Business

What is hot and cold fundraising?

Pavel Zryumov
Professor of finance, Wharton

This article is published in collaboration with Knowledge@Wharton.

It’s the ultimate financial conundrum for entrepreneurs: They need money in order to make money. Investment is key to growing a fledgling business, but it can also be one of the toughest components to secure. In “Dynamic Adverse Selection: Time Varying Market Conditions and Endogenous Entry,”Pavel Zryumov, a Wharton professor of finance, explores the fundraising process in both hot and cold markets, finding that in cold market conditions, entrepreneurs and firms with projects above the average quality strategically delay their fundraising decisions.

An edited transcript of the conversation appears below.

Crucial to Growth

Firms reach out to external financial markets for additional capital throughout their life cycles. At the very early stage, it is venture capitalists that provide both guidance and capital to young entrepreneurs. At the later stage, big private equity firms and public markets provide additional financing for the more mature firms.

External financing is crucial for the firm’s growth. It allows financially constrained entrepreneurs to develop and later bring their new ideas to the market. It also allows public mature companies to invest in new and profitable projects. However, external financing is costly. Usually, the problem is known as adverse selection. In short, investors are willing to provide financing on terms that reflect expected or the average firm quality. This implies that issuances of firms that are better than average might be underpriced. This problem is particularly pronounced for firms that either have no history of cash flows or no tangible assets, such as start-ups at the very early stage of development.

Entrepreneurs, on the other hand, have better information about both their own abilities and the quality of these ideas. This makes the market for venture capital financing a great laboratory for analyzing adverse selection. In my research, I ask the question, how does the quality of projects that receive financing, and the liquidity in this funding market, respond to the exogenous changes in the cost of investor’s capital? In other words, I analyze how the projects that raise funds in hot markets are different from those that raise funds in cold markets, and how the fundraiser process itself differs across the two market conditions.

Strategic Delays

The key takeaway is that in cold market conditions, entrepreneurs and firms with projects above the average quality strategically delay their fundraising decisions Twitter . This delay serves as an informative signal for investors and allows the companies to secure better terms of financing at a later date. The worst-quality firms, on the other hand, prefer to raise funds earlier, albeit at less attractive prices. In contrast, in the hot market conditions, both high- and low-quality firms raise funds immediately, regardless of the quality. This pooling of high and low firms together results in the overpricing of the latter and attracts more low-quality firms to the market.

Another interesting finding of this research is that firms and entrepreneurs strongly react to changes in the investment conditions. For example, a decline in the investor’s cost of capital decreases the incentives of entrepreneurs to strategically delay their fundraising and signal their type. This triggers a wave of high-quality deals at the onset of hot markets.

In the public debate about the optimal size of, say, the venture capital industry, the most popular arguments tend to focus on the negative consequences of the hot market conditions— namely, millions of dollars spent on unprofitable ventures. My research shows that, indeed, tighter market conditions do deter some entrepreneurs with low-quality projects from entering the market. However, they also create disturbances at the higher end of the quality. Namely, it is the entrepreneurs and the firms with very high-quality projects that delay their fundraiser or even forgo the projects altogether. Thus, any policy aiming at regulating such markets has to take into account both inefficiencies rising in the cold and hot markets at the same time.

Regulating Market Inefficiencies

The most natural follow-up to my research on capital markets with adverse selection is to directly analyze possible policy regulations aiming to reduce inefficiencies in these markets. A theoretical model allows me not only to analyze the direct consequences of such policies but also to take into account the unintended consequences that arise from the equilibrium response of market participants on such regulations.

Another interesting venue would be to think deeper about designing strategic information environments, instead of taking them as given. For example, one can think about the stress tests of banks as additional information that regulators provide to the public and to the market participants in order to affect their beliefs about the stability of the financial system. The natural questions here concern the structure of such signals and the optimal timing of those.

Publication does not imply endorsement of views by the World Economic Forum.

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Author: Pavel Zryumov is a Wharton professor of finance.

Image: U.S. dollar notes are seen in this picture. REUTERS/Nicky Loh 

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