Master thesis
Signaling theory: a systematic literature review
How do signals influence funding of innovations?
University of Groningen Faculty of Economics and Business
EBM723B20 Supervisor: Pedro de Faria Co-assessor: Florian Noseleit
By: Jan Baarveld
S2582260
MSc BA Strategic Innovation Management
2
Abstract
This research elaborates on academic research in the field of signals and innovation funding of the past five years. The systematic review finds 60 relevant articles with four important theoretical frameworks: Agency theory, signaling theory, resource based view and legitimation theory. For innovative start-ups, six different forms of funding are found. To reach these funders, the literature describes 13 signals. Based on their underlying mechanism, these signals are divided in four streams. Further, different settings in which signals are valued are described. Eventually, all findings are processed into an overarching framework. The conclusions of this research are primarily based on this framework. Finally, I describe the implications for managerial and research practices.
Introduction
“The rapid pace of innovation in high-technology firms has been an important determinant of economic growth and productivity. Good ideas by themselves, however, cannot ensure continued success at innovation. A critical component of corporate research and development (R&D) efforts is access to funding (Wu, 2012, p.928).” Innovation occurs since people or firms
3 should reduce information asymmetry with investors (Knockaert et al. 2014). A way to reduce information asymmetry is signaling (Nam, Park & Arthurs, 2014).
The objective of this paper is to create a better understanding of the influence signals have in reducing information asymmetry between entrepreneurs and investors. To achieve this, existing literature will be systematically reviewed. An unrestricted search in academic literature, using the search engine Smartcat, combining the words Signaling, Information asymmetry and Innovation, results in 1554 peer reviewed articles. Yet, systematic literature reviews or meta-analyses on this subject are rare. Within this small set of reviews, none combines signaling with the financing of innovations. In the scattered field of literature on signaling, this research tries to elaborate on the gap that there is no clear consensus regarding the influence of signals on innovation funding. While empirical research is present, the results are scattered. This systematic review combines existing literature and come with an overview of the findings. This will help managers to make decisions concerning this subject. Next to this, the subject appeals to me personally and therefore it is chosen.
Some definitions used in this research need to be clarified to fully understand the research. A signal can be described as ‘things one does that are visible and that are in part designed to communicate’ (Spence, 2002, p. 434). This definition is used since it is in line with signaling theory, which will be discussed later. An example of a signal is a new product pre-announcement (NPPA). This is the most used signal which is a communication process used by companies to send messages to stakeholders before a new product launch (Su & Rao, 2010).
For information asymmetry, I use the following definition: “Information asymmetry manifests
itself in a transaction situation whenever the value of a product or service cannot be determined without trying, sampling or experiencing the good (Millar et al, 2012, p. 227)”. Furthermore,
Mascarenhas, Kesavan & Bernacchi (2008) state that an information asymmetry occurs when the distribution of information quantity and quality differs between parties.
Since this research elaborates on the funding of innovation, I will explain which definition of innovation is used in this research. This research follows Giordani (2015, p. 157): An innovation
is the outcome of a successful matching between an entrepreneur with a good idea and a capitalist recognizing the value of that idea. This definition is applicable for this research since
4 an innovation. Entrepreneurs need backers to fund their innovation, but since information asymmetry may hinder this, signals must be send to reduce the asymmetry (Kumar & Park, 2012). To achieve the objective of this research, the following question is formulated: How is
the funding of innovative start-ups influenced by signals?
The results of this article are based on a systematic review of 60 articles. The consideration set provides us with four main theoretical frameworks: agency theory, signaling theory, resource based view and legitimation theory. These four theories are the basis for this research. Further, six funding forms are described and elaborated on. The literature describes 13 signals which are clustered into four groups based on their underlying mechanism: knowledge related signals, funding related signals, certification related signals and management related signals. The last insight provided by the literature is the setting in which signals are most valued. With some specific settings matching specific signals. To conclude, I combine all the given insights into an overarching framework. This gives an overview of the relation between funding types, signals, mechanisms, theories and settings. The managerial implication from this research is the practical use of signals. The overarching framework helps managers to decide which signal they should use to reach a desired effect. Next to this, the main contribution of this research are directions for future research. Four future research directions are distinguished: ethical aspect of signaling, negative influence of signals in competitive markets, signaling in open innovation and additionality of different funding forms.
To answer the research question, the article is divided in several sections. First, the methodology part will explain how this research is conducted. In the results section, interpretations of the relevant articles will be summarized and codified in to a scheme and will be the basis for the conclusion of this research. The conclusions are aimed at pointing out gaps in the existing literature which may serve as a starting point for future research. This will be the primary added value of this research. This review aims to provide a overview of relation between signaling, information asymmetry and innovation.
Methodology
5 First, the need for research is identified, after that, the research question for this review is formulated, the research terms will be set, the resources used will be determined and finally the inclusion and exclusion criteria for articles will be formulated. During the analysis, articles resulted from the search with predetermined keywords, are codified and scanned for their relevance.
In the interpretation stage, results will be interpreted and from the insights following from that, conclusions, in the form of implications and future research directions, will be presented. The interpretation of this data is the primary added value to this research as it produces new knowledge based on data collection and analysis (Crossan & Apaydin, 2010).
The following steps are based on several systematic literature reviews (e.g. Crossan & Apaydin, 2010; Beecham et al. 2008; Ireland, Hitt & Vaidyanath, 2002) and the most applicable steps are put together to come to the following research method:
This research systematically reviews existing articles on this subject and codify them. The codified knowledge will be presented in an overview. In this way, research gaps for future research can be found. The research question is: How is the funding of innovative start-ups
influenced by signals? The intent in undertaking this study is to bring together all parts of
available research, identify different research streams and combine/connect these research streams into a framework which displays the main findings. The research terms used in this literature review are: Signals, Innovation, Fund*, Finance and Invest. The search engine for this research will be Smartcat. This search engine is connected to the library of the University of Groningen and has access to a broad range of articles. This search resulted in 195 peer reviewed articles written in English. To enhance the quality of the articles, only peer reviewed articles were selected. Books and other sources of information are excluded. I made no distinction regarding country or industry. In the trade-off between achievability and completeness of literature, I decided to base this research on articles published between 2011 and 1-10-2016. The literature from this time frame is based on previous literature and therefore there is a high likelihood that all the main aspects of signaling theory are discussed. Next to this, the implementation of this timeframe narrows the literature down to make this research more achievable.
6 research is described in a log, which is enlisted in appendix I. During the analyzing process of the relevant papers, the main characteristics are put in a database. If during this process the article is proven to be irrelevant, it is excluded. The database is based on the research of Ireland et al. (2002). This framework has a rather general approach and therefore some research specific columns are added to make it more applicable. The database contains a scheme, which exists of 11 columns containing: author, title, research question/objective, type of signal, type of paper, theoretical framework, research setting and data, main conclusions, keywords, year and country. During the coding process, I concluded that the diversity in signals was too broad, therefore the signals are grouped based on their underlying mechanism. The groups are: knowledge related signals, funding related signals, management related signals, certification related signals & the setting in which to signal. After the descriptive analyses of the consideration set, the important theoretical frameworks are described. Next to this, funding mechanisms found in the consideration set will be explained. Finally, the signals will be explained together with their underlying mechanism and setting in which they are most useful.
The synthesis of this data is the primary added value to this research as it produces new insights based on data collection and analysis (Crossan & Apaydin, 2010). The interpretation of this research will include combining the theoretical insights from the analysis to a general answer on the research question. Based on the analysis method described above, findings will be identified. From these findings, the main streams of results are grouped. These findings will be mapped into a framework to make it more tangible. This framework gives an overview of the signals and their influence on different forms of funding. From this framework, gaps in the literature will be identified. This research is based on the articles from the consideration set, and uses the snowball effect to explain underlying concepts. When an article, found through the snowball effect, is important it will be included in the consideration set.
7 research. Therefore, the final consideration set consist of 60 articles. In the reference list, articles from the consideration set are indicated with an *.
Results
This chapter elaborates on the main findings which emerged from the 60 articles of the consideration set. Based on a descriptive analysis, different findings are discussed. At first, the most important theories used in the literature are explained. Second, different funding possibilities found in the literature are described. Next, the different signaling forms will be explained including their mechanisms. Each signaling form is summarized in a table which combines the most important literature streams and theories to the signals. This chapter also discusses settings in which signals are more valuable. At last, these insights will be combined in one overarching framework.
Theories
Graph 1 shows the theoretical frameworks on which literature is based.
Graph 1: Different theories in the consideration set.
8 Agency theory stems from an economic view of risk-sharing in which risk is shared between two parties, principals and agents, and both may have different approaches to assess this risk. (Bendickson, Muldoon, Liguori & Davis, 2016). In this research the agency theory is applied in articles where the risk of an innovation is shared between the innovator and the funding institute. According agency theory, information asymmetry can cause agency conflicts (Knockaert et al. 2014) and may result in a change of the importance of risk control (Drover et al. 2014). Therefore, agency theory underpins the importance of reducing information asymmetry (Guillamón-Saorín & Sousa, 2014). For high-tech companies, where it is hard for investors to value the technology and assess the commercial implications of strategic choices, agency theory is especially important. Search and transaction costs associated with the difficulties for investors to define the value, can be large for early-stage high-tech venture capitalists (VC) (Knockaert et al. 2014). The adverse selection problem is one of the problems related to agency theory (Drover et al. 2014). Adverse selection entails the uncertainties that investors have regarding the expectations of an innovation. The reason for this is uneven knowledge distribution between the entrepreneur and the investor. Trust can help overcome this obstacle (Drover et al. 2014).
9 degrees and certificates are examples of signals which are both observable and costly (Connelly, Certo, Ireland, & Reutzel, 2011; Moss et al. 2015). Following this theory, signals can be used to show characteristics and intent and are considered effective when they are costly and observable.
Resource based view evolves around the resources of an entrepreneur. Barney (1991) defines resources as “all assets, capabilities, organizational processes, firm attributes, information, knowledge etc. controlled by a firm that enable the firm to conceive of and implement strategies that improve its efficiency and effectiveness” (Barney, 1991, p. 101). For a resource to provide a sustained competitive advantage and to appropriate value from the innovation the resources must meet four criteria: valuable, rare, non-imitable and non-substitutable (Barney, 1991). In this research the resource based view is important since some resources are considered as signals. Certain forms of knowledge or information can provide a sustained competitive advantage, signaling the presence of this knowledge (e.g. by using a patent) can help to raise funds.
Legitimation can be described as: “A social process whereby the entrepreneurial idea is judged
and valued in relation to the cultural context resulting in a ‘generalized perception or assumption that the actions of an entity are desirable, proper or appropriate within some socially constructed system of norms, beliefs and definitions” (Suchman, 1995, p. 574).
10
Funding possibilities
This chapter elaborates on funding possibilities that were found in the literature from the data set. Viable companies will try to finance innovation themselves by retaining profits. For start-ups, this is not realistic. Next to this the most original form of funding, a bank, is unlikely to fund start-ups since the outcome of their innovation has a high uncertainty and risk (Popov & Roosenboom, 2012). From the literature, other forms of funding come forward: investments made by Founder, Family and Friends (FFF), Crowdfunding, VC funding, business angel (BA) funding and finally initial public offering (IPO) (Conti, Thursby & Rothaermel, 2013; Lehner & Nicholls, 2014; Ning, Wang & Yu, 2015).
Bank funding is a general concept; therefore, I will not explain the concept. However, the decision making of banks is relevant for this research. Banks base funding decisions on the characteristics of an entrepreneur’s business, with a focus on quality and commitment. Eddleston, Ladge, Mitteness, & Balachandra (2016) find some aspects on which the amount of bank loans is predicted. Number of employees and past performances are positively related to the size of a loan, while hours devoted to the business are negatively associated (Eddleston et al, 2016).
FFF investments are funds invested in a project by the founder or friends and family of the founder. These funds are normally used in the early start-up phase of a firm. Due to their proximity, family and friends of the founder are considered to have private information concerning the innovation, the dedication of the founder, commitment and founder attributes (Conti et al. 2013a).
The concept of crowdfunding is described by Lehner & Nicholls (2014, p. 274), as “tapping a
large, dispersed audience dubbed as ‘the crowd’, for small pledges that can sum up to incredible amounts due to the sheer numbers of participants”. Two constructs are important
11 decision (Moss et al. 2015). In crowdsourcing the highest chance for receiving funding is if the entrepreneur appeals to the intrinsic motivation of funders, most of the time this is to help other (Allison, Davis, Short & Webb, 2015).
“VC is a type of private equity (PE) capital for financing early-stage, high-potential companies” (Ning et al, p. 315). The success of innovators is highly uncertain. VCs provide
equity investment to these innovators and therefore they share in both the profits and the losses of the innovation. In Contrast to banks, since they only provide loans which only gives the banks a share in the losses. Next to the equity, VCs can assist the innovator in their development, this is also a thing a bank often is not capable of (Popov & Roosenboom, 2012). VC has developed as an important fund provider for start-ups. Due to uncertainty and information asymmetry these firms may have difficulties in finding funds (Ning et al. 2015). An important factor in the decision of investors whether to fund a firm or not is the expected return.
A BA can be described as a high-net worth individual, with relevant business experience, who makes personal investments in start-ups (Becker-Blease & Sohl, 2015; Wetzel, 1986). The investments are normally not over $1 million and are critical for short-term survival and a precursor for later-stage capital (Becker-Blease & Sohl, 2015). Legitimacy of the venture is an important signal on which BAs address their decision. The relation between a BA and an entrepreneur is more trust-based and informal when comparing with VCs. BAs view ventures with revenues more favorably, since an existing revenue stream signals legitimacy and helps to reduce information asymmetry between the entrepreneur and the investor.
12 This chapter elaborates on the concepts of the different funding possibilities. Next to that, decision making factors for every funding possibility are described. For banks quality and commitment is important. Characteristics and intentions are important for the crowd. VC base their decisions on expected return. BAs consider legitimacy as important. Finally, after an IPO, potential shareholders base their decisions on the purposes of the applications of the funds.
Signals
There is a large diversity in signals described in the consideration set. However, there are some similarities in the underlying mechanisms, when approaching these signals with a broader scope. Therefore, the signals are linked to a group which they are related to. Next to papers who describe signals, there are other papers that do not describe a certain signal, but describe a setting in which signals are more valued or have a different impact.
Graph 2: Different signals in the consideration set.
Graph 2 shows how these signals are represented in the consideration set. After describing the
signals individually, the underlying mechanisms of the signals is explained together with its intended effect. Each signal is summarized in a table which shows: the effect, the underlying mechanism, receivers which are specially attracted to this signal and the connections to theories. Finally, this chapter will elaborate on the influence of signals in different settings.
Knowledge related signals (12%)
13 knowledge related signals.
The United States Patent and Trademark Office (USPTO) (2015) defines a patent as: A patent
for an invention is the grant of a property right to the inventor. Any person who invents or
discovers a new and useful process, machine, manufacture or composition of matter or a new improvement on such a thing may obtain a patent (USPTO, 2015). Manufacture is described as an article that is made and composition of matter refers to chemical compositions. Together these classes cover practically everything that is made by man and the processes for making these products. Following the patent law, subject matter must be useful and new. Where useful refers to the condition that the matter has a useful purpose and is operative. A patent must be codified since it cannot be obtained upon an idea or suggestion. The patent is granted for the codified knowledge of an invention and not on the idea of it (USPTO, 2015). From this one can conclude that the presence of a patent in an organization means that new and useful knowledge is present in the entrepreneurial firm.
An NPPA is a communication process used by companies to send messages to stakeholders before a new product launch (Su & Rao, 2012). Many firms preannounce a new product before introducing it to the market. Reasons for preannouncing are: discouraging competitors, impacting financial markets, discourage potential customers from purchasing existing products and to test market a new product concept (Klastorin, Mamani & Zhou, 2016). An NPPA may reduce information asymmetry, which can harm the firm since competition can get insights in the newly developed product which stimulates imitation (Klastorin et al, 2016).
For funders, an NPPA which contains signals regarding a firm’s intent and ability to commercialize are considered useful (Lee et al. 2016).
14 From these insights, I conclude that a patent is the property right over new and useful knowledge. A NPPA is a means to signal information quality regarding the innovation or knowledge of an entrepreneur. Hence, both are a means to signal the presence of new knowledge. An entrepreneur with new knowledge means he/she has potential to successfully create and commercialize an innovation. Taken together with the fact that patented innovations are more likely to succeed, in comparison to innovations without patents, one could say that the risk for investors to fund these innovations is lower (Fabrizi, Lippert, Norbäck & Persson, 2013). When an entrepreneur possesses a larger pool of patents, this will positively influence funding. Which means that the higher the amount of patents a start-up has, the higher the chance of receiving funding and the bigger the size of the funds (Conti et al. 2013a; Conti, Thursby & Thursby, 2013; Popov & Rosenbloom, 2012). When entrepreneurs invest more in patents, they have a higher chance of receiving VC investment (Conti et al. 2013a), which implies that the FFF investment and the VC investment are related. While patents are a signal to reach VCs, it is not a signal to reach private investors like BAs (Conti et al. 2013b).
Thus, patents are means to signal quality and potential by showing the presence of new knowledge (Smith & Cordina, 2015; Conti et al. 2013a). The literature discusses mainly patent impact on VC investments, this implicates that a patent is a way of signaling to VC investors. When using patents as a signal, information asymmetry will drop, this will result in a reduction of risk and uncertainty. For an NPPA the underlying mechanism is that it is a means to signal information quality based on trust, verifiability and consistency. Next to intent, based on information quality, an NPPA also signals potential by showing the presence of new knowledge (Chen et al. 2014). The effects of a patent and an NPPA are almost the same and therefore the conclusion is that knowledge related signals are a means to signal quality, intent and potential.
15 A short recap of this chapter shows that knowledge related signals are a means to signal quality, intent and potential. The underlying mechanism is signaling the presence of new knowledge. Receivers, that value knowledge related signals, are especially VCs. Linking this signal to the important theories of this literature, I find a connection to agency theory, signaling theory and the resource based view. These findings are combined in table 1.
Table 1: Overview of knowledge related signals.
Funding related signals (41%)
The largest group of signals is funding related signals. This may be confusing since all signals are related to funding because signals are a means to reduce information asymmetry between start-ups and investors and thus a tool to get funding. This chapter approaches funds as a signal to receive funds. From the described funding possibilities, the literature finds that some funding forms are also a means to signal. In this chapter the signaling role of several funding
Knowledge related signals
Means to signal Explanation Author(s):
Quality § An NPPA can be used as a signal of quality
of new products.
§ Patents show quality through the signaling the presence of new knowledge
Chen et al. 2016
Smith & Cordina, 2015 Conti et al. 2013a
Intent By a high information quality, based on trust,
verification and consistency. Information asymmetry regarding ability and intent is decreased.
Lee et al. 2016
Potential Potential is based on the presence of new
knowledge.
Klastorin et al. 2016 Fabrizi et al, 2013 Smith & Cordina, 2015 Conti et al. 2013a Mechanism
Signal presence of new knowledge Lower uncertainty and risk by reduced information asymmetry
Fabrizi et al. 2013
Receiver
Venture capitalists Venture capitalists value patents and therefore the chance of getting funded by a venture capitalist is higher.
Conti et al. 2013a
Theories
Agency theory Trust can help to overcome the adverse selection
problem, which is an agency problem.
Bendickson et al. 2016 Drover et al. 2014 Knockaert et al. 2014
Signaling theory These signals provide information about the
presence of new knowledge, which is costly and observable and therefore it is efficient.
Lee et al. 2016 Connelly et al. 2011 Moss et al. 2015
Resource based view New knowledge can provide a sustained
competitive advantage.
16 forms is described. FFF, crowdfunding, VC, BA and IPO are all considered as a funding possibility which are also a signal.
While the investment in FFF does not have a statistically significant impact on VC funding, the use of FFF money is considered a means to signal founder commitment (Conti et al. 2013a). FFF is strategically used to attract funding by BAs (Conti et al. 2013a). This implies that financing by BAs is affected by founder commitment, and BA investment is a follow up from FFF funding.
A successful crowdfunding process can be a means to signal legitimacy, trustworthiness and commitment (Macht, 2014; Lehner & Nicholls, 2014). Combining this with the insight provided in the knowledge related signals that trust is a characteristic of information quality and information quality signals intent, this implies that a successful crowdfunding campaign signals intent. From the funds that are obtained from a crowdfunding campaign, the entrepreneur can expand his/her business models (Lehner & Nicholls, 2014). These business models provide financial institutions with more information on which a credit rating can be based. This will reduce information asymmetry and therefore also uncertainty and risk for funders to invest will be lower (Lehner & Nicholls, 2014).
Innovators funded by VCs are less dependent on short-term borrowing, indirect it facilitates access to the long-term credit market, by reducing information asymmetry and lowering the risk to third parties through track records (Haro-de-Rosario, Caba-Pérez & Cazorla-Papis, 2016). BA investment is in this research also considered as a private equity. Getting financed by a private equity fund has a positive effect on the amount of credit obtained and on the relationship between the focal firm and the bank (Coin & Vacca, 2016). The involvement of VC or another form of private equity signals quality and independence (Tan, Huang & Lu, 2013). A higher amount of quality and independence will result in lower information asymmetry and lower risk and uncertainty.
17 but are less concerned with quality.
Combining the theoretical insights discussed earlier, with this signal, the connection between funding related signals and three theories can be made. First, funding related signals relate to legitimation theory since the association with VCs or a BA increases cognitive legitimacy (Macht, 2014; Lehner & Nicholls, 2014). The second theory associated with funding related signals is signaling theory. Several funding related signals are a means to signal quality and intent, which makes the signal costly and observable (Connelly et al. 2011, Moss et al. 2015). Finally, agency theory is related to funding related signals. The presence of these signals result in a lower risk for investors, which will reduce agency conflicts.
Table 2: Overview of funding related signals.
Funding related signals
Means to signal: Explanation Author(s):
Passion & commitment § The investment of a founder shows that he/she is passionate and committed.
§ A successful crowdfunding campaign signals commitment
Conti et al. 2013a
Macht, 2014
Lehner & Nicholls, 2014
Quality § The involvement of private equity signals
quality.
§ Post-IPO firms may have a decrease in quality.
Tan et al. 2013
Wu, 2012
Legitimacy § A successful crowdfunding campaign signals
legitimacy.
§ Being associated with a venture capitalist or business angel improves legitimacy
Macht, 2014
Lehner & Nicholls, 2014 Petkova et al, 2013
Independence The presence of private equity signals independence. Tan et al. 2013
Intent § Intent is based on information quality which
exists of trust. A successful crowdfunding campaign signals trust.
§ Use of proceeds and narratives provide information about intent
Macht, 2014
Lehner & Nicholls, 2014
Wyatt & Cahan, 2014 Moss et al. 2015
Productivity Post-IPO firms have an increase in productivity. Wu, 2012
Mechanism:
The presence of funds shows trust and reduces risk for other investors.
Short term borrowings provide access to long-term borrowings by reducing information asymmetry and risk through track records.
Haro-de-Rosario et al. 2016
Receiver:
Business angel Business angels favor entrepreneurs with high FFF funding, since this signals commitment and passion.
Conti et al. 2013a
Theories:
Agency theory Less agency conflicts due to lower risk. Bendickson et al. 2016
Drover et al. 2014 Knockaert et al. 2014 Haro-de-Rosario et al. 2016
Signaling theory Funding related signals are costly and observable and therefore efficient.
Connelly et al. 2011 Moss et al. 2015
Legitimation theory Firms associated with venture capitalists or business angels have a higher legitimacy.
18
Certification related signals (3%)
When a start-up gets a third-party certificate (e.g. a design award) it can be used as a signal to stakeholders (Xia, Singhal & Zhang, 2016). In the case of design awards, Xia et al. (2016) find that product innovations with the potential for a great design have a large chance of being a success. Next to this Etilé & Teyssier (2016) find that a third-party certificate in the form of a corporate social responsible certificate has gains compared to situations where signaling is not possible. The presence of a certificate signals a certain level of quality, however, a CSR certificate in a market without benchmark is useless.
Thus, a design award is a means to signal innovation potential. A CSR certificate signals quality (Xia et al. 2016; Etilé & Teyssier, 2016).
The theories related to this signal are signaling theory and resource based view. Since certification related signals are a means to show quality, it is considered a costly and observable signal according signaling theory (Connelly et al. 2011; Moss et al. 2015). The presence of a certificate implies that there is knowledge available which may result in a sustained competitive advantage (Barney, 1991). However, a design award implies the presence of valuable, rare and non-substitutable knowledge. I assume that a design is relatively easy to imitate, which means that not all the predecessors of the resource based view are present.
Certification related signals
Means to signal: Explanation Author(s):
Quality The presence of a CSR certificate is a means to
signal quality
Xia et al. 2016
Potential The presence of a design award is a means to signal
potential by showing a large chance on success.
Etilé & Teyssier, 2016
Mechanism:
Signal a higher chance of success by the presence of a third-party certificate.
Lower uncertainty and risk by reduced information asymmetry increase the chance of success of a product.
Xia et al. 2016
Receiver:
No receiver in particular
Theories:
Signaling theory This signal is efficient since it is costly and observable.
Connelly et al. 2011 Moss et al. 2015
Resource based view A certificate shows the presence of quality and potential, which may result in a sustained competitive advantage.
Barney, 1991
19
Management related signals (31%)
This group consists of different signals related to the management team and the policy of the firm. It elaborates on the characteristics of founders and the signals that are related to these characteristics (e.g. reputation or social ties). Next to this, board composition and its policy, are signals to potential investors. An effective board of directors protects funders from managerial misbehavior, reduce cost and facilitate access to external capital (Bertoni, Meoli & Vismara, 2014). Entrepreneurs or the management team of a firm have a reputation and a network of contacts which can be used as a signal. Therefore, this group focuses on four main topics: composition of the board, policy, reputation of board members and social ties of board members.
When an information asymmetry is present, the existence of social ties does not result in the understanding or receiving of required information. While social ties are a means to signal trust, they do not transfer knowledge (Millar et al. 2012). However, it may be a reason for investors to ask additional questions and receive reassurance that their claims are trustworthy. Even in the absence of social ties, it is possible for entrepreneurs to receive funding. This implies that the investor’s need for information is critical, but since there is often a lack of fully understandable information, investors must also rely on other signals for the desired information (Millar et al. 2012). Reputation is the key for a company, where reputation is defined as “the perception of the organization shared by its multiple constituencies over time” (Millar et al. 2012). A good reputation must be earned; it is linked to the image stakeholders have of a firm over time. It is important that the image matches the firm identity. When an information asymmetry exists, customers are more likely to do business with firms that have an established reputation (Millar et al. 2012). For innovative start-ups signaling establishing reputation is valuable, especially when intellectual property rights (e.g. patents) make it hard for funders to validate opportunities (Millar et al. 2012; Fuller & Rothaermel, 2012). The reputation of start-up’s first partner has a positive impact on the legitimacy of the start-up (Milanov & Shepherd, 2013).
20 management team, a proven track record is beneficial. The quality of ideas is hard to determine and a proven track record can show quality of the innovator. If the innovator has proven to bring innovations with a high quality, the perceived risk for investors is reduced (Luo, 2014).
Faculty inventors have a high level of passion and commitment for the succeeding of their invention, next to this they are motivated and have a lot of knowledge (Fuller & Rothaermel, 2012). This signals quality to potential investors. The change from faculty inventor to firm founder matters to the outcome of the start-up. The presence of an academic will increase the likelihood that the firm will get funding and eventually go public (Fuller & Rothaermel, 2012; Bonardo, Paleari & Vismara, 2011). By using the board composition as a signal, potential investors are aware of the capabilities of the board members. Next to their capabilities, also the gender of board members is discussed in literature. Gender diversity in board composition plays a significant role in mitigating the adverse effect of R&D risk. The R&D risk and cost of debt is reduced by the presence of female participation in the boardroom (Chen, Ni & Tong, 2016). This means that the presence of a female board can lower risk and uncertainty. With a lower uncertainty, the likelihood investors are interested becomes higher. Board structure and highly qualified board members are important in signaling internal governance. This can attract investors and can also increase the speed of funding (Ahlers, Cumming, Günther & Schweizer, 2015).
When the board chooses to handle a policy in which the firm provides information about risks, this signal will positively influence funding success (Ahlers et al. 2015). Next to this, the policy of a firm can be a means to signal intent (Millar et al. 2012).
21
Management related signals
Means to signal: Explanation Author(s):
Value of the firm Social ties are a means to signal firm value Mazzola et al. 2016
Quality § The composition and structure of an
entrepreneur’s network can signal quality. § Academics in the board signal quality. § Track records can show the presence of high
quality entrepreneurs
Milanov & Shephard, 2013
Fuller & Rothaermel, 2012 Bonardo et al. 2011 Luo, 2014
Passion & commitment Faculty inventors in the board have a high level of passion and commitment.
Fuller & Rothaermel, 2012
Intent Policy can be a means to signal intent Millar et al. 2012
Legitimacy Reputation of an entrepreneurs first partner has a positive impact on status. Therefore, social ties can be used to signal legitimacy.
Mazzola et al. 2016
Mechanism:
Build trust towards investors to influence their funding decision
Due to a lack of information, funders must base their decision on other aspects, like legitimation, passion and trust.
Millar et al. 2012
Receiver:
Venture capitalists Social ties are a means to signal which positively influences venture capitalist investments.
Wuebker et al. 2015
Theories:
Legitimation theory Reputation and social ties increase cognitive legitimacy
Mazzola et al. 2016 Petkova et al. 2013
Signaling theory Signals are costly and observable and therefore efficient.
Connelly et al. 2011 Moss et al. 2015
Agency theory The presence of female board members reduces
adverse effect of R&D risk, which is considered as an agency problem.
Drover et al. 2014
Table 4: Overview management related signals.
Each group of signals (knowledge, funding, certification and management related signals) describes the general mechanism and their implications. However, they all consists of multiple signals with each a slightly different impact when compared to the group. To compare these signals, they are combined into table 5, showing their effect on an individual level. The table describes whether the effect is positive (+) or negative (-).
22
Table 5: overview of influences of individual signals.
Setting (13%)
This chapters elaborates on the 13% of the literature which describes several settings in which signals are valued differently. For instance, this can be a setting, in which a certain signal is preferred over others or in which legal systems of a country reinforces a signal. Next to this, settings which prefer signals in general are discussed.
23 performance of a firm after their IPO (Deb, 2013). Firms that recently went public can use this to their advantage.
The setting in which founders of startups invest more in FFF is in a situation of asymmetric information (Conti et al. 2013a). Signaling with FFF funds is especially useful to attract BA investment (Conti et al. 2013a). Therefore, a setting in which the entrepreneur prefers BA investment, is a setting to use this signal. A reason for attracting BA investors is their network. BAs often cluster near universities that promote entrepreneurship, since these places have high potential business activity. The connection with a BA can create value for the innovator since it may connect the innovator with other entrepreneurs (Hechavarría, Matthews & Reynolds, 2016). This implies that FFF money is especially valued by entrepreneurs with a small network or no social ties.
Signaling reputation is beneficial in multiple settings. Generally, reputation is beneficial in a setting in which there is competition for financial support (Millar et al. 2012). Next to this, reputation may help founders strengthen their bargaining position to VCs (Mahto & Khanin, 2013). This can be beneficial when discussing terms with VCs. Furthermore, reputation can improve post-IPO performance (Deb, 2013).
Signaling with the given policy, can be used to attract relatively uninvolved investors, they favor firms with fully developed business plans and with many employees (Becker-Blease & Sohl, 2015). Policy can show the degree of perceived control, which has a positive influence on VCs initial investment decisions (Drover et al. 2014).
Certification related signals are especially helpful for small firms, since small firms benefit more from design awards than large firms (Xia et al. 2016). Furthermore, market reactions to a third-party certificate do not changes with market competitiveness. This implies that third-party certificates matter irrespective of the setting of an industry (Xia et al. 2016).
24 financed by VCs. This implies that getting financed by VCs and a country’s legal system are complementary (Vanacker et al. 2014). Further, differences in disclosure practice across countries due to their legal system are confirmed (Guillamón-Soarin & Sousa, 2014).
A setting in which the economy expands with a high GDP growth rate, a great industry production index and a low unemployment rate is favorable for VC investment. In this setting, more investments with a higher average amount per deal are given (Ning et al. 2015). After a financial crisis (like the 2008 financial crisis) firms become more cautious and risk averse. Through these changes VCs are more cautious, therefore they invest less. To reduce risk, investments are made in later staged companies (Ning et al. 2015). Strong personal ties are more valued in dense networked capital industry like the United States than in Europe which is a less dense networked industries (Hopp & Lukas, 2014).
25 Table 6 shows the overview of settings described above.
Settings
Patents Explanation Author(s):
Experienced venture capital industry Experience helps investors to assess patents Knockaert et al. 2014
Setting with focus on high-quality In settings with a focus on high quality, investors value patents most
Conti et al. 2013a
Post-IPO setting Patents improve post-IPO performance Deb, 2013
FFF invest
Lack of social ties or network FFF investment attracts business angel investors. Business angel investors can be helpful in connecting to other entrepreneurs.
Hechavarría et al. 2016
Reputation
Competition for financial support When competition for financial support is high, a reputation is beneficial for achieving funds.
Millar et al. 2012
Setting in which entrepreneurs are discussing terms.
Reputation will strengthen an entrepreneur’s bargaining position.
Mahto & Khanin, 2013
Post-IPO setting Reputation improves post-IPO performance Deb, 2013
Policy
Setting with uninvolved investors Uninvolved investors will be attracted by a policy which stimulates the use of high amounts of employees and fully developed business plans.
Becker-Blease & Sohl, 2015
Certification
Helpful for small firms Small firms benefit more from certification than large firms.
Xia et al. 2016
Social Ties
Setting with dense networks Dense networks value social ties more than less dense industries
Hopp & Lukas, 2014
IPO
High level of protection of minority shareholders
Higher level of protection results in a higher probability of equity funding.
Vanacker et al. 2014
Overall
Situation of asymmetric information Signals help to reduce information asymmetry Conti et al. 2013a Conti et al. 2013b
Economic expansion with high GDP In such a setting, higher average amounts of funds are given
Ning et al. 2015
Great industry production In such a setting, higher average amounts of funds are given
Ning et al. 2015
Low unemployment rate In such a setting, higher average amounts of funds are given
Ning et al. 2015
Low competition In a setting with high competition, signals
encourage competitors to join the market. Therefore, it is more beneficial to signal in a market with low competition
Guillamón-Soarin & Sousa, 2014
26
Overarching framework
Table 7 combines all the given insights in an overarching framework.
Table 7: Overarching framework
This framework elaborates on the groups of signals, their underlying mechanism, receivers that particularly value specific signals and the connection to different theories. It incorporates the settings in which signals are highly valued on an individual level and more generally spoken. Quality is an effect which can be reached with all four signaling mechanisms. Next to this, every mechanism is related to signaling theory, which is not surprising. In tables one to four, receivers are discussed on an individual level. However, table 7 shows that the receivers are investors in general. When approaching the mechanisms with a broader perspective, knowledge, funding and certification related signals have a mechanism which is based on the reduction of information asymmetry. Next to this, management related signals have a
27
Concluding remarks
From this systematic literature review, based on 60 articles, several main findings come forward. First, four theoretical frameworks were identified as important. They explain and support the concepts used in this research. These are: agency theory, signaling theory, resource based view and legitimation theory. Second, six different funding forms are distinguished and explained. Bank funding is the most well-known, next to this, investments of founder, family and friends, crowdfunding, venture capitalist investment, business angel investments and initial public offerings were described in the literature. Third, the literature shows 13 different signals, which are clustered into four groups based on the underlying signaling mechanism. For knowledge related signals, this mechanism is showing the presence of new knowledge and quality. This reduces information asymmetry and eventually risk and uncertainty. Funding related signals are a means to signal quality and intent in different ways. Based on track records of these funds, information asymmetry for the investor will decrease and therefore investing is less risky. Certification related signals are a means to signal potential and quality. The underlying mechanism for this signal is showing a larger chance of success by the presence of certificates. The fourth group is management related signals. These signals are used to signal intent and legitimacy. In this group the underlying mechanism is to build trust between the start-up and the potential investors, which is important in a setting with asymmetric information. In such a setting, firms cannot base their decision on the quality of knowledge. They must base their decision on the entrepreneur or management team of a start-up and on the degree of a potential investor’s trust. Next to this, the literature describes settings in which signals are more valuable than normal. Some specific settings are related to specific signals. The overall setting for signaling entails an asymmetry in information between start-ups in need for funds and investors. Finally, all these insights are combined in an overarching framework. These insights are the answer to the research question: How is the funding of innovative start-ups influenced
by signals? Based on the findings, a general answer to the research question is: The risk of
28
Future research directions
Directions for future research, derived from this research, contribute to the theoretical field of signaling and funding of innovation.
While conducting this research only a few times the ethical perspective of signaling was encountered. Especially the funding of start-ups with low potential isn’t discussed. Empirical research on the relationship between the funding of low potential firms and the failure of these firms may address this perspective. In addition to this, empirical research on the relationship between guidance and innovation success may provide other insights on the ethical perspective of funding innovations. These insights may help to reduce the high failure rate of innovation and therefore make funding of innovations ethically responsible.
Second, I did not encounter articles discussing the influence of signaling in open innovation. While open innovation is an important form of innovating, literature of signals focusses on closed innovation with high information asymmetry between parties. Open innovation may have a smaller information asymmetry, but I assume that these innovations also need to send signals towards stakeholders. A multiple case study on successfully funded open innovation projects will give insights on this. In addition, empirical research on the relationship between open innovation projects and the successful funding of open innovation will give insights in this. Combined with a moderating effect of signals on this relation new insights can be found regarding the influence of signals on this relationship.
Third, the following up of different funding types is under elaborated. My expectation is that different types of funding follow up each other. However, the literature makes no clear ranking in funding types. Empirical research on the relation between funding type and start-up phase may provide insights on this subject.
Finally, the positive influence of signals is discussed in depth, but the negative influence of signaling is badly represented. Signaling in a high-competition environment could encourage competitors to join the market (Guillamón-Soarin & Sousa, 2014), which can have a negative impact on the success of an innovation. Empirical research on the relationship between signaling and innovation success with a moderating effect of high-competition markets can give insights in this research.
29
Managerial implications
In addition to the contributions to research, this research contributes to managerial practice. The tables and the overarching framework resulted from this research can be used as a guideline for entrepreneurs and managers. Managers are often aware of their needs; however, it is difficult to recognize the right signal to fulfill this needs. This research elaborates on that, in a way that it provides different funding mechanisms and combines them with signals, theories and settings. These insights can be used as guidelines to find the right signal(s) to attract the desired investor. Next to this, it will give insights in the underlying mechanisms of the signals which may be of interest for managers.
Limitations
One limitation of this research is that it is only based on literature of the past five years. Literature from the consideration set used in this research is based on the most important theories concerning this topic and together with the snowball effect, most aspects of signaling to attract funds are described. If the literature review was based on all available literature, other aspects could come to mind. Further, this research is conducted by only one person, which implies that the reliability may be lower. A project group to discuss relevance of the papers may have resulted in a different dataset.
Thirdly, this research is based on one database. The use of multiple databases could have resulted in more relevant articles.
30
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37
Appendix I: Log with all important decisions regarding this research
Date: Description
7-09-2016/ 21-09-2016
Search for highly cited systematic literature reviews and analyzing their methodology. The methodology section is based on these research methods.
21-09-2016/ 24-09-2016
Search for peer reviewed articles with the keywords: Signaling, information asymmetry and innovation. Main findings are used to find a gap in the mature literature field.
25-09-2016/ 26-09-2016
Define key search terms 27-09-2016/
06-10-2016
Narrow down subject
06-10-2016 Decided to focus on the influence of signals on funding of innovations 06-10-2016/
11-10-2016
Rewriting introduction and methodology to make it more applicable for the narrowed down topic. And redefine key search terms
11-10-2016/ 23-10-2016
Systematic search for articles, by using the search terms: Signals, Innovation, Fund*, Invest and Finance. These search terms are chosen since this combination will cover the subject I want to research. When checking for synonyms, innovation and signals did not have synonyms which provide the same charge. For fund that where investing and financing. This search resulted in a selection of 195 articles
23-10-2016/ 8-11-2016
Study for exams 8-11-2016/
20-11-2016
Check the articles which are found for relevance. First the title and abstract were scanned for relevance. In this search for relevant articles I focused especially if the articles described a signal, described the influence of a signal, described a setting in which signals are used or describe receivers of signals. This search resulted in a set of 64 articles.
20-11-2016/ 28-11-2016
Scan the important articles completely for relevance and during this process codify the important characteristics into the database. Again, during this search for relevance, I focused especially if the articles described a signal, described the influence of a signal, described a setting in which signals are used or describe receivers of signals. This process resulted in the exclusion of four irrelevant articles. Further all the characteristics of the relevant articles are put in the database.
Write first results 28-11-2016/
5-12-2016
Process all characteristics in research streams and make a distinction between different signals. Improve and expand the results
5-12-2016/ 12-12-2016
Process all the signals and group them based on their effect. Improve and expand the results
12-12-2016/ 20-12-2016
Elaborate on funding mechanisms and setting in which signals are important. Improve and expand the results
20-12-2016/ 24-12-2016
Decide on how to group the results: resulted in the grouping of signals based on their underlying mechanism Reformat database and use descriptive analyses to structure the article.
24-12-2016/ 09-01-2017
Improve and expand results
Come to conclusions based on the overarching framework Define limitations and future research directions 10-01-2017 Finalize draft version
11-01-2017/ 22-01-2017
Implement feedback of draft version Finalizing lay out
