Financing Entrepreneurship and the Old‐Boy Network

• Published date: 01 June 2013
• Author: Eren Inci,Simon C. Parker
• DOI: http://doi.org/10.1111/jems.12009
• Date: 01 June 2013

Financing Entrepreneurship and the Old-Boy

Network

EREN INCI

Faculty of Arts and Social Sciences

Sabanci University

Orhanli TuzlaIstanbul Turkey 34956

ereninci@sabanciuniv.edu

SIMON C. PARKER

RichardIveySchoolofBusiness

University of Western Ontario

1151 Richmond St. London Ontario N6A 3K7 Canada

sparker@ivey.uwo.ca

We study entrepreneurs’start-up financing from banks and local financiers. An informal network,

whose membership cannot be observed by outsiders, conveys the good signals it gets about the

hidden types of network entrepreneurs to local financiers, which are then reflected in different

loan terms. We show that there are winners and losers as a result of the network even among

its members. Because all projects have positive net value, it is efficient to finance them even

in the absence of a network. Thus, the formation of the network is inefficient as entrepreneurs

incur networking costs for purely redistributive gains in the form of better loan terms as network

members.

1. Introduction

“Old-boy” networks are informal groupings of individuals who provide favorable re-

ferrals about co-members to third parties such as resource providers. One can think of

many ways that such informal networks arise and perpetuate themselves, through per-

sonal and business interactions. Those outside the network do not enjoy these benefits

and so may be disadvantaged—a well-known criticism of old-boy networks (Taylor,

2000). If informal networks reveal information that would otherwise remain hidden,

there may be far-reaching implications for the nature of equilibria which arise under

asymmetric information, potentially affecting efficiency and welfare (Bac and Inci, 2010).

For example, even some insiders may become disadvantaged in the end.

Informal networks may be formed by many different parties with many different

goals. They are distinct from formal networks (see, Parker, 2008, for an analysis of the

latter) in that they are neither officially recognized nor mandated as organizations in

their own right and that their membership cannot be observed by outsiders. Unlike

formal networks, which may be bound by legal governance structures that encourage

transparency of communication, informal networks face no formal restrictions and may

The authors thank Tom Astebro, Jose Guedes, Peter Thompson, and other participants at the Workshop on

Frontiers in Entrepreneurship Research in Lisbon, and Daniel Spulber (the editor), an anonymous associate

editor, and two anonymous referees for their helpful comments. Any remaining errorsare the responsibility

of the authors.

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 2, Summer 2013, 232–258

Financing Entrepreneurship and the Old-Boy Network 233

be able to convey a richer array of information to third parties. This is precisely the

set-up we study in this paper in the particular context of entrepreneurial finance.

In their historical case study of financing of invention in Cleveland, Ohio during

the second industrial revolution, Lamoreaux et al. (2007) provide a compelling example

of informal networks in the context of entrepreneurial finance. They argue how some

established firms, such as Brush Electric Company, served as a meeting place (i.e.,

a hub) for potential entrepreneurs with promising ideas and local financiers seeking

profitable investment opportunities. These hub firms had close relationships with local

financiers; some of them had former employees working at financial institutions; others

even formed financial institutions by themselves. All these channels were used to help

entrepreneurs in finding cheaper finance for their projects provided that the hub firm

believed that these projects were promising. Because these hub firms had a strong

record of successful commercialization of innovative ideas, they had an informational

advantage over financiers in evaluating start-up projects.1

Keeping the historical case study of Lamoreaux et al. (2007) in mind, we develop a

model comprising two hidden entrepreneurial types who both apply for external finance

and whose risky project returns are ranked by first-order stochastic dominance `

alade

Meza and Webb (1987). Finance is provided either by banks or local financiers: both

issue standard debt contracts. An old-boy network conveys imprecise but informative

signals to local financiers about the hidden types of its network members (which we

call an old-boy mechanism), which are reflected in different loan contract terms. The

network is initially exogenous and we ask a fundamental question: do all network

entrepreneurs actually benefit from being members of the network? The answer turns

out to be a qualified “yes”: high-type entrepreneurs always benefit (since it enables

high types to signal their quality), but low-type entrepreneurs only do so (i) if the

network signals are not sufficiently informative, (ii) if the network is small in terms

of number of members, (iii) if there are relatively few high-type entrepreneurs in the

economy.

The intuition for these results goes as follows: The cross-subsidization induced

by the contractual structure of the credit market results in undervaluation of the

start-ups of high-type entrepreneurs and overvaluation of the start-ups of low-type

entrepreneurs. The old-boy mechanism alters the degrees of under- and overvalua-

tions in the market. High-type entrepreneurs are always better off with the old-boy

mechanism because signals are informative and thus they are more likely to be cor-

rectly identified by the network, in which case they are offered lower lending interest

rates.

The situation is different for low-type entrepreneurs, who always want to mimic

their high-type counterparts. All else equal, they prefer the old-boy mechanism when the

network signals are not sufficiently informative so that they can have a higher chance of

not being correctly identified. All else equal, they also want to be in a smaller network,

because their payoff is the same regardless of the size of the network if they are not

correctly identified, but if they are correctly identified and left out of the network, the

fraction of high-type entrepreneurs will be relatively larger outside the network when

the network is small and they have positive externalities on the loan prices offered to

1. Although there can be different interpretations of the informal network we have in the model, we shall

stick to this motivational example throughoutthe paper for conceptual consistency. One could adapt the model

to other kinds of “informal” entrepreneurial networks with some modifications on the contractual structures

among the three parties (i.e., network owner, network members, and financiers), but the basic negative effect

of an informal network that we focus on in this paper will still be there and thus it is general.