The Happy Story of Small Business Financ

Journal of Banking & Finance 31 (2007) 2648–2672
www.elsevier.com/locate/jbf
The happy story of small business financing

a,*
Ed Vos , Andy Jia-Yuh Yeh b, Sara Carter c, Stephen Tagg d
a
Department of Finance, Waikato Management School, University of Waikato, Private Bag 3105,
Hamilton, New Zealand
b
Financial Stability Department, Reserve Bank of New Zealand, New Zealand
c
Department of Management and Organization, University of Stirling, United Kingdom
d
Department of Marketing, University of Strathclyde, United Kingdom
Received 9 June 2005; accepted 21 September 2006

Available online 26 January 2007
Abstract
We examine two data sets, one from the UK (n = 15,750) and one from the US (n = 3239), to
show that SME financial behaviour demonstrates substantial financial contentment, or ‘happiness’.
We find fewer than 10% of the UK firms seek significant growth and only 1.32% of US firms list a
shortage of capital other than working capital as a problem. Financial performance indicators
(growth, return on assets, profit margin) were not found to be determinants of SME financing activ-
ities, as might be expected in a ‘rational’ risk–return environment. Younger and less educated SME
owners more actively use external financing – even though more education reduces the fear of loan
denial – while older and more educated (‘wiser’) SME owners are found to be being less likely to seek
or use external financing. The contentment hypothesis for SME financing also extends to high-
growth firms in that we show that they participate more in the loan markets than low-growth firms.
By way of contrast to the finance gap hypothesis, the contentment hypothesis observes the impor-
tance of social networks (connections) [for finance] and confirms the ‘connections – happiness’ link-
age in the literature on happiness while doubting the theoretical suitability of Jensen and Meckling
[Jensen, M., Meckling, W., 1976. Theory of the firm: Managerial behavior, agency costs, and own-
ership structure. Journal of Financial Economics 3, 305–360.] base-case analysis for SMEs.
2007 Elsevier B.V. All rights reserved.
*
Corresponding author. Tel.: +64 7 856 2889; fax: +64 7 838 4145.
E-mail addresses: evos@waikato.ac.nz (E. Vos), andrew.yeh@rbnz.govt.nz (A. Jia-Yuh Yeh), sara.carter@
stir.ac.uk (S. Carter), s.k.tagg@strath.ac.uk (S. Tagg).
0378-4266/$ - see front matter 2007 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankfin.2006.09.011
E. Vos et al. / Journal of Banking & Finance 31 (2007) 2648–2672 2649
JEL classification: D82; G19; G29; L33
Keywords: Small- to medium-sized enterprises (SMEs); Small business financing; Informational opacity; Growth;
Human capital; Sustainable; Happiness
1. Introduction
The finance gap hypothesis suggests that small and medium-sized enterprises (SMEs)
suffer from a shortage of finance and that informational asymmetry is the likely cause
of this problem (Ang, 1992; Avery et al., 1998; Berger and Udell, 1998; Gregory et al.,
2005). Financial analysis of SMEs, therefore, traditionally begins with the presumption
that growth is expected (Berger and Udell, 1998; Gregory et al., 2005), but market failures
(Stiglitz and Weiss, 1981) or credit rationing (Storey, 1994) restrict growth. Further, SMEs
‘over’ or ‘under’ invest (Ang, 1992) and suffer from agency costs (Ang et al., 2000). It
seems that SMEs are financially frustrated.
We paint a very different picture. We examine SME financial behaviour across two data
sets, one from the UK (n = 15,750) and one from the US (n = 3239), to show that SME
financial behaviour demonstrates substantial financial contentment, or ‘happiness’. By
focusing on SME use of external sources of funds, we suggest that utility maximization
is observed in the financial behaviour of SMEs, who we find to be a non-growth orien-
tated, or ‘sustainable’, form of business. Furthermore, we show that SMEs who are more
interested in growth participate more in the use of and access to external sources of funds.
In short, we tell the happy story of small business financing.
Our findings are not only consistent with the literature showing that for SMEs ‘connec-
tions’ are essential for [financial] success (Petersen and Rajan, 1994; Petersen and Rajan,
1995; Petersen and Rajan, 2002; Cole, 1998), but suggest that ‘connections’ themselves pro-
vide utility. To conclude the paper, we briefly reflect on the differing world views which result
in ‘seeing’ financial frustration (assumption: we are all separate individual utility maximizers
(Jensen and Meckling, 1976)) as a ‘core reality’ – as in the publicly listed environment, and
‘seeing’ contentment (assumption: we are all connected, and connections provide utility
(Diener and Seligman, 2004)) as a core reality – as in the SME environment. This paper is
important because we add to the literature support for an alternative to the finance gap
hypothesis for SMEs – let us call it the contentment (or ‘happiness’) hypothesis – by provid-
ing more detailed documentation of the factors that determine small business financing
activity.
After further motivating the paper within the literature in Section 2, in Section 3 we
identify many determinants of the use of multiple sources of funds in a large UK sample.
For cross-country comparisons, we then analyze the determinants of loan applications,
approvals and fear of denial in a US sample in Section 4. Section 5 summarizes and
concludes.
2. Literature and approach
That there are financial differences between the SME form of business and the publicly
listed form of business have long been agreed. Vos (1992a) simply states that the two forms
2650 E. Vos et al. / Journal of Banking & Finance 31 (2007) 2648–2672
of business are not financial clones of each other. Ang (1992) speculates on the nature of
those differences by comparing and contrasting possible SME financial behaviour with
what might be expected from a publicly listed firm. Differences in SME financial perfor-
mance from the ‘norm’ of the well-studied publicly listed firm have provided structure
for the literature. For instance, we have learned that SME owners are rarely inspired to
invest some of the firm’s cash flows in suboptimal projects (Fama and Jensen, 1983;
Vos and Forlong, 1996); are not inherently riskier in terms of their propensity to ‘fail’
(Watson and Everett, 1993; Watson and Everett, 1996; Watson and Everett, 1998; Everett
and Watson, 1998; Headd, 2003); and have returns that are not related to bank-generated
risk scores, but rather to the degree of involvement by the owner with more involvement
being more profitable (less risky) (Vos and Smith, 2003). We also know that SME owners
self-select to run businesses that best match their own areas of expertise (Bates, 1991;
Wiklund et al., 2004). In fact, most SME owners, who are aware of growth prospects,
competitive forces, seasonality etc., perceive lower fundamental risk than others (Vos,
1992b,c, 1995).
In general, entrepreneurs mitigate risk by way of the development of technical skills and
practical experiences. We tease out evidence of this risk-mitigation behaviour as we estab-
lish ways in which SMEs interact with external sources of finance. While Bitler et al. (2001)
document the financial services used by SMEs, they say that ‘‘understanding the factors
that affect small business financing require a rigorous analytical framework that accounts
for the financial characteristics of the borrowers and the markets in which they operate.’’
In this spirit we examine determinants of the use of and access to external sources of funds
as well as determinants for fearing loan denial. We find that firm financial characteristics
are not important considerations, as might be expected in a rational risk–return
environment.
The literature points toward SME financial contentment and control by suggesting
that most SMEs do not opt for rapid growth (Curran, 1986; Hakim, 1989) and that
most SME owners prefer to retain control by not applying for external capital (Curran,
1986; Jarvis, 2000). Internal equity, as opposed to external equity, is the main source of
finance for SMEs (Ou and Haynes, 2003). Most SMEs rely on internal sources of funds
(owner’s starting capital, owner’s loans, and retained earnings) and external debt from
financial institutions to finance their business operations and real options for growth.
This suggests that there appears to be a pecking order of SME finance from insiders
to financial institutions, then to non-financial lenders (with only 34 out of 3561 US
SMEs acquiring equity from external parties). And, there is evidence that SMEs whose
growth ambitions are above average have better access to external finance (Storey,
1994). For those getting loans, Mester (1997) says banks discovered that business owner
characteristics rather than business characteristics are better predictors of commercial
business loan performance. We also find owner’s characteristics to be determinants of
financing activity.
Yet, the conventional wisdom suggests that informational opacity hinders SMEs’ access
to external funds (Ang, 1992; Berger and Udell, 1998; Gregory et al., 2005). It is thus pre-
dicted that there is a ‘finance gap’ for SMEs (Ang, 1992; Avery et al., 1998), also charac-
terized as a result arising from market failure or credit rationing (Stiglitz and Weiss, 1981;
Storey, 1994). SMEs, it seems, live in a world where growth is the normative expectation
but they are unable to grow due to informational asymmetry which results in a finance gap
contributing to the inability to grow.
For example, as Berger and Udell (1998) study SMEs’ capital structure (and, therefore,
financing) decisions, they do so within a financial-growth cycle paradigm where different
capital structures are optimal at different points in the cycle. Most SMEs rely on internal
sources of funds in their early years of operation. As SMEs grow in size and age, these
firms ought to have better access to external funds. This concept follows from the fact that
bigger and older SMEs have better collateralizable assets and technical sophistication to
reduce informational opacity. Gregory et al. (2005) empirically support this paradigm.
Growth is the supposed goal, with firms progressing through a life-cycle. Unlike publicly
held businesses, unlisted businesses are not required to provide private information to pro-
spective investors, regulators, creditors, and customers (Ang, 1992). In the absence of
transparent disclosure, SMEs are less able to send credible signals to venture capitalists,
banks, or trade creditors. This lack of transparency implies that SMEs have limited access
to external funds due to informational asymmetries. Further, the difficulty with gaining
external capital impedes SMEs’ accumulation of revenue-generating assets and potential
growth. In general, this story has been labelled as the finance gap for privately held busi-
nesses (Storey, 1994; Deakins, 1996; Berger and Udell, 1998).
Storey’s (1994) overview of bank lending to SMEs highlights a number of assumptions
that underpin the research literature: asymmetric information; agency issues; higher objec-
tive risk in lending to small firms; costly monitoring; competing banks; the variability of
entrepreneurs with regard to their ability, honesty and motivation; and the view that entre-
preneurs gain from increased project valuation while banks gain only from repayment.
Storey’s review of demand and supply side factors sheds light on the following conclusion:
it is ‘‘perfectly feasible for there to exist a ‘gap’ in the sense that rarely are small sums of
equity provided, and yet there has been no evidence of market failure in the sense of a case
for government to intervene’’ (Storey, 1994, pp. 250). We provide evidence as to why there
does not appear to be market failure by showing that few SMEs desire external capital in
the first place and also by showing that those who are more interested in growth do indeed
participate more in the market for capital than those who are less interested.
If there is a so-called ‘finance-gap’, this gap occurs in a world where personal relation-
ships and social interaction (which we call ‘connectedness’, as compared to an arm’s length
‘separate’ environment ala Jensen and Meckling (1976)) matter to the SME, including
when it comes to access to capital. Social relations are crucial for SMEs to broaden the
available sources of funds (Petersen and Rajan, 1994; Petersen and Rajan, 1995; Petersen
and Rajan, 2002). Cole (1998) shows that potential lenders are more likely to extend credit
to SMEs in the presence of pre-existing transactions. This behaviour follows from the fact
that previous banking relations help convey private information about SMEs’ near-term
financial performance. Conditional on past experiences with viable and trustworthy small
businesses, lenders perceive further loans to be less risky (Diamond, 1991). Moreover,
sociologists demonstrate that SMEs whose commercial transactions are embedded in
social attachments with their lenders receive lower interest rates on loans (Uzzi, 1999).
At the network level, SMEs are more likely to receive loan approval and to make lower
interest payments if their business ties motivate SME peers to share private resources while
SME owners’ social ties facilitate access to public information on market prices and loan
opportunities. According to Uzzi and Gillespie (2001a,b), networks of social ties enhance
SMEs’ competitive advantage, creating knowledge spillover effects into transactions with
trading partners who do not exist in the networks of ties. In essence SME owners’ social
ties ensure the ongoing cash inflows from financial institutions and creditors. Indeed, the
theme of Franks et al. (2003) is that informal relations of trust are the primary stimulus for
the development of capital markets.
We observe that the continuum of the ‘connected’ – ‘separate’ presumptions of the nature
of human relationships are seen as a key reason for alternative SME financial performance
compared to what is expected of a publicly listed firm. We also note that the link between
social connections and happiness is consistent with the emerging literature on well-being
(Diener and Seligman, 2004). This paper is important because we suggest that since SMEs
exhibit signs of financial contentment then this form of business should be honoured – even
if they shun [significant] growth – if spreading of happiness is a policy goal.
Given the importance of ongoing social relationships for the supply of capital, the
potential impact of loan denial is greater for growth-oriented SMEs. Thus we would
expect these firms to apply for new loans less often. Further, if the finance-gap hypothesis
holds true, growth-oriented SMEs are less likely to acquire loan approval to fund growth
opportunities. This motivates the structure of part of our analysis. Suppose that owner–
managers are aware of the finance gap. If this gap exists, SMEs may potentially upset
the well-established social relations with the existing creditors and in turn may receive loan
denials. We would expect owner–managers to self-select and apply less often for new loans
in times of growth, in order not to damage their access to capital. Following this line of
reasoning, SMEs whose growth ambitions are above average could be expected to ‘suffer’
from insufficient funds and, logically, use fewer sources of external funds. Also, these
growth-oriented SMEs could be expected to be financially constrained if and only if their
loan applications are least likely to be approved. After controlling for size, our analysis
compares high-growth and low-growth SMEs’ use of external funds (in the UK data) as
well as these SME’s propensity to apply for loans (in the US data) and show that high-
growth firms use and apply for external loans more often than low-growth firms.
We apply this analysis to two data sets, providing some cross-country comparisons.
The much larger (n = 15,750) UK survey occurred in a bearish market. In contrast, the
US survey was much smaller (n = 3561) and conducted in a bullish market. However, both
data sets only have survivors in them. Therefore, small businesses that fail due to a lack of
finance are not included. This survivorship bias leads to the inclusion of only those SMEs
that, at the time of the survey, were successful in remaining in business. Our analysis could
underestimate the importance of access to finance for survival.
3. Analysis of UK SME financing
The UK data is derived from the third biennial membership survey of the Federation of
Small Businesses (FSB), undertaken in 2004 (Carter et al., 2004). With 155,000 members,
the FSB is the largest voluntary membership business association, and its biennial mem-
bership survey the largest business survey, in the UK. The 2004 FSB survey attracted
18,635 responses, a response rate of 12.02%.
The profile of survey respondents bears many similarities to both the regional and the
industry distribution of UK VAT registered enterprises (Office for National Statistics,
2003; Small Business Service, 2003). As Table 1 shows, the regions comprising the highest
levels of survey response are South East England (19.8%) and South West England
(17.3%). These two regions, together with London, comprise 41.2% of respondents.
Although there are differences in the London boundary definitions used, these three areas
comprise a similar proportion (41.8%) of VAT registered enterprises.
Table 1
Regional and industry profile of FSB survey respondents and UK VAT registered enterprises
E. Vos et al. / Journal of Banking & Finance 31 (2007) 2648–2672

a b
UK RDA area Survey no. Survey % % UK VAT reg. Industry sector Survey no. Survey % % UK VAT reg.
Enterprises enterprises
c
London 766 4.1 16.1 A./B. Agriculture, Forest, Fishing 630 3.4 8.6
c
South East 3699 19.8 15.7 C. Mining & Quarrying 51 0.3 0.1
c
South West 3224 17.3 9.3 D. Manufacturing 1985 10.7 8.8
West Midlands 1426 7.7 8.3 E. Energy & Water 132 0.7 –
East Midlands 1599 8.6 6.8 F. Construction 1908 10.2 10.9
East England 1083 5.8 10.1 G. Retail, Wholesale, Motor 4179 22.4 22.2
Yorks Humber 1105 5.9 7.1 H. Hotels, Pubs, Restaurants 1315 7.1 6.8
North East 537 2.9 2.5 I. Transport & Communication 759 4.0 4.6
North West 1720 9.2 9.6 J.-O. Fin. Bus. Other Services 4699 25.2 37.8
Wales 836 4.5 4.4 Other 2810 15.1 –
Scotland 2045 11.0 7.0
N. Ireland 390 2.1 3.2
Not answered 205 1.1 – Not answered 167 0.9 –
Total 18,635 100 100 Total 18,635 100 100
The descriptive statistics of the third biennial membership survey of the Federation of Small Businesses (FSB), which was undertaken for small- to medium-sized
enterprises in 2004. In total, 18,635 responses were received, a response rate of 12.02%. To date, the FSB is the largest voluntary membership business association and
to date, the FSB’s survey is the largest business survey in the UK. The following table summarizes the regional and industry distribution of UK VAT registered
enterprises included in the 2004 survey.
a
Small business service statistical press release ‘Business Start-Ups and Closures: VAT Registrations and Deregistrations in 2002’, 21st October 2003.
b
Office for National Statistics ‘Commerce, Energy & Industry: Size Analysis of UK Businesses, PA 1003, Data for 2003’, Table 1a, published in June 2003.
c
Differences between survey responses and VAT data in London, South East and South West are due to differences in London boundary definitions.
2653
Table 1 also shows both the industry profile of respondents and the industrial distribu-
tion of UK VAT registered enterprises. Survey responses reflect the heterogeneity of the
SME sector. Over a quarter (25.2%) operate in the services sectors, and a further 22.4%
in retail, wholesale and motor trades. Manufacturing (10.7%), construction (10.2%) and
hotels, pubs and restaurants (7.1%) are also well represented. Overall, there are close sim-
ilarities between the industry profiles of survey respondents and VAT registered
enterprises.
Table 2 presents the key characteristics of the FSB survey respondents. The legal form
of business closely reflects that of VAT registered enterprises, in which 43% are registered
as limited companies, 34% as sole traders and 21% as partnerships (Office for National
Statistics, 2003). The age and gender profiles of the sample also closely mirror known own-
ership patterns within the UK (Small Business Service, 2003). Just over a quarter (25.2%)
had started their business within 3 years prior to the survey, with the remainder operating
older enterprises. The median sales turnover was between £100,000 and £500,000 and the
mean full-time equivalent employment was 6.3.
Table 2 also presents the 2-year business growth objectives of respondents. The largest
proportions report an objective of moderate expansion (49.1%) or to remain the same size
(24.7%). Fewer than 10% want to either sell (6.9%) or to hand on (1.9%) their businesses.
Table 2
UK FSB survey sample characteristics
Sample characteristics No. % Sales turnover (Q20)
Years in business (Q1) Less than £25,000 1483 8.0
Under 3 4693 25.2 £25,001–£50,000 2442 13.1
4–5 years 3514 18.9 £50,001–£100,000 3009 16.1
6–10 years 3240 17.4 £100,001–£500,000 6773 36.3
11–20 years 3354 18.0 £500,001–£1m 2146 11.5
21–30 years 2206 11.8 £1m–£5m 1518 8.1
More than 31 years 36 0.2 More than £5m 160 0.9
Legal form (Q2) Full-time equivalent employment
Limited company 8448 45.3 0 1873 10.1
Sole trader 5934 31.8 1 2774 14.9
Partnership 3889 20.9 2–4 7073 38.0
Age of owner (Q4) 5–9 3787 20.3
Under 21 157 0.8 10–49 2881 15.5
22–34 1790 9.6 50–99 185 1.0
35–44 4482 24.1 100+ 62 0.3
45–54 5909 31.7 Growth objective (Q12)
55–64 5180 27.8 To expand moderately 9149 49.1
Over 65 1023 5.5 To remain about the same size 4603 24.7
Gender of ownership (Q5) To grow rapidly 1543 8.3
Male owned 9324 50.0 To sell the business 1278 6.9
Female owned 2732 14.7 To downsize/consolidate business 592 3.2
Male and female co-owned 6454 34.6 To close it down 381 2.0
To hand on business/succession 356 1.9
Sales turnover (Q20)
Less than £25,000 1483 8.0
£25,001–£50,000 2442 13.1
The average characteristics of the FSB survey respondents (see the descriptive legend of Table 1).
Rapid growth is cited as the main objective for just 8.3% of the total sample. Hence, less
than one-tenth of UK SMEs opt for rapid growth. For these firms expansion is clearly
beyond their retained-earnings capabilities. Respondents in the younger age groups (under
34 years) and those SMEs operating new businesses (under 3 years) are much more likely
to report a rapid growth objective. In contrast, respondents in the older age groups (over
55 years) and those operating mature enterprises are more likely to want to close, sell and
hand on their business and less likely to aspire to rapid growth. Ambition for rapid growth
decreases incrementally, while ambitions for closure, sale, succession or remaining the
same size increase incrementally, with years in business.
Out of 26 itemised potential sources of business finance in the last 2 years, five sources
were used by more than a quarter of respondents. Bank overdraft, used by 50.8%, is the
most frequently used source, while personal savings (30.6%), bank loans (29.5%), retained
profits (28.5%) and credit card debt (25.5%) are also frequently used. Equally noteworthy
is the limited use of other finance sources. Only a small minority make use of leasing
(11.5%) and factoring (3.7%), and few use informal finance sources, such as finance from
family (8.4%) and friends (3.1%). Rapid growth serves as a key objective for 8.3% of the
sample, the use of venture capital (0.8%) and informal business angel or private investor
finance (0.7%) is insignificant.
To better understand the determinants of UK uses of external sources of funds, we run
the following unweighted logit regression to explore for significant variables, in the first
instance:
MSFi ¼ bYRbusi YRbusii þ bOwnAge OwnAgei þ bGrowthAmb GrowthAmbi
X
5 X
10
þ bln S ln S i þ bSG SGi þ bPG PGi þ c1;i OrgFormi þ c2;ii SWi
i¼1 i¼1
X
7 X
6 X
3
þ c3;i MainCusi þ c4;i MainMari þ c5;i OwnGenderi
i¼1 i¼1 i¼1
X
7 X
3
þ c6;i BusiObji þ c7;i Ratei ; ð1Þ
i¼1 i¼1
where
MSF is set at 1 if the SME has more than two sources of funds, and 0 otherwise,
YRbusi represents the number of years in business (FSB 2004: Question 1),
OwnAge denotes the main SME owner’s age (scaled from 1 to 6; Q4),
GrowthAmb denotes the number of ticks in answer to (Q13) which asks which of 19 busi-
ness activities are planned in the next 2 years,
ln S denotes the natural logarithm of total net sales (Q20),
SG indicates whether sales turnover has increased or decreased in the most recent year
(Q22),
PG indicates whether profitability has increased or decreased in the most recent year
(Q23),
OrgForm denotes the organizational form (Q2),
SW denotes the main strengths and weakness (scaled from 1 to +1; Q18),
MainCus represents the main customer group that contributes to more than 50% of sales
(Q14),
MainMar represents the main market group that contributes to more than 50% of sales
(Q15),
OwnGender denotes the main owner’s gender (Q5),
BusiObj indicates the major business objective (Q12),
Rate denotes the perceived rate of change (scaled from 1 to +1; Q17).
Notice that Eq. (1) first includes the discrete-numbered, index variables that summarize
the SME’s financial performance and accumulation of ‘wisdom’ (owner’s age and on-the-
job training) followed by several qualitative dummy variables that summarize the SME’s
firm and owner characteristics. Our rationale for using MSF as the qualitative dependent
variable is twofold. First, multiple sources of funds provide entrepreneurs the discretion to
sponsor projects with a mix of internal and external finance. With more alternative sources
of funds, SMEs usually find it easier to start new investments for firm expansion or refi-
nance existing projects for stability. Second, SMEs’ internal funds are largely comprised of
retained profits and entrepreneurial injections of cash from their owners and/or non-man-
aging stockholders. Our construction of the qualitative dependent variable, MSF, is meant
to allow for the two main sources of internal funds. In brief, we are interested in the deter-
minants of the use of multiple sources of funds for UK SMEs.
A more complete understanding of the finance-gap would require information about
the access to, as well as use of, multiple sources of funds – both for start-up and existing
SMEs. A limitation of this study is that this UK data set does not directly examine ‘access’
issues. However, the following US data set does permit an examination of ‘access’-related
issues. The concluding comments of this paper paint a pattern of financial behaviour
across both data sets. This pattern is consistent with the theme that SME financial behav-
iour demonstrates substantial contentment of entrepreneurs. While not directly providing
evidence for or against the finance gap, we suggest that the data tell a story which stands in
contrast to what ‘finance-gap’-based theory in a socially connected financial environment
would predict. And, we should recall that this analysis also suffers from a survivorship
bias.
Table 3 summarizes the logistic regression results for Eq. (1). Points worthy of mention
include:
• Both the number of years owning the business and the main owner’s age are negatively
related to SMEs’ use of more than two sources of funds (p-values less than 0.0001). This
implies that the accumulation of experience – both in the business and at ‘life’ – exac-
erbates the owner’s level of loss aversion. In turn, this increase in loss aversion leads to
a lower propensity to use alternative sources of capital. For these UK SMEs, it seems
easier to use more capital from the existing lenders (as compared to new creditors) due
to the establishment of social networks and firm reputation. Another possible interpre-
tation is that since firms that achieve rapid growth would continually be leaving the
sample (firm size limited to less than £500,000) these findings suffer from a self-selection
bias. Nevertheless, many other findings in this paper – including analysis of the US data
below as it relates to owner’s age and loan approval – support our story.
• Entrepreneurs who have more management adjustments are likely to use more sources
of finance (p-value less than 0.0001). This positive link between management adjust-
ments expectations and actual use of multiple sources of funds suggests that entrepre-
neurs who anticipate expansion for their businesses seem able to use additional external
Table 3
Logistic regression of MSFs on SME characteristics (UK)
Parameter ML estimated coefficients Odds ratio estimates Wald v2 p-value
YRbusi 0.0623 0.940 21.083 <0.0001
OwnAge 0.1496 0.861 76.893 <0.0001
GrowthAmb 0.1803 1.198 463.198 <0.0001
ln S 0.2263 1.254 29.609 <0.0001
SG 0.1379 1.148 11.959 0.001
PG 0.2351 0.790 34.908 <0.0001
Org1 0.3160 0.729 1.663 0.197
Org2 0.3880 0.678 1.472 0.225
Org3 0.2477 0.781 0.582 0.446
Org4 0.0121 1.012 0.002 0.961
Org5 0.1210 0.886 0.240 0.624
SW1 0.0654 0.937 3.200 0.074
SW2 0.0789 1.082 2.392 0.122
SW3 0.0707 0.932 2.908 0.088
SW4 0.0732 1.076 3.639 0.057
SW5 0.0053 0.995 0.016 0.898
SW6 0.1042 1.110 4.373 0.037
SW7 0.2636 0.768 47.356 <0.0001
SW8 0.1025 0.903 6.449 0.011
SW9 0.1454 1.157 7.674 0.006
SW10 0.0071 1.007 0.033 0.857
MainCus1 0.0065 1.007 0.012 0.913
MainCus2 0.1627 0.850 6.049 0.014
MainCus3 0.0045 0.996 0.004 0.950
MainCus4 0.1888 1.208 2.510 0.113
MainCus5 0.1933 0.824 1.094 0.296
MainCus6 0.0630 1.065 2.041 0.153
MainCus7 0.0040 0.996 0.003 0.954
MainMar1 0.0405 1.041 0.882 0.348
MainMar2 0.0242 1.024 0.141 0.708
MainMar3 0.1465 0.864 7.560 0.006
MainMar4 0.2505 0.778 1.707 0.191
MainMar5 0.2127 1.237 0.340 0.560
MainMar6 0.2870 0.751 3.924 0.048
OwnGender1 0.1661 0.847 0.597 0.440
OwnGender2 0.3734 0.688 2.940 0.086
OwnGender3 0.1412 0.868 0.427 0.514
BusiObj1 0.0622 0.940 0.074 0.786
BusiObj2 0.1105 1.117 0.300 0.584
BusiObj3 0.0704 0.932 0.108 0.742
BusiObj4 0.2709 0.763 2.262 0.133
BusiObj5 0.0362 0.964 0.035 0.851
BusiObj6 0.0862 1.090 0.185 0.668
BusiObj7 0.1060 1.112 0.207 0.649
RateVar1 0.0254 0.975 0.579 0.450
RateVar2 0.0189 1.019 0.196 0.658
RateVar3 0.1074 0.898 5.371 0.021
(continued on next page)
Table 3 (continued)
Null hypothesis: b = 0
Estimates Likelihood ratio Likelihood score Wald statistic
Degrees of freedom 47 47 47
Estimated v2 statistic 1524.96 1459.10 1341.46
p-value <0.0001 <0.0001 <0.0001
Association of predicted probabilities and observed responses
Percent concordant 67.0%
Percent discordant 32.7%
Percent tied 0.4%
Max-rescaled R2 12.30%
Hosmer and Lemeshow decile partition v2 test
Degress of freedom 8
Estimated v2 statistic 28.70
p-value 0.0004
Note: YRbusi denotes an index variable that classifies SMEs into six age groups: ‘‘0–3’’, ‘‘4–5’’, ‘‘6–10’’, ‘‘11–20’’,
‘‘21–30’’, and ‘‘31+’’. OwnAge denotes an index variable that sorts SMEs into six groups: ‘‘Under 21’’, ‘‘22–34’’,
‘‘35–44’’, ‘‘45–54’’, ‘‘55–64’’, and ‘‘65+’’. GrowthAmb is an index variable that equals the number of ticks (19
possible) for Question 13 of the 2004 FSB survey asking about planned business activity in the next 2 years. SG
denotes an index variable that classifies SMEs into five groups: ‘‘Gone down’’, ‘‘Gone down slightly’’, ‘‘Stayed the
same’’, ‘‘Gone up slightly’’, and ‘‘Gone up’’. PG represents an index variable that sorts SMEs into five groups:
‘‘Gone down’’, ‘‘Gone down slightly’’, ‘‘Stayed the same’’, ‘‘Gone up slightly’’, and ‘‘Gone up’’. Both SG- and
PG-related index variables range from 1.0 and 0.3 for below-average performance, 0.0 for neutral perfor-
mance, to +0.3 and +1.0 for above-average performance. OrgForm denotes five dummy variables that indicate
the legal form of the SME: ‘‘limited company’’, ‘‘franchised operation’’, ‘‘limited liability partnership’’, ‘‘sole
trader’’, or ‘‘partnership’’. SW denotes ten index variables for the SME’s strengths and weaknesses, including
‘‘selling price’’, ‘‘product or service quality’’, ‘‘specialised expertise or products’’, ‘‘flair and creativity’’, ‘‘distri-
bution channels’’, ‘‘customer service’’, ‘‘costs’’, ‘‘quality of staff’’, ‘‘reputation’’, and ‘‘environmental friendli-
ness’’. SW-related index variables range from 1.0 and 0.5 for weaknesses, 0.0 for neutral areas, to +0.5 and
+1.0 for strengths. MainCus represents seven dummy variables that indicate the SME’s main customer: ‘‘retailers
and wholesalers’’, ‘‘manufacturers’’, ‘‘other non-manufacturing firms’’, ‘‘local government’’, ‘‘central govern-
ment’’, ‘‘direct to the public/consumers’’, or ‘‘other’’. MainMar denotes six dummy variables that are required to
indicate the SME’s main market: ‘‘local markets’’, ‘‘regional markets’’, ‘‘national UK-wide markets’’, ‘‘rest of the
EU’’, ‘‘rest of Europe (non-EU)’’, or ‘‘rest of the world’’. OwnGender denotes three dummy variables that are
required to indicate the owner’s sex: ‘‘male’’, ‘‘female’’, or ‘‘male and female’’. BusiObj denotes seven dummy
variables that indicate the SME’s objective function: ‘‘to close it down’’, ‘‘to sell the business’’, ‘‘to downsize/
consolidate the business’’, ‘‘to remain about the same size’’, ‘‘to expand moderately’’, ‘‘to grow rapidly’’, or ‘‘to
hand on the business/succession’’. A series of specification test results are provided in the lower part of the table.
sources of finance to fulfil, at least in part, their expectations. This pattern of financing
works to mitigate any so-called overall ‘finance-gap’ expectation of constraints on
growth due to finance availability.
• We observe a size effect. That is, bigger SMEs use more alternative sources of funds.
While size implies survival for SMEs and also additional collateral to lender, size also
indicates more use of alternative financing means. This finding seems logical.
• There is a significantly positive relation between recent sales growth and use of at least
three sources of funds (p-value equal to 0.001). Sales growth translates into more cash
flows which can be directed into investments in capital goods, internal training, and
quality control. All these factors help SMEs broaden the network of refinancing
sponsors.
• Recent improvements in profitability reduce the use of multiple sources of funds (p-
value less than 0.0001). This finding is consistent with the pecking-order notion that
profitable firms have sufficient internal cash flows to finance investment plans and so
are less likely to seek alternative funds (Myers and Majluf, 1984).
None of the proxies for legal form, owner’s gender, and business objective(s) are found
to be important discriminators in the logit regression. In terms of strengths and weak-
nesses, we find that (a) customers service (SW6) and reputation (SW9) are positively asso-
ciated with multiple sources of funds, and that (b) sound management of costs (SW7) and
staff (SW8) lower SMEs’ propensity to use alternative sources of funds. We also find that
SMEs whose main customers operate in the mining and quarrying industry (MainCus2)
do not use multiple sources of funds as do their peers (p-value equal to 0.014). SMEs that
mainly serve the UK and international markets use fewer sources of funds. Finally, we find
that SMEs that perceive the rate of change in product or service innovations to be above
par use fewer financing alternatives.
Table 3 also shows the test statistics for examining the performance of the logistic spec-
ification. We observe that the three measures (likelihood ratio, likelihood score, and Wald
statistic) validate the chosen set of independent variables at any reasonable significance
level. Further, 67.0% of the estimated responses are concordant with the observed coun-
terparts. In other words, our predictions are consistent with at least two-thirds of the
actual responses. These results suggest that the logistic regression sheds some light on
the determinants of SMEs’ use of multiple sources of funds.
Next, we independently assign ranks to the sample SMEs according to the corre-
sponding values of sales growth and size (sales). We then form four growth-sales groups
for comparing the implied propensities to maintain multiple sources of funds: low-
growth and low-sales (LGLS), high-growth and low-sales (HGLS), low-growth and
high-sales (LGHS), and high-growth and high-sales (HGHS). In this subsection, we
would like to see if growth-oriented SMEs have lower propensities to use multiple
sources of funds. Table 4 summarizes the mean estimated probabilities – denoted as
p – of having more than two sources of funds for the four growth-size groups. Also
in this panel, we compute (a) the differences in p between the high- and low-growth
groups in the vertical right-hand column, (b) the differences in p between the high-
and low-size groups in the horizontal bottom row, and (c) the difference in p between
the LGLS and HGHS groups in the bottom-right cell. It is found that high-growth firms
are more likely to use multiple sources of funds in a probabilistic sense. Also, we observe
a reliable size effect: the differences in p for big and small SMEs are 3.4 and 3.5 percent-
age points for the two growth groups (t-statistics equal to 15.77 and 12.97 respectively).
Combining the growth and size effects together, we find that HGHS firms are more
likely to use multiple sources of funds than LGLS firms by 21.7 percentage points
(see also the difference in p down the diagonal cells). For UK SMEs, the growth effect
magnifies the size effect. We find support for our happy story that SMEs are able, at
least in part, to use additional sources of external finance required for new investment
plans.
We also independently sort SMEs into four size-growth groups in terms of growth
ambitions and total sales turnover. SMEs whose owners report rapid growth as the main
business objective (Q12, option #6) form the high-growth group (1429 firms). The remain-
ing SMEs are labelled as the low-growth group (14,321 firms). Also, we use size rankings
Table 4
Implied probabilities of MSFs (UK)
Group size Low-growth High-growth
Panel A
Low sales 3488 2833
High sales 4026 5403
Panel B
Mean Low-growth High-growth HG(p)–LG(p)
Low sales 0.338 0.521 0.182
High sales 0.372 0.555 0.183
HS(p)–LS(p) 0.034 0.035 0.217
Median Low-growth High-growth HG(p)–LG(p)
Low sales 0.331 0.513 0.182
High sales 0.368 0.547 0.179
HS(p)–LS(p) 0.037 0.035 0.216
Standard deviation Low-growth High-growth HG(p)–LG(p)
Low sales 0.093 0.119 0.003
High sales 0.093 0.126 0.002
HS(p)–LS(p) 0.002 0.003 0.002
t-stat Low-growth High-growth HG(p)–LG(p)
Low sales 3.639 4.359 66.570
High sales 4.021 4.396 81.350
HS(p)–LS(p) 15.771 12.975 93.201
Size- and growth-related rankings are assigned to 15,750 SMEs of the UK FSB 2004 survey data that carry no
missing values required for the logistic regression as specified in Eq. (1). Size is defined as total net sales (see
Question 20 of the FSB 2004 survey). Growth is defined as the pace of sales turnover growth in the most recent
year (see Question 22 of the FSB 2004 survey). Based on these size- and growth-related rankings, four size-growth
groups are formed for comparing the implied propensities to maintain multiple sources of funds: low-growth and
low-sales (LGLS), high-growth and low-sales (HGLS), low-growth and high-sales (LGHS), and high-growth and
high-sales (HGHS). This results in 3488 firms in the LGLS group, 2833 firms in the HGLS group, 4026 firms in
the LGHS group, and 5403 firms in the HGHS group, as summarized in Panel A. The sizes of the remaining
intermediate groups, namely LGMS, MGMS, HGMS, MGLS, and MGHS are available upon request.
The fact that 2895 firms carry missing values of sales growth and size leaves 15,750 SMEs in the sample. Panel B
reports the mean estimated probabilities – denoted as p – of having more than two sources of funds for the four
size-growth groups. This panel also reports (a) the differences in p between the high- and low-growth groups in
the vertical right-hand column, (b) the differences in p between the high- and low-size groups in the horizontal
bottom row, and (c) the difference in p between the LGLS and HGHS groups in the bottom-right cell. The
corresponding medians, standard deviations and t-statistics are reported in the remaining panels. Combining the
growth and size effects together, it is found that HGHS firms are more likely to maintain multiple sources of funds
than LGLS firms by 21.7% points (see the difference in p down the diagonal cells).
to distinguish small and big SMEs. Based on these independent sorts, we end up with 5784
SMEs in the LGLS group, 8537 SMEs in the LGHS group, 537 SMEs in the HGLS group,
and 892 SMEs in the HGHS group. The results are statistically similar to those shown in
Table 4, i.e. all cells from Table 4 have the same levels of significance as those in this anal-
ysis. We find that SMEs whose owners plan to attain rapid growth are more likely to use
multiple sources of funds in a probabilistic sense. As discussed above, less than 10% of the
UK SMEs aim for rapid growth. Growth-seeking SMEs are thus more of the exception,
rather than the rule. Our findings suggest that these exceptional performers indeed have
better probabilistic use of external capital.
Furthermore, finance sources vary considerably by both business and owner charac-
teristics. The newest businesses (under 3 years) are more likely to use personal savings,
family, friends and credit cards, and have least dependence on institutional sources, such
as bank overdrafts. In contrast, the older businesses are least likely to use credit cards or
supplier credit and most likely to use retained profits. Overall, more traditional industry
sectors (agriculture, transport and manufacturing) make the greatest use of bank
finance, while the services sectors make the greatest use of credit card debt. In general,
male business owners make greater use of external sources of finance, notably bank
overdrafts, bank loans and supplier credit. Male owned businesses also rely to a greater
extent than women on retained profits. The only finance source used more often by
women than men is family. With regard to age of business owner, younger entrepre-
neurs make more use of bank overdrafts, bank loans, credit cards, own savings and
family than older business owners. In turn, older owners rely to a greater extent on
retained profits.
To verify that our happy story is not only descriptive of SME financing in the UK, we
use the 1998 US Survey of Small Business Finances (SSBF) to explore access-related
issues. This exploration not only helps us ameliorate data-snooping bias, but also helps
ascertain the robustness of our happy story outside the UK. In the following section,
we show results that tell a similar story to the UK case.
4. Analysis of US SME financing
We use the 1998 Survey of Small Business Finances (SSBF). For the purposes of this
study, SMEs are defined as non-farm, for profit, non-financial enterprises with fewer
than 500 full-time equivalent employees and in operation in year-end 1997. Full-time
equivalents are defined as full-time employees plus one half of part-time employees.
While the biggest SME has 480 employees and hence may be quite large as compared
to the smallest SMEs, using such a broad definition facilitates a comprehensive examina-
tion of the finance-growth dichotomy for small- to ‘‘medium’’-sized enterprises (Wolken,
1998).
We collect data on firm, financial, and owner characteristics from the 1998 SSBF (for
instance, firm and owner age, business risk, financial statement information, and work
experience). Removing missing observations on the response variables as discussed below
yields a representative sample of 3561 SMEs of which we use 3239 with data on firm,
owner and financial characteristics. Thus, our sample matches the one used in a number
of previous studies on the financing patterns of SMEs (see Ang, 1992; Petersen and Rajan,
1994; Berger and Udell, 1995; Cole, 1998, among others).
Table 5 reports the most important issues for US SME respondents (SSBF 1998, D6).
We limit focus to the issues that yield more than 100 responses. These results help define
the relative level of importance of issues which may be seen to be constraints on growth. In
particular, we observe:
• The top four issues are not financial. Rather, these issues concern the human side of the
business. Quality of labour, competition and poor sales are all human-to-human issues.
External factors rank highly since SMEs value control and perceive these factors to be
beyond their control. This finding supports the literature which says that social net-
works and connections are most important to SME.
Table 5
What is the most important issue for SMEs? (SSBF 1998, D6)
Issue Category Number of Percentage of total sample
responses SMEs
Quality of labor Management 536 15.05
Competition (from larger or Strategy 413 11.60
international firms)
Other problems External 395 11.09
factors
Poor sales Size 261 7.33
Financing and interest rates Financing 253 7.10
Government regulations or red tape Regulation 250 7.02
Taxes Regulation 211 5.93
Cost and/or availability of labor Management 200 5.62
Cash flow Financing 165 4.63
No problems N/A 144 4.04
Acquiring and retaining new customers Management 109 3.06
Too much work and/or not enough time Lifestyle 103 2.89
Costs other than labor External 101 2.84
factors
Bill collection Financing 86 2.42
Marketing or advertising Marketing 80 2.25
Cost and availability of insurance Financing 62 1.74
Capital other than working capital Financing 47 1.32
Technology Strategy 47 1.32
Seasonal or cyclical issues External 32 0.90
factors
Inflation External 15 0.42
factors
Not ascertainable N/A 13 0.37
Growth of firm or industry Growth 4 0.11
Overcapacity of firm or industry Growth 4 0.11
Table reports the most important issues for US owners of small- to medium-sized enterprises (SMEs). These
responses are drawn from Section D6 of the US Survey of Small Business Finance (SSBF) 1998.
• Financing and interest rates and cash flow are, as expected, high on the list.
• Capital other than working capital ranks rather low with only 1.32% seeing this as an
issue.
• Firm- or industry-level growth and overcapacity are important only for eight of the
3561 US SMEs (<0.3%). Similar the UK case, firm expansion appears to be relatively
unimportant for this sample of US SMEs.
We use logit regressions to model the frequency of the sample US SMEs’ applications
for new loans in the 3 years before the US survey. We report that 405 of the 3239 US
sample SMEs applied for new credit in the 3 years before the survey, of which 345
received loan approvals. Of the 2834 US SMEs that did not apply for new loans in the
3 years prior to the survey, 595 SMEs did not do so due to their fear of loan denials.
Our analysis of the SME’s propensity to apply for new loans focuses on the following sur-
vey question:
‘‘Did your firm apply for new loans for one time or more than one time in the past 3
years?’’
Thus, we estimate the following logit regression equation:

AFCfrequency ¼ bDBrisk DBrisk þ bln S ln S þ bGrowth Growth þ bROA ROA
þ bPM PM þ bFirmAge FirmAge þ bMngt Mngt þ bFamily Family
þ bFocus Focus þ bWoman Woman þ bBossEdu BossEdu
þ bBossNW BossNW þ bBossAge BossAge þ bBossShare BossShare
þ bYREXP YREXP; ð2Þ
where
AFC stands for ‘application for credit’
AFCfrequency equals 1 if the SME applied for new loans in the 3 years before the US sur-
vey and 0 otherwise
DBrisk is the Dun-Bradstreet credit risk score purchased May 1999 on a 5 point scale
(‘‘DB_SCORE’’) with 1: low risk and 5: high risk
ln S is the natural logarithm of total net sales for the fiscal year ending in 1997
(‘‘ln(P2)’’)
Growth represents the annual revenue growth in the most recent fiscal year (‘‘P2/P3–1’’)
ROA is return on total assets for the fiscal year ending in 1997 (‘‘Profit/R12’’)
PM is the net profit margin for the fiscal year ending in 1997 (‘‘Profit/P2’’)
FirmAge denotes the number of operating years up to the end of 1997 (‘‘C_FAGE’’)
Mngt represents the system of management responsibility, which serves as a proxy for
the distance between ownership and control; Mngt carries a value of 1 if stock-
holders, owners, or partners are responsible for day-to-day management, and 0
otherwise (‘‘C_MGR’’)
Family equals 1 if a family owns more than 50 percent of the SME and 0 otherwise
(‘‘C_FAM’’)
Focus is a binary variable equal to 1 if the most important problem for the SME is re-
lated to the day-to-day operating activities (for instance, ‘‘poor sales’’, ‘‘competi-
tion’’, ‘‘quality of labor’’, ‘‘cost and/or availability of labor’’, ‘‘marketing/
advertising’’) and 0 otherwise (‘‘D6’’)
Woman is a dummy variable, carrying a value of 1 if female ownership is at least 50 per-
cent and 0 otherwise (‘‘C_SEX’’)
BossNW is the main SME owner’s net worth (‘‘U_NETW’’)
BossEdu denotes an index variable on a 1–7 scale, which indicates the main SME owner’s
level of educational attainment (‘‘C_EDUC’’)
BossAge indicates the main SME owner’s age (‘‘C_OAGE’’)
BossShare represent the main SME owner’s equity share of the business (‘‘C_OWNSH’’)
YREXP is the number of years of the main owner’s work experience in the business
(‘‘C_EXP’’)
The US SSBF database has a couple of additional questions relating to the SME’s pro-
pensity (a) to obtain loan approval if the SME applied for new credit in the 3 years before
the US survey, or (b) to fear loan denial if the SME did not apply for new credit in those 3
years. Our joint examination of both loan approvals and loan denials needs to deal with an
econometric issue which arises from the fact that the SSBF database provides ‘censored’
data. SMEs that applied for credit anytime in the 3 years before the US survey could differ
in their access to external finance from SMEs that did not apply for new credit during the
same period. We frame the following research questions to resolve this censoring issue:
• For those SMEs that applied for new loans in the 3 years prior to the US survey, what
could be the determinants of a greater propensity to receive loan approvals?
• For those SMEs that did not apply for credit in the 3 years before the US survey, what
could be the determinants of a greater propensity to fear loan denials in the first
instance?
We follow the technique of Boyes et al. (1989) and Greene (1992) to account for the
censoring issue. Greene (2003, pp. 713–714) describes this econometric technique in detail.
To shed light on these survey questions, we run the following conditional logit regressions
that account for the censoring issue: [In each of these conditional logit regressions,
AFCfrequency serves as the censoring variable (1 if yes and 0 otherwise).]
AFCapproval ¼ bDBrisk DBrisk þ bln S ln S þ bGrowth Growth þ bROA ROA

þ bPM PM þ bFirmAge FirmAge þ bMngt Mngt þ bFamily Family
þ bFocus Focus þ bWoman Woman þ bBossEdu BossEdu
þ bBossNW BossNW þ bBossAge BossAge þ bBossShare BossShare
þ bYREXP YREXP; ð3Þ
AFCdenial ¼ bDBrisk DBrisk þ bln S ln S þ bGrowth Growth þ bROA ROA þ bPM PM
þ bFirmAge FirmAge þ bMngt Mngt þ bFamily Family þ bFocus Focus
þ bWoman Woman þ bBossEdu BossEdu þ bBossNW BossNW
þ bBossAge BossAge þ bBossShare BossShare þ bYREXP YREXP: ð4Þ
The overall pattern of results, shown in Table 6, is consistent with our happy story.
For example, notice that firm financial performance (as measured by Growth, ROA and
PM) is not a significant determinant of the propensity to apply for loans, receive loan
approval, or fear loan denial. Said differently, SMEs in this sample are neither more
nor less likely to apply for loans, have loans approved or fear loan denial based on their
ability to generate profits or growth. This finding is not rational in the sense of the con-
ventional risk–return, growth-focused paradigm. In a rational risk–return, growth-
focused environment, the analyst should expect these variables to be significant for all
three equations (positive for Eq. (2), positive for Eq. (3), negative for Eq. (4)). These
findings are at odds with the conventional financing-gap story. Other observations from
Table 6 include:
• Neither the firm’s relationship to its owners (Mngt, Family) nor the gender of the own-
ers are found to be determinants of loan activity.
• The results for DBrisk are consistent with a self-selection bias in applications (poor-
rated firms are less likely to apply) and show that poor DBrisk scores contribute
to the fear of denial (logically). Yet, interestingly, DBrisk for ‘approval’ shows no
Table 6
Results of estimations of Eqs. (2)–(4)
Parameter Eq. (2) (apply) Eq. (3) (approval) Eq. (4) (denial)
ML Odds p-value ML Odds p-value ML Odds p-value
ratio ratio ratio
DBrisk 0.1003* 0.905 0.0408 0.0277 1.028 0.4379 0.3685* 1.446 <0.0001
ln(Sales) 0.0258 1.026 0.2499 0.2195* 1.245 <0.0001 0.0720* 0.931 0.0032
Growth 0.0046 0.995 0.6928 0.0050 1.005 0.3736 0.0006 1.001 0.9102
ROA 0.0005 1.000 0.6217 <0.0001 1.000 0.1437 0.0021 0.998 0.2497
PM 0.0819 1.085 0.2603 0.0031 0.997 0.8986 0.0016 0.998 0.8921
FirmAge 0.0188* 0.981 0.0029 0.0032 0.997 0.4481 0.0144* 0.986 0.0125
Mngt 0.1410 1.151 0.3986 0.0314 0.969 0.7838 0.0626 0.939 0.6940
Family 0.0199 1.020 0.9064 0.0923 1.097 0.4361 0.0049 0.995 0.9758
ProINV 0.0253 0.975 0.8213 0.0599 1.062 0.4761 0.2248* 0.799 0.0071
Woman 0.1449 0.865 0.1885 0.0056 1.006 0.9487 0.0161 0.984 0.8519
BossEdu 0.0262 0.974 0.3481 0.0335 0.967 0.1025 0.0410* 0.960 0.0552
BossNW <0.0001* 1.000 0.0093 <0.0001 1.000 0.8394 <0.0001* 1.000 0.0004
BossAge 0.0251* 0.975 <0.0001 0.0104 0.990 0.0521 0.0055 0.995 0.2811
BossShare 0.0060* 0.994 0.0029 0.0013 1.001 0.4615 0.0003 1.000 0.8769
YRexp 0.0197* 1.020 0.0075 0.0033 0.997 0.5679 0.0005 0.999 0.9328
Global null hypothesis: b = 0 Eq. (2) Eq. (3) Eq. (4)
Estimates L.R. L.S Wald L.R. L.S Wald L.R. L.S Wald
Degrees of freedom 15 15 15 15 15 15 15 15 15
Estimated v2 statistic 2075.45 1823.10 1293.65 136.13 137.31 134.99 230.78 195.19 182.37
p-value <0.0001 <0.0001 <0.0001 <0.001 <0.001 <0.001 <0.001 <0.001 <0.001
Eq. (2)
Percent concordant 56.2%
Percent discordant 42.2%
Percent tied 1.5%
Max-rescaled R2 63.08%
Degrees of freedom 8
Estimated v2 statistic 11.45
p-value 0.178
Table provides the maximum-likelihood (ML) coefficients, odds ratios, and p-values for Eqs. (2)–(4). The lower panel of table
provides some additional test results.
indicates agreement with sign and finding of statistical significance by a robustness test using sub-samples as shown in
Appendix 1.
significance. This again is not consistent with a risk–return paradigm from the lender’s
perspective – where we might expect to see a positive significant relationship.
• Firm size (ln(Sales)) both enhances likelihood of loan approval and reduces the fear of
denial – which seems consistent with a collateral-based lending environment. On the
other hand, size is not a determinant of propensity to apply. Even though larger firms
are more likely to receive approval, they do not apply more (or less) often. This dem-
onstrates financial contentment, or happiness since size brings with it increasing secu-
rity of loan approval and less fear of denial, but not an increased (or decreased)
likelihood of applying for loans.
• Firms operating in the finance area (ProINV) fear denial less (again, logically).
• More years of work experience (YRexp) is a determinant of the propensity to apply for
loans. Increasing years of work experience provides time to establish and begin using
social networks for capital. And since increasing years of experience are not significant
determinants of either fear of denial or loan approval, the social networking for capital
story is again supported.
• The significant negative signs for education (BossEdu) and owner’s age (BossAge) as
determinants for loan approval indicate lenders do not favour relatively ‘smarter and
older’ owners – as we may expect, but rather approve loans for relatively younger (in
agreement with the UK finding above) and less educated owners. In spite of this, edu-
cation is significantly negatively related to fear of denial. In other words, in spite of
lenders choosing the less educated (and younger), increased education reduces the fear
of denial.
• Consistent with our happy story we notice that with increased owner’s age there is a
significantly lower propensity to apply in the first place, with no significant relationship
to fear of denial. This describes contented financial behaviour increasing with age.
• Similarly, firm age (FirmAge) is not a determinant of loan approval and is a signifi-
cantly negative determinant of fear of loan denial. Nevertheless, firm age is also a sig-
nificantly negative determinant of propensity to apply in the first place. Since older
Table 7
Implied probabilities of MSFs (US)
Group size Low-growth High-growth
Low sales 797 747
High sales 811 884
Mean Low-growth High-growth HG(p)–LG(p)

Low sales 0.110 0.118 0.009
High sales 0.135 0.143 0.008
HS(p)–LS(p) 0.025 0.025 0.033
Median Low-growth High-growth HG(p)–LG(p)
Low sales 0.109 0.131 0.022
High sales 0.115 0.136 0.021
HS(p)–LS(p) 0.006 0.005 0.027
Standard deviation Low-growth High-growth HG(p)–LG(p)
Low sales 0.034 0.035 0.002
High sales 0.045 0.054 0.009
HS(p)–LS(p) 0.011 0.019 0.020
t-stat Low-growth High-growth HG(p)–LG(p)
Low sales 92.6 92.2 4.2
High sales 86.2 79.3 3.5
HS(p)–LS(p) 12.8 10.2 15.5
We independently assign ranks to the US SMEs according to their sales growth and size (sales). We then form
four growth-sales groups for comparing such SMEs’ propensities to access multiple sources of funds: low-growth
and low-sales (LGLS), high-growth and low-sales (HGLS), low-growth and high-sales (LGHS), and high-growth
and high-sales (HGHS). This table is similar to Table 4 for the UK data. We show (a) the differences in p between
the high- and low-growth groups in the vertical right-hand column, (b) the differences in p between the high- and
low-size groups in the horizontal bottom row, and (c) the difference in p between the LGLS and HGHS groups in
the bottom-right cell. The other panels of this table present the corresponding medians, standard deviations and
t-statistics.
firms fear denial less and yet apply less often, firm age also contributes to financial
contentment.
• While owner’s wealth (BossNW) has no significant impact on loan approval (not
rational from a risk–return paradigm), wealthier owners are significantly more apt to
apply for loans while also having significantly lower fear of denial.
• Also in support of the happy story we note that the owner’s share of the firm (Boss-
Share) is not a determinant of either fear of denial or loan approval yet significantly
reduces the propensity to apply for loans. Increasing control can be seen to contribute
to financial happiness. This is consistent with a non-growth-focused (or financially ‘con-
tented’) environment where control provides utility.
Finally, in order to compare these results to those of the UK above we independently

assign ranks to the US SMEs according to their sales growth and size (sales). We then
form four growth-sales groups for comparing such SMEs’ propensities to access multiple
sources of funds: low-growth and low-sales (LGLS), high-growth and low-sales (HGLS),
low-growth and high-sales (LGHS) and high-growth and high-sales (HGHS). Our goal is
to examine if growth-oriented firms exhibit overall ‘finance gap’ behaviour due to their
infrequent visits to potential outside creditors. The results are shown in Table 7 which
shares the same format of Table 4 above. We find that high-growth SMEs are more likely
to apply for new loans in a probabilistic sense. The differences in p for low- and high-
growth SMEs are 0.9–0.8 percentage points for the low- and high-sales groups. In addi-
tion, we find a significant size effect: the differences in p for big and small SMEs are 2.5
percentage points for the low- and high-growth groups (t-statistics equal to 12.8 and 10.2
respectively). Combining the size and growth effects together, we show that HGHS SMEs
are more likely to apply for new loans than LGLS SMEs by 3.3 percentage points with a
t-statistic of 15.5. Our results are statistically similar to the results as shown in Table 4 in
that cells from Table 4 have the same significance as those cells in this analysis. In
essence, growth-oriented SMEs appear to have access to loan funds although these SMEs
represent a fraction of the SME population. This finding appears to be consistent across
the US and UK samples. Hence, there is evidence in support of our proposed happy
story: SMEs are able, at least in part, to access external funds as required for growth
plans.
5. Summary and conclusions
In contrast to the publicly listed firm where shareholder wealth maximization and,
therefore, growth are expected so that the investors can maximize their separate utility
functions, in the SME world we observe that the desire for growth is tempered. Only half
of the UK SME sample seeks moderate growth while less than 10 percent seek significant
growth. That growth is not a significant objective for SMEs is also seen in the US sample
where only 1.32% list capital other than working capital as their most important issue.
Availability of finance, other than for working capital or funding moderate growth, seem
a relatively unimportant in agreement with the literature suggesting that SME growth is
funded out of retained earnings (e.g. Ou and Haynes (2003)).
Confirming the findings of Vos and Smith (2003) we find that SME financial perfor-
mance indicators (growth, ROA, PM) are not determinants of the propensity to apply
for, receive, or fear denial of loans in the US sample. This supports the suggestion of Vos
(1992a) and Vos (1992b) that we rethink our approach to SME finance away from tradi-
tional ‘rational’ risk–return models. For an alternative, Vos and Smith (2003) propose that
the degree of owner involvement in the firm – or ‘connectedness’ as used here – is most
related to the returns. They also note that traditional risk measures, including bank-gen-
erated risk scores, were not related to returns. We confirm this by noting that the US firms’
risk rating (DBrisk) is related to fear of denial and thus seems to cause SMEs to self-select
and not apply for loans, however the risk score is not a determinant of loan approval as
might be expected in a ‘rational’ risk–return lending decision.
Support for the literature on the importance of social networks (Petersen and Rajan,
1994; Petersen and Rajan, 1995; Petersen and Rajan, 2002; Cole, 1998; Diamond, 1991;
Uzzi, 1999) is seen in the US sample in that increasing years of work experience (YRexp)
is a positive determinant of loan applications, indicating that more time in business per-
mits the establishment of the required connections. However, older firms fear loan denial
less than younger firms and also apply less often – showing signs of increasing financial
contentment with firm age. These findings are also in contrast to publicly listed companies
(Fama and French, 1992; Fama and French, 1996; Daniel and Titman, 1997; Berk et al.,
1999) since the owner’s characteristics – not just the firm’s characteristics (size and age) –
matter in determining SMEs’ use of external funds.
In the UK SME sample, the use of multiple sources of funds are negatively related to
years in business, age, and profitability growth, but are positively related to management
adjustments and size. Findings for the determinants of loan approvals in the US are in
harmony with the UK findings in that loan approvals are more likely for younger and less
educated owners, even though more education reduced fear of loan denial for the US sam-
ple. If age and education contribute to wisdom, then it is interesting to observe that wis-
dom leads to financial contentment, or happiness, in the SME sector. These owners can
more easily use internal funds for (mostly moderate) growth first. This link between wis-
dom and happiness is in agreement with the emerging literature on happiness (for exam-
ple, see Diener and Seligman (2004)).
In the high-growth versus low-growth comparisons, we show that high-growth SMEs
use more sources of capital than do low-growth SMEs after controlling for size in the
UK sample. In the US sample, high-growth SMEs apply for loans more often than
low-growth SMEs after controlling for size. Those SMEs that operate in the growth mode
appear to apply for and use more external sources. We can not directly refute the finance
gap hypothesis with the findings in this paper, since we did not directly test it. But these
results show that our contentment hypothesis seems robust in that it applies not only to
the majority of SMEs who are either not seeking growth or seeking just moderate growth,
but also to those firms that are actually seeking growth. This pattern would not be
expected in the ‘finance gap’ story. This finding casts doubt on the view that SMEs operate
in financial markets characterized by market failure or credit rationing (Stiglitz and Weiss,
1981; Storey, 1994).
Rather, they operate in a [financially] connected world. SME financial behaviour ema-
nates from a perspective of reality that sees connectedness not as a pre-requisite of wealth
maximization, but as providing utility (‘contentment’, ‘happiness’) itself. Money is a
means to an end, not the end itself. Independence and control are oft-given reasons for
the differences in SME financial behaviour (Curran, 1986; Jarvis, 2000) compared to what
might be expected of the publicly listed firm. This paper is important because we suggest
that the more fundamental differences between the two forms of business lie in their views
of [financial] reality. Finance theories emanating from study of publicly listed firms are
based on the presumption that shareholders are separate from each other and that each
honours the other’s right to maximize utility. Within this view of ‘reality’, logically firms
are formed to maximize shareholder wealth and, also logically, agency costs arise as a by-
product (Jensen and Meckling, 1976).
By contrast, consider this symmetrical logic: SMEs live in a connected reality, which is
in agreement with the wide literature on SME networking (for example, see Wincent,
2005). They exhibit signs of [financial] contentment as shown in this paper. If behaving
as a sustainable form of business means not seeking growth beyond their ability to
control – and sustain – the business, then this financing pattern describes much of the
SME sector. The rest, i.e. those seeking growth, participate more in the external capital
markets than those not seeking growth. Notice: In the way that agency costs arise from
a presumption of separateness, so too sustainability (or ‘contentment’, or ‘happiness’)
emerges as a by-product from seeing the structure of reality as one of connectedness.
The linkage between happiness and social connections is increasingly well established in
the literature (see, for example, Diener and Seligman, 2004) and this paper supports that
linkage. SMEs are a form of business that seek independence and control and, through
understanding the value of connectedness, end up finding utility and happiness. This sus-
tainable form of business should be honoured if spreading of happiness is a policy goal –
even though most shun significant growth.
Future SME researchers must consider their underlying research paradigm since alter-
nates exist: one based on the separate presumption, the other based on the connected
presumption. For example: Rather than see the glass as half empty in the way that
Ang et al. (2000) showed that agency costs are higher when non-managers manage
the business, it is possible to see the glass as half full in the way that Vos and Smith
(2003) show that increased owner involvement improves profitability. Rather than see
financial frustration in the structure of the analysis of SMEs financing decisions as in
Berger and Udell (1998), we can see financial satisfaction as in the analysis of this paper.
Financial research based on presumptions of separateness seem inappropriate for the
SME sector, since financial frustration (e.g. agency costs and a finance-gap) does not
describe a connected reality with happiness as a by-product. The challenge for future
researchers is to avoid using a Jensen and Meckling (1976) base case for SME financial
analysis and honour the connectedness – happiness linkage shown here and elsewhere so
that we may build structures for analysis from a connectedness perspective. Then we will
gain a deeper understanding of the total – not just financial – contribution SMEs make
to society.
Acknowledgements
We are grateful to Philip McCann, Sumit Agarwal, John Watson, Frank Scrimgeour,
Hung Wan Kot, the reviewers and editor at JBF, and participants at the 2005 Babson-
Kaufman Center for Entrepreneurship, the 2005 meeting of the Financial Management
Association, and the 2005 International Congress of Small Business conferences in 2005
for their helpful comments.
Appendix 1
Robustness checks Dep. No. Significant explanatory

variable obs. variables
1. Use only SMEs with sales less AFCapproval 2899 ln S (+), BossEdu (), and
than $7.9 billion BossAge ()
2. Use only SMEs with owner age AFCapproval 2952 ln S (+), BossEdu (), and
no less than 37 years BossAge ()
3. Use only SMEs with Dun- AFCdenial 2972 DBrisk (+), ln S (), FirmAge
Bradstreet risk score less than 5 (), ProInv (), BossEdu (),
years and BossNW ()
4. Use only SMEs with sales less AFCdenial 2899 DBrisk (+), FirmAge (),
than $7.9 billion ProInv (), and BossNW ()
5. Use only SMEs with firm age no AFCdenial 2909 DBrisk (+), ln S (), FirmAge
greater than 29 years (), ProInv (), BossEdu (),
and BossNW ()
6. Use only SMEs with owner’s AFCdenial 2617 DBrisk (+), FirmAge (),
level of educational attainment ProInv (), BossEdu (), and
no greater than 6 years BossNW ()
7. Use only SMEs with owner net AFCdenial 2899 DBrisk (+), FirmAge (),
worth no greater than $1.5678 ProInv (), and BossNW ()
billion
References
Ang, J., 1992. On the theory of finance for privately held firms. Journal of Small Business Finance 1 (3),
185–203.
Ang, J., Cole, R., Lin, J., 2000. Agency costs and ownership structure. Journal of Finance 55 (1), 81–107.
Avery, R.B., Bostic, R.W., Samolyk, K.A., 1998. The role of personal wealth in small business finance. Journal of
Banking and Finance 22 (6), 1019–1061.
Bates, T., 1991. Commercial bank financing of white and black owned small business start-ups. Quarterly Review
of Economics and Business 31 (1), 64–80.
Berger, Allen N., Udell, Gregory F., 1995. Relationship lending and lines of credit in small firm finance. The
Journal of Business 68 (3), 351–382.
Berger, A.N., Udell, G.F., 1998. The economics of small business finance: The roles of private equity and debt
markets in the financial growth cycle. Journal of Banking and Finance 22 (6), 613–673.
Berk, J.B., Green, R.C., Naik, V., 1999. Optimal investment, growth options, and security returns. Journal of
Finance 54 (5), 1553–1607.
Bitler, M.P., Robb, A.M., Wolken, J.D., 2001. Financial services used by small businesses: Evidence from the
1998 survey of small business finances. Federal Reserve Bulletin 87 (April).
Boyes, W., Hoffman, D., Low, S., 1989. An econometric analysis of the bank credit scoring problem. Journal of
Econometrics 40 (1), 3–14.
Carter, S., Mason, C., Tagg, S. 2004. Lifting the Barriers to Growth in UK Small Businesses: The FSB Biennial
Membership Survey, 2004. Federation of Small Businesses, London.
Cole, R.A., 1998. The importance of relationships to the availability of credit. Journal of Banking and Finance 22
(6), 959–977.
Curran, J., 1986. Bolton fifteen years on: A review and analysis of small business research in Britain 1971–1986.
Small Business Research Trust, London.
Daniel, K., Titman, S., 1997. Evidence on the characteristics of cross-sectional variation in stock returns. Journal
of Finance 52 (1), 1–33.
Deakins, D., 1996. Entrepreneurship and Small Firms. McGraw-Hill, London.
Diamond, D.W., 1991. Monitoring and reputation: the choice between bank loans and directly placed debt.
Journal of Political Economy 99 (4), 688–721.
Diener, E., Seligman, M.E.P., 2004. Beyond money: Toward an economy of well-being. Psychological Science in
the Public Interest 5 (1), 1–31.
Everett, J., Watson, J., 1998. Small business failure and external risk factors. Small Business Economics 11 (1),
371–390.
Fama, E.F., Jensen, M.C., 1983. Separation of ownership and control. Journal of Law and Economics 26 (1),
301–325.
Fama, E.F., French, K.R., 1992. The cross-section of expected stock returns. Journal of Finance 47 (2),
427–465.
Fama, E.F., French, K.R., 1996. Multifactor explanations of asset pricing anomalies. Journal of Finance 51 (1),
55–84.
Franks, J., Mayer, C., Rossi, S. 2003. Ownership: Evolution and Regulation. Oxford Financial Research Centre
Economics Series Ref: 2003-FE-14.
Greene, W. 1992. A statistical model for credit scoring. Stern Business School Working Paper #EC-92-29.
Greene, W., 2003. Econometric Analysis, fifth ed. Prentice Hall Press.
Gregory, B.T., Rutherford, M.W., Oswald, S., Gardiner, L., 2005. An empirical investigation of the growth cycle
of small firm financing. Journal of Small business Management 43 (4), 382–393.
Hakim, C., 1989. Identifying Fast Growth Small Firms, Employment Gazette January, pp. 29–41.
Headd, B., 2003. Redefining business success: Distinguishing between closure and failure. Small Business
Economics 21 (1), 51–61.
Jarvis, R., 2000. Finance and the small firm. In: Carter, S., Jones-Evans, D. (Eds.), Enterprise and Small Business:
Principles, Practice and Policy. FT Prentice Hall, London, pp. 337–353.
Jensen, M., Meckling, W., 1976. Theory of the firm: Managerial behavior, agency costs, and ownership structure.
Journal of Financial Economics 3, 305–360.
Mester, L., 1997. What’s the point of credit scoring?’’ Federal Reserve Bank of Philadelphia Business Review.
September/October, pp. 3–16.
Myers, S.C., Majluf, N.S., 1984. Corporate financing and investment decisions when firms have information that
investors do not have. Journal of Financial Economics 13 (2), 187–221.
Office for National Statistics, 2003. Commerce, Energy & Industry: Size Analysis of UK Businesses, PA 1003,
Data for 2003. Office for National Statistics, London.
Ou, C., Haynes, G.W., 2003. Uses of Equity Capital by Small Firms – Findings from the Surveys of Small
Business Finances (for 1993 and 1998). Paper presented at the Academy of Entrepreneurial Finance 14th
International Conference in Chicago, IL.
Petersen, M., Rajan, R., 1994. The benefits of firm-creditor relationships: Evidence from small business data.
Journal of Finance 49 (1), 3–37.
Petersen, M., Rajan, R., 1995. The effect of credit market competition on lending relationships. Quarterly Journal
of Economic 110 (2), 407–443.
Petersen, M., Rajan, R., 2002. Does distance still matter? The revolution in small business lending. Journal of
Finance 57 (6), 2533–2570.
Small Business Service, 2003. Business Start-Ups and Closures: VAT Registrations and Deregistrations in 2002,
Press Release, 21st October 2003.
Stiglitz, J., Weiss, A., 1981. Credit rationing in markets with imperfect information. American Economic Review
71 (3), 393–410.
Storey, D., 1994. Understanding the Small Business Sector. Routledge, London.
Uzzi, B., 1999. Embeddedness in the making of financial capital: How social relations and networks benefit firms
seeking financing. American Sociological Review 64 (4), 481–505.
Uzzi, B., Gillespie, J.J., 2001a. Financing networks and knowledge spillover. In: Nagao, D. (Ed.), Academy of
Management Proceedings. Academy of Management Online at Pace University.
Uzzi, B., Gillespie, J.J., 2001b. Social Embeddedness and Corporate Finance: The Case of Trade Credit
Financing. Mimeo.
Vos, E., 1992a. Unlisted businesses are not financial clones of listed businesses. Entreprenurship Theory and
Practice 16 (4), 57–68.
Vos, E., 1992b. A conceptual framework for practical risk measurement in small business. Journal of Small
Business Management 30 (3), 47–56.
Vos, E., 1992c. Differences in risk measurement for small unlisted businesses. Journal of Small Business Finance 1
(3), 255–267.
Vos, E., 1995. Risk, return, and price: Small unlisted businesses examined. Small Enterprise Research 3 (1&2),
112–120.
Vos, E., Forlong, C., 1996. The agency advantage of debt over the lifecycle of the firm. Journal of Entrepreneurial
and Small Business Finance 5 (3), 193–211.
Vos, E., Smith, B., 2003. Risk, return, and degree of owner involvement in privately held firms. Journal of
Entrepreneurial Finance and Business Ventures 8 (1), 31–56.
Watson, J., Everett, J., 1993. Defining small business failure. International Small Business Journal 11 (3), 35–48.
Watson, J., Everett, J., 1996. Do small businesses have high failure rates? Journal of Small Business Management
34 (4), 45–62.
Watson, J., Everett, J., 1998. Small business failure rates: Choice of definition and the size effect. Journal of
Entrepreneurial and Small Business Finance 5 (1), 271–285.
Wiklund, J., Delmar, F., Sjoberg, K., 2004. Entrepreneurship at any expense? The effect of human capital on high
potential entrepreneurship. Paper presented to the Babson–Kauffman Entrepreneurship Research Conference,
University of Strathclyde in Glasgow.
Wincent, Jokim, 2005. Does size matter? A study of firm behaviour and outcomes in strategic SME networks.
Journal of Small Business and Enterprise Development 12 (3), 437–453.
Wolken, John D., 1998. New data sources for research on small business finance. Journal of Banking & Finance
22 (6–8), 1067–1077.

The Happy Story of Small Business Financ

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Happy Story of Small Business Financ

Uploaded by

Copyright:

Available Formats

Journal of Banking & Finance 31 (2007) 2648–2672

The happy story of small business ﬁnancing

Received 9 June 2005; accepted 21 September 2006

JEL classification: D82; G19; G29; L33

2. Literature and approach

3. Analysis of UK SME financing

E. Vos et al. / Journal of Banking & Finance 31 (2007) 2648–2672

4. Analysis of US SME financing

Thus, we estimate the following logit regression equation:

AFCapproval ¼ bDBrisk DBrisk þ bln S ln S þ bGrowth Growth þ bROA ROA

Mean Low-growth High-growth HG(p)–LG(p)

Finally, in order to compare these results to those of the UK above we independently

5. Summary and conclusions

Robustness checks Dep. No. Signiﬁcant explanatory

You might also like