Financing Through Advance Selling: The Role of Social Ties

Advance selling – the practice of selling a product in advance of its consumption date – has received significant attention in the recent operations literature, and has shown to be beneficial in a variety of industries as a tool for implementing price discrimination, reducing demand uncertainty, and managing capacity more effectively. More recently, start-up companies have been exploring the use of advance selling as a mechanism to help capital-constrained firms secure bank financing. This paper conducts a theoretical investigation into the efficacy of this alternative financing approach. We consider a small-to-medium sized service firm operating in a local market. Adopting the standard fixed-investment moral-hazard model, we assume that the firm requires a fixed level of external funding in order to remain in operation (e.g., to conduct a repair). Should the firm secure the funds it requires, it then exerts an unverifiable level of effort which directly influences its profit potential, and by extension its ability to repay its debt. The firm may seek to raise the funds it requires through two channels, which may be used in conjunction: the first is the traditional banking channel, which is represented by a competitive bank loan; the second is a group of “loyal” consumers (i.e., the firm’s established consumer base), to which the firm may advance sell its product at a discount. The firm chooses the initial price discount in order to maximize its expected profit, the consumers make forward-looking purchasing decisions in order to maximize their expected utility, and the bank chooses the break-even interest rate, if such a rate exists. The results of our analysis can be summarized as follows. We find that the ability of advance selling to alleviate the firm’s financial distress depends critically on the strength of “social ties” between its established consumers. In particular, we find that if consumers consider only their individual expected utility when deciding whether to advance purchase, the benefits of advance selling in terms of reducing the firm’s borrowing needs are completely offset by the negative impact of these sales on the firm’s subsequent effort level. By contrast, when the consumers value the expected utility of their peers in addition to their own, we find that their increased willingness-topay in advance renders advance selling beneficial. Exploring the latter finding further, we show that