Abstract

Entrepreneurs seek venture capital support not only for financial support; but also since the backing of VCs is a quality signal to the market. In this paper, we aim to draw from signaling theory to shed light into how the early termination of investment in an entrepreneurial venture by an existing investor conveys a negative signal, resulting in a “side-effect”. We argue the side effect is a consequence of the presence of information asymmetry in entrepreneurial financing. Information asymmetry is a prevalent feature of entrepreneurial financing since entrepreneurial ventures have a short track record of performance and lack legitimacy. We find that the decision of potential investors is adversely affected if an investor gives up funding the subsequent rounds of financing, furthering adverse selection problems.

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