The Choice between Bank Debt and Trace Credit in Business Start-ups

The Choice between Bank Debt and Trace Credit in Business Start-ups This paper investigates the choice between bank debt and trade credit in business start-ups. While trade credit is more expensive than bank debt, suppliers tend to follow a more lenient liquidation policy when client firms encounter financial distress. As a result, suppliers are more willing to renegotiate the outstanding debt or grant additional debt whereas banks are more likely to liquidate borrowers upon default. Given the risky nature of business start-ups, we argue that the entrepreneur’s choice of debt instruments reflects these differences in liquidation policy between lenders and is thus determined by the venture’s failure risk, the entrepreneur’s private control benefits that are lost upon liquidation and the liquidation value of firm assets. Using unique data on 325 first-time business start-ups, we find that firms in industries with high historical start-up failure rates and entrepreneurs who tend to highly value private benefits of control use less bank debt. These effects are especially prevalent in start-ups where assets have a high liquidation value and thus banks are more likely to liquidate the venture following default. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Small Business Economics Springer Journals

The Choice between Bank Debt and Trace Credit in Business Start-ups

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Publisher
Springer US
Copyright
Copyright © 2007 by Springer Science+Business Media, Inc.
Subject
Business and Management; Management; Microeconomics; Entrepreneurship; Industrial Organization
ISSN
0921-898X
eISSN
1573-0913
D.O.I.
10.1007/s11187-006-9005-2
Publisher site
See Article on Publisher Site

Abstract

This paper investigates the choice between bank debt and trade credit in business start-ups. While trade credit is more expensive than bank debt, suppliers tend to follow a more lenient liquidation policy when client firms encounter financial distress. As a result, suppliers are more willing to renegotiate the outstanding debt or grant additional debt whereas banks are more likely to liquidate borrowers upon default. Given the risky nature of business start-ups, we argue that the entrepreneur’s choice of debt instruments reflects these differences in liquidation policy between lenders and is thus determined by the venture’s failure risk, the entrepreneur’s private control benefits that are lost upon liquidation and the liquidation value of firm assets. Using unique data on 325 first-time business start-ups, we find that firms in industries with high historical start-up failure rates and entrepreneurs who tend to highly value private benefits of control use less bank debt. These effects are especially prevalent in start-ups where assets have a high liquidation value and thus banks are more likely to liquidate the venture following default.

Journal

Small Business EconomicsSpringer Journals

Published: Jan 9, 2007

References

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