Small Business Investment With Financing Constraints and Moral Hazard

This paper investigates the interaction between investment and risk for financially constrained firms. Financially constrained firms are only able to grow through the use of debt, inducing individuals to choose riskier projects: an increase in risk-taking leads to a decrease in investment by raising the financing cost. I show the risk profile of investors follows an inverse-U shape in firm productivity and leverage for capital constrained firms. Both small projects with low debt and large, but highly leveraged, projects take relatively low risk compared to projects with average productivity. Date: December 2, 2014. I would like to thank Jack Mintz, Joanne Roberts, and seminar participants at the University of Calgary for their comments. *Department of Economics, University of Calgary, 2500 University Drive NW, Calgary AB T2N 1N4, Canada; Current Address: Statistics Canada, Economic Analysis Division, 18-C R.H Coats Building, 100 Tunney’s Pasture Driveway, Ottawa ON K1A 0T6; Email: matt.krzepkowski@statcan.gc. ca. External financing remains an integral source of capital for small business start-ups. Lacking sufficient personal wealth to develop their firm to an optimal size and maximize their potential profit entrepreneurs must seek capital investment from outside lenders. Over 61%of all small businesses in the Euro Zone use or are considering using banks loans in the future (European Central Bank, 2014). Loans to small businesses in the United States accounting for close a third of total business loans, with an outstanding balance of $500B in 2012 (Mills and McCarthy, 2014). Access to debt allows firms to grow, but comes with a well-known tradeoff. An increase in working capital from external sources implicitly encourages individuals to take on excessive risk: entrepreneurs with external financing need higher rates of return to fulfill their debt obligations, and limited liability allows them to pass risk off onto lenders by defaulting if their business fails. In this paper, I develop a simple model incorporating this tradeoff between risk and investment for financially constrained firms. Themodel consists of a group of entrepreneurs with the option of starting a new project. Each individual has control over both the size of the project and its overall risk. If the individual chooses to invest more than their personal wealth they must acquire a loan for the remainder. The riskiness of a project increases the potential return while decreasing the probability their project is successful. The amount invested has a direct effect on risk decisions. A small project will be funded largely from the individual’s personal wealth and theywill bearmost of the risk. They have limited incentive to increase risk and will choose a relatively safe project. As the size of the project increases, a greater fraction of the investment is funded by outside lenders, giving individuals an larger incentive to take greater risk. However, for a given interest rate a project will only be larger than another if its investment is potentially more profitable. With debt contracts being a fixed repayment on the size of the loan, the greater the profit of the firm when successful the less risk an entrepreneur is willing to take.