Undercapitalization
Vance H. Fried
Undercapitalization occurs when a firm either fails to invest in the optimal mix of real assets because it cannot properly finance its investments, or experiences financial distress or bankruptcy because it has too much leverage in its capital structure. Undercapitalization is a readily observable, but scantily researched, phenomenon in entrepreneurial finance. It has been the subject of extensive interest in mainstream finance, but the supporting empirical work focuses on large firms.
Underinvestment
Underinvestment, the finance literature’s term for the first form of undercapitalization, occurs when a firm invests less than it should in real assets (assets, both tangible and intangible, used to carry on business) because it is costly or impossible to secure external financing. External equity financing is more costly than internal equity or debt financing, so when internal cash flow is available, firms invest freely. But when internal cash flows are inadequate to fund in vestment, the firm may be reluctant to invest because it does not want to seek more expensive external financing. Fortunately, the extra costs of external capital are generally not substantial; so, underinvestment occurs only on the margin and its negative effect on the firm is rarely severe. Hedging is proposed as the solution to this problem (Froot, Scharfstein, and Stein, 1993).
However, a more extreme form of underinvestment occurs under conditions of hard capital rationing. Hard capital rationing means that the firm’s access to external capital is so limited that it is forced to decline projects with substantial positive net present values. As a result, the long term performance of the firm can be significantly harmed (Brealey and Meyers, 2003).
Capital Structure
The significance of capital structure is a subject of great interest in finance. Firms prefer to finance first with either internal equity or debt. In the United States, debt is beneficial because of the tax shield. However, greater use of debt increases the risk of bankruptcy or financial dis tress. A firm is undercapitalized if it runs too high a risk of bankruptcy or financial distress. Because of information asymmetries, external equity is the worst source of capital and is only used to the extent internal equity and debt are insufficient (Newton, 1997).
Thus, the finance literature views undercapitalization as a potential problem for any firm. Based on personal observation, conversations with numerous entrepreneurs and financiers, and the literature, it appears that undercapitalization is a much larger problem for the entrepreneurial firm. There are three primary reasons for this: the nature of the entrepreneurial firm, the nature of the entrepreneur as financial manager, and the nature of entrepreneurial financial markets.
Nature of Firm
Business risk is higher in entrepreneurial firms. Further, much of the risk is company specific and cannot be hedged. As a result, cash flows for the entrepreneurial firm are often highly un predictable, thus increasing the chances of under investment, bankruptcy, and financial distress.
In addition to cash flow being unpredictable, the entrepreneurial firm often faces a growth situation where the amount of investment in needed real assets is much greater than con current cash flow. This increased gap between cash flow and necessary investment raises the risk of underinvestment.
Further, the costs of bankruptcy and financial distress are greater for entrepreneurial firms. There are significant economies of scale in bankruptcy proceedings, both for the firm and other parties involved. Short of bankruptcy, financial distress can significantly damage important relationships with the firm’s stakeholders (e.g., customers, suppliers, and employees). This is a particular problem for entrepreneurial firms be cause their stakeholder relationships are often relatively new and fragile.
From a financial theory standpoint, much of the value of an entrepreneurial firm is in the real options the firm owns (Myers, 1977). The ability to exercise these options at the appropriate time is vital. If it becomes apparent that the firm cannot exercise its real options, then the value of the firm will decline precipitously.
Nature of Decision-Maker
Finance theory starts with the assumption that the decision maker makes decisions in a totally rational manner, with the only motive being that of maximizing the total value of the firm (as op posed to any one class of securities, such as the existing stockholders). However, several import ant exceptions to the assumption are recognized.
A major agency problem exists when the man ager is also the owner of highly leveraged equity. This may lead to situations where the manager causes the firm to pursue ‘‘projects which promise very high payoffs if successful even if they have a very low probability of success’’ (Jensen and Meckling, 1976). Ownership of highly leveraged equity is common in entrepreneurial firms. This is particularly true in venture capital financed firms. While these firms generally have little if any debt, their equity is often tiered with the manager owning common stock and the venture capitalist owning convertible preferred. As a result, the manager may bear little downside risk with the potential for large upside benefit. This can result in the manager making decisions that increase the likelihood of underinvestment, bankruptcy, and/or financial distress.
In addition to being an owner of leveraged equity, the manager is often the owner of con trolling interest in the entrepreneurial firm. Corporate control is valuable to the manager, but potentially magnifies agency problems for the firm (Jensen and Ruback, 1983). Besides guaranteeing a job, control allows the owner/man ager to set the firm’s course. This is particularly important to entrepreneurial firms because enterprise control and autonomy are major non financial rewards for many entrepreneurs. As a result, the entrepreneur/manager is reluctant to seek external financing, particularly external equity, with the outcome being an increase in the likelihood of underinvestment, bankruptcy, and/or financial distress.
Other psychological factors may increase the likelihood of undercapitalization in entrepreneurial firms. If the entrepreneur/manager is risk seeking, then the firm will accept a higher level of risk of underinvestment, bankruptcy, and financial distress than a firm with a risk neutral or risk averse manager. If the entrepreneur is overly optimistic, then the entrepreneur may see the amount of business risk as lower than it actually is, thus increasing the risk of the firm being undercapitalized.
Nature of Capital Markets
Finance theory generally assumes that markets are efficient. However, this is often not the case for entrepreneurial firms. Most have equity needs that are not great enough to achieve minimum efficient scale in the public equity market because of that market’s high information and contracting costs. The private equity market provides some relief but brings a higher cost of capital and often loss of control. This significantly reduces the attractiveness of external cap ital. Further, there are also scale economies in the private equity market that foreclose firms needing small amounts of equity from access to that market. Even if available, there is usually a significant time delay in acquiring private equity (Fried and Hirsrich, 1994).
Because entrepreneurial firms have significantly less access to external equity than large mature firms, they are more likely to operate under hard capital rationing. Further, financial distress often quickly leads to bankruptcy be cause the entrepreneurial firm may not be able to raise external equity when it is experiencing financial difficulties. 240 undercapitalization Taken together, these three reasons accentuate the risk of bankruptcy and financial distress in entrepreneurial firms. The entrepreneurial firm can generally avoid problems with bankruptcy and financial distress by being financially more conservative than a larger, more mature firm. However, at times, such conservatism leads to underinvestment.
Underinvestment is a major problem for many entrepreneurial firms. At times, the effects of underinvestment are hard to directly verify because the firm remains profitable. But, in many cases, underinvestment means the entrepreneurial firm is unable to attain or sustain operations on a positive cash flow basis. Overall, undercapitalization is a significant issue for entrepreneurial firms. Its negative effects are often dramatic and draconian.
Bibliography
Brealey, R. A. and Myers, S. C. (2003). Principles of Corporate Finance, 7th edn. New York: McGraw- Hill/Irwin.
Fried, V. H. and Hirsrich, R. D. (1994). Toward a model of venture capital investment decision-making. Financial Management, 23 (3): 28 37.
Froot, K. A., Scharfstein, D. S., and Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. Journal of Finance, 48: 1629 58.
Jensen, M. C. and Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3: 305 60.
Jensen, M. C. and Rubak, R. S. (1983). The market for corporate control: The scientific evidence. Journal of Financial Economics, 11: 5 50.
Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5: 147 75.
Newton, D. P. (1997). Capital structure. In D. Paxson and W. Wood (eds.), The Blackwell Encyclopedic Dictionary of Finance. Oxford: Blackwell.
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