Financial bootstrapping in small businesses

Abstract

In recent years, small businesses have received much attention from policy makers and researchers, in that these businesses are considered important for economic growth and job creation. At the same time small businesses are assumed to face major problems in securing long-term external finance, which is regarded as restraining their development and growth. Small business managers are assumed to use institutional finance as a means of meeting the need for resources, and as a consequence the major part of the research on small business finance has focused on constraints in the supply of institutional (market) finance.

As we see it, most small business managers handle the need for resources using means other than external finance by applying different kinds of financial bootstrapping methods. Financial bootstrapping refers to the use of methods for meeting the need for resources without relying on long-term external finance from debt holders and/or new owners. However, these other means of resource acquisition have, with few exceptions, not been focused on within earlier research on small business finance. Against this background, the purpose of this study is to describe small business managers' use of different financial bootstrapping methods, and, more importantly, to develop concepts that can help us better understand small business managers' financial bootstrapping behaviors.

The research process was initiated with a number of unstructured interviews conducted with small business managers, accountants, consultants, bank officials, and researchers, in order to identify different financial bootstrapping possibilities. On the basis of the interviews and an earlier study on financial bootstrapping, resulting in the identification of 32 bootstrapping methods, a questionnaire was constructed and sent to 900 small business managers in Sweden. Given the limited knowledge within the area of financial bootstrapping, the study is based on explorative factor analysis and cluster analysis.

From the cluster analysis six clusters of bootstrappers were identified, differing from each other with respect to the bootstrapping methods used and the characteristics of the business. On the basis of this information the different clusters were labeled: (1) delaying bootstrappers; (2) relationship-oriented bootstrappers; (3) subsidy-oriented bootstrappers; (4) minimizing bootstrappers; (5) non-bootstrappers; and (6) private owner-financed bootstrappers. The groups of financial bootstrappers show differences in their orientation toward resource acquisition, representing different aspects of an internal mode of resource acquisition, a social mode of resource acquisition, and a quasi-market mode of resource acquisition. We find that the delaying bootstrappers, private owner-financed bootstrappers, and minimizing bootstrappers all represent an internal mode of resource acquisition. The relationship-oriented bootstrappers follow a socially oriented mode of resource acquisition, whereas the subsidy-oriented bootstrappers apply quasi-market oriented resource acquisition.

This study contributes to our empirical understanding by providing knowledge about the financial bootstrapping methods used in small businesses. Furthermore, by developing concepts this study contributes to the conceptual development of our knowledge about financial bootstrapping. The implication of this study is that financial bootstrapping is a phenomenon which deserves more attention in future research on small business finance. At the same time, financial bootstrapping behavior is probably a more general phenomenon, appearing in different contexts, such as R&D activities in large businesses, financing start-ups, etc. Finally, the study points out implications for small business managers, consultants, teachers, etc. Practitioners often tend to focus on market solutions to resource needs. This study shows, however, that this strong focus can be questioned. Resources needed in small businesses can in many situations be secured using financial bootstrapping methods, referring to internally oriented and socially oriented resource acquisition strategies.

Introduction

In recent years both policy makers and researchers have become interested in the importance of small businesses. It has been widely recognized that start-ups and more established small businesses play an important role for economic growth and job creation in society (see for example Davidsson et al. 1994, Davidsson et al. 1996, Storey 1994). In this context the lack of capital facing small businesses seems to be an ever-recurring theme. Several studies (see for example Bolton 1971, Stanworth and Gray 1991, Storey 1994) have referred to the financial gap facing small businesses, in terms of problems in attracting long-term finance from market actors such as banks and venture capital companies. The underlying assumption in the research and in the public debate is that the financial problems in turn restrain small businesses' development and growth (Hughes, 1996).

This reasoning sees small business managers as using financial capital to meet the need for resources. In more specific terms, it is assumed that small business managers try to raise large amounts of capital from, for example, banks and venture capital companies (Bhide, 1992). Therefore, much research on small business finance has focused on constraints in the supply of institutional finance, whereas the handling of financial needs at the demand side (i.e., the small business manager's perspective) has been given much less attention (Cressy et al., 1996).

The financial gap for small businesses can be explained by the information asymmetry between external financiers and small business managers (Storey, 1994). Small business managers most often possess superior information about the potential of their own business. Furthermore, in some situations, such as in young innovative businesses, it can be difficult for the business managers to articulate and to give as detailed information about the business as the financiers want. Additionally, some small business managers may be restrictive when it comes to providing external financiers with detailed information about the core of the business, since trade secrets, in one way or another, may leak through to competitors. This implies that financiers face problems in finding the information they need, and as a consequence they experience great uncertainty (Nooteboom, 1993). On the other hand, financiers may possess superior information on the aggregate level about the potential of the whole industry as such. The problems of information asymmetry are, in other words, not one-sided.

The information asymmetry between the external financier and the small business manager in turn increases the costs of handling the financial transaction. High transaction costs arise because of the need to organize, carry out and monitor the exchange in such a way that the information asymmetry can be reduced (Williamson, 1981). Initial as well as current assessment costs are more or less invariant with the size of the capital provided by the financier, implying that the relative costs facing the financier will be larger for smaller amounts (often provided to smaller businesses) than for larger amounts. The relatively high transaction costs will be compensated for by an increased financial cost facing small businesses (Storey, 1994), and empirical studies show that small businesses in general face higher financial costs than larger businesses (McMahon et al., 1993). The fact that the financial cost increases also implies that financiers will be exposed to problems of adverse selection (i.e., as the cost of finance increases there is a risk that the low-risk businesses will drop out of, and the high-risk businesses enter, the market) (Stiglitz and Weiss, 1981). The consequences of the high risk and the high costs can of course also be that the financiers refrain from financing some groups of small businesses altogether.

In addition to the high financial costs, small businesses face costs for identifying potential financiers and for undertaking bonding activities. Bonding costs arise because the need to provide financiers with information and guarantees about non-opportunistic behavior (Jensen and Meckling, 1976). Taken together, using the external financial market as a means of meeting a small business' need for resources is often a relatively expensive solution, if available at all.

Problems in securing external institutional finance for meeting the need for resources may imply that small business managers handle the need for resources using other than financial means. This in turn implies that the need for resources is secured without there being a financial transaction. At the same time, these other means of resource acquisition have, with few exceptions (e.g., Starr and MacMillan 1990, Bhide 1992, Freear et al. 1995, Harrison and Mason 1997), not been observed in earlier research on small business finance.

As a basis for further clarifying the purpose of this study, we present how Lars Andersson has developed his business, “Fuelinject Ltd,” and how he managed to meet the need for resources in ways other than relying on financial means provided by institutional financiers. The case is a modified version of real-world conditions.

Fuelinject Ltd is a small business developing a new fuel injection technique for cars. Lars initiated the project in 1985, while he was still working with product development at a large Swedish business. In 1987 he left his employment and formally started (registered) the business. Prototype tests undertaken at the start of 1990 showed very promising results. The new technique was planned to be introduced on the market in 1995. The market introduction required a large amount of additional resources to be allocated to production, distribution, and marketing. Besides, Lars also needed to develop further the competence already built up. However, he experienced great difficulties in attracting long-term external finance to meet the need for resources. The fact that Lars himself had no further personal savings to invest made the situation look even more problematic. He faced a situation in which the market introduction was put into jeopardy, and the future of his business made uncertain.

In 1998 we meet with Lars again. He tells us that the business has developed and expanded to employing 10 people. Even though the business developed a little slower than planned, the technique has been introduced on the market and the expansion of the business has begun. Lars informs us that the development has been taken care of without any major contributions from long-term external financiers. How was this realized?

Initially, he shared location, at a very low rental charge, with a friend who did not make full use of the space, and he used the equipment and machines of his friend's business in the evenings at no cost. He engaged students in university degree projects related to his business idea. This allowed him to obtain knowledge at no cost. During the first few years, from 1987 and onward, he refrained from withdrawing any salary, instead considering the business to be an investment. He worked as a consultant in other businesses, and relatives helped him now and then without monetary remuneration. Furthermore, he managed to achieve payments in advance from customers for the development of the product, and he gained knowledge by discussing his business with former colleagues and potential customers. The case shows that previous working relationships, family and friends, and other contacts were all important as resource providers and supporters when Lars translated the idea into a going business, in line with the reasoning made by Starr and MacMillan (1990), and Larson and Starr (1993).

It can be concluded that Lars has used a much wider spectrum of means, besides external finance, of meeting the need for resources than usually discussed within research on small business finance. Trying to explain his way of thinking, we can consider him as a genuine “financial bootstrapper.” The concept “financial bootstrapping” refers to the use of methods to meet the need for resources, without relying on long-term external finance Freear et al. 1995, Harrison and Mason 1997, Winborg and Landström 1997.

Examining the use of bootstrapping methods in small software businesses in the United States, Freear et al. (1995) show that absorbing resources from customers and suppliers in different ways together with using resources provided by the owner/manager are the most used methods. Replicating the study by Freear et al. (1995) in the Northern Ireland context, Harrison and Mason (1997) show that 95% of the businesses examined use bootstrapping methods to a greater or lesser extent. These findings indicate that financial bootstrapping plays an important role in the development of a small business, however the phenomenon has been given very little attention in earlier research on small business finance. Furthermore, the few studies that have examined financial bootstrapping in small businesses are descriptive in kind, implying that we need to develop concepts to increase our understanding of this phenomenon.

Against this background, the overall purpose of this study is to develop an understanding of small business managers' use of financial bootstrapping methods as a means of acquiring resources needed. In more specific terms, the purpose is to describe small business managers' use of financial bootstrapping methods, and more importantly to generate concepts that can help us better understand small business managers' financial bootstrapping behaviors. The purpose can be specified by formulating the following research questions:

• What financial bootstrapping methods do small business managers use?

• • What different groups of financial bootstrapping users can be identified?

• • How can we understand small business managers' use of different bootstrapping behaviors?

This study contributes to our empirical understanding by providing knowledge about the financial bootstrapping methods used in small businesses. Furthermore, by developing concepts this study contributes to the conceptual development of our knowledge about financial bootstrapping.

The structure of the article is as follows. In the next section the method of this study is described. The empirical findings are presented in three subsections. First, we describe the relative use of different financial bootstrapping methods in Swedish small businesses. Second, we present the results from a factor analysis resulting in the identification of six groups of financial bootstrapping methods. Third, on the basis of the six factors found, we identify different groups of financial bootstrapping users. Thereafter, the empirical findings are discussed in more general terms in order to understand the different bootstrapping behaviors identified. Finally, we discuss the implications of this study both in theoretical and practical terms.