1. H OW D O S TART -U P F IRMS F INANCE T HEIR A SSETS : E VIDENCE F ROM THE K AUFFMAN F IRM S URVEYS Rebel A. Cole DePaul University Tatyana Sokolyk Brock University Southern Finance Association Annual Meeting Charleston, SC November 15, 2012

2. Introduction: How do start-up firms finance their assets? How does the use of credit change from the firm’s start-up through the first critical years of business growth and development? In this study, we provide some answers to these questions by analyzing the Kauffman Firm Surveys (“KFS”) data. With this unique dataset, we are able to examine the substitutability and connections among the alternative sources of credit finance for closely held start-up firms. Cole-Sokolyk

3. Introduction: Why is this research important? According to the IRS, there are more than 30 million businesses in the U.S., of which 99.97% are privately held. According to the SBA, small businesses account for half of all U.S. private-sector employment and produced 64% of net job growth in the U.S. between 1993 and 2008. Also, recent Census research finds that the majority of all net job creation is accounted for by start-up firms at their creation; and that majority of net job destruction is accounted for by start-up firms during their early years. Therefore, a better understanding of what types of firms use credit, and what sources of credit finance they use, can help policymakers to take actions that will lead to more jobs and faster economic growth. Cole-Sokolyk

4. Summary: First, we examine firms that use no credit to finance their assets. – We find that about 25% of firms report 100% equity financing of their initial assets, and this percentage remains relatively constant during first five years of operations. Second, for the remaining 75% of start-ups, we analyze their sources of credit, which we aggregate into three groups— trade credit, personal credit, and business credit. – At start-up, we find that the majority of firms (55%) rely upon personal credit, but that a sizable fraction of firms also use business credit (44%) and trade credit (24%). – As firms develop, they decrease the use of personal credit and increase the use of business credit. Cole-Sokolyk

5. Summary: We also examine which firm and owner characteristics explain a start-up’s decision to use credit and, conditional upon using credit, what types to use. We find that firms are more likely to use credit at start- up when they: – are larger, – are more profitable, – are more liquid, – have more tangible assets; and – when their primary owner has more experience and more education, and is white. Cole-Sokolyk

6. Summary: Among firms that use credit, we find that: – larger firms are more likely to use trade and business credit, but are less likely to use personal credit; – firms with more current and tangible assets are more likely to use both trade and business credit, but are less likely to use personal credit; – firms with better credit scores are more likely to use business credit; – corporations are more likely to use both trade and business credit, but are less likely to use personal credit; – firms with multiple owners are more likely to use business credit, but are less likely to use personal credit; – owners with more prior business start-ups are less likely to use personal credit; and – female owners are more likely to use personal credit. Cole-Sokolyk

7. Related Literature: Capital structure of privately held firms Use of trade credit by privately held firms Cole-Sokolyk

8. Related Literature: Capital Structure of Privately Held Firms: Berger and Udell (JBF 1998) Cole (SBA Research Studies, 2009, 2010) Cole (FM 2012, forthcoming) Robb and Robinson (RFS 2012, forthcoming) Cole-Sokolyk

9. Related Literature: Trade Credit at Privately Held Firms: Petersen and Rajan (RFS 1997) Berger and Udell (JBF 1998) Cunat (RFS 2007) Cole (SBA Research Study 2010) Giannetti et al. (RFS 2011) Robb and Robinson (RFS 2012, forthcoming) Cole-Sokolyk

10. Data: Kauffman Firm Surveys (KFS) The KFS is the largest and most comprehensive dataset on U.S. start-up firms, providing information on firms’ use of credit, as well as various firm and owner characteristics. It tracks a panel of 4,928 U.S. businesses established during 2004. Firms are a stratified random sample of all U.S. start-ups in 2004. As of year-end 2011, data were available for the initial year and for five follow-up years (2004-2009). Plans are in place for follow-up surveys for two additional years. (2010 data was released earlier this year.)

11. Cole-Sokolyk Research Design First, we investigate what factors explain a start-up’s decision to use, or not use, any credit at start-up. (Binary Logit) Conditional upon using any credit, we examine the decision as to what type of credit to use: business, personal or trade. (Bivariate Probit with selection) Conditional upon using any credit; we examine what portion of total credit is allocated to each of our three categories: business, personal and trade. (Two-tailed Tobit)

12. Credit Categories: Trade Credit: Firm reported that it used trade credit during the reference year Business Credit: includes either of the following categories: business bank loan, business credit line, business loan from nonbank institutions, business credit card, business credit card issued on owner’s name, business loan from the government, business loan from other businesses, business loan from other sources. Personal Credit: includes either of the following categories: personal bank loan by the primary owner, personal bank loan by other owners, the primary owner’s personal credit card used for business purposes, and the other owners’ personal credit cards used for business purposes. Any Credit: Firm reported that it used any trade credit, business credit, or personal credit Cole-Sokolyk

13. Differences from Robb and Robinson (2012): Whereas RR focus on amounts of credit, we focus on incidence of use. This is important because of zero mass points, and highly skewed distributions for non-zero use of credit, especially sub-types. The median amount can be zero while the mean is positive, as it is for trade credit, business credit, and personal credit. We also look at portion of total credit allocated to our three categories. RR look at portions to total “financial capital,” which they define as all debt plus all equity, but excluding trade credit. Cole-Sokolyk

14. Differences from Robb and Robinson (2012): RR combine owner and business credit, whereas we analyze them as separate, distinct categories. RR justify their classification because “research has shown that personal guarantees and personal collateral must often be posted to secure financing for startups.” As evidence, they cite a paper on the subject by Avery et al., JBF 1998 (and two other studies that cite Avery et al.). – In fact, Avery et al. report that 60% of SBLs are not personally guaranteed. – In addition, Avery et al. exclude credit card loans, which account for large portion of KFS business loans. Business credit cards typically are an unsecured form of credit. – Finally, Cole (2012) finds that privately held corporations use significantly more leverage than proprietorships. This should not be true if most business loans are personally guaranteed. Cole-Sokolyk

15. Table 2 (Panel A): Use of Credit by Start-Ups by Year

16. Cole-Sokolyk Table 2 (Panel A): Use of Business Credit by Startups by Year

17. Cole-Sokolyk Table 2 (Panel A): Use of Personal Credit by Startups by Year

18. Cole-Sokolyk Table 2 (Panel B): Exclusive Use of Credit by Type

19. Cole-Sokolyk Table 2 (Panel C): Use of Multiple Types of Credit

20. Cole-Sokolyk Table 3: Amounts of Credit Used

21. Cole-Sokolyk Binary Logit Regressions: Use Credit = f (Firm Characteristics, Owner Characteristics) where: Use Credit is the dependent variable which takes on a value of one if the firm indicated that it used credit and a zero otherwise; Firm Characteristics is a vector of variables related to the firm that are expected to influence availability of credit, such as credit score, size, profitability; and Owner Characteristics is a vector of variables related to the primary owner that are expected to influence availability of credit, such as prior work and start-up experience, age, education, race, ethnicity, and gender.

22. Cole-Sokolyk Table 7: Determinants of Credit Use at Start-Up: Firm Characteristics (Odds Ratios)

23. Cole-Sokolyk Table 7: Determinants of Credit Use at Start-Up: Owner Characteristics (Odds Ratios)

24. Cole-Sokolyk Two-Limit Tobit Regressions: T/B/P Credit Prt. = f (Firm Characteristics, Owner Characteristics) where: T/B/P Credit Prt. is equal to the proportion of total liabilities financed by trade credit, business credit, or personal credit, respectively; and Firm Characteristics is a vector of variables related to the firm that are expected to influence availability of credit, such as credit score, size, profitability; and Owner Characteristics is a vector of variables related to the primary owner that are expected to influence availability of credit, such as prior work and start-up experience, age, education, race, ethnicity, and gender.

25. Cole-Sokolyk Table 8: Determinants of the Percentage of Total Liabilities: Trade, Business or Personal Credit: Firm Characteristics

26. Cole-Sokolyk Table 8: Determinants of the Percentage of Total Liabilities: Trade, Business or Personal Credit Owner Characteristics

27. Conclusions: In this study, we use data from the Kauffman Firm Survey to analyze how U.S. start-up firms finance their assets. Our study contributes, in several important ways, to both the entrepreneurship and finance literatures. First, we contribute to the growing literature that analyzes data on start-up firms from the Kauffman Firm Survey. (See, e.g., Coleman and Robb 2009; Fairlie and Robb 2009; Cole 2011; Coleman and Robb, 2011; Robb and Watson, 2011; and Robb and Robinson, 2012). We present new evidence on the use of credit by start-up firms during their first five years of existence. Second, we contribute to the strand of the capital-structure literature that focuses on privately held firms. (See, e.g., Ang, 1992; Berger and Udell, 1998; Cole, 2008; Ang, Cole and Lawson, 2010; and Robb and Robinson, 2012). We provide new evidence on the mix of credit upon which privately held firms rely at start- up and during their first five years of life. Cole-Sokolyk

28. Conclusions: Third, we contribute to the trade-credit literature on privately held firms. (See, e.g., Petersen and Rajan, 1997; Cunat, 2007; Cole, 2010; and Giannetti et al., 2011.) We document the importance of trade credit to start-up firms during their first five years of life, including its explosive growth during the first year. Finally, we provide new evidence to the growing literature on zero-debt firms. (See, e.g., Strebulaev, 2006; and Cole, 2012). We document that about 25% of privately held firms are financed exclusively with owners’ equity at start-up, and that this percentage changes by very little during the firms’ first five years of life. Cole-Sokolyk