Owner-Managed UK Corporate Start-Ups: An Exploratory Study of Financing and Failure

2.1 Research Questions

Leland and Pyle (1977) posit that information asymmetries between firms and lenders result in owners signaling the quality of their firms via their own equity investments, with such information asymmetries underpinning the pecking order hypothesis (Myers 1984). As stressed by Howorth (2001, 79), “The observed pecking order of demand for finance (internal equity; short-term debt; long-term debt; external equity) is argued to be a response to imperfect markets characterized by information asymmetries.” Related to information asymmetry, Berger and Udell’s (1998) financial life cycle theory is prefaced on the informational opacity of small firms.

In particular, opacity is more severe in small start-up enterprises who have not built reputations. This may lead to a higher cost of capital/credit rationing since external investors cannot differentiate between high- and low-quality businesses. In consequence, such firms rely initially on inside finance. As firms age and grow in size and accumulate experience through the cycle, they become progressively more informationally transparent, facilitating the raising of external finance via debt and then external equity. In this regard, Berger and Udell (1998, 620) reported that equity comprised 48 % of the financing of small US “infant” firms (aged 0–2 years). The following research questions (RQ) are therefore addressed in the current study:

RQ1: How are UK small OM corporate start-ups financed?

RQ2: Is the financing of UK small OM corporate start-ups consistent with the life cycle or pecking order hypotheses?

From an economic and policy perspective the factors associated with business failure are of major import. In terms of avoiding losses and the sub-optimal allocation of resources, empirical evidence regarding the determinants of enterprise survival is also of clear significance to banks and other providers of finance. For instance, as stressed by Lussier and Halabi (2010, 360), “understanding why firms fail and succeed is crucial to the stability and health of the economy”. Importantly, small firms may fail at any stage of their life cycle. For instance, for all UK start-up companies, Wilson, Wright, and Altanlar (2014, 14) report that the failure rate – using the same definition of failure as the current study – is around 1.1 % after 1 year, rising to about 1.2 % after 2 years and then remaining relatively stable over the following five years. Hence the third research question is:

RQ3: What factors are associated with the failure of UK small OM corporate start-ups?

With regard to these research questions, extant SME studies typically focus on either the financing (capital structure) of businesses or the factors associated with firm failure/exits, but not both (e. g. Harkins and Forster-Holt 2014). As described in more detail in Section 3, the current study explores both issues; and in particular, after controlling for owner and firm characteristics, it investigates the association between financial gearing and corporate failure. In this context, Serrasqueiro and Nunes (2012, 628) stress that “SMEs at the start of their life-cycle, struggling to survive with low or no retained earnings, may become excessively dependent on short-term debt, where repayment of the debt and interests are easily monitored by creditors.”

Furthermore, Berger and Udell (1998, 645) state that “One reason that smaller firms typically have less access to longer maturity debt is that they tend to be more both informationally opaque and more risky than large firms”. Importantly, other things equal, an advantage of debt finance is that interest payments are tax deductible for the purpose of corporation tax. Ceteris paribus, the flip side is that the higher is gearing, the higher is the risk of failure, when a company is unable to pay debt interest/repayments as they fall due. More generally, based on balancing the risk-return trade-off, companies may adopt a maturity matching approach to financing, such that short-term (long-term) assets are financed by short-term (long-term) finance sources (e. g. Pike and Neal 1993, 403).

2.2 Method

All UK companies must file statutory annual accounts at Companies House (CH). However, as described below in more detail, small private companies are only required to file a balance sheet (and not a profit and loss) statement of their assets, liabilities, and capital. The accounts must be prepared in accord with accounting standards to provide a “true and fair view” of a company’s financial position. This differs from self-reported comparable data in survey studies which may be subject to measurement error.

The archival data collected for the current study is from the first set of statutory accounts filed at CH by 21,147 small private single OM newly incorporated companies in the corporate fiscal year ending in 2011. Specifically, none of the start-up companies (including 350 failed ones) had filed their second set of annual accounts. As with the current study, typically, extant studies do not model the time to failure (e. g. Appiah and Abor 2009). Also consistent with prior archival studies (e. g. Brabazon and Keenan 2004), the current study examines the financial information contained in the accounts filed prior to failure; and more specifically, the first set of accounts filed at CH prior to failure.

A limitation of archival corporate data is that it relates to the financial position at the end of a company’s financial year. ^[1] Hence financial data is not available at the date a company is incorporated. ^[2] However, relative to survey research, the principal advantage of archival accounting data is its objectivity and reliability, such that financing variables (e. g. gearing) can be readily compared across different corporate studies. A further advantage of archival data is that larger samples are usually available. ^[3] Also, to the author’s knowledge, the current study is the first archival one to examine single OM start-up companies. Hence, comparisons with prior studies which employ archival (Clatworthy and Peel 2013) or survey data (Ang, Cole, and Lawson 2010; Robb and Robinson 2014) are made only for comparable variables/results. As with all studies, comparisons are subject to specified temporal, country and sample design differences.

3.1 Data

The Bureau Van Dijk FAME April 2012 DVD disc is the data source for the empirical study. It contains data for the population of UK companies (Clatworthy and Peel 2013), which is compiled from the statutory filings at CH. This includes annual accounts together with information obtaining to directors’ attributes and company-specific characteristics. The sample of 21,147 companies comprises all live (non-failed) and failed OM small, private, independent, newly incorporated companies, with full data available on the April 2012 disc, and which filed abbreviated accounts. ^[4] Specifically, owner-managed (i. e. a sole director who holds 100 % equity) private independent (i. e. held by individuals and not as subsidiary) companies, which are newly incorporated, and which are small companies filing abbreviated accounts, are included in the sample. ^[5] Financial data is extracted from the first set of annual accounts filed at CH following incorporation for the corporate fiscal year ending in 2011, the latest available on FAME. ^[6]

Under the Companies Act, an independent private company is classified as small and may file abbreviated unaudited accounts, ^[7] if it meets two of the three following criteria: turnover (total assets) do not exceed £6.5 m (£3.26) and the number of employees ^[8] is ≤50. As recorded on their publicly available files at CH, and as indicated on FAME, small companies filing unaudited abbreviated accounts are classified as “total exemption small” (TES). Only TES companies were selected from the FAME database for inclusion in the current study. For accounts data for 2008/2009, Clatworthy and Peel (2013, 11) report that a total of 876,687 UK small independent private companies of all ages were classified as TES by CH. TES companies file annual accounts which comprise an abbreviated balance sheet and no profit/loss account, though profitability measures can be derived from the balance sheet as explained below.

3.2 Variables

Annual accounts data and other statutory information filed at CH is recorded on FAME, enabling a range of variables to be compiled relating to owner, financing and company-specific characteristics. Following extant research, and as indicated on FAME records, the formal definition of corporate failure ^[9] (FAIL) is employed. In the UK, under the Insolvency Act, this occurs when a company it is unable to pay its debts and insolvency proceedings follow via receiver/administrator appointments or a court or creditors’ winding-up order. It is important to note that companies are known as being technically insolvent – also referred to as negative net worth or negative equity/shareholder funds – where the balance sheet value of total liabilities (TL) exceeds that of total assets (TA). This relates to the gearing ratio (TLTA), which reflects financial risk as follows: TA=current assets+fixed assets, which must be financed. TL (total debt)=short-term debt (liabilities)+long-term debt (liabilities). Shareholder funds (SF or total equity)=owners’ equity (issued capital+share premium)+revaluation reserves+retained earnings (profit or loss).

Hence TA=TL + SF (total equity); so for a company with a gearing (TL/TA) ratio of 0.7, 70 % of its financing (TA) is represented by debt and 30 % by total equity (SF). If TL > TA, then a company is technically insolvent. In this case, there must be a negative balancing figure for retained earnings (i. e. retained losses) in the balance sheet profit and loss account. As in this study, for a company producing its first annual accounts, this equates to the loss after tax for the period. ^[10] Importantly, although higher gearing ratios reflect higher financial risk, a company which is technically insolvent will not necessarily fail so long as it has sufficient liquid assets to service debt interest. Similarly for one which fails, the reverse may obtain; that is, it may be technically solvent, but have insufficient funds to meet debt obligations.

Of the 21,147 companies, 43 had share premium balances in their shareholder funds. Share premiums reflect the difference (premium) between the value of the issued capital and the amount owners actually invested as equity. ^[11] Share premiums are therefore added to issued capital to accurately measure the owners’ initial equity investment. Unfortunately, unlike larger ones, small UK companies are only required to disclose the figures for current and long-term liabilities, and not their elements. Hence it is not possible to ascertain the proportion of debt capital provided by owners, which is a limitation of the current archival study relative to survey research ^[12] (e. g. Ang, Cole, and Lawson 2010).

In line with the preceding discussion, Table 2 provides definitions, labels and summary statistics for all variables collected for the study, including those used to investigate initial financing (RQ1 and RQ2) and/or which are employed to examine the factors associated with corporate failure (RQ3). With reference to prior failure research, and as shown in Table 2, a range of variables were collected to model the influence of financing and company/owner attributes on the likelihood of failure (FAIL). As well as the gearing ratio ^[13] (GEAR), the variables retained profit/loss to total assets (RPTA), and whether a company is technically insolvent (NEGEQ) or is making a loss (LOSS), were also computed.

LIQ, the ratio of current assets to current liabilities, is expected to be negatively associated with FAIL, since higher values indicate higher liquidity. The ratio of fixed to total assets (FATA) reflects asset tangibility and has been found to be negatively associated with corporate failure in prior research (Theodossiou 1993, 445; Wilson, Wright, and Scholes 2013, 1380). This may be because creditors are more likely to defer instituting formal failure procedures for defaulting companies where they exhibit higher asset tangibility. As commented by Bessler, Drobetz, and Kazemieh (2011, 24) “A high ratio of fixed to total assets provides debtors with a high level of security since they can liquidate assets in case of bankruptcy”. A further variable which has been found to be positively related to failure (Wilson, Wright, and Scholes 2013, 1380) is whether a charge (CHARGE) is registered by creditors against a company’s assets. This is probably because, in cases of debt default, secured creditors are more likely to institute insolvency proceedings to recover the value of their collateralized loans.

Following prior research, I examine the impact of company size quadratically employing the natural logarithm of total assets (SIZE) and its squared value (SIZE²). Wilson, Wright, and Altanlar (2014) and Wilson, Wright, and Scholes (2013) report a positive (negative) relationship between SIZE (SIZE²) and failure for UK start-up companies and medium and large ones respectively. This indicates that company size is positively related to failure but at a declining rate. In this context, Bernhardsen (2001, 20) emphasizes that “if the firm is sufficiently small, (administrative) bankruptcy costs will exceed the expected liquidation value of the firm, and thus the creditor may not want to initiate bankruptcy proceedings”.

COURT indicates whether or not a court order for non-payment of debt has been obtained against a company in the preceding 12 months and is expected to be positively related to FAIL (Wilson, Wright, and Scholes 2013).

Other things equal, firms with more diversified operations (earnings’ streams) would be expected from portfolio theory to be less failure prone. A variable (DIVERS) is therefore included, denoting whether a company has more than one standard industrial classification (SIC) code (i. e. operates in more than one industrial sector). Following prior research, to control for any systematic industry effects, the following industry dummies were computed using SIC codes: service sector (SERV), retail/wholesale sector (RET), manufacturing sector (MAN) other industrial sector (OIND, i. e. construction, utility, agriculture or mining).

From the available information on the FAME, and as shown in Table 2, a number of variables were collected relating to owner characteristics. The owner’s age ^[14] (AGE) is included to control for accumulated general experience (e. g. Ang, Cole, and Lawson 2010; Clatworthy and Peel 2013). Two further variables are available on FAME relating to experience. EXDIR indicates whether an owner is currently the director of another company; whereas EXINACT denotes whether an owner was previously a director of an inactive company that failed or was voluntarily dissolved. ^[15]A priori, the relationship between these variables and FAIL is not clear cut. For instance, increased expertise may result from being the director of another company (EXDIR), but it may mean less time is devoted by owners to their current one. Similarly, owners may learn from mistakes associated with having been a director of an inactive company or it (EXINACT) may be associated with a relative lack of competence.

Boyer and Blazy (2014, 667) report that start-up micro French enterprises with owners who had studied to at least undergraduate level were more likely to survive. A variable is constructed (QUAL) indicating if owners had disclosed in filing documents that they had a degree or were professionally qualified (e. g. FCA, solicitor or chemist). However, since the disclosure of qualifications is not compulsory, estimates associated with QUAL are conservative ones. FEM is a binary variable with unity indicating a female owner and zero a male one. Though the evidence on the impact of gender on business survival is mixed (e. g. Boyer and Blazy 2014), for UK companies, higher female board representation has been found to be negatively associated with failure (Wilson, Wright, and Scholes 2013; Wilson, Wright, and Altanlar 2014).

Finally, FAME records indicate whether a director is of foreign nationality (FOROW). It is possible that foreign nationals who locate their companies in the UK will be more international in outlook (Higon and Driffield 2011), may possess more expertise/networks in international markets (especially their home ones), and may have access to more sources of debt finance via institutions in their home countries, as well as from those in the UK. In this regard, based on UK SME survey data, Higon and Driffield (2011) report that foreign-owned firms are significantly more likely to export than their UK counterparts. Other thing equal, therefore, a negative association between FOROW and FAIL might be expected. ^[16]

3.3 Empirical Results

Table 2 reports variable means for the total sample and for the failed and non-failed ones. Just over 24 % of the start-up companies are female owned, with 12.1 % being in foreign ownership, and with the mean age of owners approaching 42 years. About 15 % of owners had previously been the director of an inactive company (EXINACT) with a higher proportion (22 %) currently serving as a director of another company (EXDIR). Given that firms in the current study are managed by single owners, this is consistent with prior comparable research which reports that a high proportion (45 %) of Scottish start-up companies had boards where at least one director was a director of another company (Rosa and Scott 1999, 27).

With respect to RQ1 and RQ2, the mean level of gearing (0.954) for all companies is very high, with the median (typical) value also being high (0.894). For the failed and non-failed samples, the means (medians) are 1.202 (0.990) and 0.950 (0.891) respectively. The high reliance on debt financing is reflected in the other financing ratios; with retained profits (RPTA), owner’s equity (OEQTA) and in consequence total equity (TEQTA) making only modest contributions to the financing of new single OM companies. This is reflected in their sample means of 0.053, 0.016 and 0.066, respectively. Furthermore, 23.2 % of companies have negative equity and are technically insolvent, with 24.2 % making losses. These findings contrasts with recent US survey evidence that 29.1 % of small business start-up finance was in the form of owners’ equity (Robb and Robinson 2014). More particularly, excluding failed companies and those with negative equity to facilitate comparability, the mean (median) gearing ratios of 0.720 (0.781) in the current study are more than double those of 0.356 (0.305) reported by Ang, Cole, and Lawson (2010) for small US single-owner companies of all ages.

While not examining financing and corporate failure, the study of Clatworthy and Peel (2013) provides some comparable summary statistics for all UK independent small private companies as defined above under the Companies Act. As shown in Table 3, though lower than for the current study (89 %), they report (p. 10) a median gearing ^[17] ratio of 78 %, with around a fifth (21.8 %) of companies having negative equity. The failure rate (2.2 %) is higher than for the current study (1.7 %), which is consistent with larger companies being more failure prone ^[18]; with the reported (p. 10) mean total assets in Clatworthy and Peel’s study (£286,490) being substantially higher than that for the current one (£52,451). This is unsurprising, in that the Clatworthy and Peel study examines small companies of all ages.

Table 4 presents a correlation matrix of the principal financing variables. As expected, there is a high degree of correlation between GEAR, NEGEQ, RPTA and LOSS. A principal components analysis on these variables revealed that only one component (PC) had an eigenvalue > 1, explaining 86 % of their variance. This variable (PC) is employed in an alternative failure logit model specification (below) as a robustness test. Consistent with expectations and maturity matching (above), the table shows that companies with higher asset tangibility (FATA) are associated with higher gearing (GEAR), with the degree of correlation (0.20) between FATA and long-term debt financing (LTDA) approaching twice that (0.11) of the correlation between short-term debt financing (SDTA) and FATA. In accord with this, CHARGE is positively and significantly related to LTDA, but the correlation between CHARGE and SDTA is statistically insignificant. Hence, companies with a charge against their assets and higher asset tangibility are associated with higher long-term debt financing.

Table 5 provides further evidence on financing. Based on the sum of actual company balance sheet items, it shows total (aggregated) figures for all companies, together with those for the failed and non-failed sub-samples. For all companies, financing amounted to £1,109.19 million (3.41 % of which is represented by failed companies), with total debt comprising 83.8 % of all finance; and with short-term debt making a much higher contribution (70.0 %) than long-term debt (13.8 %), confirming the reliance of small companies on the former. Retained profits and owners’ equity amount to only 15.0 % and 1.2 % of financing respectively. As can be seen in Table 5, for failed companies, total debt exceeds total assets, which is also reflected in retained loss and negative total equity figures, with owners’ equity amounting to only 0.24 % of total financing. For non-failed companies, debt comprises 83 % of financing with the remainder being in the form of retained profit (15.71 %) and owners’ equity (1.27 %). In summary, contrary to the pecking order and life cycle hypotheses (RQ2), UK single OM UK start-up companies rely very heavily on debt financing; and considerably more so than that reported in recent US survey studies of small OM companies more generally (Ang, Cole, and Lawson 2010) and small business start-ups in particular (Robb and Robinson 2014).

In addressing RQ3, on a univariate basis, Table 2 reveals that most of the variable means differ significantly between the failed and non-failed sub-samples and are generally consistent with prior expectations. More specifically, failed companies are larger (TA), have lower liquidity (LIQ), are more highly geared (GEAR), have a lower (negative) ratio of retained profit to assets (RPTA), and are more likely to be making a loss (LOSS) and to exhibit negative equity (NEQEQ). In addition, they are more likely to be male-owned, have a court order for non-payment of debt issued against them in the preceding year (COURT) and to have a registered charge against their assets (CHARGE). Interestingly, foreign-owned companies (FOROW) are associated with a lower likelihood of failure.

Table 6 presents multivariate logit estimates for FAIL. Model 1 shows the principal estimates, with the remaining models reporting alternative specifications. It reveals that, other than for DIVERS, the logit coefficients of all the financial and firm-specific variables exhibit their expected signs and are all highly significant. Specifically, companies are more likely to fail if they have higher gearing, lower liquidity, lower asset tangibility, have a charge against their assets and have a court order against them for unpaid debt. The positive (negative) signs attracted by SIZE (SIZE²) are consistent with extant research (above), indicating a quadratic relationship with FAIL. Hence, company size is positively associated with failure, but at a reducing rate. As discussed above, this may be explained in terms of debts being written-off on cost grounds for smaller companies. It may also be related to owners, or family members, providing loan capital. ^[19] Nonetheless, and importantly, gearing is still a significant determinant of failure after controlling for size and other factors.

With regard to owner characteristics, AGE is negatively related to FAIL, but is statistically insignificant; whereas FEM has a positive but insignificant coefficient (p=0.653). The statistical insignificance of FEM is not necessarily inconsistent with the prior research of Wilson, Wright, and Altanlar (2014), since the benefits of female board representation may be associated with mixed (rather than unitary) gender boards – with extant research indicating that balanced gender boards are the most effective (Litz and Folker 2002; Clatworthy and Peel 2013). EXDIR and EXINACT are negatively and positively related to FAIL, though only EXINACT is significant. The latter finding is consistent with prior research (Wilson, Wright, and Scholes (2013), and suggests that companies with owners who were previously directors of inactive companies are more likely to fail. Model 1 also shows that companies with owners who disclosed they had a degree/professional qualification are less failure prone. Of particular interest, is that new companies owned by foreign nationals (FOROW) are significantly less likely to fail, a finding which warrants further research in a wider context.

As described previously, GEAR, NEGEQ, RPTA and LOSS exhibit a high degree of collinearity. Models 2–6 illustrate this. ^[20] More specifically, Model 3 reveals that, though significant in Model 2, NEGEQ is insignificant (p=0.883) in the presence of GEAR. Models 4 and 5 produce similar findings for RPTA. In all cases, including Model 6 which contains the PC variable, the empirical findings are stable and robust to these specification variations whilst demonstrating the principal role of GEAR. In addition, Model 7 shows that the results are also robust to the omission of SIZE².

Finally, for comparison with Model 1, Model 8 reports estimates for a specification which omits the vector of variables representing owner attributes. Thought the remaining model coefficient estimates are stable, the model chi-square and pseudo R² decline. This is consistent with extant research findings (above) that directors’ characteristics are influential in determining failure.