The Impact of Entrepreneurs' Personal Wealth Allocations in Determining Their Firms' Capital Structures

ABSTRACTWe study the effect of entrepreneurs' wealth allocations on their firm level capital structure by using a sample of small privately owned firms in U.S. from the 2003 Surveys of Small Business Finance. We find that financial leverage decreases as entrepreneurs allocate more wealth on their firm investments. We also find that wealth allocation only affects capital structure in limited liability firms. Lastly, we show that the effect of wealth allocation on capital structure does not disappear after adjusting for collateral and personal guarantees.JEL Classifications: G11, G32Keywords: capital structure; wealth diversification; entrepreneurship(ProQuest: ... denotes formulae omitted.)I. INTRODUCTIONCapital structure is one of the most important issues in corporate finance because it leads to the firm's valuation and its cost of capital. Extant empirical literature has focused primarily on publicly traded firms. However, according to Kobe (2007), small privately owned firms account for about 50% of non-farm real GDP and 50% of the job growth in the period from 1998 to 2004. It is important for us to pay serious attention to small businesses. Research on the capital structure determinants in these firms is desirable because capital structure affects cost of capital, which eventually affects the survival and growth of small privately owned firms.Extant literature has attempted to explain the observed capital structure as a result of bankruptcy costs, tax shields, adverse selection, and agency conflicts. However, few studies have examined the link between firms' capital structure decisions and their decision-makers' personal wealth allocations. Entrepreneurs (principal owners1) in private firms own significant portions of their firms and face fewer governance constraints. Thus their tolerance of losing their firm investments might play a significant role in determining the amounts of financial leverage2 on the firm level. In this paper, we contribute to the existing literature by studying the effect of decision makers' wealth allocations on firm-level capital structure.We use data on limited liability firms from the 2003 Surveys of Small Business Finance (SSBF) and find firms with limited liability protection tend to use more financial leverage as the entrepreneurs allocate more wealth outside of their firms. This result remains unchanged after we adjust our measure of wealth allocation by the amount of loans that entrepreneurs obtain by using personal guarantees or out -of-firm personal assets as collateral. As a robustness test, we also examine a larger sample that includes both limited liability firms and unlimited liability firms. We find that wealth allocation only affects the capital structure of limited liability firms. Moreover, our tests show that wealth allocation does not play a significant role in determining the capital structure of unlimited liability firms.II. LITERATURE REVIEWModern capital structure theory begins with the theory of capital structure irrelevancy developed by Modigliani and Miller (1958). It suggests that in the absence of corporate taxes, transaction costs, bankruptcy costs, and information asymmetry, capital structure does not have any effect on the value of a firm.By relaxing the assumptions in the Modigliani and Miller framework, several alternative capital structure theories have been developed. For example, when both corporate tax and bankruptcy costs exist, the trade-off hypothesis suggests that there is an optimal leverage level for the firm when the marginal benefit of tax shields is equal to the marginal expected deadweight costs of bankruptcy (Kraus and Litzenberger, 1973).The pecking order hypothesis suggests that there is a pecking order when firms decide their capital structures. Firms first use their retained earnings, then debt, and then equity (Myers and Majluf, 1984; Myers, 1984).The agency theory suggests agency conflicts exist not only between managers and shareholders, but also between shareholders and debt holders (Jensen and Meckling, 1976). …