Active investors provide entrepreneurs with risk-sharing and value-adding effort, e.g., in form of advising, networking and monitoring. However, holdup problems may create a conflict between two key objectives for high-quality entrepreneurs: to elicit investor effort and to credibly signal their firm type by retaining shares. As a result, pooling of startup firms of different types may arise, in particular when investor effort is essential. More established firms, with access to multiple signals, can always realize both of these objectives. If investor effort is essential, however, to avoid holdup these firms need to deviate from the cost-minimizing signal combination: they will retain fewer shares and instead rely more on other signals, even though the credibility of share retention as a signal increases as investor effort becomes more important. If investor effort is contractible, the cost of signaling to active investors may be greater or less than in otherwise comparable pure-exchange settings; whereas signaling to investors contributing non-contractible actions always causes additional costs. A key departure from earlier studies is that signaling can be welfare-enhancing by guiding investors' effort towards more promising ventures.
Baldenius, Tim, and Xiaojing Meng. "Signaling Firm Value to Active Investors." Review of Accounting Studies 15, no. 3 (2010): 584-619.
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