Pecking order theory of entrepreneurship
The Pecking Order Theory was developed in the 1980s by finance scholars (Myers and Majluf) seeking to understand the financing preferences of firms.
The theory suggests that there is a specific hierarchy (a "pecking order") that entrepreneurs follow when deciding how to fund their business. They do not choose randomly; they choose based on the path of least resistance and lowest cost.
The Hierarchy of Preferences
Entrepreneurs typically prefer funding sources in this specific order:
- Internal Funds (Bootstrapping): Personal savings and retained earnings (profits reinvested). This is the preferred choice because it requires no disclosure to outsiders.
- Debt (Loans): If internal funds run out, entrepreneurs prefer debt. Banks are less intrusive than equity partners.
- New Equity (Investors): Selling shares to outside investors is the last resort. It is the most expensive (you lose ownership) and requires the most disclosure.
The Cause: Information Asymmetry
At the core of the theory are information asymmetries between the entrepreneur and the financier.
Entrepreneurs and insiders have better information about the business’s operations and potential than prospective financiers do. Financiers usually have to rely on second-hand information provided by the leadership team.
While corporate officers have a fiduciary duty to be truthful, there is still plenty of room for understatement, overstatement, and obfuscation (see Agency Theory for more on this).
The Cost of "Not Knowing"
To make up for their informational disadvantages, financiers typically demand higher interest rates or more favorable terms to protect themselves against risk (Paul, Whittam and Wyper, 2007).
- The Result: Entrepreneurs avoid these costs by using their own money first.
- The Preference: Entrepreneurs also prefer short-term loans over long-term loans, as these typically carry lower interest rates.
These asymmetries are more acute for complex firms. For instance, Warren Buffett is famous for stating that he only invests in simple businesses that he understands. If a business model is too complex, the "cost" of the information asymmetry is too high, and investors demand a much higher rate of return.
