Small business efficiency in the macroeconomic context: probability of default indicator for early entrepreneurs

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Small Business Efficiency in the Macroeconomic Context: Probability of Default Indicator for Early Entrepreneurs

Ekaterina Murzacheva

(Department of Economics, State University - Higher School of Economics in Moscow, Russia)

"An investor without investment objectives

is like a traveler without a destination"

Ralph Seger

Abstract

The paper considers the financial choice of entrepreneurs at their initial stage of development as a key criterion of a new firm potential riskiness. The main objective of the research is the methodology elaboration aimed at the numerical estimation of the role of informal financial resources involved in the small business creation. Two fundamental considerations have been tested. The former implies that informal investment is a substitution for unavailable formal sources, including venture capital (because of the lack of essential networks and connections with business associations). The latter performs the opposite concept of negative effects: economic reasoning discouragement and inefficient resources allocation.

A special technique is introduced in order to measure the credit quality of early entrepreneurial activity and to estimate its contingency with the financial strategy. The methodology validation is realised under Global Entrepreneurship Monitor conceptual framework. The results are received for 42 countries in 2006-2007, depicting the influence of informal support on potential losses under the second consideration.

As a result, informal investments are inefficient when the concentration of credit risk in the economy is rather high. Investors' expectations about the entrepreneurial growth of the firm are pessimistic, anticipated returns on investments are too low to be economically reasonable. The outcome leads to the irrecoverable losses, both financial (short-received profitability) and non-financial (decreased output, the lack of innovativeness, flexibility, and inventiveness).

Keywords: Global Entrepreneurship Monitor; entrepreneurship efficiency; informal capital; credit risk

Ekaterina Murzacheva, master student, researcher, Department of Economics, State University - Higher School of Economics in Moscow, research fields: social and economic statistics, risk management, finance in entrepreneurship

financial choice small business

1. Introduction

Traditionally the literature on the financial aspects in entrepreneurial activity is based on the "rational actor" hypothesis originated from the works of Myers (1984). Capital structure dilemma (Mason and Harrison, 2002), equity to debt puzzle (Lemmon, 2006), let alone the developing dimension of pecking order theory (Chittenden, et al., 1996) as well as agency costs (Kaplan and Stromberg, 2004) and information asymmetry theories (Cassar, 2004) have been deeply rooted into the understanding of the nature of small business financial decisions.

These concepts imply dealing with formalised financial institutions: a debt is regarded as a form of banking (non-banking) credit, equity involves IPO, venture capital is represented by professional institutional market participants, business angels are not detachable from specialised associations and communities. Notably that the scope of such financial sources is comparable with informal capital attraction which is widely used especially at the beginning stage of entrepreneurial activity (Gaston, 1989; Abernethy and Heidtman, 1999; Bygrave, et al., 2003). However the relationships arising from such a kind of financing agreement do not fit well the theories mentioned above because of the violation of the principal assumption about rationality or bounded rationality (Hancock, 2009).

The unique features of informal capital in terms of economic reasoning and consequences give rise to the indefinite outcome both for a small business firm and overall economic activity. The main objective of the paper is to reveal the role of informal capital: whether it fills in the financial gap or provokes inefficiency in the entrepreneurial activity.

In other words, keeping in mind that all the formalised financial institutions are the subject to prudential control from the government side, informal capital is an unattainable area for any regulations, and thus it can provoke undesirable and uncontrolled processes. In this sense it is essential to identify the nature of such relationships and estimate (or anticipate) the potential damage to the entrepreneurial activity and overall economic system (in case if the informal capital is a feasible source of financial instability).

To shed more light on the issue and in order to come to the results and propose some practical implications the following steps have been undertaken in the analysis:

Firstly, the theoretical foundation of the research is provided. The connection between the financial strategy of entrepreneurs and their potential sustainability is established. The assumption that small business activity fosters the GDP growth is highlighted and is opposed to the statement about the possibility of negative impact of entrepreneurial activity on the economic development.

Secondly, the overview of the demand for and supply of informal funds in different countries is presented. The relation between the availability of such kind of investments and economic development of a country is investigated.

Thirdly, a special indicator has been constructed in order to assess the credit quality of informal investments and the potential effect of such a financial strategy. Some results are concluded in concern with the role of informal capital in a concrete economy.

Lastly, depending on the probability of significant quality deterioration of entrepreneurial activity (caused by the dominant informal financing strategy) some implications are suggested. In case informal funds play a negative role in the small business process it should be formalised in order to keep the process under control. Microfinance perspective is considered as an instrument for the risk mitigating along with preserving the cash flow intensity.

2. Contextual Background and Hypotheses

In a growing stream of academic literature on the topic of small business activity and financial resources attraction the concern about entrepreneurial contribution to the growth and competitiveness is evident (Kirzner, 1973). Keeping this statement in mind, two explanations of the relationship between entrepreneurial growth and overall economic development are set forth.

On the one hand the dissemination of small firms in the economy triggers off an increase in production rates and output growth. For this reason the nature of such a relationship should be understood. One of the arguments lies in the conceptual framework elaborated by Paul Reynolds who managed to establish "a comprehensive assessment of the role of entrepreneurship in national economic growth" (Reynolds, 2005, p.205).

On the other hand there is one more channel for the impact of entrepreneurial activity on the socioeconomic development - creation of additional workplaces. This theory runs smoothly in practice unlike the previous one. It is generally accepted that the rise in the number of employed people stimulates the production growth as well as individual welfare improvement in terms of higher income rates (North, 1995).

However the empirical evidence denies the stated argument about the favourable entrepreneurial impact, especially in relation to small typical start-ups in retail business. A growth of the welfare of a country is often combined with the real income per capita rebound: people tend to work for others in pursue of high wages than starting up own businesses (Caree et al., 2003). Moreover, facts speak for minor contribution of small firms to the employment rates upturn (Acs and Armington, 2004). Summing up, only distinguished (firms with high growth potential) start-ups are able to enhance economic growth and stimulate job creation (Shane, 2009).

So the key issue sounds in a following way: "How can we (the society or the government) identify a right start-up to support?", "Is there any technique to measure the quality of the ongoing entrepreneurial activity in order to define the policy correctly?" The answer originates from the clarification what the quality of small business activity is.

To come up to the solution it is essential to recognise that the first step towards realisation of any start-up is getting financial resources (Shane, 2003). Furthermore, the financial strategy of a starting entrepreneur leaves an imprint on the future business development and its impact on the overall development (Kon and Storey, 2003).

For an entrepreneur as for a single economic unit two ways of financing are available: own funds and a debt. As far as the equity financing (IPO or own funding) is concerned it does not cause negative effects in any case if we consider instability from the credit risk aspect (risk, initiated by the creditor-borrower relationships). The side of debt financing is rather multifaceted and includes a wide range of options which are not discussed in corporate finance theories: venture capital, business angels and informal capital.

The side of formal financial support is thoroughly investigated in the literature and taken into consideration by policy makers. Until recently it has been considered that the small business financing through banking facilities is the most convenient and effective source. Nevertheless, the study of Thorsten Beck (2004) reflected upon the contentious issue about the positive role of banking sector "in enhancing economic growth through more efficient resource allocation". Additionally, small firms are often out of the credit institutions' target customer base at their early stage of development because of the lack of credit and trading history, collateral (Verheul and Thurik, 2001). Vice versa, credits are not attractive for entrepreneurs either: high rates and complicated conditions come as insuperable barriers (Berger et al., 2005).

Informal capital (as well as bootstrapping) investigations are in tune with the drive towards the growing demand for alternative financial sources due to the lack of available loan products (Atherton, 2009). The prevailing form of informal investments is venture capital which is the subject of an acute interest for both researchers and policy makers. Such an investment source fills in the financial gap during the growth of a new firm. Anyway, classic venture capital implies the allocation of financial funds among young entrepreneurial firms with a high growth potential (Mason and Harrison, 2002), in other words, among technologically innovative small businesses. Venture capital (as institutional private equity finance) is also well addressed in the literature and is out of the focus in this paper.

In respect to business angels - private investors who provide capital to new and growing businesses in which they had no prior connection and excludes investments in their own firms or in family businesses (Mason and Harrison, 1995) - it is also a formalised financial source in terms economic reasoning. Investors are seeking for the gain and returns whereas borrowers are interested in the essential resources based on rational risk assessment (Kaplan and Stromberg, 2004).

In this sense the informal financing (in the form of funds from family and friends) lacks such an inevitable economic grounding as rationality because of the biased perception. Formalised institutions are engaged in the special procedures to assess the quality of the borrower (both credit risk and internal, business risk). Such organisations summarise available information and make decisions whether to invest or not according to their objectives. At the same time informal capital is much cheaper and lacks these burdensome requirements. However the costs can be higher than expected at the outcome:

1) Adverse selection of business projects (violation of the risk-return relationship) (Baumol, 1968);

2) The weakening of the responsibility for the efficient resources allocation and capital management in front of the investor (violation of the profit maximisation principal under restricted resources) (Lerner, 1998);

3) Industry retargeting of the business from the innovative trend to the traditional activities such as retail trading, transport services and others (Landstrцm, 2005). The latter do not demand for the large investments, special skills and knowledge, inventiveness at the beginning stage. It is easy to enter the market and overcome administrative barriers.

From this point, the quality of entrepreneurial activity can be measured in compliance with the financial sources attracted to finance a start-up at the early stage of its development. Such a kind of indicator is a challenge for the risk analysis. Two aspects are incorporated here: credit risk element (the possibility of a firm to generate sufficient cash flow to fulfil its obligations) and business risk facet (the possibility of an entrepreneur to produce a successful business idea and to realise it efficiently). In order to build on the theory in the field of informal small business financing and its consequences for the entrepreneurial performance as a whole it is proposed to test the following hypotheses:

Hypothesis 1: Informal capital is a substitution of the unavailable formal funds for small business.

The development of early entrepreneurial activity would be impossible without such a source. It is a leading financial strategy of beginning entrepreneurs in countries where the financial system is immature.

Hypothesis 2: Informal capital is a crucial source to get the business started but the financial system is sound enough to suggest a wide range of formalised sources (credits, venture capital, business-angels associations e.t.c.).

Informal capital is not an inevitable element to keep small business afloat. It means that either it is demanded by the businesses which are not able to pass formal procedures of credit institutions or are rejected by other potential investors because of their inefficiency and lack of prospects. Or it is attracted by entrepreneurs who look for "easy money", without subsequent obligations to return it or to earn additional gain.

Hypothesis 3: Informal capital is a marginal financial source and does not play a significant role in the economy.

If the second hypothesis is supported the "quality indicator" should reflect it. It is the case when informal capital harms the entrepreneurial activity. It effects the overall economic development negatively (through the discouragement channel). The formalisation of such investments should be undertaken through the setting cooperative microfinance organisations up.

3. Methodology

3.1 Data collection and sample description

The following study is a part of the international project Global Entrepreneurship Monitor (GEM), aimed at the investigation of entrepreneurial activity in the world. The Russian team's participation in the project made possible to carry out several researches concerning small business development in Russian Federation (2006-2009) and to implement cross-country analysis broken down 42 nations in the world.

The harmonised GEM dataset is available for the consistent intertemporal and international comparisons and provides the unique opportunity to measure differences in the level of entrepreneurial activity between countries, to uncover factors determining it and to identify policies that may enhance the level of entrepreneurial activity. Within GEM context the whole life-cycle of entrepreneurs is covered: from intentions to start a new firm till the established functioning (Reynolds et al., 2005).

Representative samples of randomly selected adults based on the two-stage proportional stratified selection (ranging from 2000 to 43000 respondents) are surveyed each year in each participating country (given the harmonisation and comparability ensured). A set of core questions (identical in each country) about attitude to, involvement into and conducting entrepreneurial activity are asked as well as basic social and demographic characteristics of the respondents are covered (Quill et al., 2006). The opportunities of GEM data compared with the scope of official statistics allow to capture a deeper field of entrepreneurs' and their sponsors' internal incentives. For example Russian statistical system, as well as ones in other countries, which are based on the United Nations Organization concept, enables researchers to investigate small and medium size enterprises only after 2 years have passed since their official registration (Obraztsova, 2008).

3.2 Terms and definitions

The time period of the survey concerns the dataset for 2006 and 2007 with indicators harmonized and standardized for comparisons in 42 countries - GEM project participants. According to the policy conditions only these years are available for the open publishing (in the international aspect) to date.

The object of the study is a group of early entrepreneurs marked out in accordance with the accepted classification of GEM methodology. These are people aged between 18 and 64, who have committed resources to start a business they expect to own themselves (solely or jointly) and people, who actively involved in managing a business which they already own solely or jointly for more than three months but less than 42 months.

According to the GEM methodology formal resources include capital in the form of banking credit or in the form of the financial governmental support. The GEM methodology also makes it possible to factor in various sources of financial resources, including the funds of business angels and love capital. The category of "love capital" (money from relatives, friends, neighbours, work colleagues) differs from the business-angels' investments (third parties who invested their own funds into detached business activity). Although both categories are combined into a group of informal investors: people who have personally provided funds for start-ups of others in the last 3 years.

The indicator of the default among early entrepreneurs is used in the analysis in order to measure the small business stability and efficiency. Defaulted businesses refer to the people in the sample who responded „yes" to the statement that they discontinued business in the past three years and the reason for it was one of the following: too much competition, lack of customers, problems with getting finance or the business was not profitable.

Credit risk is understood as a possibility of relative losses (relative to the expected level) caused to the lender by the default of the borrower. Business risk is treated as a possibility of relative losses (relative to the expected level) caused to the entrepreneur by the wrong business strategy (Crouhy et al., 2005).

3.3 Measurement

Keeping to the research framework the credit and business quality of entrepreneurial activity should be estimated. In addition it is necessary to provide a universal macroeconomic indicator which can be aligned to the level of riskiness of the dominant financial strategy among early entrepreneurs. Moreover, the received indicator should be linked to the social and economic development of a country in order to check the stated hypotheses. As a result, the implementation of such an objective is divided into two steps in conjunction with the different nature of the research subject.

Step 1

Firstly, as far as the quality of a business is concerned microeconomic approach is applicable. Depending on the internal features of a start-up (in combination with economic, social, political environment) it is more or less likely to fail (either to fulfil its credit obligations - credit risk issue - or conduct sustainable activity - business risk issue).

Following this sense, the risk-management outlook should be embedded into this part of the analysis. In this research credit risk evaluation is based on the calculation of minimum capital requirements methodology elaborated by Basel Committee on Banking Supervision and presented in the document called "International Convergence of Capital Measurement and Capital Standards" (2006).

According to the concept mentioned above, credit risk assessment consists of three elements: probability of default (PD) measure, the exposure at default parameter and the level of losses as a percentage of the total exposure in case of the default.

In the research context the PD indicator can be transferred to the analysis and be used as an instrument for the quality of entrepreneurial activity measurement. It shows the potential soundness of a small business unit and its survivability in the economic environment. That is exactly the case when both credit quality (as an opportunity to fulfil obligations) and business quality (as an element to foster the overall economic development) are captured.

In order to adjust the Basel methodology an indicator of the Probability of Default among early entrepreneurs is introduced. It is calculated as an estimated share of early entrepreneurs, who will possibly be in default during the forthcoming year.

Binary logistic regression is the most widespread method for the binary choice modelling, including the PD estimators (Engelmann and Rauhmeier, 2006). Moreover, this procedure is inevitable when dealing with input variables measured in different statistical scales, in particular nominal and ordinary ones. It is a single model which imposes a limited range of restrictions on the parameters (admitting small sample sizes and different measurement scales of input variables) and delivers appropriate results (Verbeek, 2008).

On the basis of the default history in the sample (in 2006 and 2007 for a number of countries where sufficient data are available - see appendix 1) a set of significant factors has been distinguished. The binary logistic model has been applied based on the stepwise method along with forward selection procedure. The input block of factor variables is presented by three strands: demographic characteristics of entrepreneurs; social factors; motivation and self-recognition of entrepreneurs (see table 1).

Table 1 Input variables description

Demographic and social factors	Gradation	Motivation and self-recognition factors (the opinion of the respondents is asked)	Description	Gradation
Gender	1 - male	Social networks	Personally knows entrepreneurs	1 - yes
	0 - female			0 - no
Age	de facto	Environment perception	Good opportunities to start business	1 - yes
Work status	1 - full			0 - no
	2 - part time	Competence	Sufficient skills and knowledge to start a business	1 - yes
	3 - retired			0 - no
	4 - homemaker	Confidence	Fear of failure prevents from starting up a business	1 - yes
	5 - student			0 - no
	6 - no work	Social perception	People around prefer uniform living standard	1 - yes
Income (calculated in percentiles)	1 - low			0 - no
	2 - middle	Career game	Starting a business is a good career choice	1 - yes
	3 - high			0 - no
Education	0 - none	Social position	Starting a business leads to the high status	1 - yes
	1 - under secondary			0 - no
	2- full secondary	Publicity	Lots of media coverage of entrepreneurial activity	1 - yes
	3 - post secondary			0 - no
	4 - additional

Data source: GEM APS individual database (2006-2007)

After the relevant determinants in explaining the default event (at the 5% level of significance) are received, the outcome coefficients have been applied to the same factors among early entrepreneurs. The goal is to obtain the individual PDs among early entrepreneurs on the basis of the available information:

, where

- significant parameters revealed in the analysis

- coefficients received from the binary logistic regression model

It is proposed to use average and median values in order to estimate the overall PD among early entrepreneurs based on the individual PDs. However a special adjustment should be implemented to take some sample features into the account and to improve the estimates.

Within the quantitative approach the PD is a random variable that complies with binomial distribution (default either occurs or does not). Keeping in mind small samples of defaulted entrepreneurs (less than 40) and PD assessments near 0, it is advised to use Jeffray's confidence intervals for the received estimations. The limits of the interval are calculated based on the assumption about prior Beta distribution of random binomial variable (Lawrenz, 2006).

The validation procedure conforms to the assessment of the discriminatory power of the model received with the help of Receiver Operating Characteristic (ROC-curve or Lorenz - curve) and Accuracy Ratio (AR, Gini ratio). Concavity of the ROC-curve is equivalent to the property that the conditional probabilities of default given the underlying factors is a decreasing function of the factors. AR - is the area under the ROC curve (Tasche, 2005). It is considered that values of AR measure which are higher than 40% indicate very good discriminatory power of the model (Moody's, 2000).

Step 2

The next stage of the analysis implies the connection between the financial choice of early entrepreneurs and their potential stability and solvency. Since the historic data do not allow including these variables (whether funds attracted in the form of formal, informal capital or supplied by business-angels) into the default estimation the other approach is applied.

The focus is concentrated on the four financial strategies available for early entrepreneurs: self financing; funds from relatives; financial support from friends, neighbours and work colleagues; formal capital. According to the theoretical aspect covered above, all these sources can be ranged in compliance with the risk associated with it. We can interpret it in terms of credit risk and business risk based on the price of the attracted capital. The highest price is observed for formal capital, whereas self financing is free for an entrepreneur. From this viewpoint, the higher the price is the more credit risk is associated with it. The borrowers are of high responsibility for the gained credit resources from formal investors (price, collateral, and property) while potentially insolvent ones will appeal to informal funds with no tough recovery obligations. The opposite logic concerns business risk treatment: the risk is higher when the business is not under the outside control, there are incentives to turn to cheaper but less efficient strategies (e.g. industry retargeting). (See table 2).

Table 2 The risk ranging of the financial strategies of early entrepreneurs

Credit risk - the possibility of losses incurred to the lender owning to a change in the credit quality of a borrower	Grade	Business risk - the possibility losses incurred to the entrepreneur owing to the downgrading of control and responsibility	Grade
Self financing (no credit relationship)	1	Self financing (no outside control)	4
Funds from relatives (the lowest price of capital)	2	Funds from relatives (the weakest outside control)	3
Capital from friends, neighbours and work colleagues	3	Capital from friends, neighbours and work colleagues	2
Banking credit and governmental grant or transfer (the highest responsibility in front of a lender)	4	Banking credit and governmental grant or transfer (the toughest outside control)	1

As a result we managed to change the statistical scale according to the sense implied behind the variable. We have received an ordinary measured parameter which is applicable to the contingency analysis. If the individual PDs are ranked among early entrepreneurs and their grades of financial strategies are known then it is possible to evaluate the association between the quality of entrepreneurial activity and the financial strategies of the small business units. If several financial sources are attracted the average grade is used in the contingency analysis (as an average measure of the risk implied). The nonparametric Spearmen's rank-order correlation criterion is used in order to assess the contingency between two variables in the ordinal scale. The conclusions are made at the 5% level of significance.

This approach gives rise to the explanation of the role of informal investments: the higher the contingency is (the sign of the criterion does not matter because of the ranging in both directions), the less efficient businesses are financed by the informal capital.

4. Results

4.1 Descriptive statistics

The dataset opportunities allow making structural comparisons of various financial strategies of early entrepreneurs across the countries in 2006 (see fig. 1). However, the international sample lacks the detailed information about the demand for financial capital in 2007. In 2006 the picture is quite heterogeneous: the nations vary greatly in the financial preferences distribution.

Fig. 1 The percentage of early entrepreneurs willing to attract different kinds of financial sources to start a business across 42 countries in 2006

Data source: GEM APS individual database (2006)

Nevertheless common tendencies can be tracked. Formal financing is of high demand in Europe: Greece, Netherlands, Belgium, Norway, Finland, Ireland, Italy and some others. The same pattern is observed in Canada and Russia with the exception of the dominant position of informal capital in the second country. Formal funds are not attracted and substituted by own capital and funds of close people in Brazil, Mexico, Peru, China, Jamaica and others.

As far as the US, the UK, Australia are concerned the formal sources are suppressed by own financing. Business-angels' support is disseminated in Northern Europe: Denmark, Sweden, Norway, Iceland, and Finland.

Summarizing the idea above, one could identify the importance and prevalence of the borrowed capital, particularly informal financing for early entrepreneurs, although such a choice doesn't signify any kind of trade-off between borrowed and own funds in terms of financial leverage.

In order to reveal more concrete tendencies in small business financial strategies across different countries deeper analysis is applied. The key interest lies in the following: is there any consistent dependency between the financial strategy of an entrepreneur and the development of a country?

To explain this issue, one should mark out the supply side of the process. If informal capital (as hypothesis 1 suggests) is a substitution for the unavailable formal sources, then it should be a priority source in countries with immature financial system. Moreover, the readiness to provide these cheap and "easy" funds should be also observed among informal investors.

Fig. 2 The dependence between social and economic development of a country and the prevalency of informal funds available to entrepreneurs in 2006

Data source: GEM APS individual database (2006)

It is possible to drill down into the supply of informal capital by estimating the percentage of informal investors among adult population. A similar picture appears as in the case of the demand analysis.

From one side, countries such as Peru, India, Indonesia, Latvia, Chile, Colombia, Argentina where the level of social and economic development can be said to be low, have typically a large share of informal investors (see fig. 2). Therefore, this group of countries demonstrates high levels of informal funding as the only possible way to promote business activities because there is no other possibility to set up an optimal infrastructure (Saemundsson, 2003). Hypothesis 1 is confirmed.

From the other side, United States, France, Ireland, Norway, Canada also demonstrate high proportion of family financing, although the welfare of these nations is in the upper cluster. The availability of spare financial resources is able to encourage the credit risk acceptance and to enforce informal investments. At the same time, biased relations with the borrower can trigger off the underestimation of risk factors and lead to the excessive risk taking. However, the credit risk concentration is no more harmful for the economy until it is perceived by informal investors as their voluntarily deposits of available financial resources into the business activity. The occurrence of losses will correct the situation - inefficient investments will not be repeated. In this sense it is essential to estimate the potential sustainability and adjacent it to the financial strategy of early entrepreneurs in order to clarify the second hypothesis.

Lastly, the rest of the countries can be divided into two groups. There are highly developed nations and nations with low GDP per capita indicator among the countries with minor (or moderate) percentage of informal investors. The former group includes European countries and Japan, the latter one covers Russia, China, Brazil, Mexico. The high demand for informal funds in the last group speaks for the reluctant behaviour of informal investors and for the necessity nature of family financing. At the same time, low demand in the first group points out the credibility of the third hypothesis.

It is noticeable, that the results concerning the supply side are stable during the time (see fig. 3). China and Romania have come out to the cluster with high percentage of informal investors: the tendency is converging to the support of the hypothesis 1. The US and Norway have descended to the middle group with high GDP per capita indicators along with the restrained supply of informal investments. An inclination towards the hypothesis 3 confirmation is loomed.

Given these facts, more details are necessary to clarify the role of informal capital in the range of countries where the situation is ambiguous.

Fig. 3 The dependence between social and economic development of a country and the prevalency of informal funds available to entrepreneurs in 2007

Data source: GEM APS individual database (2007)

4.2 Risk analysis

Relevant factors which determine the historical defaults among entrepreneurs are presented in the table 3 (based on the binary logistic regression assessment, see appendix 2). It is worth mentioning that the counties have been chosen according to their belonging to each group distinguished in the descriptive analysis and depending on the sample size available for the statistical estimations. However, not all the countries in 2006 were transferred to 2007 to draw intertemporal comparisons because of the database restrictions.

India represents the argument for the hypothesis 1 confirmation. The US and Norway stand for the discouraging effect of informal investments (hypothesis 2). Russia, China and Brazil are at the edge of the hypothesis 1 and hypothesis 3 confirmations, as well as Slovenia. The UK, Germany (as the representatives of Western Europe), Denmark (as a representative of the Northern Europe) and Sweden (with high demand for informal funds and low supply of it) are considered at the edge of either hypothesis 2 or hypothesis 3 support.

Table 3 Results of binary logistic regression (X - significant factors at 5% level) based on the sample of defaulted entrepreneurs

2006

Gender

Age

Work status

Income

Education

Social net-works

Environ-ment perception

Compe-tence

Confi-dence

Social perception

Career game

Social position

Publicity

USA

X

X

X

X

Norway

X

X

X

X

UK

X

X

X

X

X

X

X

X

X

X

X

Germany

X

X

X

X

X

X

X

Denmark

X

X

Sweden

X

X

X

X

Slovenia

X

X

X

X

Russia

X

X

X

X

X

X

X

India

X

X

X

X

X

China

X

X

X

X

X

X

X

X

X

X

X

X

X

Brazil

X

X

X

2007

Gender

Age

Work status

Income

Education

Social networks

Environ-ment perception

Compe-tence

Confi-dence

Social perception

Career game

Social position

Publicity

USA

X

X

X

X

X

X

Norway

X

X

X

UK

X

X

X

X

X

X

X

X

X

X

Slovenia

X

X

China

X

X

X

Brazil

X

X

X

X

Data source: GEM APS individual database (2006-2007)

Competence and confidence of entrepreneurs were the most crucial factors among the countries in 2006: the less confidence they feel as well as the less qualified they are the default is more likely to occur. Environment perception influenced the business stability in 2007. Interestingly, social position and publicity were more important in determining business stability in the countries with low social and economic development (BRIC) than in wealthier nations.

The derived default model has been validated with the help of ROC-curves and Accuracy rates. Models for each country turn out to be adequate instruments for the PD-forecasts according to the selected criteria (see appendix 3). This issue gives an opportunity to pass on to the next step: to assess the credit and business quality of early entrepreneurial activity.

After the stated factors are applied to the same characteristics of early entrepreneurs the following estimations of potential entrepreneurial consistency have been received (see fig. 4).

In 2006 Russia, India, Brazil, China as is the case with the US and the UK demonstrate the highest predictions of PD among early entrepreneurs. The most stable group (in terms of central values) is presented by the US, the UK, India, Brazil and China. Remembering the substantial demand for informal funds in the last three countries as well as significant percentage of informal investors in the economies of the USA and the United Kingdom, one can link it to the hypothesis 2 and 1 correspondingly.

2006

2007

Fig. 4 Probability of Default (PD) among early entrepreneurs in the selected countries in 2006-2007 (with Jeffray's confidence interval limits at the 5% significance level)

Pink colour - median values

Blue colour - average values

Data source: GEM APS individual database (2006-2007)

However, the downgrading quality of early entrepreneurial activity in China and India (see fig. 4, 2007) can hamper the overall economic development instead of filling in the financial gap due to the unavailable or inaccessible micro credit facilities or other formalised sources. The similar situation can be considered within the developed countries, where the PD rates either increase through the time (Slovenia) or remain stable (the UK, Norway). The downturn in the quality of entrepreneurial activity can be connected not only with the incorrect (from the economic point of view) financial choice but with the deteriorating market, political, social environment and other factors, which has not been considered in the models.

In this way, the financial strategies of early entrepreneurs should be taken into the account in order to draw a line between irrational incentives (if they take place for some countries) and the credit and business quality of a start-up.

Table 4 The contingency between PD rates of early entrepreneurs and their ranged (according to business risk) financial choice

	Spearman rank criterion	Significance (P-value)
Russia	-0,077	0,0228
China	-0,077	0
Brazil	-0,128	0
India	0,298	0
Slovenia	0,188	0
Norway	-0,044	0,0176
Sweden	-0,063	0,061
UK	0,137	0
USA	0,184	0
Germany	0,043	0
Denmark	0,355	0

The results of the contingency analysis are presented in the table 4. If early entrepreneurs prefer financial sources which are associated with high business risk and almost the lack of credit risk (self-financing or informal capital, in particular family support) then the aggregate PD rate among early entrepreneurs in the economy increases. It is true for India, Slovenia, the UK, the USA and Denmark.

As far as India is concerned, informal capital as a single source to keep small business afloat is not justified. It fosters entrepreneurial growth but it initiates a negative effect on overall economic development. It means that the informal cash flows should be formalised in order to have a positive impact at the outcome. Both of the hypotheses 1 and 2 are confirmed in respect with countries with low social and economic development and the downgrading credit quality resulted from the informal capital priority.

The second hypothesis is not confirmed for Russia and China (informal capital - is a substitution for unavailable formal resources and does not harm overall economic development, only hypothesis 1 is supported). Hypothesis 2 is not applicable to Norway, Sweden and Germany as well. These countries are characterised by the sound nature of early entrepreneurial activity (PD rates are quite low) and simultaneously the moderate demand for informal funds (except Norway) - so, the third hypothesis is accepted (informal capital does not impede a high-quality entrepreneurial growth, except a threat of the overinvestment by informal creditors in Norway).

In Brazil less business risk is associated with the growth of the small business instability. So, the more formal capital is attracted the more the default among early entrepreneurs is likely to occur. It could be connected with some peculiarities in Brazil financial system: government or credit institutions accept too much credit risk from small business in order to stimulate such a kind of activity. It triggers off moral hazard problems or wrong selection criteria. However such relationship is of medium significance which can lead to the same result as observed in Russia and China (in favour of hypothesis 1).

The received results display the multidimensional nature of informal investments. The challenge is that even if such a kind of financial resource is a single way to support small business activity materially, there is an opportunity that the final effect will be negative (as for India in 2006). Moreover, informal investments are able to block healthy entrepreneurial activity being attractive for typical start-ups, who are seeking for cheap and easy ways for their idea implementation (the case of the UK, the USA, Denmark and Slovenia). The reason for it - inefficient resources allocation, no anticipated returns, activities with low valued-added, and so on. The task is to transform such cash flows into beneficial ones, to formalise them in order to eliminate these destructive incentives.

5. Conclusion

Thus, it has been considered that by choosing a source of financing at the initial stage of the development, entrepreneurial activity shapes the general economic environment. On the whole, the fundamental idea of the study throws light on the fact that each small business entity while making its decision at the microeconomic level causes global effects at the same time. By aggregating these individual impacts the overall outcome is negative when the combination of the considered factors is critical. After individual risk profiles of the defaulted businesses were marked out they were used to provide a single indicator which reflected the credit and business quality of early entrepreneurial activity.

As a result, informal capital in the small business financing can trigger off various effects. Firstly, it is an irreplaceable source for the early entrepreneurial activity at the addressed point of time. The lack of other sources due to the immature financial system, the absence of trust among investors and unstable environment encourage the choice in favour of this financial strategy in order to make good career or to enhance social status or to improve the well-being. Such an outcome is typical for the countries with low social and economic development.

Secondly, informal capital is a generator of potential instability in terms of the downgrading the quality of entrepreneurial activity. People are more likely to attract this source if they feel unconfident about their business activity, or they need moderate amount of money to start some typical activity: trading, transport and so on. This leaves an imprint on the profitability and solvency of such firms. They neither provide sufficient jobs nor enhance economic growth due to the low value-added. The described course of event is appropriate to any nation: both with high and low values of macroeconomic indicators. It is especially dangerous for the developed countries because it can overwhelm the positive effect from the entrepreneurial activity substantially. However, it is worth considering in regard to less wealthier nations in order to ease the recovery process.

Thirdly, informal investments can exist as some additional and minor source, because it is an inevitable and uncontrolled element of any society: personal relationships. Notwithstanding this fact, other financial sources are affordable enough to be attracted by the most part of successful businesses. That is the balance which should be found to insure consistency in the economic growth.

To achieve this balance, micro-finance institutions should be spread around. More specifically, credit cooperatives are able to replace informal cash flows being the formalised analogue of them. The legal structure of such institutions preserves the most attractive features of informal capital: easy access, low prices and close relationships (an opportunity to resolve all the disputes inside the organisation). The reorganisation will give rise to the efficient resources allocation and to the turn to rational economic incentives.

Small business is the most flexible and mobile economic structure, at the same time it is the most fragile and susceptible to the external fluctuations one. It is necessary to capture both the inner side of a small business activity and the outer impact on its perceptions in order to imprint the economic situation. It will give an opportunity to reveal certain movements in the process, thus controlling tendencies in the behavour of small business as a beacon for the economic pitfalls.

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