use of credit affect the firm s outcome during the first critical years of operation. We test the hypotheses that firms obtaining credit (H 2 ), particularly business credit (H 5 ), at the firm s startup benefit from lenders monitoring. We also test H 6 that start-up firms obtaining personal credit do not receive such benefits. In section III.B.1, we examine the relation between credit use at the firm s start-up and firm survival three years after the start-up; in section III.B.2, we examine the relation between credit use and the level of revenue three years after the start-up. In sections III.B.3 and III.B.4, we perform robustness tests by examining the relation between credit use and revenue and survival in propensity-score-matched sample and by controlling for the endogeneity between the probability of credit use and performance outcomes

22 B.1. Survival Table IV presents the results from the survival analysis and alludes to the idea that firms that obtain credit at the firm s start-up are more stable, as measured by the hazard rate of going out of business. The table presents hazard ratios, which equal 100*(e ß - 1) and summarize the economic significance of a given variable. In column 1 of Table IV, the coefficient for Credit is a statistically significant 0.848, which indicates that a firm that uses credit at start-up has about a 15% lower hazard rate of going out of business; or, equivalently, a 15% greater survival rate. Furthermore, as shown in column 2, which differentiates between the use of business and personal credit, this relation is driven by the use of business credit. The coefficient for Business Credit also is a statistically significant 0.848, whereas the coefficient for Personal Credit is not statistically significant in explaining the firm s survival rate. In the next columns, we sequentially add the vectors of Firm Characteristics, Owner Characteristics, Industry Classifications, Other Sources of Capital, and State-Level SME Lending, which proxies for the credit supply to small entrepreneurial firms. Thus, our analysis controls for a large range of firm, owner, and industry characteristics. For brevity, the results for control variables are not shown in Table IV, but are reported in Appendix Table A.1. Columns 3, 4, and 5 show that, after controlling for differences in various firm, owner, industry, and other financial capital characteristics, the coefficient of Business Credit remains statistically significant at better than the 0.01 level, and the magnitude of the coefficient falls to , indicating that a firm obtaining business credit at start-up has a 20% to 23% higher survival rate than does a firm unable to obtain such financing. B.2. Revenues Table V presents the results of the regressions examining the relation between credit use at the firm s start-up and the level of revenue three years after the firm s establishment (KFS 2007). In each specification, we control for sample selection (i.e., we observe only the firms that have survived to 2007) by including the Inverse Mills Ratio estimated by using the probit model