New research by Professors Robert Carpenter and Bruce Petersen, published in the
latest issue of the Economic Journal, underscores the importance of public equity
markets for the growth of high-tech firms. Their study of the financing of young hightech
firms in the United States that have gone public over the past two decades reveals
that debt financing was generally insignificant while equity financing often brought about
dramatic changes in firm size.
These findings help to explain why America’s high-tech sector, with its highly accessible
equity markets, appears to have developed more rapidly than Europe’s, where many
countries’ equity markets are small, and their financial systems are largely centred
around banks and debt finance. Carpenter and Petersen argue that the availability of
external equity finance may give a nation a comparative advantage in developing its
high-tech sector.
The fact that the Unites States has highly developed public equity markets, extensive
venture capital focused on early-stage investment, and a booming high-tech sector, are
probably not coincidental. In contrast, financial obstacles to entrepreneurship, including
relatively poor access to equity capital, have been the focus of much policy discussion
within the European Union. Public policies designed to reduce barriers to listing publicly
traded firms, and to encourage early-stage venture capital, may improve European
firms’ access to equity finance and stimulate the growth of its high technology sector.
Carpenter and Petersen’s study examines the financing behaviour of young high-tech
firms that went public over the period 1981-98. They show that the typical young hightech
firm used very little debt, either at the time of the IPO (initial public offering) or in
the years immediately following it. New equity financing, in contrast, is very important
for growth, and permits the newly p ublic firm to increase its size dramatically. The funds
from the average firm’s IPO are nearly large enough to increase its assets threefold,
and many firms receive funds that allow them to increase their assets by tenfold. This
dramatic increase in size of assets would not be possible if firms were forced to rely on
either internal funds or debt.
New equity financing has important advantages compared to debt. Equity finance does
not require the firm to post collateral and investors share in the upside returns of
profitable firms. In addition, equity financing does not create incentives for managers to
substitute towards riskier projects and unlike debt, equity does not increase the
probability of financial distress.
Carpenter and Petersen note that young firms may face financial constraints on growth.
The source of the difficulties lies in the ‘information asymmetries’ that are thought to be
widespread in the markets for capital and which can disrupt the supply of funds to firms.
Theoretical research into the nature of information problems has become very
influential among academic economists. Indeed, the 2001 Nobel Prize in Economics
was awarded to George Akerlof, Michael Spence, and Joseph Stiglitz for their research
on asymmetric information.
The Nobel Laureates’ insights apply particularly well to high-tech investment because it
is often intangible and involves new science. The risks and returns of such ventures are
difficult to evaluate. Compared to potential outside suppliers of finance, however,
managers know much more about their own risk of bankruptcy and future profitability.
Suppliers face an information disadvantage, known as an ‘adverse selection’ problem,
which may cause them to finance a disproportionate number of unattractive projects. In
such a setting, suppliers may charge a large adverse selection premium, restrict the
supply of finance to any given firm, or leave the market entirely.
In an environment where there are large information asymmetries, high-tech firms are
unlikely to obtain meaningful quantities of debt finance for reasons apart from the
adverse selection problem. For example, firms that use debt finance have an incentive
to switch to riskier projects after receiving their loans, a phenomenon called ‘moral
hazard’, because creditors do not share (beyond interest and principal payments) in the
returns from highly successful projects.
With greater debt also comes a greater likelihood that the firm will suffer financial
distress, which can result in costly delays of investment projects or even lead to
bankruptcy. Should the firm fail, the intangible nature of high-tech assets means that
there will be little collateral for the lender to seize.
ENDS
Notes for Editors: ‘Capital Market Imperfections, High-tech Investment, and New
Equity Financing’ by Robert E. Carpenter and Bruce C. Petersen is published in the
February 2002 issue of the Economic Journal. Carpenter is at the University of
Maryland, Baltimore County; Petersen is at Washington University, St Louis.
For Further Information: contact RES Media Consultant Romesh Vaitilingam on 0117-
983-9770 or 07768-661095 (email: romesh@compuserve.com); or Bob Carpenter via
email: bobc@umbc.edu