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Vol. 83, No. 6
Posted 2001-11-01

Equity Financing of the Entrepreneurial Firm

by Frank A. Schmid

Equity financing of the entrepreneurial firm has achieved a rapid increase over the past decade. Venture capital funds, which finance privately held start-ups, raised a record $92.3 billion in 2000. This is a 30-fold increase relative to 1990. At Nasdaq, initial public offerings raised an all-time high of $53.6 billion in 2000, which is 24 times as much as in 1990. This article studies venture equity financing and equity financing through initial public offerings against the background of asymmetric information between the entrepreneur and the (outside) investor. The analysis shows that venture capital financing (i) is superior to initial public offerings when the entrepreneur has low initial wealth relative to the size of the project and (ii) is equivalent otherwise. This result highlights the importance of private equity in financing entrepreneurial enterprises. The Gramm-Leach-Bliley Act of 1999 allows banks to expand the scope of their activities in this arena. The act allows financial holding companies to provide equity financing to nonfinancial enterprises for up to ten years. In particular, the act defines a framework in which financial holding companies can sponsor private equity funds that may provide venture capital to entrepreneurial start-ups.

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