Signaling theory and 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.

Sources:
 
Bhattacharya, S. (1979). Imperfect information, dividend policy, and" the bird in the hand" fallacy. The Bell Journal of Economics, 259-270.

Connelly, B. L., Certo, S. T., Ireland, R. D., and; Reutzel, C. R. (2011). Signaling theory: A review and assessment. Journal of Management, 37(1), 39-67.