Early-stage entrepreneurial financing: A signaling perspective

We analyze an entrepreneur's choice between angel and venture capital (VC) financing in a competitive investment market, where the entrepreneur seeks to maintain his ownership share as well as equity value. The key to our analysis is the idea that a negative signal is inferred by the market if an inside investor chooses not to follow on a subsequent investment. We first show that when ventures are ex-ante identical, entrepreneurs retain higher ownership shares by financing with angel investors who commit to not participate in a future round. When entrepreneurs are ex-ante heterogeneous, there is a separating equilibrium where entrepreneurs with higher (lower) likelihoods of success choose VC financing (angel financing) in the first round.