Who would buy a second-hand car without examining it? Who would have purchased a Hyundai Excel in the US in the 90’s ? Which investor would purchase a business without knowing it inside out? Why investors buy presale making loss companies stock? Why profitable companies distribute dividends?
Asymmetric Information and Signal examples
All the above relates to the so-called asymmetric information where one party has more or better information than the other when taking decisions. The imperfect information causes an imbalance of power and the market fails: the selling/purchasing transaction simply does not happen. The informed agent needs to reveal, “Signal” the information to the other interested party to bridge the gap and close the transaction.
Car Dealer Market
Suppose purchasers in the used-car market value good cars—“peaches”—at $1,000 and malfunctioning used car—“lemon”—at solely $500.
In a perfect world, buyers can spot lemons and peaches apart and trade in both will flourish, however, buyers might struggle to tell the difference: scratches can be touched up, engine problems left undisclosed.
To account for the risk that a car may be a lemon, buyers cut their offers to an average price of $750, but the peach dealers will reject such an offer. Sellers of lemons end up to gain the market and peaches stay in the garage.
Hyundai Car Back in the 90’s was perceived as a low-quality car and its reputation in the US market was bad: You can double the Hyundai Excel price filling up with gas. The companies knew that the quality was there and they end up offering the 10 yrs / 100 000 km warranty. This was a strong (true) signal that rebounded the sales.
Dividends as signalling, a way of communication.
The theory of signalling can also help to explain why companies pay dividends, although they are less tax-efficient than share-price rises in compensating investors.
Signalling solves the enigma: paying a dividend is a sign of strength, showing that a firm feels no need to hoard cash.
A reduction in the dividend per share reveals that the company is in financial difficulties, a failure to pay out any dividend indicates that the company is in financial distress.
A company with a lengthy history of dividend increases is signalling to the marketplace its management and board see profits within the future. Dividends are not increased unless the board is certain the cost can be sustained.
Why an investor would buy stock of an early stage presale going public business?
In modern Economy investors focus their attention more on what the business can deliver than where it stands now (Leland and Pyle). The Pipeline, R&D and the quality of the team signals a bright future and good perspectives. The investors are averse to invest without adequate information and in absence of effective communication the IPO fails and stock price drops.
Is your business case signalled correctly?
As I always use to say to my clients, the financial market is highly competitive. There is lots of money available but there are many leads too. My client’s business case is not the only one in the arena and the competitors may introduce lots of noise (disinformation) around: the risk is that peach won’t find a serious investor, or will be valued as a lemon. The client loses its time, and most likely its business image will be endangered.
Form vs Content the 80:20 rule.
Communicating to investors needs effort and it is a work by itself. This is a process that must result in a business plan and in accurate business projections.
There is a prolific school of thought, that recons no utility in the planning and budgeting process especially in erratic periods. Provided that there is low likelihood to hit the projections, better not to produce the budget and save the time and costs. In my opinion the more the environment is unstable the more budgeting and planning becomes key to success. In an unstable environment the company certainly needs to draw a possible scenario, a reference to follow, to evaluate the deviations of the actual results over the projection (backward view) and take actions to recover (forward view).
Without a planning process the company is basically blind and does not have any reference to compare and consequently no concrete messages to provide to investors, unable to answer to its basic questions: Are we following the right path? Are we executing and generating the right level of cash and profit?
There are several barriers to effective communication making noise. The signal is the wanted part of the message, the noise is the miscommunication the unwanted part that must be eliminated. The sender has omitted necessary information, he is using jargon, he is sending an excessive amount of information. For a communication to be high in quality, signal to noise ratio should be a high value.
Investees needs to prepare investor ready documents: a relevant set of consistent documents and ready to be used. Effective communication means minimize the noise in the introduction process, choosing the right document at the right moment and being effective in signalling the corresponding business case.
As a rule of thumb 80% of the time is dedicated to preparation and 20% to execution.
The ethical aspect of signalling and the market correction.
There is an ethical aspect of signalling, the information provided needs to be accurate and given in good faith. Signalling create expectations and if the investee do not deliver the expected results the market will adjust sharply.
Mario d’Aragona is a seasoned finance executive, who serves as CFO for fire & security, food, energy and clean-tech global companies. He has turn-around experience and managed to re-finance growing businesses. Mario is the Managing Partner at TML Venture Ltd. and supports companies in finding tailor-made investment solutions.