Why are innovative nascent entrepreneurs financially constrained? This involves three main factors. The first factor is information asymmetries, which arise if the firm has better information about the returns occurring from their investment in intangible assets than do potential investors. Hence, “external finance may be expensive, if available at all, because of adverse selection and moral hazard problems” (Carpenter & Petersen, 2002, p.F56). It is likely that information asymmetries are higher for nascent entrepreneurs who do not have any established track record.
The second factor involves the fundamental uncertainty inherent in knowledge and new ideas. As Arrow (1962) pointed out, this uncertainty characterizes the relationship between innovative efforts, or inputs into the innovation process, and their resulting outcomes. New knowledge is intrinsically uncertain in its potential economic value (Arrow, 1962). Thus, “the challenge to decision making is ignorance, the fact that nobody really knows anything” (O’Sullivan, 2006, p.257), or at least, anything for sure. So the degree of uncertainty inherent in the innovative process renders the decisions by potential investors to be based on subjective judgments, which may or may not coincide with the assessment by the nascent entrepreneur. This implies that innovative activity may be burdened with difficulties in obtaining finance, even at the prevailing market interest rates. While this problem exists for all firms per se, one can argue that in the case of nascent entrepreneurs, potential investors tread their path extra carefully and many times abstain from investing in the seed stage itself. Moreover, nascent entrepreneurs, due to inexperience, may not qualify for finance through the subjective judgments/heuristics commonly used by the investors
The third factor, also pointed out by Arrow (1962), involves the propensity for knowledge to exhibit, at least partly, characteristics and properties of a public good, that is, it is nonexcludable and nonrival in use. Thus, to fully appropriate investments in innovative activity, the associated intellectual property must be protected through some regime such as patents, copyrights, or secrecy. If knowledge spills over to other firms, the benefits accruing from innovation cannot be fully appropriated by the innovating firm.
Taken together, uncertainty, knowledge asymmetries, and the potential nonexclusive nature of investments in intangible assets make it difficult to evaluate the expected value of an innovative firm, especially of an innovative nascent firm (Audretsch & Weigand, 2005).
While problems with innovation are universal, one may therefore ask the question, “why consider nascent entrepreneurs?” In recent years, a number of empirical studies have investigated external financing of innovative firms. However, most of these studies have been based on financing innovative activity in incumbent firms that already exist (Hall, 2002). While existing firms have at least some history, nascent entrepreneurs are people who have not even founded a new firm, and in some sense can be placed to the left of zero of the firm-age distribution and at zero for the firm size distribution. These conditions that are strongly associated with nascent entrepreneurship should exceed those for a new venture that is actually launched and a startup subsequently matures over its life cycle. Thus, nascent entrepreneurs would be expected to face financing constraints at least as great, but presumably even greater, than do new ventures.