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Attracting private investors through early stage debt

Attracting private investors through early stage debt

A study by Mircea Epure (UPF) and Martí Guasch (Tilburg University) analyzes the relationship between debt secured by newly-founded companies and the private investments they attract. The study shows that debt imposes an effective start-up governance, which outside equity investors can interpret as a signal of accountability.

19.06.2020

Imatge inicial

The increasing supply of private equity investments in early stage firms stimulates aggregate employment, wages, and firm creation. Attracting external financing is especially critical for early stage firms (start-ups), with important effects on their growth, innovation capabilities, and survival. However, investors are very cautious when selecting companies at initial stages. Start-ups operate in highly uncertain environments and have no financial track record; thus, investors need to rely on “signals” to inform their decision-making process.

“Outside investors can rely on the signaling value of debt, which is given by its effective governance role”.

.A study conducted by the researchers Mircea Epure (Department of Economics and Business at UPF) and Martí Guasch (Tilburg University) published last March in the Journal of Business Venturing analyses the relationship between debt secured by the start-up - which can act as an information channel - and the private equity it attracts.

The study highlights that debt imposes firm governance processes (for example, it limits the entrepreneur’s discretionary use of cash flows, and requires more professional management practices) that can operate as a trusted and reliable signal for equity investors in initial stages.

This increased start-up governance alleviates the information asymmetries associated with such investments and facilitates agreement between entrepreneurs and investors. The authors state: “Outside investors can rely on the signaling value of debt, which is given by its effective governance role. Contracting early stage debt institutes a governance mechanism that raises accountability and can transmit valuable information to outsiders”.

Importance of business debt compared to personal debt

The researchers examine the differences between business debt (on behalf of the company) and personal debt (on behalf of the entrepreneur). They posit that the signaling value of debt is higher in the case of business debt, which acts as a governance mechanism, due to being subject to more rigorous screening and monitoring of firm activity; in contrast, personal debt acts mostly as a signal of the entrepreneur’s commitment.

“With high levels of business debt and in the presence of personal debt, the entrepreneur is not only accountable to external constituents, who actively monitor firm activity, but also signals personal commitment to the firm and thus enhances the reliability of the signal to outside investors”, the authors suggest.

The signal of improved governance imposed by debt is more important for investors in capital intensive industries.

Although the analysis is general, it also shows that the signal of improved governance (imposed by debt) is more important for investments in industries that are more reliant on capital. “Lenders can institute a more effective governance mechanism in capital intensive industries that feature more reliance on financing needed to scale up their business models,” they explain.

The paper uses the Kauffman Firm Survey (KFS) to confirm its predictions: a survey which provides eight years of data on 5,000 independent businesses founded in the US in 2004.

Reconciling investor and lender perspectives: business and political repercussions

By focusing on the governance mechanisms that debt imposes, the study reconciles some of the perspectives on the lender versus investor information process.

Lenders tend to focus on governance mechanisms that minimize downside risk, while investors look for (and finance) companies with high growth potential. Incentives and financing perspectives may not coincide between lenders and investors, but especially in the case of start-ups investors positively value the governance implications of securing debt (e.g., overcoming screening processes by financial institutions or greater external accountability). Overall, obtaining debt improves firm governance —sometimes unconsciously for the entrepreneur—, which can prove highly informative to investors in initial stages, who are continuously in search of quality indicators.

Moreover, the authors state that their findings have implications for entrepreneurs and policymakers. “Entrepreneurs could rely on the governance role of debt to signal accountability to external constituents through channels such as early stage bank firm relationship,” they assert.

Reference: Epure, Mircea and Guasch, Martí (2020). Debt signaling and outside investors in early stage firms. Journal of Business Venturing, 35(2): 105929. https://doi.org/10.1016/j.jbusvent.2019.02.002

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Unitat de Comunicació i Projecció Institucionals

Unidad de Comunicación y Proyección Institucionales

Institutional Communication and Promotion Unit