Abstract
In the still challenging world of the seminal Modigliani-Miller model the mix of financial instruments is irrelevant, since there is no incentive to the issuing company to employ or to avoid any particular mix1. However, the irrelevance of the mix disappears as the assumptions creating that world of perfect financial markets are relaxed. Then a particular mix is desirable2 if it
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partitions the income stream of the company in a way that reduces tax exposure of both company and investors;
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reduces payments to third parties by both company and investors or equivalents to such payments (e.g. direct and indirect costs of bankruptcy, costs of monitoring devices protecting bondholders or external shareholders, flotation costs, costs of countering present or anticipated regulatory or self-regulatory resistance, transaction and monitoring costs of investors);
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takes advantage of differences in expectations among investors;
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meets demands of investors hitherto unsatisfied, frequently because of regulatory restrictions.
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Notes
Franco Modigliani and Merton H. Miller. The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, Vol. 48. 1958, pp. 261–297.
For a brief survey of relevant literature see Richard Brealey and Stewart Myers, Principles of Corporate Finance, 2nd ed. . New York: McGraw-Hill, 1984. pp. 369–403. and Thomas E. Copeland and J. Fred Weston, Financial Theory and Corporate Policy. 2nd ed., Reading. Mass.: Addison-Wesley, 1983. pp. 440–459.
J.S.G. Wilson, Some Aspects of the Development of Capital Markets. Banca Nazionale del Lavoro, No. 79. December 1966, p. 307. and. as a recent source. Gunter Dufey and Ian H. Giddy, The Evolution of Instruments and Techniques in International Financial Markets. SUERFSeries 35 A. 1981. pp. 4, 18, 23, 31.
The most recent volumes on the Commission’s Luxembourg Symposia are: John Michael Gibb. ed., Venture Capital Markets for the Regeneration of Industry, Amsterdam: North- Holland. 1984. and J.M. Gibb and Siegfried Neumann, eds., The Needs of New Technology- Based Enterprises, Luxembourg: Infobrief. 1983.
For a survey the reader is referred to Hartmut Schmidt. Special Stock Market Segments for Small Company Shares: Capital Raising Mechanism and Exit Route for Investors in New Technology Based Firms, Luxembourg: Office for Official Publications of the European Communities. 1984 (with contributions of E. Wymeersch, A. Young, H. Reuter, H M. Domke and Ch. Herms).
For a comparative survey of this research see: The State of Small Business, a report of the President transmitted to Congress, Washington: USGPO, 1983, pp. 61–88. and David Birch. The Contribution of Small Enterprise to Growth and Employment, in: Herbert Giersch, ed., New Opportunities for Entrepreneurship, Tübingen: J.C.B. Mohr, 1984, pp. 1–16.
This implies that debt financing would most likely give rise to expectations of non-trivial bankruptcy costs and to relatively high promised yields on debt instruments.
Wilson Committee, Interim Report: The Financing of Small Firms, London: HMSO, 1979. p. 14. Stanley C. Golder, Structuring and Pricing the Financing, in: Stanley E. Pratt and the editors of the Venture Capital Journal, eds., How to Raise Venture Capital. A Guide to Locating Start-Up and Development Capital and Dealing with Venture Capitalists, New York: Charles Scribner’s Sons, 1982, p. 138 (25–50%). Occasionally such discounts may be readily observed, of. Bolton Quits Making Markets in OTC Stocks. Wall Street Journal. December 27. 1982. p. 20.
For a more detailed discussion see H. Schmidt, op. cit., pp. 512–516.
Other parts reflect additional monitoring costs and additional execution and settlement costs.
The only alternative to this that the author has come across is to make the price ultimately to be paid for a regular share contingent on the development during two or three years after the transaction. In other words, the investor will receive for the amount paid to the entrepreneur an interest in the company increasing step by step during this period if the company fails to measure up to certain targets (or a decreasing interest if the company meets ambitious targets - on which the entrepreneur based his valuation).
The Unlisted Securities Market. Bank of England Quarterly Bulletin. Vol. 23. 1983. p. 230.
Cf. the tables appended, which are taken from H. Schmidt, op. cit.. pp. XXXIX-XL.
David L. Cohen. Small Business Capital Formation, in: Board of Governors of the Federal Reserve System, ed., Public Policy and Capital Formation, Washington: Publication services. Board of Governors of the Federal Reserve System. 1981. p. 256. U.S. Securities and Exchange Commission and U.S. Small Business Administration. The Role of Regional Broker-Dealers in the Capital Formation Process: Underwriting. Market-Making and Securities Research Activities. Phase II report. August 1981, p. 26. Walter Holman and Allan Young. Small Business in the United States: Failures and Public Financing. Strathclyde Convergencies Issues in Accountability. No. 9, October 1983, p. 31.
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© 1986 Martinus Nijhoff Publishers, Dordrecht/Boston/Lancaster
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Schmidt, H. (1986). Causes of Change and Innovation in the Mix of Financial Instruments: The New Emphasis on Small Company External Equity Financing and Its Impact on Capital Market Structure. In: Fair, D.E. (eds) Shifting Frontiers in Financial Markets. Financial and Monetary Policy Studies, vol 12. Springer, Dordrecht. https://doi.org/10.1007/978-94-009-5157-0_6
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