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Attracting early stage investors through an effective start-up governance

Published: 31st March 2020 Last updated: 21st December 2022

An important question for academics and practitioners alike is whether entrepreneurial firms rely on signals to demonstrate their attractiveness in the financing market. Traditionally, most attention was focused on the US (venture) capital market; but recently countries like the Netherlands have emerged in the start-ups arena featuring big fundraisings such as Picnic (€250 million) or GitLab (€268 million). However, attracting outside investors remains a key challenge.

In their recent paper published in the Journal of Business Venturing, Mircea Epure (University Pompeu Fabra and BGSE) and Martí Guasch (Tilburg University) argue that early stage equity investors can use debt financing as an information signal to navigate the high uncertainty inherent in the investment selection process. By commanding greater accountability to external constituents, debt can serve as a valuable signal of the presence of a market type governance. The governance role of debt directs new ventures towards more professional management practices, it ties control rights to cash flow monitoring by lenders, and it institutes dire penalties that can go as far as fully shifting the control of the firm. Figure 1 summarizes these arguments.

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Figure 1. The governance role of debt in early stage firms (Epure and Guasch 2019)

Delving deeper into their arguments, they show that the governance role of debt is stronger in the case of business debt, which is subject to more rigorous screening and monitoring of firm activity, while personal debt acts mostly as a signal of the entrepreneur’s commitment. There are specialization advantages in these signaling rationales: banks can specialize in using soft information on entrepreneurial firms, and impose a more effective governance by actively monitoring credit lines. While the analysis is general, it shows that the governance role of debt can send a stronger signal in capital intensive industries which feature business models that are more difficult to scale up (see here).

The study is conducted using the Kauffman Firm Survey (KFS), and confirms the predictions outlined above. Moreover, producing a debt signal at firm inception can matter more in times of economic distress, when capital providers are constrained. Importantly, start-ups with higher levels of debt, but similar in other respects, display higher growth in revenues and market share, especially in capital intensive industries. In short, the presence of lenders can help investors to assess arm’s length equity transactions by providing informational advantages based on the costly to reproduce screening and governance mechanisms. By using early stage soft information, lenders are able to guide the prevalent discretionary, less professional management of young firms towards a more market oriented one, which investors can evaluate as a positive mechanism of growth prospects.

Finally, the authors open the gate to managerial and policy implications. Entrepreneurs could rely on the governance role of debt to signal accountability to external constituents through channels such as early stage bank firm relationship. In turn, regulators could rely on capital markets when signals hold higher value (e.g. in capital intensive industries), and strategically consider intervening (e.g. via competitive financing programs) when interested in fostering growth in emerging and low capital intensive industries.

Reference: Epure, M., and M. Guasch. 2020. Debt Signaling and Outside Investors in Early Stage Firms. Journal of Business Venturing 35(2): 105929. Link at publisher

Academic profile: Marti Guasch