What Do We Know about the Capital Structure of Privately Held US Firms? Evidence from the Surveys of Small Business Finance

• Date: 01 December 2013
• DOI: http://doi.org/10.1111/fima.12015
• Author: Rebel A. Cole
• Published date: 01 December 2013

What Do We Know about the Capital

Structure of Privately Held US Firms?

Evidence from the Surveys of Small

Business Finance

Rebel A. Cole∗

This study examines the capital-structure decisions of privately held US firms using data from

four nationally representative surveys conducted from 1987 to 2003. Book-value firm leverage,

as measured by either the ratio of total loans to total assets or the ratio of total liabilities to

total assets, is negatively related to firm age and minority ownership;and is positively related to

industry median leverage,the corporate legal form of organization, and to the number of banking

relationships. In general, these results provide mixed support for both the Pecking-Order and

Trade-Off theories of capital structure.

What do we know about the capital structure of privately held US firms? The answer is

“not much,” as almost all existing empirical studies of the capital structure of US firms have

relied upon Compustat data for large corporations with publicly traded securities.1Although

such large, publicly traded corporations hold the vast majority of business assets, they account

for only a small fraction of the number of business entities. In the United States, for exam-

ple, there are fewer than 10,000 firms that issue publicly traded securities, yet according to

the US Internal Revenue Service, there were approximately 30 million small businesses as of

2006.2

Privately held firms are vital to the US economy.According to the US Small Business Admin-

istration, small businesses account for half of all US private sector employment, produce more

I thank seminar participants at DePaulUniversity, at the Melbourne Centre for Financial Studies, and at the 2008 Annual

Meeting of the Academy of Entrepreneurial Financein Las Vegas, NV. In addition, I thank CharlesOu and Ivo Welch for

helpful comments and suggestions. The US Small Business Administrationprovided funding for this research. In addition,

I thank James Ang, Jonathan Dombrow, Dan Lawson, Chad Mowtry, Charles Ou, and Ivo Welch for helpful comments

and suggestions. The comments of an anonymous referee and Bill Christie (Editor) significantly improved the content

and exposition of the paper.Any remaining errors are solely the responsibility of the author.

∗Rebel Cole is a Professor of Financein the Driehaus College of Business at DePaul University in Chicago, IL.

1See Frank and Goyal (2008) for a recent summary of the literature on the capital structure of public US companies. Two

notable exceptions that look at the capital structure of private US firms are Robb and Robinson (2010), which analyzes

the capital structure of start-up firms using data from the Kauffman Firm Survey, and Ang, Cole, and Lawson (2010) that

analyzes the capital structure of small firms using data from the 2003 Survey of Small Business Finances. In addition,

Brav (2009) examines the capital structure of privatelyheld f irms in the UK.

2See the US Internal Revenue Service statistics for nonfarm sole proprietorships at http://www.irs.gov/

taxstats/indtaxstats/article/0,,id=134481,00.html, for partnerships at http://www.irs.gov/taxstats/bustaxstats/article/0,

id=97153,00.html, and for corporations at http://www.irs.gov/taxstats/bustaxstats/article/0,,id=97145,00.html. The year

2006 is used for reference, as it was the latest year for which statistics wereavailable at the time this article was written.

Financial Management •Winter 2013 •pages 777 - 813

778 Financial Management rWinter 2013

than half of the nonfarm private gross domestic product (GDP), and generated almost two-thirds

of the net job growth over the past 15 years.3

Privately held firms also are fundamentally different from the public firms that have enjoyedso

much attention from researchers. Ang (1991, p.1) writes “the theory of modern corporate f inance

is not developed with small businesses in mind” as “the stylized theoretical firm is assumed to

have access to external markets for debt and equity” and “shareholders have limited liability and

own diversified portfolios.” Berger and Udell (1998, pp. 615-616) write “the private markets that

finance small businesses . . . are so different from the public markets that fund large businesses”

and “perhaps the most important characteristic defining small business f inance is informational

opacity.” Ang, Cole, and Lin (2000) find that ownership is much more highly concentrated at

private firms so that owner-manager agency problems are typically less severe than at public

companies.

Ang (1992, pp. 194-196) includes a number of reasons as to why privately held firms should

be more highly levered than public firms. These include the value of reputation and informal

relationships, no (or partial) limited liability, fewer lenders, quasi-equity and unreported equity,

and behavioral issues such as risk-taking overoptimistic entrepreneurs.

He also suggests reasons for lower leverage.These include tax disadvantages relative to public

firms, the desire to maintain control leading owners to forego projects that require outside

financing, a lack of diversification on their personal portfolio, and the high costs to a lender

of monitoring a large number of small businesses. For these reasons and many more, there is

little reason to think that the fundamental determinants of capital structure at public companies

documented by Frank and Goyal (2009) hold true for private firms.

Therefore, a fundamental and unresolved issue in the finance literature is what factors are

reliably important in determining the capital structure of privately held firms. I examine the

capital structure of private US firms based upon data from four nationally representative surveys

conducted by the Federal Reserve Board spanning 16 years from 1987 to 2003.

My univariate results indicate that firm leverage at privately held firms, as measured by either

the ratio of total loans to total assets or by the ratio of total liabilities to total assets:

(1) is consistently higher at corporations than at proprietorships and partnerships;

(2) is consistently higher at larger firms than at smaller firms;

(3) is consistently higher at younger firms than at older firms; and

(4) is consistently lower at firms whose primary owner is female or black than at firms whose

primary owner is a white male.

I find that that privately held firms, in general, employ a comparable degree of leverage relative

to small publicly traded firms when leverage is measured by the ratio of loans to assets, but

employ less leverage when leverage is measured by the ratio of total liabilities to total assets.

This finding is quite different from Brav (2009), who reports that in the United Kingdom, private

firms use much more leverage than do public firms.

I find that leverage ratios by industry of privately held and public firms are highly correlated in

most years when leverage is measured by loans to assets, but less so when leverage is measured

by liabilities to assets. Hence, these differences appear to be driven by the use of trade credit.

Small firms are thought to me more reliant upon trade credit than are larger f irms.

3See “Frequently Asked Questions,” Office of Advocacy, US Small Business Administration (SBA) at:

http://www.sba.gov/sites/default/files/files/sbfaq.pdf. For research purposes, the SBA and Federal Reserve Board de-

fine small businesses as independent firms with fewer than 500 employees. I follow that definition in this research.

Cole rWhat Do We Know about the Capital Structure of Privately Held US Firms? 779

In addition to my univariate tests, I conduct multivariate tests where I use weighted-least-

squares regressions to analyze the determinants of my two leverage ratios. These results reveal

that firm leverage as measured either by the ratio of total loans to total assets or by the ratio of

total liabilities to total assets:

(1) is consistently and positively related to median industry leverage;

(2) is consistently higher at corporations than at proprietorships;

(3) is consistently lower at older firms;

(4) is consistently higher at firms with more bank and nonbank relationships;

(5) is consistently lower at profitable firms;

(6) is consistently higher at firms with more bank and nonbank relationships;

(7) is consistently higher at firms that have recently taken out a loan; and

(8) is consistently lower at minority-owned firms than at white-owned firms.

I also find a consistently negative relation between leverage and firm size at private firms,

whereas Frank and Goyal (2009) document a consistently positive relation at public companies.

Further analysis, however, reveals that mynegative association is driven by negative-equityf irms,

which make up between 8% to 22% of my samples. When I limit my analysis to positive-equity

firms, I f ind inconsistent results across the four surveys for the relation between leverage and

firm size. I also f ind that the consistently positive relation between leverage and profitability

disappears, as unprofitable firms are dispropor tionatelyfound in the negative-equity subsamples.

My study contributes to the capital-structure literature in at least five important ways. First,

I complement Frank and Goyal (2009), who document the factors that are reliably important in

predicting book-value leverage at public US companies. Here, I determine the factors that are

reliably important in predicting book-value leverage at privately held US companies.4

Second, I provide new evidence regarding how the use of financial institutions influences

capital structure, which also contributes to the literature on relationship lending (Petersen and

Rajan, 1994; Berger and Udell, 1995, 2002; Cole, 1998; Boot, 2000; Degryse and Cayseele,

2000; Detragiache, Garella, and Guiso, 2000; Ongena and Smith, 2000; Cole, Goldberg, and

White, 2004). As Berger and Udell (1998) write, “financial intermediaries play a critical role in

the private (capital) markets.” I find that a firm with no banking relationships has signif icantly

lower leverage, whereas a firm with multiple banking relationships has signif icantly higher

leverage than a firm with a single banking relationship. In contrast, Cole (1998) finds that a f irm

with multiple banking relationships is more likely to be denied credit on any particular credit

application. This suggests that the increased probability of denial on a particular application can

be offset by multiple credit applications at different prospective lenders.

Third, I provide new evidence regarding how the characteristics of the firm’s primary owner

influence capital structure, which contributes to a growing literature on this topic (Mishra and

McConaughy,1999; McConaughy, Matthews, and Fialko, 2001; Villalongaand Amit, 2006; Ang

et al., 2010). I find that minority-owned firms generally choose less leverage. This is consistent

with the existence of discrimination in the credit markets for small firms, as reported by Cavalluzzo

and Cavalluzzo (1998), Cole (1999, 2009), Cavalluzzo, Cavalluzzo, and Wolken (2002), and

Blanchflower, Levine, and Zimmerman (2003). None of my other owner characteristics are

consistently reliable in explaining firm leverage across the four surveys.

4Berger and Udell (1998) discuss the distribution of debt at small US firms based upon 1993 data, but do not analyze the

determinants of capital structure.