Formal debt financing is the most important source of external financing for startups. But creditors face information gaps, as startups lack a proven track record. Felix Bracht, Jeroen Mahieu and Steven Vanhaverbeke argue that credit providers use a startup’s legal form choice to infer its default risk. Empirical evidence shows that choosing a legal form with low minimum capital requirements signals higher default risk resulting in lower access to debt financing.

For startups, debt financing is a crucial source of external financing. Not only is it less costly after tax than equity financing, but it also does not require giving up ownership control. However, many startups face challenges obtaining external debt financing due to the lack of a track record of performance and informational opacity.

To address this challenge, startups need to effectively signal their risk of defaulting on a loan allowing lenders to separate between high- and low-quality borrowers. Previous studies have identified several signals that can help, including the composition of the founding team, intellectual property, and partnerships with third parties. However, these signals are not available to all new ventures. We argue that entrepreneurs can make use of a different signal which is available to all new ventures, namely, the choice of legal form at startup.

The signaling value of legal forms

Selecting a legal form is a highly visible and important choice that all new business owners must make at the start of their venture. An important distinction between different types of legal forms is the amount of paid-in capital that is required to found a company. This is a crucial aspect because founders are liable for the amount of paid-in capital in case of bankruptcy.

We argue that choosing a legal form with high minimum paid-in capital requirements signals that a venture will be less likely to default on a loan. This is because entrepreneurs who expect a higher chance of default will likely avoid selecting a legal form with high minimum capital requirements, as they remain accountable for the paid-in capital amount in case of bankruptcy. Additionally, high-risk entrepreneurs may face greater opportunity costs when starting a high-capital company as they may forego alternative, safer investment opportunities. Furthermore, the risk of damaging one’s reputation and facing potential stigma from failing may push high-risk entrepreneurs to choose a low-capital legal form rather than a high-capital one.

Importantly, we propose that the legal form choice has signalling value beyond the amount of paid-in capital. This implies that, even if two startups possess the same amount of equity and share other firm and founder characteristics, the one with a low-capital legal form has more difficulty attracting external funding. Given that the legal form choice is likely only a weak signal for predicting credit risk, some firms might get disproportionally negatively affected by their legal form choice if credit providers use the legal form as a screening device.

In a recent study, we provide empirical evidence supporting our hypotheses using rich administrative and survey data for a sample of German firms. Since 2008, entrepreneurs in Germany can choose a new type of legal form when establishing a limited liability company (LLC), the “Unternehmergesellschaft (haftungsbeschränkt) – UG”. This new legal form is commonly referred to as the “low-capital LLC”. It is similar in almost all dimensions to the regular high-capital LLC, the “Gesellschaft mit beschränkter Haftung – GmbH”. However, the low-capital alternative does not require the regular minimum paid-in capital of 25,000 euros at startup. Instead, entrepreneurs can choose any amount between 1 euro and 24,999 euro to set up a low-capital LLC. Because firms are required to put the legal form suffix at the end of the company name (“UG” vs. “GmbH”), outside investors can easily infer their type.

Results

Our empirical results show that low-capital LLCs tend to receive less debt and are more likely to face financial constraints than their high-capital counterparts. That happens even after controlling for a wide set of firm and founder characteristics that influence the quality of the firm and the likelihood of choosing a high and low capital LLC legal form (characteristics such as the difference in capital and founder educational level, among others). These findings support our signalling explanation but are inconsistent with the idea that low-capital LLCs have a lower demand for external funding.

Relationship vs. transactional banks

In addition, the relation between legal form and access to outside debt can be stronger in the case of small relationship lenders. Large transactional lenders benefit more from technological advances and deregulation, which provide them with other reliable instruments to assess creditors’ default risk. Therefore, large lenders are less likely to rely on a startup’s legal form as a signal of quality. Consistent with this idea, our empirical results show that in regions with a higher share of small relationship banks, low-capital LLCs obtain less debt. Moreover, we find that in these regions low-capital LLCs are more likely to indicate that they are financially constrained. Taken together, these results support the idea that especially smaller credit providers limit the supply of debt to low-capital LLCs due to concerns about their default risk.

Conclusion

Our findings have implications for nascent entrepreneurs and policymakers. The choice of a firm’s legal form can serve as a mechanism for entrepreneurs to communicate their quality to outside investors and mitigate the liability of newness. This strategy will be most useful when applying for credit at small relationship banks. Furthermore, several scholars have pointed out that countries with low regulatory requirements have attracted a substantial number of new businesses, causing regulatory competition among countries. (Over the last two decades, more than 100 countries have lowered the minimum capital requirements to set up a limited liability company (LLC). Many countries such as in Croatia, Denmark, Germany and Luxembourg did so by allowing entrepreneurs to choose a new type of legal form that has the same perks and benefits as a regular LLC, but with no statutory minimum capital . The goal of these legislative changes was to spur entrepreneurship. However, as an unintended consequence, entrepreneurs that opted for a LLC with less paid-in capital might face increased financing constraints.

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Notes:

• This blog post is based on The signaling value of legal form in debt financing, LSE’s Centre for Economic Performance (CEP), Discussion Paper no. 1914
• The post represents the views of the author(s), not the position of LSE Business Review or the London School of Economics.
• Featured image by Cytonn Photography on Unsplash
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