Some evidence of the external financing costs of new technology-based firms in Canada

Abstract

This exploratory study attempts to estimate the external financing costs (EFCs) for a sample of new technology-based firms (NTBFs). A large body of literature describes the constraints these companies face when trying to obtain outside equity from venture capitalists or non-institutional investors. The theory explains some of these difficulties by the prevalence of information asymmetry, agency costs and moral hazard problems. For NTBFs, these phenomena cause the search for outside equity to be a time-consuming, costly process: the EFCs should thus be considerable, but are a largely unexplored aspect of the small business financing problem. We propose an estimation of these EFCs. Some of these costs are not reported in the financial statements and can be determined only through a field survey and case analyses. In this study, we identify the elements that generate the EFCs and estimate the time frames and costs associated with 18 financing rounds undertaken by 12 NTBFs in Canada. We show that these costs are indeed substantial and heavily penalize small companies, especially during the initial financing round and prior to the commercialization phase. Based on our initial propositions and observations, we conclude that the EFCs are higher for the first round of financing, for companies that have not reached the commercialization stage, and are lower as gross proceeds increase.

Key Words:

• External financing cost
• new technology-based firms
• small business
• financing
• information asymmetry

Acknowledgements

The authors thank the executives and administrative and accounting managers of the firms studied for their valuable participation in this study. The authors thank Pierre Tardif and Claude Racine, of the Quebec Ministry of Economic Development, Innovation and Exports, and Éric Pichon, of Laval University, for their help in conducting this study. The authors also thank two anonymous reviewers and the editor for very helpful comments. Cécile Carpentier gratefully acknowledges financial support from the Fonds Québécois de Recherche sur la Société et la Culture (FQRSC).

Notes

1 See Hutchinson (1999) for a review.

2 Consistent with the studies of EFCs of new public offerings, these papers do not consider the intangible costs of the issues, or the tangible costs other than broker compensation and administrative costs as reported in the prospectus.

3 Because of lax listing requirements, IPOs can be initiated by very small companies, and the median gross proceeds in Canada are consequently less than C$1 million. A specific version of the chart was produced for IPOs, which are characterized by distinctive expense items.

4 Two rounds were not closed and all the costs were not taken into account, particularly legal expenses.