Capital Structure Decisions in Small and Large Firms: A Life-cycle Theory of Financing
July 31, 2000
Zsuzsanna Fluck
ABSTRACT
This paper focuses on the dynamic capital structure of firms: Why do firms use very different financial contracts
in different stages of their life-cycles? In a model of optimal financial contracting, we investigate whether firms'
subsequent financing decisions are affected by the outcome of their previous financing decisions. We find that
the initial and subsequent financing decisions of the same firm may lead to different security choices. The firms'
financing decisions will differ in two respect. First, there will be equilibrium contracts that investors would
reject for some startup firm, but would accept for an otherwise identical ongoing firm (i.e. even when the two
firms have identical projects). Secondly, even the set of the equilibrium financial contracts differs in different
stages of the firm's lifecycle: some contracts which are never sustainable as an initial contract but become sustainable
as a subsequent contract. The reason is the stage-dependency of the control rights of subsequent claim holders:
in addition to their own rights, holders of subsequent security issues may also rely on the firm's existing investors
to enforce their claims. Whether or not they can do so, depends on the priority structure of the claims.
Consistent with empirical evidence, our theory implies a life-cycle pattern of financing: firms will issue outside
equity, short-term debt or convertible debt first, then use their retained earnings, issue longer-term debt, or
outside equity to satisfy subsequent financing needs. Despite the presence of severe market imperfections, the
Modigliani-Miller indifference result between debt and equity does hold for ongoing firms in our model, but at
the same time, it fails to hold for entrepreneurial startups. Since the control rights of previous securityholders
represent an externality for subsequent claimholders, the marginal decision of which security to issue next becomes
irrelevant once a firm has sufficient contractual complexity in place.
Zsuzsanna Fluck
Institution: Stern School of Business, New York University
Email: zfluck@stern.nyu.edu
Telephone: (212) 998-0341
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