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Entrepreneurial Startups Find Financing Through External Debt Sources, Not Family and Friends

Capital Structure cover

Kauffman Foundation research underscores importance of credit markets to firm formation

(KANSAS CITY, Mo.) Oct. 30, 2008 — Contrary to widely held beliefs that startup companies rely heavily on funding from family and friends, a Kauffman Foundation research paper released today reported that external debt financing such as bank loans are the more common sources of funding for many companies during their first year of operation. According to the study, nearly 75 percent of most firms’ startup capital is made up in equal parts of owner equity and bank loans and/or credit card debt, underscoring the importance of liquid credit markets to the formation and success of new firms.

"If nascent firms hold the key to growth in Western economies, then surely economic growth hinges critically on the smooth functioning of credit markets that enable young firms to be formed, to grow and to succeed," said Alicia Robb, Kauffman Foundation senior research fellow and one of the paper's authors. "There's a critical role for policymakers right now to ensure that the credit markets start functioning better so that we minimize the negative effect the credit crunch is having on startup businesses."

The research paper, titled The Capital Structure Decisions of New Firms, is second in a series of Kauffman Firm Survey (KFS) studies. The KFS surveyed nearly 5,000 businesses founded in 2004 and tracks them annually over their early years of operation. The survey focuses on the nature of new business formation activity and characteristics of the firms and owners over time. This dataset provides a rich picture, and a first-time glimpse, of the early capital structure decisions of new firms.

Interestingly, the Capital Structure paper also found that high-tech firms are more likely to get outside equity investments in their first year of operations than any other type of company. According to the data, high-tech firms received an average of $31,216 in this type of financing, compared with firms overall, which received only $7,000 on average.

Other key findings in the Capital Structure paper include:

  • Outside debt (financing through credit cards, credit lines, bank loans, etc.) was the most important type of financing for new firms, followed closely by owner equity. These two sources accounted for about 75 percent of startup capital.
  • Insider debt (from friends, family, and spouses) and outsider equity were much less important sources of startup capital.
  • Owner debt and insider equity were the least important sources for startup capital.
  • Firms with high credit scores (low risk) started businesses with much higher levels of startup capital than firms with low credit scores. The average amount of startup capital was $136,000 and $50,000 respectively. These compare with about $78,000 for firms overall.
  • High-tech firms with high Dun & Bradstreet Credit Scores (low risk) started with nearly $275,000 in financial capital. More than $100,000 of this financing was from outside equity investors such as venture capitalists and other informal investors.
  • Outside equity financing was the most important source of startup capital for high-tech firms with high credit scores.

"These findings reveal how important smoothly functioning credit markets are to the success of startups," David T. Robinson, one of the paper’s authors and professor of finance at Duke University. "I think many people understand the importance of bank credit for firms that are already up and running—our results show bank credit is critical at the very earliest stages of a firm's life."







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