performance of newly-formed micro firms

Journal of Developmental Entrepreneurship

World Scientific

© World Scientific Publishing Company

www.worldsclentific corn

PERFORMANCE OF NEWLY-FORMED MICRO FIRMS: THE ROLE OF CAPITAL FINANCING IN MINORITY-OWNED ENTERPRISES

ROWENA ORTIZ-WALTERS Department of Management Quinnipiac University

Hamden, CT06518 Row ena. Ortiz- Walters@quinnipiac. edu

MARK Girds Department of Economics Quinmpiac University

Hamden, CT 06518 Mark. Gius@quinnipiae. edu

Received September 2011 Revised March 2012

'1

We sought to ascertain whether newly-formed micro firms owned by minority" entrepreneurs would be as likely to be profitable or not when compared to non-minorityb business owners Additionally,

we placed special emphasis on the impact of equity and debt to determine if capital financing influences firm profitability the same or differently for minority as compared to non-minority owned micro firms. Using longitudinal data from the Kauffman Firm Survey, micro fimas owned by Hispanic and Black entrepreneurs were less likely to be profitable than non-minority owned micro firms, whereas profitability differences were not found between the latter and Asian-owned micro firms. Moreover, Hispanic and Black-owned micro finns that made use of personal debt were more likely to be profitable than those using only equity to finance operations. Asian-owned micro firms that utilized business debt were more likely to earn a profit than those solely using equity. Alternatively, non-minority owners benefited in terms of profitability from the use of both personal and business debt. Implications of these findings for minority entrepreneurship are discussed. Keywords: Firm profitability, small business finance, minority entrepreneurs.

1. Introduction The latest census data indicate small companies, those with fewer than 500 employees, make significant contributions to the U.S. economy (U.S. Census Bureau, 2012). In this study, we investigate newly-formed micro firms, defined here as companies that employ

b

We use the term minority to refer to individuals of Hispanic, Black or Asian racial!ethnic backgrounds. The term non-minority refers to individuals who identify as non-Hispanic and of CaucasiardWhite descent

2

Ortzz-Walters and Gius

25 or fewer individuals because the vast majority of small businesses-over 90 percent-are concentrated within this range of employees (U.S. Census Bureau, 2012). Within this category of finns, racial or ethnic minorities have entered into self-employment at faster rates than their non-minority counterparts (Christopher, 1998; Fairlie, 2004). According to the Survey of Business Owners (SBO), the number of businesses started by Latino, Black and Asian entrepreneurs grew by over 43 percent, 60 percent and 40 percent, respectively, from 2002 to 2007 (U.S. Census Bureau, 2012). During the same time period, the growth in businesses owned by non-minorities saw a much smaller increase.

Collectively, minority-owned micro firms generate revenues of over $920 billion and employ over 5 million persons (U.S. Census Bureau, 2012). Despite the positive growth pattern being reported, research has consistently found that minority-owned firms are less successful on a number of dimensions than non-

minority owned firms. Minority-owned firms are more likely to close and thus, have lower survival rates than non-minority firms (Boden and Headd, 2002; Christopher, !998; Robb, 2002). Not only are they less likely to survive, minority-owned firms also have a lower probability of growth than non-minority owned firms (Rogers, Gent, Palumbo and Wall, 2001). Moreover, research finds significant differences in access to and amount of start-up and operating financial capital between minority and non-minority business owners (Blanchard, Zhao and Yinger, 2008; Coleman, 2004a; Smith-Hunter and Boyd, 2004). However, prior research shows financial capital has a strong positive association with firm outcomes such as profitability, sales and growth and a negative relation to the likelihood of business closure (Coleman, 2007; Robb and Fairlie, 2009). Given this, the purpose of the present study is threefold. First is to examine whether minority-owned micro firms are less likely to earn a profit than non-minority owned micro firms, because few prior studies have made this racial/ethnic comparison and yet, profitability is a key issue for small firms (Coleman and Cohn, 2000). Another important goal is to compare the similarities and differences in the impact of financial capital-specifically equity versus debt-ÿn firm performance for minority and non-minorityowned firms. Along these same lines, a final salient contribution of this study is to examine the impact of financing on the profitability of minority-owned firms, which research, to date, has not addressed. We do so both for minority groups separately (i.e., Hispanics, Blacks and Asians) and longitudinally because entrepreneurs may learn lessons along the way (Bates, 1990) that should help them improve firm performance. Because minority-owned firms have lower survival rates and financial success than non-

minority owned ventures (Boden and Headd, 2002; Carvajal, 2004; Christopher, 1998; Robb, 2002), what we seek through these analyses is to help determine what sources of financial capital are likely to be most beneficial and, in so doing, contribute to the growing body of literature on minority entrepreneurship. We address these issues by analyzing longitudinal data from the Kauffman Firm Survey (KFS), a recent, national database of newly-formed firms, which contains a large number of minority-owned ventures. Many of the prior studies on minority business owners have utilized the Survey of Small Business Finances (SSBF), Characteristics of

Performance of Newly Formed Micro Firms: Role of Capital FinanchTg

3

Business Owners (CBO) Survey or Survey of Minority-Owned Business Enterprises (SMOBE) but, as suggested by Blanchard et al., (2008), an interesting comparison can be made to see if similar results and new insights can be generated by using a different and more current dataset. 2. Literature Review

2.1. Firm performance and financial capital In this study, we are interested in examining minority-owned venture performance and the extent to which reliance on capital financing by these owners impacts micro firm profitability--defined as business income alter all expenses and taxes have been deducted (DesRoches and Robb, 2009). To inform us, we focused on the literatures related to type of financing available (supply-side) and sought by small firm owners (demand-side) and research that looked at determinants of small firm performance and profitability (e.g., Astebro and Bernhardt, 2003; Bosma, van Praag, Thurik and de Wit, 2004; Davila, Foster and Gupta, 2003; Hamilton and Fox, 1998). This literature suggests access to both debt and equity may play a significant role in firm profitability. Regarding debt, there are many methods by which it may be obtained, ranging from traditional bank loans to the use of credit cards. For purposes of the present study, we are investigating two classifications of debt: personal debt, which is obtained in the owner's ,y

name; and business debt, which is obtained in the name of the business. Examples of personal debt include home equity loans, personal credit cards and loans from family or friends taken out in the owner's name. Examples of business debt include business or corporate credit cards, business loans from banks or other financial institutions and loans from non-financial institutions such as government agencies. Equity, on the other hand, likely involves the owner putting in personal funds or obtaining money from close relations such as family members and friends (internal equity) or taking on one or more partners, who may choose to be either actively involved or "silent," in exchange for a capital investment in the firm (external equity). Studies conducted examining the financing of fiÿmns show there to be a positive relationship between financial capital and venture performance (Brush and Chaganti, 1998; Cooper, Gimeno-Gascon and Woo, 1994; Haber and Reichel, 2005). More specifically, when there is a shortage of financial capital, this can hurt the survival and growth of the finn (Cooper et al., 1994) because firms are dependent on the influx of capital to make operations more efficient, expand into new markets, or serve a new

customer base. In addition, more financial capital means there will be an increase in the earnings of the firm (Honig, 1998) leading to "financial slack" (Coleman and Cohn, 2000). Thus, access to greater amounts of financial capital allows firms to invest in the development of new products and/or services, hire more employees and grow (Coleman, 2007). Higher levels of financial capital have also been found to decrease the likelihood of business closure (Bates, 1990).

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Ortiz-Walters and Gius

Regarding minority-owned businesses, few studies have examined differences in finn profitability between minority and non-minority ventures (for an exception see Scott, 1983; Robb and Fairlie, 2009) and, specifically, the impact of financial capital. However, what generally has been found is that minority-owned firms underperform on a number of measures compared to non-minority owned ventures. For example, non-

Hispanic firms generate more sales than Hispanic firms even with identical characteristics (Carvajal, 2004). Minority-owned firms are also more likely to close (Boden and Headd, 2002; Christopher, 1998; Robb, 2002) and have a lower probability of growth than non-minority owned firms (Rogers et aL, 2001). A review of the findings from these studies shows minority-owned enterprises tend to be at a disadvantage When compared to non-minority owned firms. In addition, the results highlight the importance access to financial capital can have for firm performance. As such, we extend this line of research and contribute to the literature on minority and ethnic entrepreneurship by comparing the firm profitability of minority-owned micro finns to that of non-minority owned micro firms over time. In addition, because research has begun to tease out some of the nuances in the experiences of different minority groups (Bates, 1989; Feldman, Koberg and Dean, !991; Pointer, Jackson and Smith, 2004), we examine Hispanic, Black and Asian entrepreneurs separately. Finally, we investigate whether financial capital structure--debt versus equity has a differential impact on venture profitability in minority micro frms compared to non-minority owned micro firms.

3. Theoretical Framework and Hypotheses The first goal of this study is to gain a better understanding of performance for minorityowned ventures by comparing firm profitability to that of non-minority owned enterprises. Not many studies have done so, to our knowledge, with the exception of

Scott (1983) and Robb and Fairlie (2009). Scott (1983) found that minority-owned firms were no less likely to be profitable than non-minority owned ventures; however, it should be noted this study looked at mature successful firms within restricted geographic areas and it is unclear what the make-up of the sample of minority owners is because this information was not provided. In contrast, Robb and Fairlie (2009) found that Black and Hispanic-owned firrns were less likely to be profitable than non-minority firms while no profitability differences were observed between this latter group and Asian-owned firms. We build on these studies by looking at the profitability of newly-formed micro firms for multiple minority groups using more recent, longitudinal data in addition to examining the impact of capital structure. Considering so little research attention has been paid and the current findings are mixed, we address these issues in the sections that follow given firm profitability matters because it can contribute to firm growth and survival as well as it has been found to influence access to external debt (Coleman and Cohn, 2000).

Perfolwlance of Newly Formed Micro Firms: Role of Capital Financing

5

3.1. Profitability of minority versus non-minority micro flrms Drawing on arguments grounded in a human capital perspective (Coleman, 2004b, 2005b), we would expect micro firms owned by minority entrepreneurs to be less likely to earn a profit than those owned by non-minority entrepreneurs. Human capital refers to owner-related factors such as managerial expertise and financial management (Thornhill and Amit, 2003) as well as educational attainment (Coleman, 2004b) and pre-ownership experience that can facilitate the process of running a business. New (and often smaller) companies are likely to fail when there is a lack of this important organizational resource because, in the context of a small business, the effects of human capital of the owner/manager may be inseparable and therefore, more pronounced on firm performance

(Bates, 1990; Chrisman, Bauerschmidt and Hofer, 1998; Coleman and Cohn, 2000). For example, in small firms, research has shown that an owner's education level is a positive and strong contributor to business longevity (Bates, 1990). This is akin to a resourcebased view of the firm (Barney, 1991), which argues that it is the unique and inimitable resources a firm has that allow it to enjoy a competitive advantage and outperform the competition. However, firms of minority entrepreneurs tend to be younger and smaller in size than non-minority owned firms (Rogers et al., 2001), which subjects them to liabilities of newness and smallness that often result in poorer firm performance (Steffens, Davidsson and Fitzsimmons, 2009). However, an interesting paradox exists when examining minority-owned firms. Although some research finds no differences in human capital between Hispanic, Black, Asian and non-minority owners (Ando, 1988), other research indicates differences between minority and non-minority business owners and also among minority entrepreneurs themselves. For example, it appears Asian owners are more highly

educated in that more Asians than Hispanic and Black entrepreneurs have been found to hold a college degree (Feldman et al., 1991). In light of this latter perspective, we make separate predictions of expected differences between non-minority owned micro firms and those owned by Hispanic, Black and Asian micro 15nn entrepreneurs. Hispanic and Black 01ÿners. Although generally highly educated (Dadzie and Cho, 1989), Black and Hispanic owners may not have sufficient levels or the right types of human capital necessary for business success. For example, Black and Hispanic entrepreneurs are less likely to graduate college when compared to non-minority entrepreneurs (Bates, 1997; De Carlo and Lyons, 1979; Rogers et al., 2001; Smith-Hunter and Boyd, 2004). Yet owners' formal education has a positive association with firm performance such as sales, growth, profitability and firm survival (Christopher, 1998; Coleman, 2007; Robb and Fairlie, 2009; Roger et al., 1991). Moreover, research has distinguished between minority firms that make it past ten years and those that are in business for less than ten years. One difference is that those iTrms less likely to survive for longer periods are owned by minority entrepreneurs who lack business expertise in areas such as marketing and obtaining working capital (Dadzie and Cho, 1989). In general, Black and Hispanic venture owners may have little business

6

Ortiz-Walters and Gius

specific knowledge and managerial experience needed to run a business (Ahiarah, 1993; Hisrich and Brush, 1986); however, research suggests executive and supervisory experience increases the odds of a business surviving (Christopher, 1998), ga-owing and being profitable (Coleman, 2007). Regarding prior entrepreneurship experience, research finds Hispanics and Blacks have little pre-ownership experience and few have parents who themselves where business owners (Shim and Eastlick, 1998; Smith-Hunter, 2006). However, experience as an entrepreneur has been linked to enhanced firm profitability (Robb and Fairlie, 2009). Furthermore, although training may be a mechanism for increasing human capital they lack, Hispanic entrepreneurs do not attend training seminars or workshops to a great extent (Gavino and Ortiz-Walters, 2011). Thus, we anticipate that: HI: After controlling for owner, industry and firm-specific characteristics, micro firms owned by Itispanic entrepreneurs will have a lower probability of being profitable than micro firms owned by non-minority entrepreneurs.

H2: After controlling for owner, industry and firm-specific characteristics, micro firms owned by Black entrepreneurs will have a lower probability of being profitable than micro firms owned by non-minority entrepreneurs.

Asian Owners. Some research indicates little difference between Asian and nonminority owners in terms of human capital (Ando, 1988). On the other hand, Bates (1997) finds Asian owners are more likely to graduate college than non-minority business owners. This is corroborated by other research, which finds Asian entrepreneurs are highly educated (Dadzie and Cho, 1989) and more so than other minority business owners such as Hispanics and Blacks (Feldman et al., 1991) as well as non-minority owners (Robb and Fairlie, 2009). In addition to education, it is said Asians are typically socialized early on to the world of self-employment through the family business (Pointer et al., 2004). Exposure to the family business is said to enhance an individual's motivation of entrepreneurial pursuits (Bates, 1990). As well as here, they gain invaluable experience useful for business ownership both vicariously as well as hands-on by being employed in the family firm. Indeed, prior work experience in a family member's business is positively related to firm profitability (Robb and Fairlie, 2009). That said, no differences in profitability between Asian and non-minority owned small finns have been found (Robb and Fairlie, 2009). However, given the higher levels of human capital, we propose:

Performance of Newly Formed Micro Firms: Role of Capital Financing

7

tI3: After controlling for owner, industry and firm-specific characteristics, micro firms owned by Asian entrepreneurs will have a greater probability of being profitable than micro-firms owned by non-minority entrepreneurs.

3.2. Impact of financial capital on profitability Another goal of ours is to explore whether there are differences between minority and non-minority owned ventures with respect to the impact financial capital has on firm profitability. From the research available, one reason to suspect a differential impact on firm profitability is because of differences in access to financial capital by minority and non-minority entrepreneurs (Pointer et al., 2004). In particular, restricted access to

financial markets (Ahiarah, 1993) because of personal characteristics (Chaganti, De Carolis, and Deeds, 1995) may play a role in the amount and choice or sources of capital funding available to and used by entrepreneurs (Orser, Riding and Manley, 2006), which should have an impact on firm performance. Hispanic and Black Owners. Compared to non-minorities, minority business owners are more likely to utilize internal equity, such as personal savings, to start their businesses (Feldman et al., 1991; Smith-Hunter and Boyd, 2004). Hispanic business owners tend to use primarily personal funds to start their ventures and to a lesser degree personal and business debt (Smith-Hunter, 2006). This may be because of constraints in access to other types of capital; they have expressed difficulty obtaining bank loans, especially at start up (Smith-Hunter, 2006) and research indicates Hispanic firms have higher loan denial rates than non-minority owned firms (Cavalluzzo and Cavalluzzo, 1998). The challenge this presents is that studies find the personal wealth of Hispanic and Black business owners is less than that of non-minority owners (Coleman, 2005a; Lussier, Greenberg and Corman, 1998). For instance, it has been shown that minority business owners have lower amounts of personal funds for start up than non-minority

entrepreneurs (Rogers et al., 2001). Given their limited personal wealth, one would surmise they have less overall internal and owner equity to invest in their firms than nonminority business owners. Thus, limited access to financial capital may restrict minority entrepreneurs' ability to spend money on important business functions such as product development and marketing necessary to generate future profits. As with Hispanic entrepreneurs, Black owners receive loans in smaller amounts (Bates, 1996; Lussier et al., 1998) and have fewer loans at start up than non-minority owners (Rogers et al., 2001). This is the case even among highly educated Black owners because as Coleman (2004a) found, they were more likely to be rejected for external debt such as a bank loan than non-minority business owners. For those Black owners who were approved for debt financing in the form of loans, Coleman (2008) found they paid higher interest rates than non-minority owned firms. Perhaps as a result, they are less likely to apply for loans in the future because they expect to be denied (Coleman, 2004a), as well as to pay higher interest rates. Therefore, Black owners are more likely to rely on loans from non-financial sources such as family members and friends than non-minority owners (Coleman, 2005a).

8

Ortiz- Walters and Gius

In summary, Black and Hispanic entrepreneurs may experience some latent discrimination that, as suggested by previous findings, could impact the levels of start-up capital they can invest in the firm (Hnck, Rhine, Bond and Townsend, 1999) and decrease the desire to use external equity and debt financing, which constrains their ability to operate profitable micro firms. So from both a supply- and demand-side argument, as well as amount of financial capital, we would expect the following set of relationships: H4: The impact of financing capital structure on firm profitability will differ between Hispanic and non-minority-owned micro firms.

HS: The impact of financing capital structure on firm profitability will differ between Black and non-minority-owned micro finns.

Asian Owners. Interestingly, in a comprehensive study of minority business owners, Bianchard et al., (2008) found that although they are equally as likely to apply for loans, Asians were not more likely to be denied for a loan than non-minority owners, even after controlling for other potentially confounding variables such as credit history, firm and owner characteristics, loan and lending characteristics and geographic location. Thus, we are finding the lending experiences of Asian entrepreneurs appear to differ from those of the Black and Hispanic entrepreneur and possibly the non-minority owner. Using data from the 1992 CBO survey, Robb and Fairlie (2009) find Asian-owned businesses are more successful--i.e., less likely to close and more likely to grow in terms

of sales and employment--than non-minority owned businesses. This is partially because of differences in the use of financial capital. More so than non-minority owners, Asians have been found to use personal savings as well as proceeds from the sale of personal assets to fund the start up of their ventures (Robb and Fairlie, 2009). That they rely so heavily on internal equity is consistent with the fact they have high personal wealth. In addition, Bates (1997) finds Asian business owners' use of equity comes primarily from family sources. Robb and Fairlie (2009) corroborate this in that they find Asian owners are more likely to use family savings and proceeds from assets owned by the entrepreneur's family than non-minority business owners.

Even when it comes to debt, research finds Asian venture owners utilize more sources of non-family loansÿ.g., loans from banking, commercial lending or

government institutions--than non-minority owners (Robb and Fairlie, 2009). However, one study has indicated Asian male owners are less likely than non-minority male owners to have loans or lines of credit (Coleman, 2004a). In addition, Bitler and colleagues (2001) find Asian entrepreneurs are more likely than non-minority owners to borrow through the use of credit cards. Robb and Fairlie (2009) similarly find Asian-owned firms use credit cards more than non-minority owned firms. Finally, Asian small business owners start their ventures with a greater amount of financial capital than Hispanic, Black or non-minority small business owners (Christopher, 1998).

Performance of Newly Formed Micro Firms: Role of CapitaI Financing

9

Thus, overall, Asian business owners seem to rely heavily on internal equity, personal and business debt when compared to non-minority business owners. Given these differences, we anticipate the impact of financial capital on profitability will differ for Asian, as compared to non-minority owned, firms. Therefore, we suggest that:

tI6: The impact of financing capital structure on firm profitability will differ between Asian and non-minority-owned micro firms.

Iÿ - - ',

] 0 Ortiz- Walters and Gius

4. Method 4.1. Sample

Data were obtained from the longitudinal Kauffman Firm Survey. In this database, new firms were surveyed annually beginning in 2004. The years examined in this study are from 2004 to 2008. Data include personal characteristics of owners, as well as financial data and descriptive information on the firms. The entire sample population included in this dataset was 4,928 firms in 2004. In reality, it is quite likely a firm owner will use multiple sources of financial capital when borrowing. That said we are interested in capturing the unique and individual as well as relative contributions of each of the financing options being examined so we can better inform pertinent stakeholders about which matter most. Therefore, certain parameters were applied to the sample when selecting what firms to include in the analyses. First, to capture the unique and individual contributions of the financing variables, firms that used more than one type of financing, such as both personal and business debt, were excluded from the sample. Second, very few firms in this sample used external equity like funding from a venture capitalist (VC), which is consistent with a financial growth cycle of the firm in that smaller ventures are unlikely to have access to this type of equity during the early start-up stage (Berger and Udell, 1998; Gregory, Rutherford, Oswald and Gardiner, 2005; Van Auken and Holman, 1995). Other theories of financing such as the pecking order framework (Myers and Majluf, 1984) would concur that external equity is unlikely to be used by small firnls and generally used only as a last resort given the associated higher costs and negative signal of firm potential to future investors. Moreover, there likely are substantial differences between a small, newly-formed firm that can acquire external equity (e.g., VC backing) and one that cannot, so these firms were also excluded because they have the potential to skew the results. Consequently, the only firms included in the sample were firms that utilized only one of the three following financing options: personal debt, business debt, or internal equity, thereby allowing us to examine the relative contributions to micro firm profitability of each. Finally, we are interested in comparing the effects of owner ethnicity for the following minority categories: Hispanic, Black and Asian. Owners who are Native American and those who reported a race of"other" were not included in our sample. The excluded, comparison variable was a non-minority owner. Note that for all owner-

specifc variables, the characteristic reported in this study is that of the primary owner. After application of these restrictions, this resulted in the following sample sizes across a 4 year time-frame (2004 to 2008) available for analysis. For the Hispanic sample, there were 1!0 firms with a total of 355 observations and for the Black sample, there were 162 firms with 528 observations. The Asian sample consisted of 64 firms with 236 observations, whereas for the non-minority sample, there were 1,469 firms with 6,123 observations.

Petformance of Newly Formed Micro Firms: Role of Capital Financing

11

4.2. Study variables and empirical technique In attempting to model micro firm performance, guidance was obtained from prior research. The typical explanatory variables used in studies of firm profitability and firm performance more generally (e.g., Astebro and Bernhardt, 2003; Bosma et al., 2004; Glancey, 1998; Roper, 1999; Zinger, LeBrasseur and Zanibbi, 2001) include age, educational attainment, sex and business experience of the owner; and size, legal status and industrial classification of the firm. Compared to younger and less educated entrepreneurs, older and more highly educated owners have a greater likelihood of earning a profit (Coleman, 2007; Roper, 1999) and manage ventures that are more likely to survive (Bates, 1990). This would be expected because increases in age and education likely enhance the breadth of experience and expertise gained by the owner. Findings from prior studies show women and male-owned small firms differ in firm profitability (Coleman, 2007) and sales potential (Carvajal, 2004). Having supervisory, managerial or executive experience, which can provide business specific human capital, is also positively related to survival of a firm (Christopher, 1998) and firm profitability (Robb and Fairlie, 2009). Larger firms as well as corporations and partnerships have been found to have higher survival rates as compared to smaller firms and sole proprietorships, respectively, (Robb, 2007) likely because of differences in organizational resources. Finally, significant differences have been reported for survival, growth, sales and profitability by industry classification (Christopher, 1998; Cooper et al., 1994; Robb and Fairlie, 2009; Rogers et at., 2001). These variables are used to control for the human capital of entrepreneurs and any firm or institutional-level factors that may affect profitability beyond the impact of race/ethnicity and financial capital, the primary variables of interest in this study. Most of the data are not continuous; hence dummy variables were constructed from the available public use KFS data. In terms of the independent variables, race/ethnicity dummies were included for Hispanic, Black and Asian micro firm owners. Here the excluded category was non-minority micro firm owners. Regarding financial capital, two dummy variables were created to capture the various debt alternatives available to a firm: personal debt, which denotes debt obtained in the owner's name, and business debt, which denotes debt obtained in the firm's name. The excluded or base category in this analysis is internal equity, which is equity invested by the owner, the owner's spouse, or the owner's parents. Regarding the dependent variable, profitability is a binary variable; the actual level of profit is not known. All that is known is whether or not the finn earned a profit for the year in question. In the data set used, prot]t is defined as business income after all expenses and taxes have been deducted (DesRoches and Robb, 2009). Because the dependent variable is dichotomous, the following firm profitability equations were estimated using logistic regression. Equation 1 is estimated based on the entire sample of micro firm owners (with the applied restrictions). Tiffs sample consisted of 1,805 firms with 7,242 observations across 2004-2008. The results of this estimation should allow us to compare the probability of being profitable between minority and non-

12

Ortiz-Walters and Gius

minority owned micro firms.

Equation 1: PR (Profitability) = ao + aIMALE + a2COLLEGE + a3HIGH + a4 EXPER + asMANUF + a6TRADE + aTSERVICE + asA1834 + agA3554 + aloSOLE + a11LLC + a12HISP + aÿ3BLACK + aI4ASIAN By estimating equation 2 for each race separately (i.e., Hispanic, Black, Asian and non-minority), it will be possible to ascertain whether or not the determinants of profitability differ between the races/ethnicities and, more specifically, which types of financing have positive effects on profitability depending on the race of the owner.

Equation 2: PR (Profitability) = a0 + atMALE + a2COLLEGE + a3HIGH + a4PDEBT + asBDEBT + a6EXPER + a7MANUF + aaTRADE + a9SERVICE + a10A!834 + alÿA3554 + ax2SOLE + a13LLC The variables for each of the equations are defined as follows: 1. PR equals one if the firm earned a profit and zero otherwise; 2. MALE equals one if owner is male and zero otherwise; 3. COLLEGE equals one if owner has at least a four-year college degree; 4. HIGH equals one if owner's highest level of education is high school; 5. PDEBT equals one ifonly personal debt was used; 6. BDEBT equals one if only business debt was used; 7. EXPER is the number of years of work experience of the owner; 8. MANUF (manufacturing) equals one ifNAICS classification is 31-33; 9. TRADE (wholesale, retail trade, transportation, warehousing) equals one if

NAICS is 42-49; 10. SERVICE equals one if firm has an NAICS classification orS1 or greater; 11. A1834 equals one if owner is between the ages of 18 and 34; 12. A3554 equals one if owner is between the ages of 35 and 54; 13. SOLE equals one if the firm is organized as a sole proprietorship and zero otherwise; 14. LLC equals one if firm is organized as a limited liability corporation and zero otherwise; 15. HISP equals one if the owner is Hispanic and zero otherwise; 16. BLACK equals one if the owner is Black and zero otherwise; 17. ASIAN equals one if the owner is Asian but zero otherwise; and 18. Non-minority equals one if the owner's self-reported race is White and zero otherwise. 4.3. Results

Descriptive statistics for the sample are presented in Table 1. According to these statistics, 62 percent of firms earned a profit. Of the current sample, over 80 percent of business owners employed debt while 16.1 percent drew from internal equity as a source of financial capital. These percentages are consistent with the notion that young firms in the growth phase will require capital but may not be in a position yet to rely solely on

Pelformance of Neu,ly Formed Micro Firms. Role of Capital Financing

13

personal funds or retained earnings (e.g., Coleman, and Colin, 2000; Kushnirovich and Heilbrunn, 2008). In terms of personal characteristics, 72.6 percent were male owners while 64.1 percent were between the ages of 35 to 55. Owners were generally highly educated and experienced; 50.8 percent had a college degree and the average work experience was 12.5 years. Over 86.1 percent of firms were owned by non-minority entrepreneurs. The make-up of the remaining sample was 5 percent Hispanic, 3.3 percent

Asian and 7.4 percent Black. Close to half of the firms were organized as soleproprietorships (46.5 percent) while 61 percent could be found in the services industry. Table 1. Descriptive statistics for study sample.

Variables Legal Organization

% of Firms

Sole proprietor

LLC Partnerships/S-corporations Education

46_5

26.5 27

High School Some College College

12.6 36.6 50.8

Manufacturing

13.2

Industry Service

61

Trade

16.6

Agriculture, Mining, Utilities, and Construction Owner Age

less than 35 years old

9.2

16

Between 35 and 54

64.1

Older than 55

19.9

Male Female

72.6 27.4

Gender

Race/ethnicity* Hispanic Asian Black Non-Minority

5 3.3 7.4 86.1

Financial Capital* Internal Equity 16.1 Personal Debt 76 Business Debt 7 Firm Performance

Profitability

62

Notes: This sample consisted of 1,805 firms with 7,242 observations over a 4 year period. * The variable race/ethnicity does not equal 100% as we did not include small samples of Native Americans and the racial category of "other". The financial capital variables do not sum to 100% as we excluded those finns using external equity.

Correlations among the study variables are reported in Table 2. The correlations indicate sole proprietorships are less likely to be profitable whereas firms organized as

14 Ortiz- Walters and Gius

LLCs had a greater likelihood of being profitable. Firms headed by male owners, those who have a college degree, or greater work experience were more likely to be profitable. However, firms in the manufacturing and trade industries were less likely to generate a profit. The correlations also indicated those micro firms that used personal and business debt were more likely to earn a profit. Non-minority entrepreneurs were more likely to be profitable than Hispanic and Black owners, although it still remains to be seen if these relationships hold when other factors are controlled. Table 2. Correlations and Descriptive Statistics for Study Variables.

1 1. Sole proprietor 2.

LLC

2

-.56'*

3_ High School

3

-.15"*

5. Manufacturing 6. Service

-.01

7. Trade

.05**

8

9

-.10"* -.17'* -.56**

-.01

-.08"*

-.02

.05** .04**

-.04**

.01

.03** -.03*

.01

.02

.05**

11. Experience

-.08**

.02*

.02

.03** -.02

.04**

-.06"*

-.04** -.01

-.05**

.09** -.01

-.04** .03*

14. Black

.02

15. White

-.02

.05**

-.01 .02

16. PersonalDebt

.49"*

17. Business Debt

-.25**

-.04**

1

.10"*

-.06** -.01 .07**

1

.21"* -.49"*

12. Hispanic

18. Profit

7

1 -.05**

-.02

.07** -.15"*

9. Age (35-54) -.01 10. Male -.10"*

13. Asian

6

1

.13"* -.39**

-.05** -.03*

8. Age (less 35)

5

1

.09** -.09**

4. College

4

1

-.28"*

.03**

.02

-.58**

-.04**

-.06"*

1

.03**

-.04**

-.01

.08** -.14"* -.25** .04**

-.01

-.01

.01 .01

-.01

-.06"* .05**

.01

-.01

.05** -.04** -.02 -.05**

.05"*

.06**

-.02

.08"* -.02 .05** -.01 -.12"* .04**

.03"*

.00

.00

.09**

-.07**

-.00

.00

.02

-.05"*

.06**

-.06**

.02

-.02*

.02

.03* -.01

1

-,05**

.03**

-.06""

.09** -.01

1 -.03*

.00

Table 2 (continued). Correlations and Descriptive Statistics for Study Variables.

10

11

12

13

14

15

16

17

19. Sole proprietor

20. LLC 21. High School 22. College 23. Manufacÿg 24. Service 25. Trade

26. Age (less 35) 27. Age (35-54) 28. Male 29. Experience 30. Hispanic 31. Asian

32. Black 33. White 34. Personal Debt 35. Business Debt 36. Profit

1 .15"* .02

1 -.04**

1

1

.01 -.06**

-.03"* .02 -.07** -.04**

.03*

.09** -.25"*

-.43**

-.69**

1

-.06**

-.05**

.01

-.03*

-.06"*

.06**

.06**

.04**

.00

.03*

-.05**

.03* -.51"*

.09"*

.12"*

-.02+

-.05"*

-.01

1

-.11"*

1

.11"* .08**

Notes: Correlations based on 1,805 finns with 7,242 observations over a 4 year period; +p < .10; *p < .05; ** p < .01

1 .06**

Pelformance of Newly Formed Micro Ftrms: Role of Capital Financing

15

In interpreting the logistic regression results presented in Tables 3 and 4, it is important to note that, for dummy variables, the odds ratios from the analyses are in comparison to the omitted category. So, for example, the odds ratio of 1.34 for MALE in the regression implies that male-owned micro firms are 34 percent more likely to earn a profit than female-owned micro firms (see Table 3). Firms owned by entrepreneurs who had at least a four-year college degree were 17 percent more likely to be profitable than micro firm owners who only had some college education. For continuous explanatory variables, the odds ratios are interpreted as the change in the odds of a firm being profitable when the X variable increases by one unit. For example, for EXPER, every additional year of experience an owner has increases the odds the firm will be profitable by 2.2 percent. For the industrial classification variables, the excluded category is agriculture, mining, utilities and construction. For the age variables, the excluded category is any age greater than 55. For the legal status of the firm, the excluded category is partnership and s-corporations. For education, the excluded category is individuals who attended but did not graduate from college. Table 3. Logistic Regression Results for Differences in Firm Profitability by Owner Race. Micro-Firm Profitability Variables Constant MALE

Parameter Estimates 0.140 0.289***

COLLEGE HIGH

Odds Ratio 1.34

0.155"* -0.005

1.17

EXPER TRADE MANUF

0.022"** -0.279"* -0.414"**

1.02 0.76 0.66

SERVICE

-0.022

A1834

0.282**

A3554 SOLE

LLC HISPANIC ASIAN

1.33

0.015 -0.116"

-0.026 -0.216" -0.233

BLACK

-0.809***

0.89

0.81 0.45

Notes: This sanaple consisted of 1,805 firms with 7,242 observations over a 4 year period. Firm age was not included in the regression as all firms started the same year. Number of employees, U_S. citizenship of owner and year of survey were also included as explanatory variables in preliminary regressions. Because none altered the significance of the results, they are not reported here. * p