What is the pecking order theory of entrepreneurship?
The pecking order theory was developed by in the 1980’s by finance scholars seeking to understand the financing preferences of firms. Pecking order theory also relates to entrepreneurs’ preferences about financing choices. Financing options include using one’s own personal funds, reinvesting profits back into the business, selling equity to outside investors, and bank debt or loans.
At the core of the theory are information asymmetries between the entrepreneur or the startups’ executive team, and the prospective sources of funds for the business—that is, the financiers. Entrepreneurs and other insiders have better information about the business’ operations and potential than do prospective financiers because the former deal with stakeholders and problems on a day to day basis. Financiers usually have to rely on second hand information provided by the leadership team of the startup and the financial statements they provide. While corporate officers have a fiduciary duty toward shareholders, that is, they are legally required to be truthful, there is still plenty of room for understatement, overstatement, and obfuscation (see agency theory for more on this).
To make up for their informational disadvantages, financiers typically demand higher interest rates or more favorable terms to protect themselves against what they do not know (Paul, Whittam and Wyper, 2007). As a result, entrepreneurs tend to prefer to fund their ventures using their own funds and profits of the business rather than submitting to the costly demands of outside investors and lenders. New equity investors will typically demand a higher rate of return on their investment than the founding investors, thus entrepreneurs will typically prefer loans. Entrepreneurs also prefer short-term loans to long-term loans, as these will typically have lower interest rates (Paul et al., 2007).
The information asymmetries are more acute for some types of firms than for others. For instance, firms with complex business models that are difficult for outsiders to understand will typically have greater asymmetries than simple or conventional business models that are easy to understand. Warren Buffett is famous for stating that he only invests in simple businesses that he understands. Presumably, he would require a much higher rate of return to invest in more complex businesses.