3. Pecking Order Theory

We have seen before that asymmetric information could be an important consideration in the debt-equity choice. In particular, in the presence of asymmetric information, firms might refrain from issuing equity because of the negative signal it sends to the market.

This is the basic idea behind the so-called Pecking-Order Theory of financing, which was developed by Gordon Donaldson in the early 1960ies and modified by Myers and Majluf in 1984.

The theory states that the cost of financing increases with asymmetric information. Of the three sources of funding that we have considered at the beginning of this module (internal funds, debt, and equity), internal financing have the lowest asymmetric information whereas equity has the highest asymmetric information.

Firms therefore have a pecking order when financing projects, according to which they

  • first use internal funds (retained earnings)
  • When internal funds are depleted, they switch to external funds
  • with external financing, they first issue debt
  • only when the firm has reached its debt capacity, equity is issued.

 

Consequently, equity financing is a measure of "last resort" according to the theory.

Note that the evidence about the sources and uses of funds that we have presented at the beginning of this module seems to be roughly consistent with the pecking order established above: There, we have seen that (listed) firms rely to a large extent on internal funding. If they tap into external capital market, the typical source of financing is debt, whereas equity financing is almost negligible.

However, while these patterns are consistent with the pecking-order theory, they cannot be interpreted as direct evidence to support the theory. Other phenomena could produce the same results, for example, that listed firms simply do not have that many attractive projects to invest in and therefore have only limited capital needs. Alternatively, it could also be that firms want to avoid ownership (or EPS) dilution and therefore shy away from equity financing. In fact, studies that look at the financing patterns of firms with actual capital needs find only limited support for the pecking-order theory.

Still, asymmetric information and the heterogeneous expectations they bring about play an important role in financing decisions, especially in the context of startup companies. Startups often rely heavily on external financing and they generally do not have access to the traditional debt markets. At the same time, issuing equity could be unattractive to the entrepreneurs because the investors are generally less optimistic about the prospects of the firm than the entrepreneurs (heterogeneous expectations). Consequently, investors put less weight on the upside potential (which is the main source of equity value) and more weight on downside protection (which is the main source of debt value). As we discuss in great detail in the module Deal Structuring, the common solution to these considerations is to attach debt-like elements to equity investments by issuing preferred stock rather than common stock.