An Investigation of the Types of Problems Faced by Small Firms and How They Affect the Funding Choices Made by Three Distinct Market Segments

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The Journal of Entrepreneurial Finance Volume 12 Issue 3 Summer 2008 Article An Investigation of the Types of Problems Faced by Small Firms and How They Affect the Funding Choices Made by Three
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The Journal of Entrepreneurial Finance Volume 12 Issue 3 Summer 2008 Article An Investigation of the Types of Problems Faced by Small Firms and How They Affect the Funding Choices Made by Three Distinct Market Segments Barbara K. Fuller Winthrop University Darrell F. Parker University of South Carolina Upstate Follow this and additional works at: Recommended Citation Fuller, Barbara K. and Parker, Darrell F. (2008) An Investigation of the Types of Problems Faced by Small Firms and How They Affect the Funding Choices Made by Three Distinct Market Segments, Journal of Entrepreneurial Finance and Business Ventures: Vol. 12: Iss. 3, pp Available at: This Article is brought to you for free and open access by the Graziadio School of Business and Management at Pepperdine Digital Commons. It has been accepted for inclusion in The Journal of Entrepreneurial Finance by an authorized administrator of Pepperdine Digital Commons. For more information, please contact An Investigation of the Types of Problems Faced by Small Firms and How They Affect the Funding Choices Made by Three Distinct Market Segments Barbara K. Fuller* Winthrop University and ** Darrell F. Parker University of South Carolina Upstate This article looks at the relationship between the problems faced by small business owners and the funding sources used to solve those problems. Three problem types are identified: organizational systems, external, and sales and marketing problems. Based on these three problem types and the funding sources used by owners, the market is segmented into three groups using cluster analysis. Segment 1 is made up of firms with few problems. This segment uses the widest array of financial sources. Segment 2 has more problems than segment 3, but both need help with organizational systems resulting in the use of fewer sources. The financial literature has long stated that small firms operate in different financial environments than large companies, thus indicating that different rules apply when making financial decisions (Ang, 1991). Small firms seeking capital for start-up, operation, or growth of their businesses continually face funding decisions concerning how, when, and from whom to obtain needed financial support. Funding solutions may vary depending on the situation or type of problem faced by the firm. For example, developing a new product or technology application * Barbara K. Fuller is an Associate Professor o f Marketing at Winthrop University, Rock Hill, South Carolina. She teaches entrepreneurship, business plan writing and marketing strategy. Her research interests consist of small business topics including global and financial issues and geographical information systems. ** Darrell F. Parker is Dean o f the Johnson College o f Business and Economics at University of South Carolina Upstate. His research interests include economics, small business and applied economic behavior. 72 An Investigation of the Types o f Problems Faced bv Small Firms,..{Fuller & Parker) may require a different funding source than penetrating a new geographic territory. Financial options vary depending on the type of problems the owner faces, his knowledge of the market, and his experience with different funding sources. One firm may face internal organizational problems and therefore lack the ability to get a bank loan for additional equipment or growth. Other firms may struggle with issues associated with sales and marketing. It is the founder who must analyze the current situation and make decisions about the best mixture of financial resources. This research looks at the relationship between the most common situations or types of problems experienced by small business owners and the funding sources they use to solve these problems. The first challenge was to develop a comprehensive list of common problems faced by small firms. Understanding how problems are classified provides a basis for linking a specific type of problem to a specific problem-solving activity. In this research we look at the funding sources that were used by small firm owners to solve specific types of business problems. Dutton and Jackson (1987, pg. 85) indicate that The simple labeling of issues not only determines decision makers affective responses to issues, but also it sets into place predictable, cognitive, and motivational processes that move decisions and organizations in predictable directions. This study asks: Will small firms with similar problem types have similar financial responses? To answer this question we look at contingency theory. Contingency theory claims that there is no one best way to make decisions. The theory asserts that managerial decision-making depends on the elements of the situation. As applied in this study, there is no one best source of funding for small firms. A funding source that is highly effective in solving one type of problem such as attaining market share may not be useful in dealing with the development of financial systems and internal controls. The optimal funding source is contingent upon the type of problem faced by the business owner. The contingency approach suggests that there are patterns that can be seen in common situations (types of problems) that will cause individuals and groups (business owners) to interpret and react with specific behavioral responses (funding decisions). As early as 1958, March and Simon discussed problem classification much like a stereotyping process, where placement of a problem into a group creates a series of likely reactions. The label, and the body of knowledge that accompanies it, stimulates specific strategic decisions (Walsh, 1988). It is through the owners continued confrontation with the problematic stimuli that a response to specific problems is developed; eventually resulting in the formulation of a taxonomy of problem types (Ramaprasad & Mitroff, 1984). The categorization of problem types consolidates daily situations into groups of activities that help to simplify the process of decision making (Schwenk & Thomas, 1983). D raf s (1988, pg. 56) claims that when logical patterns occur in organizations, it is possible for managers, in this case business owners, to... apply similar responses to common types of problems. In this study the researchers investigate the link between common problem types and decisions made on the type of funding that is used to solve those problems. In other words it is hypothesized that the type of financing sought by a small business owner is contingent upon the type of problems the company faces. I. Problem Type Classifications Problem type formulation is based on the belief that business owners characterize the many situations in which they find themselves every day as problems. Once identified, these problems can be classified in a way that makes the owner s life less complicated and simplifies his interpretation process. Using contingency theory Cowan (1988) suggests there are common types of problems that business owners can identify and react to consistently. As owners The Journal o f Entrepreneurial Finance & Business Ventures, Vol. 12, Iss experience problems they experiment with a variety of solutions. This experimentation creates a base of knowledge that affects the way the problem is resolved in the future. As a particular solution is connected with a particular type of problem, a link is created that will surface again when the business owner faces the same type of problem (Daft & Weick, 1984; Dutton & Duncan, 1987; Dutton & Jackson, 1987; Walsh, 1988). Repeated experience with the same type of problem allows business owner to become more proficient at classifying problems and identifying solutions. Behaviors are learned and used again and again, resulting in similar response patterns when business owners face similar types of problems (Daft, 1988). This learned behavior helps to guide subsequent decision making activities (Schwenk & Thomas, 1983). A review of the literature indicates that there are a number of frameworks categorizing the type of problems commonly faced by small firms. In 1993, Terpstra and Olson reviewed the predominant classification fi*ameworks for categorizing organizational problem types. These firameworks look at functional problem type classifications (Dearborn & Simon, 1958; Walsh, 1988; Cowan 1990), classifications based on business failure (Bruno, Leidecker & Harder, 1987), classification associated with growth (Anderson & Dunkleberg, 1987), and classifications based on lifecycle information (Kazanjian, 1988; Kuratko & Hodgetts, 1989; Churchill & Lewis, 1983). Although each of these studies identified different numbers and groupings of problem types, there were similarities in the problem categories. The Terpstra and Olson study (1993) examined 115 rapidly growing firms and identified nine problem classifications for start-up firms and 10 for later growth firms. The problem types were obtaining external financing, internal financial management, sales/marketing, product development, production/operation management, general management, human resource management, economic environment, and regulatory environment. Organizational structure/design was added to the list for later growth firms. Sales/marketing, obtaining extemal financing, and internal financial management problems were the dominant start-up problems, whereas during the later grow stage sales/marketing, internal financial problems, human resource management, and general management problems were dominant. Kazanjian s (1988) study identified the most comprehensive Hst of 18 problem types based on a review of two case studies. Using factor analysis these problem t)^es were condensed into six factors: organizational systems, sales/marketing problems, people problems, production problems, strategic positioning, and extemal relations. His results indicated that extemal relations problems were more dominant in the start-up stage and sales/marketing and organizational systems problems were more dominant in the later growth stage. However, some problems such as sales/marketing and strategic positioning were found to dominate across all lifecycle stages. Kazanjian s 18 types of problems compared favorably to the nine problem types identified by Terpstra and Olson (1993). Therefore, Kazanjian s original 18 dominant types of problems were used in this study. This section summarized the literature on problem type formulation and identifies the instmment used to measure problem types in this research. The next step is to look at financial decision making in small firms. II. Financial Decision Making within Small Firms Traditional finance theory is based on the assumption of perfect capital markets and the behaviors of large corporations (Modigliani & Miller, 1958). Frank and Goyal (2006) provide a recent review of the literature on capital stmcture decisions. However, much research has 74 An Investisation o f the Types of Problems Faced by Small Firms,.. {Fuller & Parker) documented that applications of basic financial theory has less relevance when discussing the financial behavior of smaller firms (Ang, 1992; McMahon & Stanger, 1995; Walker & Petty, 1987). According to Ang (1991), small businesses have unique issues associated with the challenges of asymmetric information, undiversified portfolios, unhmited liability, high risk tolerance, incomplete management teams, high failure and transaction costs, and the integration of personal and business factors. The presence of these intervening variables creates a more complex picture when looking at how small business owners evaluate and use financial resources. McMahon and Stanger (1995) outline a framework, the financial objective function for small enterprises, that takes into account return and wealth maximization covered in the traditional financial theory for large companies but also covers the issues of risk from the small firm perspective. Consistent with traditional financial theory, the major goal of larger firms is the amount of return or maximizing wealth and profit (Brealey, Myers, & Allen 2006). This may also be the goal for more aggressive entrepreneurial or growth-oriented small firms (Ray & Hutchinson, 1985). However, for smaller family and lifestyle-oriented firms, wealth maximization might represent only one of a group of complex interrelated goals held by their owners. Boyer & Roth suggest (1978) that too many small firms non-pecuniary rewards such as self-actualization, community status, job security, a stable income, and pride are more important than the pecuniary rewards. Because of these beliefs, pecuniary returns are traded off for nonpecuniary returns. These non-pecuniary goals become a significant part of the financial decision process for small firms (Timmons & Spinelli, 2004, 1978; Pandey & Tewary, 1979). The second dimension that McMahon and Stanger (1995) looked at in their financial objective function for small firms is risk--both systematic risk, which is associated with large company financial theory, and unsystematic risk, which takes into account the dimensions associated with financial small firms: liquidity, flexibility, control, accountability, diversification, and transferability. The first dimension, liquidity, is an especially difficult issue for small business owners. Because of the small firm s lack of access to financial markets, cash and working capital often become scarce resources and require a great deal of the owner s time and energy (Ang, 1991). In many cases, the amount of profit becomes a secondary issue to cash flow. Small firms can survive with lower profit levels and even losses for long periods. The critical issue for the small firm is cash flow and making the necessary immediate payments to stay in business (Welsh & White, 1981, pg. 29). The second dimension relates to the small firm s need to be flexible. However, in reality resources are often encumbered. It is important to be able to respond to changes in technology or economic conditions when necessary. Ace, Carlsson, and Karlsson (1999, pg. 34) suggest that management competence is more important than availability of financing. Knowing how, when, and from whom to obtain capital is essential for growth and survival; therefore, it is... important to have multiple and diverse sources of finance, with different capabilities, viewpoints, risk assessment and willingness to absorb risk working closely with SMEs (Small and Medium Enterprises). The third and fourth dimensions of control and accoimtability are multifaceted and have far reaching effects on the future of small firms. The owners personal and business goals must be combined and evaluated to fully understand the issue. Overall, small business owners would prefer to have control over strategic decisions (Shrivastavo & Grant, 1985). Therefore, the fear of losing control may result in many owners refusing to accept an offer for external funding. The Journal o f Entrepreneurial Finance & Business Ventures, Vol. 12. Iss.,? 75 And finally, McMahon and Stanger (1995) examine the risk associated with diversification and transferability. Transferability deals with the inability of the business owner to quit or transfer from the enterprise. The lack of transferability is based on the owner s limited ability to sell shares at will in the market, thus preventing the acquisition of capital by the sale of stock. The small firm by nature also lacks diversification in financial and human capital which may affect the value of the business. Since the owner s assets are tied up in the company, there are no other stock options to balance a potential decline in the firm s stock price. Overall, this framework by McMahon and Stanger (1995) provides insight into the business owner s financial decision-making based on the complex risk factors facing small firms. Looking at how these risk factors intervene in financial decision-making can help explain what may seem to be irrational financial behavior from the perspective of traditional financial theory and perfect capital markets. Recent results from research by Cole (2008) and funded by the Small Business Administration are important because this study is the first to look at how small privately held company s use of leverage differs from publicly traded firms. Until this study, much of the research on small business owner s financial behaviors was based on small publicly owned firms or theory. Cole s (2008) research concludes that as small privately held firm leverage increases firm size, profitability, liquidity, and credit quality decreases, whereas firm tangibility and limited liability increases. Furthermore as firm leverage increases, the number of business relationships with banks as well as nonbank financial institutions also increases. This research is important because it provides evidence of the relationship between the leverage circumstances of the smallest privately held firms and the financial decision-making of the firm s owner. III. Research Objectives The primary objective of this research is to look at the relationships between the types of problems faced by small firm and their use of funding sources. In other words, do small firms rely on certain funding sources when facing some problems and other types of funding when the problems are different? Second, the study investigates the number of funding sources used by business owners. More funding sources are thought to be available to businesses with fewer problems. And finally we look at how problem types may affect the use of the more traditional low cost funding sources versus less traditional higher cost funding sources. More traditional, lower cost sources are thought to be used by those firms with fewer problems. Hypothesis 1: The funding sources used by the small firm owners are related to the type of problems faced by the firm. Hypothesis 2: The number of funding sources used by a small firm owner is inversely related to the number of problems faced by the firm. Hypothesis 3: Low cost traditional funding sources such as commercial bank loans are more likely to be used by small firm owners with fewer problems than higher cost, less-traditional funding sources such as credit cards. IV. Methodology A list of 4,000 small business owners in the retail and service industry in the Southeastern United States was purchased from Dun & Bradstreet. The questiormaire asked respondents to indicate 76 An Investigation o f the Types o f Problems Faced hv Small Firms... {Fuller & Parker) whether they were users or nonusers of 15 funding sources. Development of the problem types section of the survey was based on previous research on dominant problems facing small businesses by Kazanjian s (1988). Respondents were asked to indicate whether their businesses encountered the problem type and to rate the importance of the problem type on a seven-point Likert scale. Kazanjian s 18 problem types are listed in Appendix A. The questionnaire also contained sections with questions relating to the demographic characteristics of the firm and the current level of satisfaction with the firm s performance. The questionnaire was initially pretested on a group of three marketing instructors and three retailers and revised for clarity. Subsequently, the questionnaires were mailed and reminder notes sent three weeks later. A total of 200 usable questionnaires were returned, providing a response rate of 5.5%. The response rate for this survey was low. Response rate data indicates average response rate for small businesses is 27% (Bartholomew & Smith, 2006) versus an average response rate for larger firms of 56% (Baruch, 1999). Nevertheless, research on small firms relies heavily on mailed questionnaires for data collection (Bartholomew & Smith, 2006). Several factors make it more difficult to obtain a high response rate from these firms. Bourgeois (1981) indicates that small firms might have less
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