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ABSTRACT This research examines capital structure theory as it applies to small, privately held firms. We hypothesized that, given the fine line between the firm and the firm owner in small firms, lenders should take both the characteristics of the firm and those of the borrower into consideration. Our findings reveal that leverage is predominantly a function of firm characteristics rather than owner characteristics. The owner's educational level, however, was a positive predictor of external debt, suggesting that lenders may use education as a proxy for human capital. INTRODUCTION In recent years the importance of small businesses to the United States economy has been widely recognized. According to the U.S. Small Business Administration (The Facts About Small Business, 1997), small businesses employ 53 percent of the workforce. In addition they contribute 47 percent of sales and 51 percent of gross domestic product. Small businesses have become the major source of new jobs as well as product and service innovations. Key issues for small businesses include financing, growth, profitability, and ownership structure. These concerns, and others, are addressed by research in the areas of small firm and entrepreneurial finance, both of which are producing a rapidly growing set of findings. Some of the most interesting questions in small firm finance research relate to the extent to which the principles of corporate finance the small firm. Almost every undergraduate business major includes a business finance course in which we teach theories of present value, risk, capital structure, cost of capital, and capital budgeting, typically within the framework of a corporate environment. Do these theories and principles, which were developed within the context of the large, publicly owned firm, appear to fit when we apply them to small firms which vastly outnumber large ones? This paper explores the relevance of current theories pertaining to capital structure and leverage while attempting to identify factors contributing to small firm use of debt as a financing source. Prior research on capital structure, of which there is a considerable quantity, focuses heavily on the use of debt within the context of publicly held, relatively large, corporations. There are few studies addressing the issue of capital structure in small firms, and many of those rely on a relatively small sample of firms. This study explores small firm capital structure using a very large, national data sample. It is our hypothesis that the use of debt in small firms is determined by characteristics of the firm owner as well as by characteristics of the firm. This is consistent with the notion that, for small firms, the financial affairs of the firm are inseparable from those of its owner. CAPITAL STRUCTURE THEORY Modigliani and Miller's (1958) theory of capital structure is based on the notion that firms will select the mix of debt and equity that minimizes their weighted average cost of capital, thereby maximizing the value of the firm. Because interest expense is tax deductible, debt tends to be favored over equity as a source of capital. It therefore follows that firms, in principle, act to minimize the cost of capital and maximize the value of the firm by financing exclusively with debt. This view assumes that there are no real resource costs associated with the issuance or exchange of securities, financial distress, or even bankruptcy and financial reorganization.1 In the case of privately held small businesses, however, the decision to finance with debt rather than equity may be driven by necessity rather than choice, because small firms do not have the same access to capital, particularly equity capital, that larger public firms do. Small firms are not able to issue publicly held debt or equity or even commercial paper because of their size and the high cost of issuing securities. As a result, small firms tend to be heavily reliant on debt in the form of bank financing and trade credit. …
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