Growth Firms and Relationship Finance: A Capital Structure Perspective

Abstract

We analyze how relationship finance, such as venture capital and relationship lending, affects growth firms’ capital structure choices. We show that relationship investors that obtain a strong bargaining position because of their privileged information about the firm optimally cash in on their dominance by pushing it to finance follow-up investments with equity. The firm underinvests if its owner refuses to accept the associated dilution. However, this problem is mitigated if the firm’s initial relationship financing involves high leverage or offers initial investors preferential treatment in liquidation. By contrast, if initial investors are unlikely to gain a dominant position, firms optimally lever up only in later rounds. Our implications for relationship and venture capital financing highlight that the degree of investor dominance is of key importance for growth firms’ capital structure decisions. This paper was accepted by Gustavo Manso, finance.