It’s practically Friday, meaning it’s time for the second entry in our new series looking at practical applications from the world of research. I promised last week we would cover some business-specific questions. Today, we’re looking at a working paper by William Bradford and Tatyana Sokolyk, “Ownership Structure and Performance of Closely Held Young Firms,” available here. I’m going to focus on the part of paper concerning the primary business owner’s personal finances.
If you are a supremely confident entrepreneur that knows you are going to succeed no matter what, this post is not for you. The rest of us face a lot of uncertainty. How do you really know if your startup is a good business idea?
Let’s assume your startup needs some financing. You can finance it yourself with personal accounts, look to other people or institutions for lending or investing, or take a mix of the two.
Bradford and Sokolyk look at subsample from the Kauffman Firm Survey. For this subsample of 3,293 firms, 45% of the primary business owners borrowed funds on a personal account to finance the firm’s operations, and the average amount contributed was almost $42,000.
Bradford and Sokolyk find that six years after being started, firms that receive any financing from the owner’s personal accounts are less likely to survive and if they do survive, have lower performance (measured by assets or sales to income ratios) than firms that don’t rely on the owner’s personal debt. Clearly, taking $1 of money from your checking account is not the same as taking $100,000. Unfortunately, due to the way the research is structured, we don’t know anything about different levels of personal debt and performance outcomes. Still, the results are striking: use of owner personal debt financing is correlated to negative performance outcomes.
They find similar results using a different dataset, the Survey of Small Business Finances—the greater the portion of personal wealth invested by the primary business owner, the weaker the firm performance.
The practical application I think is to shy away from borrowing from your personal accounts as much as possible. Bradford and Sokolyk hypothesize that the use of personal debt means outside investors and lenders were pessimistic about that business’s chances. Given the poorer results of firms financed through personal debt, this interpretation makes sense. I think there are also potentially other benefits to receiving outside financing—e.g. you are financially responsible to another party, so perhaps this gives you a little more discipline. Bottom line: if you have a choice to go with outside financing instead of personal owner accounts, really consider taking it; if you aren’t able to secure outside financing options, take a step back and really think about your business plans.