Tutorial 4: Capital Structure of Startups

Question 1

Why is equity preferably used in startup financing?

Answer 1

• Information asymmetries between principal and agent may lead to moral hazard issues. Solution: equity aligns incentives and guarantees control for investor.
• Large amount of debt creates incentive problems on its own:
  
  • Risk shifting problem: incentive to invest in inefficient high risk projects -> gambling with investor’s capital
  • Debt overhang problem: lack of incentive to improve the company