You are Known by the Directors You Keep: Reputable Directors as a Signaling Mechanism for Young Firms

Abstract

In this paper, we develop an analytical model of outside directors' signaling role—a role that is especially important for entrepreneurial firms. We formally demonstrate that in the face of a market failure in which stakeholders refuse to align themselves with new firms, high-quality new ventures may be able to credibly signal their type by appointing reputable directors to their boards. However, this option is not universally feasible. Both directors' reputations and the quality of their information determine the effectiveness of this strategy. In contrast to earlier adverse selection models, we demonstrate that when the middlemen (directors) have incomplete information on firm quality, bad and good firms can coexist in equilibrium. In this equilibrium, the quality of the directors' information determines the mix of good and bad firms in the population of surviving firms. Avenues for future research and normative implications for practitioners are discussed.

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