Insider information can mislead start-up investors

Michael Maiello | Mar 08, 2018

In the world of start-ups and venture financing, a lot of success is credited to relationships developed with entrepreneurs based on early-stage financing deals. By becoming an insider years before a new company seeks capital from public markets, an investor gains an information advantage that serves him or her well, the thinking goes. Banks develop similar relationship with their start-up clients.

But this kind of “insider” information may actually be designed to gin up more funding for the entrepreneur, rather than help an investor make the best decision about whether to continue the relationship into future rounds, according to Chicago Booth’s Lin William Cong and Booth PhD candidate Ehsan Azarmsa. Their research suggests that what you know is at least as important as who you know.

The information given to an initial financier is perfectly legal and distinct from the “insider information” typically mentioned in discussions about securities trading. A start-up may share news about internal experiments, or details about the background and dynamics of the company’s founding team—the kind of data that can flow easily to someone working closely with or monitoring an entrepreneur.

By modeling this sort of information, the researchers identify a new source of inefficiency in relationship financing. And based on their findings, Azarmsa and Cong propose a way of structuring start-up or early-stage capital injections so that the incentives of entrepreneurs better align with those of investors and lenders.

The researchers cite the drone company Skycatch, which chose to pursue a big contract with a well-established company rather than smaller trial projects. Even though Skycatch could have used the same resources to complete several smaller projects with a greater rate of success, landing one big partnership—though making the task challenging—would likely wow its financiers and persuade them to continue the relationship past the initial financing round, the researchers learned.

The Skycatch case suggests that management teams make decisions intended to persuade or convince investors to make future investments, according to the researchers, in which case information gleaned from what seems like a privileged view of the company might not be all that valuable. This can be partly counterbalanced by an investor’s sophistication and, perhaps counterintuitively, by a moderate level of investor competition. A company may be reluctant to tell too much to an initial investor for fear of giving that investor more bargaining power down the line. But if an initial investor commits to including other financiers in the next round, that could allay the entrepreneur’s concern.

Even better, the researchers argue, might be for companies to structure fund-raising in a way that would eliminate the information design problem. In the initial round of financing, investors could get warrants to later purchase convertible securities, while in later rounds, outsiders—new, arms-length investors—could purchase securities such as equities. In this way, entrepreneurs would still control the flow of information, but cash flow would ultimately provide an objective scorecard.

Investors would execute warrants only when a company’s valuation made doing so economical. Meanwhile entrepreneurs, knowing that new investors could end up purchasing the securities at competitive prices, would have a reason to produce information efficiently.