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What determines new ventures financial structure?
An exploration of the influencing factors for capital structure and the entrepreneur’s decision making during the search for new venture finance.
Master Thesis Master of Science in International Business & Management University of Groningen
Faculty of Economics and Business Landleven 5
9747 AD Groningen The Netherlands http://www.rug.nl
Supervisor: dr. B.J.W. Pennink Co-Supervisor: drs. H.A. Ritsema
1 ABSTRACT
2 TABLE OF CONTENT
1. INTRODUCTION………... 3
2. LITERATURE REVIEW...………. 6
2.1 THE DETERMINANTS OF CAPITAL STRUCTURE………...… 6
2.1.1 SUPPLY SIDE……….. 6
A. ASSET STRUCTURE…………..………. 6
B. PRODUCT TYPE………..… 7
C. THE FIRM‟S LEGAL STRUCTURE……….………….. 7
D. ENTREPRENEURS WEALTH……..………... 8
E. HUMAN CAPITAL: EDUCTION & EXPERIENCE ……….. 8
2.1.2. DEMAND SIDE……….. 10
A. GOALS AND PREFRENCES: CONTROL………... 10
B. GOALS AND PREFRENCES: GROWTH OPPORTUNITIES….….… 11
2.2 ANALYZING DECISION MAKING……….…. 11
2.2.1 AN INTRODUCTION TO DECISION MAKING……….…… 12
2.2.2 THE INFORMATION PROCESSING APPROACH…………....……. 13
2.2.3.THE REASON BASED APPROACH……….……… 17
3. RESEARCH DESIGN……….……… 20
3.1 THE FRAMEWORK FOR FIELD RESEARCH…….……….………. 22
4. THE INTERVIEW METHODOLOGY………... 23
4.1 METHOD VOOR DATA ANALYSIS….…..……… 24
4.2 THE INTERVIEW PROCOL……….. 26
5.FINDINGS………...… 31
5.1 SUPPLY SIDE……….……….………...…. 32
5.2. DEMAND SIDE………..……… 38
5.3.THE DECISION MAKING PROCESS……….……….……… 41
6. DISCUSSION………….………...……... 45
7. LIMITATIONS AND SUGGESTIONS FOR FURTHER RESEARCH…………. 50
3
1. INTRODUCTION
The financing of business start-ups is of considerable concern for managers (Thomas, 2004) as it is one of the key-factors determining business success or failure (Cassar, 2004, Verheul & Thurik, 2001) Substantial capital provides managers with the opportunity to expand and is necessary to execute daily operations. It is money that can turn great ideas into valuable companies, but the lack of it is also the biggest constrain for starting companies. Chaganti et all (1995) questioned potential entrepreneurs and asked them what their biggest constrain for starting their business is, the results are clear: “Lack of capital”.
Dodge et all (1994) as well indicate the allocation of resources as one of the main problems start-ups encounter. New ventures have characteristics that make it extra hard for them to collect money in comparison to more mature firms. For example, young firms are associated with higher risk levels as they have no past-performance where investors can rely on to predict future sales, ( Atherton, 2012; Berger & Udell, 1998; Huyghebaert & van der Gucht, 2007; Sanyal & Mann, 2010). Furthermore they lack a credible reputation and failure risk is high (huyghebaert & van der gucht, 2007). Unfortunately, the difficulties associated with the financing of new businesses have increased due to the recent crisis (Jarboe & Ellis, 2010). Studies revealed that 23,7% of new small businesses do not make it to 2 years, while more than 50% defaulted within 4 years after start up ( Milton & Raviv, 1991; Berger & Udell, 1998). It is therefore important to understand how entrepreneurs where able to find financial resources and on which ground they made the decision for certain sources of money. A better understanding of the way in which capital structures arise, may help in improving further financial decisions (Chaganti et all, 1995).
4 search for funding as the selection process was already finished. Cassar (2004) highlights this limitation: they only focus on the results of the choice. The decision process that leads to that outcome is neglected while this part is crucial in understanding the creation of firms capital structure. As Eckhardt et al 2006) explain; some ventures are more likely to obtain external finance than others and this highly depends on the selection criteria of the money supplier (Eckhardt et al, 2006). Nowadays most research has focused on the supply side of capital instead of the demand side (Howorth, 2001). But, in reality, capital structures do not only arise because of the demands of money suppliers. As, for small firms, the demand side factors or preferences might even have a bigger influence on capital constrains than the supply of money (Howorth, 2001). Thus in order to examine what factors influences capital structure, demand as well as supply side factors need to be examined.
Next to this Cassar (2004) states that these studies do not tell us anything about the structure of the search for capital and on how the sources where obtained (Romano et all, 2000). Besides, data collection often occurred survey wise and the data used commonly contained numbers and figures (Bhide, 1992; Fan, Titman & Twite, 2010; Gaud et all, 2005; Hellman & Puri, 2002). Gartner et all (2011) support the statement that these large data-bases do not provide any information on why these funds where acquired. As a result there is a lack of empirical evidence on the factors that affect entrepreneurs financial decisions (Romana et all, 2000). As Bhide (1992) points out: The only way of gathering date on the entrepreneurs
motives in decision making is by conducting face-to-face interview (Bhide, 1992). There is a
need for using a different methodology in studying business venture financing.
The uncommon method of gather data, interviews, allows for an in-depth understanding of the creation of new ventures capital structure. Gartner et all (2011) emphasized the need for a better picture in their study:” there is much anecdotal speculation about the venture creation
process (for example, that entrepreneurs acquire their venture funding from friends and family), but there is little empirical evidence to support such claims.” Next to examining the
explanatory factors for capital structures, this study provides the opportunity to investigate what the used financial sources for new enterprises are.
5 hold. The funding patterns of the new ventures differed from what was explained in game-behavior theories. The same result was found by Howorth (2001); who analyzed 13 cases and concluded that the pecking order theory does not always hold in real life, strong preferences of the owner disrupt the pattern. We should keep in mind that these samples where too small to make generalizations. However, it signals that what is predicted in game-behavior theories or what is examined without sufficient empirical support, is not always the case in real life. Thus, it is interesting to observe to what extend the explanatory factors from precious studies are able to explain capital structure,
The process of new venture funding within the Netherlands will be examined in this paper. The motivation for nation‟s specification follows from the statement that a country‟s system highly influences the sources for financing as it is depending on factors that are affected by national rules and regulations, such as the national economy, tax systems and bankruptcy policies (Ueda, 2004; Gratchev& Bobina, 2001; Fan, Titman & Twite, 2010; Berger & Udell, 1998). Choosing one country controls for differences in finance methods used created by the national system. The focus will be on the Netherlands, the researcher‟s home country, as past studies revealed that it is very hard to collect data on the determinants of business start-ups, entrepreneurs are reluctant to reveal this information.
Furthermore the current methods used do not provide adequate space for researching the topic, thus a different method is needed. This study will fill these gaps by using a different method; Case study research using the interview approach. Which not only gives the
opportunity to deeply investigate the decision making process itself and the motives that the entrepreneurs encounter, but is also gives room for empirically investigating existing theories.
6
2. LITERATURE REVIEW
2.1 THE DETERMINANTS OF CAPITAL STRUCTURE
The biggest problem in the financing of new firms is caused by information asymmetries between investors and entrepreneurs and the agency problem. Information asymetries occur as new venture funders have information that the new venture potential funders do not have. This phenomena is likely to increase the cost of external capital as the money suppliers seek greater compensation for the additional risk caused (Atherton, 2012). Small and newborn firms are especially information opaque as they have no trading history, a high risk due to uncertain future perspectives (Atherton, 2012) and they do not have financial statements yet. In order to compensate for this lack of information investors look at other characteristics to determine firm value. These characteristics can decrease the information opacity in the following matters: first, they can serve as collateral and guarantees increasing liquidation value and entrepreneurs credibility and consequently leading to more favorable terms for lending (Berger & Udell, 1998) Secondly, they can aid investors to estimate the current firm value and third, they can serve as predictors for future operations. In all of these ways, uncertainties from the investor/lender‟s point are decreased which will lead to better conditions for obtaining capital and better access to capital from the entrepreneurs point of view. The next paragraphs review the factors that are studies most. First supply side influencers will be examined, where after demand side factors will be studied.
2.1.1 The supply side A. Asset structure
7 often hard to sell as it might be questionable if there is any demand for it. Empirical evidence support this as a negative relationship between debt financing and uniqueness of assets has been found (Sanyal & Mann, 2010).
B. Product type
Uniqueness of the product or service the firm operates in influences capital choice as it is suggested that firms producing special or unique products or services may lack residual value in case of default, as they might be hard to re-sell (Titman & Wessel, 1998). Uniqueness increases even more when a product can be classified as innovative as innovative products are relatively more complex in nature (Elston & Audretsch 2011) An innovation is an idea, practice, or object that is perceived as new by an individual or other unit of adoption (Rogers, 1995), subsequently innovative products require a large portion of R&D investment. Investors thus invest in a very risky bias: knowledge, which is an intangible asset, in the hope that in the future profits will be generated from that knowledge. The risk associated with the knowledge is that it can be spread easily as it is nonrival (Hall, 2005). Entrepreneurs can be highly reluctant to share their information with the investor as the chance of expropriation is large, making the existence of a trust bund between the entrepreneur and the investor extra important. However, risks of expropriation can be reduced significantly in case the firm operated in a country with strong IP protection (Hall, 2005). Another uncertainty with innovative products lies in the future perspective; the likeliness of its success on the market is uncertain, making it a risky investment. Empirical support for the explanatory power of product type in capital structure is provided by Titman & Wessel (1998). They measured uniqueness by the amount of money spend on R&D, and found a negative significant relationship with debt ratio‟s.
Nevertheless, in some cases innovativeness can foster the access to capital as there are governmental support programs that are specially developed to aid firms with innovative products, of which SBIR is an example (Cooper, 2003).
c.. The firm‟s legal structure
8 Empirical support is provided by Gartner et all (2011) and Cassar (2004); incorporated firms acquire more external finance in comparison to non-incorporated firms and the level of sources for external finance increases (Gartner et all, 2001) However, Cassar (2004) did not find explanatory power in relation to firm leverage. Besides firms quality, the legal structure has some important consequences for the demand side of capital, the legal structure of the organization influences the amount of tax the corporation has to pay on dividends and personal income (Cassar, 2004). Moreover legal structure has an effect on the amount of start-up capital that is required before the company can be registered at the Chamber of Commerce and start operations and therefore can affect the demand side for capital. An analysis on the legal structure possibilities for start-ups in The Netherlands is provided by the Dutch Chamber of Commerce (KVK). A summary of options for legal firms in the Netherlands can be found in appendix 1.
D. Entrepreneurs wealth
Entrepreneurs wealth is valued as it influences the ability to self-finance (Fluck et all, 1998) consequently the availability of personal wealth serves as an important qualification to become an entrepreneur (Elston & Audetsch 2011) in capital constraint markets. From the investor‟s perspective it can serve as outside collateral and thus increases credibility and residual firm value (Berger & Udell, 1998; Elston & Audretsch 2011). The entrepreneur is indirectly indicating that he is willing to suffer a personal lose as well, thus decreasing incentives for risky behavior (Gaud et all, 2005). The later is called a “signalling effect” (Atherton, 2012) since the author „is providing a signal of commitment and confidence in the new venture‟ (Atherton, 2012) Elston & Audretsch (2010) examined 80 entrepreneurial firms and found that personal wealth is positively related to the usage of loan financing (Elston & Audretsch, 2010).
E. Human capital: Education & Experience
9 experience might less overestimate future perspectives and forecast numbers that are prevailed by someone with experience are perceived as more valuable by investors (Zaleski??). Furthermore, having education and experience, especially in start-ups or in the same industry might offer access to valuable funding networks (Gartner et all, 2011; Eckhardt et al, 2006))
Empirical results on the influence of education on the ability to attract capital are mixed. The results of Gartner et all (2011) indicate that lower educated entrepreneurs obtained less external capital, which was supported in an earlier study conducted by Bates (1990). Sanyal et Mann (2010) also found support for a positive relationship between debt use and education. However, Korosteleva & Mickiewicz (2010) were not able to find a significant relationship between the variables, although they did found that education matters for the scale of the financial project for which finance was seeked. Nevertheless, it should be noted that these studies did not test whether entrepreneurs where able to obtain external finance looking at their education level, but they test whether they actually did.
Zaleski (2011) tested the relationship between the entrepreneurs experience and the firm‟s ability to raise external capital during start-up in a sample with 1359 firms. The results indicate that the more experienced groups, obtained more external equity than the inexperienced group, thus experience influences a start-ups ability to obtain external equity. The results found by Sanyal et Man (2010) support this outcome: Serial Entrepreneurs, those who previously started a venture, where better able to finance the firm with bank loans and external equity, as more information was available about these entrepreneurs. More support is provided Blumberg et all (2007) whose results suggest that banks value owners past experience in similar jobs and industries.
2.1.2 The demand side
10 A. Goals and preferences: Control
Regarding these preferences it is vital to what scale the owner is willing to lose control (De Bettignies & Brander, 2007) as it affects the choices for financial method. „Capital structure decisions of small firms are influenced by top management values and owner's goals which may significantly influence the pattern of funding‟ (Chaganti et al, 1996). Thus at new venture‟s the entrepreneurs goals direct affects the funding method used. Owners gain private benefits of control such as prestige, status, power to decide on decision making and independence from superiors (Huyghebaert & Van de Gucht, 2007) and these private benefits of control can be quite large, it is therefore not unlikely to assume that financial decisions are influenced by these control considerations (hughebaert & van der gucht, 2007). In a previous study entrepreneurs where asked why they where unwilling to raise debt and reluctance to lose control was listed as one of the arguments (Atherton, 2012)
11 B. Goals and preferences: Growth opportunities
Another preference relates to the owner lies in its intentions with regard to the growth opportunities. The higher the entrepreneur‟s intention to let the firm grow, the more capital it requires to pay for the expansion (Gatner et all, 2011) As growth opportunities increase, the potential for agency conflicts and thus agency costs increase, as there are more decisions that need to be made on which shareholders en managers interest can differ (Cassar, 2004). These tensions can be reduced by issuing short instead of long-term debt ( Gaud et all, 2005). However, both Harris and Raviv (1991) and Cassar (2004) found mixed results while reviewing studies that empirically investigated the relationships between growth opportunities and firm leverage, next to this some studies showed insignificant relationships. A possible argument for this phenomenon of mixed outcomes is given by Titman & Wessel (1988) & Gaud et all (2005) who state that growth opportunities do not increase the real value of the firm today neither can it serve as collateral nor does it create income. Another reason for the contrasting results is provided by Cassar (2004) who analyzed the measurements of the scholars and concluded that they have measured Growth opportunities ex-post, thus the actual that growth the firm encounters over a few years. Cassar (2004), changed the method for analysis (2004) by asking the firms owners if they have intentions to increase production levels, open new locations or where planning to introduce new goods and services within the upcoming 3 years. In that way, he really focused on real growth intensions of the firm ex ante. He was able to empirically support the relationship between bank-financing and the intention to grow. He found that if intention to grow is high, than the owners have high incentives to build up long-term credit relationships (Cassar, 2004).
2.2 ANALYZING DECISION MAKING
12 become clear what point to focus on in the interview in order to analyse the decision making process.
2.2.1 An introduction to decision making
Human beings are able to make decisions based upon reasons and logic and often it is said that this trait differentiates humans from animals ( Shafir & le boeuf, 2002). A decision is the act of reaching a conclusion or making up one's mind (dictionary online) and it indicates that someone has access to two or more alternatives (Certo, 2008). A decision is “good” when it links the decision-makers utilities with the decision outcomes (Certo, 2008). A decision arises when one faces two or more options (Zelensky, 1982) and the outcome of a decision process is a specific commitment to action (Mintzberg, Raisinghani & theoret, 1976).
Decision making is often tackled from theories developed in the psychological field as psychologist have conducted extensive research explaining decision making behavior (Hey& Knoll 2011). It wasn‟t until 1947 that the first literature on decision making in organizations became available. The first scholar examining decision making in organizations was Herbert Simon, who argued that decision processes are built upon decision premises and that these premises and the organizational structure impact each other. Before Simon no scientist in administrative behavior saw the need for exploring decision making processes, they only studied the administrative hierarchies in organizations. However, after Simon wrote his book,
Administrative Behavior, decision making became an important factor for understating
organizational behavior ( Starbuck & Hodkingson, 2008).
13 decision making in which the weights of multiple characteristics are important. As more attributes and more options become available, it becomes harder to capture the aspects in a single measure of utility (Zelensky, 1982). Questions that are central in the normative field are what and when, rather than how (Zelensky, 1982).
On the other hand are the descriptive studies, elaborating on how decisions are actually made. They describe the actual behavior of human decision making (Edwards & Fasolo 2001) and the manner in which the values and believes of the decision making are merged into the decision making process (Slovic, Fischoff & Lichtenstein, 1977). The aim of these studies is to detect a „train of thought‟ (Nutt, 2008) and to determine What content of information is processed and how it is processed.
In order to elaborate on the methodologies commonly used and to clarify the appropriate methodology for this study it should be noted that this is a descriptive study; focusing on how the actual decision process evolved. The aim is to detect the underlying framework in the decision making (Nutt, 2008). Demerislanl (2011) reviewed multiple studies on the current field of knowledge in psychological judgment and decision making and found that there are three broad frameworks in analyzing decision making theory: The information processing approach, the reason-based approach and the modeling approach
The important theories necessary for this study will be discussed using this same categorization, although he modeling approach is eliminated as the approach differs from the one in this study. The aim of the approach is to study the connections between decision makers and the environment to detect what signals they use to make a decision. This is not the scope if this study and therefore an elaborating of that approach does not add value. At the end this section follows a discussion on what is applicable to this research.
2.2.2 The information processing approach
14 The research question in information processing approach studies can be framed as: Which strategies or procedures are followed in making a judgment or decision?
Rationality in decision making
In order to elaborate more on the rationality of decisions, it should be made clear what it meant by a rational decision. “Rationality is the notion that a person is largely entitled to his or her own views or preferences, these should cohere and adhere to basic rules of logic and probability theory and should not be formed or changed based on immaterial factors related to, for example, mood, context, or mode of presentation” (Shafir & le Boeuf, 2002) Thus: Judgment and decisions cohere and follow basic rules of logic and probability theory and should not be formed or influenced by irrelevant factors. Simon (1993) explained it really clear by saying that an action is rational when it‟s well adapted to its goals. A rational decision will lead to such action.
Herbert Simon acknowledged that there were some restrictions in rational thinking (Demerislanl, 20011) and with this notion he introduced a term that became widely important in decision making theories: Bounded rationality, a process in which people where acting rational, but within certain boundaries, thus they are not acting perfectly rational. (Starbuck & Hudgkingson, 2008) He argued that the reason for boundaries in rationality stream from the fact that the minds capacity for formulating and solving problems is very small compared to the complexity of the problems that need to be solved (Demerislan 2011). Another reason why decisions are imperfect is because managers don‟t have access to all the information and necessary resources or they simply lack time (Certo, 2008; Simon, 1957) Thus, instead of optimal decisions, managers make decisions that are “satisficing or good enough” (Simon, 1957; Elbanna & Child, 2003). Decisions are taken within the limits of one‟s own capabilities (Elbanna & Child, 2003). Contrary to rationality stand irrationality. A decision becomes irrational when it is not endowed with reasons, thus actions and goals are poorly adapted. Another term is arationality which refers to a decision making process in which the lack of knowledge prevents us from deciding what is rational (Dequech, 2000).
15 courses of action and he used a decision rule that can select a single action to take. Thus these theories do not cover how decisions are made, but how they should be made (Correia et all, 2011). They differ from real life cause they ignored that goals often change over time and they assumed that actions taken flow from preferences that where defined before the actions were taken, while in practice this sometimes occurs the other way around. ( March, 1997; Starbuck & Hodkingson, 2008). Moreover in testing rationality of decisions opponents of rationality argue that studies that support rational decision making are often not based on real-life settings. They are conducted under controlled conditions (Arielry, 2008; Shafir & Le Boeuf, 2002; …) and do not include the most important distractor from making rational decisions: The large, competitive environment of the market (Arielry, 2008). As soon as decisions need to be made under rich contexts, where the applicability of normative rules is less visible, people tend to focus more on intuitive heuristics than normative judgment‟s and statistical rules (Shafir & le Boeuf 2002), thus they are not processing information in a rational manner.
Heuristics
16 opportunity for their business. It might be the case that at the time when all information becomes available and thus rational decisions can be made, the window of opportunity might have been gone, thus they are forced to make decisions irrational. Furthermore, the entrepreneurs environment is complex and uncertain, a situation in which heuristics are more often used (Busenitz & Barney, 1997).
Analyzing decisions: decision rules attributes and alternatives
Using heuristics is one example of decision rules applied to decision making. Descriptive studies showed that people use multiple strategies and rules during the decision making process ( correia et al, 2011; Slovic, Fischoff & Lichtenstein, 1977). According to Svenson (1978) the decision outcome is determined by the attractiveness of the attributes characterizing the alternatives. The alternatives are the available options while the attributes are characteristics of those options. An example can clarify this: if one decides to buy a car several types are available. Let‟s assume that the choice can be made between a Ford Ka, a Volkswagen Polo and a BMW Mini Couper. That these are the alternatives. What the decision makers finds important are the attributes: price, color, quality, the amount of pollution etc. Consequently in making decisions lists of alternatives and attributes can be made. The attractiveness of each alternative is determined by the degree to which the outcome on attributes matches decision makers preferences and needs. After examining the alternatives and attributes the decision maker applies a decision making rule. Scholars observing the decision making process aim to reveal the attributes and the decision rule that is applied to choose between the alternatives (Svenson, 1978; Levin & Japers, 1995)
Svenson (1978) examined decision rules in multiple studies and classified them. The rules studied by Svenson (1978) are rather complex, it is argued that in most decision dilemmas simple rules are preferred that do not rely on numerical computations (Slovic, Fischoff & Lichtenstein, 1977). An example of a less complicated rule is the one applied in the Classical decision making model that describes how people should make decisions (George & Jones, 2005. The assumptions on which it rests, suggest that it has overlap with rational decision making. At first is the notion that people have access to all the information necessary to make the decision (George & Jones, 2005) and secondly, the decision maker chooses the best
possible solution. Four steps are prescribed, following these directions will lead to an optimal
17 consequences of each alternative should be analyzed. Next step is to list one‟s own preferences and ordering them in terms of importance. Finally, count for each alternative how many consequences of the alternatives correspond with personal preferences and select the mode which includes most. (George & Jones, 2005). Accordingly , the decision rule applied is select the alternative which has the highest overlap with decision makers preferences and needs.
The scholars advocating against the classical decision model use the same arguments as those against rationality in decision making: Decision makers have limited cognitive capability, it is impossible to gather all the information available, they cannot oversee all the consequences of the alternatives and decision makers don‟t know all the alternatives to choose from. Furthermore, it isn‟t always clear what you want and consequently It is hard to rank preferences. However, using some of these steps as a guideline might be very helpful for the entrepreneurs when allocating funds. It is therefore not very unlikely to assume that the model might be partially true/effective. This is also what March and Simon thought when they developed the administrative decision making model (George & Jones, 2005) a model in which describes how people actually make decisions, striving for an acceptable instead of optimal decision, and acknowledging that decision makers have cognitive limitations. The kind of information the decision maker incorporates in the process caused by the decision makers personality, ability, perceptions, experiences and knowledge (George & Jones, 2005).
2.2.3 The reason based approach
The central question in the research based approach is what are the underlying reasons and
arguments used for judgment in decision making? People‟s reasoning and argumentation are
20
3. RESEARCH DESIGN.
This research strives to achieve multiple goals. At first is to explore the decision-making process entrepreneurs encounter when selecting funding sources from the available financial funds. An examination of explored research on decision making (section 2.2) revealed that decision processes are generally analyzed by creating an understanding on the selection criteria, the selection process and the decision rule applied. In line with those studies, these aspects will be examined in this study.
RQ1: What are the selection criteria entrepreneurs take into account when choosing between
the options for funding their business start-up and what was the decision rule applied?
Another aim is to explore to what extent explanatory factors described in the theory on the determinants of capital structure explain patterns and structures of start-up financing in this sample. Do the explanatory factors that where derived from large samples hold when examining a smaller sample into depth? A distinction is made between what the “available” methods where and which of these options was “executed”. Most explanatory factors focus on the supply side, in this study the entrepreneurs criteria, thus the demand side is incorporated. Thus: finding more empirical support on explanatory factors for new venture capital structure as current studies lack empirical support.
RQ2: Which factors influence the supply side of capital and which factors affect the demand side for capital?
As explained, these factors will be derived from former studies. They are characteristics of firms, their owner‟s and the environment the firm operates in. They influence the decision as they exclude or include certain options for financing. These are often referred to as the determinants of capital structure. With the aid of this information, we can draw a framework including factors that influence the new venture‟s capital structure from a theoretical viewpoint. In order to draw this model, literature was reviewed in the previous section in order to answer: What are the determinants of capital structure in new venture’s?
21 This will be the desk-research. The data was subtracted from articles from well-known business journals and academic journals of which the journal of banking & Finance, Harvard Business Review, Small Business Economics and the Journal of Business Venturing are examples. These articles are found using the EBSCO-host search database from the University of Groningen. With the aid of this method a framework was constructed which contained information on Firm, entrepreneurial and country characteristics that are likely to affect capital structure, including a overview on how they affect the availability of capital. Next to this relevant theory on decision making is examined in order to develop a method to analyse the decision making process. The desk research section served as a base to conduct the field-research.
22
3.1 THE FRAMEWORK FOR THE FIELD RESEARCH
In this study the process of judgment and decision making of entrepreneurs is studied in their search for new venture capital. Furthermore, one of the goals is to detect the underlying reasons and arguments that lead to the decision. The verbal protocol approach is suitable for both methods. The retrospective approach is preferred above the concurrent approach since the decision making process for financial sources is long and due to time-limitations there is no space to search for decision makers who are making this choice right now. Furthermore, not only the process, but also the outcome will be included in the analysis, it requires that the decision is made already. Based on the discussed topics the following questions on the decision process need to be analyzed in the interviews:
What are the alternatives the entrepreneur could choose from?
What are the attributes the entrepreneur had in mind? The reasons for picking or eliminating alternatives will reveal these (Svenson, 1978)
What was the decision rule applied to choose between alternatives? Was there a rank order in attributes?
What was the sequence of steps taken?
What is the decision makers preferred cognitive process in general? As it is hard to detect the cognitive process used. (deliberation or intuition)
23 FIGURE 1. THE FRAMEWORK OF ANAYSIS IN THE FIELD RESEARCH
4. THE INTERVIEW METHODOLOGY
The aim of this study is to widely examine the units of interest: the determinants of a new firms capital structure and the entrepreneurs decision making process. Based on this goal the sample should not be strictly defined beforehand, data collection should continue until it becomes possible to detect patterns or differences in decision processes. Flick (2006) states that an a priori determination of sample structure is not suitable as it restricts the space of
theory in an essential dimension. There is no vast amount of cases that should be analyzed in
case studies (Thomas, 2004), it depends on the purpose as well as practical considerations. AVAILABLE OPTIONS FOR BUSINESS START-UP FINANCE
EXECUTED OPTIONS FOR BUSINESS START-UP FINANCE THE DECISION PROCESS
Attributes
Decision rule applied
Rationality of the decision
Cognitive process Heuristics used Product type Asset structure Legal organization Entrepreneurs wealth Experience Education level
DEMAND SIDE INFLUENCERS
Preference for control
24 However, there are practical considerations that do restrict the amount of case studies. Case studies are time consuming, especially when personal interviews are held. After the conversations where finished, interviews where written down, almost word for word. What followed next was a careful classification of arguments used. Writing down the interviews to manageable data and analyzing them consumes to much time when the sample becomes to large, therefore the amount of cases was set beforehand at six. Since there is no data-base that consists of start-ups in the Netherlands, possible candidates are found using the internet and personal network of the researcher. The investigator posted a message on facebook in which he asked if anyone knew entrepreneurs who started a business between 2010 and today for a master thesis on decision making in the new venture finance process. The result is that the sample is not randomly selected.
25 Another condition for a start-up company that can be found in multiple studies is that it should be legally independent. (Burgel & Murray, 2000; Peña, 2002), it should not be financed by a mother company. The information above leads to the following definition: “A start-up is a legally independent company that started to conduct business less than 2,5 years ago.” However, it should be noted that the closer to start-up the more likely it is that entrepreneurs remember the financing and how the decision making process evolved. Thus start-ups should be as young as possible.
Beforehand the aim was to find a sample of entrepreneurs that started the company alone, however practice revealed that it is very hard to find those entrepreneurs as most of them had a co-founder. Therefore this condition was skipped, although close attention was paid to the amount of say and knowledge the interviewee had in the financing process. For example one entrepreneur started the company with a companion, but the interviewee was the one with most experience in the business-side while the companion was more focused on developing the technologies.
4.1. Method for data analyses
Flick (2006) distinguished between three steps in the process of documenting data. First the actual collection, second the editing or transcription of the data and finally constructing a “new reality”. Data was collected by conducting face-to-face interviews with 6 entrepreneurs. On average these conversations took 43 minutes, ranging from 32 till 67 minutes. All interviews where tape-recorded in order to minimize data error and to memorize the participant answers correctly. Only little notes where taken during the interview, so that in case the recorder would fail, some data was available but luckily these where not necessary. The recordings where transcribed afterwards. For the first interviews they were written down word-for-word but for the last interviews, when the researcher became familiar on what information was useful and which was not, only the important elements where transcribed cause it consumes a lot of time and energy (Flick, 2006).
26 information needed to be linked back to the related element afterwards. Quotes are categorized by grouping them around the sub-theme‟s being studied. An example of a categorized interview can be found in appendix 3. Attributes where discovered by carefully examining the arguments the entrepreneurs gave for included or excluding an option. All argumentations where written down and linked to an attribute. (Appendix 4)
4.2. The interview protocol
The interview is semi-structured with a focus on a list of aspects, which are results of the examination of literature in part 3. A list of theme‟s arose from the examination of literature (Figure 1). The next paragraph explains how these themes are transcribed into questions.
Supply side influencers
First are the factors that are likely to influence the availability of capital. The net worth of total assets will be obtained from the firm‟s balance sheets at time = 0 (start fundraising) Time= 1 and time =2 Furthermore is it important to distinguish between tangible and intangible assets. Tangible assets will be defined as; cash on hand, value of buildings, machinery and other property owned by the firm (Sanyal et mann, 2010). The entrepreneur will be asked if there are any assets that are unique.
To analyze product type the interviewee will be asked to explain the product or service he is conducting business in. Furthermore, it was asked if the entrepreneur considered the product or service his business is offering to be unique (Fluck et all, 1998). It should be kept in mind that uniqueness of product is rather subjective (Fluck et all, 1998). In order to check if the product is innovative it will be examined if the entrepreneur applied for any patent, copyrights or trademarks (Sanyal et mann, 2010).
The legal organization will be measured by asking the entrepreneur under which legal form the company is registered at the KVK.
27 Education and previous experience not only influences the supply of capital, but as found in decision making theory it is likely to affect the decision making process. Consistent with the methodologies of other scholars (Garther et all (2011) and Korosteleva & Michiewicz and Sanyal et mann, 2010)) the entrepreneur was asked which diploma‟s he had received. Furthermore, the type of study finished is important as those who have finished a financial study might already obtained knowledge in the field of financing.
In terms of work experience, it is asked if the interviewee has some experience in entrepreneurship (Sanyal et mann, 2010), more specifically; how many companies the entrepreneur has started previously (Eckhardt et al, 2006). And if he currently owns other ventures or has any experience in the current industry of the start-up (Sanyal et mann, 2010). Furthermore the numbers of years of experience need to be indicated as well.
Demand side influencers.
What follows next are the factors that are likely to affect the decision process. Past studies indicate that the reason why an entrepreneur has started his own business influences decision making as it affects degree of control. By first asking open questions on the motives for starting a business, the most important reasons are likely to be told first. Chaganti et al (1995) provided a method to measure the goal orientation of the owner and related it to control. They have asked the respondents to indicate on a 5 point likert scale ranging from 1 till 5, to what extent ownership of a business satisfied the objectives stated in table 3. The craftsman entrepreneur is related to one who seeks more control.
Table 3
Measuring Control preferences
Type of entrepreneur Objective motivation
Craftsman Personal challenge Overcoming the challenge of
starting and managing a business, Gaining greater respect and recognition, Fulfilling
expectations other have of the owner and Using one‟s skills and abilities
Craftsman Life style need Having greater control over one‟s
28 likes
Managerial entrepreneur Building something for
family
Building wealth for family members and earning lots of money
Managerial entrepreneur Economic need Having steady employment
Growth opportunities will be measures ex-ante, in line with the methodology developed by
Cassar (2004). Before Cassar (2004) growth opportunities where measured ex-post, thus the real growth the firm encounted (Fluck et all, 1998). However, it does give insights on the entrepreneurs intentions to growth at the start. Consitent with Cassar the question will proceed as following: Q: Do you have intentions to increase production levels, open new locations or
are you planning to introduce new goods and services within the upcoming 3 years.
Analyzing the decision making process.
A semi structured format is used to probe the aspects that where needed for analyzing the decision making process. These aspects are: the rationality of the decision, the decision process, criteria for making decision, alternatives and executed options.
The interviews need to reveal information of the decision strategy, cognitive preference and the reasons and arguments used. In order to analyze the decision strategy the sequence of steps taken and the decision rule applied need to be revealed.
The first question on the process is an open question on the process in general without any interruption by the interviewer. In that way a context for understanding is created, furthermore the memory of the interviewee is activated and cooperation is fostered by being a listener (Klein et al, 1989) It gives the entrepreneur the opportunity to tell whatever comes up in his mind first, consistent with Riedll et al (2008) it is asked: “Can you say in your own words how the process of seeking finance evolved and how you have made the final decision”
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how the final decision was made. Consistent with Klein et all, (1989) “ How was the option
selected or other options rejected? What rule was being followed?”
The alternatives will reveal the available options. „What other courses of action were considered by or available to you?‟ (Klein et al, 1989) The question on the available options where first asked openly, hereafter a list of possible options was listed and the interviewee was asked if they were used or considered.
Furthermore it the rationality of the decision is examined. As explained in the section on decision making, it is very hard to detect which of the cognitive systems was used during the process. As a substitute for this aspect Betsch & Kuntz (2008) used a method by which the general preferred cognitive process can be discovered. On a five-point likert scale, ranging from 1, “I very much disagree” till 5, “I agree very much”. The survey consists of 18 items of which 9 show a preference for deliberation (system 2) and 9 indicate a general favorability for intuition (System 1). The items can be found in appendix 5. They are translated to Dutch and the translation is checked by a native English speaker, who lives in the Netherlands for 30 years and a Dutch man who is living and working in New York, in order to assure that the translation is right.
Furthermore, a rational decision process is one in which decision maker “Knew all the alternatives for actions and all the consequences of alternative action, at least well enough to be able to state a probability distribution. Had a consistent preference ordering for alterative courses of action and he used a decision rule that can select a single action to take” (March, 1997). Therefore all the alternatives for financing where examined, in order to check if the entrepreneur was aware of their presence and if they have included the options in the process. Asking the entrepreneur why a certain alternative was included or excluded will reveal more information about the attributes; the reasons or arguments (Svenson, 1978).
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5. FINDINGS
Among the interviewed entrepreneurs, 12 sources of finance where identified, 11 that where incorporated in the questionnaire before the interviews where hold, as a result of an eximantion of literature, and 1 source of finance that was added later. This form of finance was not included in the list with common finance methods, as it is normally not available for startups; private equity. Not all entrepreneurs provided precise numbers on the amount of investment needed, however an order can be made as it became clear that a few entrepreneurs where looking for amounts of money, that could only be provided by a few sources. Capital necessary was lowest for entrepreneur D and F, less than 20.000 euros. The initial start-ups cost for entrepreneur E‟s first company lied between 20.000 and 50.000 euros‟. Entrepreneur A,B and c where looking for capital with a total sum exceeding 50.000 euro‟s.
Table 4.
Results of the financial sources used, not used, considered and not considered.
Entrepreneur Methods Used Methods considered and not used Methods not considered A Private equity * retained earnings. Own money Bank Crowdfunding
Subsidies & governmental fees, Own money Angels Venture Captalist Friends Family Buying on credit/creditcard B Own money Bank * Crowdfunding ** Friends
Subsidies & governmental fees Retained earnings ** Angel ** Venture Capital ** Family Buying on credit/creditcard C Bank Angel Subsidies & Governmental fee‟s Retained earnings Own money Venture capital** Friends Family Crowdfunding Buying on credit/creditcard D Own money
(Government private loan *** & Family) Retained earnings * Subsidies & governmental fee‟s * Familie Angels Venture Capitalist Friends Buying on credit/creditcard Bank E Own money retained earnings Venture capitalist
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Bank Angels Crowdfunding
Credit/creditcard F Own money Family Retained earnings Bank Friends
Subsidies & Governmental Fee‟s
Buying on credit/creditcard Venture
capital/Angel
* The method is not used yet, because the finance process is not finished yet. However it is very likely that this form will be used.
** entrepreneur is willing to include this form, but it is not clear yet if it is possible and currently there are no negotiations with someone in this area.
*** this is a loan that students can subscribe for during their study, in order to pay for the cost of studying.
Table 6.
Frequency of methods used, considered and excluded and not considered.
METHOD Used Considered and not used Not considered Own money 5 1 - Family 2 - 4 Friends - 2 4 Bank 3 2 1 Angel financing 1 4 1 Venture capitalist - 5 1 Subsidies & governmental fees 2 4 - Retained earnings 5 1 - Credit/creditcard - - 6 Crowdfunding 2 2 Private equity 1 - -
Own money and retained earnings are used most often. It should be noted that among the 5 cases in which own money was used, in one case the own money was backed by a private loan and family money (entrepreneur D) and on one case with family money (entrepreneur F). It was classified as own money, because the loan at the source was not closed on behalf of the company. None of the entrepreneurs considered buying on credit or credit cards for firm financing.
5.1 Supply side
Product type
33 Twenty-two times the criteria “availability” was used. Of those, nine arguments where related to exclusions because the options was not available due to product type. An overview can be found in Appendix X. We can conclude that the “product type” influences supply side as it caused several finance options to be excluded. The majority of these exclusions concerned Subsidies & Governmental fees. This is not surprising, as subsidies are often developed to stimulate the use of certain products or production processes. In these days, hot items are businesses that relate to products and services that focus on a cleaner environment. The same holds for crowdfunding, although the concept is relatively new, the entrepreneurs all argue that it only works for certain types of businesses and only one of them thinks that it might be applicable for him.
Asset structure.
The examination of literature suggested that asset structure influences supply side. Unfortunately, not enough data is collected on asset structure to develop a sound conclusion. Only one of the availability criteria can be linked to asset structure, but only indirectly. Entrepreneur B argued that in order to apply for a bank loan, securitization was necessary, which he could not provide. Therefore it might be possible to assume that the firm lacked tangible assets. As explained in the literature section, especially banks tend to look at the value of tangible assets for securitization (Berger & Udell, 1998) consistent with the experience of the interviewee. The lack of data can be explained by the fact that these start-ups where very immature, and did not start operations yet; there were no assets.
Product type
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Table7 Product type
Company Product description unique
A Online business support platform No.
B Online business support platform Yes,
C Business support with twitter No
D fleet control for companies No
E Online platform to raise money Yes in NL.
E secondment agency No
F Recruitment Agency No
Information is left out due to privacy reasons entrepreneurs. Type of business is made general.
Legal structure
Most of the companies are B.V‟s which resulted in the fact that the owners had to collect a minimum of €18.000 for seed money as this is obligated by the Dutch Law (KvK, 2012) . A holding, that most interviewees have set up as well, is a special form of B.V. The companies daily operating activities take place in the subsidiary and the valuables such as profits and patents are incorporated in the holding. In case of failure, the Holding is not responsible and not all valuables are lost. Another advantage can arise when the holding becomes responsible for the management of the operating subsidiary, in that case it will receive a management fee. Company D is a VOF, as a result the owners are not required to hold a certain amount of seed money, but the downturn is that owners are personally liable. In the future company D wants to create a BV as well. Another outstanding legal form is those executed by company B: cooperation with excluded liability. The profit of the company will be divided over its members. (KvK, 2012). On overview of legal structures used can be found in table 8.
Table 8.
Legal structures used. Company Legal structure
A B.V
B Cooperation U.A. in which the software company (B.V) participates C B.V, in which a holding participates
D V.OF, future plans are to turn it into a holding and three B.V‟s. E B,V, in which a holding participates
35 they participate in the existing b.v.
Comparing the legal structure table with the table summarizing the methods used and considered, no relationships can be discovered, but they can be find exploring the concepts more deeply in the conversations being held. Proof has been found that legal structure influences supply side of capital, as entrepreneur B, who wanted to set up a cooperation and a B.V. could not issue equity in the cooperation. What was not stated as a hypothesis beforehand, but what became visible is that the legal organization influences demand side of the firm, cause all the owners who will set up a BV need to raise 18.000 euro‟s in order to start. However, this rule will be eliminated from the start of October 1, 2012. Also interesting to notice is that firm‟s capital is related to legal structure in an inverse way; the amount of turnover affects the legal structure as entrepreneurs include tax benefits on earnings when deciding which legal form to use. Four out of six entrepreneurs mention that a combination of fiscal rules and turnover caused the choice for a legal structure.
Entrepreneurs wealth.
The interviewer felt uncomfortable by explicitly asking the interviewee about his wealth. However, the interview question on the inclusion of certain forms of finance revealed that none of the entrepreneurs was extremely rich as most did not have the resources to invest in the company from their own pocket, except for entrepreneur E, who primarily set up another company that became profitable enough to finance the other companies he owns. The owner of company C explained that his parents forced him to apply for a governmental fee for starters because he had no money and entrepreneur E and F explained they were working for such a short period that they did not had enough money to start-up the company themselves. .
Experience
36 or they need to save that money in order to pay for costs of living. They are therefore forced to look at other methods, that the others did not consider. It could have caused that both entrepreneurs have applied for a subsidy for new young entrepreneurs. Based on these findings, it can be stated that experience in month, affects the demand side of capital instead of the supply side.
Next variable of explanation is work experience within the industry. Two out of six respondents had work experience directly in the industry they are operating in. (information is left out due to privacy reaons enterepreneurs)… The process of obtaining finance is ongoing for both entrepreneurs and until now, no financer asked about their previous experience, thus based on these data only, the information is still irrelevant for the money suppliers.
However, when losing the concept from “work experience within the industry” to “relevant past experience” , other insights become apparent. For entrepreneur A, the biggest investor is probably going to be a company where the owners did his internship in the past. The company told him explicitly that normally they don't work with start-ups, but they are willing to make an exception for him. This shows how important experience & past track can be. They know him personally, thus are willing to work with him, they are therefore making an exception on the rules for investment they normally follow. Entrepreneur C found his angel due to experiences in the past as well. These result support the findings of Gartner et all (2011) and Eckhardt er al (2006) that experience within the same industry might offer access to valuable funding networks.
The Case of entrepreneur D provide real case evidence to the assumption that experience lends credibility to any information the entrepreneur provides, as the bank that first rejected the loan, offered the company credit after the owner had showed that he successfully raised other firms. Banks value owners past experience (Blumburg et al, 2007) But, it can be argued that this was a result of an increase of collateral, as the firms he started where proven to be valuable. Considering that Entrepreneur B,C and E, who started firms earlier, where better able to obtain external funding compared to entrepreneur D and F and that the large amount of external equity raised by entrepreneur A is an exception to normal rules, it makes sense to state that the findings of Sanyal et Man (2010) that serial entrepreneurs, are better able to finance with bank loans and external equity, is proven in this case.
37 Subsequently follows the examination of financial experience. Entrepreneur A gained financial experience through his last job and during his study finance. Entrepreneur B had no financial experience before he started but is currently owning a other company so learned how to deal with financial practical matters. However, for setting-up that company no start-up money was needed so there is no experience in raising money. Respondent C already had a strong interest in entrepreneurship when he was done studying. He participated at several start-up contests. Respondent C obtained financial tricks & tips through active involvement with these start-up weekend and several pitch-contest he had won. Furthermore, he met several investors through these events and he had started a few small other companies. Interviewee D did not obtain any experience on financing companies in the past, however, his companion had experience in the financial field. There is one entrepreneur who has started several companies in the past of which a successful company… (information is left out) As a result of this track he obtained a lot of financial knowledge: “I have experienced so many financial things nowadays”. The last respondent had no financial experience.
Table 9.
Experience and education Left out due to privacy reaons
Comparing methods used with financial experience, there is one financial method that the entrepreneurs without experience used, which was not used by more experienced entrepreneurs: family money. But since no logical clarification can be made by that, it is not sufficient to state that within this sample, financial experience has led to different capital structures.
5.2 Demand side
Preference for enhancing control
38 while answering why they started a business. The scores for the Chaganti control test are listed in table 10.
Table 10:
Scores on the Chaganti Control test
Entrepreneur a b c d e f
Score craftman 6 5 4 3 3 3
Score managerial entrepreneur 6 9 10 6 7 7
Scores: 1 = very important, 5 =not important
For entrepreneur A working for a boss or having your own business is not that different as long as you have a job where you can implement your own ideas and receive freedom in decision making. His motivation was not that he explicitly wanted to start a company of his own but his reasons indicate a preference for control. The scores of the Chaganti control test (Chaganti et al 1995)that there is no clear distinction if entrepreneur A is a lifestyle or a serial entrepreneur, although “Having greater control over one‟s life and Living where and how one likes” is classified with very important.
Entrepreneur B scores highest on the craftsman entrepreneur values, indicating that he is seeking for control. Furthermore, he classified the control statement as very important. The reasons why he had started a job indicate that he was looking for more freedom. His other quotes on control direct to a high validation of control. “It‟s my baby, I want to keep control”, was the answer on a question on how he important weighted control. However, he is willing to share an acceptable share in control in exchange for experience and aid from professionals. This will be discussed later.
Respondent C motives to start a business where that he experienced a lack of challenge in the jobs he saw during his internship at a bank and other jobs he investigated. He was looking for a job where he did more than just executing operations. Furthermore he was thrilled by the online business world when he joined start-up weekend. Also he highly values freedom. His scores show a strong preference for enhancing control as the outcome is that he is a craftsman entrepreneur.
39 freedom is very important for him. His scores are highest on craftsman an the control statement is classified as very important. Furthermore, he quitted a contest in which you could win money for the business because the exchange for that money was that you had to give up control. Overall he shows a strong preference for controlling one‟s life.
The same conclusion can be made for entrepreneur E. He wanted to do something for himself and did not even care what. As the main reason to start he answers “freedom that really is the main reason.” He values it highly and “never wants to give it up again.” The preference for control scores indicates a strong preference for control.
The last entrepreneur, F, was inspired by parents and other people he know who are entrepreneurs. He saw a challenge in “doing things yourself”. Furthermore he could be creative, determine his own things and he valued the other degree of responsibilities you encounter. Also he has a clear vision on how things should go in the recruitment business and wanted to build a “young club” and “create his own rules”. Preference for control scores point to a strong preference for control
The participants who scored highest on control, d, e and F, are not interested in giving up control in exchange for money, thus they are not issuing equity. They are seeking for money more closely at friends or families or at the bank. Nevertheless, it should be kept in mind that entrepreneur E did not consider angel financing and venture capitalist during the search for capital of its first firm, because he thought it was unavailable. The lower scores for A, B and C are in line with the financial options (likely to be) chosen. They are willing to attract external investors such as angels, venture capitalists or private investment companies and thus need to share control. Based on the data distracted from the interviews, preference for control affects the demand side of capital.
Growth opportunities
40 intentions to grow in the current financing round, but all, except for entrepreneur B, answered that they do not take that into consideration. However, exploring deeper the argumentation of participant B, it became apparent that the only reason why the entrepreneur valued it highly, is because in his business he needs to deal with a large frequency of transactions, thus it is product related and not growth-intensions related. Therefore we can reject the assumption that growth intensions influence demand side within this sample of entrepreneurs. They did not take it into consideration.
5.3 The decision making process.
What follows next is an examination of the decision process. Criteria considered will be presented and the rationality of the decision will be analyzed. An analyses of the decision making process for each entrepreneur can be found in the appendix. In this result section, they will only be presented briefly.
Criteria for choice/ attributes.
The criteria for the choice are summarized in table Table 11, it includes a lists of attributes which the entrepreneurs have taken it into consideration. The frequency of attributes used varied among the entrepreneurs.
Table 11.
Attributes used in the decision making process
Frequency per entrepreneur
Attribute A B C D E F Total Frequency Total entrepreneurs who included variable Control 1 2 1 3 1 2 10 6
Effort & Time 1 1 1 4 1 2 10 6
Availability 4 2 5 2 8 0 21 5 Feelings 0 1 2 1 1 1 6 5 Costs 1 2 0 3 0 2 8 4 Moral issues 0 2 2 2 1 0 7 4 Risk 1 1 1 0 1 0 4 4 Alignment of interest 2 1 0 1 0 0 4 3
Experience and aid from
