The growth in new businesses continues to be the engine that drives the American economy. According to the 2008 Kauffman study, The Capital Structure of New Firms, 17 percent of new firms in the longitudinal study have more than three employees and more than 87 percent have a medium or low credit score. That is to say that these enterprises have a leveraged compensation structure and generally highly constrained access to cash, at least during capital-intensive stages such as start up or market entry.
Access to cash secured by assets is and has been exceptionally tight, leaving entrepreneurs with the dilemma of having to either reduce overhead costs and thereby decrease the speed at which the company achieves profitability from operations or sell off its earnings in the venture capital market and thereby hope to capitalize itself adequately for long enough to access the marketplace.
The venture capital marketplace is, however, not currently a likely candidate for most businesses to access liquidity. From June 2001 to June 2011, venture capital funds earned an average of 1.3 percent on their investments. Over this same period, the DJIA returned 4.2 percent, the S&P delivered 2.7 percent and the NASDAQ provided a 2.5 percent return. The “barbell” strategy of most venture funds has left early and mid-stage companies with stagnant capital plans.
The inevitable valuation discount based on asymmetric information imposed by outside equity investors, combined with the ubiquitous distaste by company founders for diluting their ownership proportions, renders debt a much more attractive source for capital than is outside equity. As a result, founders initially tend to prefer internal financing methods, followed by the issuance of debt until the anticipated service of that debt appears no longer reasonable to service (a decision as often as not reached without qualified analysis), and finally by selling equity in the company.
As debt increases and equity stays level during early stage and even mid-stage enterprise development, founders are incentivized to take on increasingly risky projects, often in the hopes of windfall revenue that will liquidate the dent burden. All too often, once the debt to equity ratio of the firm approaches unity, the founders have increased risk appetite because the return from the increased risk flows exclusively to the equity owners, whereas the debt holders retain all the increased risk of loss. This mismatch in incentives, called the asset substitution effect, becomes increasingly more dramatic once the D/E is below one and the founders have, in effect, nothing to lose by taking on larger risks. Obviously, temporal information asymmetries underlie the difficulties in managing this problem and can be overcome with diligent, even aggressive, transparency protocols, such as real time financial disclosure and debt-holder monitoring of all financial activity. While burdensome on all parties, these time-tested mechanisms operationally align the interests of the equity –constrained enterprise and its creditors.
But what of the company struggling to bring its innovation to the market or to grow in a competitive environment?
Enterprises seeking to retain or attract talent should be aware that, since, 2004, the use of stock options has generally decreased in the U.S., with a notable exception for full time employees in New England, where the use of stock options has rebounded measurably in the last few years. Interestingly, the tightening of credit and cash has not appeared to have shifted a substantial emphasis to options. Rather, companies have become, across the entire country, less willing to dilute the equity of their founders in order to remain competitive. In short, in the last couple of years, business owners have been becoming more optimistic about the future.