A Demand-Side Approach to Smes' Capital Structure: Evidence from Argentina

Abstract

ABSTRACT Corporate finance, especially capital structure theory, studies a firm's decisions from the normative perspective of maximizing shareholder value. We propose a descriptive approach to understanding how small and medium enterprises (SMEs) make their choices. Considering owner-firm intertwinement as a fundamental characteristic of these firms, we include behavioral features as explanatory variables of capital structure. We test the implications of our approach in a sample of small Argentine firms. The evidence partially supports our hypothesis: the owner-manager's age and previous experience with personal debt are relevant in an SME's choices. We believe this reflects the owner's level of aversion to risk and uncertainty. (ProQuest: ... denotes formulae omitted.) INTRODUCTION Researchers in small and medium size enterprises (SMEs), like Storey (1994), argue that differences between small and large firms are not only a matter of size; consequently, special models are required to study SMEs. Several characteristics differentiate small firms from large firms. First, management and ownership unification leads to an owner-firm intertwinement (Ang, 1992) at economic as well as emotional levels. Second, private equity factors affect the diversification possibilities and risk position of the owner. Moreover, the lack of professional management causes business problems, such as shortsighted planning. Agency equity costs also exist in these firms, where firm control and ownership are shared among the business partners. Only a firm with a single owner-manager is free of agency costs of equity (Ang, 1991, 1992). In family firms, the inclusion of younger generations is another source of agency problems. Furthermore, information asymmetry problems between small firms and external funds providers are especially large because of the informality and scarcity of information available. Finally, small firms have shorter life expectancy, given that the firm may cease to exist if just one person (the owner) leaves, due to a lack of succession planning. Capital structure theory has been built around Modigliani and Miller's (1958) propositions of irrelevance in a context of perfect capital markets. The acknowledgment of market imperfections such as corporate and personal taxes, transaction costs, and information asymmetries has led to refinements in capital structure theory. However, there is still no theoretical agreement on the relevance of capital structure to overall firm value, because the trade-off and pecking order theories do not agree. While the trade-off theory argues that costs and benefits of debt lead to an optimum value, the pecking order theory suggests that capital structure is just the result of cumulative requirements for external financing (Myers, 1984, p. 581). Traditionally, SME studies have focused on information asymmetry problems (e.g., Berger & Udell, 1998; Petersen & Rajan, 1994). As SMEs have restricted access to capital markets, due to high costs or legal form limitations, the credit rationing effect is expected to be particularly strong for these firms. However, Hamilton and Fox (1998) and Hutchinson, Hall, and Michaelas (1998) propose a hierarchy with preference for internal funds, based on the owners' desire for control and flexibility. While the original proposition of the hierarchy results from the undesirable signaling effect of new equity issues, this argument can be considered a demand-side explanation. We continue this line of investigation and propose a new approach to SME financing. This approach is based on demand factors that are complementary to traditional variables such as size, growth, profitability, and taxes. The originality of this proposition lies in the consideration of personal and behavioral aspects of the capital structure decision; we focus on qualitative distinctions among sources instead of measuring the quantitative capital structure of the firm. …