ABSTRACT. As the amount of information about an enter-
prise is generally not neutral with respect to firm size,
financiers have problems to identify the default risk associ-
ated with a borrower or to have control over a borrower’s
investments. This review paper analyses how various control
mechanisms are fit to reduce this information problem and
how various types of capital suppliers are endowed to finance
small business enterprises.
This review paper focuses on financing alterna-
tives for small business enterprises (SBEs). This
focus is warranted as the financial conditions of
small business differ from those of large business
(Lucas, 1978). Small and young firms often have
difficulty in signalling their creditworthiness.
Informational asymmetries between lenders and
borrowers and incentive asymmetries between
owners and managers are more pronounced in the
case of small firms than with large ones.
Consequently, small firms tend to be disadvan-
taged over large business in terms of access to
bank loans and they are very limited in the poten-
tial to issue stock. This paper aims at analysing
these problems from a theoretical perspective.
contrast to Chittenden et al. (1996), who study
factors that may affect the financial structure of
small firms, we focus on the alternative financing
mechanisms and capital suppliers. Thus, we aim
at complementing the discussion concerning SBE
finance (see Reid, 1996; Bornheim and Herbeck,
1998). Section 2 highlights the informational
asymmetries that arise in conjunction with external
financing. Section 3 goes into the co-ordination
mechanisms that exist to reduce the market imper-
fections. Section 4 analyses the financing alterna-
tives, both within the context of the life cycle
approach and in relation to the pecking order
framework. The conclusion is in section 5.
2. Financial market imperfections
The financial market distinguishes itself from the
real market regarding the fact that the exchange of
money is intertemporal: the investor exchanges
money at present against the promise of the
entrepreneur that it will be paid back in the future.
The transfer of finance from the investor to the
entrepreneur depends on the question whether the
promise of entrepreneurs is sufficiently credible.
Credibility is endangered by conflicting interests
between investors and entrepreneurs. Obviously,
the entrepreneur has incentives to renege on the
previous stated promise and to give in to oppor-
tunistic behaviour. The investor/lender does not
know with certainty the chance that the entrepre-
neur reneges because he is less informed about the
entrepreneur’s actions and intentions than the
entrepreneur himself. Moreover, the price mecha-
nism does not resolve the investor’s uncertainty
because it still does not restrain the high risk entre-
preneurs from applying for finance.
The effect of asymmetric information is that
well-deserving investment projects may not be
financed and undertaken at all or may not obtain
funding at reasonable cost. It results in adverse
selection in case of an ex ante information asym-
metry between the entrepreneur and its financier
with respect to its current operation, the quality of
the project and/or its prospects (Leland and Pyle,
1977). If the management has more information
Analytical Issues in External
Financing Alternatives for SBEs
Small Business Economics 12: 137–148, 1999.
1999 Kluwer Academic Publishers. Printed in the Netherlands.
Final version accepted on July 20, 1998
University of Amsterdam
Department of Economics
1018 WB Amsterdam