Rethinking Capital Structure in Entrepreneurial Firms: Equity, Debt, and the Hidden Cost of Personal Guarantees

We develop an entrepreneur-centred model of capital structure for small entrepreneurial firms that explicitly incorporates (personal) recourse debt (bank loans guaranteed by the entrepreneur’s personal wealth) alongside equity and non-recourse debt. Departing from traditional corporate finance approaches, the model recognises that entrepreneurs are undiversified investors whose required remuneration must compensate not only for venture risk but also for the impact of potential bankruptcy on their personal wealth. Moreover, we conceptualise personal guarantees as additional personal wealth invested in the venture and derive an adjusted weighted average cost of capital that captures this hybrid form of financing. The model shows that (i) the cost of (personal) recourse debt can exceed the cost of equity, thereby challenging the traditional pecking order of financing sources; and (ii) the optimal capital structure of small entrepreneurial firms generally relies on only two of the three financing types. The findings provide theoretical and practical insights into how small firms finance growth, offering explanations for the frequent dominance of equity and the preference for trade credit or internal funds over personally guaranteed bank loans. JEL: G31, G33