The Capital Structure Decisions of New Firms

Alicia M. Robb David T. Robinson

UC Santa Cruz Duke University

February 11, 2009

Abstract

This paper investigates the capital structure choices that firms make in their
initial year of operation, using restricted-access data from the Kauffman Firm
Survey. Contrary to many accounts of startup activity, the firms in our data rely
heavily on external debt sources such as bank financing, and less extensively on
friends and family-based funding sources. This fact is robust to numerous controls
for credit quality, industry, and business owner characteristics. The heavy reliance
on external debt underscores the importance of well functioning credit markets for
the success of nascent business activity.

1 Introduction

Understanding how capital markets affect the growth and survival of newly created
firms is perhaps the defining question of entrepreneurial finance. Yet, much of what we
know about entrepreneurial finance comes from firms that are already established, have
already received venture capital funding, or are on the verge of going publicthe dearth
of data on very early stage firms makes it difficult for researchers to look further back in
firms life histories.1 Even data sets that are oriented towards small businesses do not

The authors are grateful to the Kauffman Foundation for generous financial support and to the
participants at the Kauffman/Cleveland Federal Reserve Bank Entrepreneurial Finance Conference for
helpful comments on an earlier draft. The usual disclaimer applies.
1
A recent exception is Kaplan, Sensoy and Stromberg, 2009, which follows a small sample of firms
beginning at business plan stage.

Electronic copy available at: http://ssrn.com/abstract=1345895

allow us to systematically measure the decisions that firms make at their founding. This
paper uses a novel data set, the Kauffman Firm Survey (KFS), to study the behavior
and decision-making of newly founded firms. As such, it provides a first-time glimpse
into the capital structure decisions of nascent firms.

In this paper we use the confidential, restricted-access version of the KFS, which
tracks nearly 5,000 firms from their birth in 2004 through their early years of operation.2
Because the survey identifies firms at their founding and follows the cohort over time,
recording growth, death, and any later funding events, it provides a rich picture of firms
early capital structure decisions.

There are two main motivations for our analysis. The first is practical, the second,
theoretical. At a practical level, there is a widely held view that startup firms face
credit constraints, and that the inability to access formal credit markets drives many
firms to pursue financing from informal channels to finance their startup activity. This
motivation is at the heart of an important literature in banking that considers the role of
relationships in establishing information flows between banks and firms (see, for example,
Peterson and Rajan, 1994, 2000.) The richness of the KFS data allows us to explore
the extent to which startups rely on friends and family versus more formal financing
arrangements, such as bank loans, credit cards, and venture capital.

Indeed, the tradeoffs between alternative capital providers point directly to our sec-
ond motivation; namely, what theories best describe the capital structure decisions of
new firms? Is there a pecking order for startups? If so, how does the pecking order we
observe in the data correspond to the pecking order prescribed by theory?
2
To be eligible for inclusion in the KFS, at least one of the following activities had to have been
performed in 2004 and none performed in a prior year: Payment of state unemployment (UI) taxes;
Payment of Federal Insurance Contributions Act (FICA) taxes; Presence of a legal status for the
business; Use of an Employer Identification Number (EIN); Use of Schedule C to report business income
on a personal tax return.

Electronic copy available at: http://ssrn.com/abstract=1345895

 Studying the capital structure of nascent firms helps to shed light on existing models
of capital structure by focusing on an environment in which many of the modeling
assumptions are particularly salient. At a theoretical level, many theories of capital
structure are built from asymmetric information models of the firm that explicitly model
the firm as an owner-managed entity seeking to raise funding to begin a project of
uncertain value to outside investors. Most large, modern corporations simply do not fit
this description. Yet the types of firms covered by the Kauffman Firm Survey fit this
description well. As such, they provide a natural laboratory for testing the predictions
of many existing theories of capital structure.

We find that newly founded firms rely heavily on external debt financing, such as
that provided by banks and credit cards. Our calculations indicate that external debt
financingprimarily through owner-backed bank loans and business credit cardsis the
primary source of financing during a firms first year. Indeed, our data suggest that the
reliance on friends and family is an urban myth. The average amount of bank financing
is seven times greater than the average amount of insider-financed debt; three times as
many firms rely on outside debt as do inside debt. Even if we discard firms that do not
use this source of financing, the average amount of external debt is nearly twice that of
internal debt.

The reliance on formal credit channels over personal credit cards and informal lending
holds true even for the smallest firms at the earliest stages of founding. The average
pre-revenue firm in our sample has twice as much capital from bank loans than from
insider sources.

Of course, these calculations only speak to the equilibrium amount of borrowing from
inside and outside sources; they are driven by both the supply of credit as well as the
demand for credit. To control for the fact that there may simply be much more readily
available outside funding, we make use of commercial credit scores of the firms. By
regressing the credit score on industry dummies as well as firm and owner characteristics

Electronic copy available at: http://ssrn.com/abstract=1345895

that affect the demand for capital (such as the legal form of organization of the business
and the owners education), we can purge the credit score of demand-side variation,
leaving us with a measure of supply-side variation in credit access. Using this strategy
to partition the data into firms with easy access versus constrained access to capital,
we can explore how much the capital structure decisions of nascent firms are driven by
supply-side factors.

Surprisingly, this partitioning has little effect on the observed capital structure
choices firms make. To be sure, firms with high unexplained credit scores have more
financial capital. The level of financing of these firms is nearly three times larger on
average than constrained-access firms. But the relative amount of outside debt to total
capital is about the same for both types of firms.

Apart from the possibility that cross-sectional variation in credit quality drives our
results, a second possibility is that credit conditions at the time of our survey were
unique, and do not necessarily reflect the broader patterns from other time periods.
While ultimately we are limited to the data that are available, we speak to this possibility
by considering the impact of capital structure decisions on outcome variables like firm
survival, employment growth, and profitability growth. We find that having a capital
structure that is more heavily tilted towards formal credit channels results in a greater
likelihood of success. This fact holds even when we include the credit score as a measure
of firm quality to guard against the possibility that unobserved factors drive both success
and credit access. Our findings indicate that even if credit conditions in 2004 were
unique, credit market access had an important impact on firm success.

This paper is related to a number of papers in the banking, capital structure, and
entrepreneurship literature. It offers a new perspective on a vast and important literature
in financial economics that deals with the determinants of corporate capital structurea
literature that has reached few unambiguous conclusions on the determinants of capital
structure (see the discussion in Leary and Roberts, 2007). Most of this literature has

4
relied on Compustat data to test predictions of pecking order (Myers and Majluf, 1984)
and other theories. Given the emphasis in the current work on the role of formal banking
channels, our paper is also related to the literature on the role of banks and other
sources of financing for small firms (Peterson and Rajan, 1994, 1997, 2000). Finally, we
also speak to a literature in entrepreneurship that focuses on the role outside financing
alternatives to help firms grow.3

The remainder of the paper is as follows. We begin in Section 2 by describing the KFS
in greater detail. Section 3 examines initial capital structure choices. We incorporate
credit scores and other firm characteristics in Section 4. Section 5 explores multivariate
regressions of capital structure on a range of business and owner characteristics to explain
capital structure decisions. In Section 6 we examine how initial capital structure affects
firm outcomes. Section 7 concludes.

2 The Kauffman Firm Survey

The KFS is a longitudinal survey of new businesses in the United States. This survey
collected information on 4,928 firms that started in 2004 and surveys them annually.
These data contain detailed information on both the firm and up to ten business owners
per firm. In addition to the 2004 baseline year data, there are two years of follow up data
(2005 and 2006) now available. Additional years are planned. Detailed information on
the firm includes industry, physical location, employment, profits, intellectual property,
and financial capital (equity and debt) used at start-up and over time.

Information on up to ten owners includes age, gender, race, ethnicity, education,

previous industry experience, and previous startup experience. For more information
about the KFS survey design and methodology, please see Ballou et. al (2008). A
3
For a noteworthy recent example of the role of outside capital in entrepreneurship decisions, see
Cosh, Cumming and Hughes, 2008. Gompers and Lerner, 2001, provide an excellent summary of venture
capital. Wong, 2003, is one of the first treatments of angel investing.

5
public-use dataset is available for download from the Kauffman Foundations website
and a more detailed confidential dataset is available to researchers through a secure,
remote access data enclave provided by the National Opinion Research Center (NORC).
For more details about how to access these data, please see www.kauffman.org/kfs.

A subset of the confidential dataset is used in this researchthose firms that either
have data for all three survey years or have been verified as going out of business in either
2005 or 2006. This reduces the sample size to 4,163 businesses. The method we used for
assigning owner demographics at the firm level was to define a primary owner. For firms
with multiple owners (35 percent of the sample), the primary owner was designated by
the largest equity share. In cases where two or more owners owned equal shares, hours
worked and a series of other variables were used to create a rank ordering of owners
in order to define a primary owner. (For more information on this methodology, see
Ballou et. al, 2008). For this research, multi-race/ethnic owners are classified into one
race/ethnicity category based on the following hierarchy: black, Asian, other, Hispanic,
and white. For example, an owner is defined as black, even if he/she is also Hispanic.
As a result of the ordering, the white category includes only non-Hispanic white.

Tables 1 and 2 provide details on business characteristics. In Table 1, we report

key features of the businessits legal form, location, and other features of operations.
Nearly 37% of all businesses in the data are sole proprietorships, while the remaining
63% are structured to provide some form of limited liability to owners. However, only
around 30% of businesses are incorporated, and of these, only 10% of the sample are
incorporated as C-corporations.

Nearly half of the businesses in the survey operate out of the respondents home or
garage; the vast majority (86%) market a service, and only a quarter of the firms in the
survey have any form of intellectual property (patents, copyrights, and/or trademarks).
Reflecting the fact that they are being measured at their inception, the firms are also
tiny by almost any conceivable measure. Nearly 60% of the firms have no employees

6
other than the founder, and less than 8% of firms in the sample have more than five
employees in their first year of operations.

Table 2 considers the cash flow characteristics of these nascent businesses. Even
though these firms are small, nearly twenty percent of firms (16.8%) have over $100,000
in revenue in their first year. Indeed, 45% of the firms in the sample have more than
$10,000 in annual revenue in their first year. Of course, over 57% of firms have more
than $10,000 in expenses, and almost one firm in four reports zero profit or loss.

Table 3 examines owner characteristics in more detail. The entrepreneurs in our

data are overwhelmingly male and white: less than one-third of respondents are female
and over three-quarters are non-Hispanic white. In spite of the fact that most of the
businesses in our data begin at home, in peoples garages, with fewer than five employees,
the overwhelming majority of business owners have at least some industry experience.
Less than ten percent of owners have no previous industry experience, while more than
half have more than five years of industry experience. Likewise, more than forty percent
of business owners have started a business before. More than 80% of respondents are
over the age of 35 when they start their business, and roughly half the sample is aged
45 or older.

The entrepreneurs in our sample are relatively well educated. Less than 20% of re-
spondents have less than a high school degree, while well over half of respondents have
completed some form of a college degree. Finally, nearly a quarter of all respondents
have received some form of advanced, post-graduate education. In broad terms, these
demographics match those reported in other data sources. For example, these demo-
graphics are similar to those reported in Puri and Robinson (2008), using the Survey of
Consumer Finances, and Fairlie and Robb (2007), using the Characteristics of Business
Owners Survey.

7
3 A New Pecking Order?

The standard prescription from pecking order models is that firms first should use inter-
nal cash, then rely on debt financing, and then rely on equity financing. Of course, most
capital structure models implicitly assume an owner-managed firm but are most often
tested using large, well established firms. How well do capital structure theories describe
how beginning firms actually make their initial financing decisions? In this section we
begin to answer this question by describing the capital structure decisions of startup
firms.

3.1 A detailed look at capital structure

In Table 4, we provide a detailed look at the capital structure choices that nascent
firms make. It provides a breakdown of thirty different sources of capital for startup
businesses. Over 75% of firms have at least some owner equity; of these, the mean
amount is just over $34,500. If we include the quarter of firms with no reported owners
equity, the average owner equity amount drops to $27,365.

Owner debt plays a much smaller role. Only about 1/4 of firms have some form of
owner personal debt, and the vast majority of this is mostly in the form of debt carried
on an owners personal credit card. The overall average amount of credit card debt used
to finance startups is a modest $3,400, but this includes the roughly 75% of owners
who do not use personal credit cards to start their businesses. Among those who do,
the balance is considerably larger$10,000, or about 1/3 of the size of owner equity.
But in general, personal credit card balances make up a relatively small fraction of the
startups overall capital structure at inceptiononly about 4 to 5% of the firms total
capitalization is in the form personal credit card balances held by firm owners.

8
 While the owner-level capital structure is heavily tilted towards equity, the capital
structure of insiders and outsiders is completely reversed. If we include the firms with
zero values, firms use about five times as much debt as they do equity. This holds for
both inside debt ($7,605) to equity ($1,695), as well as outside debt ($31,255) to equity
($6,979). But seven times as many firms report outside debt as report outside equity.
Yet, among those who do receive outside equity, there is no question that it is important.
The average amount of outside equity among the 223 firms who access this source of
financing is over $150,000, roughly twice as large as the total financial capital for the
average firm in the survey.

Turning first to insiders, we see that equity is uncommon. Only about five percent
of the sample relies on equity from a spouse or other family members, and the overall
average amount (including the 95% with no family equity) is only about two percent
of the average funding. Yet, among the group who uses family equity, the source is
important: the magnitude of insider equity is roughly the same as that of owner equity,
and many times larger than the magnitude of owner debt.

Insider debt is more common, but still a small source of funding relative to outside
debt and equity. The mean value of inside debt for all firms is $7,605, and this primarily
comes from personal loans received by the respondent from family and other owners.
Loans directly to the business from owners or other family members are also important,
but the fact that less than ten percent of surveyed firms rely on any one type of inside
debt suggests that this funding source is not commonly relied upon by new firms.

When we turn to outsider debt, we see that on average it is the largest single financing
category for startups during their first year of operation. While this no doubt reflects
the relative supply of outside debt to other funding sources, it is noteworthy that only a
relatively small fraction of this comes from credit card balances issued to the business.
Of the $31,255 average debt level, less than $2,500 on average comes from business credit
cards.

9
 One widely held view about entrepreneurial finance is that startups lack access to
formal capital markets, and thus are forced to rely on an informal network of family,
friends, and other financing sources like credit cards to bootstrap their initial financing.
Table 4 speaks against this idea. First, outside capital is extremely important, even at
the earliest stages of a firms life. The average new firm has approximately $78,000 of
financial capital. Of that, roughly half comes from outside sources.

To be clear, however, informal investors do play an important role for those firms who
obtain external equity funding. Looking solely at the external equity funding, of the 223
firms who received some form of external equity funding, over half received funding from
outside informal investors. The average amount, around $100,000, is roughly one-third
the average for the handful of firms that report obtaining venture capital.4

Second, the vast majority of this outside capital comes in the form of credit, either
through personal loans made directly to the owner or through business credit cards.
Moreover, credit cards play a relatively small role for the average startup. If we total
the average credit card holdings on all personal and business accounts associated with
the business, the amount sums to less than half the average personal bank loan. If we
tally the average personal bank loan and the average business bank loan, this amount is
roughly four times the size of the average total credit card balances outstanding.

In some respects, these descriptive statistics suggest that pecking order does a good
job of describing the capital structure decisions of new firms. If we treat owner debt
and equity as internal funding, and abstract away from its capital structure, then we
see that many firms rely on internal funding, fewer firms rely on debt, and fewer firms
still rely on equity. This broadly conforms to the basic message of the Myers and Majluf
pecking order. At the same time, this characterization misses important details, because
it abstracts away from the interaction between capital choice (debt vs. equity) and from
whom to raise capitalwhether the capital comes from insiders or outsiders.
4
Some firms may indeed misclassify angel investors as venture capital, as the average amounts are
quite low.

10
3.2 Capital Structure and Firm Type

Perhaps the most surprising finding in Table 4 is that formal credit channelsbusiness
and personal bank loansare the most important sources of funding for startups. To
push this observation further, we segment the data in Table 5 to report capital structure
patterns for different types of startup firms.

The idea behind Table 5 is to isolate those firms that are in their very earliest stages
of starting up, to see if the overall capital structure patterns hold there as well. This can
be done according to a number of criteria. In the first column of Table 5, we examine
the 2,425 firms who have no employees other than the founder. These firms are small
relative to the average reported for all firms in Table 4there total capital is only around
$35,000 as compared to the roughly $78,000 in Table 4. But proportionately, outside
debt plays a quite similar role: the average non-employer firm has $12,000 in outside
debt, or about 36% of its total capital, compared to approximately $31,000, or about
39% of total capital on average for firms overall. Of the outside debt, we again see that
business bank loans and personal bank loans make up the bulk of the $12,000. Only
about $2,500 comes from other sources on average.

The second column examines the 2,168 businesses which are home-based, meaning
that they do not operate any office or warehouse space outside the home. These too are
small, presumably including the proverbial garage business as well as businesses of a
professional nature that operate out of a home office. The capital structure patterns
for these businesses are remarkably similar to the non-employer businesses: about forty
percent of their total capital is financed through outside debt, and the lions share of
that comes from personal and business bank loans, rather than credit card balances.

Another way to pinpoint firms at their earliest stages is to focus only on pre-revenue
or pre-profit firms. We examine these firms in columns (3) and (4), respectively. These
firms are considerably larger than the previous two categories, presumably because these

11
include many firms that have secured inventories in advance of sales, or require external
building space to operate. Indeed, these columns look quite similar to the averages
reported in Table 4 for the whole sample.

Because the first four columns of Table 5 monotonically expand the size and scope
of firms under consideration, they offer an alternative way to examine pecking order
and access to capital, albeit descriptively. Moving from the first column of data to
the fourth column of data more than doubles the firms size by adding an additional
$50,000 of total capital to the firm. By far the bulk of this comes from outside debt
and equity, which together make up about half the increase in firm capital. To put it
differently, going from non-employer to pre-revenue adds only about $1,000, or doubles,
the amount of insider equity, but it nearly triples, or adds over $20,000, to outside
debt. Since columns (3) and (4) also contain some non-employer and home-based firms,
this comparison understates the magnitude of the shift in capital structure. Thus, the
comparisons across the columns of Table 5 indicate that friends and family is probably
an earlier source of financing than outside debt, as previous accounts have indicated. It
is just not terribly important in terms of total size.

The final two columns of Table 5 split the data according to whether the firm con-
tinued to operated throughout the first three waves of the KFS, or whether the firm
ceased operations. Firms that survive look very much like the overall average reported
in Table 4. On the other hand, firms that ceased operations sometime before 2006 not
only began smaller, but also had considerably smaller proportions of outside debt to
total capital. Of course, it is impossible to draw any causal connection between these
two observations, but in the next section we can examine causation more carefully by
considering how credit quality affects these findings.

12
4 Firm Quality and Capital Structure Decisions

4.1 Credit worthiness, technology and pecking order

Table 6 takes the richness of Tables 4 and 5 and boils it down to six categories: owner
debt, owner equity, inside debt, inside equity, outside debt, and outside equity. These
classifications are as described in the left-most column of Tables 4 and 5. Reducing the
amount of detail not only makes the pecking order that most firms use more apparent,
it also facilitates more comparisons across different types of firms.

The rows of Table 6 are arranged from highest to lowest in terms of the overall
weighted average level of 2004 funding. If we interpret the magnitudes as an indication
of relative importance, then we see a clear pecking order emerge: first outside debt, then
owner equity, then debt from insiders. Fourth in the pecking order is outside equity,
followed by owner debt; the least used source is inside equity.

An alternative way to characterize the pecking order of nascent firms is to combine

owner debt and equity into a single category, internal funding. Looking at capital
structure this way, the average firm is roughly equal parts internal funding and outside
debt. These two sources of funding are each roughly four times larger than the next
largest source of financing. Regardless of how the financial pieces are assembled, outside
debt plays a paramount role in funding newly founded firms.

One reason for this may simply be that outside debt is more plentiful than other
sources of funding. To explore this possibility, we obtained commercial credit scores
for each firm to identify high credit worthiness and low credit worthiness firms. Table 6
shows that while high credit worthiness firms have access to much more financial capital,
they access capital in roughly the same proportions as low credit worthiness firms. Thus,
a firms credit score induces a first-order shift in the level of financing it obtains, but
only a second-order shift in capital structure choice it makes.

13
 Outside equity plays a substantially more important role in the capital structure of
high tech firms. Across all high tech firms, outside equity is the third largest funding
source behind outside debt and owner equity. Among high tech firms with high credit
scores, outside equity is the largest form of financing. It is only the low credit score
firms in the high tech sector that display a pecking order that resembles the average
firm in the databut even for those firms, owner equity is a more important source of
financing than outside debt.

4.2 Separating credit supply from credit demand

To separate credit supply and credit demand, we exploit the availability of credit score
information to identify cases in which firms faced unexpectedly easy or difficult access
to capital. If the capital structure choices depicted in the previous tables are polluted
by differences in the availability of capital, then this should control for that.

To account for this possibility, we regress the firms credit score on variables that
proxy for demand-side factors that would influence credit ratings. We consider two
models. First, we run the following regression:

scoreij = + j + i (1)

where scoreij is the credit score of firm i in industry j, j are industry fixed effects.
Thus, the first estimation simply includes a set of 60 industry dummies.

For the second specification, we run the following regression:

scoreij = + j + 1 Fij + 2 Kij + i (2)

where scoreij is the credit score of firm i in industry j, j are industry fixed effects, and
F is a vector of owner characteristics, and K is a vector of firm characteristics, both

14
of which likely vary with demand for credit. For this specification, we include a full
set of industry dummies, a set of education dummies corresponding to the breakdown
presented in Table 3, and we also include factors such as race, ethnicity, industry ex-
perience, intellectual property, legal structure of the enterprise, whether the business is
home-based, and whether the business sells a product or provides a service. While these
coefficient estimates are interesting in their own right, a full discussion is beyond the
scope of this paper. Indeed, in Robb, Fairlie and Robinson (2009) we explore the issue
of race and access to credit in greater detail.

The idea behind both specifications is that by purging the credit score of variation
that is linked to factors driving the demand for credit, the remaining variation in credit
score would reflect supply-side credit restrictions. Firms with high unexplained credit
scores should have easier access to capital, while firms with low unexplained credit scores
should have relatively more difficult access to capital. Moreover, the differences in their
access to capital should reflect suppliers willingness to lend, rather than differences in
capital needs.

Recovering the regression errors from these two models gives us a mechanism for
classifying firms as credit constrained or unconstrained. Of course, a firm with a low
unconditional credit score is constrained, but this low score may arise endogenously
because the firm has little need for external capital, low growth prospects, and therefore
does not take the steps needed to boost its credit score. By relying on the conditional
credit score as opposed to the raw credit score, we circumvent these problems.

Tables 6 and 7 report pecking orders for firms in the lowest and highest quintiles
of the unexplained credit score distribution. Firms in the lowest quintile face the most
severe unexplained restrictions to credit access, since their credit scores are much lower
than would be predicted based on their demand characteristics. In contrast, the top
quintile have the easiest access to credit, since they have high unexplained credit scores,
given their access to capital.Table 6 presents the detailed classification of funding sources,

15
while Table 7 presents the aggregated data.

In general, the results of Tables 6 and 7 mimic the results from the previous table,
in that they show a first order affect on the amount of capital raised, but only a second
order effect on capital structure choice. Credit constrained firms have capital structures
that look very similar to those of unconstrained firms. The primary difference is that
unconstrained firms have much higher levels of capital investment.

5 Explaining Funding Decisions

Having described initial capital structure choices in detail, we now turn to the task of
explaining the observed variation in capital structure choice. We do this in Table 9,
where we regress capital structure ratios on owner and firm characteristics. In general,
Table 9 reports OLS regressions of the following form:

Financing Category
= + j + 1 Fij + 2 Kij + i (3)
Total Capital

where j are industry fixed effects, F is a vector of owner characteristics, and K is

a vector of firm characteristics. The dependent variable in each column is a financial
ratioeither outside debt, outside equity, outside loans, or inside financeeach scaled
by the firms total capital. (The unmeasured category is the ratio of owner financing
to total capital.) Outside loans are a subset of outside debt that include only personal
bank loans and business loans. The firm characteristics include not only the survey
characteristics described in Tables 1-3, but also the firms credit score, a measure of
quality that might well be unobserveable to the econometrician in other circumstances,
but would be readily observable to credit market participants.

Do gender and race play a role in determining initial capital structure choices? Table
9 suggests that this is definitely the case. First, gender: women receive significantly less

16
outside capital than other groups. The results for women indicate that the average
female-owned business holds about 6-7% less outside debt than the same male-owned
business. Although these results may reflect the fact that women face more restricted
access to capital in the credit market, the data do not allow us to rule out the possibility
that, notwithstanding the industry fixed effects, female-owned businesses simply may
demand less outside capital, perhaps because they are more likely to be second-income
businesses.

Next, the question of race. Table 9 shows that black-owned businesses hold much
less outside debt in their initial capital structure than other businesses. The magnitudes
are similar to those found for gender: the ratio of outside debt to total capital is about
7% lower for black-owned businesses than for otherwise equal white-owned businesses.
Whether this attributable to supply-side or demand-side considerations, it is important
to note that these regressions hold constant the industry of the business, the firms
credit quality, the owners education, and their prior industry and startup experience.
Thus, unobserved heterogeneity in underlying business quality seems unlikely to be a
first-order explanation for the difference.

We also observe other racial differences in capital structure choice. Hispanics and
Asians, but not Blacks, rely heavily on inside finance.5 While Hispanic or Asian ethnicity
explains little variation in access to external capital, these groups average about 8% more
inside capital in their total capital structure. Given that the average firm in Table 4
has an inside-to-total capital ratio of around 12%, this effect is enormous in economic
magnitude, representing a 75% increase in the average amount.

Across the board, increasing hours worked in the business is associated with greater
outside and inside capital, and consequently, lower owner financing. Similarly, owner
age has an increasing but concave relationship with access to external capital, for both
debt and equity, while it has the opposite relationship for inside financing.
5
This is measured as the sum of inside equity and debt.

17
 Prior experience plays an interesting role in determining initial capital structure.
Owners with prior startup experience tend to rely on external equity more than others.
In contrast, Table 9 indicates that owners with more industry experience rely signifi-
cantly more on their own financing, since the association between industry experience
and capital type is negative across all types reported in the table.

The regressions also include, but do not report, owner education. Different categories
of education have similar experiences accessing external debt equity, but there is a
pronounced effect associated with inside financing. Namely, those who do not finish
high school are significantly more likely to rely on inside financing than other groups.
Since the regressions include industry fixed effects, it is not the case that this is driven
by sorting of low education respondents into industries with low capital requirements.
Rather, this is probably an indication that lower quality businesses are more likely to
rely on inside financing instead of accessing external capital markets.

The business characteristics reported in the bottom of the table demonstrate that
firms with lower asymmetric information problems enjoy more ready access to external
capital sources, and in particular, external credit funding. Home-based businesses rely
more heavily on owner financing, while firms with multiple owners have larger fractions
of outside-to-total capital. Comparing the point estimates in Table 9 to the averages
in Table 4 suggests that multiple-owner firms receive about a ten percent increase in
the baseline amount of outside debt, and about a 25% increase in the baseline level of
external equity (from around 8% to around 10%). Firms that have intellectual property
are not more likely to access outside debt, but are more likely to access external equity,
than those that do not.

18
6 Does Financial Access Affect Survival?

It is widely noted that startup firms are a key driver of growth in our economy. How
then, do capital structure choices affect the growth of startup firms? This question is
important for two reasons. First, the question provides normative implications for credit
market access. Second, the question provides an important robustness check against the
possibility that our main finding of interestthe fact that startups rely extensively on
external credit markets to fund their early lifeis being driven by peculiarities in the
credit market in 2004. If our findings simply reflect the fact that credit was readily
available in 2004, then there is no reason to believe that access to external credit should
affect firm success.

To take up this question, we report Probit analysis of three key measures of growth
from 2004-2006. First, we create a dummy for whether a firm has above median rev-
enues in 2006. Then we repeat this calculation for profits and for employees. Our key
explanatory variable is the ratio of outside debt to total capital. The hypothesis that
we are testing is that firms with greater levels of external capital had better growth
prospects.

Table 10 tests this hypothesis. It includes the same basic set of owner and firm
characteristics, plus the ratio of outside debt to total capital and the level of 2004 sales.
The outside debt ratio has a positive and highly significant effect on revenue growth and
employee growth, but a statistically insignificant positive effect on profit growth.

To attach a causal interpretation to these findings, it is important to control for

unobserved characteristics that might affect access to debt and success. In that regard,
including the credit score and other firm characteristics are essential for our findings.
Including the credit score allows us to conclude that controlling for firm creditworthiness,
firms that accessed more external debt were nearly ten percent more likely to be in the
top revenue group, and nearly six percent more likely to have hired employees. Note too

19
that this also controls for the initial revenues the firm experienced in 2004, therefore the
effect is not attributable to initial size. Table 10 indicates that, indeed, initial capital
structure decisions are important for firm success.

The owner and firm characteristics, which are included as controls in Table 10, are
interesting in their own right and raise many questions for future research. First, they
show that female-owned businesses are significantly less likely to grow than male-owned
businesses. Black-owned businesses are significantly less likely to have grown in terms
of profits or sales, but they are more likely to have added employees than white-owned
businesses. Asian-owned businesses are also more likely to have added employees, al-
though Asian ownership is unrelated to revenue or profit growth. And finally, the vector
of firm characteristics that might describe a firm, a priori, as a lifestyle business or not
indeed predicts whether a firm has grown.

7 Conclusions

This paper uses a novel data set to explore the capital structure decisions that firms
make in their initial year of operation. In the vast majority of cases, this is when the
firms in question are still being incubated in their founders homes or garages, before
outside employees have joined the firm in any significant number, and certainly well
before the firms in question would be attractive to the types of funding sources that are
the focus of most discussions of early stage financing.

In spite of the fact that these firms are at their very beginning of life, they rely to
a surprising degree on outside capital. The notion that startups rely on the beneficence
of a loose coalition of family and friends seems misleading given our findings. While the
data suggest that informal investors are important for the handful of firms that rely on
outside equity at their startup, the data also indicate that most firms turn elsewhere for
their initial capital. Indeed, roughly 80-90% of most firms startup capital is made up in

20
equal parts of owner equity and bank debt. The fact that the debt is financed through
arms length relationships, and not through family and friends networks, is worthy of
further research.

To be sure, our findings underscore the importance of liquid credit markets for the
formation and success of young firms. If startups hold the key to growth in western
economies, then surely economic growth hinges critically on the smooth functioning of
credit markets that enable young firms to be formed, to grow, and to succeed.

21
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24
 Table 1: Business Characteristics
Weighted
Percentage
Business Legal Status
Sole Proprietorship 0.367
Partnership 0.056
Corporation 0.272
Limited Liability Corporation 0.305
General/Limited Partnership and Others 5.7

Business Location
Home Based 0.505
Leased Space 0.391
Other 0.104

Business Product/Service Offerings

Service Offered 0.859
Product Offered 0.508
Business Offers Both Service(s)/Product(s) 0.371

Intellectual Property
Patents 0.022
Copyrights 0.088
Trademarks 0.134
Employment Size
Zero 59.2
1 14.0
2 9.1
3 4.6
4-5 5.8
6-10 3.9
11+ 3.6
Credit Score
High Credit Score 0.120
Medium Credit Score 0.536
Low Credit Score 0.335

Source: Kauffman Firm Survey, Baseline data. Sample Size: 4,163

25
 Table 2: Cash flow characteristics of startups in the KFS
Panel A: Percent of Businesses by Revenues and Expenses
Weighted Weighted
Revenues Percentage Expenses Percentage
Zero 35.5% Zero 7.0%
$1,000 or less 5.1% $1,000 or less 8.5%
$1,001- $5,000 7.9% $1,001- $5,000 16.3%
$5,001- $10,000 5.9% $5,001- $10,000 11.2%
$10,001- $25,000 10.5% $10,001- $25,000 16.1%
$25,001- $100,000 18.3% $25,001- $100,000 25.2%
$100,001 or more 16.8% $100,001 or more 15.8%

Panel B: Percent of Businesses by Amount of Profits or Losses

Weighted Weighted
Profit (44.5
Zero 19.0% Zero 3.4%
$1,000 or less 9.8% $1,000 or less 14.0%
$1,001- $5,000 16.8% $1,001- $5,000 27.1%
$5,001- $10,000 12.5% $5,001- $10,000 17.3%
$10,001- $25,000 17.4% $10,001- $25,000 17.2%
$25,001- $100,000 20.4% $25,001- $100,000 17.1%
$100,001 or more 4.1% $100,001 or more 3.9%

Source: Kauffman Firm Survey, Baseline data. Sample Size: 4,163

26
 Table 3: Business owner demographics
Weighted Weighted
Characteristics Percentage Characteristics: Percentage
Male 69.2
Female 30.8 Industry Exp. (Yrs.)
Zero 9.6
White 78.8 1-2 13.5
Black 9.0 3-5 16.0
Asian 4.2 6-9 9.9
Others 2.2 10-14 13.8
15-19 11.5
Non-Hispanic 94.2 20-24 9.4
Hispanic 5.8 25-29 7.4
30+ 9.2
Owner Age
24 or younger 1.4
25-34 16.5 Previous Start-ups
35-44 33.8 0 58.2
45-54 29.3 1 21.3
55 or older 19.0 2 10.1
3 5.0
Owner Education 4 or more 5.4
HS Grad or Less 14.2
Tech/Trade/Voc. Deg. 6.7
Some Coll., no deg. 21.7 Hours Worked
Associates 8.3 Less than 20 18.7
Bachelors 24.7 20-35 19.3
Some Grad, No Deg. 5.9 36-45 14.2
Masters Degree 13.4 46-55 15.3
Professional/Doctorate 5.1 56 or more 32.5
Source: Kauffman Firm Survey, Baseline data. Sample Size: 4,163

27
 Table 4: Sources of Financing for 2004 Startups
All firms All >0 firms
Category Funding Source Mean Mean Count
Owner Equity $27,365 $34,509 3292
Owner Debt $3,506 $11,695 1221
Personal CC balance, resp. $3,179 $10,899 1185
Personal CC balance, others $304 $10,008 133
Personal loan, other owners $23 $15,853 5

Insider Equity $1,695 $34,984 186

Spouse equity $479 $28,697 67
Parents equity $1,217 $34,509 131

Insider Debt $7,605 $51,221 564

Family loan $2,798 $28,656 350
Family loan to other owners $276 $34,689 28
Personal loan to other owners $592 $30,046 78
Other personal loans $883 $69,567 51
Business loan by family $1,258 $42,610 116
Business loan by owner $1,732 $118,065 64
Business loan by emp. $66 $19,349 9

Outsider Equity $6,979 $150,733 223

Other informal investors $2,736 $101,718 121
Business equity $1,807 $162,097 61
Govt. equity $401 $81,821 26
VC equity $1,655 $335,868 28
other equity $380 $183,295 10

Outsider Debt $31,255 $85,681 1487

Personal bank loan $11,066 $65,154 669
Owner bus. CC balance $1,358 $9,710 556
Personal bank loan by other owners $1,430 $62,251 97
Bus. CC balance $856 $7,417 463
Other Bus. CC balance $190 $11,929 62
Bus. bank loan $9,357 $150,704 242
Credit line balance $3,237 $62,156 216
Non-bank bus. loan $2,033 $123,622 75
Govt. bus. loan $721 $80,333 37
Other bus. loan $163 $61,586 20
Other individual loan $246 $52,529 21
Other debt $597 $122,512 21

Total $78,406 - -
Source: Kauffman Firm Survey, Baseline data. The mean for 4,163 firms is reported in the first column. The second
column reports the mean for only firms with positive amounts of that source of funding. The sample size for that source
of funding is reported in the third column.
28
 Table 5: Sources of Financing for 2004 Startups by Firm Type

Non- Home- Pre- Pre- Survived Closed

Funding Source Employer Based Revenue Profits thru 2006 by 2006
Owner Equity $14,875 $18,626 $25,675 $29,938 $27,856 $25,394
Owner Debt $2,374 $2,627 $2,347 $4,138 $3,430 $3,813
Personal CC balances, resp. $2,144 $2,322 $2,205 $3,697 $3,145 $3,315
Personal CC balances, other owners $230 $305 $140 $406 $283 $392

Insider Equity $813 $895 $1,935 $2,153 $1,357 $3,054

Spouse Equity $296 $205 $521 $641 $324 $1,101
Parents Equity $517 $690 $1,414 $1,512 $1,033 $1,953

Insider Debt $2,642 $3,189 $6,721 $8,598 $7,731 $7,100

Personal family loan, resp. $1,046 $1,688 $2,256 $3,506 $2,589 $3,638
Personal family loan, other owners $195 $116 $238 $243 $260 $338
Bus. loan from family $246 $405 $1,567 $1,619 $1,179 $1,573
Bus. loan from owner $232 $263 $1,469 $1,636 $2,045 $477
Other personal loan, resp. $317 $401 $287 $491 $579 $645
Other personal debt, resp. $596 $315 $897 $1,005 $999 $415

Outsider Equity $1,728 $2,425 $7,338 $9,176 $7,777 $3,777

Other informal investors $754 $1,389 $2,724 $3,680 $3,098 $1,284
Businesses $621 $628 $2,014 $2,163 $1,949 $1,238
Government $8 $75 $214 $509 $462 $155
Venture Capitalists $239 $245 $2,378 $2,267 $1,795 $1,092
Others $105 $89 $8 $557 $473 $8

Outsider Debt $12,837 $16,875 $28,738 $33,455 $34,114 $19,770

Personal bank loan, resp. $6,281 $7,872 $9,576 $10,994 $12,008 $7,284
Bus. CC balance, resp. $658 $545 $626 $1,061 $1,491 $822
Personal bank loan, other owners $404 $785 $1,079 $1,673 $1,667 $479
Other bus. CC balance $20 $41 $226 $166 $194 $175
Bus. CC balances, Bus. $524 $481 $588 $927 $906 $656
Bus. bank loan $3,528 $5,322 $10,282 $11,045 $10,249 $5,773
Credit line $442 $646 $2,545 $3,766 $3,712 $1,329
Non-bank Bus. loan $444 $329 $2,216 $1,904 $2,005 $2,146
Government Bus. loan $53 $276 $606 $763 $773 $511
Other Bus. loan $136 $242 $21 $111 $203 $3
Other individual loan $159 $183 $22 $184 $303 $16
Other business debt $188 $155 $952 $861 $602 $577

Total $35,269 $44,636 $72,754 $87,457 $82,264 $62,908

Observations 2,425 2,168 1,615 2,144 3,390 773
Source: Kauffman Firm Survey, Baseline data.

29
 Table 6: A New Pecking Order?
All firms: Only High Technology firms:
All High credit Low credit All High Tech High credit Low credit
Owner Equity 27364.93 42708.10 18301.95 46754.39 57296.93 36304.99
Owner Debt 3506.47 3361.97 3248.57 4434.69 3241.10 6375.07

Insider Equity 1695.12 2509.92 1196.55 2191.42 3510.30 2681.05

Insider Debt 7605.15 15879.41 4767.96 10612.12 20856.81 12638.73

30
Outsider Equity 6979.31 13381.48 3215.69 31135.51 108457 11736.80
Outsider Debt 31254.59 57450.35 19481.08 41689.74 80215.75 21657.70

Total Financial Capital 78405.58 135291 50211.81 136817 273578 91394.35

% Zero Financial Capital 0.10 0.11 0.11 0.09 0.07 0.10

N 4163 502 1322 592 89 133

Source: Kauffman Firm Survey, Baseline data. This table reports mean levels of 2004 startup funding by type of funding. The first column matches the category-level
data reported in the previous table. The remaining columns report breakdowns for various types of firms. Columns 2 and 3 focus on firms with high and low Dun
and Bradstreet credit scores. The final three columns repeat the first three, but only examine high-tech firms.
 Table 7: Sources of Financing for 2004 Startups
Model 1 Model 2
residual quintiles: residual quintiles:
Category Funding Source Top Bottom Top Bottom
Owner Equity 39503.07 18672.38 33969.85 24084.69

Owner Debt 3648.61 3350.51 3431.19 3848.06

Personal Credit Card -Owner 3380.61 2793.11 3190.29 3186.45
Personal Credit Card-Other Owners 268.01 553.09 240.90 657.23
Other Personal Owner Loan 0.00 4.31 0.00 4.38

Insider Equity 3012.21 1496.76 2102.11 1660.04

Spouse Equity 563.51 545.94 143.55 658.05
Parent Equity 2448.70 950.82 1958.56 1001.99

Insider Debt 13022.88 6574.25 11738.18 7180.53

Personal Family Loan 3443.65 3609.57 2883.87 3520.30
Personal Family Loan-other owners 142.95 76.25 394.04 161.13
Business Loan from family 3993.71 1165.88 3852.34 1402.63
Business Loan from Owner 3754.77 501.20 3102.94 549.38
Business Loan from Employee(s) 301.56 14.11 149.74 13.10
Other Personal Loan 856.59 448.99 829.05 628.40
Other Personal Funding 529.65 758.25 526.20 905.58

Outsider Equity 14194.24 4116.68 8392.17 6621.79

Other Informal Investors 3955.26 1176.47 3214.70 1857.32
Other Business Equity 2784.83 288.21 403.41 1680.43
Government Equity 1004.00 151.34 703.33 329.26
Venture Capital Equity 6334.49 1080.65 3959.07 1318.90
Other Equity 115.65 1420.02 111.68 1435.87

Outsider Debt 51620.95 18758.03 45014.00 27647.95

Personal Bank Loan 15093.91 6836.93 13071.64 8046.63
Business Credit Card 1328.30 734.75 1115.98 853.12
Other Bank Loan 2059.68 1758.63 1053.89 2043.17
Business Credit Card-other owners 452.34 267.24 86.23 319.59
Business Credit Cards 1199.84 782.75 1108.69 876.09
Bank Business Loan 14001.16 5967.25 12570.12 10937.90
Credit Line 10155.99 954.57 9660.25 1740.30
Other Non-Bank Loan 3021.69 715.38 2934.76 1346.60
Government Business Loan 1408.04 276.18 733.50 884.71
Other Business Loan 371.37 43.72 336.62 44.45
Other Individual Loan 533.84 30.21 519.14 39.53
Other Business Debt 1994.79 390.44 1823.20 515.86

Total Financial Capital 1.3e+05 52968.61 1.0e+05 71043.05

31
N 790 820 810 811
 Table 8: Pecking order differences between High Access and Low Access Firms
Panel A: Regression based on INDUSTRY CONTROLS
Overall Bottom Quintile Top Quintile Difference
Mean Percent Mean Percent Mean Percent Mean Percent
Owner Equity 27,365 35% 39,503 32% 18,672 35% 20,831 -4%
Insider Equity 1,695 2% 3,012 2% 1,497 3% 1,515 0%
Outsider Equity 6,979 9% 14,194 11% 4,117 8% 10,078 4%
Owner Debt 3,506 4% 3,649 3% 3,351 6% 298 -3%
Insider Debt 7,605 10% 13,023 10% 6,574 12% 6,449 -2%
Outsider Debt 31,255 40% 51,621 41% 18,758 35% 32,863 6%
Total Capital 78,406 100% 125,002 100% 52,969 100% 72,033 0%
% Zero Capital 10% 9% 12% 3%

Panel B: Regression based on FULL MODEL

Overall Bottom Quintile Top Quintile Difference
Mean Percent Mean Percent Mean Percent Mean Percent
Owner Equity 27,365 34.9% 33,970 32.5% 24,085 33.9% 9,885 -1%
Insider Equity 1,695 2.2% 2,102 2.0% 1,660 2.3% 442 0%
Outsider Equity 6,979 8.9% 8,392 8.0% 6,622 9.3% 1,770 -1%
Owner Debt 3,506 4.5% 3,431 3.3% 3,848 5.4% (417) -2%
Insider Debt 7,605 9.7% 11,738 11.2% 7,181 10.1% 4,558 1%
Outsider Debt 31,255 39.9% 45,014 43.0% 27,648 38.9% 17,366 4%
Total Capital 78,406 100.0% 104,648 100.0% 71,043 100.0% 33,604 0%
Zero Capital 10% 9% 9% 0%
Source: Kauffman Firm Survey, Baseline data.

32
 Table 9: Explaining Capital Structure Choices of Startup Firms
(1) (2) (3) (4)
Outside Debt Outside Equity Outside Loan Inside Finance
Female -0.0616*** -0.0209*** -0.0412** 0.00777
(0.0211) (0.00578) (0.0169) (0.0158)
Black -0.0749** -0.00364 -0.0632** 0.0394
(0.0317) (0.0110) (0.0252) (0.0259)
Hispanic -0.0161 -0.0133 -0.00522 0.0794**
(0.0406) (0.00998) (0.0335) (0.0341)
Asian 0.00480 -0.00708 -0.00754 0.0858**
(0.0479) (0.0116) (0.0373) (0.0409)
Other Ethnicity -0.0239 -0.00860 -0.0633 0.0581
(0.0589) (0.0204) (0.0415) (0.0539)
Hours worked 0.00266*** 0.000278** 0.00151*** 0.00225***
(0.000415) (0.000127) (0.000338) (0.000290)
Owner Age 0.0152** 0.00375* 0.0131** -0.00789*
(0.00598) (0.00200) (0.00517) (0.00413)
Age2 -0.000146** -0.0000366* -0.000117** 0.0000572
(0.0000635) (0.0000205) (0.0000552) (0.0000447)
Work Experience -0.00429*** -0.000300 -0.00361*** -0.00252***
(0.000969) (0.000296) (0.000804) (0.000747)
Startup Experience 0.00615 0.0108* 0.00913 0.00153
(0.0193) (0.00623) (0.0160) (0.0139)
Multiple Owners 0.0521*** 0.0276*** 0.0376** -0.0208
(0.0201) (0.00745) (0.0170) (0.0144)
Credit Score 0.00229*** 0.000166 0.00148*** -0.0000295
(0.000418) (0.000124) (0.000344) (0.000302)
Home-based -0.0848*** -0.0266*** -0.0747*** -0.0685***
(0.0202) (0.00702) (0.0166) (0.0149)
Intellectual Prop. -0.00870 0.0216** -0.00484 0.0450**
(0.0238) (0.00853) (0.0192) (0.0193)
Comparative Adv. 0.0360* -0.00912 0.00324 0.0149
(0.0197) (0.00674) (0.0164) (0.0144)
Sells Product 0.0629* 0.0113 0.0486* 0.00720
(0.0324) (0.00958) (0.0259) (0.0234)
Sells Prod. & Service -0.0256 -0.0148* -0.0180 -0.00209
(0.0300) (0.00765) (0.0235) (0.0218)
Observations 3934 3928 3934 3928
Robust standard errors in parentheses. 2-digit industry dummies and owner education
dummies included. *** p<0.01, ** p<0.05, * p<0.1.

33
 Table 10: Capital Structure Choices and Firm Outcomes
(1) (2) (3)
Revenue Profits Employee
Outside debt ratio 0.0944*** 0.0289 0.0564*
(0.0289) (0.0293) (0.0332)
2004 Revenue ($100K) 0.0460*** 0.0263*** 0.0377***
(0.0105) (0.0720) (0.0114)
Female -0.0917*** -0.0848*** -0.0739***
(0.0202) (0.0208) (0.0238)
Black -0.121*** -0.126*** 0.0628*
(0.0274) (0.0282) (0.0379)
Hispanic -0.0630* 0.00758 0.0726
(0.0358) (0.0395) (0.0450)
Asian 0.0253 0.0133 0.0841*
(0.0455) (0.0454) (0.0494)
Other Ethnicity -0.0623 -0.0899* 0.0740
(0.0567) (0.0531) (0.0672)
Hours worked 0.00281*** 0.00281*** 0.00283***
(0.000399) (0.000403) (0.000472)
Work Exp. 0.00268*** 0.00331*** 0.00320***
(0.000963) (0.000955) (0.00107)
Startup Experience 0.0134 -0.00198 0.00815
(0.0190) (0.0191) (0.0213)
Multiple Owners 0.0827*** -0.0206 -0.0156
(0.0199) (0.0195) (0.0221)
Credit Score 0.00307*** 0.00164*** 0.00306***
(0.000407) (0.000412) (0.000469)
Home-based -0.169*** -0.0619*** -0.122***
(0.0195) (0.0203) (0.0223)
Intellectual Prop. 0.0226 -0.0454** 0.00998
(0.0231) (0.0227) (0.0262)
Comparative Adv. 0.0392** 0.0711*** 0.0240
(0.0195) (0.0193) (0.0221)
Sells Product -0.0362 -0.128*** -0.0902**
(0.0319) (0.0334) (0.0362)
Sells Prod. & Service 0.00655 0.0744** 0.0989***
(0.0294) (0.0327) (0.0340)
Observations 3534 3514 3564
2-digit industry dummies, owner age, age2 , and education dum-
mies included. Robust standard errors are reported in paren-
theses. *** p<0.01, ** p<0.05, * p<0.1

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