Small Firm Financing: Implications from a Strategic Management Perspective

The main thesis of this article is that a corporate strategy perspective (which includes managerial choice) may be superior to a traditional finance perspective in explaining small firm financing decisions. The traditional finance perspective tries to explain a complex financial decision process (e.g., optimal debt level) without fully considering the impact of managerial choice. It is likely, however, that managerial choice exerts considerable influence on small firm financing decisions. Thus, a new paradigm is needed which includes the many factors that are a part of the small firm financing decision process, among them: goals, risk aversion, and internal constraints. Such a paradigm would: (1) allow for a more complete understanding of the small firm financing process; (2) address more fully the needs and concerns of the small firm practitioner; and (3) provide a sound basis for future empirical research. Recent literature has attempted to explain small firm financing decisions using modern financial theory. For example, McConnell and Pettit' suggest that small businesses generally have proportionally less debt than large firms. They propose this is so because: (1) small firms generally have lower marginal tax rates than larger firms (suggesting less tax deduction benefit of debt); (2) small firms may have higher bankruptcy costs than large firms (which increases the financial risk of debt); and (3) small firms may find it more difficult to "signal" their business health to creditors (therefore raising the "cost" of debt to small firms). Another attempt to explain small firm financing behavior relies on agency theory.2 Agency theory holds that people who have equity or debt in a firm require costs to monitor the investment of their funds by management or the small business owner (i.e., agency costs). This view suggests that financing is based on the owner/ manager being able to assess these agency costs" for each type of financing, and then selecting the lowest-cost method of financing the firm's activities. One weakness of this explanation is that no one has yet been able to measure agency costs, even in large firms. Nor has agency cost theory (or any other modern financial theory) been able to explain capital structure in large, public firms, let alone in small, private ones.3 In contrast, recent theoretical and empirical work suggests that a strategic perspective (which includes multiple firm objectives and managerial choice) may have promise in explaining the financing decision in large, public firms. The objective of this article is to use a strategic perspective as a basis for developing propositions-and a new research paradigm-to explain the financing decisions of small, private firm management. First, the Barton and Gordon argument for the applicability of a strategic management perspective in understanding large firm financing decisions is reviewed.5 Second, the argument's validity and relevance as applied to small firm financing decisions is assessed. Third, propositions regarding the small firm financing decision are developed. Finally, follow-up empirical work is proposed. THE CASE FOR A STRATEGY PERSPECTIVE Barton and Gordon point out that while financing decisions are an important aspect of firm strategy, neither finance theory nor empirical research has provided useful guidance for practitioners or academics regarding this decision.6 They suggest that the finance paradigm may not permit adequate representation of complex behavior at the individual firm level. They point out that unrealistic assumptions are made in developing theoretical financial models, and note that the representation of the firm as a rational economic entity with the singular goal of shareholder wealth maximization is an oversimplification. Barton and Gordon suggest that the following characteristics must be accounted for in any explanation of firm financing decisions: (1) behavior at the firm level; (2) the fact that the capital structure decision is made in an open systems context by top management; (3) the capital structure decision must be consistent with an overall corporate plan; and (4) the decision reflects multiple objectives and environmental factors, not all of which are financial in nature. …