Is the Growth of Small Firms Constrained by Internal Finance?

Robert E. Carpenter UMBC

Bruce C. Petersen Washington University

First Version: December 4, 1998 Second Version: June 18, 2000 This Version: January 22, 2001

Abstract This paper examines the long-standing theory that small firm growth is often constrained by the quantity of internal finance. Under plausible assumptions, when financing constraints are binding, an additional dollar of internal finance should generate slightly more than an additional dollar of growth in assets. This quantitative prediction should not hold for the relatively small number of firms with access to external equity. We test these predictions with a panel of over 1600 small firms and find that the growth of most firms is constrained by internal finance. Our results have implications for several different research literatures, including models of firm growth. JEL Codes: L0, D9

We thank Steven Fazzari, Lauren Lax, Josh Lerner, Dorothy Petersen, Laura Rondi, Alessandro Sembenelli, Jim Rebizter, James Stock and three anonymous referees for valuable comments and suggestions. We also thank seminar participants at Binghamton University, Case Western Reserve University, the CEPR Conference on Industrial Structure, CERIS-CNR, Depaul University, the 1998 EARIE meetings, the International Conference on Funding Gaps at the University of Warwick, the London School of Economics, the University of Michigan, the University of Missouri, the University of Turin, and the University of Wyoming.

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I. INTRODUCTION
Despite a recent revival in research, comparatively little is known about firm growth or its determinants. Indeed, standard microeconomics textbooks say little or nothing about the topic. Understanding how firms grow, however, especially small firms, is an important issue. In most U.S. industries, small firms account for