Information Asymmetry Reduction in Opaque Contexts: Evidence from Debt and Outside Equity Financing in Early Stage Firms
Abstract: This study analyzes the relationship between debt and outside equity investments in early stage firms. The existing evidence on this relationship is scarce and inconclusive, mostly due to the pervasive opaqueness of new ventures. We argue that debt and its usage can be valuable signals for outside investors facing severe information asymmetries. In addition, we examine how personal and business debt could signal different information to outside investors. Using panel data on new ventures in the US from the Kauffman Firm Survey, we find evidence consistent with our arguments. We reveal that debt, and particularly business debt, is positively related to outside equity investments, especially in times of economic distress. We posit that start-ups with higher levels of business debt can send more credible signals to capital markets, and identify cash holdings and the firm-bank relationship as possible information channels for outside investors.