Entrepreneurship Theories

Information asymmetry refers to a conditions whereby two parties in a market or organizational relationship have access to different information about the exchange.  It can be seen as an alternative to the classical assumption of "perfect information" in economics. Information asymmetries have been acknowledged by regulators who have made laws forbidding insider trading. Insiders have special access to the real financial picture of a company and have an unfair advantage when buying and selling company stock (Aboody, 2000). Company executives, like CEOs also have fiduciary responsibilities toward their investors which require them to be truthful and forthcoming. Information asymmetry is also a potential source of problems in entrepreneurship. For example, an entrepreneur knows much more about the real potential of their ventures because they have inside access to knowledge about their customers and the issues with production. The investors, on the other hand, have less informa

Real options theory is concerned with investments in real assets that are similar in structure to financial options like put and call options that allow investors to bet on the upside or downside of stocks without tying up too much capital (Bowman and Hurry, 1993) According to McGrath (1999), real options theory is supposed to be superior to net present value analysis and other time value calculations, especially under conditions of uncertainty. The fundamental idea behind real options theory is that an opportunity that has a way out is worth more that one that does not have a way out. For example, startups can be merged, one startup can be stripped of resources to help another, a team can be moved from one opportunity to another etc... Thus, entrepreneurs and investors in entrepreneurial ventures are apt to view failure as a learning opportunity that contributes to the assessment of future projects. Real options thinking reduces the social cost of failure and thus increases the r

Founding a new venture is more common among individuals with greater access to financial capital because financial capital makes it easier to acquire the resources needed to start ventures. For instance, Evans and Jovanovic (1989) find that wealthier individuals are more likely to enter into entrepreneurship because they can risk their own capital. There is some evidence that many employees make the leap to entrepreneurship during liquidity events such as initial public offerings and acquisitions of their parent firms which can put significant financial resources into the hands of employees that own shares or options in the company. These employees, now flush with cash, have the financial freedom to spin out new ventures from their parent firms into independent companies (Stuart and Sorenson, 2003). Hurst and Lusardi (2004) find some evidence for liquidity constraints however only at the top of the range, suggesting that only very wealthy individuals are more likely to become e

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 po

What is the pecking order theory of entrepreneurship? The pecking order theory was developed by in the 1980’s by finance scholars seeking to understand the financing preferences of firms. Pecking order theory also relates to entrepreneurs’ preferences about financing choices. Financing options include using one’s own personal funds, reinvesting profits back into the business, selling equity to outside investors, and bank debt or loans. At the core of the theory are information asymmetries between the entrepreneur or the startups’ executive team, and the prospective sources of funds for the business—that is, the financiers. Entrepreneurs and other insiders have better information about the business’ operations and potential than do prospective financiers because the former deal with stakeholders and problems on a day to day basis. Financiers usually have to rely on second hand information provided by the leadership team of the startup and the financial statements they provide.

Agency theory was developed in the 1980s by economist Michael C. Jensen at the Harvard Business School for the purposes of explaining and predicting the behaviors of investors and managers. Agency theory distinguishes between principals and agents, the former being parties that delegate responsibility for some set of actions to the latter. For instance, entrepreneurs and managers are often the agents of investors, who delegate the responsibility over a business organization. The theory’s underlying assumption is that both parties are self-interested and that the interests of principals and agents diverge or are in conflict. Therefore, agents may make decisions on behalf of principals that are not in the principals’ interests, which is called an agency problem. For instance, agents may take greater risks than principals would want them too because agents are betting with the principals’ capital. Agency problems are exacerbated when there is information asymmetry between pri