Start-Up Financing: Outside Equity

We investigate the extent to which start-ups use outside equity, and interpret our results in relation to financial contracting theory. We do so by studying the start-up and founder characteristics that are associated with the use of outside equity financing, using a unique dataset from Norway. Our findings suggest that adverse selection are less of a concern for start-ups than ex-post opportunistic behavior (risk shifting) by the entrepreneur as in Myers (1977) and Ravid & Spiegler (1997). One implication of this finding is that outside equity and debt are complements rather than substitutes, and that an extra unit of equity financing has a multiplicative effect on total financing through releasing additional debt financing. We do not find convincing evidence that the use of outside equity has detrimental effects on entrepreneurial effort, nor that a possible shortage of available outside equity leads to investor monopolization and excessive investor returns. Thus we provide evidence that outside equity provides an important avenue for entrepreneurs to escape liquidity constraints.