When an entrepreneur starts a new firm she often need external funding. For this, the entrepreneur will typically rely on equity, provided by the "three F's" (Friends, Family and Fools), by
business angels, and/or by Venture Capital (VC) funds. At least, this is a popular perception of how start-up financing works. For example,
Aswath Damodaran describes the financing decision in the start-up phase of a firm as "Equity funding optimal, debt only if desperate".
Desparate. Do entrepreneurs really need to be desparate before they use debt finance? Not in the real world it seems. In a recent study that covers basically all independent Belgian firms founded in the period 2006-2009,
Tom Vanacker and I find that bank debt is the most important finance source for new firms. More than two thirds of the Belgian start-ups in this period used bank debt at the time of start-up. For the start-ups with bank debt on their balance sheet, it was a (much) more important finance source than equity, trade credit or other debt types. These findings of Tom and me are not unique for Belgium, not even for Europe. Studies of start-up financing find that bank debt also plays a crucial role in the financing of start-ups in
the US and
Australia.
Access to bank debt is important for start-ups, because it allows them to finance investments, increase their growth and avoid bankruptcy. In our study, Tom and I distinguished between new firms founded before and after the 2008 crisis. During this crisis, many banks got into serious financial troubles and evidently had less money to lend. Not surprisingly, we find that new firms in this period had less bank debt than new firms
before the crisis. The reduced access to bank debt negatively affected the growth and the chance of survival of these firms. Start-ups invested less, had a lower growth, and were more likely to go bankrupt if they ware founded during or after the crisis, compared to start-ups before the crisis. Furthermore, this effect was significantly stronger for start-ups in industries which depend on bank financing and start-ups with a lack of equity. This suggests that reduced access to bank debt during the crisis harmed many start-ups.
Where does the idea that start-ups only rarely use debt come from, given the evidence of the contrary? Research on start-ups tends to focus on
high-tech start-ups which, due to the nature of their assets (intangible growth opportunities), indeed have limited access to bank debt and rely much more on
business angels (I love that word, I wonder who invented it) and VCs for external funding. However in the real world, most start-ups are not about "cool" nerdy guys and girls wanting to
become billionaires when the app they are creating is going to conquer the world. Most start-ups are about hard working people in many different industries, for which bank debt is very useful. These start-ups are still very important for our economy. More important than the guys and girls trying to invent new apps. Just not as sexy.
