Banks' Screening and the Leverage of Newly Founded Firms

Abstract

Banks finance newly-founded firms extensively despite severe asymmetric information. Whereas the demand for credit usually follows from entrepreneurs' lack of liquidity, we ask why and how banks supply credit to new firms of unknown value. We propose a model of credit allocation in which, due to banks' screening, new firms with higher future value issue debt below capacity to avoid costly investment delay. Consistent with this prediction, new firms with a lower first leverage ratio (initial leverage) perform better ex post in a unique US representative sample. In the model and in the data, this negative association is more pronounced in lending markets in which banks have stronger incentives to screen. Our results are robust to controlling for characteristics such as entrepreneurs' net worth, skin in the game, and education levels. We conclude that banks ensure that profitable new ventures develop.

Keywords: Entrepreneurial Finance, Screening, Lending, Kauffman Firm Survey, Capital Structure

JEL Classification: D82, G21, G32, G34, L26