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 and entrepreneurs. Pecking order theory relates to entrepreneurs’ preferences about financing choices. Financing options include using one’s own funds, reinvesting profits back into the business, selling equity to outside investors, and bank debt.
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. To make up for this, financiers typically demand higher interest rates or more favorable terms, to protect themselves against what they don’t know (Paul, Whittam and Wyper, 2007).
As a result, entrepreneurs tend to prefer to fund their ventures using their own funds and profits of the business rather than submitting to the costly demands of outside investors and lenders. New equity investors will typically demand a higher rate of return on their investment than the founding investors, thus entrepreneurs will typically prefer loans. Entrepreneurs also prefer short-term loans to long-term loans, as these will typically have lower interest rates (Paul, Whittam and Wyper, 2007).
The information asymmetries are more acute for some types of firms than for others. For instance, firms with complex business models that are difficult for outsiders to understand will typically have greater asymmetries than simple or conventional business models that are easy to understand.
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. To make up for this, financiers typically demand higher interest rates or more favorable terms, to protect themselves against what they don’t know (Paul, Whittam and Wyper, 2007).
As a result, entrepreneurs tend to prefer to fund their ventures using their own funds and profits of the business rather than submitting to the costly demands of outside investors and lenders. New equity investors will typically demand a higher rate of return on their investment than the founding investors, thus entrepreneurs will typically prefer loans. Entrepreneurs also prefer short-term loans to long-term loans, as these will typically have lower interest rates (Paul, Whittam and Wyper, 2007).
The information asymmetries are more acute for some types of firms than for others. For instance, firms with complex business models that are difficult for outsiders to understand will typically have greater asymmetries than simple or conventional business models that are easy to understand.
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