CFA Affiliation and Chal..
An important question for academics and practitioners alike is whether entrepreneurial firms rely on signals to demonstrate their attractiveness in the financing market. Starting up a business is becoming appealing even as a first “job” after graduating; this is largely due to the increasing supply of equity. And while traditionally all eyes were set on the US market, more recently cities like Barcelona have built a reputation through big fundraisings such as Cabify (€130 million) or Glovo (€115 million). However, attracting outside investors remains a key challenge.
In their recent paper forthcoming in the Journal of Business Venturing, BSM-Pompeu Fabra University Professor and QTEM Dean Mircea Epure and Martí Guasch (a recent graduate of UPF now at Tilburg U.) argue that outside investors in an entrepreneurial context are cautious in the selection process since they face a higher informational risk with respect to incumbent firms. Also, a usual tension in start-ups is that, subsequent to being invested, they may exhibit discretionary behavior pursuing private benefits. Contrasting with this ex post focus, the authors posit that investors can attempt to identify early stage firms with an effective governance already in place.
Epure and Guasch propose that by commanding greater accountability to external constituents, debt can serve as a valuable signal of the presence of a market type governance. The governance role of debt entails a magnified impact in the case of entrepreneurial firms. It directs them towards more professional management practices, rather than their prevalent personal management; it ties control rights to cash flow monitoring by lenders, and it institutes dire penalties that can go as far as fully shifting the control of the firm. Figure 1 summarizes these arguments.
Delving deeper into their arguments, they show that the governance role of debt is stronger in the case of business debt, which is subject to more rigorous screening and monitoring of firm activity, while personal debt acts mostly as a signal of the entrepreneur’s commitment. There are specialization advantages in these signaling rationales: banks can specialize in using soft information on entrepreneurial firms, and impose a more effective governance by actively monitoring credit lines. While the analysis is general, it shows that the governance role of debt can send a stronger signal in capital intensive industries which feature business models that are more difficult to scale up (see here).
The study is conducted using the Kauffman Firm Survey (KFS), and confirms the predictions outlined above. Producing a debt signal at firm inception can matter more in times of economic distress, when capital providers are constrained. Importantly, there are economic effects: start-ups with higher levels of debt, but similar in other respects, display higher growth in revenues and market share, especially in capital intensive industries. In short, the presence of lenders can help investors to assess arm’s length equity transactions by providing informational advantages based on the costly to reproduce screening and governance mechanisms to which firms adhere.
This work serves to reconcile some of the perspectives on the lender versus investor information interpretation processes. Lenders tend to focus their governance mechanisms on the downside risk, while investors have been shown to select firms mostly based on their upside growth potential. By using early stage soft information, lenders are able to guide the prevalent discretionary, less professional management of young firms towards a more market oriented one, which investors can evaluate as a positive mechanism of growth prospects.
Finally, the authors open the gate to managerial and policy implications. Entrepreneurs could rely on the governance role of debt to signal accountability to external constituents through channels such as early stage bank firm relationship. In turn, regulators could rely on capital markets when signals hold higher value (e.g. in capital intensive industries), and strategically consider intervening (e.g. via competitive financing programs) when interested in fostering growth in emerging and low capital intensive industries.