An Empirical Investigation of the Growth Cycle Theory of Small Firm Financing

This paper empirically tests the financial growth cycle model for small and medium-sized enterprises (SMEs), which postulates that as firms become larger, older, and more informationally transparent, their financing options become more attractive. We add to the literature by providing one of the first empirical tests of the model using a large, cross-sectional data set. Our results partially support the financial growth cycle model. Specifically, our results show larger firms, as measured by total number of employees, are more likely to use public equity funding or long-term debt as opposed to insider funding. Introduction Interest in small and medium enterprises (SMEs) has increased significantly over the last decade. Even before the recent surge in entrepreneurial ventures, SMEs contributed greatly to the U.S. economy, producing between 40 and 60 percent of the U.S. gross national product and employing about 50 percent of the workforce (Neubauer and Lank 1998). Much of the attention surrounding growth in the smaller firm has focused on capital structure decisions, because problems related to financing are dominant in the small and young firm (Terpstra and Olson 1993). The literature is rich with anecdotal and empirical studies describing inadequate financial resources as a primary cause of SME failure (Coleman 2000; Van Auken and Neeley 1996; Gaskill and Van Auken 1993; Welsch and White 1981; Jones 1979; and Wucinich 1979). Small businesses differ from larger firms in terms of capital structure decisions. Their reliance on private markets limits the types of financing they can receive. This, coupled with the small firm's initial use of internal sources of capital, creates a unique situation in which capital structure decisions are made. It is widely accepted that small firms have different optimal capital structures and are financed by various sources at different stages of their organizational lives (Berger and Udell 1998). The novelty of a small business's options for raising capital has spurred a line of research focusing on the specific characteristics of small firms that may contribute to the capital structuring decision. The most widely accepted view of small-business capital structure is that of Berger and Udell's (1998) financial growth cycle model. Other researchers have found that specific attributes of small firms impact the types of funds used to finance the firm's operations, (for example, Romano, Tanewski, and Smyrnios 2001; Hall, Hutchinson, and Michaelas 2000; Van Auken and Neeley 1996); however, the Berger and Udell (1998) work, which proposes that optimal capital structures vary at specific threshold points, seems to have captured the attention of most researchers. Specifically, Berger and Udell (1998) contend that changes in optimal capital structure are a function of the firm size, age, and information availability. In this paper, we empirically test Berger and Udell's (1998) model on a sample of 954 U.S.-based SMEs, using firm-level data. Although much interest has arisen in SME capital structure decisions, we found no research that specifically tests the Berger and Udell model on a large sample of cross-sectional data. Thus, we contribute to the literature by providing an empirical foundation for this widely held model on SME capital structure decisions. We begin with a discussion of the financial growth cycle model. Berger and Udell's Financial Growth Cycle Model Berger and Udell (1998) propose a financial growth cycle for small businesses where the financial needs and financing options change as the business grows, becomes more experienced and less informationally opaque (Figure 1). They further suggest that firms lie on a size/age/information continuum where the smaller/younger/more opaque firms "lie near the left end of the continuum indicating that they must rely on initial insider finance, trade credit, and/or angel finance" (Berger and Udell 1998, p. …