How Entrepreneurs Mitigate the Investor's Adverse Selection Problem : New Evidence from Private Firm Sales

Tests of Leland and Pyle's (1977) signaling model in the public setting face a number of empirical challenges. We revisit the implications of their model with new evidence from a setting in which entrepreneurs sell their firms in private transactions. In this setting, it is common for sellers to provide financing (i.e., seller financing) for the transaction, with sellers providing billions of dollars in subordinated financing each year. We find that seller financing is more common when capital is costly or scarce, and its use decreases when other sources of informed local capital are available. Further, seller financing appears to be a substitute for the reduction of risk associated with government loan guaranties for private firms. When we separately examine high and low information asymmetry firms, our evidence suggests that seller financing is used both to mitigate adverse selection and as an alternate source of capital when debt financing is costly or scarce. Overall, we conclude that seller financing is an important channel through which entrepreneurs mitigate the adverse selection problem faced by buyers in the financing of the transaction