How Do Banks Finance the Unproven Startup?

SMITH BRAIN TRUST – It’s well known that banks extensively finance newly founded firms, or startups. What is less widely understood is that outside debt, including bank debt, is actually the largest source of external financing for those startups. And that might seem surprising, particularly because asymmetric information about firm quality is at its highest for firms in their nascent, startup stage.

They don’t, for example, have a record of performance when they issue debt, and banks don’t have the expertise, nor the resources or motivation, to monitor startups the way that venture capital firms and angel investors would.

In recent research, Maryland Smith’s M. Cecilia Bustamante and Boston College’s Francesco D’Acunto take a close look at the situation, asking two central questions. First, says Bustamante, is how do banks circumvent the effects of asymmetric information so as to facilitate debt funding to firms in their early stages? And second, she says, is there a relation between banks’ debt allocation policies to startups and firms’ subsequent performance?

“Our analysis is both theoretical (using a mathematical model) and empirical (where we use a confidential dataset of newly founded firms collected by the Kauffman Foundation),” says Bustamante, an assistant professor of finance at the Robert H. Smith School of Business at the University of Maryland.

Using a dynamic model of credit allocation, the authors hypothesize that banks mitigate the effects of asymmetric information by engaging in low-cost screening at the time of loan origination. In particular, banks offer alternative menus of debt contracts and firms self-select into the menu that reveals the underlying quality of their future growth prospects.

Under this hypothesis, Bustamante explains, a firm's first leverage ratio (or “initial leverage”) contains information about its future growth opportunities, because it represents the credit allocation decision of the bank at the time in which the degree of asymmetric information about the underlying quality of the startup is the highest.

“In a nutshell, we argue that, due to banks’ screening behavior, the initial leverage ratio of a newly founded firm is a signal about its underlying growth prospects,” Bustamante says. “In particular, our model predicts that firms with better growth prospects bear the costs of asymmetric information by issuing a leverage ratio that is lower than their actual debt capacity, so as to avoid costly delay in their investment plan. Using a unique representative sample of U.S. startups, we provide supporting empirical evidence on this unique prediction.”

The authors document that startups with a lower first leverage ratio (or “initial leverage”) perform better “ex-post,” even after controlling for observables available to banks at the time of origination – such as the credit score of the owner-entrepreneur, the net worth of the firm and the alma maters of the management team. “We also observe that startups with a lower first leverage ratio have a higher survival rate,” she says.

Consistent with the conjecture that banks screen startups, the paper concludes by showing that the negative relation between initial leverage and ex-post performance, or duration, is even stronger when banks have a higher incentive to screen. For example, in more concentrated regional lending markets and also for corporate loans, in which startups enjoy limited liability.

“Quite intuitively, banks’ lending policies tend to be laxer when competition in the regional lending market is tighter – as a result, and in line with the predictions of our model, the initial leverage ratio of a newly founded firms is a better signal of its future growth prospects in less competitive regional lending markets,” she says.

Read more: Banks' Screening of Startups: The Role of Initial Leverage, by M. Cecilia Bustamante and Francesco D’Acunto is available at SSRN. 

M. Cecilia Bustamante is an assistant professor of finance at the University of Maryland’s Robert H. Smith School of Business.

Research interests: Executive compensation; dynamic corporate finance; industrial organization; asset pricing implications of corporate decisions.

Selected accomplishments: Chosen as one of six finance scholars who presented papers on March 4, 2017, at the inaugural Showcasing Women in Finance series, organized by the Academic Female Finance Committee (AFFECT) of the American Finance Association; papers published in the Journal of Finance, Review of Financial Studies and Journal of Financial and Quantitative Analysis, among others.

About this series: Maryland Smith celebrates Women Leading Research during Women’s History Month. The initiative is organized in partnership with ADVANCE, an initiative to transform the University of Maryland by investing in a culture of inclusive excellence. Other Women's History Month activities include the eighth annual Women Leading Women forum on March 5, 2019.

Other fearless ideas from:  Rajshree Agarwal  |  Ritu Agarwal  |  T. Leigh Anenson  |  Kathryn M. Bartol  |  Christine Beckman  |  Margrét Bjarnadóttir  |  M. Cecilia Bustamante  |  Jessica M. Clark  |  Rellie Derfler-Rozin  |  Waverly Ding  |  Wedad J. Elmaghraby  |  Rosellina Ferraro  |  Rebecca Hann  | Amna Kirmani  |  Hanna Lee  |  Hui Liao  |  Jennifer Carson Marr  |  Wendy W. Moe  |  Courtney Paulson  |  Louiqa Raschid  |  Rebecca Ratner  |  Rachelle Sampson  |  Debra L. Shapiro  |  M. Susan Taylor  |  Niratcha (Grace) Tungtisanont  |  Vijaya Venkataramani  |  Janet Wagner  |  Yajin Wang  | Liu Yang  |  Jie Zhang  |  Lingling Zhang