THE ROLE OF RISK ORIENTATION ON FINANCING EXPECTATIONS IN NEW VENTURE CREATION: DOES SEX MATTER?
Nancy M. Carter, University of St. Thomas
This study extends previous research on how entrepreneurs capitalize their ventures and risky decision-making by empirically testing the effect of nascent entrepreneur’s risk orientation on their expectations for debt financing. We examine whether non-financial resources like human capital, relationship capital and time investment mediate the effect of founders’ sex on risky capitalization decisions after controlling for owner aspiration and industry sector. The findings reveal that female founders are more risk averse and less likely to expect debt financing to capitalize their businesses. Hypotheses that the effects will be mediated by non-financial resources were not supported. Even after controlling for risk propensity, risk orientation and non-financial resources, females still expect less debt financing from all sources for their businesses.
The capital structure of large businesses has a long history in finance and economics research. Increasingly, this research has been extended to small businesses, which purportedly face very different financing requirements and challenges (Pettit & Singer, 1985; Scherr, Sugrue & Ward, 1993; Berger and Udell, 1998). Far fewer studies have examined the capital structure of new ventures during the first several years of the operation, and virtually none has examined entrepreneurs’ expectations or decisions for how they intend to financially structure the business—decisions made during the preliminary stages of the start-up process.
Previous research indicates liquidity constraints prevent many individuals from entering into business ownership and cause others to open and operate businesses with sub-optimal levels of capital (Evans and Jovanovic, 1989). Businesses with sub-optimal levels of capital are likely to be smaller and have increased risks of failure (Evans & Leighten, 1989; Evans and Jovanovic, 1989). How do nascent entrepreneurs, those in the process of starting new ventures, avoid such constraints? Scheer, Sugrue & Ward (1992: 21) suggest that new ventures should follow Myer’s Pecking Order Hypotheses where, “firms finance their needs in hierarchical fashion, first using internal equity, followed by debt, and finally external equity. This ordering is caused by the effects of asymmetric information and agency problems on the return required by providers of various sources of funds.” While new ventures often have few resources or cash flows that can be used to convince external sources of financing the validity of investing in the business, the organization in emergence is likely to have even greater difficulty convincing outside agents of the business’ risk/reward potential. Consequently, at the emergence stage of the new venture, costs associated with obtaining external funding can be quite high and nascent entrepreneurs may view this option as a risky way to capitalize their new venture. Yet, some nascent entrepreneurs are willing to incur this risk, and expect from the outset to capitalize their businesses with external debt and equity.
Why is it that some entrepreneur’s are willing to incur greater risk in capitalizing their venture while others adopt choices perceived as less perilous? Does the answer to this question vary by gender? Prior research has shown that females are less likely to finance their businesses with external debt and equity. Some have theorized that adverse discrimination has unfairly disadvantaged females in accessing debt from banks and other financial institutions (Brophy, 1989; Cavalluzzo, Cavalluzo, and Wolken, forthcoming). Others have charged that females are more risk averse than males, more likely to avoid debt, and less likely to put personal collateral at risk (Carter & Cannon, 1992). A third perspective argues that females don’t capitalize their ventures with debt because it is not necessary; females prefer to start businesses that are small and concentrated in service sectors, such that they can effectively integrate work and family concerns. Because capital requirements for such businesses are small, the owners can finance the business with personal resources (Coleman, 2000).
From these theories, only the fact that females tend to have smaller ventures concentrated in retail and service sectors has been substantiated. Untested is whether or not this is the result of capitalization decisions made during the start-up process. Findings on the effects of discrimination are mixed at best, and although there has been much speculation, we could find no research that has directly tested the relationship between females’ risk orientation and start-up financing decisions.
In this study we extend Sitkin’s & Weingart’s (1995) mediated model of the determinants of risky decision-making behavior (MMR hereafter) to examine the effect of gender on the risky capitalization decision to use debt financing. Our purpose is to extend previous research by empirically testing the effect of risk on expectations regarding capitalization decisions and examine whether or not the effect is mediated by non-financial resources the entrepreneur brings to the start-up process.
Using “prospect theory”, Sitkin & Weingart (1995) argued that while most research on risky decision-making assumes a direct effect of organizational and personal situations as determinants of risky decisions, in actuality, risk propensity and risk perception mediate the determinants. They defined risk propensity as an individual’s tendency to take or avoid risk. Contrary to traditional thinking that assumes risk propensity is a stable dispositional attribute, Sitkin and Weingart viewed it as an emergent property of the individual, a trait that can be learned or changed as a result of experience. We adapt their model as displayed in Figure 1.
For nascent entrepreneurs, one of the greatest risks is committing personal financial resources to the business venture. Scheer, Sugrue & Ward(1993) argued that the higher the owner’s investment relative to their wealth, the more under-diversified their financial portfolio and the higher their risk. This lack of diversification presumably leads to relatively conservative capitalization decisions. Several studies have found that females are less willing (indicating a lower risk propensity) to commit their personal assets. In a study of stock investment, Jianakoplos & Bernasek (1998) found that men allocated a greater proportion of their assets to stocks than women. We hypothesize:
Hypothesis 1: The more likely the venture is to be started by a female, the lower the risk propensity.
Consistent with MMR however, we hypothesize that the relationship between sex and risk propensity may be mediated by experiences and learning. We expect that several non-financial resources mediate the relationship: human capital, relationship capital, and time investment. We reason that the higher the individual’s formal education, industry, managerial and previous start-up experience; the less risk they will perceive investing personal assets in the new venture. Findings from Johnson & Powell (1994) support this supposition. They found that risk aversion related to experience, formal management education and training.
Similarly, we posit that nascent entrepreneurs starting a venture with a team of people, particularly other family members will be less risk averse. Team members can increase the skill set in the venture, improve capacity for innovation, provide emotional and financial support, all of which can reduce the nascent entrepreneur’s risk propensity and lead them to reduce their reluctance to invest personal assets. Likewise, the entrepreneur’s willingness to invest time in their business can increase their risk propensity.
Hypothesis 2a: The effect of sex on risk propensity will be fully mediated by individual’s human capital.
Hypothesis 2b: The effect of sex on risk propensity will be fully mediated by individual’s relationship capital.
Hypothesis 2c: The effect of sex on risk propensity will be fully mediated by individual’s time invested in the new venture.
As the entrepreneur’s risk propensity increases, the likelihood of risky capitalization decisions should increase. An escalating effect should occur whereby the greater the ratio of the individual’s personal financial investment, the less likely they are to view external debt financing as risky. The entrepreneur’s expectations regarding capitalizing their new venture with outside funds should increase. Furthermore, we expect that the advantages of non-financial resources like work and industry experience, a start-up team, and time invested will mitigate the influence of sex on risky capitalization decisions by increasing their risk propensity.
Hypothesis 3: The effect of sex on risky capitalization decisions will be partially mediated by non-financial resources and risk propensity.
Sitkin & Weingart (1995:1575) defined risk perception as, “the extent to which there is uncertainty about whether potentially significant and/or disappointing outcomes of decisions will be realized.” They say that, “To the extent that a decision involves high uncertainty or extreme outcomes, either in terms of the choice among alternatives or for individual alternatives in aggregate, the decision is characterized as risky.” One of the greatest uncertainties for the nascent entrepreneur is the future outcome of the business. At the outset they can only speculate about the future growth rate of the business, or whether future revenue streams will be sufficient to replace current sources of household income. The greater the share of the household’s expected future income from the business, the less diversified the total income pool. As such, as the nascent entrepreneur’s expectations about the business providing household income increases, their risk perceptions will increase. If, as some speculated, females are more risk averse than males, they should attribute lower probability to the business becoming the primary source of future household income.
Hypothesis 4: The more likely the new venture is to be started by a female, the lower the risk perception.
Like risk propensity, we expect that the relationship between sex and risk perception will be mediated by the non-financial capital of the nascent entrepreneur. Education, work and start-up experiences, and time invested in the business all have been linked to performance and can impart a sense of control over the new venture’s future revenue production. High levels of human capital also can minimize perceptions of risk since they can be applied to other employment opportunities offering a means for recouping losses that may be incurred in the new venture. We expect these sources of non-financial capital to mediate the relationship between sex and risk perceptions.
Hypothesis 5a: The effect of sex on risk perception will be fully mediated by individual’s human capital.
Hypothesis 5b: The effect of sex on risk perception will be fully mediated by individual’s relationship capital.
Hypothesis 5c: The effect of sex on risk perception will be fully mediated by individual’s time commitment to the new venture.
The more certain the entrepreneur is that the future success of the business, for example it’s ability to provide the primary source of the family’s income, the more likely they are to use debt financing to capitalize the business. Their reliance on non-financial sources of capital will make them more willing to risk debt financing to capitalize their business. We expect that the relationship between sex and risky capitalization decisions will be mediated by these risk perceptions.
Hypothesis 6: The effect of sex on risky capitalization decisions will be partially mediated by non financial resources and risk perceptions.
Covariates
Finally, we expect that the nascent entrepreneur’s aspirations and the industry sector they choose to enter will influence the relationship between sex on risky capitalization decisions. Prior research has shown that the intentions and aspirations of the entrepreneur influences small business performance (Davidsson, 1991; Kolvereid, 1992). Females have been characterized as desiring life-styles that hinder intentions (and choice) to develop growth businesses; lifestyles based on preference for smaller businesses where they can integrate work, family and community (Carter & Allen, 1997; Cliff, 1998). Such businesses require lower levels of financial investment and often the entrepreneur can rely on personal resources to get the business operating. Males, conversely, have been seen as having higher growth expectations. Research shows that entrepreneurs who choose rapid, high growth businesses are more apt to rely on outside capital to finance their business. Presumably the higher the aspiration the more likely entrepreneurs will make risky capitalization decisions and rely on debt financing to establish the business.
Strategic choice derives from aspirations. Where the entrepreneur positions the business in the economic landscape, what products they intend to produce, what marketing approaches they initiate affect the amount of capital required to get the business up and running. Businesses that are upstream closer to the source of raw materials typically require greater resources, than businesses downstream closer to the end consumer. Female led businesses have been concentrated downstream, in retailing and service sectors that presumably require fewer financial requirements. Research has found that after controlling for factors such as business size, location, age, industry, and form of business, females were no less likely than males to use credit to finance their businesses (Robb and Wolken, 2002; Riding and Swift, 1990).
We use data from the Panel Study of Entrepreneurial Dynamics (PSED) to analyze the effect of sex on risk and expectations for capitalizing new ventures. Between July 1998 and January 2000 a total of 64,622 individuals in the U.S. were contacted by telephone using a random digit dialing process to identify those in the process of starting a business (“nascent entrepreneurs”). In total 830 nascent entrepreneurs were identified, agreed to be interviewed, and given a cash payment for completing an extensive phone interview. Detailed descriptions of the methods and sampling used to generate the PSED can be found in Reynolds (2000) and in Shaver, Carter, Gartner, and Reynolds (2001).
In the final sample of 830 nascent entrepreneurs, seven respondents indicated that “non-persons” expected to own more than 50 percent of the venture. We removed these cases from analyses, reasoning that they were influenced unduly by corporate interests. Six respondents indicated that their new venture had positive cash flow for more than 90 days before the initial phone interview. We considered these efforts to be infant businesses and disqualified them from analyses. One respondent indicated the start-up involved a team, but failed to provide socio-demographic information that could be used to identify which team member was the respondent. The case was disqualified.
Additionally, since our study ties owner’s expectations to their expectations for capitalizing the new venture, we eliminated cases where the respondent may play only a minor role in the start up process. To identify “lead entrepreneurs” we compared the amount of funding the respondent expected to personally invest in the business to the investments expected of other start up partners. We disqualified respondents if they reported expecting to invest less then any of the other partners. The elimination resulted in disqualifying 44 cases. Similarly, since this is a study of expected financing, we disqualified cases where the respondent reported no financial investment of any kind, either from the start-up team, partners, friends, family, employers or institutional sources. An additional 62 cases were disqualified along with one outlier that reported expecting seven times as much funding as any of the other respondents (more than $15 million expected). The final sample contained 683 cases.
Since the PSED involved over-sampling of certain sub-groups of the population we used post-stratification weights in analyses. Details about the computation of the weighting scheme can be found in Reynolds (2000).
Dependent Variables
Two sets of dependent variables were of interest; (1) individuals’ risk orientation, and (2) the extent to which the entrepreneur expects to finance their venture with debt. Risk Propensity was measured as the ratio of total funds the lead entrepreneur expects to personally invest in the business relative to household assets. Included in household assets is current market value of the home minus any mortgages still owed; total value of tangible assets other than primary residence; and, current value of household savings and investments. Because the distribution of the variable was highly skewed, the log transformation was used in analyses. Risk Perception was measure by assessing the nascent entrepreneurs’ expectation that the new business would become the primary source of their family’s income. Respondents indicated the likelihood on a scale of 0 (completely unlikely) to 100 (absolutely certain).
This study surveyed nascent entrepreneurs in the process of establishing new businesses. Thus, measures of financial capital assessed how they expected to capitalize the business. Following the lead of Scherr, Sugrue and Ward (1993), we measured capitalizing risk as the ratio of start-up debt to expected total capital that will be invested from all sources. Two measures were derived; 1) the percentage of debt expected from all sources including monies from family, friends, employers, credit cards, government programs/foundations, and institutional sources to total investments, relative to total capitalization expected; and 2) the percentage of institutional debt expected (debt from banks, second mortgages, SBA, venture capitalists, personal finance companies) to total expected capitalization.
Independent Variables
Various sources of capital are presumed to mediate the effect of the respondent’s sex on risk orientation, and on the likelihood of financing the new business with debt. Relationship capital derives from dependency among the start-up team. Three categories of start-ups were identified: (1) solo, no relationships, the respondent expects to be the sole owner; (2) family businesses, more than fifty percent (50%) of the team have kinship relationships (two member teams of spouses are included in this category); and (3) teams not dominated by kinship ties among the founders. Dummy codes indicated membership in the category (1=yes; 0=no).
Four aspects of human capital were assessed. Education was measured by collapsing a ten-category question asking about the highest level of education into two categories reflecting achievement of at least a college education (1=yes; 0=no). Industry experience was measured as the total number of years the respondent had worked in the industry in which the new business would operate. Due to its skewed distribution, the square root of the variable was used in analyses. Managerial experience was assessed as the number of years the entrepreneur had worked as a manager. The square root of the index was used in analyses due to the variable’s skewed distribution. Business start-up experience was measured from a question that asked how many other businesses the respondent had previously started. We collapsed the continuous variable to reflect whether the nascent entrepreneur had started at least one other business. We reasoned that it was more relevant to know whether or not they had start-up or ownership experience than to know the total number of experiences. There is likely only incremental knowledge gained from multiple experiences (1=had started prior business; 0=no previous start-up experience).
Time Invested to establish the business may influence the nascent entrepreneur’s general perceptions about risk and their willingness to assume risk in capitalising their company. Time was measured as the number of months since the nascent entrepreneur first undertook any activity to get the business started to the time of the phone interview. The log of this variable was used in the analyses.
Covariates
Owner’s Aspirations regarding the future size of the business were assessed from a question that asked respondents what they expected the total sales, revenues or fees to be in their fifth year of the business’ operation. The log transformation was used in analyses.
Industry Sector was measured from a question asking the entrepreneur to indicate in which economic sector they consider the new business to be. Responses were assigned to one of ten categories. We collapsed the ten categories into three groups: (1) upstream (agriculture, forestry, fishing; mining; construction, manufacturing; and transportation, communications, public utilities); (2) midstream (wholesale; retail); and, (3) downstream (business services; consumer services; health education, medical, government services). Dummy codes indicated membership in the category (1=yes; 0=no).
Sex of the respondent was dummy coded (female=1; male=0).
Table 1 displays descriptive statistics of the variables of interest. Fifty percent of the females expect that their own investment in the new venture will represent only two percent of the household’s total assets; whereas half of the males expect to invest three percent. More than 50 percent of the respondents expect that the venture will become their family’s primary source of income, and more males have this expectation than females (60% vs. 70%). More than half of the respondents report expecting to own the business by themselves (n=353). Of the 330 nascent businesses being created by teams, 209 have all family members; 179 the respondent and their spouse. Males are almost three times as likely to be starting businesses not dominated by family members than females. Females are more likely to be starting alone as sole proprietors. Although females are somewhat more likely to have a college education (43% vs. 39%), other aspects of their human capital tend to be lower. Males are more likely to have experience starting new businesses (49% vs. 43%), to have worked longer in the industry where the business is starting (9.58 years vs. 8.03 years), and to have more managerial experience (9.2 years vs. 7.8 years).
Females tend to have much lower aspirations for the future size of their businesses. The median amount females expect in sales revenue by the end of the fifth year of the businesses operation is $60,000, whereas fifty percent of the males expect two and one-half times that amount, $150,000. Males have been working on the venture somewhat longer than females (32 months median value vs. 28 months) and are two and one-half times more likely to be starting businesses upstream in the industry chain where a more heavy outlay of financial resources is required (25% vs. 10%). Females are more likely to be starting midstream (33% vs. 26%) or downstream (57% vs. 49%) in retail and service.
Males expect total capitalization of their businesses to be considerably larger than females. The median amount of total financing expected by males is $10,000, twice that of females ($5,000). Males expect a greater percentage from team partners, friends, family, employers, and from institutional sources. Of the 256 females in the study 49 percent expect some type of debt investment to capitalize their business but only 12% expect it to come from institutional sources. Of the 427 males, 54% expect some type of debt investment and almost 20% expect it to come from institutional sources.
To test the hypotheses we performed regression analyses. We used a step-down approach entering the variables hierarchically to test the direct and mediating effects hypothesized. Table 2 reports results.
Hypotheses 1 and 4 regarding the direct effect of females starting business and risk orientation were confirmed. The more likely the business is to be started by a female, the lower the risk propensity (asset to wealth ratio invested) and the higher the risk perception (less likely to see the business as the primary source of future household income). Hypotheses 2 and 5 regarding the effect of non-financial resources on risk orientation were partially supported. Teams with non-majority family ownership, a measure of relationship capital, and time invested in the start-up significantly predict risk propensity (putting personal financial assets at risk). Human capital has no apparent effect on risk propensity, but was significantly related to risk perception. As expected, the more likely the nascent entrepreneur is to have a college education, the less likely they are to perceive the business outcome as risky. The less likely nascent entrepreneur are to have a college education and the higher their aspirations for the business, the more likely they are to see the business providing the primary future household income. Contrary to expectations, relationship capital has no apparent effect on risk perceptions.
Females trying to start new ventures have lower expectations that debt will be used to capitalize their business, this includes both total debt and institutional debt. However, hypotheses 3 and 6 regarding risk orientation mediating this effect received only mixed support. Having a college education increases the likelihood of total debt financing whereas time invested in the business decreases the likelihood, as does investing fewer assets. However, neither the non-financial resources nor risk orientation mediates the effect of sex on the total amount of debt financing. Risk propensity does though mediate the effect on institutional debt financing. Time invested in the business and starting the venture in less capital-intensive economic sectors each has a negative effect on institutional debt financing.
Using data from the Panel Study of Entrepreneurial Dynamics (PSED) we analyze the effect of sex on nascent entrepreneur’s risk orientation and expectations for capitalizing their new ventures with debt. We extend the research of Scheer, Sugrue & Ward by using a sample of entrepreneurs in the process of starting the business rather than using retrospective reflections of entrepreneurs that already have an established business. We extend research on risky decision-making behavior from the organization behavior area to understanding the relationship between nascent entrepreneur’s risk orientation and expectations for capitalization of their businesses. Expectations can have a powerful affect on behavior. Finally, we extend the research on women-owned businesses by empirically testing female’s risk orientation relative to capitalization decisions.
Our findings reveal mixed support for the hypotheses. Contrary to our expectations, non-financial resources like human and relationship mediate the effect of sex on risk propensity, but not the effect on risk perception. Females view investing a higher level of their assets relative to wealth as risky, and they are less likely to expect the business to provide the primary household income. Furthermore, neither the non-financial resources, nor risk orientation mediate the relationship between sex and expectations regarding debt financing, even though risk propensity has a direct effect on capitalizing decisions. After controlling for risk orientation and non-financial capital resources, women still have lower expectations regarding the use of debt for financing their new businesses.
These findings suggest that the entrepreneur’s choice regarding debt financing may provide greater explanation for differences in the capital structures of male- and female-owned businesses than discrimination in the capital markets. Apparently women are choosing from the outset to have smaller businesses that will rely less on outside funding to get established. If these initial decisions bind the company’s future, they can be expected to have less capacity, less capital, and less collateral all of which can have an adverse effect on the company’s success.
Finally, the findings extend those of Scheer, Sugrue & Ward (1992) who found little consistent support for the owner’s educational and experience-based characteristics as determinants of capitalization. A college education reduces uncertainty about the business providing future household income, and increases the likelihood of debt capitalization. The amount of time invested in the business increases entrepreneur’s expectation about investing a greater share of personal assets into the business and decreases their expectations regarding the use of debt financing. Aspirations only affect the extent to which the entrepreneur expects the business to provide the primary household income. Surprisingly, previous work experience, whether related to the industry, managerial or in starting other companies, has no significant effect on risk orientation or debt capitalization.
CONTACT: Nancy M. Carter, University of St. Thomas, 1000 LaSalle Avenue, Minneapolis, MN . 55403-2005 (T) (651) 962-4407; (F) (651) 962-4410; nmcarter@stthomas.edu
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