Research Summary: Drawing on entrepreneurial finance theory, we examine the trade-offs among different sources of capital for entrepreneurial firms in emerging economies and their impact on innovation. In emerging economies, one of the unique aspects of firm financing is the presence of informal capital, as many formal sources of capital for new entrepreneurs have more constrained access than is the case in mature economies. We suspect that informal debt has an important effect on innovation, and this effect is contingent on the accessibility of formal debt and institutional development. The hypotheses are tested using survey data from 3,235 entrepreneurs in an emerging economy, China.

Managerial Summary: This study demonstrates an inverted U-shaped relationship between the level of informal debt and entrepreneurial ventures’ innovation performance. The value of informal debt for promoting innovation was found to be weaker for firms having little or no access to often less expensive institutional finance, whereas a better-developed institutional environment strengthens the effects of informal debt.