The signaling value of legal form in entrepreneurial debt financing

Abstract

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.