Show Me the Right Stuff: Signals for High Tech Startups

Abstract:     
This paper revisits a central issue in entrepreneurial finance, namely the signals technology startups send to external investors to convey information about their quality. We examine the potential for technology startups to use patents and founders, friends and family money (FFF money) as signals to attract business angel and venture capital funds, patents reflect technology quality and FFF money reflects founder commitment. We find that if investors value technology quality more (less) than founder commitment, the optimal mix of signals is a relatively higher (lower) use of patents than FFF money. Regardless of investor preferences, high quality founders should invest more in both signals than in the absence of private information. This investment is inversely related to the opportunity cost of investing in the signals. We test our predictions empirically and find strong support for our theoretical view that FFF and patents are endogenously determined signals. Moreover, we find that startups who invest in both signals receive greater external funds. When we distinguish between venture capitalist and business angel investment, we find that patents serve as a signal for venture capitalists and FFF money is a signal for business angels (but not vice versa).

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