DETERMINANTS OF DEBT AND (PRIVATE) EQUITY FINANCING: THE CASE OF YOUNG, INNOVATIVE SMEs FROM GERMANY, THE

Industry and Innovation, Sep 2004 by Schäfer, Dorothea, Werwatz, Axel, Zimmermann, Volker

Recently the CEO of a large German public bank noted that German start-ups should be financed almost exclusively with equity, since debt financing is not appropriate for bearing the huge risks that newly founded firms entail. In this paper we investigate whether young, small and medium-sized enterprises (henceforth SMEs) classified as innovative firms indeed favour equity financing, and explore the factors determining their choice of financing mode. Financial theory discusses the optimal financial structure of firms extensively. But empirical evidence on the choice of the financing mode in young high-tech SMEs is rather limited. Our paper contributes towards closing this gap.

Much of the literature on financial contracting focuses on debt contracts, which are often assumed rather than derived as the optimal method of financing. However, as de Meza and Webb (1987) point out, some distorting phenomena like rationing (Stiglitz and Weiss 1981) may simply disappear if equity contracts are allowed. Despite the clear-cut results on the relation between the type of asymmetric information and the preferred financial instrument in de Meza and Webb (1987), the theoretical results on financing decisions are far from conclusive. In particular, the impact of both the intrinsic and the financial risk on selecting either debt or equity financing remains an unresolved issue.

Only recently have contradictory results been derived. On the one hand Hellmann and Stiglitz (2000) show that high-risk entrepreneurs choose debt contracts whereas low-risk entrepreneurs select equity contracts. On the other hand the literature on financing start-ups predicts that high-risk projects are associated with venture capital rather than with bank financing (for example, Ueda 2004). In these models the venture capitalist has superior expertise in screening, monitoring and providing managerial support for the founder. This expertise seems to be of more value for high-risk projects. Explicit reference to equity contracts is rare. But as venture capitalists normally draw up equity or equity-like contracts, these findings imply a close tie between highly risky entreprenevirs and equity financing. Venture capitalists themselves consider it as the core of their own business model that they select high-risk, high-return ventures and contribute towards improving their prospects during the period of investment (Manigart and Sapienza 1999).

In this paper we examine empirically whether and how the market for financing young German high-tech companies is divided between credit financiers, normally banks, and equity financiers, normally venture capitalists. We rely on a data-set that contains detailed financial and project information sampled from firms with investors refinanced by the KfW Group (henceforth KfW).1 KfW is a government-owned support bank that manages most national programmes for promoting SMEs. The main focus of our study is to explore whether entrepreneurs pre-select financing modes according to their project's characteristics. In particular we ask:

What is the role of risk for choosing debt and equity financing? What is the relationship between the provision of informed capital, risk and the mode of financing? Finally, what lessons for start-up finance can be derived from the evidence?

Regarding the indicators of financial risk in our data, the results are clear-cut: risky enterprises with a low cash flow (price cost margin) or a low ratio of equity to total assets tend to receive equity financing. Also, equity financing is more likely the larger the size of the project. The latter result is not surprising, given that the costly screening and coaching activities of equity financiers favour larger deal sizes. Moreover, in order to control their exposure to risk, banks may ration their high-tech clients with respect to investment size.

Regarding the variables measuring the intrinsic risk of a project or an enterprise we find ambiguous results. Surprisingly, most indicators of the intrinsic project risk either fail to significantly influence the choice of financial mode or have a negative effect on the probability of being equity financed. In particular, investing in a real R&D project significantly decreases the likelihood of receiving equity finance. This result is quite robust. It also emerges if only the choice between equity investment with management or technical support and debt is analysed. On the other hand, if we measure an enterprise's intrinsic risk by whether it regularly performs R&D then a positive relation between intrinsic risk and the propensity to receive equity financing emerges.

Recent studies show that start-up finance in Europe and Canada hardly resembles the picture drawn from empirical studies in the USA (e.g. Gumming 2002b; Bascha and WaIz 2001; Schwienbacher 2002). We have the same aim as the authors of these papers in that we also attempt to filter out particularities of a market for start-up finance embedded in a financial system that is less market-based than the US system. Nonetheless, our approach is novel in many respects. First, we examine a sample that provides information about the financing practices of the two most important financial intermediaries for high-tech SMEs: banks and venture capitalists. Second, we use project-related and financing-related micro-data that are mostly drawn from the entrepreneurs' balance sheets as well as from questionnaires filled in by investors when they approach KfW for refinancing. Thus we do not rely exclusively on self-reporting by financiers. Third, our analysis is the first one to explicitly focus on the role of credit and equity financing in young non-listed high-tech firms in Germany. By concentrating on this type of firm we avoid two biases, the survivor and the "high-flyer" bias.2 Both biases arise naturally in studies that investigate listed firms. Fourth, our sample is unique in that it contains direct information on whether high-tech firms receive informed capital. We observe directly whether private equity financiers also support their client with managerial or technical advice. Fifth, and most importantly, by explicitly referring to the theoretical evidence on the choice between the two standard financial instruments we provide new evidence about the impact of risk on the financing decision. Knowing this impact is important. The potential of different financing modes (of different types of financiers) to contribute to young firms' development can only be estimated accurately if the role of both the financial risk and the project risk for the pre-selection of a specific method of financing is clarified.