August 27, 2014

Financing Minority-Owned Start-ups

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Does start-up financing differ for minority-owned businesses? Until recently, this has been a difficult question to examine because most data on small businesses looked at existing businesses of varying ages. But the development of the Kauffman Firm Survey (KFS) – an effort to track a sample of firms founded in 2004 over time – has allowed researchers to explore that question.

In a paper prepared for the Minority Business Development Agency, and in another report produced by the Kauffman Foundation, Alicia Robb of the Kauffman Foundation and her colleagues Rob Fairlie of the University of California Santa Cruz and David Robinson of Duke University examined the KFS data and found that minority-owned new businesses are less likely than White owned new businesses to be financed with external debt and equity. But the reasons why have less to do with the businesses being minority-owned than with differences between White and minority-owned start-ups.

WHAT THE DATA SHOW
Robb and Fairlie report that initial capitalization of minority-owned businesses is lower than that of White-owned businesses ($75,000 versus $90,000, on average). Moreover, this gap widens as the firms mature, they explain, because minority-owned young companies average annual investment inflows roughly two-thirds those of White owned businesses ($30,000 versus $45,000) over the subsequent three years.

In particular, the capitalization gap between White and Black-owned start-ups is very large. According to Robb, Fairlie and Robinson, “White-owned business have more than $80,000 of initial capital on average, while Black owned businesses have less than $30,000 of startup capital.” Moreover, this gap in capitalization persists over the early years of the ventures. The authors report that White-owned businesses receive double the amount of cash injections of Black-owned businesses over the subsequent two years

Minority-owned start-ups raise less money from outside sources (those other than the founders and their friends and relatives) than White-owned businesses. Robb and Fairlie found that 4.7 percent of White-owned start-ups raised external equity in their initial year, but only 3.5 percent of minority-owned start-ups did so. Combined with the lower overall capitalization of minority-owned new businesses, these different percentages meant that the average minority-owned start-up raised $2,984 in outside equity, whereas the average White-owned new businesses raised $7,607, Robb and Fairlie report.

These gaps persist as the firms mature. According to Robb and Fairlie’s study, over the next three years, minority-owned start-ups received 46 percent of their new capital from founders, while for White-owned start-ups, this figure was only 33 percent.

Similar gaps can be seen in external debt, with Robb and Fairlie reporting that minority-owned start-ups average $30,000 in outside debt at founding versus $37,000 for White-owned new businesses.

The Black-White comparison is again very different as well. According to the Robb, Fairlie and Robinson, “Outsider debt accounts for more than 40 percent of the white-owned business financing, whereas it makes up just 27 percent for black-owned businesses.”

WHY THE FINANCING PATTERNS DIFFER
Are these differences benign, resulting from who the founders are and the kind of businesses that they start, or do they point to a problem in the system of financing start-ups? Robb and Fairlie try to answer this question.

Controlling for a variety of factors, from credit scores to owner demographics to firm characteristics to the industry in which the businesses are founded, the two authors find that minority owners have a lower level of external debt and equity financing at start-up. However, they don’t find that being a minority influences amount of additional external equity and debt invested in the firms over the subsequent three years. Moreover, they find that the amount that being a minority lowers external debt and equity at start-up was small.

Even the meaning of their finding that being a minority has a small effect on the level of external debt and equity financing at start-up isn’t clear to the authors. Robb and Fairlie concede that the minority effect might reflect differences in personal wealth rather than minority status per se.

THE TAKEAWAY
The facts are clear. The KFS data indicate that White-owned start-ups are capitalized at higher levels, raise more subsequent capital, and obtain more external debt and equity than minority-owned new businesses.

The explanation for why this pattern exists, however, is unclear. Robb and her colleagues’ examination of the KFS data shows little evidence that minority ownership alters how new businesses are financed. Rather the analysis suggests that minority business founders have different demographics and start different types of businesses from White business founders, and these differences result in different financing patterns.

Of course, it’s still possible that the way that external capital sources treat Whites and minorities affects how those businesses are financed. But the KFS provides no evidence of it.

3 Comments ▼

Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

3 Reactions

  1. Minority or not, business owners of all varieties are resourceful and able to succeed against long odds. It’s good to see that so many are making the effort to start and grow businesses.

  2. Very revealing post. As a black woman, I scoured for financial aid. After my search, I decided to invest as little as possible initially because my business was not in a position to receive the aid. It was bummer. But I think I’m doing just fine.

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