Patterns of Financing: A Comparison between White- and African-American Young Firms

from the introduction:

This short report examines racial differences in access to financial capital. We focus on the role of capital injections—that is, injections of financial capital in the early, formative years after the business is started. Our results indicate that stark racial differences in capital injections after a business is formed are an important and under-studied component of the racial gap in new business formation. Although nearly three-quarters of all new firms inject capital in either their second or third year of existence, we know relatively little about racial differences in financial capital use in the early years of operation. The lack of empirical evidence on this issue largely reflects the lack of panel data with information on financial capital inputs in years after start up as well as the demographic background of the business owners. In this paper, we make use of detailed information on capital injections through the Kauffman Firm Survey (KFS), a longitudinal study of businesses that began operation in 2004. The KFS tracks a panel of almost 5,000 firms from their inception in 2004 through 2006, detailing capital injections, sales, employment, and owner characteristics. The richness of these data allows us to study capital injections in great detail.

Understanding how African-American firms access capital markets for injections of later-stage capital is important for a number of reasons. Previous research indicates that blacks have substantially lower levels of personal wealth, home ownership, bank loans, and startup capital, but there is no evidence on access to financial capital in subsequent years among young black firms. We also know little about whether black and white firms differ in the dynamics of financial capital use—in particular, substituting between external and internal capital over time.

The median level of net worth among blacks is $6,200, eleven times lower than the white level. Low levels of black personal wealth may be detrimental to securing capital because this wealth can be invested directly in the business or used as collateral to obtain business loans. In addition to relatively low levels of personal wealth, previous research provides evidence that is consistent with black entrepreneurs facing lending discrimination. Black-owned firms experience higher loan denial probabilities and pay higher interest rates than white-owned businesses even after controlling for differences in creditworthiness and other factors. Finally, black-owned businesses have very low levels of startup capital relative to white-owned businesses and these differences persist across all major industries. If new black firms are constrained in their access to capital not just at startup, but also in subsequent years, then this could have a detrimental effect on their long-term performance. Of course, it also could be an indication that external investors expect lower long-term performance, and direct their capital accordingly. The existing literature suggests that lack of black access to capital is a potential barrier to successful entrepreneurship. Indeed, there is some evidence that racial differences in startup capital affect the relative performance of black-owned firms.