The Demand for Debt Finance by Entrepreneurial Firms

Abstract

We model the entrepreneurial firm's choice of debt finance, allowing for debt renegotiations in the event of financial distress. We differentiate two sources of debt finance, bank debt and trade credit, by the implicit equity stake that lenders hold in the borrowing firm. Lenders with a large implicit equity stake, such as suppliers, adopt a more lenient liquidation policy when firms have a relatively high liquidation value, but set a higher price for their credit. Entrepreneurs, who have private information about their probability of financial distress, borrow exclusively from lenders with a small implicit equity stake, such as banks, only when the price advantage of bank debt outweighs the cost of a stricter enforcement of liquidation rights. Entrepreneurs who prefer the lenient liquidation policy adopted by suppliers contract only partial bank finance in order to avoid a potential default against the bank. Using data on a sample of 152 true business start-ups in the manufacturing sector, we provide empirical evidence that supports this theoretical model.

JEL Classification: C70, G32, G33