Entrepreneurial Finance and Innovation: Informal Debt as an Empirical Case

• Date: 01 September 2016
• Author: Xiaobo Wu,Jie Wu,Steven Si,
• Published date: 01 September 2016
• DOI: http://doi.org/10.1002/sej.1214

ENTREPRENEURIAL FINANCE AND INNOVATION:

INFORMAL DEBT AS AN EMPIRICAL CASE

JIE WU,

1

STEVEN SI,

2,3

* and XIAOBO WU

2

1

University of Macau, College of Business, Macau, China

2

Zhejiang University, School of Management, Hangzhou, China

3

Bloomsburg University of Pennsylvania, College of Business,Bloomsburg,

Pennsylvania, U.S.A.

Research Summary: Drawing on entrepreneurial finance theory, we examine the trade-

offs among different sources of capital for entrepreneurial firms in emerging economies

and their impact oninnovation. In emerging economies,one of the unique aspects of firm

financing is the presence of informal capital, as many formal sources of capital for new

entrepreneurs have more constrained access than is the case in mature economies. We

suspect that informal debt has an important effect on innovation, and this effect is

contingent on the accessibility of formal debt and institutional development. The

hypotheses are tested using survey data from 3,235 entrepreneurs in an emerging

economy, China.

Managerial Summary: This study demonstrates an inverted U-shaped relationship

between the levelof informal debt and entrepreneurial ventures’innovationperformance.

The value of informal debt for promoting innovation was found to be weaker for firms

having little or no access to often less expensive institutional finance, whereas a better-

developed institutional environment strengthens the effects of informal debt. Copyright

© 2016 Strategic Management Society.

INTRODUCTION

New businesses and smallventures have increasingly

become an important and indispensable element of

emerging economic systems, given their roles in

employment growth, competition, and innovation.

However, entrepreneurs usually have insufficient

resources to fund their new ventures from internal

sources and must seek finance from external sources.

Furthermore, how entrepreneurial firms receive external

funding is one of the most fundamental questions for

research on entrepreneurship in emerging economies

(Cassar, 2004). The literature on entrepreneurial finance

has recognized that capital decisions about which

financing sources to use can have important implication

for the operations of a business, including risk of failure,

firm performance, and sustainable development (Denis,

2004; Hall, Daneke, and Lenox, 2010; Sirmon, Hitt,

and Ireland, 2007).

Although the literature on entrepreneurial finance

has grown substantially over the past decade

(e.g., De Bettignies and Brander, 2007; Chemmanur

and Fulghieri, 2014; Denis, 2004; Zhang, 2014),

two important deficiencies remain. Previous research

on entrepreneurial finance has centered on the

question of the trade-offs among different sources of

capital for entrepreneurial firms; but, this question

has been examined, so far, primarily as the trade-offs

associated with outright formal debt versus equity

funding. Very little has been published on the trade-

offs associated with formal versus informal funding.

Formal sources include capital frominstitutions, such

Keywords: entrepreneurial finance; informal debt; innovation;

institutionaldevelopment; emerging markets

*Correspondence to: Steven Si, Zhejiang University, 866

Yuhangdang Rd., Hangzhou, Zhejiang China. E-mail:

ssi@bloomu.edu

Strategic Entrepreneurship Journal

Strat. EntrepreneurshipJ.,10:257–273 (2016)

Published online 4 May 2016 in Wiley OnlineLibrary (wileyonlinelibrary.com). DOI: 10.1002/sej

Copyright© 2016 Strategic Management Society

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as banks and credit unions, or from government or

nongovernmental (NGOs) organizations, such as the

post office, whereas informal sources include capital

from supplier credit, customer prepayments, personal

savings, or gifts from family or friends. Informal

finance has emerged as a popular source of finance

in many emerging economies (Bruton, Khavul, and

Chavez, 2011). There is a need, however, for greater

examination of informal finance (Webb et al., 2013).

The second deficiency related to studies on

entrepreneurship and entrepreneurial finance is the

topic of innovation. Van de Ven (1986) defined

innovation as the development and implementation

of new ideas by people who over time engage in

transactions with others within an institutional order.

Innovation factors are largely related to key

entrepreneurial issues, such as the generation or

adoption of new ideas, entrepreneurial behaviors,

transactions, and refinements of the institutional

context. Recent studies (e.g., Christensen and Raynor

2003; Li and Si, 2007; Wright et al., 2005; Bruton

et al., 2013; Si, 2015) have also reported that there

are a variety of interactive relationships between

innovationandentrepreneurshipinbothmatureand

emerging economies. Entrepreneurs commonly

recognize opportunities that can be discovered or

created (e.g., Suddaby, Bruton and Si, 2015). Such

entrepreneurial opportunities are often found or

created in markets where only innovation, or

innovative products and services have the potential

to address unsatisfied customer needs (e.g., Suddaby,

Bruton, and Si, 2015; Burgelman and Hitt, 2007;

Christensen and Raynor, 2003). To capture the value

from opportunities newly recognized, entrepreneurs

identify or create inventions and commercialize them

as parts of new productsand services, thereby creating

innovations in the marketplace (Burgelman and Hitt,

2007). Often, innovations need to be put in place as

soon as possible, so speed becomes an important

factor in bringing an innovation to market. In this

manner, innovation is in the context of entrepreneurship

and is a primary way for entrepreneurs to create value

and exploit entrepreneurial opportunities (Li and Si,

2007; Suddaby, Bruton, and Si, 2015).

This study will address these issues. Specifically,

we bring informal debt into the discussion of

entrepreneurial finance and examine how the various

financial options can impact the success of

entrepreneurs in emerging economies. As noted

earlier, to takeadvantage of an opportunity discovered

or created, entrepreneurs need to engage in

innovations—creating new products and services in

the marketplace and appropriating value from them

(Suddaby, Bruton,and Si, 2015). Innovation typically

requires enormous investments,so entrepreneurs must

acquire the requisite financial resources to exploit

them. However, entrepreneurs often face financial

constraints and experience difficulty in quickly

obtaining working capital from formal financing

channels (Ebbenand Johnson, 2006). Suchconditions

are particularly critical for entrepreneurs in emerging

markets where financial markets are underdeveloped

and alternatives for capital are limited. For these

reasons, entrepreneurs often are forced to rely on

informal debt to deal with the financial needs of

innovation. In this study, we suspect that informal

debt has an important effect on innovation, and this

effect is contingent on the accessibility of formal debt

andthecontextprovidedbyacountry’s instituti onal

development. We test our hypotheses by using the

data garnered from a large sample of 3,235

entrepreneurs in China, examining their sources of

financing and the role of innovation in their ventures.

This study makes several contributions to the

literature. First, we contribute to the understanding

of the theory of entrepreneurial finance by exploring

the trade-offs among various sources of capital for

entrepreneurial firms and their implications for the

key variable of innovation, which has not yet

adequately served as the focus of serious studies. We

emphasize innovation-based entrepreneurial activities

in emerging economies that center on product/service

innovation with the considerable uncertainties of risk

balanced against the potential for high growth. We

focus our discussion on the trade-offs of formal and

informal funding on innovation performance in

entrepreneurial ventures. Second, we deepen the

understanding of entrepreneurial finance by

examining informaldebt, a topic that largely has been

ignored. Third, we advance scholarly understanding

of entrepreneurship in its relationship to the use of

informal capital in emerging economies.

THEORY AND HYPOTHESES

Sources of capital

There are numerous trade-offs to consider as

entrepreneurs choose the means by which to build up

the capital structure of each venture. Scholars have

typically focused on issues of entrepreneurial trade-

258 J. Wu, S. Si, and X. Wu

Copyright© 2016 Strategic ManagementSociety Strat. Entrepreneurship J.,10:257–273(2016)

DOI: 10.1002/sej