SMEs generally follow a pecking order in their quest to raise external finance, i.e. they start with cheaper sources of funds and then graduate to costlier financing sources. Apart from internally generated cash flows such as retained earnings, capital from proprietors and financial support from families and friends for start-ups, small businesses find debt finance one of the relatively cheapest means of raising funds for their operations. Bank credit is an extremely convenient form of finance for the firm that has a good relationship with his banker
(Bates and Hally, 1982). Debt finance may be preferred to equity finance because it does not dilute share ownership. Moreover, it is less likely to transmit control over the business, except in instances where loan covenants and other contractual terms may cede a sizeable level of control to external creditors (Berger and Udell, 2003). Debt finance may also reduce verification costs because outside creditors will have to bear the cost and time of monitoring the company’s cash flows or project returns in the event that debt repayment is not forthcoming or is not paid in full. Optimal financial arrangements such as loan covenants and other debt contracts will help to reduce monitoring costs and exert corporate control over managers of the borrowing firm.
A borrower’s choice of financing sources is likely to be a function of its ‘credit history’ and its ‘investment opportunities’ (Bhattarcharya and Thakor, 1993:7). According to Diamond (1991), new and inexperienced borrowers without a verifiable reputation prefer to borrow from banks, while older firms with well-established reputation choose the capital market. Rajan (1992), however, argues that when borrowers anticipate huge profitable project returns in the future, they prefer arm’s length8 (direct) financing. In other words, while Diamond’s
view that the borrower’s reputation is a key factor in the choice of financing source is ‘retrospective’, Rajan’s prediction is rather ‘prospective’ (Bhattarcharya and Thakor, 1993:38), i.e. dependent on future investment returns. In essence, it can be noted that the decision of a firm to choose to access funds from the capital market arises from the firm’s financial growth life cycle. Many de novo firms use bank finance initially to gain credibility or build public image before accessing capital markets as they become more profitable.
Another interesting argument in the literature focuses on the conflict between debt and equity holders (see Campbell, 1979). Here, small high-quality, innovative firms tend to prefer (bilateral9) bank finance to equity finance because they want to avoid the disclosure of private information to product market competitors or to third parties10. Yet Campbell’s framework
8 Arm’s length debt here refers to financing sources which do not entail huge disclosure costs aside from publicly available information e.g. bondholders (See Rajan, 1992)
9 Bilateral financing is often characterised by a close relationship between a borrower and a lender and where because of this intimacy the lender does not require the borrower to disclose as much verifiable information to be able to access credit. Thus bilateral financing is less costly.
10 Interested third parties may be a regulator, the tax authority, or even the firm’s own labour union (See Rice, 1990)
does not take into account the risk of conjecture on the part of interested third parties when they discover that a bank loan has been granted (see Yosha, 1995). There can be scenarios particularly under multilateral11 financing arrangements, where the private information of a borrowing firm could be disclosed by a bank to a product market competitor who has borrowed from the same bank. In fact, most models ignore the possibility of this kind of tensions between the issuers of securities, on the one hand and third parties on the other hand. This is especially the case with Diamond (1991) and Rajan (1992) where, since monitoring and control rights are of meagre importance to low risk firms, they may prefer (less informed) arm’s length debt to (informed) bank finance.
It is possible for a borrower’s financing choice to be adversely affected by information leakages. Firms whose probability of success cannot be ascertained when they invest in private knowledge-producing activities (i.e. R&D) might as well find multilateral financing more beneficial to bilateral financing since it is baseless to try to shield their proprietary information from the public. Conversely, if firms can significantly influence their chances of making profits, they may find that because of free riding by competitors, multilateral financing may not be a viable option (Bhattarcharya and Chiesa, 1995; Yosha, 1995)
Another potential source of finance for SMEs is venture capital (VC). It is hypothesised that the most inexperienced borrowers who lack managerial skills resort to this type of capital (e.g Chan et al., 1990), while those who can convince investors of their managerial skills but lack credit reputation tend to approach banks (e.g. Bhattarcharya and Thakor, 1992). Larger firms who are both skilled in management and have a reputation for creditworthiness opt for capital market financing. It has been argued that small firms tend to be heavily reliant on bank finance as opposed to venture capital for a number of reasons: First, there are huge fixed costs associated with arranging venture capital finance and this may not be readily affordable by small firms (e.g. Cowling, 1998). Most venture capital firms may not even be willing to admit small risky businesses and incur huge operational costs (e.g. Harrison and Mason, 1986). There is also considerable evidence of the increasing unwillingness of small firms to dilute equity ownership to outsiders and thus risk losing their autonomy and control (e.g. Dow, 1992).
11 In contrast to bilateral financing, multilateral financing requires borrowers to disclose as much information as possible, and even to be audited to be able to convince lenders that they are credit worthy.