Startup Financing and Capital Structure: A Signaling Approach

Abstract

Purpose Our question is about the entrepreneur’s choice of the capital structure. How does the entrepreneur choose the amount of debt or equity investment in order to send a credible signal about the project value to potential investors? To find the answer to the question, we construct a single-stage signaling game model between a penniless entrepreneur who wants to launch an innovative project and investors. Design/Methodology/Approach We construct a single-stage signaling game model between a penniless entrepreneur who wants to launch an innovative project and debt and equity investors. The entrepreneur strategically chooses a debt level as a signaling device in order to inform his project value to the investors. Observing the amount of debt taken by the entrepreneur, investors evaluate the entrepreneur’s project value and make investment decisions. Findings We derive separating perfect Bayesian equilibria in the signaling game and refine them into a unique equilibrium by invoking the Intuitive Criterion of Cho and Kreps (1987). Then we characterize the refined equilibrium. Research Implications In startup financing, the minimum debt level to make investors perceive the entrepreneur high type is affected by the low type’s expected project value and the ratio of the low type’s equity share to the high type’s.