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«Abstract One of the reasons business start-ups face credit constraints is their lack of credibility in the nancial markets. Yet, debt nancing is ...»

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Is Leverage Leveraging the Business Start-ups?

Indu Khurana

This Version: October 2011

Abstract

One of the reasons business start-ups face credit constraints is their lack of

credibility in the nancial markets. Yet, debt nancing is one of the major sources

of funding a new business. Although initial capital structure lays the path for the

future growth trajectory, regular supply of funds is also important for rm survival,

enhanced productivity, and higher innovation. Apart from nancial structure, organizational practices and employee satisfaction likewise contribute to a higher level of innovation. Using a rich dataset on American business start-ups provided by the Kauman Firm Survey, this paper examines the simultaneous relationship between rm leverage and employee well-being, and their impact on innovation.

Negative binomial xed eects are used to analyze the eect of employee well-being and leverage on count data of patents and copyrights which are used as a proxy for innovation. The paper demonstrates that employee well-being positively aects the rm's innovation while a higher leverage ratio has a negative impact on innovation.

No signicant relation is found between leverage and employee well-being.

JEL Classication Codes: G32, J32, M13, O34 Keywords: Leverage, Fringe Benets, New Firms and Start-ups, Technological Innovation ∗

Department of Economics, Florida International University, FL 33199, USA. E-mail:

ikhur002@u.edu. I am indebted to my advisor, Dr. Peter Thompson, for the guidance. I am also grateful to the Ewing Marion Kauman Foundation for providing access to the Kauman Firm Survey data.

1 Introduction Researchers have investigated which factors aect a rm's level of innovation and over the years various reasons have come up (rm size, market structure, cash ows).

One of the important factors that has not yet been analyzed in detail is the eect of the capital mix on the innovation trajectory. Studies which have explored this linkage have reported results for large and established rms, overlooking the small and young business start-ups. Analyzing the eect of capital-mix, i.e. the ratio of debt to equity, studies have reported contradictory results ranging from a positive eect of leverage on innovation (Smith, 2010), to a negative (Chiao, 2002; Czarnitzki and Kraft, 2004;

Singh and Faircloth, 2005), or insignicant (Mac An Bhaird and Lucey, 2006), relation between the two. Using the Kauman Firm Survey (KFS), a survey data of 4,928 rms founded in 2004, this paper examines the eect of leverage on the level of innovation among rms that are in their fth year of existence.

Incorporating the impact of organizational practices via an index of employee wellness, I explore the three-way linkage between a rm's leverage, its level of innovation and employee well-being, and study to what extent leverage and employee well-being aect innovation. Contrary to the results from a recent study (Smith, 2010), I nd that, for young rms, higher leverage has a negative eect on innovation. I show that a rm with a higher score of total-employee well-being is more innovative, and that there is no signicant eect of employee well-being on leverage ratio of the rm.

Innovation has been considered to play a crucial role in survival and growth of a rm. For established rms, innovation is a way to retain their competitive edge in the market (Christensen, 1997); and for newer rms, innovation helps them in entering the market (Ces and Marsili, 2005). Citing the relevance of innovation, Porter (1990), mentions that one of three cornerstones of global competitiveness is innovation, other two being, continuous improvement and change. Smith (2010) reports the eect of leverage on innovation. Controlling for the initial level of patents and copyrights, she reports a positive relation between leverage and new innovation. Exploring this linkage longitudinally, in my study, I nd that leverage has a negative impact on innovation.

This is an important result, because a regular supply of funds can positively aect innovation, and for young rms this can be a problem because they face capital market constraints. In addition, studying the relation over a period of time yields dierent results.

Work place practices aect a rm's performance (Therrien, 2003; Laursen and Foss, 2003). Organizational structures and human resource practices foster newer ideas in workers which can generate innovation in the rm. Human resource practices per se might not generate innovation, but they do motivate employees to come up with newer ideas (Zoghi et al., 2010). In addition, as knowledge is stored in human beings, studying the impact of these human resource practices and employment relations on innovation is important. Following this line of reasoning, Koski et al., (2009) explore the linkage between organizational factors and innovation and nd that practices that improve employee welfare aect innovation positively in small rms, whereas large rms do not show this positive eect. They conclude that large rms have a decentralized decision-making structure that does not motivate employees. I explore this linkage empirically, and nd a positive impact of employee well-being on innovation. Following the same reasoning as given by Koski et al., I interpret this result as implying that, small rms can generate a close-knit environment, which helps a rm in generating a higher level of innovation.





Linking up the above two variables which aect innovation, Verwijmeren and Derwall (2009), suggest an inverse relation between employee well-being and leverage. Using the KLD STATS database for their study, they argue that the risk of bankruptcy, which is bad for employees, motivates a rm to keep lower levels of leverage. In addition, they also argue that rms with a higher employee well-being score have higher credit ratings. When I explore this reasoning using the KFS, I nd that employee well-being is not associated with the level of leverage. This seems to imply that, the argument of employee welfare guiding the debt-equity ratio does not work for young rms. Even though the rms care more for their employees, and the index measuring the well-being of employees increased for both full-time and part-time employees, leverage shows an upward trend. The risk of bankruptcy pressing a rm to have lower levels of debt would be justied for large publicly traded rms, but does not seem to be justied in case of small and young rms. Moreover, I nd that there is no signicant relation between credit rating and leverage.

Observing the three linkages in the above mentioned studies, I examine them using the KFS. The focus of these studies is on large publicly traded companies. It is interesting to examine these questions in a dataset where rms are just ve years old. Even though these rms have the maximum risk of exiting the industry and face the risk of bankruptcy, the question I ask is: will a rm formulate a policy that will be directed to lower the debt level just because it cares for its employees; or choose a capital mix ratio that will yield a higher level of innovation?

To examine the above relation, I create an index of employee well-being, which is based on a set of nine dichotomous questions asked in the survey. These questions focus on exploring, whether the rm provides fringe benets like an employee stock-option plan or paid holidays to its employees. Responses for both full-time and part-time employees are included in creation of the index. I use the total number of patents and copyrights held by a rm at the end of each year to measure innovation. Firm leverage is scaled by total nancing resources and is therefore calculated as total debt divided by the total nancing resources.

Young rms cannot access nancial markets with the same ease as large and established rms. Young rms generally lack market credibility and in order to take loans and debt they have to pledge their assets as collateral. Owners' personal assets like house or rms' assets like land or machinery, generally act as collateral. With a moderate amount of equity in the capital mix, debt acts as a leverage device and investments made with external borrowings amplify the rm's return to equity. With capital constraints binding in the initial years, young rms do not target an optimal ratio of external borrowings to owner's resources. The Small Business Administration, in its guidelines, mentions that for business start-ups  [M]ost banks want to see that the total liabilities or debt of a business is not more than 4 times the amount of equity. Or stated dierently, when you divide total liabilities by equity, your answer should not be more than 4. In this paper I nd that leverage ratio rises as rms age, whereas a uctuating pattern is witnessed for total debt. Equity tends to decline with the age. It is interesting to observe the eect of nancial turmoil in 2007 in this analysis. Innovation levels and the index of employee well-being show a decline after the crisis hit in 2007. The results of this analysis contribute to the literature in four ways. First, I document the important role played by leverage for young rms and the risk associated with higher amounts of debt and lesser equity levels. In this context, there is an evidence of uctuating levels of debt and declining level of owner's equity in the fth year when compared to levels of debt and equity at the time of their birth. Debt level falls in the very next year, then rises and then falls again in the fourth year, nally rising in the fth year. Second, from the perspective of the organizations which lend and assist small and young businesses, uctuating levels of debt imply the lack of readily available funds. Debt being the largest source of funding for the rms in the KFS, highlights the importance of liquid credit markets. But uctuating levels of debt also point to a lack of regular ow of funds.

This reasoning comes from the fact that when asked during the survey owners reported that in most cases their loan applications were denied because of lack of collateral and poor credit history. They also reported that their applications were denied because of inadequate documentation and even on the basis that it is a new business. There are some policy implications for these organizations where they should try to provide a smooth ow of funds to business start-ups. Large amounts of collateral as a requirement makes it more dicult for an entrepreneur to apply for funds. Further, there is a need to educate the entrepreneurs about the availability of loans and nancial services: 18% of the entrepreneurs never applied for credit when they needed it as they were pessimistic about their loan application and thought that it would be denied.

Third, an increase in leverage should be interpreted with caution, because the increase can come from either increasing the debt or decreasing the owner's equity. Changing levels of debt do not allow rms to take advantage of the leverage which comes with using debt as part of their capital structure. Moreover, empirically, absence of a significant relation between the rm's leverage and employee well-being implies that young rms are not guided by the considerations of employee welfare when they decide their capital mix. Fourth, small and young rms lack the cushion which can support them in case of a macroeconomic shock. Therefore, results are obtained need to be interpreted 1 There is no exact value of debt-equity ratio which can be termed as optimal; generally it varies with industries.

2 http://www.sba.gov/smallbusinessplanner/start/nancestartup/SERV_BORROW.html in the light of nancial crisis of 2007. The trend depicted by debt and equity is justied when I linked to the current economic environment.

The remainder of this paper is organized as follows. Section 2 gives a detailed analysis of the three variables and linkages involved in them. Section 3 describes the data and how the indices of employee well-being and innovation are constructed. Empirical estimation in section 4 is followed by the conclusion in section 5.

2 Literature2.1 Importance of Small and Young Businesses

Small and young businesses have always been considered an engine of economic growth. For the past 20-25 years, research has indicated that young rms are the main generator of net employment. Birch (1981), highlights the fact that small rms create more jobs than large rms. He points out that rms with employees of 1to19 accounted for 88% of all net new jobs during 1981-1985 (also see Birch, 1987, 1989). Although researchers have debated the credibility of the statements that, young and small businesses contribute to job creation (Davis et al, 1993), there has been a recent line of research based on new datasets which argue that small businesses not only contribute to the creation of new paid jobs in an economy, but also add entrepreneurial jobs to the workforce. (Hijzen et al. 2010, Ying Lowrey, 2009).

Despite the growing interest in this area, little is known about the dynamics of business start-ups in the initial stages. Because of complexity involved in the data collection, there has been an informational gap in the research between small and young rms and large and established business formations. The availability of data-sets, like the KFS, makes it possible to analyze the founding conditions of the start-ups and track their performance subsequent to their birth. The KFS is the world's largest longitudinal study of new businesses and contains a detailed information on both, the entrepreneurs and the rms. The original sample consisted of 4928 rms, out of which 3361 rms made it to their fth year. These rms are at the cusp of childhood and adolescence, which makes the study of this unique data of special interest to both researchers and policy makers alike. The data oers an opportunity to study a cohort of rms, all born in the same time period, maturing at the same pace and facing the same macro-economic shocks.

3 Term was coined by John Tozzi, Business Week reporter in:  The Entrepreneurship Job, http://www.businessweek.com/smallbiz/running_small_business/archives/2009/04/the_entrepreneu.html 4 In her study using Kauman Firm Survey, she mentioned that, 4,928 new startups utilized the eorts of 6,871 entrepreneurs.



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