Can businesses afford to grow?

Financial capital is one of the key resources a business requires to support its growth. Although few in number, high growth businesses contribute disproportionately to employment and wealth creation in an economy.  As a result it is important to know, not only how high-growth businesses fund growth, but the reasons behind this choice.


New research from Belgium looked at a sample of more than 32,700 companies over an 8 year period and investigated how those with the highest growth supported the expansion financially. The research focused on the pecking order theory to explain the financing choices of these companies which predicts the existence of a financing hierarchy, where business managers avoid the cost of external financing if possible. As a result, they prefer to use internal funds first, then debt and finally outside equity as a last resort to finance investments.

On a superficial level, these latest results are consistent with this premise- the research consistently showed that less profitable companies are more likely to finance new investments with external equity and that businesses with more internally generated cash have a lower probability of issuing external equity.However, these Belgian researchers went further. Rather than looking at profitability and cash flows in isolation, the team also examined the interaction between debt and cash flow. The extensive use of new equity issues observed by small and high growth businesses in particular may be explained by taking into account debt capacity.

Current studies have defined debt capacity as the point at which companies reach “sufficiently high debt ratios” that curtail further debt issues or make them prohibitively expensive. Furthermore, high growth ventures traditionally have more restrictive debt capacity constraints and hence have a lower debt capacity. Consequently, it follows that high growth companies will reach their debt capacity quickly and will therefore need to look at issuing outside equity in order to fund expansion.
Also, given that debt capacity is not only determined by a firm’s leverage, but also by its capacity to carry out the fixed debt-related payments, this would suggest that particularly highly levered businesses with limited cash flows are most likely to issue new equity.

In fact, the full results showed that financial debt is the most common financing route, accounting for almost 45% of the financing events. This is interesting in light of prior studies claiming that high growth businesses seem to consistently use less debt financing. Internally generated finance is the second most frequently used way to finance growth- nearly 39% of the financing events are increases in retained earnings despite the assumption of prior research that rapidly growing ventures have insufficient internal funds to finance their growth internally. Finally, only 16% of the financing events relate to raising external equity financing, although nearly 44% of the companies in the sample raised outside equity financing at least once during the period of the study.

Why is Equity the Least Preferred Method of Financing?

At a certain point the cost of additional debt may be excessively high or debt financing may simply be unavailable meaning business owners may turn to new equity issues as a substitute. However, contrary to the disadvantages associated with additional financial debt, previous research found that new equity issues do not increase the probability of failure, do not accentuate moral hazard problems and do not require collateral.
So why is equity so unpopular? Asymmetric information is probably one of the most important reasons why outside funds are considered by management to be substantially more costly compared to internal funds. Informational asymmetry entails that while business managers have private information about the value of assets in place and future growth options, outside investors can merely estimate these values and will demand a “lemons” premium for the securities offered by the business. The more risky the security is considered to be, the higher the premium will be, as risk exacerbates the effects of information asymmetry.
As a result, companies prefer to finance new investments with retained earnings, which are not subject to these asymmetric information problems. Only when internal funds are insufficient to meet the financing needs will managers will turn to more costly outside funds. In this situation companies are expected to issue the safest securities first as these will suffer less from information asymmetries and hence be subject to lower premiums. However, the cost of issuing new equity is still thought to be significant, especially for smaller and unquoted businesses. Venture capital investors, for example, require an average yearly return of more than 15% per cent for later stage investments and as much as 30% for early stage investments, and such returns are not tax deductible for the company as debt finance may be.
Equity financing is clearly considered a substitute for alternative forms of financing, but are owners and managers following a financing hierarchy purely because of the economic costs associated with it, or owing to a fear of losing control and independence or lack of knowledge about financing alternatives?

Other Factors Affecting Choice of Financing Method

Although companies with more tangible assets are more likely to issue outside funding, the level of tangible assets does not discriminate between new equity issue and new debt finance choice. However, the results strongly support the idea that businesses with more intangible assets are more likely to fund their investment projects with external equity financing rather than with either debt financing or internal equity.
Under the pecking order theory, companies with a lot of spare debt capacity would be expected to attract financial debt which would allow profitable companies to benefit from the tax advantage of additional interest payments. However, and in line with previous studies, this research finds that profitable high growth companies with a lot of debt capacity prefer to retain their debt capacity. Finally, businesses with a high risk of failure are more likely to issue new equity.
In summary, these results indicate that retained earnings and outside financing are substitutes rather than complements. Bank debt is primarily used by low risk businesses, while external equity is used by high risk businesses. Profitable businesses prefer to finance investments with retained earnings, even if they have unused debt capacity. Although external equity is undeniably an important source of finance, almost 85% of the financing events relate to retained earnings and financial debt. External equity is particularly important for unprofitable businesses with high debt

Related paper

Vanacker T. Manigart S. 2010. Incremental financing decisions in high growth companies: pecking order and dept capacity considerations. Small Business Economics. 35 (1) : 53 - 69

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