What is Pecking Order Theory?

When raising capital, your enterprise's choices will send signals to the public.

Pecking Order Theory suggests a hierarchical order in which businesses utilize three types of financing: internal funds, debt, and equity to fund investment opportunities.

To fund operations, companies first utilize internal funds, such as earnings. If these funds are low, companies turn to debt, such as loans. Should the company still require funds, it considers equity (for example, selling business shares).

The theory postulates that this method of raising capital is in the company’s best interests, and sends a message to the public about a company’s future. Learn how the Pecking Order Theory signifies a business’s financial state.

Pecking Order Theory and asymmetric information

The Pecking Order Theory begins with asymmetric information. Asymmetric information is a concept used by economists to study decision-making during transactions. It suggests that there can be an imbalance of information during a transaction. For example, the seller of a product may know more about the product and purposefully withhold information that would deter the buyer from making a purchase.

We can consider asymmetric information for products, such as cars (a dealership will likely know more about a used car than the buyer possibly could). We can also apply asymmetrical information to larger products, such as entire companies.

In terms of businesses, asymmetric information affects the choice between internal and external financing. Managers and board members will know more about their company’s risks, prospects, and value than an outside investor, which suggests asymmetric information and a disadvantage (risk) for investors.

Once companies settle on external financing, asymmetric information also impacts the decision to fundraise via debt or equity. While there is asymmetric information between the debt issuer and the company, the company seeking debt over equity is a good sign: it indicates that decision-makers believe in the company’s value and current stock price. Issuing equity could indicate the board believes the company’s stock is undervalued.

What the Pecking Order Theory says about your business

This order of operations for using and raising capital (often called a pecking order, hence the name) is vital to organizations because it indicates the company’s performance to the public. Here are a few examples:

• If a company is financing itself internally, the public can assume that the company is doing well because earnings are high enough to fund current operations and growth.

• If a company is financing itself through debt, this is a signal that management is confident the company’s earnings are enough to cover the costs of loan repayment.

• If a company seeks financing through equity by issuing new shares of its company, this is a sign that the company considers its own stock to be overvalued. The internal hope may be that the company can raise funds through selling shares––something it may not be able to do once its share price falls.

When choosing how to raise capital, businesses should take into account the perceived and real risks of straying from the order of operations for the Pecking Order Theory.