Frontiers of Entrepreneurship Research
1996 Edition
SUMMARIES

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THE ENTREPRENEUR AND THE BANKER: A COMPARATIVE STUDY OF PERCEPTIONS


(1)J. William Petty
(2)Nancy B. Upton

(1)P.O. Box 98004
Department of Finance
Baylor University
Waco, Texas 76798

(2)P.O. Box 98011
The John F. Baugh Center for Entrepreneurship
Baylor University
Waco, Texas 76798

Telephone
817-755-2260
214-755-2265

Fax
817-755-1092
817-755-2271

Principal Topics

This study examines the fundamental issue of the entrepreneur-banker relationship, particularly as it relates to the banker as a provider of debt capital. Essentially, the banker and the venture capitalist are about the same business: effectively structuring the financing instrument so as to find the right balance of sharing cash and risk. In determining this balance, there are two central issues as it relates to investor risk. First, there is a need to reduce the risk associated with information asymmetry between the lender/ investor and the entrepreneur. The entrepreneur may exploit this information asymmetry to obtain financing terms that do not adequately compensate the investor for the risks being undertaken. The second potential concern regards moral hazard. The problem relates to the borrower having an incentive to use funds obtained from external sources to finance a riskier project than originally envisioned since any upside benefits are captured entirely by the equity holders of the firm, while downside risks are shared with the lender. The thinner the equity position of the firm’s insiders, the greater is the moral hazard problem.

The banker has two avenues for minimizing the risks of information asymmetry and/or moral hazard: (1) maintaining an on-going relationship for the purpose of monitoring the entrepreneur’s performance, and (2) structuring the loan to reduce the likelihood that the entrepreneur will make decisions that negatively impact the lender. Thus, this research endeavor specifically looks at:

• The nature of the relationship between the banker and the entrepreneur, and

• The purpose and implications of how loans are structured.

We are particularly interested in a comparison of perceptions and expectations between the banker and the entrepreneur regarding these two matters.

Method

The research process is being done in two stages. First, individual bankers and entrepreneurs of small- and mid-sized firms have been interviewed for the purpose of identifying the key issues as perceived by both groups. Based on these interviews and complemented by the relevant literature, a survey instrument is being developed for use with a broader sample of firms (borrowers) and banks. The sample of borrowers consists of the following groups: (1) the "Best Small Companies" selected by Business Week and Forbes, (2) the Inc. 500 firms, and (3) a random sample of firms taken from the D&B database with sales between $2 million and $30 million--excluding financial institutions and real estate companies. The banks are also selected from a random sampling of the D&B database, stratified geographically, by asset size, and by involvement and interest in small-company loans.

Major Findings

Based on the findings to date, entrepreneurs and bankers generally have a fundamental respect and appreciation for one another--contrary to the anecdotes often cited. Furthermore, the amount of trust and openness in the relationship between the banker and the entrepreneur serves as the foundation for the structuring of a loan. There are, however, differences which can result in frustrations. Some of these include:

• Entrepreneurs view the banker as too interested in the financial numbers and not enough in understanding the business.

• Entrepreneurs frequently see bankers as inflexible and lacking creativity.

• Entrepreneurs have a fear that the banker will be there in the good times but not in the bad.

• The entrepreneur thinks of himself or herself as a possibility thinker, while the banker views his or her role as bringing realism to the situation, especially in the financial projections.

• Bankers want to be perceived as doing more than just providing money; they think of themselves as facilitators of a firm’s goals and plans. They question, however, if entrepreneurs have an appreciation for their desire to add value beyond the loan.

• Bankers are reluctant to make a loan to a new firm where the repayment of the loan primarily depends on the success of the business.

• While bankers do not like being surprised by the entrepreneur--especially bad surprises--neither do entrepreneurs like being surprised by the banker.

• Bankers perceive entrepreneurs as failing to appreciate the concept of shared risk.

• In structuring a loan agreement, the banker usually has two non-negotiables: (1) personal guarantees for closely-held firms, and (2) the need for equity investment by the entrepreneur to complement the loan.

• For the banker to make a loan, there must be both a primary source of repayment (usually cash flows from operations) and a secondary source for repaying the loan(usually collateral).

Implications

The purpose of this research is to come to a better understanding of the on-going relationship between the banker and the entrepreneur. As a primary provider of capital to smaller companies, there is a great need for an increased understanding and appreciation for the perspectives of each group. To date, we have little more than anecdotal evidence of this relationship. There is much more that needs to be done.

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