Research on Entrepreneurial Signals

Venture capital has outperformed for many institutional investors recently. None of this would have been possible, however, if the founders in their portfolio did not take that first step on that arduous, entrepreneurial path long ago.

But what kind of a person would choose to found a startup?

We thus offer and test a novel explanation for entrepreneurship: those who are undervalued by the traditional labor market, reject it and become entrepreneurs. Asymmetric information about ability leads existing firms to employ only “lemons,” relatively unproductive workers. The relatively talented retain the benefits of their superior productivity by choosing entrepreneurship. This implication, that entrepreneurs are, in fact, “cherries” contrasts with a large literature in social science, which casts entrepreneurs as “lemons” – those who either cannot find, cannot hold, or cannot stand real jobs.

Previous research has described entrepreneurs as overconfident, even hubristic. That may be, but we find that entrepreneurs’  higher estimates of their own ability are generally correct, and they earn more for their decision to strike out on their own. Our findings may also explain why several groups with less credible ability signals, such as immigrants, gravitate toward entrepreneurship, and why families and friends are a dominant source of financing for early stage ventures when asymmetric information about entrepreneurs’ quality is greatest.

Asymmetric Information and Entrepreneurship

Steve Blank, author of The Startup Owner’s Manual, summarized it best:

The authors’ research came from following 12,686 people over 30+ years. Here are some of their key findings:

      1. Signaling. When you look for a job you “signal” your ability to employers via a resume with a list of your educational qualifications and work history. Signaling is a fancy academic term to describe how one party (in this case someone who wants a job) credibly conveys information to another party (a potential employer).
      2. Capable. People choose to be entrepreneurs when they feel that they are more capable than what employers can tell from their resume or an interview. So, entrepreneurs start ventures because they can’t signal their worth to potential employers.
      3. Better Pay. Overall, when people choose entrepreneurship they earn 7 percent more than they would have in a corporate job. That’s because in companies pay is usually set by observable signals (your education and experience/work history).
      4. Less Predictable Pay. But the downside of being an entrepreneur is that as a group their pay is more variable — some make less than if they worked at a company, some much more.
      5. Smarter. Entrepreneurs score higher on cognitive ability tests than their educational credentials would predict. And their cognitive ability is higher than those with the same educational and work credentials who choose to work in a company.
      6. Immigrants and Funding. Signaling (or the lack of it) may explain why some groups such as immigrants, with less credible signals to existing companies (unknown schools, no license to practice, unverifiable job history, etc.) tend to gravitate toward entrepreneurship. And why funding from families and friends is a dominant source of financing for early-stage ventures (because friends and family know an entrepreneur’s ability better than any resume can convey).
      7. Education. Entrepreneurs defer getting more formal education because they correctly expect their productivity will be higher than the market can infer from just their educational qualifications. (There are no signals for entrepreneurial skills.)

Why Entrepreneurs Start Companies Rather Than Join Them, Forbes

Nothing gained, nothing ventured.

The view of Washington Square Park from Kimmel Center at NYU.
Twitter @nyuniversity

Post by Marcelino Pantoja