The signaling value of legal form in debt financing

We examine if a startup's legal form choice is used as a signal by credit providers to infer its risk to default on a loan. We propose that choosing a legal form with low minimum capital requirements signals higher default risk. Arguably, small relationship banks are more likely to use legal form as a screening device when deciding on a loan. Using data from Orbis and the IAB/ZEW Start-up Panel for a sample of German firms, we find evidence consistent with our hypotheses but inconsistent with predictions of several competing explanations, including differential demand for debt or growth opportunities

The signaling value of legal form in entrepreneurial debt financing

This study examines the impact of mandatory legal form choices on startups' debt financing opportunities. We posit that an entrepreneur's initial legal form decision serves as a reliable signal to outside lenders, reducing adverse selection concerns. Using data from German startups, we find that limited liability companies with low capital requirements disproportionately secure less debt than their high-capital counterparts. This financing disparity is particularly pronounced for younger firms in areas dominated by small relationship banks, but it diminishes with firm age. Our findings highlight the unintended consequences of recent global deregulation efforts. Executive summary: Formal debt financing is arguably the most important source of external financing for startups. Despite its importance, many startups find it challenging to secure such financing due to informational opacity: they lack the track record or publicly available evidence needed to prove that they are a sound investment. This raises a pressing question: How can startups credibly convey their creditworthiness to potential lenders? We posit that a startup entrepreneur's choice of legal form acts as a pivotal signal to potential lenders, allowing them to differentiate between high-risk and low-risk ventures. Every startup must decide what legal form it will adopt at incorporation. Unlike most other, industry-specific decisions, the choice of legal form acts as a consistent and universally applicable signal. Moreover, recent shifts in global regulations have seen the emergence of companies with low-capital legal forms, a development further underscoring the importance of studying these choices (World Bank, 2020). We theorize that adopting a legal form with high minimum paid-in capital requirements signals that a venture will be less likely to default on a loan: entrepreneurs who anticipate a higher likelihood of default will be less inclined to pick a legal form with high minimum capital requirements since they would be liable for the amount of paid-in capital in the case of bankruptcy. The opportunity costs of such a choice would also be higher as founding a high-capital firm would entail foregoing alternative, safer investment opportunities. Furthermore, the reputational costs and potential stigma of failure associated with defaulting when choosing a high- versus low-capital legal form may induce high-risk types to choose the latter. Importantly, we posit that the legal form choice has signaling value beyond the amount of paid-in capital: among firms with the same amount of equity and similar firm and founder characteristics, those ventures with a low-capital legal form have more difficulty in attracting the necessary external funding. We utilize comprehensive administrative and survey data from German firms to empirically test our hypotheses. In 2008, Germany introduced the “mini-LLC” or “low-capital LLC,” allowing founders to opt for a lower minimum capital requirement than the traditional 25,000 Euro. This shift presented a unique opportunity to study the implications of legal form choice on external financing. Our findings suggest that low-capital LLCs typically secure less debt and more frequently experience financial constraints, despite the lack of any significant difference between their financing needs and those of high-capital LLCs. We further demonstrate that the total effect consists of a mild positive intentional impact from choosing a high-capital legal form and a strong negative unintentional impact from opting for a low-capital form. Notably, these signaling effects are more pronounced for smaller, “relationship banks,” which tend to rely more on nonfinancial cues for risk assessment due to their limited access to sophisticated financial evaluation tools. As the firm-bank relationship matures, the weight of this signal diminishes, indicating that banks adjust their assessment based on acquired knowledge of the firm's quality. However, larger, “transactional banks,” which focus more on hard data, tend to maintain their reliance on this signal for extended periods. For entrepreneurs, the key takeaway is that a trade-off exists between capital requirements and debt accessibility. The stigma tied to low-capital legal forms disproportionately affects their ability to secure debt. Opting for a legal form with low capital requirements might be advantageous to those not heavily dependent on external financing in the early stages, and fostering long-standing relationships with banks is one way of mitigating the unintended consequences of choosing a low-capital legal structure. Entrepreneurs should consider the prevalent banking landscape in their regions; in areas dominated by smaller banks, the legal form choice is especially crucial. For policymakers, the implications are clear. Regulations regarding firm incorporation can unintentionally impact startups' access to external funding, potentially stifling growth. Understanding these dynamics when formulating policies that shape the entrepreneurial landscape is essential

Mandatory financial information disclosure and credit ratings

When firms are forced to publicly disclose financial information, credit rating agencies are supposed to improve their risk assessments. Theory predicts such an information quality effect but also an adverse reputational concerns effect because credit analysts may become increasingly concerned about alleged rating failures. We empirically examine these predictions using a large scale quasi-natural experiment in Germany, where firms were required to publicly disclose annual financial statements. Consistent with the reputational concern hypothesis, we find an average increase in credit rating downgrades that is entirely driven by changes in the discretionary assessment of the credit analysts rather than changes in firm fundamentals. Analysts tend to give positive private information a lower weight in their risk assessment, while they put a higher weight on negative public information. A last set of results indicate that professional credit providers understand that the resulting downgrades are not warranted, while unsophisticated lenders did indeed reduce the provision of trade credit in response to the rating downgrades

Disclosure and financial reporting regulation.

Recent events have spurred the debate about financial reporting and disclosure regulations around the world. International financial crises and corporate scandals brought ever greater reporting and disclosure requirements. The Asian Financial Crisis of 1997, the Enron debacle in the U.S., and the recent credit market crisis are only a few examples. Only in Europe millions of firms are forced to disclose financial information each year. Despite the claimed importance of corporate transparency, there is limited research on the costs and benefits of financial reporting and disclosure regulation. Most of the literature focuses on voluntary disclosures of financial information of U.S. publicly listed firms. While these studies provide important insights into the private benefits associated with voluntary reporting, the costs and benefits of mandatory information disclosures are still unknown, particularly for non-listed privately held firms. The proposed research aims to close these gaps in the literature. Drawing on insights from theoretical and empirical studies from accounting, economics, finance and law, we will examine firm-specific as well as macro-level costs and benefits of private firms’ forced disclosure activities (e.g. credit ratings, productivity). Our comprehensive empirical analysis of these questions should prove useful to researchers, as well as standard setters, policy makers, and regulators, debating the economic consequences of past and future regulatory choices.nrpages: 140status: publishe

International Financial Reporting Standards and Private Firms’ Access to Bank Loans

Prior research has focused on publicly listed firms when examining the economic consequences of adopting International Financial Reporting Standards (IFRS). This study extends the literature by examining the ability of private firms to attract bank loans through the use of IFRS. Based on firm-level data from 25 countries, we show that private firms that voluntarily use IFRS are associated with a higher propensity to attract debt from foreign banks. We find no such association when examining their relationships with domestic banks. Supplementary analyses show that the results are mainly driven by private firms operating in countries with strong regulatory enforcement. The findings suggest that, conditional on adequate enforcement, the use of IFRS provides useful information for foreign non-relationship banks.nrpages: 48status: publishe

International financial reporting standards and private firms’ access to bank loans

Prior research has focused on publicly listed firms when examining the economic consequences of adopting International Financial Reporting Standards (IFRS). This study extends the literature by examining the ability of private firms to attract bank loans through the use of IFRS. Based on firm-level data from 25 countries, we show that private firms that voluntarily use IFRS are associated with a higher propensity to attract debt from foreign banks. We find no such association when examining their relationships with domestic banks. Supplementary analyses show that the results are mainly driven by private firms operating in countries with strong regulatory enforcement. The findings suggest that, conditional on adequate enforcement, the use of IFRS provides useful information for foreign non-relationship banks.status: publishe

Reporting regulation and corporate innovation

We investigate the impact of reporting regulation on corporate innovation. Exploiting thresholds in Europe’s regulation and a major enforcement reform in Germany, we find that forcing firms to publicly disclose their financial statements discourages innovative activities. Our evidence suggests that reporting regulation has significant real effects by imposing proprietary costs on innovative firms, which in turn diminish their incentives to innovate. At the industry level, positive information spillovers (e.g., to competitors, suppliers, and customers) appear insufficient to compensate the negative direct effect on the prevalence of innovative activity. The spillovers instead appear to concentrate innovation among a few large firms in a given industry. Thus, financial reporting regulation has important aggregate and distributional effects on corporate innovation

Innovatie-inspanningen van de Vlaamse ondernemingen: Kernresultaten van de Europese Innovatievragenlijst van 2013

no isbnedition: 2015status: publishe