Excerpt
TABLE OF CONTENTS
1 Introduction
2 Trends and Developments in Entrepreneurial Finance
2.1 Factors Explaining the Transformation of the Finance Landscape
2.2 Traditional and New Forms of Entrepreneurial Finance
3 Implications for a Startup’s Signaling Strategy
3.1 Theoretical Foundations
3.2 Research on Signaling Strategies based on Startup Characteristics
3.3 Research on Signaling Strategies based on Startup Actions
3.4 Research on Signaling Strategies based on Third-Party Endorsements
4 Avenues for Future Research
4.1 Adjusting the Research Focus
4.2 Fostering Conceptual Development
4.3 Promoting a Cross-Disciplinary Approach
5 Conclusion
6 Appendix
7 References
ABSTRACT
The landscape of entrepreneurial finance is currently subject to a process of transformation, driven by globalization, technological advancements, regulatory adjustments, and the emergence of winner-take-all markets. These factors jointly pave the way for new forms of financing, which differ significantly from traditional forms in terms of investor structure, experience, and behavior. To analyze how startups can ensure financial coverage in the light of these changing conditions, this review compares strategies of attracting traditional and new types of investors from a signaling perspective. In business practice, this topic is highly relevant, as many young startups require substantial amounts of external capital to grow, but often have no objective firm data to provide to investors. Thus, the selection of effective “soft” signals about startup quality, preferably aligned with the preferences of the respective investor group, can decide about short-term survival and long-term performance. Findings include that the most promising signaling strategies for traditional forms of financing are based on startup characteristics, i.e. what a firm is. In contrast, the most effective signals for new forms of financing are based on startup actions, i.e. what a firm does. Moreover, while personal networks have been found to be highly relevant for traditional forms, online networks increase the funding prospects for new forms of financing. Through a consolidation and analysis of the current state of research in leading management, entrepreneurship, and finance journals, this review aims at providing a comprehensive overview of the issue and identifying avenues for future research.
III LIST OF FIGURES
2.2 Figure 1: Comparison of Common Characteristics: Traditional vs. New Forms of Financing
3.1 Figure 2: Elements of Signaling Research on Funding by Company Phase
IV MAIN BODY
1 Introduction
The entrepreneurial finance landscape has experienced an extensive process of change during the last years, primarily driven by globalization and technological advancements (Block et al., 2018). Most notably, new forms of external financing have emerged which differ significantly from traditional forms in terms of investor structure, communication channels, financial intermediation, and geographic distribution (Chemmanur & Fulghieri, 2014). This transformational process presents new challenges for startups which seek funding, as the emerging investor types might pay attention to different startup attributes than traditional investors. In order to determine how startups can make sure that, even under changing conditions, they have access to the required financial resources, this thesis reviews and compares studies on strategies of attracting traditional and new types of investors from a signaling perspective.
In business practice, signaling strategies to ensure financial coverage are of major relevance for the short-term survival and the long-term performance of a startup (Plummer, Allison & Connelly, 2016). While its initial funding may have been sourced from the founding team itself or borrowed from family members and friends, the amount of money required for a subsequent growth strategy often substantially exceeds the resources of the entrepreneurs’ personal networks (Gilbert, McDougall & Audretsch, 2006). Thus, obtaining capital from external sources becomes a critical success factor for startups (Lee, Lee & Pennings, 2001). Since most nascent firms are unable to provide objective market- and product related data to investors, they rely on forwarding “soft” signals that help investors judge their quality and future value, thereby mitigating the existing information asymmetry (Plummer, Allison & Connelly, 2016).
Despite the high practical relevance of signaling strategies in a transforming entrepreneurial finance landscape, current research does not provide an ideal foundation for startups to develop comprehensive signaling strategies for two reasons. First, the vast majority of studies either focuses only on traditional forms of financing, such as venture capital and business angels, or exclusively on new forms of financing, such as crowdfunding. This lack of comparative studies complicates the development of signaling strategies for approaching different types of investors. Second, current signaling research places a strong emphasis on initial public offerings, even though effective signals are of higher strategic importance in earlier funding stages (Plummer, Allison & Connelly, 2016). While the information asymmetry during initial public offerings is reduced through the legally required provision of standardized information, early-stage ventures often have no reliable firm data to provide, rendering “soft” signals essential for survival (Daily, Certo & Dalton, 2005). The large number of early-stage startups, compared to those few firms reaching initial public offerings, further increases the importance of meaningful signals to stand out from a variety of investment options (Connelly et al., 2011).
Against the background of the aforementioned underrepresentation of this research area, as well as partially oversimplifying methodologies and a high degree of research segmentation by journal type (Bergh et al., 2014; Cumming & Johan, 2017), this thesis aims at providing a comprehensive comparison of traditional and new forms of financing from a signaling perspective. The objective is to both provide guidance for startups to develop signaling strategies in a transitioning entrepreneurial finance landscape and help scholars identify potential research gaps and inconsistencies.
The thesis consists of three main sections. The first section explains which factors led to the transformation of the entrepreneurial finance landscape, which new forms of financing have emerged, and how they differ from traditional forms of financing. On that basis, the second section compares the effectiveness of different signaling strategies based on startup characteristics (3.2), startup actions (3.3), and third-party endorsements (3.4) with regard to traditional and new forms of financing. In the final section, avenues for future research are outlined.
2 Trends and Developments in Entrepreneurial Finance
2.1 Factors Explaining the Transformation of the Finance Landscape
Current trends and developments in entrepreneurial finance are driven by macroeconomic, technological, legal, and market-related factors, jointly facilitating the emergence or abandonment of forms of finance (Block et al., 2018). Since the turn of the millennium, particularly four major factors were shaping the entrepreneurial finance landscape: globalization, technological advancements, regulatory adjustments, and the rise of “winner-take-all markets” (Schilling, 2002, p. 387).
Globalization. The worldwide movement towards economic integration creates new possibilities for both startups and investors. First and foremost, the location of the venture does no longer need to resemble, or even be in close proximity to, the location of the investment (Chan, Hameed & Lau, 2003). From a startup perspective, this implies access to a larger number and more diverse types of potential investors (Short et al., 2017). From an investor perspective, the number of potential investment opportunities increases significantly, resulting in both potential diversification benefits and greater funding flexibility (Jang, 2017). This might explain that cross-border investments gain in importance in many finance areas, including venture capital and crowdfunding (Chemmanur & Fulghieri, 2014; Vismara, 2016). Moreover, globalization goes hand in hand with an increased economic activity, empowering actors in emerging nations to participate in the global financial system as both entrepreneurs and investors (Kalemli-Ozcan, Papaioannou & Peydró, 2013).
Technological advancements. New internet-based technologies accelerate information diffusion, facilitate the involvement of non-professional investors, and initiate a process of disintermediation, thereby enabling the emergence of new forms of financing (Block et al., 2018). First, the rise of the internet entails fast and inexpensive ways for startups to communicate with potential investors, e.g. via funding platforms, social media sites, and videoconferencing (Guenther, Johan & Schweizer, 2018; Chan, Hameed & Lau, 2003). Second, it leads to an “entrepreneurial finance democratization” (Vismara, 2016, p. 581), allowing a large number of non-professional investors throughout the world to participate in new small- and large-scale investment options. Third, and most important, the need for intermediation can be questioned as investors and investees can engage directly via online platforms. According to Leland & Pyle’s (1977) theoretical finance model, financial intermediaries only exist because of the presence of information asymmetries and high transaction costs. Since online platforms might offer inexpensive ways for investors to both obtain reliable information about investment quality and to directly make an investment, the high costs for intermediaries might no longer pay off (Guenther, Johan & Schweizer, 2018). In combination, these fundamental changes create space for new forms of financing and even result in new business models. For instance, FinTech startups have developed several hundred cryptocurrencies, based on blockchain technology, which enable people to make transactions faster, cheaper, and regardless of background (Dogson et al., 2015). Further innovations like big data analytics, cloud computing, advanced storage and encryption, as well as machine learning are likely to continue to reshape the structure of the financial industry (George, Haas & Pentland, 2014).
Regulatory adjustments. A global trend towards tighter banking regulations in combination with more liberal legislation for emerging finance areas paves the way for new forms of financing. As a reaction to the 2008/2009 financial crash, many countries initiated tighter regulations for banks and traditional stock markets, including Basel II and III (Block et al., 2018). Stricter rules with regard to minimum capital requirements and risk assessment made it significantly more difficult for startups with risky business models to obtain bank financing, especially if they could not provide collateral (Wright et al., 2016). Meanwhile, many new funding areas, which previously have been restricted or even considered unlawful, are being deregulated and legally clarified throughout the world (Ahlers et al., 2015). For example, the 2012 Jumpstart Our Business Startups Act, often referred to as JOBS Act, allows US firms to sell equity to a large number of small-scale investors via online platforms (Vismara, 2016). Even though some new forms of financing are still at least partly restricted in many countries, most economists expect the process of deregulation and legal clarification to continue, as countries attempt to leverage new funding sources for small businesses (Dogson et al., 2015; Vismara, 2016).
Winner-take-all markets. The increasing global interconnectedness of product markets results in more “winner-take-all markets” (Schilling, 2002, p. 387), urging particularly innovative technology startups to grow rapidly. These markets are characterized by the survival of very few, large firms, which are able to establish their technologies as a market standard and lock out competing technologies (Lee, Lee & Lee, 2006). Current examples include Facebook and Google (Block et al., 2018). In order to enhance the technology, build a large network of users, engage in a continuous learning process, and ultimately establish a new technology standard, nascent startups require high amounts of funding in the early stages of the venture cycle (Schilling, 2002). Such a “get-big-fast strategy” (Lee, Lee & Lee, 2006, p. 1846) is likely to result in significant financial losses, requiring the willingness of investors to carry great risks (Lee, Lee & Lee, 2006). Since disruptions of existing markets happen more frequently, established firms become more likely to invest in startup technology, thereby trying to avoid future rivalry (Block et al., 2018).
2.2 Traditional and New Forms of Entrepreneurial Finance
Globalization, technological advancements, regulatory adjustments, and the rise of winner-take-all markets jointly enable the emergence of new forms of entrepreneurial finance, which might gradually replace the traditional forms. In the following, the most important traditional and emerging forms of finance for startups are presented. Thereafter, common characteristics of both groups are outlined and juxtaposed to form a basis for the subsequent analysis of the implications for startups that want to signal their quality to potential investors.
In general, funding sources of startups can be grouped into two blocks: personal and external (Gartner, Frid & Alexander, 2012). This paper focuses on external sources, as only they require startups to communicate their strengths to investors and in many cases, after an initial phase of self-funding, ultimately decide about startup success or failure (Gilbert, McDougall & Audretsch, 2006). Therefore, funding sources from company insiders, including the entrepreneur himself, his team, family members, and friends, will not be discussed.
The most prominent traditional forms of external financing are bank loans, venture capital, business angels, and initial public offerings (Wright et al., 2016). Bank loans, the only source based on debt, are usually difficult to obtain for innovative startups and, often being in the lower five-digit-euro range, hardly sufficient to pursue a growth strategy (Colombo & Grilli, 2007). Both venture capital firms and affluent individuals, so-called business angels, provide equity to startups with a high-risk, high-return profile (Parhankangas & Ehrlich, 2014; Ozmel, Reuer & Gulati, 2013). In contrast to venture capital firms, business angels usually invest over a longer time horizon and provide advice on company matters (Elitzur & Gavious, 2003). Both venture capital firms and business angels can form syndicate networks in order to exchange information about startup quality and diversify risks (Kerr, Lerner & Schoar, 2014; Zhang, Gupta & Hallen, 2017). A special form of venture capital is corporate venture capital, which refers to established firms investing into and providing complementary assets for startups (Park & Steensma, 2012). Those firms often invest for strategic reasons, e.g. attempting to avoid future rivalry with startup technology in winner-take-all markets (Block et al., 2018). Initial public offerings describe the first issuance of public stock and in most cases require preceding support from other external financiers, such as venture capital firms (Arthurs et al., 2008).
The most important new forms of external financing are equity crowdfunding, debt crowdfunding, reward-based crowdfunding, and initial coin offerings (Block et al., 2018). Crowdfunding describes efforts of startups to get funded by a large number of people that make small contributions through online platforms (Mollick, 2014). The categorization of the different types of crowdfunding is based on what investors get in return from the startup (Ahlers et al., 2015). The three most common forms involve the provision of equity, debt, and non-financial benefits, referred to as rewards (Short et al., 2017). The aspired funding goals can vary significantly, ranging from a few euros in microfinancing in emerging markets to several millions of euros for new technologies (Moss, Neubaum & Meyskens, 2015; Giudici, Guerini & Rossi-Lamastra, 2018). A special form of crowdfunding is an initial coin offering, in which a firm creates a cryptocurrency and distributes shares, so-called tokens, to its investors (Kastelein, 2017). This funding source is particularly interesting for blockchain startups, as they might already own the required knowledge to create a distributed database, which is needed for an initial coin offering (Kastelein, 2017).
The shift from traditional towards new forms of financing can be recognized by comparing total investment volume and research attention over the last two decades. In 2012, the global investment volume of crowdfunding reached 2.7 billion dollars, corresponding to an 80% increase compared to 2011 (Colombo, Franzoni & Rossi, 2015). A study of the World Bank predicts strong growth for the coming years, forecasting a total investment volume of up to 300 billion dollars by 2025, including a market potential of 96 billion dollars for the developing world only (The World Bank, 2013). In contrast to that, angel financing as one of the most prominent traditional sources of funding also showed significant growth in the US between 2002 and 2013, but researchers expect an upcoming decline in relative importance compared to new sources (Hellmann & Thiele, 2015; Block et al., 2018). This trend is also reflected in the fact that, since 2013, crowdfunding research has gained in popularity, while the popularity of research on initial public offerings and venture capital has declined, measured by the number of Google Scholar hits (Cumming & Johan, 2017).
New forms of financing have common characteristics which are fundamentally different from those of traditional forms (see Figure 1). While in most traditional forms one or very few investors provide large amounts of capital, new forms are characterized by the presence of many investors who provide small amounts money (Allison et al., 2017). Moreover, crowdfunding investors usually have significantly less investment experience and expertise in the conduction of due diligence, compared to venture capitalists and angel investors (Ahlers et al., 2015). However, the behavior of other crowdfunding supporters is often transparent and thus might support decision-making (Zhang & Liu, 2012). Another difference is that new forms of financing do not require a financial intermediary, as investor and investee communicate directly via online platforms (Chemmanur & Fulghieri, 2014). There are also major differences regarding the types of communication between investor and startup. While traditional forms of finance, often after an initial online application, ultimately rely on personal conversations, most new forms of finance exclusively use the internet as a communication channel (Guenther, Johan & Schweizer, 2018; Shane & Cable, 2002). This entails the need for geographic proximity for traditional forms of financing, but not for the emerging, internet-based ones. Thus, as most of the traditional investors reside in large cities in developed countries, startups in rural parts of emerging economies have few opportunities to obtain traditional funding. In contrast, crowdfunding is available for everyone with access to the internet, as long as the regulatory prerequisites are fulfilled (Guenther, Johan & Schweizer, 2018; Vismara, 2016).
Figure 1
Comparison of Common Characteristics: Traditional vs. New Forms of Financing
Abbildung in dieser Leseprobe nicht enthalten
3 Implications for a Startup’s Signaling Strategy
Having identified current trends and developments in entrepreneurial finance, the question arises which implications they might have for startups that seek funding. To answer this question, this paper will first introduce signaling theory, a framework used to describe how startups communicate their characteristics to investors. To gain a better understanding of how the emergence of new forms of financing impacts the effectiveness of signaling strategies, this paper will thereafter compare studies on traditional and new forms of financing.
3.1 Theoretical Foundations
Signaling theory describes how one party, the agent, forwards signals to a second party, the principal, in order to mitigate the level of asymmetric information (Connelly et al., 2011). In the context of startup funding, the nascent entrepreneur attempts to communicate the quality of his venture to a potential investor through signals based on startup characteristics (3.2), startup actions (3.3), or third-party endorsements (3.4), thereby potentially reducing the harmful effects of adverse selection and moral hazard (Sanders & Boivie, 2004; Plummer, Allison & Connelly, 2016). The origins of signaling theory can be traced back to Akerlof’s (1970) description of the used car market involving low-quality “lemons” and Spence’s (1973) model of job market signaling, in which employees can communicate their abilities to employers by costly education. Based on these concepts, and further accelerated by the emergence of new forms of financing, a rich and growing body of research on startups’ signaling strategies has developed, involving scholars from management, finance, and entrepreneurship (Connelly et al., 2011; Spence, 2002).
The separating equilibrium is an extended framework suitable to analyze startups’ signaling strategies (Bergh et al., 2014). It explains how a Pareto-optimal solution can occur if the initial signal is confirmed through later experience (Bergh et al., 2014). The framework consists of four central elements. First, an information problem for both the sender and the receiver of the signal needs to exist. In a startup funding scenario, the investor usually has no reliable data to evaluate the startup’s quality, as technologies might be unproven, markets unexplored, and products unfinished (Parhankangas & Ehrlich, 2014). Second, the realization of a credible signal needs to entail signal costs, thereby preventing imitation strategies of low-quality senders (Connelly et al., 2011). Third, a Pareto-optimal solution in which no other feasible solution exists that represents an improvement for one actor without harming another one needs to be possible (Bergh et al., 2014). Last, the signal needs to be confirmed through subsequent experience. Referring to the startup funding scenario, startups with strong signals need to, on average, outperform those with weaker ones in the long run (Bergh et al., 2014).
Signaling research on growing ventures can be divided into three subcategories: seed phase, startup phase, and growth phase (see Figure 2). This paper focuses on the startup phase, as signaling strategies during this period are of utmost strategic importance for startups’ short-term survival and long-term performance (Plummer, Allison & Connelly, 2016). One major reason is that the information asymmetry during this period is particularly pronounced, as entrepreneurs neither approach people they know personally, like during the seed phase, nor are legally required to provide standardized information, like during the growth phase (Daily, Certo & Dalton, 2005). Furthermore, the number of competing firms seeking external capital is large, rendering the signaling environment especially noisy (Connelly et al., 2011).
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