Capital Structure Decisions in Small and Large Firms: A Life-cycle Theory of Financing

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 ¯rm (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 claimholders: 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.