Recently, the relevance of patents for access to external financial resources has been analyzed by Engel and Keilbach (2007), who found that those firms with a higher number of patent applications (size corrected) have a higher probability of obtaining venture capital. Previous studies in the same manner have been restricted to analyzing how existing, incumbent firms are subject to financing constraints. In this study, the focus is on nascent entrepreneurs as financing constraints have the greatest impact on deterring potential entrepreneurs from even starting a new firm.
How can external finance be obtained? Financial signaling theory has suggested that profits and assets can be used as signals to gain finance. But nascent entrepreneurs do not yet earn profits or have very less assets. What they often possessis innovative ideas and intellectual property rights like patents. From a law perspective, patents can serve as signals. Long (2002) shows that patents serve as a signal and patentees use patents for acquiring future benefits rather than only excluding others from accessing their intellectual property (I.P). Patents are primarily information
transfer mechanisms (Horstmann et al., 1985) because they convey information about both the invention and the firm. In this manner, appropriability signals potential investors to anticipate the true value of an innovation. Therefore, the signal through patent acts in the mode of information and characteristic about the firm.
If patents are used to convey information to uninformed potential investors, then at the same time valuable information is also being leaked out to competitors. Bhattacharya and Ritter (1983) call this the “feedback effect equilibrium” for which they suggest using partial disclosure or strategic disclosure as a remedy. There are
mainly two reasons why informed agents always find alternatives to safeguard their secrets (while informing potential investors). First, the learning effect, where agents learn about leakage problems and try to find alternatives. The second reason is that when informed agents realize that the same kind of signal is being used by many,
they search for other, more unique signals that they can send to stand out. Therefore, when such “signal search” happens, we can assume that always new signals are emerging in the process.
While appropriability indicates the characteristics and information about the agent, feasibility of the project particularly acts as a signal for the ability of the agent. One indicator of feasibility is the development of a prototype. Prototyping is a crucial step in the commercialization process. Prototyping increases the scope and
scale of appropriability by enabling the agent to benefit from subsequent intellectual property rights, such as design rights (on the prototype and production designs), copyrights and trademarks, etc. Therefore, the expected benefit from investing in a start-up having prototypes tends to be high for investors, thus increasing the probability
of the agent to obtain external finance. Feasibility via prototyping can also signal higher ability and therefore a higher likelihood of obtaining external funding, mainly from investors who want to be part of the start-up and be involved at every stage. This tends to be most relevant in the case of nascent entrepreneurs confronting the most severe credit rationing, as well as information asymmetry problems. A nascent entrepreneur who can signal both appropriability and feasibility therefore has an advantage in terms of obtaining external finance
We portray our arguments using a simple signaling model to show that having both patents and prototypes sends a stronger signal to investors than having only patents or prototypes. We build a dataset from the USA, called the Innovative Nascent Entrepreneurs Database (INED); a novel dataset where we identify over 900 individuals who are in the process of starting a new business or have just started, along with their financing information. Another novelty in this database is that unlike other existing databases, it provides us with information on development of prototypes and patent ownership. Although we are unable to track these individuals, our dataset allows us to distinguish between nascent entrepreneurs who are planning to start a business and those in the very early start-up stage. After estimating our equations using multinomialmethods and several robustness checks, we find that the empirical results support our arguments. The results suggest that nascent entrepreneurs who possess patents as well as prototypes have a higher probability of obtaining equity finance from business angels and venture capitalists. However, we find that the signal matters to investors only if the nascent entrepreneurs are in the early stage of the start-up rather than in the planning stage. Bank finance, however, does not seem to value any of the signals and is based only on collateral.