Collateralisation, interest rates and signalling in entrepreneurial finance
Berger and Udell (1990) made an important distinction between sorting-byobserved- risk (SBOR) and sorting-by-private-information (SBPI) as responses to asymmetric information in financing entrepreneurial ventures. The current research seeks not to distinguish, but to integrate, these responses in what is called Signalling and Self-Selection (SASS) model. By developing Bester’s (1985) model, the SASS model is one in which the type (high or low) of the entrepreneur is private information known only to the entrepreneur and the bank offers a menu of contracts as a self-selection mechanism. The SASS model proposes that high-type entrepreneurs, who have a high probability of success and high project returns, are more likely to choose a contract with high collateral but low interest rate. Low-type entrepreneurs, who have a low probability of success and low project returns, are more likely to choose a contract with low collateral but high interest rate. The SASS model predicts that the arrangement and choice of debt contracts is influenced by loan characteristics, signals transferred by entrepreneurs and the relationship between the entrepreneur and the bank. The 1998 U.S. Survey of Small Business Finances is used to empirically test the hypotheses derived from the SASS model. This research includes, for the first time, many personal characteristics of the entrepreneur in regressions seeking to explain collateralisation and interest rates. The empirical results imply that both the signalling process and the self-selection mechanism influence the outcome of entrepreneurial debt finance, which in turn depends on the scale of asymmetric information. Less risky entrepreneurs are more likely to pledge collateral, suggesting that private information strongly influences the collateralisation decision. It also seems that the signals of the entrepreneur are as important as the signals of the business, since entrepreneurs with ‘good’ signals enjoy more favourable contracts than those with ‘bad’ signals. The evidence from this thesis emphasises that there are considerable returns to the ‘good’ entrepreneur, in conditions of asymmetric information, in signalling her ability to the lender. Moreover, it also finds that relationship lending significantly reduces the interest rates charged on loans. Another contribution of this research is that, by investigating discouraged borrowers, it empirically examines the degree of problem of information asymmetries in small business financial markets, on which the above hypotheses tests are based. This research, for the first time, reports evidence that information asymmetries influence the discouragement of high-risk and low-risk small business from applying external finance in opposite directions. It also suggests that small business financial markets are informationally efficient because bad borrowers are more likely to be discouraged by symmetric information than good borrowers by asymmetric information.