Signaling theory and entrepreneurship
Signaling theory has been used to explain how firms communicate their quality and intentions to investors. It addresses a fundamental problem: Information Asymmetry.
[Image of signaling theory diagram economics]Entrepreneurs have private (insider) information about their venture's prospects that outsiders do not have. For example, entrepreneurs may know early R&D results, sales data, or human capital details. They may also know about impending lawsuits or union troubles before the public does.
Because investors know they lack this information, they look for signals to determine which startups to fund.
What Makes a "Good" Signal?
The best signals are costly and observable.
- Observable: The investor must be able to see it easily.
- Costly: It must be difficult to fake. If a signal is cheap, low-quality firms will mimic it. If it is expensive (like ISO9000 certification or a high degree of founder equity), only high-quality firms can afford to send it.
Types of Signals in Entrepreneurship
The typical study identifies a set of signals sent by a firm around the time of an Initial Public Offering (IPO). These can be positive or negative (see review by Connelly et al., 2011).
- Positive Signals: Founder involvement (demonstrates commitment), top management team characteristics, and the presence of reputable Venture Capitalists or Angel Investors.
- Negative Signals: Often communicated unintentionally. For example, issuing new shares can signal that the owners believe the shares are currently over-valued (Bhattacharya, 1979).
Assumptions and Challenges
One of the key assumptions of the theory is that the signalers and signal receivers have somewhat conflicting interests. If interests were perfectly aligned, the signaler would simply tell the truth without needing a costly signal.
Signaling theory also challenges human capital theories. It suggests that individuals may seek education not to acquire skills, but simply to signal their abilities in areas that are hard to observe directly (the "credentialing" view).
Video Overview: Signaling Theory in Economics
Sources
- Bhattacharya, S. (1979). Imperfect information, dividend policy, and "the bird in the hand" fallacy. The Bell Journal of Economics, 259-270.
- Connelly, B. L., Certo, S. T., Ireland, R. D., and Reutzel, C. R. (2011). Signaling theory: A review and assessment. Journal of Management, 37(1), 39-67.
