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Relationship with Growth?.
White Rose Research Online URL for this paper:
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Version: Accepted Version
Article:
Bhaumik, S.K., Fraser, S. and Wright, M. (2015) What Do We Know About Entrepreneurial
Finance and Its Relationship with Growth? International Small Business Journal, 33 (1).
pp. 70-88. ISSN 1741-2870
https://doi.org/10.1177/0266242614547827
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1
What Do We Know About Entrepreneurial Finance and
Its Relationship with Growth?
*
Stuart Fraser
Warwick Business School
Sumon Kumar Bhaumik
University of Sheffield
Mike Wright
Imperial College
Abstract
We examine the existing literature to highlight what we do (and do not) know about
entrepreneurial finance and its relationship with growth. Broadly, there is a need for research
to go beyond traditional supply side/market failure issues to better understand the role of
entrepreneurial cognition, objectives, ownership types and firm life-cycle stages in
financing/investment decisions. We show that we know little about the pivotal relationship
between access to external finance and growth due to limitations in current approaches to
testing financial constraints. Instead, we propose that we should look at the relationship
between funding gaps and business performance as a direct and nuanced approach to
identifying financial constraints in different entrepreneurial finance markets. There is also a
need for research to disentangle cognitive from financial constraints and to better
understand the role of financiers in enabling growth. In particular, there is a need to better
understand the relationship between non-bank sources of finance and growth, shorn of
inherent survival and selection bias. We outline an agenda for future research to address
gaps in our understanding.
*
The research for the paper was funded by ESRC grant no. ES/K006614/1.
2
Introduction
Following the financial crisis, many economies have seen a significant decline in both debt
and equity finance flows to SMEs. Consequently, there are concerns that the associated
funding gap may be limiting firm growth and as a result constraining economic recovery.
The UK, in particular, provides strong prima facie evidence about the persistent structural
problems in the markets for both traditional bank credit and alternative sources of finance
such as venture capital. Indeed, the UK Government has established a British Business
Bank, modeled on the lines of the German state-owned bank Kreditanstalt für Weideraufbau
(KfW), to help improve flows of debt/equity finance to SMEs.
The issue of funding gaps, in the provision of debt and equity, as a constraint on the
development of small businesses is not new. In the UK, The MacMillan Committee (1931)
and Bolton Committee (1971) long ago identified gaps in the supply of small scale equity
investments to small businesses. The Small Firms Loan Guarantee (SFLG) was introduced
in 1981 to overcome a perceived gap in credit availability reported in Wilson Committee
(1979). More recently, reports have drawn attention to: the lack of competition in the supply
of banking services to SMEs (Cruickshank, 2000; Independent Commission on Banking,
2011); shortcomings in the provision of growth capital (Rowlands, 2009); the need to
promote the supply of non-bank sources of finance since the financial crisis (Breedon,
2012); and the benefits of establishing a ‘one stop shop’ for business support in the UK
similar to KfW (Breedon, 2012).
The issues involved in understanding funding gaps are complex. It is not easy to disentangle
whether a drop in the amount of funding results from low demand or contraction in funding
supply. The explanation of the latter, which has dominated the policy discussion, is often
rooted in market failure: the fixed costs of screening and monitoring smaller/younger
businesses, which are more informationally opaque, may be prohibitively high. The resulting
information asymmetries may give rise to problems of adverse selection and/or moral hazard
leading to credit rationing (Stiglitiz and Weiss, 1981). In these circumstances, funding may
only be available where the entrepreneur has some track record (Petersen and Rajan, 1994)
or can demonstrate commitment to the business, such as through providing collateral
(Bester, 1985). Recent developments in credit scoring have helped lower the fixed costs of
lending and reduce reliance on collateral improving small firms’ access to finance (Allen et
al., 2004). Indeed, improvements in the credit information infrastructure might be expected to
help the flow of finance to SMEs and overcome some of the asymmetries. A potential
downside is that existing lenders hoard information on commercial lending via the credit
3
referencing agencies (CRA) which creates a barrier to entry for new lenders (Ariccia, 1998;
Bofondi and Gobbi, 2006). The need to make credit data on SMEs available is understood
and acknowledged by governments, and in the UK it is an integral part of the policy
discussion about competition in the banking industry.
1
As with bank borrowing, firms seeking equity finance often lack a track record to mitigate the
informational asymmetry problem. In situations of high informational asymmetries which
would deter an ordinary investor, venture capitalists have developed various efficient
methods of selecting high quality ventures and monitoring/adding value to their portfolio
(Amit et al., 1998). However, the contrast between the UK and US experience suggests that
the growth of a venture capital industry to support SME financing is not guaranteed (Wright,
et al., 2005).
Whilst research has focused on supply side issues, a largely underdeveloped area is the
role of entrepreneurial cognition in financing/investment decisions (Wright and Stigliani,
2013). Individuals face limitations in their ability to process information, which may lead to
various heuristics and cognitive biases (Kahneman and Tversky, 1979). These biases are
especially likely in entrepreneurial contexts (Baron, 1998). Cognitive biases may affect how
entrepreneurs frame and evaluate the options available to them. For example, preferences
for avoiding losses may mean entrepreneurs decide not to invest in and grow their
businesses. Other research suggests a tendency among entrepreneurs toward ‘positive
illusions’ (Taylor, 1989). Entrepreneurs tend to over-estimate their ability/under-estimate risk
(Kahneman and Lovallo, 1994) which may lead to over-investment (de Meza and Southey,
1996). While previous research points to the importance of cognitive biases in
entrepreneurial finance, we still have little understanding of their actual impact on
investment/financing decisions and growth.
These supply and demand side factors play out across the financial life-cycle of the firm. The
informational opacity of the firm changes over time (Berger and Udell, 1998) and this affects
the nature of firm financing. On the demand side cognitive biases may change over time as
the entrepreneur gains experience (Fraser and Greene, 2006). Additionally, path
dependencies may play an important role in locking firms in and out of markets for finance.
In aggregate, the overall observed changes in access to finance would then be affected by
the distribution of firms along the aforementioned life cycle.
1
See https://www.gov.uk/government/consultations/competition-in-banking-improving-access-to-sme-
credit-data/competition-in-banking-improving-access-to-sme-credit-data.
4
Recognizing the nuanced and dynamic nature of supply and demand side factors, our aim is
to address the following question: What do we understand about the relationship between
entrepreneurial finance and growth? We review the academic literature on the relevant
issues. In section 2 we present a schematic view of the relationship between entrepreneurial
finance and growth which draws together different parts of the literature whilst also
highlighting areas we are less sure about. This sets the scene for the discussion in the
remainder of the paper: financing decisions (section 3); debt and equity funding gaps and
their relationship with growth (section 4); and, beyond finance, the role of financiers in
enabling growth (section 5). We conclude by discussing some of the gaps in understanding
that future research needs to address. Overall, we attempt to identify the gaps in the
literature that should be addressed to better inform policy making.
Relationship between entrepreneurial finance and growth – schematic overview
Entrepreneurs have differing growth objectives and may be at different stages in their own
lifecycle and the lifecycle of their ventures. Many entrepreneurs, for example, are motivated
by lifestyle factors and may have little need for external finances. Others, whilst having
future growth plans, may not yet be ready to grow.
There are also other complexities. Entrepreneurial cognition influences the decision to seek
external finance by affecting perceptions of growth opportunities and/or the desire/perceived
ability to exploit these opportunities. Start-up entrepreneurs may be reluctant to let go of
control but also established family firms with underlying growth prospects may be reluctant
to take on external funding that either dilutes family ownership or involves taking on debt that
would put family ownership at risk in the event of difficulties in servicing the debt.
Previous research has looked at different parts of the relationship between entrepreneurial
finance and growth: capital structure and sources of finance; market failure in the supply of
entrepreneurial finance; internal/personal finance constraints on growth; and the special role
of venture capital in building high growth firms. We, therefore, start by locating these
different parts of the entrepreneurial finance literature into paths leading from the initial
funding decisions through to growth mindful that, in view of the gaps in understanding
identified in the introduction, we may think we are measuring financial constraints on growth
when in fact we are measuring cognitive (and motivational) constraints.