Business Finance – Entrepreneurial Finance
Lecture 1
Access to Finance
Da Rin & Hellmann, Fundamentals of Entrepreneurial Finance, 2020 [DaRH] !!!
Financial constraints / credit rationing? -> a firm is financial constraint if
it has a need for external funding, but is unable to obtain it.
-> equilibrium. Higher interest rate = more
willingness to fund, but lower demand for borrowing -> here no constraints.
Credit rationing: there exist firms that are willing to borrow at the equilibrium
interest rate, but are unable to do so. -> In a perfect market as above, this
wouldn’t happen (market failure?)
There needs to be some characteristic of how funding providers and
borrowers interact that means there is a long-run equilibrium outcome in
which there would still be unmet funding needs
Eg: asymmetric information betwn S & D (firms have information that
finance providers cannot observe) => in the presence of adverse
selection or moral hazard, asymmetric information can lead to market
failure
Credit rationing can be rational under asymmetric information
Models of Credit rationing
1. Adverse selection (Stiglitz & Weiss):
- banks face borrowers with unknown risk type (risky firms/projects but bank cant
observe this)
- bank knows there are risky types and the distribution of the firms, but not of
each individual firm specifically
- firms with risky projects have low chance of success (start-ups) but if successful,
very high return
- firms with safe projects but high chance of success (mature firms), not
particularly high return
So banks choose how much credit to supply at the market interest rate, ceteris
paribus, higher interest rate means higher profits. But, twist in the model, safe
firms don’t accept high interest rates only risky firms do.
, Leads to adverse selection if the interest rate is too high!
High interest rates = high borrowing costs.
For safe firms who repay with high certainty, their return is low: borrowing
costs > return when successful
Risky firms, for them: borrowing costs < return when successful
This means the ceteris paribus no longer holds: increasing interest rates doesn’t
just mean you earn a higher return, it also means the composition of the pool to
whom you’re lending is not the same. At some point you will lose more of the
safe borrowers and have more risky borrowers.
As safe firms start to drop out, from that point increasing R no longer increases
bank profits. -> it is rational for banks to not lend beyond a threshold interest
rate (the equilibrium). Even though there are firms with a positive demand at
higher interest rates.
If you could observe the risk type of each individual firm you could offer an
appropriate interest rate, but since you can’t the bank has to set an
interest rate to serve an optimal pool of firms.
The unserved firms are credit rationed in equilibrium
Large part of this course is about how firms handle this. Firms try to prove as
much as possible their credit worthiness to banks, and we will learn how they do
this. The idea is to reduce the information asymmetry as much as possible, and
the bank then has to decide whether it is the firm just ‘talking’ to put themselves
in the best light, or if there is actual substance there. (How credibly can firm
communicate their type).
2. Moral hazard (Holmström & Tirole):
Banks face borrowers with same risk type, but different assets (collateral ->
should not affect success of project). Success likelihood depends on
entrepreneur’s effort.
Banks again choose funding supply to maximize profits, dependent on manager
exerting effort.
Twist in model: entrepreneurs benefit from leisure. The more effort they
exert, the less time they have for leisure.
Here we again have information asymmetry, banks can’t contract based on effort
managers are exerting. They might promise to exert high effort (no cost to this)
but change their effort once they have received the funding.
-> banks cannot observe this, and thus will need to find a way to involve
entrepreneur in the success, like claiming collateral in case project is not
successful. You can only do this if the asset is sufficiently valuable. So firms with
insufficient assets cannot convince bank that they will exert effort -> they are
credit rationed, their projects will not get funded.
Due to moral hazard under asymmetric information, it is rational for banks not to
lend to some firms.
,Key friction in both models is the asymmetric information!
Implications of financial constraints
It has important consequences for exports, investments, asset growth,…, startup
formation -> see graphs next slides for proof
Chapter 1: Introduction to Entrepreneurial Finance
What is entrepreneurial finance?
Intersection of corporate finance -> funding side (VCs, Angels, Crowd, Family and
friends, Banks, Government,…) and entrepreneurship -> borrower side (young,
innovative companies, /= SMEs)
Entrepreneurial finance is defined as the provision of funding to young,
innovative, growth-oriented companies. (<10y, tech or business model, diff from
SMEs)
Investors side: great variety we need to understand ; Process: long & risky -> we
need to understand actors & steps.
Helpful to define 3 fundamental principles: 1) Gathering & recombining of
resources. 2) Uncertainty. 3) Experimentation.
Three fundamental principles
1. Entrepreneurship as a recombination of existing resources to create new
sources of value (destroy something that is out there to create new value)
-> convince resource owners to share their resources. Financing is a key resource
because money allows to acquire other resources (employees, equipment,…)
2. Entrepreneurial process is inherently uncertain
-> potential outcomes and their probabilities are unknown (<-> risk). Once
outcomes are understood, business opportunities are no longer entrepreneurial
but managerial.
3. Entrepreneurship consists of experimentation & dynamic flexibility
-> exploration (entrepreneurial firms) <-> exploitation (established firms). The
organizational structure matters for incentives & ability to pivot (respond
dynamically to market feedback)
Why is it challenging?
Entrepreneurial perspective: starting business when you have an idea is difficult,
you need funding. People who can provide this funding have diff characteristics,
who aren’t easy to reach and convince that your business is worth investing in.
Investor perspective: swamped with proposals, most of them bad -> default. Only
a few manage to grow and be successful. It is a long & risky process. Hard to
distinguish between worthwhile and worthless projects.
, It is very different from providing a bank loan (has regular interest
payments) as long as you pay there is no need to intervene. Funding to a
startup -> typically you don’t see any money back until next funding round
or exit of company (very long horizon) and you’re expected (in your
interest) to help this firm.
Challenges are not easy to overcome!
Why is it important?
Entrepreneurial perspective: get access to resources (money is key), money is
not green -> investors impact the company in terms of structure & guidance of
the business.
Investor perspective: returns, portfolio diversification, strategic objectives (gain
benefits over competitors, build name by being related to successful VC,…) ->
pass on knowledge & expertise
Broader economic & Societal perspective: it’s a market-driven selection system -
> creates jobs, innovation, and economic growth
Nobel insights: What drives growth? -> we will link to fundamental economic
insights occasionally
1) Once you account for capital & labor, most of the growth comes from TFP
(total factor productivity) = technological progress -> economists have
found a positive link btwn TFP & entrepreneurship
Examples of findings about drivers of LT-growth:
- startups that received VC have significantly higher TFP than without
- VC generates more innovative outputs than corporate R&D spending
- increases in local VC funding increase the local startup rate, employment &
aggregate income
-> Entrepreneurial finance contributes to economic growth !
Which companies create jobs ? Young firms make a very significant contribution
to net job creation (young /= small!!!) -> Our focus is on startups that aim at
growing fast into large companies, i.e., on entrepreneurial ventures we do not
study SME financing
A key fact of these ventures is that ‘death is the rule’. Only few start-ups survive.
Not VC backed US startups fail more often, than those without support. -> 2 key
takeaways!!
How can we understand it? (Using 2 frameworks)
1. The FIRE Framework
Fit: matching btwn firm and funding provider, entrepreneurs & investors
Invest: process of closing a deal, typically involves an exchange of money
and ownership in the firm -> how do you tie down the conditions
Lecture 1
Access to Finance
Da Rin & Hellmann, Fundamentals of Entrepreneurial Finance, 2020 [DaRH] !!!
Financial constraints / credit rationing? -> a firm is financial constraint if
it has a need for external funding, but is unable to obtain it.
-> equilibrium. Higher interest rate = more
willingness to fund, but lower demand for borrowing -> here no constraints.
Credit rationing: there exist firms that are willing to borrow at the equilibrium
interest rate, but are unable to do so. -> In a perfect market as above, this
wouldn’t happen (market failure?)
There needs to be some characteristic of how funding providers and
borrowers interact that means there is a long-run equilibrium outcome in
which there would still be unmet funding needs
Eg: asymmetric information betwn S & D (firms have information that
finance providers cannot observe) => in the presence of adverse
selection or moral hazard, asymmetric information can lead to market
failure
Credit rationing can be rational under asymmetric information
Models of Credit rationing
1. Adverse selection (Stiglitz & Weiss):
- banks face borrowers with unknown risk type (risky firms/projects but bank cant
observe this)
- bank knows there are risky types and the distribution of the firms, but not of
each individual firm specifically
- firms with risky projects have low chance of success (start-ups) but if successful,
very high return
- firms with safe projects but high chance of success (mature firms), not
particularly high return
So banks choose how much credit to supply at the market interest rate, ceteris
paribus, higher interest rate means higher profits. But, twist in the model, safe
firms don’t accept high interest rates only risky firms do.
, Leads to adverse selection if the interest rate is too high!
High interest rates = high borrowing costs.
For safe firms who repay with high certainty, their return is low: borrowing
costs > return when successful
Risky firms, for them: borrowing costs < return when successful
This means the ceteris paribus no longer holds: increasing interest rates doesn’t
just mean you earn a higher return, it also means the composition of the pool to
whom you’re lending is not the same. At some point you will lose more of the
safe borrowers and have more risky borrowers.
As safe firms start to drop out, from that point increasing R no longer increases
bank profits. -> it is rational for banks to not lend beyond a threshold interest
rate (the equilibrium). Even though there are firms with a positive demand at
higher interest rates.
If you could observe the risk type of each individual firm you could offer an
appropriate interest rate, but since you can’t the bank has to set an
interest rate to serve an optimal pool of firms.
The unserved firms are credit rationed in equilibrium
Large part of this course is about how firms handle this. Firms try to prove as
much as possible their credit worthiness to banks, and we will learn how they do
this. The idea is to reduce the information asymmetry as much as possible, and
the bank then has to decide whether it is the firm just ‘talking’ to put themselves
in the best light, or if there is actual substance there. (How credibly can firm
communicate their type).
2. Moral hazard (Holmström & Tirole):
Banks face borrowers with same risk type, but different assets (collateral ->
should not affect success of project). Success likelihood depends on
entrepreneur’s effort.
Banks again choose funding supply to maximize profits, dependent on manager
exerting effort.
Twist in model: entrepreneurs benefit from leisure. The more effort they
exert, the less time they have for leisure.
Here we again have information asymmetry, banks can’t contract based on effort
managers are exerting. They might promise to exert high effort (no cost to this)
but change their effort once they have received the funding.
-> banks cannot observe this, and thus will need to find a way to involve
entrepreneur in the success, like claiming collateral in case project is not
successful. You can only do this if the asset is sufficiently valuable. So firms with
insufficient assets cannot convince bank that they will exert effort -> they are
credit rationed, their projects will not get funded.
Due to moral hazard under asymmetric information, it is rational for banks not to
lend to some firms.
,Key friction in both models is the asymmetric information!
Implications of financial constraints
It has important consequences for exports, investments, asset growth,…, startup
formation -> see graphs next slides for proof
Chapter 1: Introduction to Entrepreneurial Finance
What is entrepreneurial finance?
Intersection of corporate finance -> funding side (VCs, Angels, Crowd, Family and
friends, Banks, Government,…) and entrepreneurship -> borrower side (young,
innovative companies, /= SMEs)
Entrepreneurial finance is defined as the provision of funding to young,
innovative, growth-oriented companies. (<10y, tech or business model, diff from
SMEs)
Investors side: great variety we need to understand ; Process: long & risky -> we
need to understand actors & steps.
Helpful to define 3 fundamental principles: 1) Gathering & recombining of
resources. 2) Uncertainty. 3) Experimentation.
Three fundamental principles
1. Entrepreneurship as a recombination of existing resources to create new
sources of value (destroy something that is out there to create new value)
-> convince resource owners to share their resources. Financing is a key resource
because money allows to acquire other resources (employees, equipment,…)
2. Entrepreneurial process is inherently uncertain
-> potential outcomes and their probabilities are unknown (<-> risk). Once
outcomes are understood, business opportunities are no longer entrepreneurial
but managerial.
3. Entrepreneurship consists of experimentation & dynamic flexibility
-> exploration (entrepreneurial firms) <-> exploitation (established firms). The
organizational structure matters for incentives & ability to pivot (respond
dynamically to market feedback)
Why is it challenging?
Entrepreneurial perspective: starting business when you have an idea is difficult,
you need funding. People who can provide this funding have diff characteristics,
who aren’t easy to reach and convince that your business is worth investing in.
Investor perspective: swamped with proposals, most of them bad -> default. Only
a few manage to grow and be successful. It is a long & risky process. Hard to
distinguish between worthwhile and worthless projects.
, It is very different from providing a bank loan (has regular interest
payments) as long as you pay there is no need to intervene. Funding to a
startup -> typically you don’t see any money back until next funding round
or exit of company (very long horizon) and you’re expected (in your
interest) to help this firm.
Challenges are not easy to overcome!
Why is it important?
Entrepreneurial perspective: get access to resources (money is key), money is
not green -> investors impact the company in terms of structure & guidance of
the business.
Investor perspective: returns, portfolio diversification, strategic objectives (gain
benefits over competitors, build name by being related to successful VC,…) ->
pass on knowledge & expertise
Broader economic & Societal perspective: it’s a market-driven selection system -
> creates jobs, innovation, and economic growth
Nobel insights: What drives growth? -> we will link to fundamental economic
insights occasionally
1) Once you account for capital & labor, most of the growth comes from TFP
(total factor productivity) = technological progress -> economists have
found a positive link btwn TFP & entrepreneurship
Examples of findings about drivers of LT-growth:
- startups that received VC have significantly higher TFP than without
- VC generates more innovative outputs than corporate R&D spending
- increases in local VC funding increase the local startup rate, employment &
aggregate income
-> Entrepreneurial finance contributes to economic growth !
Which companies create jobs ? Young firms make a very significant contribution
to net job creation (young /= small!!!) -> Our focus is on startups that aim at
growing fast into large companies, i.e., on entrepreneurial ventures we do not
study SME financing
A key fact of these ventures is that ‘death is the rule’. Only few start-ups survive.
Not VC backed US startups fail more often, than those without support. -> 2 key
takeaways!!
How can we understand it? (Using 2 frameworks)
1. The FIRE Framework
Fit: matching btwn firm and funding provider, entrepreneurs & investors
Invest: process of closing a deal, typically involves an exchange of money
and ownership in the firm -> how do you tie down the conditions
