Signaling theory and entrepreneurship

What is the signaling theory of entrepreneurship?

Signaling theory has been used to explain how firms communicate their quality and intentions to investors. For instance, debt and dividends signal quality because low quality firms presumably cannot keep up interest payments over the long run (Bhattacharya, 1979).

Signaling theory is used to explain which startups get funded by investors and which do not raise capital. The typical study identifies a set of signals sent by a firm around the time of an initial public offering (IPO). Signals may include top management team characteristics, founder involvement, or the presence of venture capitalists or angel investors. Signalling theory predicts how these signals will affect the signal receiver’s decisions.

The next step is to characterize the signals as either positive or negative in terms of their effects on subsequent investments or valuations by public or private investors (see review by Connelly, Certo, Ireland and Reutzel, 2011). For example, founder involvement may be viewed as a positive signal by investors in an IPO because it demonstrates commitment to the venture. Most of the research looks only at deliberate positive signals because of the tendency to suppress negative signals (Connelly et al., 2011). Yet, some negative signals are communicated unintentionally as a by-product of some other action (i.e., issuing new shares can signal that shares are over-valued). The best signals are costly and observable because costly signals are difficult to fake, especially if the signal cost is lower for higher quality firms (e.g., ISO9000 certification).

Signals can correct information asymmetries, such as when entrepreneurs’ private (insider) information about their own ventures’ prospects (unobservable quality) are superior to that of outsiders. For example, entrepreneurs may be privy to the early results of research and development projects or early sales data of a new product. They may also learn about impeding lawsuits or union troubles earlier than outsiders. This type of information can also shape entrepreneurs’ intentions about the business, such as whether they will sell out their share or stay for the long haul (Connelly et al., 2011).

One of the key assumptions of the theory is that the signalers and signal receivers have somewhat conflicting interests, otherwise the signaler would have no reason not to fully divulge their private information. Outsiders, such as investors, could make better decisions if they had access to the entrepreneur’s private information, but since they often do not have such access, at least not without considerable costs, signals are the next best thing. Signaling theory poses a special challenge to the “perfect information” assumption of economists. It also challenges human capital theories, because individuals may seek education and training to signal their abilities in areas that are hard to observe directly rather than actually acquiring the knowledge.

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2 comments for this post
  1. Jessyca Rusyn

    Islam’s paper Signaling by Early Stage Startups: US Government Research Grants and Venture Capital Funding studies the role of signals for early stage startups when winning prestigious government research grants. The U.S clean energy sector was studied and it was found that startups who received these grants in the past were 12% more likely to receive further venture capital (VC) funding. However, this signaling effect is only viable for the six months after receipt of the government grant. It was also found that startups with no patents or patent applications were 7% likely to receive future VC funding. This indicates that signaling can redistribute benefits as well as provide an additional advantage (Islam, 2018).
    It is more likely that the receipt of a grant is a strategic decision between the startup and the venture capitalist rather than a starting point of a relationship. Since the signaling effect is time dependent, startups should start networking with venture capitalists while applying for grants since the receipt of a grant has a significant lead time in order to more successfully secure future VC (Islam, 2018).

    Reference:
    Islam, M., Fremeth, A., & Marcus, A. (2018). Signaling by early stage startups: US government research grants and venture capital funding. Journal of Business Venturing, 33(1), 35-51.
    https://www.sciencedirect.com/science/article/abs/pii/S088390261730811X

  2. BER

    Epure’s paper Debt signalling and outside investors in early-stage firms analyze the signalling effect of early-stage debt. The hypothesis was that debt, in particular, business or personal debt can serve as a reliable signal for outside equity investors and stakeholders. The rationale being that debt imposes governance and directs entrepreneurs towards professional development. Accordingly, these signals indicating accountability can alleviate the information asymmetry between prospective investors and firms. Epure and his team used the Kauffman Firm Survey and found evidence to support their hypothesis. Accordingly, outside investors assume the presence of early debt to imply better than average governance. Their findings also corroborated that younger firms tend to focus on growth instead of profitability. This paper supports the information shared in the blog post. This paper, however, looked at a signal that the signaler might not necessarily be withholding. The signal discussed here is more about proven ability instead of information.

    Reference:
    Epure, M., & Guasch, M. (2019). Debt signaling and outside investors in early stage firms. Journal of Business Venturing. doi: 10.1016/j.jbusvent.2019.02.002

    https://www.sciencedirect.com/science/article/abs/pii/S0883902617301775

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