Venture Capital Investors and Portfolio Firms

R Foundations and Trends in Entrepreneurship Vol. 9, Nos. 4–5 (2013) 365–570 c 2013 S. Manigart and M. Wright DOI: 10.1561/0300000040

Venture Capital Investors and Portfolio Firms By Sophie Manigart and Mike Wright

Contents

1 Introduction

366

1.1

367

Focus of the Monograph

2 What Do Venture Capital Investors Do? 2.1 2.2 2.3

Monitoring, Information Asymmetries and Goal Incongruencies Venture Capital Value-Adding The Post-Investment Venture Capital Investor–Entrepreneur Relationship

3 The Impact of Venture Capital on Portfolio Companies and Stakeholders 3.1 3.2 3.3 3.4 3.5 3.6

Access to Financial Resources Innovation Venture Capital and Internationalization Growth of Portfolio Firms Venture Capital Process and Portfolio Company Outcomes Venture Capital Effect on Stakeholders

371 372 410 416

425 425 426 444 444 447 448

4 Syndication

453

4.1 4.2 4.3 4.4

473 476 478 480

Motives for Syndication Partner Selection Managing the Syndicate Syndication and Performance

5 Venture Capital Exits

483

5.1 5.2 5.3 5.4

496 501 502

Exit Type Exit Timing Initial Public Offering’s Underpricing Post-Initial Public Offering Performance and Venture Capital

517

6 Venture Capital Returns

520

6.1 6.2 6.3

520 521 532

Dimensions of Venture Capital Fund Returns Venture Capital Returns and Risk Determinants of Venture Capital Return and Risk

7 Conclusions and Future Research

534

7.1 7.2 7.3 7.4

535 538 540 541

The Nature and Processes of Venture Capital Activity Syndication Returns to Venture Capital Exit

Acknowledgments

545

References

546

R Foundations and Trends in Entrepreneurship Vol. 9, Nos. 4–5 (2013) 365–570 c 2013 S. Manigart and M. Wright DOI: 10.1561/0300000040

Venture Capital Investors and Portfolio Firms Sophie Manigart1 and Mike Wright2 1

2

Ghent University and Vlerick Business School, Ghent, Belgium, [email protected] Centre for Management Buy-out Research, Imperial College Business School, London, UK and Ghent University, Ghent, Belgium, [email protected]

Abstract The principal goal of this monograph is to provide an overview of relevant aspects and research findings pertaining to the period after the venture capital firm (also known as venture capitalist or VC) has made the decision to invest in a particular portfolio company (or entrepreneur). Drawing principally upon refereed journal papers in entrepreneurship, finance, and management, our review is divided into six principal areas: (1) what venture capital firms do, (2) the impact of VCs on portfolio firms and other stakeholders, (3) the role of syndication, (4) the nature and timing of exit from VC investment, (5) the role of VCs in portfolio companies that undergo an initial public offering (IPO), and (6) the returns from investing in VC. The monograph concludes with a detailed outline of an agenda for further research. We provide a summary of the main papers in this literature in a set of tables in which we identify the authors, publication date, the journal, the main research question, the theoretical perspective, data, and the principal findings.

1 Introduction

It is well documented that venture capital is a special form of financing for an entrepreneurial venture, in that the venture capital firm is an active financial intermediary. This is in sharp contrast with most financial intermediaries such as banks, institutional, or stock market investors that assume a more passive role. Once the stock market investors invest in a company, they may monitor the performance of the company periodically but they seldom interfere with the decision making. In order to overcome the huge business and financial risks and the potential agency problems associated with investing in young, growth-oriented ventures (often without valuable assets but with a lot of intangible investments), venture capital firms specialize in selecting the most promising ventures and in being involved in the ventures once they have made the investment. The principal theme of this monograph is to provide an overview of relevant aspects and research findings pertaining to the period after the venture capital firm (or venture capitalist or VC) has made the decision to invest in a particular portfolio company (or entrepreneur). The early papers on venture capital, venture capital investors, and the venture capital process started from the observation that venture 366

1.1 Focus of the Monograph

367

capital cannot be considered as merely another category of financial intermediaries, which limit their activities to deciding on buying or selling shares, or on providing loans (Timmons and Bygrave, 1986). Given the high levels of information asymmetries and agency risk and given the low levels of collateral in the ventures which are the target of venture capital investors, venture capital investors are specialized in screening and valuing their investment targets, writing complex contracts, monitoring and adding value to their portfolio companies, and finally exiting their investments (Gorman and Sahlman, 1990). Importantly, venture capital investments often involve multi-stage decisions as investors typically provide funds to entrepreneurial investors over several investment rounds (Wright and Robbie, 1998).

1.1

Focus of the Monograph

We limit our overview of venture capital research to a narrow definition of venture capital and to specific topics. A broad definition of venture capital includes the range of entrepreneurial finance from earlystage “classic” venture capital through to later stage private equity for management buyouts and buy-ins. There has recently been an explosion of interest in private equity-backed buyouts, although the origins of this literature stretch back to the early 1980s. This literature has been the subject of detailed reviews elsewhere and is largely excluded here unless samples also include VC investments or raise general issues for the VC literature (for detailed reviews see for example Gilligan and Wright, 2010; Wright et al., 2009). Similarly, business angels which provide funding for entrepreneurial ventures as informal investors are also excluded. This extensive literature has also been reviewed elsewhere (for example Kelly, 2007). This book is therefore limited to the narrow definition of VC as investor in young growth-oriented companies. We chose to focus on the later phases of the VC investment process, hence emphasizing monitoring, value-adding, and exiting activities. We thus take VC investment decisions and contracts as given (for introductions to this literature, see Wright et al., 2003). Further, we review the literature on the outcome of venture capital investment activities. What does venture capital contribute to portfolio companies, to entrepreneurs

368

Introduction

and to economic (regional) development at large? How does the syndication of venture capital investments impact the relationships between VCs and portfolio companies? Does the financial return generated through these activities benefit investors in venture capital funds? Even with this limited focus, the number of papers reviewed is substantial reflecting the explosion of the literature on post-investment venture capital over the past four decades (Figure 1.1). Of the over 240 venture capital papers reviewed here, only one was published in the 1970s. From 14 published in the 1980s, the number of papers published trebled in the 1990s and more than trebled again in the first decade of the 2000s. The literature reviewed here represents only about 16% of all papers on venture capital referenced in the Web of Science during this time period (Figure 1.2). The annual number of papers on venture capital has exploded in the last 15 years, to reach between 140 and 185 papers per year in the last five years. Interestingly, the growth in the number of papers on venture capital mirrors the importance of the venture capital industry, with a peak in publications following venture capital boom periods.

30

25

20

15

10

5

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0

Included in review

Fig. 1.1 Number of papers reviewed, per publication year.

1.1 Focus of the Monograph

369

200 180 160 140 120 100 80 60 40 20

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0

Included in review

Web of Science

Fig. 1.2 Total number of venture capital papers published per year. Source: Web of Science.

Our choice to focus on a limited number of topics implies that this monograph will not do justice to numerous excellent papers and important insights generated on topics like venture capital selection and contracting, but also on the insight that the venture capital industry is not uniform (Timmons and Bygrave, 1986). The dominant type of venture capital firm is an independent partnership managing one or more limited life, closed-end investment funds. VC firms act as general partners in managing the fund on behalf of the limited partners (e.g., pension funds). Other types of venture capital firms are often captive firms. Captive firms obtain their funding from a parent financial institution. Corporate VC firms are parts of trading corporations. Semi-captive VC firms obtain their finance partly from their parent and partly by raising closed end funds. Public sector funds obtain their finance mainly from government agencies. Some venture capital firms are also listed companies. Different goals, organizational forms, incentive schemes, and covenants mean that different types of venture capital firms develop specific investment strategies, activities, and outcomes (Cumming and Johan, 2009; Heughebaert and Manigart, 2012). These different types

370

Introduction

of venture capital firms may be assessed on different criteria by their investors, which influences the type of deal selected, the time horizon of the investment, and the exit route (Chiplin et al., 1997; Mayer et al., 2005). This monograph focuses mainly on independent venture capital firms and captive investors with commercial objectives, hence largely ignoring the insights generated on, for example, public or universityrelated venture capital. Further, recent studies have begun to focus on the relationship between venture capital and the institutional context, explaining variations in venture capital activity and involvement with portfolio companies worldwide based upon differences in the legal and social context (Cumming and Knill, 2012; Cumming et al., 2009; Cumming and Zambelli, 2010, 2012; Meuleman and Wright, 2011). In what follows, we highlight the differential effects of institutional context as appropriate. We draw principally upon refereed journal papers in entrepreneurship, finance, and management. We therefore omit VC literature relating to other disciplines, notably law. Within the disciplines covered by our overview, we did not restrict our search only to a limited number of “top journals” primarily because of the subjectivity of deciding what constituted a top journal across disciplines. We incorporate theoretical and empirical papers and among empirical papers we include both qualitative and quantitative papers. We also restrict our review principally to papers published or forthcoming in refereed academic journals and thus largely omit working papers and books or book chapters, as well as industry reports. In the chapters that follow, our review is divided into six principal areas: what venture capital firms do; the impact of VCs on portfolio firms and other stakeholders; the role of syndication; the nature and timing of exit from VC investments; the role of VCs in portfolio companies that undergo an initial public offering (IPO); and the returns from investing in VC. We conclude with a detailed outline of an agenda for further research in this area. To aid the reader wishing to pursue particular papers in more detail, we provide a summary of the main papers in this literature in a set of tables where we identify authors and date, journal, main research question, theoretical perspective, data, and principal findings.

2 What Do Venture Capital Investors Do?

Early research focused on how VCs differentiate from traditional financial intermediaries by describing what VCs do beyond investing in portfolio companies (e.g., Tyebjee and Bruno, 1984; Macmillan et al., 1989; Rosenstein, 1988), defining their roles and extent of involvement. Early descriptive evidence showed that there is a lot of variation with respect to both what VCs do and the extent of their involvement (Gorman and Sahlman, 1989; Macmillan et al., 1989), without explaining differences. Subsequent research examined the conditions under which VCs become more involved in their portfolio companies, especially with respect to variations in the characteristics of the portfolio companies. For example, the impact of greater agency risk (Gupta and Sapienza, 1994; Sapienza et al., 1996), business risk, and task uncertainty (Gupta and Sapienza, 1994) on VCs’ interactions with the CEOs of their portfolio companies was highlighted. More recently, research acknowledges that the extent and impact of VCs’ monitoring and value-adding is not only driven by portfolio company characteristics, but also by the VCs’ characteristics. Resource dependence theory and the resource endowments of both VCs and entrepreneurs, such as their human, social, or intellectual capital (e.g., Baum and Silverman, 371

372

What Do Venture Capital Investors Do?

2004), have been used to explain the nature, level, and effectiveness of the interaction between VCs and entrepreneurs. Attention has also been paid to the nature and intensity of VCs’ involvement in different parts of the world, showing that their behavior shows commonalities, but also differences driven by differences in institutional and cultural environments (e.g., Bonini et al., 2012; Bruton et al., 2005; Sapienza et al., 1996; Wright et al., 2005). The early research on the post-investment relationship between VC and entrepreneur has revealed that VCs mainly engage in monitoring and value-adding activities (Table 2.1). Whereas these two broad types of activities overlap with one another, the assumptions underlying these activities are quite different. While monitoring relates to VCs’ attempts to reduce agency risk between entrepreneur and venture capital investors, the focus on value-added relates to VCs’ attempts to increase the upside potential of their investments. We first provide an overview of the literature on monitoring and value-adding. This is followed by a focus on process-related aspects of the venture capital– entrepreneur relationship.

2.1

Monitoring, Information Asymmetries and Goal Incongruencies

Research has indicated that an important aspect of the VCentrepreneur relationship relates to the former’s monitoring of the latter’s actions in order to reduce agency risks by regularly evaluating the entrepreneur’s behavior and performance through information transfer (Barry et al., 1990; Bergemann and Hege, 1998; Gorman and Sahlman, 1989; Sapienza and Korsgaard, 1996; Sahlman, 1990). A VC’s involvement in monitoring activities stems from the presence of goal incongruencies coupled with information asymmetries between the two parties. Agency theory suggests that this may lead to moral hazard problems, in which the agent does not exert sufficient effort on behalf of the principal or lacks capabilities to do so (Eisenhardt, 1989). First, VCs and entrepreneurs may not always have the same goals (T ¸ urcan, 2008). For example, firm survival or generating a personal income, rather than value creation, may be of primary importance for

Authors

Tyebjee, Bruno

Timmons, Bygrave

Florida, Kenney

Year

1984

1986

1988

Research Policy

Journal of Business Venturing

Management Science

Journal

VC-financed innovation and technological change in USA

VC’s role in financing innovation for economic growth

41 U.S. VCs

1,501 U.S. portfolio firms, 464 U.S. VC firms

Questionnaire

Venture Economics, field interviews

Case studies, interviews

Sample

Information flows

Theoretical framework

What do venture capital investors do?

Data source

Table 2.1.

A model of venture capital investment activity

Title

Panel A: Roles of Venture Capital Investors

The cooperative relationship between a VC and an entrepreneur is more important to the success of the business than the capital itself. What differentiates VCs backing high and low innovative companies?

(Continued)

VCs reduce risk through their networks with important gatekeepers, which facilitate information flows

A small group of high-quality VCs help to find key management team members, provide legitimacy, and help to shape strategy. They increase the speed with which innovations are brought to the market.

Post-investment activities include recruiting key executives, strategic planning, locating financing, orchestrating M&A, or IPO.

Findings

What are the activities of VCs?

Research question

2.1 Monitoring, Information Asymmetries and Goal Incongruencies

373

Authors

Rosenstein

Gorman, Sahlman

MacMillan, Kulow, Khoylian

Year

1988

1989

1989




Journal

VCs’ involvement in their investments: Extent and performance

What do venture capitalists do?

The board and strategy: VC and hightechnology

Title

49 U.S. VCs

62 U.S. VC managers

Questionnaire

six Dallas VC firms

Sample


(Continued)

Survey

Interviews

Data source

Table 2.1.

What determines the degree and type of VCs’ involvement?

What do VCs do?

How do boards of VC-backed firms differ from those of small firms and large corporates?

Research question

(Continued)

VCs have different involvement levels and strategies.

VCs are active in development and operations, management selection, personnel management, and financial participation.

VCs are mainly involved in fund raising, strategy, and management recruiting.

A significant amount of time of VCs is spent to post-investment activities, especially to portfolio firms in which they have a board seat.

VC expertise and network makes the board of VC-backed companies powerful and mainly active in strategy formulation. Outsiders control the board.

Findings


Authors

Barry, Muscarella, Peavy, Vetsuypens

Chan, Siegel, Thakor

GomezMejia, Balkin, Welbourne

Year

1990

1990

1990

Learning, corporate control and performance requirements in venture capital contracts Influence of venture capitalists on high-tech management

Journal of HighTechnology Management

The role of VC in the creation of public companies: Evidence from the going-public process

Title

International Economic Review

Journal of Financial Economics

Journal

Theory

Data source

—

US VC-backed IPOs

Institutional power, organizational dependence

Learning, Control

Monitoring


(Continued)

Sample

Table 2.1.

What impacts how strongly VC investors are involved in their portfolio companies?

Research question Findings

(Continued)

Monitoring and value-adding is contingent upon entrepreneur characteristics (experience), firm characteristics (stage and perceived performance), and VC investor characteristics (size and lead position of VC)

VCs have disproportionate control, compared to their equity stake, to allow learning about entrepreneurial skills. If performance is below expectations, CEO can be replaced.

Experienced VCs on the board lower UP at IPO.

VCs take action to monitor: specialization, concentrated ownership (retain stake after IPO), board seat.


375

Authors

Sahlman

Lam

Year

1990

1991

Journal of Business Finance and Accounting


Journal —

Theory

Theory

The structure and governance of VC organizations

VC financing: A conceptual framework

—

Sample Agency risk, information asymmetry


(Continued)

Data source

Title

Table 2.1.

How do VCs add value to portfolio firms?

How is the relationship between VC and portfolio companies structured?

Research question

(Continued)

VCs extend the production possibility frontier directly (through financing) and indirectly through strategic planning, participation in operations, use of networks, and increasing legitimacy.

VCs tightly control ventures to decrease agency risk. Control mechanisms include investment staging, incentivise management through appropriate compensation schemes and active involvement. They help with raising funding and M&As, use their network to recruit managers, customers and suppliers, are active in strategy and, if needed, in operations and bring credibility.

Findings


Authors

Gupta, Sapienza

Norton, Tenenbaum

Year

1992

1993



Journal

Sample

Questionnaire 169 VC firms from three U.S. states

Data source

Finance, strategic management

Productmarket as key component of strategy


(Continued)

Specialization Questionnaire 93 U.S. VC firms versus diversification as a venture capital investment strategy

Determinants of venture capital firms preferences regarding the industry diversity and geographic scope of their investments

Title

Table 2.1.

How do VC firms chose between industry diversity and geographic scope?

Research question

(Continued)

VC investors that were heavily involved in seed round financing were diversified across fewer numbers of firms, industries, and investment stages, suggesting that information-sharing favors specialization. It improves access to networks, information, and deal flow.

VCFs specializing in early-stage ventures prefer less industry diversity and narrower geographic scope relative to other VCFs; larger VCFs prefer greater industry diversity and broader geographic scope than do smaller VCFs; corporate VCFs prefer less industry diversity but broader geographic scope relative to non-corporate VCFs. Outcomes (timing, magnitude, and riskiness of returns) of choosing such alternatives will vary widely and will depend on the strategies of the VCFs involved.

Findings


377

Authors

Rosenstein, Bruno, Bygrave, Taylor

Sapienza, Amason, Manigart

Year

1993

1994 Managerial Finance


Journal

The level and nature of venture capitalist involvement in their portfolio companies: A study of three European countries

The CEO, venture capitalists and the board

Title

Sample 162 VCbackedU.S. high-tech firms

156 VCs in France, the Netherlands, UK

Survey

Survey

Agency risk, institutional theory


(Continued)

Data source

Table 2.1.

What determines the level and nature of venture capitalist involvement in their portfolio companies?

What is the contribution of VCs on the board?

Research question

(Continued)

VCs’ value-adding behavior differs depending on the institutional context they operate in, although VCs consistently stress three key roles: a strategic role as generators of and sounding boards for strategic initiatives, an operational role, including providing key external contacts for professional service providers or key customers, and a personal role as friends, mentors, and confidants. VC managers spend more time with companies with high business and agency risk as exemplified by their innovativeness and stage of development.

CEOs with a top 20 venture capital firm as the lead investor, on average, did rate the value of the advice from their venture capital board members significantly higher. Value-added was rated higher for early-stage than later-stage companies.

Findings


Authors

Elango, Fried, Hisrich, Polonchek

Lerner

Gompers

Year

1995

1995

1995

Journal of Finance

Journal of Finance


Journal

Optimal investment, monitoring and the staging of venture capital investments

Venture capitalists and the oversight of private firms

How venture capital firms differ

Title 149 VCs

271 U.S. VC-backed biotech firms

794 U.S. VC-backed companies

VE, industry sources

VE

Sample

Asymmetric information, agency risk, monitoring costs

Monitoring, moral hazard problem


(Continued)

Survey

Data source

Table 2.1.

Is VCs’ representation on the board greater when the need for oversight is larger?


(Continued)

The staging of capital infusions allows VCs to gather information and monitor, maintaining the option to periodically abandon the project.

VC representation on the board increases around CEO turnover (i.e., when the need for oversight is greater) and is greater for less distant companies.

Big variation in the amount of time spent with ventures. Early-stage investors spend more time in evaluating and recruiting managers than later stage investors. Larger VCs provide the least, and medium-sized VCs provide the most assistance.


379

Authors

Mitchell, Reid, Terry

Steier, Greenwood

Barney, Fiet, Busenitz, Moesel

Gompers

Year

1995

1995

1996

1996

Grandstanding IPO data in the venture capital industry

433 U.S. IPOs

54 VC-backed firms, electronic industry

Surveys

Substituting bonding for monitoring in venture capitalist relations with hightechnology ventures

Journal of HighTechnology Management Research


One VC-backed company

20 U.K. VCs

Interviews

Case study

Sample

Data source

VC relationships in the deal structuring and postinvestment stages of new firm creation

Postinvestment demand for accounting information by venture capitalists

Title

Reputation of VC

Agency and market risk

Agency theory


(Continued)

Journal of Management Studies

Accounting and Business Research

Journal

Table 2.1.

What salient features emerge in the relationship between entrepreneurs and multiple investors?

What influences VCs’ information requirements?

Research question

(Continued)

Young VC firms take their portfolio companies early to build a reputation.

Firms with CEOs that own equity and that have longer tenure and profitable firms retain a larger equity stake and minimize the number of board seats given to VCs during their first round of VC financing.

While VCs establish milestones and tight timelines, they contribute to the delays experienced by startups.

VCs appreciate the dangers of moral hazard and information asymmetry. Information demands are designed to provide safeguards through bonding agreements.

Findings


Authors

Murray

Sapienza, Manigart, Vermeir

Year

1996

1996

Title


VC governance and value-added in four countries

Entrepreneur- A synthesis of ship Theory six exploratory, and Practice European case studies of successfully exited, venture capital-financed, new technology-based firms

Journal

221 VCs from U.S., U.K., France, the Netherlands

six successful European technologybased VC-backed companies

Case studies

Surveys

Sample

(Continued)

Data source

Table 2.1.

Agency theory, uncertainty


Research question

(Continued)

Strategic involvement (providing financial and business advice) is most important role, followed by interpersonal role (mentor and confident) and networking role. U.S. and U.K. VCs are more active than European VCs. Interaction is more intense in new investments, in early-stage ventures, and when CEOs have more experience in the venture, but less when CEOs have more industry experience. VCs add more value in highly uncertain environments, when ventures are performing well and when VCs have industry experience.

The investments by VCs are seen as critical to the success of young ventures. The nature and extent of VC contribution is driven by the venture’s need, the investors’ skills, and specific advice and support (including financial). Technical knowledge of VC managers facilitates communication.

Findings


381

Authors

Gifford

Fiet, Busenitz, Moesel, Barney

Bergemann, Hege

Year

1997

1997

1998

Journal of Banking and Finance



Journal —

205 U.K. VC-backed firms

Theoretical model

Survey

Theory

Complementary theoretical perspectives on the dismissal of new venture team members

Venture capital financing, moral hazard and learning

Limited attention and the role of the venture capitalist

Sample

Agency theory, learning

Agency theory, power, procedural justice

Agency theory


(Continued)

Data source

Title

Table 2.1.

New Venture Team’s dismissals occur when ventures perform poorly. The larger the board, the more difficult it is to dismiss CEOs unless VCs occupy most of the seats. There is a negative relationship between procedural justice in the VC-New Venture Team relationship and CEO dismissal.

What are the antecedents of CEO dismissal?

(Continued)

Agency costs may lead to an inefficient early stopping of the project. Relationship financing, including monitoring and the replacement of the management, improves the efficiency of the financial contracting.

A VC, as agent of entrepreneur and limited partners, does not have the incentives to maximize their profits. VCs maximize profits of all ventures in portfolio, but devote less than optimal attention to individual portfolio firms.

Findings

How does the cost of VCs’ attention impact their allocation of attention?

Research question


Authors

Fried, Bruton, Hisrich

Hellman

Bruton, Fried, Hisrich

Year

1998

1998

2000

The allocation of control rights in venture capital contracts

Strategy and the board of directors in VC-backed firms

Title

Entrepreneur- CEO dismissal in ship Theory VC-backed and Practice firms: Further evidence from an agency perspective

Rand Journal of Economics


Journal

Sample 68 VC firms

—

68 U.S. VCs

Survey

Theory

Survey

Agency theory

Goal incongruencies

Agency theory, institutional theory


(Continued)

Data source

Table 2.1.

Why do entrepreneurs relinquish control to VCs?

Research question

(Continued)

Most important reasons for CEO dismissal are lack of agent ability, followed by good faith disagreements. Managerial opportunism ranks last. CEOs dismissed for opportunism owned more stock.

Control rights protect VCs from hold-up problems by entrepreneurs. A change of management is more frequent, if professional managers are more productive, entrepreneurs are less productive, the entrepreneurs’ private benefit is lower, and VCs have greater bargaining power.

Boards of VC-backed companies are more active in strategy formulation and evaluation.

Findings


383

Authors

Sapienza, De Clercq

Bottazzi, da Rin

Hellmann, Puri

Year

2000

2002

2002

Journal of Finance

Economic Policy

Enterprise & Innovation Management Studies

Journal

VC and the professionalization of startup firms: Empirical evidence

Venture capital in Europe and the financing of innovative companies

Venture capitalistentrepreneur relationships in technologybased ventures

Title

500 companies listed on Euro. NM

170 young Silicon vallen high-tech firms (VCand non-VCbacked)

Handcollected

Sample

Control, support

Information asymmetries


(Continued)

IPO prospectuses, annual reports

Literature review

Data source

Table 2.1.

What is the impact of VC on European portfolio companies?

Research question

(Continued)

Control (VCs act in interest of C◦ , not of founder): VC-backed C◦ have higher probability and are faster to replace founder by outsider, especially in early-stage companies.

Support: VC-backed companies are more likely and/or faster to professionalize along these dimensions

VCs impact HRM: CEO replacement, introduction of ESOPs, hiring of VP Sales & mkt, formulation of HR policies.

European VC has little effect on venture’s ability to raise equity capital, grow, and create jobs.

Given the information opaqueness surrounding technological ventures and the intangibility of most of their investments, close monitoring by VCs is essential in order to understand the actions of the entrepreneur. These conditions create a competitive advantage for VCs specializing in these firms.

Findings


Authors

Wang, Wang, Lu

Baker, Gompers

Florin

Year

2002

2003

2003

Journal of HighTechnology Management Research

Journal of Law and Economics

Journal of Financial Research

Journal

64 VC-backed companies quoted on Singapore stock exchange 1,116 IPOs

199 high-tech firms going public in 1996

IPO data

IPO data

IPO data

The determinants of board structure at the initial public offering

Substituting bonding for monitoring in technology intensive ventures going public? A two edged sword

Differences in performance of independent and financeaffiliated venture capital firms

Sample

(Continued)

Data source

Title

Table 2.1.

Agency theory, transaction cost theory

Behavior of different types of VC (independent versus financerelated)


What are the effects of early bonding decisions on IPO?

What determines the new corporate governance after IPO?

Research question

(Continued)

Early decisions to reduce VC equity stake at initial investment reduce IPO performance.

Boards of VC-backed companies have more outsiders, especially when VCs have high reputation. The probability that the founder remains as CEO decreases as the VC’s bargaining power (reputation) increases.

Finance-related VCs hold less board seats compared to independent VCs.

Value-adding goes beyond monitoring, suggested by financial intermediation literature.

Findings


385

Authors

Kanniainen, Keuschnigg

Baum, Silverman

Hsu

Year

2003

2004

2004

Journal of Finance


Journal of Corporate Finance

Journal

What do entrepreneurs pay for venture capital affiliation?

Picking winners or building them? Alliance, intellectual and human capital as selection criteria in new venture financing and performance of biotech startups

The optimal portfolio of start-up firms in venture capital finance

Title

Sample —

204 Canadian biotech startups

51 high-tech entrepreneurs; 148 financing offers

Model

Canadian biotechnology (directory)

Survey

Value-adding and certification effect of VC reputation

Evolutionary theory

Double-sided moral hazard model


(Continued)

Data source

Table 2.1.

Entrepreneurs accept lower valuations from VCs with higher reputation; the financing offers of VCs with higher reputation have three times more chances of being accepted. Is there a market for affiliation with reputable investors?

(Continued)

VCs combined ‘scouting’ out strong technology (and relationships) and ‘coaching’ via the injection of management skill.

The optimal VC portfolio results from a trade-off between the number of firms included and the attention devoted to each firm, with diminishing returns to attention per firm but with a minimum attention needed to be effective.

Findings

Do VCs emphasize picking winners or building them? Scouts or coaches?

Research question


Authors

Yoshikawa, Phan, Linton

Wang, Zhou

Bruton, Fried, Manigart

Cumming, Fleming, Suchard

Year

2004

2004

2005

2005

40 Japanese VCs with different affiliations

—

—

43 Australian VC funds

Theory

Theory

Australian Bureau of Statistics

Staged financing in venture capital: Moral hazards and risks

Entrepreneur- Institutional influences on the ship Theory worldwide and Practice expansion of venture capital Journal of Banking and Finance


Venture capitalist value-added activities, fundraising and drawdowns

The relationship between governance structure and risk management approaches in Japanese VC firms

Interviews


Sample

Title

(Continued)

Data source

Journal

Table 2.1.

Finance theory

Institutional theory

Moral hazard, uncertainty

Agency theory, compensation as goal alignment


Role of staged finance is to control risk and mitigate moral hazard. It is complementary to contracting in controlling agency risk.

What is the role of staged finance?

(Continued)

More capital is allocated to VCs that provide financial and strategic/management expertise to entrepreneurial firms, while drawdowns from capital commitments are greater among VCs that provide financial and marketing expertise to investees.

How are VC-E relationships shaped by the institutional environment?

VC firms which use more performance-based compensation schemes for their VC managers and whose managers have higher equity stakes in the funds use more active monitoring strategies.

Findings

How do VC managers’ compensation schemes impact diversification versus monitoring as risk reduction strategy?

Research question


387

Florin

Hand

2005

2005

Accounting Review


Granlund, Management Taipaleenm¨ aki Accounting Research

2005

Journal

Authors

Year

The value relevance of financial statements in the venture capital market

Is VC worth it? Effects on firm performance and founder returns

Management control and controllership in new economy firms — a life cycle perspective

Title

Sample Nine VC-backed Finnish ICT and biotech companies

277 small U.S. IPOs in 1996

204 U.S. VC-backed biotech IPOs

Interviews, questionnaires

IPO data

IPO prospectus, market data

How do MCS develop over time?

Life cycle model

Certification

Research question


(Continued)

Data source

Table 2.1.

(Continued)

The value relevance of financial statements increases as firms mature, while the value relevance of nonfinancial information decreases.

Founders have lower probability of staying as CEO when VC-backed.

Short-term horizon due to VCs; VCs also demand financial control system.

Least attention to core mgt control tasks: performance mgt, strategic planning, internal financial analysis.

Preferred activities: budgeting and reporting, R&D project control, fund raising.

First, statutory requirements are key, investments in administrative systems are not crucial.

Findings


Authors

Cumming

Williams, Duncan, Ginter

Year

2006

2006

IPO data Structuring deals and governance after the IPO: Entrepreneurs and VCs in high-tech IPOs

190 U.S. biotech and healthcare IPOs

214 Canadian VC funds

Canadian VC Association

Business Horizons

Sample

Corporate governance


(Continued)

Data source

The determinants of VC portfolio size: Empirical evidence

Title

Journal of Business

Journal

Table 2.1.

How is optimal portfolio size determined, including type of VC firm?

Research question

(Continued)

VC-backed companies have a larger proportion of outside directors and a smaller proportion of entrepreneurs who remain officers or in board positions after the IPO.

Four factors affect portfolio size: the venture capital funds’ characteristics, including the type of fund, fund duration, fundraising, and the number of venture capital fund managers; the entrepreneurial firms’ characteristics, including stage of development, technology, and geographic location; the nature of the financing transactions, including staging, syndication, and capital structure; and market conditions.

Findings


389

Authors

Bernile, Cumming, Leandres

Beuselinck, Manigart

Year

2007

2007

Small Business Economics


Journal

Financial reporting quality in private equity backed companies: The impact of ownership concentration

The size of VC and PE fund portfolios

Title Double moral hazard problem

Monitoring, information asymmetries

270 Belgian VC- and PE-backed companies

Handcollected public data


42 U.S. and European VC and PE managers

Sample

(Continued)

Model + survey

Data source

Table 2.1.

How does the shareholder structure of private companies impact the quality of their publicly available accounting information?

Research question

(Continued)

Companies in which PE investors have a high equity stake produce lower quality accounting information than companies in which PE investors have a low equity stake, as a higher equity stake allows for more internal monitoring and reduces the need for external information.

The optimal portfolio size involves a trade-off between the number of projects and each project’s expected value net of the cost of VC’s effort devoted to it. VC’s portfolio size varies nonmonotonically with the profit shares held by entrepreneurs. The evidence is consistent with the notion that VC’s portfolio size and profit sharing rule are determined jointly.

Findings


Authors

Dai

Beuselinck, Deloof, Manigart

Bottazzi, da Rin, Hellmann

Year

2007

2008

2008

Private equity investments and disclosure policy Who are the active investors? Evidence from VC


Does investor identity matter? An empirical examination of investments by VC funds and hedge funds in PIPEs

Title

European Accounting Review


Journal

Sample 113 PIPEs with VC, 397 PIPEs with HF

438 PE-backed and 438 non-PE backed firms 119 European VC firms

Public data

Handcollected publicly available data Survey + Websites, VX

Signaling, corporate governance


(Continued)

Data source

Table 2.1.

How does PE and VC backing impact voluntary disclosure?

Research question

(Continued)

VC firms with partners with business experience, but not the extent of VC experience, are more active. Independent VCs are more involved than other types of VC. Investor activism is positively related to the success of portfolio firms.

Firms do not increase voluntary disclosure to attract VC, but voluntary disclosure increases after VC investment.

VCs gain substantial ownership, request board seats after investing, and often keep their stake after PIPEs, in contrast to HF.

Findings


391

Authors

Gledson de Carvalho, Calomiris, Amaro de Matos

Hochberg

Year

2008

2012

Venture capital and corporate governance in newly public firms

VC as human resource management

Journal of Economics and Business

Review of Finance

Title

Journal 160 U.S. VCs

1041 VC-backed IPOs

IPO data

Sample Risk aversion of managers and adverse selection problem


(Continued)

Model + Survey

Data source

Table 2.1.

Venture-backed companies’ boards of directors are more independent than those of similar non-venture-backed companies, and they are more likely to separate the roles of CEO and chairman. What is the impact of VC on corporate governance after IPO?

(Continued)

HR networking is important activity for VCs. VC deploys more HR activities when the venture is more risky, their funds are larger, which is positively correlated with their networking ability and the extent to which VCs believe that the companies that they finance would tend to have difficulty in recruiting managers. Their ability to attract managers is positively related to the reputation they acquire for recycling (assisting managers with job placement in the future).

Findings

Can VCs help attract good managers through their network?

Research question


Journal Advances in Accounting


Quarterly Review of Economics and Finance

Year Authors

2008 Silvola

2009 Beuselinck, Deloof, Manigart

2009 Campbell, Frye

Data source

VC monitoring: Evidence from governance structures

Private equity involvement and earnings quality

488 Belgian VC- and PE-backed firms and matched nonVC-backed firms 881 U.S. IPOs

IPO data

105 Finnish companies

Sample

(Continued)

VC-backed firms utilize governance structures with greater levels of monitoring at the time of an IPO compared to non-VC-backed firms, but this difference dissipates over time. IPOs backed by high quality VCs use significantly more equity-based compensation. The exit of a VC materially declines the governance structure of firms.

PE- and VC-backed firms produce higher quality reported accounting information, especially if backed by independent or corporate VC. How does private equity and venture capital involvement impact quality of public financial information? How do governance structures evolve after IPO?

Business planning and use of management control techniques are more prevalent when VC-backed. This not only for young companies, but also for more mature companies.

Findings

What determines the use of management control systems?

Theoretical Research framework question

(Continued)

Accounting data

Survey Do organizational life cycle and VC investors affect the management control systems used by firms?

Title

Table 2.1.


393

Authors

Heger, Tykvov´ a

Suchard

Kandel, Leschinskii, Yuklea

Year

2009

2009

2011

Journal of Financial and Quantitative Analysis



Journal

VC funds: Aging brings myopia

The impact of VC backing on the corporate governance of Australian IPOs

Do venture capitalists give founders their walking papers?

Title

552 Australian IPOs

IPO data

—

46,459 German high-tech startups of which 659 VC-backed

German credit rating agency

Theory + interviews

Sample How do VCs impact the change of the founding team and of CEO?

Value-adding, monitoring

How does limited life of independent VC funds impact investment decisions?

How does VC-backing impact post-IPO governance?

Research question


(Continued)

Data source

Table 2.1.

(Continued)

The finite life of VC funds creates inefficiencies: it leads to the continuation of bad projects and termination of good projects, especially in older funds. This relationship is not present in corporate VC with infinite life.

VC-backed IPOs have more independent boards. VCs use their network to recruit specialist independent board members with industry experience.

The probability and speed of replacing the CEO and enlarging the executive team increases with VCs holding larger stakes and operating closer to the portfolio companies.

The probability and speed of replacing the CEO and enlarging the executive team increases with VC backing.

Findings


Authors

Bonini, Alkan, Salvi

Knockaert, Vanacker

Year

2012

2013


Corporate Governance

Journal

The association between VC selection and value-adding behavior: Evidence from early-stage high-tech VCs

The effects of venture capitalists on the governance of firms

Title

Sample 164 VC-backed companies in the US, UK, Spain, France, Germany

68 European early-stage high-tech VC investors

Questionnaire

Interviews, conjoint analysis

Research question What determines VC influence on the governance of their portfolio companies?

How does the selection behavior of VCs affect their involvement in value-adding activities?

Theoretical framework Corporate governance practices

Efficacy theory

(Continued)

Data source

Table 2.1.

(Continued)

VCs, focusing on entrepreneurial team characteristics or financial criteria during selection, are less involved in value-adding activities compared to their peers, focusing on technological criteria during selection.

More VC funding increases VC’s impact on CEO hiring, executive compensation, employee incentives, board decisions, and appointments. The extent of VC funding does not impact VC’s influence on strategy and investment planning. Results are different across countries.

Findings


395

Authors

Sweeting

Hurry, Miller, Bowman

Sapienza

Year

1991

1992

1992


Strategic Management Journal


Journal

When do venture capitalists add value?

Calls on hightechnology: Japanese exploration of venture capital investments in the United States

UK venture capital funds and the funding of new technologybased businesses: Process and relationships

Title

51 matched pairs of U.S. VCs–CEOs

20 Japanese and 20 U.S. VC firms

Interviews, Surveys

Surveys, interviews

Four U.K. VC firms

Secondary data and interviews

Agency risk, task uncertainty

Real option theory

Process model


(Continued)

Sample

Table 2.1.

Data source

Panel B: The Venture Capital Post-Investment Process

In which circumstances do VCs add value to their portfolio companies?

Research question

(Continued)

More innovative ventures have more frequent and open contact between the lead VC and the CEO Value of VC involvement is greater, the less conflict of perspective in the venture capitalist–CEO pair.

The strategic logic of Japanese high-technology VC investors reveals the existence of an implicit call option on new technology. This option is exercised by further investment in product development, manufacturing and distribution.

VCs actively work to nurture good relationships with operating business managements, but they act decisively and proactively to protect their investments when they see them being threatened. VCs are concerned with whether entrepreneurial team members can be trusted.

Findings


Authors

Gupta, Sapienza

Barney, Busenitz, Fiet, Moesel

Year

1994

1996


Academy of Management Journal

Journal

Sample

51 matched pairs of U.S. VCs–CEOs

205 U.S. VC-backed firms

Surveys, interviews

Survey

The impact of agency risk and task uncertainty on VC–CEO interaction

New venture teams’ learning assistance from VC firms

Learning theory

Agency risk, task uncertainty


(Continued)

Data source

Title

Table 2.1.

How do entrepreneurs value VC’s assistance?

How do agency risk and task uncertainty impact interaction frequency?

Research question

(Continued)

Entrepreneurs with more industry experience and longer team tenure in the current venture value advice less, but when their experience comes from another industry, they welcome business advice.

The optimal level of VC involvement is contingent on the entrepreneurial team’s openness to learning.

Frequency of interaction depends on extent of goal congruence, the degree of the CEO’s new venture experience, and the venture’s stage of development and innovativeness. Degree of management ownership has no impact.

This is positively correlated with venture performance. Neither the stage of the venture nor the CEO’s experience has a significant impact on value-added.

Findings


397

Authors

Sapienza, Korsgaard

Busenitz, Moesel, Fiet, Barney

Cable, Shane

Year

1996

1997

1997

44 graduate students, 118 U.S. VC firms

116 U.S. VC-backed entrepreneurs

—

Survey

Theory

Entrepreneur- The framing ship Theory of and Practice perceptions of fairness in the relationships between venture capitalists and new venture teams

A prisoner’s dilemma approach to the entrepreneurVC relationship

Academy of Management Review

Procedural justice in entrepreneurinvestor relations

Experiment, Survey

Academy of Management Journal

Sample

Title

Prisoner’s dilemma framework

Procedural Justice

Procedural Justice


(Continued)

Data source

Journal

Table 2.1.

What makes the relationship between entrepreneurs and VCs work?

How do conditions at first-round funding frame an entrepreneur’s perception of the fairness of its relations with its VC?

What is the impact of entrepreneurs’ management of information flows on entrepreneurVC relations?

Research question

(Continued)

The implicit similarities between entrepreneur and VCs drive entrepreneurs’ and VCs’ decisions to cooperate.

Some governance mechanisms and the background of the new venture team significantly frame perceptions of fairness in their relationship. The indiscriminant use of contractual covenants can adversely frame an NVT’s perception of how fairly it is treated by its VC, which ultimately could inhibit the former’s receptivity to advice.

Self-interested behavior can impede the success of the venture. Cooperative behavior between VC and CEO is an important driver of success. Timely feedback is important in promoting positive relations between VC and entrepreneurs.

Findings


Authors

De Clercq, Sapienza

Shepherd, Zacharakis

Manigart, De Waele, Wright, Robbie, Desbri` eres, Sapienza, Beekman

Year

2001

2001

2002

—

209 VCs in US, UK, France, Belgium, Netherlands

Survey

Determinants of required returns in VC investments: A five-country study


—

Theory

Theory

Sample

Data source

The VCentrepreneur relationship: Control, trust and confidence in cooperative behavior

The creation of relational rents in venture capitalistentrepreneur dyads

Title

How can confidence be achieved in the VC– entrepreneur relationship?

What are the determinants of the return requirements of VCs?

Resource based view, finance theory

Research question

Trust, control

Organizational learning theory, social exchange theory


(Continued)

Venture Capital

Venture Capital

Journal

Table 2.1.

(Continued)

VCs who provide more intense involvement have higher ex-ante return requirements.

An entrepreneur can build trust with the VC (and vice versa) by signaling commitment and consistency, being fair and just, obtaining a good fit with one’s partner, and with frequent and open communication. Open and frequent communication acts as a catalyst for the other trust building mechanisms.

Relational rents can be created in VC–entrepreneur dyads through relation-specific investments and knowledge sharing routines, based on an effective governance of the relationship between both parties.

Findings


399

Authors

Arthurs, Busenitz

Busenitz, Fiet, Moesel

De Clercq, Fried

Year

2003

2004

2005

Title

Venture Capital


How entrepreneurial company performance can be improved through venture capitalists’ communication and commitment

Reconsidering the venture capitalist’s “value-added” proposition: An interorganizational learning perspective

Entrepreneur- The ship Theory boundaries and and Practice limitations of agency theory and stewardship theory in the venture capitalist/ entrepreneur relationship

Journal

Sample —

183 U.S. VC-backed startups

300 U.S. VCs

Theory

Survey, longitudinal follow-up

Interviews, Survey

(Continued)

Data source

Table 2.1.

Learning theory, procedural justice

Agency theory, stewardship theory


How can communication and commitment improve performance of portfolio companies?

What are the limitations of agency and stewardship theory in explaining the VC-E relationship?

Research question

(Continued)

Both communication and commitment have an important impact on VCFs’ value-added contributions, and subsequently on portfolio company performance.

When entrepreneurs were treated in a procedurally fair manner, the chances for venture success improve. The offering of advice and information on strategic issues by VCs does not improve the chances for venture success.

Agency theory has the strongest explanatory power in the pre-funding stage. It is doubtful whether stewardship theory is an effective lens to understand the VC–E relationship.

Findings


Parhankangas, Venture Landstr¨ om, Capital Smith

2005

Title

Experience, contractual covenants and venture capitalists’ responses to unmet expectations

Entrepreneur- When do ship Theory venture and Practice capital firms learn from their portfolio companies?

De Clercq, Sapienza

2005

Journal

Authors

Year

Sample 298 U.S. VC firms

78 Nordic VCs

Survey, VE

Interviews, Survey

Contract theory

Learning theory, behavioral theory


(Continued)

Data source

Table 2.1.

What is the role of experience in VC contract writing and application?

When do VC firms learn from their portfolio companies?

Research question

(Continued)

Investors with VC and business experience include more protective clauses in VC contracts, but are also less likely to exercise these rights. Prior exposure to conflicts prompts the use of contractual rights and discourages compromise and patience in problematic situations. Control rights promote ‘relational’ approaches to solving problems in the VC–E relationship, but exit rights decrease the VC’s willingness to compromise in the face of unmet expectations.

VCF’s overall experience and trust in VCF–PFC dyads is negatively related to VCF learning. Lower levels of knowledge overlap are associated with greater learning. VCFs perceive greater learning to occur in higher-performing portfolio companies.

Findings


401

De Clercq, Sapienza

Parhankangas, Journal of Landstr¨ om Business Venturing

2006

2006


European Journal of Operations Research

Shepherd, Armstrong, L´ evesque

2005

Journal

Authors

Year

How venture capitalists respond to unmet expectations: The role of social environment

Effects of relational capital and commitment on VC’s perception of portfolio company performance

Allocation of attention within VC firms

Title —

298 U.S. VC-backed firms

78 VCs in Finland and Sweden

Survey and VX

Survey

Sample

Social environment

Social exchange theory, learning and procedural justice

Queuing network, VC as agent of entrepreneur


(Continued)

Theoretic model

Data source

Table 2.1.

What are VCs reactions to disappointments caused by entrepreneurs?

Allocation of attention of VCs between pre- and postinvestment activities

Research question

(Continued)

VCs with strong ties to their colleagues and with managerial experience are more inclined to use active and constructive approaches than venture capitalists with a lesser exposure to the venture capital and business communities.

Relational capital (trust, goal congruence, social interaction) and extent of commitment of VC are positively related to perceived performance. Driven by greater learning and affect.

Given differences in goals of investors in VC firms, VC managers, and entrepreneurs, there is significant potential for disagreement on what is a “good” level of post-investment involvement.

Findings


Authors

De Clercq, Sapienza

Fritsch, Schilder

Turcan

Year

2008

2008

2008

Venture Capital

Environment and Planning


Journal Expectancy, equity and collective effort theory


Five Scottish Goal alignment VC-backed companies that deinternationalized

85 German VC investors

160 U.S. VC firms

Survey, VE

Interviews

Sample

(Continued)

Data source

Entrepreneur- Case Study VC relationships: Mitigating postinvestment dyadic tension

Does venture capital really need spatial proximity?

Firm and group influences on venture capital firms’ involvement in new ventures

Title

Table 2.1.

Telecommunication does not act as a substitute for face-to-face contact, but syndication helps to overcome problems of spatial proximity. What is the role of spatial proximity for VC investments?

(Continued)

The concept of goal alignment is unidirectional: it is geared toward a VC’s quick exit.

Individual VCs’ involvement in a VC syndicate is focal firms’ involvement relates negatively to their own reputation. However, their involvement is dominated by group effects. Specifically, financial stake relative to that of the group and the reputation of the other VCs significantly influence the focal VC’s involvement.

Findings

What determines the level of involvement of VCs in syndicates?

Research question


403

Conflict between the VC and entrepreneur: The entrepreneur’s perspective

Venture Capital


2010 Zacharakis, Erikson, George

2013 Knockaert, Vanacker

The association between VC selection and value-adding behavior: Evidence from early-stage high-tech VCs

Venture capitalistentrepreneur conflicts: An exploratory study of determinants and possible resolutions

International Journal of Conflict Management

2008 Yitshaki

Title

Journal

Year Authors

Sample 42 Israeli entrepreneur

57 U.S. VC-backed entrepreneurs

68 European early-stage high-tech VC investors

Interviews

Survey

Interviews, conjoint analysis

(Continued)

Data source

Table 2.1.

VCs, focusing on entrepreneurial team characteristics or financial criteria during selection, are less involved in value-adding activities compared to their peers, focusing on technological criteria during selection. How does the selection behavior of VCs affect their involvement in value-adding activities?

Efficacy theory

VCs’ strategic involvement is associated with cognitive conflicts and collaboration, whereas VCs’ managerial involvement is associated with managerial replacement and affective conflicts. Affective conflicts may sometimes evolve into cognitive mode, as managerial replacement enables both parties to restructure their relations.

Findings

Task conflict, but not process conflict, is detrimental to entrepreneur’s confidence in partner cooperation.

What are the inherent and actual conflicts in VC-E relations?

Research question

Conflict theory

Conflict theory




405

the entrepreneur, but not for the VC. Alternatively, VCs aim for early exit, while entrepreneurs may have more long-term aspirations with their ventures. Second, the presence of information asymmetries may be particularly high in the case of early-stage or high-tech ventures in which the entrepreneur has an in-depth knowledge about the specifics of an innovative technology. Given the information opaqueness surrounding technological ventures and the intangibility of most of their investments, close monitoring by VCs is, albeit not easy, essential in order to understand the actions of the entrepreneur and reduce information asymmetries (Sapienza and De Clercq, 2000). VCs may have a bias toward investing in deals that are located close to their offices in order to mitigate problems of information asymmetries. Proximity to an investee company can enhance the VC’s ability to monitor more closely. Cumming and Dai (2010), based on a sample of U.S. VC investments between 1980 and June 2009, find that more reputable VCs (older, larger, more experienced, and with a stronger IPO track record) and VCs with broader networks exhibit less local bias. They also find that staging and specialization in technology industries increase VCs’ local bias. This local bias has important implications for the performance of the VC’s investments, with local ventures being more likely to have successful ultimate exits (IPOs or M&As) controlling for venture quality and VC reputation. In order to explain the impact of goal incongruencies and information asymmetries on VCs’ behavior, agency theory has been used by many early researchers as their central theoretical framework (e.g., Gupta and Sapienza, 1994; Lerner, 1995; Sapienza et al., 1996). Interestingly, recently researchers have argued that both the entrepreneur and venture capitalist can play the role of ‘agent’. In the following paragraphs we provide an overview of this research. Entrepreneur as agent Most early research on VC behavior depicted the venture capitalist as the principal and the entrepreneur as the agent (Eisenhardt, 1989; Gupta and Sapienza, 1994; Gompers, 1995). Hence, an important question for venture capital investors is how to ensure that entrepreneurs

406


do not take actions that jeopardize the VCs’ chances to generate maximum financial returns. The entrepreneur, being an inside member of the company as well as the controlling officer, has access to company information that is not necessarily readily available to the VC (Cable and Shane, 1997). Many aspects may be hidden from the VC, such as the actual progress of product development or the entrepreneur’s hidden motives for having created the company, or activities that are not consistent with the VC’s wishes (Cable and Shane, 1997; Sapienza and De Clercq, 2001). These motives and informational asymmetries may be especially important if the founder is present in the portfolio firm. Indeed, whether VCs are more actively involved depends on the presence or not of a founder CEO. Jain and Tabak (2008) in respect of VC-backed IPOs in the U.S.A. report that a stronger influence by VCs is associated with a lower probability of a founder CEO being present. In order to reduce defective behavior by entrepreneurs, VCs write appropriate contracts at the time of investment, for example by using performance-based compensation schemes or staging the investment, thereby aligning the interests of the entrepreneur and the VC (Casamatta, 2003; Kaplan and Str¨ omberg, 2003; Yoshikawa et al., 2004; Wang and Zhou, 2004), or by negotiating strong control levers, often disproportionate to the size of their equity investment (Lerner, 1995; Kaplan and Str¨ omberg, 2003).1 These contractual arrangements may affect deal outcomes (Cumming, 2008; Schwienbacher, 2007). As contracts are inherently incomplete and cannot foresee all future states of nature, VCs closely monitor their portfolio companies formally by taking a seat on the board of directors of their portfolio companies (Rosenstein, 1988; Rosenstein et al., 1993; Lerner, 1995), and informally through periodical check-ups of the day-to-day activities and through interim reports (Gompers, 1995; Mitchell et al., 1995). Informal control may also include the use of codified rules, procedures, and contract specifications that specify desirable patterns of the entrepreneur’s behavior. VC monitoring intensity is the highest for companies that just entered the VC portfolio or are performing poorly (Beuselinck et al., 1 Reviewing

the rich venture capital contracting literature lies beyond the scope of this monograph.


407

2008), consistent with the notion that monitoring intensity is higher with higher agency risk. Evidence on the nature, extent, and impact of formal and informal monitoring activities of VCs is surprisingly scarce, however. From the entrepreneur’s perspective, monitoring by VCs increases the information production in the portfolio firm, with a strong focus on budgeting and reporting, R&D project control, and fundraising, but with less attention to long-term strategic planning (Granlund and Taipaleenm¨ aki, 2005; Silvola, 2008). This leads to qualitatively improved and more extensive external reporting both in the U.S.A. (Hand, 2005; Lee and Masulis, 2011) and in Europe (Beuselinck and Manigart, 2007; Beuselinck et al., 2008, 2009; Mitchell et al., 1995). Interestingly, it has been shown that VCs’ monitoring effects are not only beneficial for young companies, but also for more mature portfolio companies (Beuselinck et al., 2009; Silvola, 2008). The demand for close control leads to stronger corporate governance in venture capital-backed companies, with the Board of Directors being the formal governance mechanism utilized by VCs (Gorman and Sahlman, 1989; Lerner, 1995). VC investors’ concentrated equity stake allows them to claim board seats, on which they — or outsiders that serve on their behalf — are active (Barry et al., 1990; Baker and Gompers, 2003). More powerful VCs have a higher probability of having a seat on the board (Chahine and Goergen, 2011). VCs actively use their network to recruit specialist independent board members with industry experience (Suchard, 2009). The board of venture capital-backed companies is powerful, often dominated by outsiders and mainly concentrates on strategy formulation (Rosenstein, 1988; Fried et al., 1998; Hochberg, 2012). Venture backed companies’ boards of directors are more likely to separate the roles of CEO and chairman (Hochberg, 2012). This avoids the duality problem in governance and may also be in preparation for exit by IPO where stock market regulations and institutional investors may expect good corporate governance practices to be adhered to. Kaplan and Str¨ omberg (2003) showed that U.S. VCs have on average a quarter of all board seats, but they control the board in 25% of their portfolio companies. Control over the board is more common with

408


higher business risk, i.e., when the company has no revenues or profits yet or when the company operates in a volatile industry, or with higher agency risk, i.e., when the CEO owns no equity, has shorter tenure in the venture (Barney et al., 1996b; Kaplan and Str¨ omberg, 2003), or is replaced (Lerner, 1995). Boards of Directors can vary widely in their size and operation, however. Venture capital investors related to financial institutions hold fewer board seats compared to independent venture capital investors (Wang et al., 2002a). There is evidence that Asian boards are, on average, larger in size, and have a larger percentage of insiders compared to U.S. boards, while Continental European boards are smallest (Bruton et al., 2005). Interestingly, it has also been found that VC board members are, on average, not of better quality than other external board members, except if the lead VC investor is ‘top quality’ (Rosenstein et al., 1993). The governance influence of VC extends beyond IPO (Williams et al., 2006; Campbell II and Frye, 2009) or PIPEs (private investments in public companies) (Janney and Folta, 2003, 2006; Dai, 2007): VCbacked companies have a larger proportion of outside directors and a smaller proportion of entrepreneurs who remain officers or in board positions after the IPO or PIPE. The exit of a VC after the IPO, however, materially erodes the governance structure of firms (Campbell II and Frye, 2009). Venture capitalist as agent Cable and Shane (1997) criticized the representation of the VCentrepreneur dyad as an agency problem, in that this framework ‘does not incorporate the possibility of opportunistic behavior by the principal’ (Cable and Shane, 1997, p. 147). Hence, some researchers have suggested that venture capitalists are the agents of entrepreneurs (Kanniainen and Keuschnigg, 2003). For example, post-investment activities that VCs undertake for one portfolio company cannot necessarily be undertaken for all portfolio companies, such that VCs are often not able to allocate an optimal amount of time to each entrepreneur (Gifford, 1997). Hence, VCs also limit the attention they give to a particular portfolio firm to a suboptimal level. From the VC’s perspective,


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more monitoring does not only reduce agency problems, but also entails larger costs with respect to time allocation (Gifford, 1997; Gorman and Sahlman, 1989). Greater governance may therefore not always be costefficient (Sapienza et al., 1996). Further, VC investors have diverging goals compared to portfolio companies, such as allocating attention to different portfolio companies or fund raising activities (Gifford, 1997; Shepherd et al., 2005). In an early study, Macmillan et al. (1989) observed that ‘a relevant issue in need of examination is the opportunity cost of [greater] involvement’, which has still not been fully addressed. Evidence suggests that VCs often economize on allocating their effort in monitoring and assisting portfolio companies in ways that are optimal for the VC, but not necessarily optimal for the portfolio companies (Gifford, 1997; Kanniainen and Keuschnigg, 2003; Shepherd et al., 2005). More specifically, given that VCs have a tendency to devote as much time as possible to those deals that generate the majority of their returns (Sahlman, 1990; Sapienza et al., 1994), entrepreneurs who are in the highest need of VC advice may in fact be left in the cold. This leads to the question as to what the optimal size of a venture capital portfolio is. VC’s portfolio size varies with VC fund characteristics, portfolio firm characteristics, deal characteristics including the profit shares held by the entrepreneur, and market conditions (Bernile et al., 2007; Cumming, 2006). It has been suggested that VCs can increase their optimal portfolio size through syndication, thereby delegating monitoring to the lead syndicate partner (Kanniainen and Keuschnigg, 2003; J¨ aa¨skeläinen et al., 2006). However, recent evidence suggests that there are significant diseconomies of scale in venture capital firms (Cumming and Dai, 2011; Humphery-Jenner, 2011). Diversification may lead to knowledge-sharing but value may be destroyed if staff are spread too thinly to be able to give adequate attention to the needs of particular portfolio companies. Another potential agency problem is that VCs may be inclined to ‘under-invest’ in their portfolio companies. It is well documented that VCs prefer to stage their investments because this reduces the amount of money invested at the earliest stages of venture development when investment risk is highest, thereby also reducing the agency risk relating to the entrepreneur. This practice is not necessarily detrimental for

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entrepreneurs as it enables them to retain a higher fractional ownership if their venture thrives. It nevertheless poses the risk that if their venture does not develop as planned, entrepreneurs may run out of money and be in a poor negotiating position to raise additional finance (Heirman and Clarysse, 2004), thereby potentially facing high levels of dilution. Furthermore, it has been argued that VCs may sometimes be inclined to distribute a firm’s profits rather than to reinvest these profits in the company as limited partners have the right to get returns on their investments before VCs can secure a profit (Sahlman, 1990). This VC behavior can prevent an entrepreneur from bringing the venture to a next growth stage. Hence, agency costs and the finite life of a VC fund may lead to inefficient early stopping of good projects (Bergemann and Hege, 1998; Kandel et al., 2011). Alternatively, investing from a fund with a finite life may also lead to the continuation of bad projects (Guler, 2007; Kandel et al., 2011). Research has further shown that some VCs may seek a premature exit in their portfolio companies, especially through IPO, in order to gain reputation and report enhanced performance when raising new funds (also see Section 5). This ‘grandstanding’ behavior is particularly strong among young VCs that want to establish a reputation in the VC community (Gompers, 1996; Lee and Wahal, 2000). In short, it has been argued that VCs’ actions can be contradictory to the best interests of an entrepreneur in terms of their allocation of time and effort, re-investment decisions, or the timing of a portfolio company exiting.

2.2

Venture Capital Value-Adding

Whereas VCs’ monitoring activities mainly focus on how VCs can minimize potentially harmful behavior by entrepreneurs, VCs try to increase the value of their portfolio company through value-adding activities after the investment decision has been made. The literature on the post-investment process starts from the dominant assumption that VCs do add value beyond financial capital that is provided to their portfolio companies (e.g., Baum and Silverman, 2004; Busenitz et al., 2004; Murray, 1996; Sapienza, 1992; Sapienza et al., 1996) and

2.2 Venture Capital Value-Adding

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highlight the question of how they increase the upside potential of their investments. From the entrepreneur’s point of view, the presence of added value beyond pure financial support compensates for the high cost of VC money (Manigart et al., 2002b). An early stream of research has emphasized the type of value-adding activities VCs engage in with respect to their investment deals. In the following paragraphs we give an overview of what we believe are two important sub-streams in the value-added literature, i.e., research on the ‘classic’ value-adding roles and on how VC involvement is related to VC firm characteristics. More recently, researchers have investigated process-related issues. These will be discussed in the following sections. Value-adding roles Providing nonfinancial assistance to portfolio companies and thereby improving the risk-return mix is an essential task of a VC as a financial intermediary (e.g., Amit et al., 1998; Gorman and Sahlman, 1989; Gupta and Sapienza, 1994; Lam, 1991; Timmons and Bygrave, 1986). As providing services to portfolio firms is costly but is usually not compensated through periodic cash payments, VCs who provide more intense involvement have higher ex-ante return requirements (Manigart et al., 2002b). Research consistently stresses three key roles played by VCs in their relationship with entrepreneurs: (1) a strategic role as generators of and sounding boards for strategic initiatives, (2) an operational role, including providing key external contacts for locating managerial recruits, professional service providers, or key customers, and (3) a personal role as friends, mentors, and confidants (Macmillan et al., 1989; Sapienza et al., 1994). VCs see their strategic roles as having the greatest importance (Fried et al., 1998), their interpersonal roles as next in importance, and their operational roles as being relatively less important to helping their portfolio companies realize their full potential (Sapienza, 1992). VCs focus on the tasks they feel most confident with. For example, early-stage high-tech investors focusing on entrepreneurial team characteristics or financial criteria during selection are less involved in value-adding activities compared to their peers who focus on technological criteria (Knockaert and Vanacker, 2013).

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Understanding the strategic and operational role of VC providers has received most attention, with studies often focusing on one specific aspect of VC involvement. VC investors exert their strategic role mainly through their presence on the board of their portfolio companies, as discussed above. The most obvious operational role is that VC investors, as financial specialists, are often strongly involved in further fundraising and M&A-operations (Gorman and Sahlman, 1989; Sahlman, 1990; Vanacker et al., 2012). Further, venture capital investors facilitate information flows through their network, thereby acting as gatekeepers for their portfolio companies (Florida and Kenney, 1988a; Lam, 1991). Much attention has also been devoted to the relationship between VCs and the human resources of their portfolio companies. Venture capital-backed companies are faster to professionalize their human resources function compared to non-venture capital-backed firms (Gledson De Carvalho et al., 2008; Hellmann and Puri, 2002). VCs deploy more HR activities when the venture is more risky and when it has more difficulty in recruiting managers (Gledson De Carvalho et al., 2008). Activities include the introduction of employee stock option plans, the hiring of VP of sales and marketing, and the formulation of HR policies (Hellmann and Puri, 2002). Besides providing valuable information, VCs’ networks also serve as a conduit to recruit managers, especially if VCs acquire a reputation for assisting managers with job placements in the future (Gledson De Carvalho et al., 2008). A special aspect of VC’s involvement in HR is their role in replacing the founder as CEO (Bergemann and Hege, 1998; Bruton et al., 2000; Chan et al., 1990; Hellmann and Puri, 2002; Florin, 2005), which may represent a strong goal incongruency between investors and entrepreneurs (Hellmann, 1998). Chan et al. (1990) and Hellmann (1998) developed a theoretical model showing that the right to replace a CEO is embedded in VC contracts, driven by the observation that the skill of the entrepreneur is typically unknown at the first investment. This permits the passage of control to the VC investor following poor performance by the entrepreneur. Further, giving VCs control over founder replacement ensures that VCs exert sufficient effort in locating a new management team (Hellmann, 1998). Empirical studies


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confirm that venture capital-backed companies have a higher probability of and are faster to replace founders by outsiders, especially in early-stage companies (Hellmann and Puri, 2002; Fiet et al., 1997). A replacement of founders is more frequent if they are less able or less productive than professional managers, if their private benefits are lower and when VC investors have greater bargaining power (Hellmann, 1998). Entrepreneurs are not only dismissed when they lack ability, but also when there are strong disagreements between entrepreneurs and venture capital investors as to which course of action the venture should follow (Bruton et al., 2000). Nevertheless, the impact of more involvement on portfolio firm success is ambiguous. Some researchers have found support for the nonfinancial value-added by VCs (e.g., Hellmann and Puri, 2000, 2002; Macmillan et al., 1989; Sapienza, 1992) and suggest a positive relationship between the level of involvement and portfolio firm performance (Bottazzi et al., 2008). Other research has suggested that VCs may not necessarily add value (e.g., Busenitz et al., 2005; Gomez-Mejia et al., 1990; Steier and Greenwood, 1995). For example, while venture capital investors typically establish tight timelines for their portfolio companies, they contribute to the delays in achieving them (Steier and Greenwood, 1995). One of the reasons for the inconsistency of findings may be that many studies examining VC value-added have a survival bias in that the surveyed samples contain relatively more success stories (Busenitz et al., 2004; Manigart et al., 2002b). Interestingly, providing relevant services to portfolio companies may also benefit VCs indirectly, as Cumming et al. (2005b) have shown that the provision of more financial and strategic expertise to entrepreneurial firms is positively related to their ability to raise more capital in following funds. Not all venture capital is the same In early research on value-added, all VCs were treated homogeneously or, if differences between VCs were acknowledged, they were not clearly explained (e.g., Macmillan et al., 1989). For example, a distinction was made between three categories of VCs, the ‘inactive’ investors, the ‘active advice givers,’ and the ‘hands-on’ investors (Macmillan et al., 1989; Elango et al., 1995), with the latter category attaching

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most importance to value-adding activities. Later research has emphasized that not all venture capital is the same, and has started to explain the differences in VC value-adding behavior. The roles VCs play in their portfolio companies differ depending on the characteristics of the VC manager or VC firm itself (e.g., its reputation — Timmons and Bygrave, 1986; Gomez-Mejia et al., 1990; Gompers, 1996) or of the portfolio company (e.g., its stage of development — Elango et al., 1995; Gomez-Mejia et al., 1990; Sapienza, 1992), as successful VCs intervene in areas where they believe that they can make an important economic contribution to their portfolio companies (e.g., Murray, 1996). Independent VCs are more involved than other types of VC investors (Bottazzi et al., 2008; Knockaert et al., 2007), while VC investors related to a financial institution or with a financial background place more emphasis on their financial role (Bottazzi and Da Rin, 2002; Hellmann et al., 2008). Furthermore, VC managers with business rather than financial (including venture capital) experience spend more time with their portfolio companies (Bottazzi et al., 2008; Sapienza et al., 1996), and especially with companies with high business and agency risk as exemplified by their innovativeness and stage of development (Sapienza et al., 1994, 1996). Drawing upon efficacy theories, Knockaert and Vanacker (2013) showed that VC investors, focusing on entrepreneurial team characteristics or financial criteria during selection, are less involved in valueadding activities compared to their peers, focusing on technological criteria during selection. VCs’ value-adding behavior may differ depending on the part of the world or the institutional context they operate in (Bruton et al., 2005; Sapienza et al., 1994). For instance, more value-adding is provided by American VC managers than by their European or Asian counterparts (Bottazzi and Da Rin, 2002; Bruton et al., 2005). However, other studies suggest a more fine-grained understanding of international differences is needed since, even within continents there are significant institutional differences and stages of development of VC markets. Hence, within Europe evidence suggests greater value-adding activity by U.K. VCs compared to Dutch VCs (Sapienza et al., 1996). Important differences are also evident in the involvement of VC firms in emerging


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markets compared to developed markets. For example, evidence from Central and Eastern Europe suggests greater emphasis on seeking more information and keeping adverse situations under review rather than taking more immediate action (Wright and Robbie, 1998). In India, VCs appear to be more likely to be involved in supporting marketing and customer-related activities (Pruthi et al., 2003), possibly because of the greater challenges for early-stage firms to establish a market position in such contexts. The behavior of domestic and foreign VCs may also differ in relation to their involvement in portfolio firms. Crossborder VCs appear more likely to be involved at the strategic level, whereas domestic investors may be more closely involved on a regular basis (Pruthi et al., 2003; Devigne et al., 2013); this may reflect the costs involved in monitoring distant investees. Partnerships between local and cross-border VCs may alleviate these information frictions (Dai et al., 2012). A more indirect but nevertheless important aspect of VCs’ value-adding potential pertains to their reputation, in that for the entrepreneur the VC’s reputation may be a critical point in gaining legitimacy in the market place (Timmons and Bygrave, 1986; Gompers, 1996). Entrepreneurs value their investors’ reputation (Sørensen, 2007), as Hsu (2004) showed that entrepreneurs are willing to accept significantly lower valuations and thus face higher dilution when the VC has a better reputation. That is, besides money, monitoring, and value-adding, VCs may provide enhanced credibility to their portfolio companies, especially when they are highly respected players in the venture capital industry. The VC’s reputation can have a positive effect on the entrepreneur because a company backed by an investor with an outstanding reputation may be more capable of attracting customers, suppliers, and highly talented managers (e.g., Timmons and Bygrave, 1986; Davila et al., 2003) as VC performance and experience are associated with a greater likelihood of success. Interestingly, it has also been argued that VC reputation may potentially have a negative effect for entrepreneurial ventures. More specifically, because of the time constraints VCs are confronted with (Gifford, 1997; Kanniainen and Keuschnigg, 2003), some VCs may be inclined to treat their own reputation as substitutes for their

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value-adding services. That is, all else being equal, some VCs with high reputational capital may devote less effort to their investments compared to their less well-known rivals because they — perhaps falsely — assume that their mere reputation will be sufficient to create value, regardless of their post-investment effort (De Clercq et al., 2008). However, Mäkelä and Maula (2006) note a more negative difference between cross-border and domestic VCs. They suggest that in crossborder syndicates, foreign VCs may be less committed to portfolio firms that are domestic VC partners, unless they are heavily embedded in the local context through other investments.

2.3

The Post-Investment Venture Capital Investor–Entrepreneur Relationship

While the literature generally suggests that VCs do add value beyond the funds invested, the majority of research to date has to a great extent treated the value-adding process played by VCs as a black box. Hence, no clear explanation is given yet of how exactly value is created. Two categories of issues arise with respect to the dynamics that occur between the two parties, i.e., (1) the content of the interactions, focusing on the type of information exchanged; and (2) the process through which these interactions take place. Content-related issues: The role of communication In the following section, we discuss the communication that takes place between the VC and entrepreneur, the role of VCs’ experience and knowledge herein, and the importance of knowledge sharing between VCs, either within a given venture capital firm or within an investment syndicate. In order to add value to portfolio companies, effective knowledge sharing routines have to be established between the VC and the entrepreneur. Communication between both parties may occur in a variety of formal and informal forms, such as through telephone, e-mail, voice mail, formal meetings, and board meetings (Fritsch and Schilder, 2008; Gorman and Sahlman, 1989; Sahlman, 1990). When effective routines are in place, the interaction between VC and entrepreneur may lead to an improved capacity for both parties to exchange and

2.3 The Post-Investment Venture Capital Investor–Entrepreneur Relationship

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process information and knowledge, and this may then lead to optimal learning outcomes for both parties (De Clercq and Sapienza, 2005). Furthermore, informal personal contacts may allow for easier exchange of information, as this allows the VC and entrepreneur to learn more about the other’s idiosyncrasies and to develop a mutual understanding of each other’s goals and capabilities. Interestingly, modern telecommunication facilities do not fully substitute for face-to-face contact in this process (Fritsch and Schilder, 2008). Also, the employment of frequent interaction routines between VC and entrepreneur enhances access to each other’s knowledge base and increases the capability of processing complex knowledge (Sapienza, 1992). It stimulates a greater understanding between the two parties, and ultimately enhances the potential for favorable investment outcomes (Sapienza, 1992). The extent of goal congruence between VC and entrepreneur is an important determinant of the frequency of interaction. Content-related issues: The role of knowledge The effectiveness of the interaction process between a VC manager and its portfolio company strongly depends on the knowledge base of the VC manager compared to the needs of the portfolio company. A VC investor’s knowledge base consists of experiential knowledge, developed through previous investments by the VC firm, inherited knowledge, embedded in its human capital through previous work experience or education of VC managers, and external knowledge accessible through a VC firm’s network (De Prijcker et al., 2012).2 The potential outcomes from the relationship between VC and entrepreneur may be highest when the two parties hold complementary knowledge that enforces the other party’s expertise and skills (Murray, 1996). VCs with deep levels of experiential knowledge, acquired through previous investments in a specific industry, perform better compared to inexperienced investors (Phalippou and Gottschalg, 2009). They are, for example, better able to successfully exploit increased market opportunities in boom markets (Gompers et al., 2008). The degree to which VC investors develop experiential knowledge depends on their 2 The

role of external knowledge will be examined in Section 4.

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investment strategy, i.e., whether they pursue a specialization or a diversification investment approach. Whereas some VCs may prefer to diversify their portfolio in order to decrease their financial risk, others prefer to specialize and focus on developing specific expertise within a given domain (e.g., in terms of industry and/or development stage) in order to reduce the uncertainty embedded in their investments (e.g., Gupta and Sapienza, 1992, 1994; Lockett and Wright, 2001; Norton and Tenenbaum, 1993). For example, VC’s specialized experiential knowledge may make it more difficult for entrepreneurs to hide issues of management incompetence, misbehavior, or other crucial information regarding company performance due to the investor’s more in-depth understanding of the company’s business (Norton and Tenenbaum, 1993). A positive relationship between specialization and performance is consistent with specialized VCs being more efficient in detecting and providing adequate resources and information to portfolio companies depending on their particular industry and stage of development (Norton and Tenenbaum, 1993; Gupta and Sapienza, 1992), CEO’s new venture experience and the venture’s stage of development and innovativeness (Gupta and Sapienza, 1994; Sapienza, 1992). The advantages stemming from building deeper experiential knowledge through investment specialization may be particularly strong in the case of high-tech investments. As high-tech investments are characterized by high levels of informational asymmetry and opacity, specialized VCs may be in a better position to reduce the uncertainty stemming from this asymmetry. It has even been argued that the high informational asymmetries typical for high-technology investing creates a competitive advantage for VCs if they decide to specialize in these technologies (Sapienza and De Clercq, 2000). In short, prior research suggests that investment specialization may facilitate the acquisition of specific information by VC investors, and this in turn may enable investors to become more effectively involved in the key decision-making processes of their ventures (Gupta and Sapienza, 1992). VCs with specialized experience may thus be better equipped to detect deficiencies (to monitor) and to deliver sound advice (to add value) to the entrepreneur.


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In addition to the experiential knowledge held by a VC firm, its inherited knowledge embedded in the human capital of its investment managers is important. Inherited knowledge affects investment outcome. For example, Dimov and Shepherd (2005) have shown that VC firms with more partners with human capital that is specifically relevant for the VC process experience fewer bankruptcies, while higher levels of general human capital are associated with proportionally more highly successful outcomes. Partners and associates have to some extent varying backgrounds and skills (Bottazzi et al., 2008), as they differ in their educational background and professional experiences. In the same vein, Bottazzi et al. (2008) find that VC firms whose partners have prior business experience (general human capital), but not the extent of their VC experience (specific human capital), are significantly more active in investee firms. As each VC manager holds different ‘chunks’ of knowledge, entrepreneurs may benefit from investors who foster effective communication routines with their colleagues within the VC firm. Intensive knowledge exchange among individual VC managers regarding a particular portfolio company may give the venture capital firm as a whole broader access to and deeper insight into knowledge that is important to successfully assist a portfolio company (De Clercq and Fried, 2005). As such, in order for a venture capital firm to optimally exploit its knowledge base, it benefits from combining and integrating knowledge from among various VC managers within the firm. Content-related issues: Learning Recent research has suggested that VC investors and entrepreneurs are involved in a learning relationship (Barney et al., 1996a; Busenitz et al., 2004; Sapienza and De Clercq, 2001). While the majority of studies assume that entrepreneurs learn most from VC investors, both sides may learn from the other (Busenitz et al., 2004; Sapienza and De Clercq, 2001; De Clercq and Sapienza, 2005). For example, Hurry et al. (1992) found that in Japan VC portfolio companies often serve as a learning mechanism to carry the VC to a new technology, and this learning transition may take precedence over the success of the

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portfolio company or the goal to produce immediate financial returns to the VC. The optimal level of VC involvement is contingent on the entrepreneurial team’s openness to learning, with entrepreneurs with more experience in the venture’s industry and longer team tenure in the current venture valuing advice less (Barney et al., 1996a). Interestingly, a VC’s overall experience is also negatively related to how much the investor learns from a particular portfolio company (De Clercq and Sapienza, 2005). It could be that, in some cases, experienced entrepreneurs or investors adopt dominant logics that filter out new information or even are guilty of assuming that their experience obviates the need to communicate with the entrepreneur or other investors (Prahalad and Bettis, 1986). Further, when entrepreneurs are treated in a manner that they experience as being procedurally fair, the chances for greater learning and venture success improve (Busenitz et al., 2004; De Clercq and Sapienza, 2005). A specific manifestation of this involves both parties undertaking relation-specific investments, i.e., investments that are specifically targeted at their mutual relationship (Dyer and Singh, 1998). Relation-specific investments by the VC for example may be to devote considerable time and energy with an entrepreneur to learn the specificities and potential of a technology. Likewise, the entrepreneur may develop and utilize reporting procedures specifically aimed at fitting the VC’s timing and reporting requirements. Sapienza and De Clercq (2001) argue that both VC and entrepreneur can benefit from such relation-specific investments, since these investments enable them to access information and capabilities not widely available in the market. Process-related issues Research on social capital suggests that knowledge is essentially embedded in a social context, and that knowledge is created through ongoing relationships among economic actors (Nahapiet and Goshal, 1998). As such, the literature on process-related issues provides additional insights into how the outcomes of VC-entrepreneur relationship can be further enhanced. Hence, there is an increasing body of research that recognizes the importance of establishing strong social relationships


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between the VC investors and entrepreneurs rather than focusing solely on behavior based on self-interest and opportunism as advanced by the agency framework. The assumptions underlying agency theory deny the establishment of a trusting relationship between exchange partners, and the theory is predicated on self-serving behavior (Eisenhardt, 1989). Given the shortcomings related to the agency framework, alternative theories such as game theory (Cable and Shane, 1997), procedural justice theory (Sapienza and Korsgaard, 1996; Fiet et al., 1997), social exchange theory (De Clercq and Sapienza, 2006), stewardship theory (Arthurs and Busenitz, 2003), or conflict theory (Collewaert and Fassin, 2013; Parhankangas and Landstr¨ om, 2006; Yitshaki, 2008; Zacharakis et al., 2010), have been applied to the context of VC-entrepreneur relationships. Cable and Shane (1997) argued that the relationship between VC and entrepreneur can be described as two parties locked together in a game, which if successfully and rationally played together will yield rewards greater than if played in a contested fashion. The core idea of procedural justice theory is that regardless of the outcome of certain decisions, individuals react more favorably when they feel the procedure used to make the decisions was fair. For instance, it has been suggested that a regular provision of information by the entrepreneur to the VC may be perceived as a fair component of the investment agreement by the latter Sapienza and Korsgaard (1996). Interestingly, VC investors with strong ties to the VC community and with managerial experience are more inclined to use constructive approaches in their relationship (Parhankangas and Landstr¨ om, 2006). While a game theoretic framework assumes economic gain as the exchange partners’ sole motivator and a procedural justice framework focuses on relational exchange, both explain why the two parties may be motivated toward cooperative behavior despite their different goals (Cable and Shane, 1997; Sapienza and Korsgaard, 1996). Applying a social exchange perspective for describing VCentrepreneur relationships highlights social capital embedded in the relationship, including trust, social interaction, and goal congruence (Nahapiet and Goshal, 1998), and commitment as important processrelated components of VC-entrepreneur relationships. Trust involves

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the presence of positive expectations about another’s motives in situations entailing risk, that is, ‘to trust another party’ essentially means to leave oneself vulnerable to the actions of ‘trusted others’ (Boon and Holmes, 1991). In the early venture capital research, trust has generally been considered as being an important aspect of relationships between investor and investee (Fiet et al., 1997; Sapienza and Korsgaard, 1996; Shepherd and Zacharakis, 2001). For instance, Timmons and Bygrave (1986) argued that having a cooperative relationship with the venture capital investor is more important to the success of the business than the capital the investor provides, while Sweeting (1991) noted that VCs are often quite concerned with whether entrepreneurial team members can be trusted. The presence of trust between VC and entrepreneur creates a context in which both parties are willing to open themselves to the other since the likelihood that the other will act opportunistically is diminished. Hence, De Clercq and Sapienza (2006) found a positive relationship between the VCs’ trust in their portfolio companies and their perception of the companies’ performance. Interestingly, too much trust in VC-entrepreneur relationships may potentially have a negative side effect: at very high levels of trust there may be less need felt by the two parties to engage in penetrating discussions and information exchange (De Clercq and Sapienza, 2005). Second, the level of social interaction that takes place between the VC and entrepreneur pertains to the social contacts and personal relationships that exist among the parties (Pina-Stranger and Lazega, 2011). Recent research in the venture capital area has found a positive relationship between the extent to which VC and entrepreneur interact with one another in social occasions and the performance of VC investments (De Clercq and Sapienza, 2006). The rationale for this positive relationship is that thanks to strong social contacts the investor may become more motivated in assisting the entrepreneur for reasons different from economical ones (Zaheer et al., 1998) and expand the nature of the knowledge exchanged in the relationship, in that social interaction increases the transfer of complex, tacit knowledge (Nonaka, 1994), and thereby enhances organizational learning (Pina-Stranger and Lazega, 2011).


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Next, goal congruence refers to the degree to which two exchange partners hold common beliefs regarding their relationship (Eisenhardt, 1989). Goal conflict may hamper the extent of the information exchange between VC and entrepreneur, and the resulting poor communication may ultimately reduce the potential of the entrepreneur to optimally benefit from the VC’s input (Cable and Shane, 1997; Sapienza, 1992). Further, goal conflict may also lead to conflicting views between VCs and entrepreneurs as to what the ‘right’ level of post-investment involvement is (Shepherd et al., 2005). Finally, although both parties may believe that they have similar goals at the time of the investment decision, they may fail to honor their commitment to these goals in the post-investment phase because of divergent interpretations, which may then lead to mutual disappointments and conflict (Parhankangas and Landstr¨ om, 2006; Parhankangas et al., 2005), with probably the most notable potential for goal conflict being the replacement of the founder as CEO (Bruton et al., 2000; Hellmann and Puri, 2002). While this creates affective conflicts between VC and CEO, managerial replacement enables both parties to restructure their relations (Yitshaki, 2008). From a more positive angle, following stewardship theory, high levels of goal congruence between VC and entrepreneur should stimulate the parties’ ability to effectively interact with one another (Arthurs and Busenitz, 2003). When the VC and entrepreneur share the same goals and expectations, it is more likely that they engage in more effective communication because each party has a better understanding of which information is important for one another and how this information may benefit the other’s objectives, ultimately leading to increased performance of a VC’s portfolio companies (De Clercq and Sapienza, 2006). Finally, research has also emphasized the importance of commitment for relational outcomes, as committed partners exert extra effort to ensure the longevity of their relationship with others and engage in closer cooperation (Morgan and Hunt, 1994). In the context of venture capital financing, the commitment of VC and entrepreneur may manifest itself in the partners’ willingness to invest highly in the relationship, for example, in their willingness to undertake significant efforts

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(Gifford, 1997; Shepherd et al., 2005) or to identification with and feelings vis-à-vis the other (De Clercq and Sapienza, 2006). Signals of commitment by the VC may increase the value created in the VC-entrepreneur relationship for two reasons. First, a deep commitment held by the VC vis-` a-vis a particular investment can reflect itself in the VC spending more time in executing various value-adding roles (Sapienza et al., 1994), which may then increase the likelihood that the entrepreneur will benefit from the VC’s assistance. Further, situations of conflict are detrimental to an entrepreneur’s confidence in partner cooperation, especially when the conflicts are related to the tasks at hand, rather than to the processes (Zacharakis et al., 2010). However, when the VC shows a deep concern about and interest in an entrepreneur’s well-being, the latter may be more likely to believe in the loyalty and motives of the VC, and therefore be more receptive to the VC’s advice (Busenitz et al., 1997), ultimately leading to a more successful investment (De Clercq and Sapienza, 2006). In contrast, if either one of the parties perceives unethical behavior with the other, conflicts escalate between them through increased fault attribution or blaming and affects venture partners’ choice of conflict management strategy (Collewaert and Fassin, 2013). Overall, this stream of research shows that VCs benefit from convincing entrepreneurs that they are ‘in the game’ for the long run and are willing to function as committed insiders.

3 The Impact of Venture Capital on Portfolio Companies and Stakeholders

Various studies have examined the impact of venture capital on investee performance at the portfolio company level and on stakeholders. Reviewing the evidence, we consider in turn their access to financial resources, innovation, and internationalization. We distinguish between the growth of venture capital-backed versus non-venture capital-backed firms. Next, we review the few studies that link the investment process to outcomes. We conclude this section with reviewing the surprisingly limited literature on the relationship between venture capital and other stakeholders.

3.1

Access to Financial Resources

An obvious impact of receiving VC is on the availability of financial resources, which is especially important as VCs invest in financeconstrained companies (Peneder, 2010). However, non-VC-backed firms also have strong financing constraints with investment rates being highly positively correlated with cash flows (Bertoni et al., 2010a,b). Bertoni et al. (2010a,b) showed that, in general, receiving VC alleviates 425

426

The Impact of Venture Capital on Portfolio Companies and Stakeholders

a firm’s financing constraints. The type of VC providing the finance is important since it is only when independent VCs provide finance that investments cease to be sensitive to cash flows, but not when corporate VCs invest. The type of VC also has further implications for obtaining other forms of finance. When banks invest as VCs, the probability of a loan being granted to the company increases (Hellmann et al., 2008). Portfolio companies of highly reputed VC firms have access to higher amounts of funding through the VCs’ network (Vanacker et al., 2012). Further, when highly reputed private equity investors invest in private placements of public firms (PIPEs), this conveys a positive signal allowing the firms to attract subsequent financing (Janney and Folta, 2006). Nevertheless, when portfolio companies switch their lead VC to more reputable VCs, they obtain smaller capital infusions and lower pre-money valuations (Cumming and Dai, 2012). Lee et al. (2001) found that the involvement of a VC in combination with the amount of financial resources invested in the first year after founding spurred a start-up’s performance during the first two years. Heirman and Clarysse (2004) further refine this observation and add that VC involvement only makes sense if they invest significant amounts of money in the company at start-up, ranging from one to five million euro depending on the technology. They find that companies in which VCs only invested a small amount of money at start-up perform worse than those companies that start without any VC money at all. Alternatively, staging the financing — which is mainly used as a monitoring mechanism — increases sales growth (Smolarski and Kut, 2011). Foregoing suggests that venture capitalists in the first place invest money and this might be the foremost important resource for start-ups.

3.2

Innovation

Hellmann and Puri (2000) analyze whether VC impacts outcomes in the product market of their portfolio companies. The study is the first to examine the interrelationship between VC and aspects of market behavior of start-ups, specifically whether investee firms follow innovator or imitator strategies. They examine a stratified random sample of

3.2 Innovation

427

149 VC- and non-VC-backed firms in Silicon Valley during the period 1994–1997. Using interviews and archival data they find that innovators are more likely to be financed by VCs than are imitators. Innovators were also faster in obtaining VC finance. VC-backed firms, especially innovators, had a faster time to market. This study therefore highlights that VCs play different roles in different companies. To spur innovation, VCs may facilitate R&D strategic alliances between portfolio companies, especially if the firms compete in the same industry (Lindsey, 2008) or if the VC firms are linked to a corporate (Van de Vrande and Vanhaverbeke, 2012). VC portfolio firms also have a higher likelihood of engaging in cooperative commercialization strategies, including strategic alliances or technology licensing and controlling for selection and the receipt of VC funding (Hsu, 2006). VC-backed firms operating in environments characterized by high-technical risk will mainly form R&D alliances, while VC-backed firm operating in environments with high market risk will mainly engage in commercial alliances (Wang and Wang, 2012a,b). Nevertheless, Peneder (2010) finds that the effect of VC on innovation disappears when the selection effect is controlled for, although there remains a positive effect on growth. A number of studies have focused on the relationship between VCs and patenting activity. Mann and Sager (2007) find a strong positive relationship between patenting and VC funding among software firms in the U.S.A. Bertoni et al. (2010a,b) also find for a sample of Italian VCand non-VC-backed new technology-based firms that before receiving VC, VC-backed firms did not have a higher propensity to patent. Following VC investment, there was a positive relationship with patenting activity. A comparable relationship was found in Spain (Arqué-Castells, 2012): after receiving VC, a firm’s patenting activity increases thanks to VC involvement. In contrast, both Engel and Keilbach (2007) and Caselli et al. (2009) find that VC-backed young firms had more patent applications than non-VC-backed firms before the involvement by the VC in Germany and Italy, respectively, but that there was no difference thereafter. The reasons for these apparent differences require further scrutiny as to whether they relate to institutional, sample, or sector differences.

Authors

Manigart, Van Hyfte

Hellmann, Puri

Year

1999

2000

Review of Financial Studies

Frontiers of Entre preneurship Research

Journal

The interaction between product market and financing strategy: The role of VC

Postinvestment evolution of Belgian venture capitalbacked companies: An empirical study

Title

Sample 187 VC-backed and 187 matched non-VCbacked Belgian firms

173 Silicon Valley high-tech companies, < 10 years old, VC and nonVC-backed

Handcollected

Handcollected

Innovators are more likely to receive VC than imitators and earlier in their life. Innovators bring products faster to the market when VC-backed, but not imitators. VC is associated with significantly higher amounts of capital for imitators, but not for innovators. Probability of raising VC Timeto-market What is the interaction between productmarket and financing strategies?

VC as expert investors versus VC as agents of LPs

(Continued)

Survival rate of VC-backed firms is comparable to that of non-VC-backed firms. VC-backed firms grow more in assets compared to non-VC-backed firms, but not in sales nor in profit. There is, however, a small proportion of VC-backed companies with very high growth and profitability.

How do companies develop after having received VC?

Selection, monitoring, and valueadding

Findings

Survival Growth (sales, assets, cash flow, profit)

Research question


Dependent variable

Impact of venture capital on portfolio companies.

Data source

Table 3.1.

Panel A: Impact on Operational Performance


Authors

Lee, Lee, Pennings

Davila, Foster, Gupta

Busenitz, Moesel, Fiet

Year

2001

2003

2004




Journal

Recon sidering the venture capitalists’ ‘value-added’ proposition: An interorganizational learning perspective

VC financing and the growth of startup firms

Internal capabilities, external networks and performance: A study on technologybased ventures

Title

193 VC-backed and 301 non-VCbacked young, high-tech, SiliconValley firms

183 U.S. VC-backed startups

Survey, longitudinal follow-up

137 Korean technological startups

Survey

VE, Venture One, Trinet

Sample

Learning theory, procedural justice

Signalling theory

Resourcebased view


(Continued)

Data source

Table 3.1.

What is the influence of internal capabilities and external networks on sales growth?

Research question

Number of employees

Sales growth

Dependent variable

(Continued)

When entrepreneurs were treated in a procedurally fair manner, the chances for venture success improve. The offering of advice and information on strategic issues by VCs does not improve the chances for venture success.

Larger changes in employees are associated with positive changes in equity value.

No difference in growth between non-VC and VC-backed C◦ before they receive VC.

# employees grows before and after VC funding rounds.

The involvement of a VC, in combination with the amount of financial resources, spurs startup sales growth during first two years.

Findings

3.2 Innovation

429

Authors

Heirman, Clarysse

Alemany, Mart´ı

Florin

Year

2004

2005

2005


Proceedings of European Finance Association Conference

Journal of Technology Transfer

Journal 99 Belgian researchbased startups

323 Spanish VC-backed startups and 323 non-VCbacked startups


Interviews, public data

Financial accounts,

IPO data

How and why do researchbased start-ups differ at founding? A resourcebased configurational perspective Unbiased estimation of economic impact of venture capitalbacked firms Is VC worth it? Effects on firm performance and founder returns

Sample

Certification

Resource configurations, resource based view


(Continued)

Data source

Title

Table 3.1. Research question

Pre-IPO endowments Funds raised at IPO; Sales & asset growth, ROS, ROA (2 yr after IPO)

Growth in employment, sales, gross margin, total and intangible assets, corporate taxes

Dependent variable

(Continued)

No difference between no VC and moderate VC (30%, then top mgt team is better educated and more experienced; firm accumulates more assets through IPO. Wealth of founders with high level of VC (>30%) is lower.

Both the selection by VC and the amount of VC are associated with higher performance.

The effect of VC is positive only if significant amounts of money are invested.

Findings


Authors

George, Wiklund, Zahra

Janney, Folta

Hsu

Year

2005

2006

2006

Moderating effects of investor experience on the signalling value of private equity placements

Ownership and the internationalization of small firms

Title

Management Venture Science capitalists and cooperative start-up commercialization strategy


Journal of Management

Journal

Subsequent financing issues

Likelihood of engaging in strategic alliances, technology licensing

Information asymmetry, signalling theory

Valueadding

328 quoted U.S. biotech firms

454 U.S. VC-backed firms and 661 U.S. SBIRbacked firms

Market data

SBA, Directory of Technology Companies

Corporate governance

889 Swedish SMEs

Dependent variable

Survey

Research question

Sample


(Continued)

Data source

Table 3.1.

(Continued)

VC portfolio firms have a higher likelihood of engaging in cooperative commercialization strategies, including strategic alliances or technology licensing. This after taking selection effects and effects of receiving VC into account.

Quoted biotech firms that are perceived to be more uncertain and that disclose the presence of more prominent investors are better able to attract subsequent financing.

VC owners are less risk averse and increase international scope compared to internal owners.

Findings

3.2 Innovation

431

Journal Journal of Empirical Finance

Research Policy



Year Authors

2007 Engel, Keilbach

2007 Mann, Sager

2007 Hellmann, Lindsey, Puri

2007 Zahra, Neubaum, Naldi

Survey, secondary sources (including VE)

384 U.S. SMEs

Knowledgebased view of the firm

How does ownership impact the development of resources for internationalization?

Relation between a bank’s VC investments and subsequent lending

Commercial 10,547 U.S. firms D-bases, including VX

Building relationships early: Banks in venture capital

The effect of ownership and governance on SME’s international knowledgebased resources

Role of patents in small (SW) firms?

1,089 Young U.S. VC-backed SW and biotech firms

VX

Research question

Patents, VC and software start-ups

Banks as strategic investors


(Continued)

Germany21375 non-VCbacked and 142 VC-backed young firms

Data source Sample

Various Firm-level databases implications of early-stage VC investment — an empirical investigation

Title

Table 3.1.

Loan price

Probability of getting a bank loan.

# patents post-VC employment growth

Dependent variable

(Continued)

There is a positive relationship between VC firms equity holding and the development of knowledge-based resources for internationalization.

These relationship loans have lower yields than nonrelationship loans.

When a bank invests as VC, the probability of granting a loan to that company increases.

There is no strong relationship between patent (applications) and funding strategy.

VCs select innovative firms and focus on commercialisation thereafter.

VC-firms have more patent applications that non-VC firms before investing; no difference after VC firms grow more after investment.

Findings


Journal Journal of Financial Economics

Journal of Finance

Applied Economic Letters

Year Authors

2008 Gompers, Kovner, Lerner, Scharfstein

2008 Lindsey

2009 Ahmed, Cozzarin

Start-up funding sources and biotechnology firm growth

Blurring boundaries: The role of VC in strategic alliances

Venture capital investment cycles: The impact of public markets

Title

Theory of the firm/ VCs as information brokerages

Uncertainty

23,767 U.S. VC-backed firms; 24,311 alliances (VC- and non-VCbacked)

52 Canadian biotech firms

VE, Thompson

Canadian surveys

Which funding sources have the biggest impact on firm growth?

How do changes in public market signals affect VC investing?

Behavioral finance, investment opportunities

1,084 VC firms, 13,785 VC-backed firms

Research question


(Continued)

VE

Data source Sample

Table 3.1.

Sales growth Sales growth/ R&D

Probability of formation of alliance Exit through IPO or acquisition

Dependent variable

(Continued)

Funding from government, alliance partners, and IPO have no impact.

Angel, VC and bank financing significantly and positively contribute to sales growth (and sales growth/R&D).

PF C◦ with strategic alliances have a higher probability of a successful exit.

VCs facilitate strategic (R&D or marketing) alliances between portfolio companies, especially if firms are still private and compete in same industry.

VC firms with the most experience in a given industry increase their investments when the markets heat up. The success rate for deals done in hot markets is lower than for deals done in cold markets, but the difference is negligible. Prior experience helps VC firms to increase investments when deal opportunities improve, leading to improved exit performance.

Findings

3.2 Innovation

433

Authors

Caselli, Gatti, Perrini

Fitza, Matusik, Mosakowski

Colombo, Grilli

Year

2009

2009

2010



European Financial Management

Journal

Owner effect

Competencebased view

439 Italian VC- and non-VCbacked NTBFs

Surveys and secondary data (RITA Dbase)

On growth drivers of high-tech startups: Exploring the role of founders’ HC and VC


3,756 U.S. VC-backed firms

37 VC-backed and 116 non VC-backed Italian IPOs

Sample

VX

Data source

(Continued)

Do VCs matter? The importance of owners on performance variance in start-up firms

Are venture capitalists a catalyst for Innovation?

Title

Table 3.1.

Growth in employees and sales

(Continued)

HC of founders has direct positive effect and indirect effect through facilitating raising VC.

VCs have positive effect on growth in employees and sales, controlling for selection.

VCs are equally good at selection, but contribute 11% to the total variance in performance. The worst VCs have a negative effect of −18%, while the best VC has an average positive effect of +19%.

Increase in round-toround valuation

What is the importance of owners of start-ups for their performance?

Having patents seems a requirement to passing the VC’s selection process; entry of VC into the company does not promote continued innovation; sales growth of VC-funded firms is higher.

Patent count, sales growth

How does VC impact patenting and growth?

Findings

Dependent variable

Research question


Authors

Bertoni, Colombo, Croce

Bertoni, Croce, D’Adda

Year

2010

2010

Venture Capital


Journal

Venture capital investments and patenting activity of high-tech start-ups: A microeconometric firm-level analysis

The effect of VC financing on the sensitivity to cash flow of firm’s investments

Title

Sample 379 Italian VC- and non-VCbacked NTBFs

351 Italian VC- and non-VCbacked NTBFs



Finance constraints


(Continued)

Data source


Before receiving VC, VC-backed firms do not exhibit a higher patenting propensity. VC investments positively affect subsequent patenting activity.

Patenting rates

(Continued)

Non-VC-backed firms have strong finance constraints (investment rate is positively correlated with cash flows). Receiving corporate VC leads to higher investment rates, but IR remains sensitive to shocks in cash flows Receiving independent VC leads to no cash flow sensitivity of investments.

Findings

Investment rate

Dependent variable

3.2 Innovation

435

TFP, ROA, sales, efficiency Do VCs create value for their portfolio companies and, if so, how?

Screening versus monitoring

1,881 U.S. VC-backed manufacturing firms and 185,000 non-VCbacked firms

LBD (Longitudinal Business Database), VX

How does venture capital financing improve efficiency in private firms? A look beneath the surface

Chemmanur, Review of Krishnan, Financial Studies Nandy

2011

Ten-year employment and sales growth

Treatment vs. selection

538 Italian VC-backed and nonVC-backed NTBFs

Growth in sales and employment; % of revenues of ‘new or significantly improved products’ as innovation output

What is the effect of VC on firm growth and innovation? Differentiating between financing, screening and valueadding

Public sources (AIFI, VE) and surveys

Dependent variable

Research question

VC financing and the growth of high-tech start-ups

250,000 Austrian firms + 166 VC-backed and 663 non-VCbacked companies

Database + Survey


Research Policy

Bertoni, Colombo, Grilli

2011

Sample

Data source

The impact of venture capital on innovation behavior and firm growth

Title

(Continued)

Venture Capital

Peneder

2010

Journal

Authors

Year

Table 3.1.

(Continued)

VCs select firms with higher TFP, sales, and salaries, and the growth thereof after receiving VC is greater for VC-backed firms. While low-reputation VCs rely on selecting more efficient firms to begin with (screening), high-reputationVCs are able to improve the

Selection effect is small, growth comes mainly from ‘treatment’ shortly after first VC investment.

VC-backed firms grow more than non-VC-backed firms.

VC provide finance to constrained companies. VC has a positive impact on company growth (both sales and employment), but not on innovation output when controlling for selection effect. Innovation output is important driver of selection.

Findings


Authors

Clarysse, Bruneel, Wright

Smolarski, Kut

Year

2011

2011

International Entrepreneurship and Management Journal

Strategic Entrepreneurship Journal

Journal

Sample

Six case studies

186 Swedish VC-backed firms

Interviews, archival data

Survey

Explaining growth paths of young technology based firms: Structuring resource portfolios in different environments The impact of venture capital financing method on SME performance and internationalization

Agency theory

Growth models, contingencies, resource based view


(Continued)

Data source

Title


Annual sales growth Export ratio

Dependent variable

(Continued)

Staged financing and financing through a syndicate has a positive effect on growth and internationalization when used separately. Negative effect when syndication and staged financing are used in combination.

VC involvement is only important to foster entrepreneurial firm growth in complex environments where customers are not easy to reach and internal cash flows are negative.

efficiency of the firms they invest in to a greater extent, through greater increases in sales with lower increases in production costs.

Findings

3.2 Innovation

437

VC investor type and the growth mode of new technology based firms


Research Policy

2013 Bertoni, Colombo, Grilli

2012 Arqu´ eCastells

How venture capitalists spur innovation in Spain: Evidence from patent trajectories

On the life-cycle of VC- and non-VC financed companies

Journal of Finance

2011 Puri, Zarutskie

Title

Journal

Year Authors

Sales, employees

233 Spanish VC-backed firms

Handcollected sample, accounting data, patent data

Grandstanding theory

531 Italian new technology based firms

Handcollected sample, accounting data

Dependent variable Employees

Research question

10,349 U.S. Life-cycle of the firm VC-backed firms and over six mio non-VCbacked firms


(Continued)

LBD (Longitudinal Business Database), VX, VS

Data source Sample

Table 3.1.

(Continued)

Portfolio firms’ patenting activity increases after VC investments. This increase is substantially more pronounced the first two years following VC investments, caused by a positive treatment effect over and beyond any likely selection effect.

Short-term sales growth is higher for companies financed by independent VC firms than for companies financed by corporate VC firms, but not short-term employee growth. Long-term growth in sales and employees is the same for both groups.

VC-financed firms are larger (employees and sales) and have a higher growth rate than non-VC-backed firms (the latter when matched with firms of equal size), but there is no difference in profitability at the time of exit. VCs focus on stimulating growth, rather than on improving profitability.

Findings


Journal Innovation



Year Authors

2012 Balboa, Mart´ı, Zieling

2012 Croce, Mart´ı, Murtinu

2013 Devigne, Vanacker, Manigart, Paeleman

How does the Sales, assets, presence of employees cross-border VC as opposed to domestic VC relate to the development of portfolio companies?

(Continued)

Companies initially backed by domestic venture capital investors exhibit higher sales growth in the short-term compared to companies backed by cross-border VC. In the medium term, companies backed by cross-border VC exhibit higher growth compared to companies backed by domestic VC; companies 692 European technology companies

Accounting The impact data of syndication and cross-border venture capital on the growth of technology companies

Resourcebased view, stage development theory

Productivity Productivity growth is not Is better growth different between VC and operational non-VC-backed firms performance before VC financing, of VC-backed whereas significant firms driven differences are found in the by selection first years after the or treatment? investment. The value-adding services provided by VC investors ‘imprint’ the portfolio firm, as higher productivity growth continues after VC exit.

Selection versus VC valueadding

Funding contributes to venture growth, but VC value-adding is only important for expansion of stage portfolio companies.

Findings

267 European VC-backed and 429 matched non-VCbacked firms

The impact of venture capital on the productivity growth of European entre preneurial firms: ‘Screening’ of ‘value-added’ effect?

Impact of funding and value-added on Spanish venturecapitalbacked firms Handcollected sample, accounting data

Sales, gross margin, EBITDA, EBIT, cash flow and employment

Dependent variable

Is better performance driven by additional funding or by VC value-adding?

Research question

Funding versus VC valueadding


1099 Spanish VC-backed firms

Data source Sample

(Continued)

Handcollected sample, accounting data

Title

Table 3.1.

3.2 Innovation

439

Rosenbusch, Journal of Business BrinckVenturing mann, M¨ uller

2011

Journal

Authors

Year

Does acquiring venture capital pay-off for the funded firms? A metaanalysis on the relationship between venture capital investment and funded firm financial performance

Title

Sample

76 samples on 36,567 firms

Metaanalysis


(Continued)

Data source

Table 3.1.

When does VC improve the performance of portfolio companies beyond selection?

Research question

Growth, profitability, stock market performance

Dependent variable

(Continued)

VC has a small positive effect on portfolio company growth (but not performance), but the effect vanishes if controlled for industry selection. Performance effects are reduced when the portfolio firms are very young or very mature.

funded by a syndicate comprising both domestic and cross-border VC have the highest growth.

Findings


Authors

Wang, Wuebker, Han, Ensley

Year

2012


Journal Strategic alliances by venture capitalbacked firms: An empirical examination

Title

Data source Alliance formation


(Continued)

2,505 U.S. VC-backed startups

Sample

Table 3.1.

How VC firms use alliances to mitigate different types of risk

Research question Likelihood of alliance formation

Dependent variable

(Continued)

Firms operating in industry environments characterized by technical risk are more likely to form alliances with partners capable of mitigating technical risks, and firms operating in environments characterized by market risk are more likely to form alliances with partners capable of mitigating market risk.

Findings

3.2 Innovation

441

(Continued)

Authors

Higashide, Birley

Jain, Tabak

Lockett, Wright, Burrows, Scholes, Paton

Year

2002

2008

2008

Sample

630 U.S. IPOs (1997)

340 European VC-backed firms

IPO data

EVCA, Europe Unlimited, survey

Factors influencing the choice between founder and non-founder CEOs for IPO firms The export intensity of venture capitalbacked companies


57 U.K. VCs

Data source

QuestionThe consenaires quences of conflict between the VC and the entrepreneurial team in the U.K. from the perspective of the VC

Title



Journal

Agency theory, resource based view, lifecycle theory

Life cycle theory

Cognitive and affective conflict


Panel B: Impact of the Venture Capital Process on Portfolio Company Development

Table 3.1.

Research question

Monitoring is most effective in promoting export for later stage ventures; value-added is most effective in promoting export in early-stage ventures. % of sales that is exported

(Continued)

Stronger VC influence (rather than merely presence) is associated with lower probability of founder CEO.

Cognitive conflicts (esp. Product related) are positively related with performance, esp. If over goals (rather than policies). Affective conflicts are not related with performance, except personal conflicts are negatively related.

Findings

FounderCEO

Five selfreported financial and nonfinancial criteria

Dependent variable


Authors

Inderst, Mueller

Chugh, Nicolaou, Barnes

Collewaert, Fassin

Year

2009

2011

2013


Venture Capital


Journal —

University spin-offs

Theory

Case studies

How does VC feedback affect start-ups? What is the process through which perceived unethical behavior may provoke conflict?

Conflict process theory

Research question

Feedback, learning, escalation of commitment

Agency theory, information asymmetries


(Continued)

11 U.S. and European VC- or BA-backed firms

Sample

Data source

Case Conflicts studies between entrepreneurs, venture capitalists and angel investors: The impact of unethical practices

How does VC feedback affect start-ups?

Early-stage financing and firm growth in new industries

Title

Table 3.1. Dependent variable

Perceived unethical behavior among venture partners triggers conflicts between them through increased fault attribution or blaming; perceived unethical behavior affects venture partners’ choice of conflict management strategy and increases the likelihood of conflict escalation and of conflict having a negative partnership outcome such as failure or another form of involuntary exit.

Consistent feedback increases the likelihood of a firm’s exit. Learning mediates the relationship between VC feedback and exit.

Firms backed by active VCs initially grow more, but firms backed by passive VCs may catch up in industries without product–market competition Value of active investors is greater in competitive industries, industries with learning curve, economies of scope or network effects.

Findings

3.2 Innovation

443

444


3.3

Venture Capital and Internationalization

Internationalization activities provide a further dimension of performance where the role of VCs may be important. George et al. (2005) find that compared to VC investors, internal owners tend to be more risk averse and have a lower tendency to increase scale and scope of internationalization. Similarly, the equity holdings of VC firms are positively related with the development of knowledge-based resources for internationalization in a U.S. sample of firms (Zahra et al., 2007). A number of studies have examined the nature of the role of VC firms in driving portfolio firm internationalization. One dimension concerns the emphasis by VC firms on monitoring versus added value activities. In contrast to Zahra et al. (2007), Lockett et al. (2008) find that the nature of the VC’s involvement, monitoring versus added value, in influencing internationalization may vary between stages of investment. They demonstrate that monitoring resources are most effective in promoting export behavior for late-stage ventures and value-added resources in promoting export behavior in early-stage venture. Venture capital firms may also be closely involved in relocating portfolio companies from developing to developed markets in order to better enable access to resources, trading partners, and stock markets as an exit route (Cumming et al., 2009). They thereby positively contribute to a portfolio firm’s internationalization. The nature of the financing provided by VCs influences the extent of internationalization. Smolarski and Kut (2011) find that staged financing and financing through a syndicate have positive effects on internationalization when used separately but not when used in combination. Further, cross-border VCs may be better able than local VCs to help portfolio companies internationalize (Maula and M¨ akelä, 2003).

3.4

Growth of Portfolio Firms

Given the relationship between receiving VC finance and access to financial resources, innovation, and internationalization, researchers have examined how VC presence relates to portfolio company growth. With respect to portfolio company growth, studies generally present a

3.4 Growth of Portfolio Firms

445

positive conclusion regarding the relationship between VC backing and firm performance, but there are some dissenting studies (Table 3.1). Early studies in different countries differentiate between companies with and without venture capital backing. Puri and Zarutskie (2011) match VC and non-VC-backed firms by size and provide further evidence that supports the general view that VC-backed firms grow revenues faster. Chemmanur et al. (2011) show that VCs select firms with higher TFP, sales, and salaries, and the growth thereof after receiving VC is greater for VC-backed firms. While low-reputation VCs rely on selecting more efficient firms to begin with (screening), high-reputation VCs are able to improve the efficiency of the firms they invest in to a greater extent, through greater increases in sales with lower increases in production costs. Caselli et al. (2009) show positive effects of VC on European companies that went public. Manigart and Van Hyfte (1999) find that VC-backed firms have higher asset growth than nonVC-backed firms in Belgium. Croce et al. (2012) document higher productivity growth in European VC-backed firms, even after the VC exits. In Canada, Ahmed and Cozzarin (2009) show that VC, business angel, and bank financing significantly positively contribute to sales growth but that funding from government, alliance partners, and IPOs have no impact. VC-backed firms have faster employment growth compared to non-VC-backed firms in the U.S.A. (Davila et al., 2003) and Germany (Engel and Keilbach, 2007). A study of Spanish firms by Alemany and Mart´ı (2005) using panel data analysis of VC-backed start-ups shows that both VC backing and its amount are associated with higher performance. Other studies of the growth of VC and non-VC-backed firms that went to IPO show mixed results, with Audretsch and Lehmann (2004) finding positive effects of VC on post-IPO employee growth but Bottazzi and Da Rin (2002) finding no effect of VC backing on growth. Important problems with many of these studies include their often cross-sectional nature and a typical failure to address the issue of endogeneity in VC backing. Differentiating between selection and treatment effects (e.g., Croce et al., 2012; Chemmanur et al., 2011) is especially important in the VC context as VCs select ventures with specific characteristics, which differ from ventures that do not seek venture capital.

446


Disentangling the effect of value-adding of VC firms from the mere effect of receiving more financial funds is also important (Balboa et al., 2011). Rosenbusch et al. (2011) analyzed 76 studies in a meta-analysis. They conclude that VC portfolio companies have higher growth rates compared to non-VC-backed companies, but a large fraction of the difference is explained by VCs selecting high growth industries. They find little effect of VCs selecting the best ventures within an industry, however. Different VC investors contribute differently to portfolio firm growth and performance (Folta et al., 2009) driven by differences in goals, knowledge, and processes employed. Recently, the question how VC investor characteristics are related with the development of portfolio companies has received more attention. Colombo and Grilli (2010) examine the influence of human capital and VC backing on the growth of VC-backed new technology-based firms (NTBFs). Using a sample of 439 Italian NTBFs and after controlling for survivor bias and the endogeneity of VC funding, they find that once an NTBF receives VC backing the role of founders’ skills becomes less important and the coaching skills of VCs become more important in contributing to firm growth. Bertoni et al. (2011, 2013) using a ten year panel study of 538 Italian NTBFs show that especially independent VCs rather than corporate VCs strongly spur employment and sales revenue growth in their portfolio companies. Importantly, their studies shows that the selection effect by VCs is small and that growth mainly comes from the treatment effect shortly after the first VC investment. Differences disappear in the long-term, however. They explain this by the grandstanding of independent VC firms, having incentives to show short-term value growth (Bertoni et al., 2013). Finally, portfolio companies receiving funding from domestic VC investors grow more strongly in the short run, but those backed by cross-border VC investors grow more strongly in the long run. Portfolio companies backed by a syndicate comprising both domestic and cross-border VC investors outperform all other combinations (Devigne et al., 2013). There is a general debate in the entrepreneurship literature concerning whether growth adequately reflects performance (Delmar et al., 2003; Clarysse et al., 2011), with some arguing that it is important

3.5 Venture Capital Process and Portfolio Company Outcomes

447

to consider profitability (Davidsson et al., 2009). VCs tend to focus on stimulating growth rather than improving profitability, with there being no difference in profitability between VC-backed firms and matched non-VC-backed firms at the time of exit by the VC-backed firms (Puri and Zarutskie, 2011; Rosenbusch et al., 2011). This apparent contradictory finding in the context of VCs’ objectives of seeking financial returns may in fact be consistent with VCs seeking to build value in revenue and technology markets, which take time to feed through into profitability, in order to obtain higher valuations in sales to strategic buyers or through IPOs where the focus is on future earnings growth. Clarysse et al. (2011) suggest this role of VC is especially important in complex environments with customers who are difficult to reach. Overall, there is limited research linking VC characteristics, such as their knowledge base, and portfolio company-related outcome variables such as innovation, internationalization, and growth, although VC characteristics strongly drive their activities. A more in-depth investigation thereof is hence warranted.

3.5

Venture Capital Process and Portfolio Company Outcomes

There is limited research on the link between the process of VC firm involvement and its impact. VCs may be actively involved in their portfolio companies or they may merely be passive investors. U.S. At the early and growth stage of the VC-backed firm, firms involving active VCs tend to grow more but those firms with passive VCs do tend to catch up in industries with little product market competition (Inderst and Mueller, 2009). Active investors appear to be especially valuable in more competitive industries and in industries where a learning curve, economies of scope, and network effects are important. There is a widespread literature on conflicts in top management and entrepreneurial teams (Wright and Vanaelst, 2009) but similar issues between VCs and entrepreneurs have been largely neglected. Conflict can take different forms and have beneficial or detrimental effects on the business. In one of the few studies in this area Higashide and Birley (2002) find that product-related cognitive conflicts between VCs and

448


entrepreneurs are positively related to performance, especially if they concern conflicts regarding goals rather than policies. In contrast, affective conflicts between VCs and entrepreneurs are not related to performance except where they are of a personal nature. When one of the parties perceives unethical behavior, however, the likelihood increases that conflicts escalate and have a negative partnership outcome such as failure or another form of involuntary exit (Collewaert and Fassin, 2013). Finally, inconsistent feedback by a VC leads to a greater escalation of commitment in start-ups, while consistent VC feedback increases the likelihood of a firm’s exit (Chugh et al., 2011).

3.6

Venture Capital Effect on Stakeholders

As VCs mainly invest in R&D intensive high-technology ventures, venture capital investments are expected to have positive externalities, hence to positively influence the wider economic field (Table 3.2). Therefore, public policy makers worldwide engage in efforts to stimulate venture capital investments. While it is not our goal to review the public policy literature, this section aims to review the literature on the relationship between venture capital investments and other stakeholders beyond the portfolio company. First, we will look at the effect on entrepreneurs, and thereafter on regional economic development. There is a specific literature studying the effect of venture capital investments on corporates and financial institutions, sponsoring venture capital funds. This literature, however, falls beyond the scope of this monograph. While venture capital-backed portfolio companies might also have spillover effects on other stakeholders such as customers or suppliers, or on competition within the sector, we are not aware of any study investigating these relationships. Some studies have clearly shown that the probability that the founder remains CEO is lower in venture capital-backed companies (see Section 2 for a review of the CEO replacement literature). Only one study looked at the wealth effects for founders raising venture capital. Florin (2005) compared the wealth of founders of small U.S. companies that did an IPO in 1996. He showed that, if VC investors have more than 30% of the equity, the wealth of the founders is lower compared to

Authors

Journal

Sahlman, Stevenson

1985

1988a Florida, Kenney

Bean, Schiffel, Mogee

1975

Regional economy



Research Policy

Effect on entrepreneurs 2005 Florin Journal of Business Venturing

Year

Interviews, literature

Archival

VCJ VC deals

The VC market and technological innovation

Capital market myopia

VC and hightechnology entrepreneurship

Seven U.S. regions

U.S. Winchester disk drive industry

U.S.


Research Data source setting

Capital market myopia

Certification

Theoretical framework Value of founders shares two yrs after IPO

Dependent variable

Outcome of differences in VC regions

Is there an equity gap for R&D entrepreneurial firms?

Research question

Effect of venture capital on entrepreneurs and the regional economy.

Is VC worth it? IPO data Effects on firm performance and founder returns

Title

Table 3.2.

(Continued)

Well-developed VC networks facilitate high-tech entry, but is not absolutely necessary. VC alone does not generate entrepreneurship and economic development: experience and networks are necessary. Syndication allows long-distance flows of VCs between regions. There is a distinction between technology, finance, and hybrid

Individual investors ignore outcome of collective action, leading to overfunding and overvaluation.

Answer to RQ is inconclusive: too little is known about VC.

VC investments are on average not very profitable, but tech investments are better.

Wealth of founders with high level of VC (>30%) is lower.

Findings

3.6 Venture Capital Effect on Stakeholders

449

Venture capital, entrepreneurship, and economic growth Venture capital and patented innovation: Evidence from Europe

Research Policy

Review of Economics and Statistics

Economic Policy

2010 Samila, Sorenson

2011 Samila, Sorenson

2012 Popov, Roosenboom

Assessing the contribution of VC to innovation VC as a catalyst to innovation

RAND Journal of Economics

2000 Kortum, Lerner

Title

Journal

Year Authors

329 U.S. metropolitan areas, 1993–2002

21 European countries

EVCA

329 U.S. metropolitan areas, 1993–2002

20 U.S. industries

VentureXpert, public databases

VE


Table 3.2. Theoretical framework

(Continued)

VC and public funding of academic research both are positively related to regional patenting rates and regional new firm formation. Increases in the supply of venture capital positively affect firm starts, employment, and aggregate income.

Patenting rate Netfirm startup rate

Net firm startup rate, employment, income

VC spurs patenting rates in countries with high levels of VC. VC is relatively more successful in fostering innovation in countries with lower barriers to entrepreneurship, with a tax and regulatory environment that welcomes venture capital investment, and with lower taxes on capital gains.

Positive relationship between VC investments in an industry and patenting rate.

complexes, but flows between all regions to fund most promising ventures.

Findings

Patenting rate

Dependent variable

What is the Patenting relationship rate between VC investments and patents in a country?

How does VC relate to firm startups?

Influence of VC investments on patents Are public and private funds substitutes or complements?

Research question


3.6 Venture Capital Effect on Stakeholders

451

IPOs in which VC investors have lower equity stakes and compared to ventures that were able to grow to an IPO without venture capital. He thereby concludes that there are other ways to wealth creation, both for entrepreneurial ventures and for entrepreneurs, than venture capital financing. Given that this is an important topic for entrepreneurs, more studies in this area are warranted. For example, are entrepreneurs better off in other exit types such as trade sales or buy-backs? Early studies are skeptical about the value and necessity of venture capital to economic development. Bean et al. (1975) were the first to investigate the impact of venture capital investments on economic development. They were hampered in their research endeavor by a lack of comprehensive databases, however. Through interviews, they concluded that venture capital investments are, on average, not profitable and create little societal value, but investments in technology companies perform better. In a later study, Florida and Kenney (1988b) claim that venture capital alone does not generate entrepreneurship and economic development, but experienced investors and networks among investors are necessary. While well-developed venture capital networks facilitate entry of new ventures in high-technology industries, venture capital is not absolutely necessary to stimulate high-technology entrepreneurship (Florida and Kenney, 1988b). Finally, they showed that venture capital flows between different regions to fund the most promising ventures, hence alleviating the need for strong regional venture capital industries. Further, Sahlman and Stevenson (1985) showed that individual venture capital investors are myopic, in that they ignore outcome of collective investment actions, leading to overfunding and overvaluation. This myopic behavior might explain bubbles in venture capital investments. Later studies are more positive, however. These studies benefit from broad databases, allowing for more refined econometric analyses. Samila and Sorenson (2011) showed that increases in the supply of VC positively affect firm starts, employment, and aggregate income in U.S. Metropolitan Areas beyond the firms that the VC industry funds, but only to a limited extent. Kortum and Lerner (2000) showed that VC investments in an industry benefit innovation, as there is a positive relationship between VC investments and patenting activity. This

452


effect is found for venture capital as well as public funding of academic research, suggesting that venture capital and public research funding are complementary (Samila and Sorenson, 2010). In Europe, VC spurs patenting rates in countries with high levels of VC only. VC is relatively more successful in fostering innovation in countries with lower barriers to entrepreneurship, with a tax and regulatory environment that welcomes venture capital investment, and with lower taxes on capital gains (Popov and Roosenboom, 2012). In a private equity setting, Bernstein et al. (2010) showed that industries where private equity investorshave invested in the last 5 years have grown more quickly in terms of productivity and employment. Nevertheless, Hirukawa and Ueda (2011) suggest that VCs especially invest in innovative industries, rather than that VCs spur innovation in a given industry. Given the importance of the topic, we call for more in-depth research in Section 7.

4 Syndication

Syndication involves two or more VC firms co-investing in a portfolio firm to share a joint pay-off (Lerner, 1994). After a few early contributions in the entrepreneurship literature by Bygrave (1987, 1988) and in the finance literature by Lerner (1994) and Admati and Pfleiderer (1994), there has since been quite an explosion of interest in this area, as reviewed below (Table 4.1; see also Jäa¨skeläinen, 2011). As VC syndication and nature of a syndicate strongly impact the relationship between the VCs and their portfolio company, we start by reviewing the literature on motives for syndication and the selection of syndication partners. Further, we report the limited literature on the management of a syndicate and end by discussing the performance of syndicated deals.

453

Authors

Bygrave

Bygrave

Admati and Pfleiderer

Year

1987

1988

1994

Journal of Finance



Journal

Panel A: Motives for Syndication

Robust financial contracting and the role of venture capitalists

The structure of the investment networks of VC firms

Syndicated investments by venture capital firms: A networking perspective

Title

Theoretic model

—

Information asymmetries and agency problems between initial VC and later VCs

Optimal investment strategy is to maintain constant equity stake, so that initial VC does not exploit informational advantage.

Why do VCs syndicate in later rounds?

(Continued)

More syndication when uncertainty is higher High-tech VCs are tightly coupled, while low-tech VCs are loosely coupled.

Resource exchange theory

464 U.S. VCs, 1,501 portfolio companies

More syndication when uncertainty is higher.

Sharing information (including deal flow), rather than risk spreading.

Findings

Is there a difference between networks of low-tech and high-tech VCs?

Why do VCs syndicate?

Resource exchange theory

VE

464 U.S. VCs, 1,501 portfolio companies

Sample

Data source

Research question

Syndication. Theoretical framework

Table 4.1.

454 Syndication

Authors

Lerner

Chiplin, Robbie, Wright

Lockett, Wright

Sorenson, Stuart

Year

1994

1997

2001

2001

American Journal of Sociology

Syndication networks and the spatial distribution of VC investments

The syndication of venture capital investments

The syndication of venture capital: buyouts and buy-ins

Frontiers of Entrepreneurship Research

Omega

The syndication of VC investments

Title

Financial Management

Journal

Syndicated and nonsyndicated buyouts and buyins 60 U.K. VCs

80406 investment rounds

questionnaire

VE

271 U.S. biotech IPOs

Sample

Sociology of information exchange; Social network theory

Syndication with VC firms with country and industry knowledge. How do networks help to overcome spatial distance?

Syndication for deal flow motives: extends geographic or industry investment scope. (Continued)

Risk sharing is important deal flow. resource-based view-important for early-stage investors.

Window dressing toward LPs: exp. investors join later rounds if the firm is doing well.

Reduce information asymmetries for later round investors: ownership % of initial VC stays frequently constant.

Improve selection: experienced VCs syndicate 1st round with equally experienced, and later rounds with experienced + inexperienced.

Findings

Why do VC firms syndicate?

What determines syndication?

Agency

Resourcebased view

Why do VCs syndicate?

Research question

Information asymmetries


(Continued)

Archivale

Data source

Table 4.1.

455

Authors

Brander, Amit, Antweiler

Huang, Xu

Kanniainen, Keuschnigg

Cumming, Fleming, Schwienbacher

Year

2002

2003

2003

2005

The optimal portfolio of start-up firms in VC finance Liquidity risk and venture capital finance


VX

Model

Model

—

—

584 Canadian exited VC deals

Model + Macdonald and Associates

Venture capital syndication: Improved venture selection versus the value-added hypothesis

Financial syndication and R&D

Sample

Data source

Liquidity risk of IPO markets

Double-sided moral hazard model

screening value-adding


(Continued)

Title


Economic Letters

Journal of Economics and Management Strategy

Journal

Table 4.1.

Relation between IPO volumes and syndication?

Why do large corporates invest in young R&Dintensive companies?

Selection versus value-adding

Research question

VCs syndicate more if liquidity risk is high, in order to better screen and to provide value-added. (Continued)

Syndicate to optimize use of time of VC managers.

Syndication by CVCs is a commitment to terminate bad projects timely (in contrast with in-house R&D).

No evidence of window dressing, i.e., VCs joining syndicates after having observed good performance.

Risk sharing may be present, but not VC capital constraints.

Expected benefits of syndication exceed expected costs.

Syndicated investments have higher performance: value-adding prevails.

Findings

456 Syndication

Authors

Hopp, Rieder

Manigart, Lockett, Meuleman, Wright, Landstr¨ om, Desbri` eres, Hommel

Filatotchev, Wright, Arberk

Year

2005

2006

2006

Working paper!

Title


Venture captialists, syndication and governance in IPOs

Entrepreneur- VCs’ decision ship Theory to syndicate and Practice

Journal

312 European VC firms

293 entrepreneurial U.K. IPOs

IPO data

Sample

Why do VC firms syndicate?

How do boards of IPO firms develop? Agency theory, corporate governance

Research question

Resource based view, diversification


(Continued)

Questionnaire

Data source

Table 4.1.

Syndicates occur in more risky firms. VC-backed IPOs have more independent boards than non-VC-backed IPOs, with board independence being higher in syndicated VC-backed firms. (Continued)

Value-adding more important for early-stage Non-leads join syndicates for selection and value-adding skills of syndicate partners

Portfolio management motives (risk sharing, diversification, access to large deals) more important than individual deal management motives (access to resources).

Experienced VCs syndicate less: benefit from improved selection is lower than the cost of syndicate.

Industries with higher risk profiles have higher probability of syndication and larger number of syndicate partners.

Findings

457

Journal of Financial Intermediation

2007 Casamatta, Harichabalet

Journal of Alternative Investments

Management Science

2007 Kaiser, Lauterbach

2007 Kogut, Urso, Walker

2007 Guler, McGahan

Journal

Year Authors

Emergent properties of a new financial market: American VC syndication, 1960–2005

The need for diversification and its impact on the syndication probability of VC investments

Experience, screening and syndication in venture capital investments

Title

1,011 VC + BO worldwide

25,714 U.S. VC portfolio companies

VE

—

Theory

VE-CEPRES

Sample

(Continued)

Data source

Table 4.1.

Social foundations of markets

Transaction costs



Do local markets develop in response to an evolving global system

Is the reduction of transaction costs a motive for syndication?

Research question

Conservative preference for repeated coinvestments to remain geographically and sectorally local is countered by the opportunities to diversify into new sectors and regions that necessitate new partners. (Continued)

Reduce transaction costs: Early-stage and venture deals have higher syndication probability.

Reduce transaction costs: VC fund size and investment experience are negatively correlated with syndication probability.

Number of syndicate members is larger if IP protection in the region of the venture is strong.

Uncertain projects have higher probability of being syndicated.

Syndication prevents competition after projects are disclosed.

Syndication improves screening, allows gathering more information. This is less valuable for experienced VCs, who will syndicate less or only with other experienced partners.

Findings

458 Syndication

Journal


Financial Research

Year Authors

2009 Meuleman, Wright, Manigart, Lockett

2010 Deli, Santhanakrishnan

Syndication in VC financing

PE syndication: Agency costs, reputation and collaboration

Title

21,595 U.S. companies

80 U.K. PEs, 1,122 buyouts

Second data, handcollected

VX

Sample

Resourcebased view Uncertainty

Agency theory, network theory


(Continued)

Data source

Table 4.1.

Why are VC investments syndicated?

Why do PE firms syndicate? How does reputation and network position of lead investor alleviate withinsyndicate agency problems?

Research question

Reduce uncertainty about firm value: more syndication for firms with greater growth opportunities. (Continued)

Mitigate HC and finance constraints: most syndication for early-stage firms, last stage of development (when HC investments are greatest) and firm requiring most finance.

Buyouts with high agency risk are more often syndicated if lead is reputated and highly networked.

Less syndication if potential agency problems (less invested by mgt).

There is a trade-off between trusted expertise (strong preference to doing repeated deals with a few firms) and diversity. Trusted relationships emerge at the national (rather than at the regional) level.

Findings

459

Authors

Dimov, Milanov

Ferrary

Verwaal, Bruining, Wright, Manigart, Lockett

Year

2010

2010

2010

The interplay of need and opportunity in VC investment syndication

Title


Resource access needs and capabilities as mediators of the relationship between VC firm size and syndication

Entrepreneur- Syndication ship Theory of VC & Practice investment: The art of resource pooling


Journal

Sample 35,757 U.S. VC investments

2,715 rounds of U.S. VC syndication


VX

PwC

Questionnaire

Resource needs Capabilities

Gift exchange theory; Resourcebased theory

Egocentric and altercentric uncertainty


(Continued)

Data source

Table 4.1.

Seed stage is less syndicated; especially invested by independent VCs. Number of investors increases during funding life cycle. Different VC investor types participate in later round syndicates (i.e., bring in different resources).

How many investors participate in a syndicate?

(Continued)

Large VC firms syndicate to access future deal flow, small VC firms syndicate to access resources of network partners.

More syndication if lead has limited experience in PF company’s industry: higher need. Higher status VCs are more likely to form syndicates as the need (“novelty”) increases. Higher reputation VCs are less likely to form syndicates as the need increases

Findings

When are investments syndicated?

Research question

460 Syndication

Authors

Hopp

Fritsch, Schilder

Year

2010

2012

Economic Geography


Journal

The regional supply of venture capital: Can syndication overcome bottlenecks?

When do venture capitalists collaborate? Evidence on the driving forces of venture capital syndication.

Title Risk diversification and needs, legitimacy, resource based view

Spatial proximity

Sample 961 German VC-backed start-ups

VC investment in Germany, 2004–2009

VE


(Continued)

Data source

Table 4.1.

Is the supply of VC driven by spatial proximity between a VC company and the portfolio firm, and can syndication play a role?

Research question

(Continued)

A short geographic distance between an investor and the portfolio company increases the probability of syndication and the syndicate size.

Syndication is more pronounced when VCs face higher risks that need to be diversified and capital burdens are larger. Industry investment experience lends legitimacy to lead VCs, allowing them to enter syndicate relationships to enhance their network positions and syndicate more. Lead VCs invite new partners in subsequent financing rounds to leverage their idiosyncratic skills to improve deal selection or provide better quality advice.

Findings

461

Authors

Wang, Wang

Year

2012a


Journal Endogenous networks in investment syndication

Title Theory, Venture Xpert

Data source

(Continued)

40 000 U.S. VC investment rounds

Sample

Table 4.1.

Network theory


Why do venture capital firms syndicate?

Research question

Theory predicts that investors’ risk aversion, project productivity, and investors’output share determine syndicate size. Empirics show that investment risk and portfolio company quality had a significant positive effect on the syndicate size.

Findings

462 Syndication

Authors

Lockett, Wright

Piskorski

Kogut, Urso, Walker

Year

2000

2004

2007

Management Science

WP

Journal

Panel B: Partner Selection

Emergent properties of a new financial market: American VC syndication, 1960–2005

Networks of power and status: Reciprocity in VC syndicates

Title

U.S. VC deals

25,714 U.S. VC portfolio companies

VE

Sample

Social foundations of markets

Local markets develop in resonse to an evolving global system

Network sociology


(Continued)

VE

Data source

Table 4.1.

How do power and status differentially affect reciprocity in VC networks?

Research question

(Continued)

Entrants invest more in start-ups and in stand-alones, but expand through investments in

Against Lerner, both entrants and incumbents prefer an established syndicate rather than investing alone.

Conservative preference for repeated coinvestments to remain geographically and sectorally local is countered by the opportunities to diversify into new sectors and regions that necessitate new partners.

VCs that occupy a powerful network position reciprocate less frequently. High status VCs reciprocate equally frequently as low status VCs.

Positive past interactions and firm reputation important partner selection criteria.

Findings

463

Authors

Tykvov´ a

Hopp

Milanov, Shepherd

Year

2007

2008

2008

Frontiers of Entrepreneurship Research

Economic Letters

Review of Financial Economics

Journal

411 U.S. VC investors

One is known by the company one keeps: Imprinting effects of a firm’s network entry on its future status

VX

—

Sample

2,400 German VC investors

Theory

Data source

Network theory, imprinting theory

Similarity theory

Learning, transfer of know-how


(Continued)

VE Are firms reluctant to engage in interorganizational exchange relationships with competitors?

Why choses whom? Syndication

Title

Table 4.1.

Characteristics of initial syndicate partnerships have long-lasting effects on the long-term status of a VC investor. How do newcomers attain privileged network positions?

(Continued)

VCs are more likely to syndicate with partners which occupy a different strategic (network) position. VCs syndicate more with competitors with more industry experience (short term).

VC syndicate with less experienced partners if they are willing to pay for it.

First-time links are mainly formed when the target already has a high number of investors, i.e., already received endorsement by established VCs

targets with large syndicates.

Findings

Does similarity between VCs enhance or deter syndication?

Research question

464 Syndication

Authors

Meuleman, Lockett, Manigart, Wright

Keil, Maula, Wilson

Year

2010

2010

Partner selection decisions in interfirm collaborations: The paradox of relational embeddedness

Title

Entrepreneur- Unique ship Theory resources of and Practice corporate VCs as a key to entry into rigid VC syndication networks


Journal

Sample 212 syndicated U.K. BOs

358 U.S. CVCs

2nd data, handcollected

VE

Social network; Relational view of strategic management

Network theory Agency theory


(Continued)

Data source

Table 4.1.

Specific resources of CVC can substitute for their lack of prior centrality and allow them to gain rapidly central positions in rigid VC syndication networks. How are CVCs able to move quickly into central positions in VC syndication networks?

(Continued)

When project agency risks are low, PEs syndicate more with unknown partners. Relational embeddedness is more important when knowledge complementarities are higher, but less important when the partner firm has a higher reputation.

Findings

How do reputation and embeddedness impact the choice of syndicate partners?

Research question

465

Authors

Wright, Lockett

J¨ a¨ askel¨ ainen, Maula, Sepp¨ a

Year

2003

2006

The structure and management of alliances: Syndication in the VC industry

Title

Entrepreneur- Allocation of attention to ship Theory portfolio and Practice companies and the performance of VC firms

Journal of Management studies

Journal

Panel C: Managing the Syndicate Sample 58/56 U.K. VCs

94 U.S. VCFs

U.K. VC Survey + documents

VE

Agency theory


(Continued)

Data source

Table 4.1.

How does syndication moderate the relationship between portfolio size and attention?

How is a syndicate structured and managed?

Research question

(Continued)

Foregoing is especially driven by benefits of being non-lead.

More syndication increases the number of pf companies a partner is able to manage optimally and the number of IPOs.

Syndication (% synd deals, number of syndicate partners, avg synd size) does not directly impact performance (measured as % IPOs).

Lead VCs maintain dominant decision-making powers.

Lead VCs interact more frequently with mgt than non-leads.

Lead VCs get more mgt info, but not acct and major event info.

Syndication imposes an agency cost in coordination and decision making.

Non-legal sanctions are more important than legal sanctions in persuading syndicate members to act appropriately.

Leads have higher equity stake than non-leads.

Findings

466 Syndication

Authors

Casamatta, Harichabalet

De Clercq, Sapienza, Zaheer

Year

2007

2008



Journal

Firm and group influences on venture capital firms’ involvement in new ventures


Title

Sample —

160 U.S. VCs

Theory

questionnaire + VX

expectancy theory; equity theory; collective effort model

Cost of competition, information gathering


(Continued)

Data source

Table 4.1.

Do firm-centric or group-centric factors shape involvement?

Research question

Board members put in more effort, but not lead investors.

Total reputation of syndicate members negative.

Focal VC investment relative to syndicate positive.

Focal VC reputation negative.

Syndication affects effort: moderately experienced VCs do not exert enough effort, but experienced too much.

Findings

467

Authors

Brander, Amit, Antweiler

Dimov, De Clercq

Lehmann

Year

2002

2006

2006

Sample 584 Canadian exited VC deals

10,057 U.S. VC-backed firms

108 VC-backed German Neuer Markt IPOs

Data source Model + Macdonald and Associates

VX

German Neuer Markt IPOs

Venture capital syndication: Improved venture selection versus the value-added hypothesis


Does VC syndication spur employment growth and shareholder value? Evidence from German IPO data

(Continued)

Syndicated investments show significantly higher growth rates in employees, supporting the resource-based view.

Impact of syndication on growth?

Risk sharing Resource based view

Level of syndication positively affects proportion of defaults. Do syndicated investments have higher failure rates?

Resourcebased view; escalation of commitment; social loafing

Findings Syndicated investments have higher performance: value-adding prevails. Expected benefits of syndication exceed expected costs.

Research question Selection vs value-adding

screening value-adding


(Continued)

Title

Entrepreneur- VC ship Theory investment and Practice strategy and portfolio failure rate: A longitudinal study


Journal

Panel D: Syndication and Performance

Table 4.1.

468 Syndication

Authors

Abell, Nisar

Casamatta, Harichabalet

Hochberg, Ljungqvist, Lu

Year

2007

2007

2007

Journal of Finance


Management Decision

Journal

Whom you know matters: VC networks and investment performance


Performance effects of VC firm networks

Title 624 European VC Funds

—

16,315 VC-backed U.S. portfolio companies

Theory

VE

Sample

Reciprocity; Selection; expertise


Graph theory


(Continued)

VE, VX, Fame, Diane

Data source

Table 4.1.

Does the network position of a VC firm impact its future performance?

Impact of VC’s network structure and content on its performance

Research question

(Continued)

Firms backed by better networked VCs (higher centrality) have higher probability of survival and of exit.

Better-networked VC firms (network size, access to better networked VCs, being invited) have higher proportion of IPOs or trade sales.

Syndicated deals CAN be more profitable, depending on experience of VCs.

VCFs inviting others in their syndicates also positively impacts: future reciprocity pays off. A VCs ‘betweenness’ has no impact.

VC relationships are relatively exclusive and stable. Networked VCFs realize significantly better performance, especially when VCs are invited into many syndicates, and when they involve other well-connected VCs.

Findings

469

Authors

De Clercq, Dimov

Dal-Pont Grand, Pommet

Year

2008

2010

Economic Letters


Journal

VC syndication and the financing of innovation: Financial versus expertise motives

Internal knowledge development and external knowledge access in venture capital investment performance

Title

Sample

14,129 initial financing decisions of 200 U.S. VCs

—

VX

Theory

Financial versus expertise motives for syndication

Knowledgebased view Strategic alliances


(Continued)

Data source

Table 4.1.

Expertise more important than selection in explaining higher performance of innovative syndicated deals. Does syndication stop inefficient projects earlier?

(Continued)

VCs knowledge positively contributes to positive outcomes, but this decreases with syndication. VCs with little experience in the field of the PF C◦ benefit most from partnering with experienced VCs. More syndicate partners and more embedded partners increases performance.

Results hold when controlling for experience.

This is not only due to access to better deals, but they also provide more value-adding. VC firms improve their network position through demonstrating skills in selection and value-adding.

Findings

How do experiential learning and learning from partners jointly contribute to exit outcome?

Research question

470 Syndication

Authors

Das, Jo, Kim

Chahine, Arthurs, Filatotchev, Hoskisson

Year

2011

2012

Polishing diamonds in the rough: The sources of syndicated venture performance

The effects of venture capital syndicate diversity on earnings management and performance of IPOs in the U.S. and UK: An institutional perspective


Title


Journal

Sample 43,658 U.S. VC portfolio companies

274 U.S. and U.K. VC-backed IPOs

VE

IPO data

(Continued)

Data source

Table 4.1.

Principal– principal agency theory


How do principal– principal agency conflicts within VC syndicates lead to additional principal– agent conflicts in two institutional contexts?

Is superior selection or value-adding leading to higher return of syndicated deals?

Research question

(Continued)

The diversity of a VC syndicate increases pre-IPO earnings management, especially in the U.S. Firms with higher earnings management and VC diversity have higher underpricing and lower aftermarket performance, especially in U.S.A.

Conditional on successful exit, syndication leads to better exit multiples through better selection.

Controlling for selection, value-adding impacts timing and likelihood of exit, as syndication leads to shorter exit times, but not exit multiples.

Syndication is positively related to probability of positive exit.

Probability of syndication increases with project risk, deal size and VCs skills, specialty and # projects financed.

Findings

471

Authors

Tian

Year

2012

Review of Finance

Journal

Data source

VentureXpert The role of venture capital syndication in value creation for entrepreneurial firms

Title 31,000 U.S. VC-backed firms, 1980–2005

Resources, information


(Continued)

Sample

Table 4.1.

How do VC syndicates create value for portfolio firms?

Research question

VC syndicates invest larger amounts in younger, riskier firms. Firms backed by VC syndicates have higher probability of IPOs, higher IPO market valuation and better post-IPO operating performance and survival.

Findings

472 Syndication

4.1 Motives for Syndication

4.1

473

Motives for Syndication

At first sight, the decision to syndicate a deal is not trivial. Why should an investor choose to share the potential rewards of a carefully selected opportunity? An early stream of the syndication literature hence pertained to understand why venture capital investors chose to syndicate some of their deals. The main motives for syndication focus on risk sharing, risk reduction, and access to future deal flow (Lockett and Wright, 2001). Risk sharing A fully diversified portfolio is difficult to obtain for VC firms because of the limitations posed by the size of a VC fund (Sahlman, 1990). By spreading investments across a greater number of portfolio firms whose performance does not covary, syndication enables VC firms to reduce risk without lowering the expected return of the portfolio (Wang and Wang, 2012a). Syndication thus reduces the transaction costs associated with portfolio diversification (Kaiser and Lauterbach, 2007). Empirical evidence broadly supports risk sharing as a motive for syndication. For example, the risk sharing motive is particularly acute when the investment is large (Hopp, 2010) and for small venture capital investors that are more exposed to the risk associated with individual investments (Manigart et al., 2006). All else equal, a smaller VC firm benefits more from risk sharing through syndication than a larger VC firm under the finance perspective, as this decreases the level of concentration in its portfolio. Further, syndication is less likely to be linked with experienced funds but is more likely in industries with higher risk profiles (Hopp and Rieder, 2005) and where liquidity risk is high (Cumming et al., 2005a). There is mixed evidence, however, on whether syndication is associated with riskier early-stage deals. Kaiser and Lauterbach (2007) find a lower likelihood of syndication for earlystage deals as it helps reduce transaction costs, while Ferrary (2010), Tian (2012), and Wang et al. (2002a) find the opposite especially for independent VCs who have the experience to select very early-stage seed deals Ferrary (2010). The illiquidity of VC investments arising from their unlisted nature also motivates syndication (Lockett and Wright, 2001). Due to ex-ante

474

Syndication

informational asymmetry, the underlying risk of an investment may only be revealed once funds have been committed because of asymmetric information problems that cannot be satisfactorily addressed through due diligence. If the risk associated with the investment turns out to be higher than anticipated, it may be difficult to adjust the portfolio by divesting because of the illiquid nature of the venture capital market. Syndication, therefore, provides a means of sharing risk on a deal-by-deal basis that may help to reduce overall portfolio risk. Risk reduction Syndication may also enable VC investors to reduce company-specific risk both ex ante and ex post. Ex-ante decision making relates to the selection of investments, whereas ex-post decision making relates to the subsequent management of the investment. Syndication may enable firms to make better investment selection decisions by enabling firms to work together in evaluating risky deals. U.S. evidence indicates a significant relationship between risk reduction motives for syndication but European findings suggest that risk reduction is not an important motivator for syndication behavior in the VC industry as a whole (Lockett and Wright, 2001; Manigart et al., 2006). Chiplin et al.’s (1997) study of syndication in the U.K. later stage PE market used archival data to identify a weak relationship between risk reduction and syndication. This insight suggests that in later stage deals, investors are better able to make an informed decision because of the investee’s track record which is not possible for early-stage ventures. Further, Casamatta and Haritchabalet (2007) and Kaiser and Lauterbach (2007) suggest that while syndication allows for the gathering of more information to help screening, this is less valuable for experienced VCs who will thus syndicate less or only with more experienced partners. Syndication may also enhance VC firms’ ability to manage better their investments as it provides access to specialist expertise in an industry that a VC firm knows less about (Dimov and Milanov, 2010; Hopp, 2010), with the formation of syndicates taking place as the need arises according to the reputation and status of the VC firm. Syndication also enables VC managers to optimize the time spent in monitoring

4.1 Motives for Syndication

475

(Kanniainen and Keuschnigg, 2003) and introduces a commitment to terminate poor projects in a timely manner (Huang and Xu, 2003). Syndication can help mitigate both human capital and financing constraints for firms with greater growth opportunities and especially in the last stage of development before exit where these constraints are greatest (Deli and Santhanakrishnan, 2010). The different findings on risk reduction as a motive for syndication in the venture capital and private equity industry (e.g., Lockett and Wright, 2001; Manigart et al., 2006) may reflect the dominance of later stage buyout investments and their different characteristics compared to venture capital investments. The importance of the risk reduction motivation for syndication may be increased in the context of distant investments (Fritsch and Schilder, 2012; Sorenson and Stuart, 2001), especially in cross-border VC investments or PE syndicates involving later stage buyouts. Local VCs assume the role of anchor, connecting the VC-backed firms to more distant investors (Fritsch and Schilder, 2012), potentially foreign investors (M¨ akelä and Maula, 2006; Dai et al., 2012). M¨ akelä and Maula (2006) look at the antecedents of venture capitalists’ commitment to portfolio firms in cross-border syndicates. Further, Guler and McGahan (2007) examine whether VC syndication varies in its effectiveness based on the institutional context. Their findings indicate that the number of investors in the syndicates for non-US ventures is larger if intellectual property protection in the region of the entrepreneurial venture is relatively strong. Meuleman and Wright (2011) argue that cross-border syndication involving PE-backed buyouts will be related to the extent to which a host country lacks formal investor protection in its legal system. They show that, in an international context, PE firms are more likely to engage in cross-border syndicates when they have limited experience of investing overseas and also have limited experience of the country they are investing in. Access to Deal Flow Access to quality investment opportunities, via deal flow, is important for all PE firms. By syndicating out deals, a VC firm may create an expectation for reciprocation in the future (Manigart et al., 2006).

476

Syndication

Reciprocation of syndicated deals between firms means that deal flow can be maintained even when an individual firm may not be the originator of the deal. Further, syndication networks in the VC industry diffuse information about investment opportunities and, therefore, expand the geographical and industrial scopes of investment opportunities a VC firm has access to. Venture capitalists that build central positions in the industry’s syndication network invest more frequently in companies that are outside a firm’s current geographical or industrial focus (Sorenson and Stuart, 2001). Syndication also helps prevent competition after projects are disclosed (Casamatta and Haritchabalet, 2007). European evidence indicates that deal flow motives are of greater importance for early-stage VCs (Lockett and Wright, 2001; Manigart et al., 2006). Arguably, the lesser importance of deal flow motives for syndication in PE-backed buyouts is driven by the greater availability of information about these companies. Deal flow motives are also more important for access to deal flow for larger VCs, while smaller VCs are more likely to syndicate in order to access the resources of network partners (Verwaal et al., 2010).

4.2

Partner Selection

VC firms with broader networks have access to a wider range of potential investments while those with more central network positions experience greater financial returns (Hochberg et al., 2007; Sorenson and Stuart, 2001). Partner selection decisions in the early life of a venture capital organization can have an enduring effect on its future network status because of imprinting (Milanov and Shepherd, 2008). Syndicating with valuable partners hence has important consequences for a VC firm. When establishing a VC syndicate, a VC does not only experience agency risk vis-à-vis entrepreneurs, but also vis-` a-vis syndicate partners. VCs therefore try to decrease partner agency risk through different strategies. Lockett et al. (1999) found that positive past interactions with the firm and its personnel are important criteria for the selection of non-lead partners, as this increases trust between syndicate partners and decreases agency risk in the syndicate. Empirical

4.2 Partner Selection

477

studies confirmed that previous syndicate relationships are one of the most important drivers of syndicate partner selection (Bygrave, 1987; Hochberg et al., 2007; Meuleman et al., 2010; Sorenson and Stuart, 2001). Previous partner experience is likely to be more important for early-stage venture capital investments as early-stage investments involve more informational asymmetries and considerable due diligence costs. Early-stage VC investments also frequently involve multiple funding rounds that may mean that incumbent investors provide a false assessment of the project that incoming investors find difficult to verify (Admati and Pfleiderer, 1994). A network of trusted partners can help resolve these incentive problems. Second, the reputation of the partner firm and its executives for being trustworthy decreases partner agency risk (Lockett and Wright, 2000). Established and high status venture capital firms appear to syndicate with one another (Lerner, 1994; Piskorski, 2004), but in later rounds they may syndicate with less established organizations. Interestingly, VC firms may choose to syndicate with less experienced partners if the latter are willing to pay for this (Tykvov´ a, 2007). However, VCs that occupy a powerful network position reciprocate less frequently (Piskorski, 2004) perhaps because of the availability of more syndicate partners. Highly networked and reputable VC leads may be more able to syndicate deals with higher agency risk (Meuleman et al., 2009a,b). If risk reduction and value creation in the portfolio company is an important motive for syndicating a particular deal, lead investors will select partners with relevant, deal-specific knowledge. Meuleman et al. (2010) show that for the buyout stage of the U.K. private equity market that lead investors are more likely to select partners with complementary knowledge with respect to the industry of the underlying investment. Hopp (2008) also emphasizes the importance of complementarities in finding that VCs are more likely to syndicate with partners occupying a different strategic network position or with more experience in a particular industry. Further, the complementarity of the specific resources of corporate VCs can enable them to enter rigid VC syndication networks and rapidly gain central positions (Keil et al., 2010).

478

Syndication

A problem with syndication with previous partners is that, while it provides the benefits of greater trust and the maintenance of a local geographical and sectoral presence, it may compromise the ability to enter into new more lucrative markets (Kogut et al., 2007) and partner networks (Meuleman et al., 2010). Examining how firms go beyond the confinements of embedded relationships, Sorenson and Stuart (2008) show that the probability that geographically and industry distant ties will form between venture capital firms increases with several attributes of the target-company investment setting: (1) the recent popularity of investing in the target firm’s industry and home region, (2) the target company’s maturity, (3) the size of the investment syndicate, and (4) the density of relationships among the other members of the syndicate. Creating a geographically and industry-diverse system of trusted partners enables venture capitalists to participate in attractive, nonlocal opportunities (Sorenson and Stuart, 2001). Extending this study, Meuleman et al. (2008) show for the buyout stage of the U.K. private equity market that previous interfirm relationships are less important for partner selection decisions and engage in network broadening strategies when: (1) potential agency problems at the level of the investee are less severe, and therefore, monitoring becomes less important, (2) when the lead investor has established a reputation for acting as a lead, and (3) when knowledge complementarities exist with potential syndicate partners.

4.3

Managing the Syndicate

The presence of multiple investors in syndicates creates additional agency problems for the management of investments. As a result, there is a need to develop mechanisms to manage syndicates effectively. Syndicates typically involve a lead investor and one or more nonlead investors. The lead has the task of coordinating the syndicate and generally seeks a larger equity stake that may also reflect its role in identifying the deal, being the party bringing the most resources to the syndicate, especially if risk sharing is the main motive for syndication. Where risk reduction is more important, equity stakes may be more even, reflecting the provision of information and expertise by the nonlead in the selection and management of the syndicated deal.

4.3 Managing the Syndicate

479

As a means to reduce information asymmetries between syndicate partners, the syndicated investment agreement typically specifies the information to be disclosed to syndicate partners and its timing (Wright et al., 2003). Information may be distinguished broadly into: (i) accounting-based, (ii) major event-based, or (iii) managementbased information. Accounting-based and major event-based information tend to be available to all syndicate members (Wright and Lockett, 2003). However, the reduction of moral hazard risk through stipulation of behavior in the agreement is more difficult because of the problems in specifying complete contracts and the need for flexibility for syndicates to deal with underperforming portfolio companies. The contractual mechanisms that may be employed to enable contractual enforcement between syndicate partners may be problematic (Cestone et al., 2006). For example, although Admati and Pfleiderer (1994) advocate the use of fixed ratio contracts, Cumming (2005) identifies problems associated with the use of fractional contracts as a means of overcoming the agency problems associated with syndicated investments. A commitment to fixed-ratio contracts across rounds may also be problematical where some partners are unable to ‘follow the money’. There may also be major informational asymmetries between initial round investors and later round syndicate partners regarding whether contracts have been complied with (Wright and Robbie, 1998). More syndication with more syndicate partners may increase the number of portfolio companies that a VC is able to manage optimally (J¨ aa¨skeläinen et al., 2006). However, though the syndicate lead may select partners with whom they know they can work, the presence of multiple investors may create complications and delays in decision making. With larger numbers of syndicate members it may be more difficult and time consuming to renegotiate both the investment agreement and to take action with respect to problem investees (Wright et al., 2003). Decision making within syndicates generally involves discussion and collective agreement. However, the residual rights of control bestowed by equity ownership mean that a dominant equity holder can force all other syndicate members to comply with their decisions if they own enough equity (Wright and Lockett, 2003). The use of “come along” or “drag along” letters enables a syndicate lead to communicate a decision to other non-lead members. For example, such letters may be used to

480

Syndication

force other investors to sell when the lead investor has received an offer for the investee. As a result of potential moral hazard and incomplete contract problems, nonlegal sanctions are used extensively (Das and Teng, 1998). As the VC sector is typically a close knit community with a high degree of interconnectivity between firms, VCs failing to abide by agreements risk damaging their reputation in an environment where repeat investing with syndicate partners is prevalent. The threat of damage to firm and personal reputations for noncompliance introduces a greater incentive to conform to syndicated investment agreements than resorting to legal sanctions or the threat of future nonparticipation by other members in syndicating further deals. The nature of involvement between the investor and investee is influenced by the role the firm performs (i.e., lead or non-lead). Lead investors are more likely to be represented on the board, and are more likely to have frequent formal and informal contacts with the investee than non-lead investors (Wright and Robbie, 2003). The amount of effort exerted in monitoring the portfolio firm appears to be influenced by the experience and reputation of syndicate members. However, the evidence is somewhat mixed. On the one hand, moderately experienced VCs do not appear to exert enough effort while highly experienced VCs exert too much (Casamatta and Haritchabalet, 2007). On the other hand, there are indications that while board members may put in more effort, this may not be the case for lead investors (De Clercq et al., 2008).

4.4

Syndication and Performance

Brander et al. (2002) show for the U.S. early-stage VC market that syndicated investments perform better than sole investments lending support to the value-adding perspective. Das et al. (2011) and Tian (2012) also show that syndication is positively associated with the probability of a positive exit and Cumming and Walz (2010) find that syndication is positively related to gross of fees fund performance. In contrast, Meuleman et al. (2009a,b) find no effect of syndication on post-buyout efficiency and growth measures. Interestingly, using early-stage VC firm data, Dimov and De Clercq (2006) illustrate

4.4 Syndication and Performance

481

the potentially detrimental effect of investment syndicates on fund performance resulting from reduced commitment and free riding on coinvestors’ efforts. Driven by higher agency conflicts in the VC syndicate, Chahine et al. (2012) find that a more diverse VC syndicates is associated with higher underpricing and lower aftermarket performance, and more so in the U.S.A. than in the U.K. These results are in line with Cumming (2006) who shows that the optimal portfolio size is smaller for investors who frequently rely on syndication because each VC must monitor other syndicated VC investors, and not just the entrepreneur. Syndication can lead to greater performance for portfolio companies but it depends upon the experience and networks of the VCs involved (Casamatta and Haritchabalet, 2007). In an interesting longitudinal study, De Clercq and Dimov (2008) examine the performance effects on 200 U.S. venture capital-backed firms of two knowledge-driven strategies, internal knowledge development, and external knowledge access through syndication. Performance is measured in terms of whether the investee firm went public, was sold, failed, and remained private. They find that investing in industries in which a VC firm has more knowledge and investing with more or familiar syndicated partners increases the performance of investees. Access to external knowledge through syndication is most valuable when there is an incongruity between what the firm knows and what it intends to do. Hochberg et al. (2007) find that after controlling for other determinants of VC fund performance, such as fund size and the funding environment, VCs that are better networked at the time a fund is raised subsequently report significantly better fund performance as measured by the rate of successful portfolio exits over a ten-year period. The most important influences on performance were found to be the size of the VC firm’s networks, the tendency to be invited into other VCs’ syndicates, and access to the best networked VCs. At the portfolio company level, a VC’s network centrality had a significant positive effect on the probability that a portfolio firm survived to a subsequent funding round. Interestingly, Hochberg et al. (2007) find that when VC networks are controlled for, the beneficial effects of VC experience are reduced. Moreover, even when persistence in performance from one fund to the next is controlled for, network centrality continues to have a significant

482

Syndication

positive effect on performance. Abell and Nisar (2007) support this evidence and also show that the most important performance effects arise when VCs are invited into many syndicates and when they involve well-connected VCs. This evidence further stresses the importance for VC firms to be invited to strong VC syndicates. It is also important to recognize that the expertise of VCs in being able to add value in syndicated deals is more important in enhancing performance than in selecting better deals (Dal-Pont Legrand and Pommet, 2010). Das et al. (2011) show that controlling for selection, syndication leads to shorter exit times but not better exit multiples. However, conditional on a successful exit, syndication leads to better exit multiples through better selection.


The ultimate goal of venture capital investors is to exit their portfolio companies as profitably as possible. The main successful exit routes considered in the literature are IPOs and trade sales, while the least successful exits include distress trade sales, company buy-backs by the entrepreneur, liquidations, and bankruptcies (Table 5.1). Exit outcomes, particularly when the outcome is firm failure, is arguably one of the least understood aspects of the VC process (Puri and Zarutskie, 2011). Some claim that VCs focus on the few successful companies in their portfolio and hence are quick to cut their losses, while others stress that VC investors are patient investors and exert effort to create value. In a broad study of U.S. companies, Puri and Zarutskie (2011) show that five years after having received a first VC round, companies have a 20% probability of being acquired, a 6% probability of going public in an IPO (both of them being much higher than for non-VC-backed companies), and a 24% probability of bankruptcy. This highlights that exit is indeed fundamental in the venture capital process, but also that a significant proportion (50%) of VC-backed firms have not experienced an exit after five years. Highlighting differences between the U.S. and 483

484

Venture Capital Exits

European VC markets, evidence collected by the VICO project finds a much lower probability of bankruptcy five years after investment (8%), over three-quarters of deals (77%) had not exited. Correspondingly, the probability of IPO (3%) was half of that in the U.S. European exit rates are comparable with U.S. exit rates ten years after a first VC round, both in prevalence and in exit type. European VCs hence take longer to exit their portfolio companies. Due to data limitations, studies on venture capital exits emerged much later than that on portfolio company development, with the exception of research on IPOs on which a lot of data are publicly available. Early research on venture capital exits showed that a large number of venture capital exits are partial exits, implying that venture capital firms do not sell all their shares at once (Cumming and MacIntosh, 2003). The highest quality portfolio firms are usually associated with full exits, either through IPO or trade sale, while partial exits are associated with higher risk and return. This is consistent with information asymmetries between acquirers and sellers driving a partial exit (Cumming and MacIntosh, 2003). Two main questions are asked in the literature: what determines the exit type? and what determines the exit timing? We will first discuss the literature on exit type, and thereafter turn to exit timing, as the type of exit and its timing are often co-determined.

Authors

Black, Gilson

Bascha, Walz

Cumming, MacIntosh

Wang, Sim

Year

1998

2001

2001

2001

Venture Capital

Journal of Multinational Financial Management



Journal U.S. versus German VC industry

—

112 U.S. and 134 Canadian exited portfolio C◦ 21 Singaporean VCs (100 exits)

Public data

Theory

Survey

Survey, interviews

Convertible securities and optimal exit decisions in VC finance VC investment duration in Canada and the US Exit strategies of VC-backed firms in Singapore

VC and the structure of capital markets: Banks versus stock markets

Sample

Grandstanding

Info asymm, max capital gain

Conflicts of interest, separation of control and pay-off


—

Dependent variable

What drives the likelihood of an IPO as exit strategy?

Relationship Hazard rate between duration and investment type

How to select between IPO and trade sale? Effect of contract

What is the relationship between active stock markets and the VC industry?

Research question

Venture capital exits.

Data source

Title

Table 5.1.

(Continued)

Family-owned companies, active in high-technology industries, with higher sales levels and having received a higher amount of VC financing have a higher probability of exiting via IPO. The probability of IPO is not

Duration is longer for later stage and unplanned investments and for lower fundraising (U.S.), no difference for high-tech.

Convertible securities assure efficient exit choice.

An active stock market facilitates an IPO exit.

Findings

485

Journal

Venture Capital



Year Authors

2002 Manigart, Baeyens, Van Hyfte

2003 Chang

2003 Cumming, MacIntosh

Handcollected secondary data

Data source

An examination of full and partial exits

Surveys

VC financing, VE strategic alliances and the IPOs of internet startups

The survival of VC-backed companies

Title

248 U.S. and Canadian exits

1,106 U.S. Internet startups (90 IPOs)

Info asymmetry

IPO hazard rate

Resources, legitimacy

Dependent variable

Hazard rate

Research question

Selection, moral hazard


(Continued)

565 Belgian VC-backed and 565 non-VCbacked companies

Sample

Table 5.1.

(Continued)

Partial exits are associated with higher risk and return (i.e., higher info asymm).

No relationship with investment duration.

Highest quality firms (highest returns) do IPO or trade sale.

More than 50% of exits are full exits.

The time to IPO decreases with VC’s IPO experience, but not with VC’s overall investment experience.

VC-backed companies backed by least experienced govt related VC firm have the lowest survival rates.

VC-backed companies backed by experienced govt related VC firm have the highest survival rates.

VC-backed companies have equal survival rates.

influenced by stock market valuations, nor by the number of investment rounds or the age of VC firms, against the grandstanding hypothesis.

Findings


Authors

Dimov, Shepherd

Cumming, MacIntosh, Schwienbacher

Year

2005

2006



Journal

Legality and VC exit

HC theory and VC firms: exploring “home runs” and “strike outs”

Title

Agency theory

HC theory


(Continued)

468 VC-backed companies from VCs from 12 Asian– Pacific countries

117 U.S. VCFs active in ICT

VX

Handcollected

Sample

Data source

Table 5.1.

How do general and specific HC contribute to success and failure in VC portfolios?


% IPOs % private exits % Writeoffs

(Continued)

Legality is a central mechanism which mitigates agency problems between outsiders and Es, fostering mutual development of stock markets and VC markets.

US-based investee companies have a high % of write-offs and higher % of private exits, but lower % of IPOs.

IPOs (compared to M&A or buyback) are more likely in countries with a high legality index (but not with a stronger stock market).

Higher specific HC leads to proportionally less bankruptcies (expect law industry exp).

% IPOs Higher general HC leads to % Bankrupt- proportionally more home cies runs in VCF portfolio; teams with more science or humanities education have more bankruptcies.

Dependent variable

487

Authors

Giot, Schwienbacher

Sorenson

Bottazzi, da Rin, Hellmann

Year

2007

2007

2008


Journal of Finance


Journal

Who are the active investors? Evidence from VC

How smart is smart money? A two-sided matching model of VC

IPOs, trade sales and liquidations: Modelling VC exits using survival analysis

Title

Sample 5,817 U.S. VC-backed firms

1,666 U.S. VC-backed companies


VX

VX

Survey + Web sites, VX

Two-sided selection versus influence

Asymmetric info, valueadding


(Continued)

Data source


Probability of IPO

Exit timing

Exit type

Dependent variable

(Continued)

VC firms with partners with business experience, but not the extent of VC experience, are more active. Independent VCs are more involved than other types of VC. Investor activism is positively related to the success of portfolio firms.

Due to sorting/selection and ‘influence’.

Companies backed by experienced VCs have higher probability of going public.

Exit times are shorter if investments occurred when more favorable IPO conditions.

Larger syndicates accelerate exit, expecially of IPOs Proximity of one VC investor makes trade sale more likely.

Achieving milestones accelerates exit (including liquidations).

IPO hazard rate first increases with time and thereafter decreases; trade sale hazard rate is less time varying.

Findings


Authors

Cumming, Johan

Dunbar, Foerster

Nahata

Year

2008

2008

2008



European Economic Review

Journal

VC reputation and investment performance

Second time lucky? Withdrawn IPOs that return to the market

Preplanned exit strategies in VC

Title 223 European VC-backed firms

1,473 withdrawn U.S. IPOs, 139 of which returned 12,124 U.S. VC-backed companies

TFSD

VX

Sample

Reputation

Which reputation measures work best?

Likelihood and time to IPO

(Continued)

Measure of reputation = IPO capitalization share.

More reputable VCs exit sooner and and are more likely to exit successfully.

More reputable VCs select better companies and more value.

VC backing is a key factor in predicting a successful IPO return.

Findings

Access to capital versus certification

Dependent variable

VCs preplanned an exit in 31% of portfolio companies. Preplanned acquisition exits are associated with stronger investor veto and control rights and the use of convertible securities. Preplanned IPOs are associated with weaker investor veto and control rights and the use of common equity.

Research question

Agency problems, bargaining power


(Continued)

Handcollected

Data source

Table 5.1.

489

Authors

Knill

Gompers, Kovner, Lerner

Year

2009

2009

Journal of Economic and Management Studies


Journal 8,978 U.S. VC-backed companies

11,297 U.S. portfolio companies

VX, Galante

Specialization Venture Source and success: Evidence from VC

Should VC put all their eggs in one basket? Diversification versus pure play strategies in VC

Sample VC Diversification vs specialization strategies


(Continued)

Data source

Title

Table 5.1.

How does VC firm and GP specialization affect performance?

Research question

Rate of IPO or M&A

Time to IPO, bankrupt

Probability of IPO, bankrupt, still private.

Dependent variable

(Continued)

Poorer performance by generalists is driven by inefficient allocation of funding across industries and poor selection within industries.

Positive relationship between specialization of individual VC GPs as a firm and its success.

Diversification has no impact on probability of failure, except that inexperienced VCs increase the probability of failure with diversification.

Industry diversification decreases probability of M&A exit, but less important effect than on IPO.

Diversification increases the time to IPO and decreases the probability of IPO, except international diversification if associated with int’l branch.

Findings


Authors

Junkunc, Eckhardt

Zarutskie

Dai, Jo, Kassicieh

Year

2009

2010

2012

Title



Crossborder venture capital investments in Asia: Selection and exit performance

The role of top management team HC in VC markets: Evidence from first-time funds

Management Technical Science specialized knowledge and secondary shares in IPOs

Journal

Upper echelon theory

318 U.S. independent VC funds

Information friction, monitoring costs

Agency theory, asymmetric information


2,190 U.S. IPOs

Sample

(Continued)

VentureXpert 2,860 Asian VC-backed companies

Data source

Table 5.1. Dependent variable

Does TMT HC predict fund performance?

IPO probability

Rate of IPOs at exit Rate of exits

Determinants Probability of ability of of selling owners and shares at IPO VCs to sell their shares at IPO

Research question

(Continued)

Firms with both foreign and local VCs as investors are 5% more likely to successfully exit as IPOs.

MBA experience is associated with lower % exits.

Funds with more mgrs with industry exp have higher % of exits.

Funds with more mgrs with VC experience and with start-up experience have higher % of IPOs among exits.

Task and industry experience are more positively related to fund success than general HC.

Former is alleviated when venture’s output has received greater market acceptance.

Insiders are less likely to sell shares at IPO in ventures that are highly dependent on technical specialized knowledge.

Findings

491

Journal Journal of Financial Economics

Journal of Finance

Year Authors

2011 Liu, Ritter

2011 Puri, Zarutskie

On the life-cycle of VC- and non-VC financed companies

Local underwriter oligopolies and IPO underpricing

Title

10,349 U.S. Life cycle of Do VCs cut the firm their losses VC-backed early? Is firms and there a over six mio difference non-VCwhen backed acquired or firms IPO?

How does differentiated underwriting services and localized competition affect IPO underpricing?

LBD (Longitudinal Business Database), VX, VS

Analyst lust theory

4,510 U.S. IPOs, 1993–2008

Theory, Thomson Financials

Research question

Sample


(Continued)

Data source

Table 5.1.

VC-financed firms have lower probability of failure up to four years after VC (20.7% versus 46.5%), but a higher probability thereafter. % IPOs % Bankruptcies % Acquisitions Timing

(Continued)

VC-backed firms have 20% chance of being acquired and 6% chance of IPO, compared to 0.6% (4.6% if matched on size) and 0.01% for non-VC-backed. Acquired or IPOed VC firms do not differ in size from non-VC backed firms. This general pattern is true for old and young VC backers.

Failing VC-financed firms are larger (number of employees) and less profitable than failing non-VC-backed firms.

VC-backed IPOs are 20% more underpriced when they have coverage from an all-star analyst.

Findings

IPO underpricing

Dependent variable


Authors

Masulis, Nahata

Smith, Pedace, Sathe

Year

2011

2011

Sample 337 U.S. acquired VC-backed companies, 1991–2006, and 2,452 non-VCbacked acquisitions

6,206 U.S. VC funds

Data source Thomson M&A, VX, market data

VentureXpert and Preqin

Venture capital conflicts of interest: Evidence from acquisitions of venturebacked firms

VC fund financial performance: The relative importance of IPO and M&A exits and exercise of abandonment options



Conflicts of interests between shareholders


(Continued)

Title

Journal

Table 5.1.

How do exits contribute to VC fund returns?

Research question

VC fund IPO and M&A outcomes are positively related to VC fund performance, but IPOs contribute more than M&As. Funds that aggressively cut their losses outperform those that continue to support their initial invetsments.

Fund IRR, total value to paid-in capital

(Continued)

Acquirers of VC-backed private firms realize a higher mean announcement return than acquirers of non-VC-backed private firms. Acquisition premia are lower for portfolio companies backed by venture capital funds closer to maturity, by venture capital firms with direct financial ties to acquirers or by corporate venture capital investors.

Findings

CAR, takeover premium

Dependent variable

493

Journal Small Business Economics

International Entrepreneurship and Management Journal

Year Authors

2013 Clarysse, Bobelyn, de Palacio Aguirre

2012 Cressy, Malipiero, Munari

Handcollected archival data

VentureXpert

Does VC fund diversification pay-off? An empirical investigation of the effects of VC portfolio diversification on fund performance


(Continued)

649 U.K. VC funds, 4,751 VC-backed companies

Resourcebased theory, Financial intermediation theory

Learning 133 theory acquired VC-backed U.K. start-ups and 133 not acquired

Data source Sample

Learning from own and others’ previous success: The contribution of the venture capital firm to the likelihood of a portfolio company’s trade sale

Title

Table 5.1.

(Continued)

% IPOs and Higher VC fund trade sales diversification by industry lowers the percentage of successful exits, but diversification by geographical region increases the percentage of successful exits. How does diversification by VC firms affect the proportion of successful exits?

Both trade sale experience of the VC firm and of the investment manager significantly increase the trade sale likelihood. Congenital trade sale experience of investment managers who join the fund partly compensates for the lack of experience within the fund itself; vicarious learning from network partners does not contribute to trade sale probability.

Findings

Likelihood of trade sale

Dependent variable

To what extent do different VCs contribute to the likelihood that a portfolio company will realize a trade sale?

Research question


Authors

Matusik, Fitza

Wang, Wang

Year

2012

2012

Journal of Empirical Finance


Journal

Economic freedom and crossborder venture capital performance

Diversification in the venture capital industry: Leveraging knowledge under uncertainty

Title

Sample 7,479 VC firm investment, 1960–2000

6,536 VC-backed firms in 35 countries, 1995–2005

VentureXpert

VentureXpert

The percentage of IPOs is higher for VC firms with low or high levels of diversification. Effects are more pronounced when uncertainty is higher (i.e., for early-stage investments, no coinvestors). In a more economically free country, a foreign VC-backed portfolio company is more likely to pull off a successful exit through an IPO (initial public offering) or an M&A (merger and acquisition), and a foreign VC firm is likely to spend a shorter investment duration in the portfolio company.

% IPOs

Likelihood of IPO and trade sale

What are the benefits of a VC firm’s diversification?

How does domestic economic freedom impact VC exit?

Knowledge, learning theory under uncertainty

Economic freedom

Findings

Dependent variable

Research question


(Continued)

Data source

Table 5.1.

495

496


5.1

Exit Type

Black and Gilson (1998) were among the first to stress the importance of venture capital exit mechanisms. Interestingly, they focused their attention to the entrepreneur, arguing that IPO exits are the only exit type in which entrepreneurs can regain control over successful ventures. They argued that, given an entrepreneur’s desire for control, active stock markets facilitating IPO exits are a necessary condition to achieve well-functioning and well-developed venture capital markets. In further multicountry studies, Cumming et al. (2006) showed that a higher legality index in a country, rather than the strength of its stock market, leads to more IPO exits, as legality is a central mechanism which mitigates agency problems between outsiders (new investors) and entrepreneurs, fostering mutual development of stock markets, and venture capital markets (Cumming et al., 2009). The nature of regulation in a particular environment may not only impact the supply of capital and its quality but also the nature of VC fund involvement with portfolio companies and the type of exit. Examining the buyout end of the PE market in the light of the extensive critique of the industry during the boom period of 2006–2007, Cumming and Zambelli (2010, 2012) show using data from Italy that extreme regulation reduces PE returns and firm performance, as well as the likelihood of an IPO exit. While IPOs are generally portrayed as a successful exit strategy for VC investors, Junkunc and Eckhardt (2009) stressed that VC investors and entrepreneurs do not always sell shares at IPO, hence that an IPO in itself is not an exit for VCs. They showed that VC investors and entrepreneurs are less likely to sell shares at IPO if information asymmetries between insiders and outsiders are higher, i.e., when ventures are highly dependent on technical specialized knowledge. This effect is alleviated when the venture’s output has received greater market acceptance, and hence when information asymmetries are lower (Junkunc and Eckhardt, 2009). Insiders staying in the company at IPO hence serve as a positive signal to outsiders, which is more valuable when information asymmetries are high. Nevertheless, U.S. VC fund performance is more strongly related to IPO success than to M&A success (Smith et al., 2011).

5.1 Exit Type

497

Venture capital and deal characteristics, in addition to macroeconomic and institutional factors, have been advanced as determinants of the type of venture capital exit (Wang and Sim, 2001; Wang and Wang, 2012b). Interestingly, almost no research explicitly focuses on portfolio firm characteristics to explain exit type (nor exit timing). Before turning to the literature on VC and deal characteristics, we briefly review the literature on exit differences between VC- and nonVC-backed companies. Venture capital-backed versus non-venture capital-backed firms Differentiating between bankrupt and surviving ventures, Manigart et al. (2002a,b) showed that European venture capital-backed firms have equal survival rates as non-venture capital-backed firms, and this despite the fact that venture capital firms have a strong ability to pick winners (Baum and Silverman, 2004). In contrast, Puri and Zarutskie (2011) show in U.S.A. that the probability of failure is lower for VCfinanced firms up to four years after having received VC, and it is comparable thereafter. The mere fact of receiving equity from a VC hence shields a firm from bankruptcy early on, but this effect does not last long. Interestingly, failing VC-backed firms have more employees but are less profitable than failing non-VC-backed firms (Puri and Zarutskie, 2011). This is consistent with VC-backed firms pursuing high growth strategies, which entails a high business risk and hence increases bankruptcy risk. In contrast with bankrupt firms, acquired VC-backed firms or VC-backed firms that did an IPO do not differ in size from non-VC-backed firms (Puri and Zarutskie, 2011). Interestingly, and in contrast with the certification hypothesis, Masulis and Nahata (2011) found that the announcement of acquisitions of venture capital-backed firms leads to higher acquirer returns compared to the announcement of acquisitions of private non-venture capital-backed firms. They showed that acquisition premia are lower for portfolio companies backed by venture capital funds closer to maturity, by venture capital firms with direct financial ties to acquirers or by corporate venture capital investors. These findings are consistent with the existence of conflicts of interest between venture capital investors and other shareholders of the portfolio company. Finally, in a study of

498


withdrawn IPOs of which almost 10% returned at some future point to the market, Dunbar and Foerster (2008) showed that VC backing is a key factor in predicting a successful IPO return, as VC investors provide legitimacy to their portfolio companies. Venture capital firm characteristics The probability of a successful or unsuccessful exit is strongly determined by characteristics of the VC investor. Portfolio firms backed by experienced government-related VC firms have higher survival rates compared to those backed by independent VC firms, explained by the fact that government VC firms have mainly a regional economic development goal and hence prefer to keep the ‘living deads’ alive (Manigart et al., 2002a,b). In contrast, those backed by inexperienced government-related VC firms have lower survival rates, as inexperienced government officials are not skilled (yet) in selection and value-adding (Manigart et al., 2002a,b). Both the type of VC firm and the knowledge embedded in the human capital of its partners or in the organization are important in explaining bankruptcy probability and bankruptcy rate, but also success. Higher levels of knowledge should enhance selection and valueadding skills, and hence lower the probability of portfolio company failure and increase the probability of success. Dimov and Shepherd (2005) have shown that independent VC firms with more partners with higher specific human capital (i.e., with portfolio company industry experience or law experience) or less partners educated in science or humanities experience proportionally less bankruptcies, implying that higher levels of relevant human capital contribute to the survival of portfolio firms. Zaturskie (2010) claims, however, that VC partners’ task and industry experience are more positively related to exit success rates (including IPOs and trade sale exits) than their general human capital: IPOs are more prevalent when VC partners have more VC experience or more start-up experience. Venture capital investors with more managers with industry experience have a higher percentage of exits in general. VC partners who are able to draw upon their experience to counsel portfolio companies have hence higher success rates. Interestingly, VC partners with MBA experience are associated with a lower

5.1 Exit Type

499

proportion of successful exits (Zarutskie, 2010). The specialization of a venture capital firm, as an indication of its firm-level knowledge, has no impact on the probability of failure (Knill, 2009), but increases the probability of an IPO or a successful trade sale (Knill, 2009; Gompers et al., 2009). VCs with more investment experience (Sørensen, 2007) or with a higher reputation (Nahata, 2008) have higher proportions of IPO exits. In the latter study, reputation is measured as the share of the VC in total IPO capitalization. These findings are explained by higher quality venture capital firms being able to select the best opportunities and to add more value (Sørensen, 2007; Nahata, 2008). Both trade sale experience of the VC firm and experience of the investment manager significantly increase a trade sale likelihood. Trade sale experience of investment managers who join the fund partly compensates for the lack of experience within the fund itself, but not experience from syndicate partners (Clarysse et al., 2013). Gompers et al. (2009) further show that the stronger exit performance of VC specialists is driven by both more efficient allocation of funding across industries and better selection within industries. Cressy et al. (2012) document in the U.K. that regional diversification is associated with a higher proportion of successful exits, including IPOs and trade sales, but diversification by industry lowers the proportion of successful exits. Interestingly, Matusik and Fitza (2012) document a more refined relationship between specialization and exit performance: both highly specialized and highly diversified venture capital firms have a higher percentage of IPOs in U.S.A. Wang and Wang (2012b) have shown that a foreign VC-backed portfolio company is more likely to do a trade sale or IPO, and to do this quicker, when the portfolio company is located in a more economically free country. Further, Dai et al. (2012) show that portfolio companies, backed by a syndicate comprising both domestic and cross-border investors, have a higher probability to exit through IPO than companies backed by either domestic or cross-border investors alone. The VC process also impacts portfolio firm exits. Bottazzi et al. (2008) showed that venture capital investors who provide more effort have higher exit performance. Examining whether investees made a

500


successful exit or not, Bottazzi et al. (2008) find a positive relationship between investor activism and exit performance that is both statistically and economically significant. This study is particularly interesting as it demonstrates the richness of data that can be collected to obtain detailed insights into the involvement of VC firms in investees as it combines both survey and archival data, including from VC firm web sites, from multiple countries. Both quantity and quality of efforts are important in achieving successful exits. Deal and company characteristics The specificities of the deal at investment may strongly influence what happens at exit. Cumming and Johan (2009) even showed that the exit is preplanned in more than 30% of European deals, implying that VC contracts have specific exit provisions. A stronger bargaining power of the VC is not only associated with stronger control rights and the use of convertible securities, but also with preplanned acquisition exits. In contrast, preplanned IPOs are associated with weaker control rights and the use of common equity (Cumming and Johan, 2009). Focusing on the choice between a trade sale and an IPO, Bascha and Walz (2001) showed theoretically how convertible securities assure efficient exit choice in a framework including potential for conflicts of interest between entrepreneurs and venture capital investors. Entrepreneurs seeking private benefits from staying independent, which is better guaranteed under an IPO, may have incentives to distort the firm’s innovation strategy in order to induce the venture capitalist to bring the company public (Schwienbacher, 2007). VCs may therefore need to introduce control rights into a deal to address the potential problem that entrepreneurs’ preference to enjoy the private benefits derived from exiting via an IPO and becoming the CEO of a publicly listed firm may be in conflict with a higher financial return available from exit through a trade sale. Using a sample of European VC investments, Cumming (2008) finds that stronger VC control rights increase the likelihood of exit by an acquisition, rather than through a write-off or an IPO. Interestingly, LiPuma (2012) showed that portfolio companies that operate solely in domestic markets have quicker IPOs

5.2 Exit Timing

501

and receive higher valuations at IPO compared to portfolio companies that are active internationally. Investors perceive internationalization of entrepreneurial companies as increasing agency risks.

5.2

Exit Timing

The timing of exit is also an important determinant of venture capital returns. The sooner a successful exit can take place, everything else equal, the better for a VC’s return. But an early exit may be suboptimal for the entrepreneurial firm or the entrepreneur (Gompers, 1996), leading to goal incongruencies and conflicts of interest. Alternatively, Guler (2007) has shown that VC firms fail to cut their losses in a timely way: due to escalation of commitment, they commit too long to a failing course of action. An important question for VC investors is whether to focus on the few successful exits and cut losses early, or invest more time and effort on fledgling ventures in trying to improve their performance. Except among the top performers, U.S. funds who aggressively cut their losses early outperform those that continue to support a large percentage of their initial investments (Smith et al., 2011). The use of hazard rate analysis has spurred a stream of research focusing on explaining the timing of venture capital exits. Giot and Schwienbacher (2007) showed that the hazard rate of a trade sale is time invariant, while the IPO hazard rate first increases with time and thereafter decreases. Further, larger syndicates accelerate exit rates, and especially IPO exit rates (Giot and Schwienbacher, 2007). Using an information asymmetry framework, Cumming and MacIntosh (2001) showed that exit takes longer for later stage and unplanned investments, but they did not find differences for high-tech investments versus low-tech investments. In general, achieving milestones accelerates exit of venture capital-backed companies, including liquidation, as this reduces uncertainty and decreases information asymmetries (Giot and Schwienbacher, 2007). As experienced and reputed venture capital investors are able to select better ventures, bring more resources to their portfolio firms and increase their legitimacy more, venture capital investors experienced in IPOs (but not their general experience) decrease the time to

502


IPO (Chang, 2004; Nahata, 2008). Alternatively, more diversified VC investors increase the time to IPO.

5.3

Initial Public Offering’s Underpricing

A long-standing stream of research on venture capital, originating in the finance literature, has investigated the role of VCs in initial public offerings (IPOs) of their portfolio companies (Table 5.2). Early research on this topic was probably driven by the availability of data on newly public firms, in contrast with the dearth of information on private firms. It is also a relevant topic, as it is often claimed that IPOs are the optimal way for venture capital investors to exit their companies, as it is widely believed that IPOs provide the highest returns to investors (e.g., Dimov and Shepherd, 2005). Early studies largely focused on the initial underpricing at IPO, while later studies also investigated longterm performance effects. It is a well-documented phenomenon worldwide that the shares of a company that goes public strongly increase in value in the first days of public trading, compared to the price investors pay at IPO. This phenomenon is known as underpricing, and constitutes a cost to the issuing shareholders of the newly public firm, as they seemingly sold their shares for a too low price to the market. Underpricing is mainly driven by information asymmetries between issuing shareholders and investors. Using a signaling framework, Bartling and Park (2009) developed a model suggesting that VC-backed firms are superiorly informed compared to non-VC-backed firms. In bargaining with banks, they impose smaller spreads but are expected to face larger underpricing. In a seminal paper, Megginson and Weiss (1991) showed, however, that U.S. VC-backed IPOs have lower underpricing and lower underwriting spreads, i.e., lower costs of going public, compared to IPOs from comparable companies that have no VC backing, and this despite the fact that they are younger on average and hence expose their investors to higher information asymmetries. Further, VC-backed IPOs attract more prestigious auditors and underwriters, and attract greater interest from institutional investors (Megginson and Weiss, 1991). Overall, this shows that the cost of going public is lower for VC-backed

136 U.S. VC-backed and 136 matched non-VCbacked IPOs

Post-IPO data

VC certification in IPOs

VC participation and the post-issue operation performance of IPO firms

1991 Megginson, Journal of Weiss Finance

1995 Jain, Kini

Managerial and Decision Economics

320 U.S. VC-backed firms and 320 matched non-VCbacked firms

IPO data

The role of VC in the creation of public companies: Evidence from the going-public process


1990 Barry, Muscarella, Peavy, Vetsuypens

US VC-backed IPOs

Title

Journal

Year Authors


Dependent variable

Certification Change in ROA Post-IPO growth in sales, capex, expenditures

Certification UP Spread Investor interest

Monitoring

Research question

Venture capital and initial public offerings.


Table 5.2. Findings

(Continued)

VC-backed IPOs have higher operating performance (and improvement) compared to non-VC-backed IPOs, with having more VCs (as investors or as board members) leading to

VCs maintain their shareholdings after IPO.

Certification role of VCs: VC-backed firms have lower UP and lower costs of IPO (underwriting spreads). VC-backed attract more prestigious auditors and underwriters. VC-backed attract greater interest from institutional investors during IPO and are younger.

Experienced VCs on the board lower UP.

VCs take action to monitor: specialization, concentrated ownership (retain stake after IPO), board seat.

5.3 Initial Public Offering’s Underpricing

503

Journal

Journal of Finance

Journal of Finance

Year Authors

1996 Gompers

1997 Brav, Gompers

433 U.S. VC-backed IPOs

4,341 U.S. VC- and non-VCbacked IPOs

Post-IPO Myth or market reality? The data long run underperformance of IPOs: Evidence from VC and non-VC-backed companies


Reputation, grandstanding


(Continued)

IPO Files

Grandstanding in the VC industry

Title


Five year post-IPO market performance

UP at IPO

Dependent variable

(Continued)

VC-backed IPOs outperform non-VC-backed IPOs, but only in an equally weighted portfolio (not value weighted).

Young VC firms have been on the board for a shorter period of time, hold smaller equity stakes, and time IPO to coincide or precede raising money.

Companies backed by young VC firms are younger and more underpriced at IPO.

VC-backed IPOs have initially higher MTB and P/E-ratios, but this difference disappears over time.

higher post-IPO performance.

Findings



1998 Amit, Brander, Zott

2000 Hamao, Packer, Ritter

PacificBasin Finance Journal

2000 Espenlaub, Venture Capital Garrett, Munn

Journal

Year Authors Macdonald and Associates, based on surveys

355 Japanese VC-backed IPOs and 355 matched non-VCbacked IPOs

Certification versus conflict of interest

Information asymmetry, hidden information, hidden action


(Continued)

369 Canadian firms backed by Canadian VCs


Post-IPO Institutional Affiliation and market the Role of VC: data Evidence from IPOs in Japan

Conflicts of interest and the performance of VC-backed IPOs: A preliminary look at the UK

Why do venture capital firms exist? Theory and Canadian evidence

Title

Table 5.2.

UP Long-run performance

Three year post-IPO market performance What are performance effects if VCinvestors are also underwriters?

Dependent variable

What are conflicts of interests if VCs and underwriters are the same?

Research question

(Continued)

Higher performance of IPOs backed by foreign VCs.

Long-run performance of IPOs backed by Japanese VCs is same as non-VC-backed performance.

Deep UP when lead VC is also lead underwriter, but no difference in long-run performance.

VC firms invest mainly in industries with high information asymmetries and in later stage firms. Although IPOs generate highest return at exit, the vast majority of exits occurs through insider sales (trade sale or MBO). There is a negative relationship between the extent of VC ownership and firm performance.

Findings


505

Journal Journal of Business Research

Economic Policy

Journal of Financial and Quantitative Analysis PacificBasin Finance Journal

Year Authors

2001 Jain

2002 Bottazzi, da Rin

2002 Bradley, Jordan

2002 Kutsuna, Okamura, Cowling

500 companies listed on Euro. NM

3,325 U.S. IPOs

247 Jasdaq companies

IPO data

IPO data

Partial adjustment to public information and IPO underpricing Operating structures preand post-IPO and the operating performance of JASDAQ companies

104 U.S. VC-backed IPOs

IPO prospectuses, annual reports

IPO data

Research Data source setting VC factors, PF C◦ strategy, industry


(Continued)

Venture capital in Europe and the financing of innovative companies

Predictors of performance of VC-backed organizations

Title

Table 5.2.

Corporate Governance

Is public information reflected in IPO prices?

What is the impact of VC on European portfolio companies?

Predictors of future performance of VC-backed firms

Research question

Pre- and post-IPO operating performance, performance growth

UP

in(de)crease of operating ROA post-IPO compared to pre-IPO

Dependent variable

(Continued)

Performance declines more if top shareholders sell at IPO; performance is higher with higher VC ownership after IPO.

VC firms decrease equity stake after IPO; 50% fully divest at IPO. Overall, performance of JASDAQ firms decreases after IPO.

No difference in UP between VC-backed and non-VC-backed IPOs.

No effect of VC on growth.

Asset turnover and number of VCs positively related to post-IPO performance.

Industry variables not related to post-IPO performance.

Findings


Journal of Financial Research

2002 Wang, Wang, Lu



2003 Janney, Folta

2003 Wang, Wang, Lu

2003 da Silva PacificRosa, Basin Velayuthen, Finance Walter Journal

Journal

Year Authors

Effect of VC’s participation in listed companies

Post-IPO data

82 Singapore VC-backed IPOs and 82 matched non-VCbacked IPOs

328 quoted U.S. biotech firms


(Continued)

333 Australian IPOs (of which 38 are VC-backed)

64 VC-backed companies quoted on Singapore stock exchange


Market Signaling data through private equity placements and its impact on the valuation of biotech firms

Differences in performance of independent and financeaffiliated venture capital firms

Title

Table 5.2.

Certification/ monitoring versus Adverse Selection/ grandstanding

IPO performance, post-IPO operational performance, after-market performance

Information CAR upon asymmetry, announcesignalling ment theory

(Continued)

Post-IPO operating performance of VC-backed companies is

VC-backed IPOs are less underpriced, have higher quality underwriters, but no lower IPO costs.

VC-backed IPOs are younger and have higher pre-IPO growth rates.

Quoted biotech firms experience positive returns when announcing private placements, especially when accompanied with the announcement of research partnerships.

Australian VCs do not certify.

No difference in long-run return, nor do IPOs underperform the market.

No difference in UP of VCand non-VC-backed IPOs.

Certification UP, long-run performance

Findings Compared with independent VC-backed IPOs, finance-related VC-backed IPOs have higher UP and lower 1and 3-month performances.

Dependent variable

Post-IPO performance of different types of VCs

Research question


507

Theory


2005 Neus, Walz

Exit timing of VCs in the course of an IPO

Grandstanding, IPO data certification and the UP of VC-backed IPOs


Public data

2004 Lee, Wahal

Title

Financing high-tech growth: The role of banks and venture capitalists

Journal

2004 Audretsch, SchmalenLehmann bach Business Review

Year Authors

—

6413 IPOs (VC + non-VC)

341 firms listed on Neuer Markt


Table 5.2.

Reputation, information asymmetries


(Continued) Dependent variable

Why don’t VCs always sell all their shares at IPO?

Certification versus grandstanding

UP, VC fundraising

Are debt and Growth in employees equity substitutes or complements in financing young tech firms?

Research question

(Continued)

Reputation serves as a credible commitment to the accurate pricing of IPOs.

Young and unseasoned VCs may underprice IPOs or delay divestments to acquire reputation.

VC-backed firms have larger UP than non-VC-backed firms. Certification supported: VCs leading IPOs with greater UP have larger future flows of capital. Younger VCs and VCs with fewer IPOs take younger and smaller companies public.

Positive effect of VC on post-IPO employee growth.

Market performance is not different between VC-backed and non-VC-backed IPOs.

lower (and declines faster), while it’s higher for non-VC-backed IPOs.

Findings


Journal Journal of Corporate Finance

Global Finance Journal

Global Finance Journal

Year Authors

2007 Dai

2007 Tykvov´ a, Walz

2008 Chahine, Filatochev

108 French non-VCbacked and 122 VC-backed IPOs

IPO data The effect of VC affiliation to underwriters on short- and long-term performance in French IPOs

113 PIPEs with VC, 397 PIPEs with HF

204 nonVC-backed and 123 VC-backed IPOs on Neuer Markt

Public data


(Continued)

How important IPO data is VC participation in German IPOs?

Does investor identity matter? An empirical examination of investments by VC funds and hedge funds in PIPEs

Title


Table 5.2.

UP, two-year return volatility

UP, LT return

Signaling, monitoring

Dependent variable

Governance structure, goals, experience differentiate between VCs

Research question

(Continued)

IPOs with VCs affiliated to lead underwriters have higher LT and ST performances than non-affiliated

IPOs with VCs affiliated to lead underwriters have lower UP than non-affiliated VC-backed and non-VC-backed IPOs.

IPOs backed by independent, international, or reputable VCs outperform; IPOs backed by public VCs underperform.

UP does not differ depending on type of VC, but is higher for reputable VCs.

Post-PIPE performance is better when VCs invest than when hedge funds invest. This is more a certification effect than a monitoring effect.

Findings


509

Journal

Applied Financial Economics

International Review of Economics and Finance

International Journal of Public Sector Performance Management

Year Authors

2009 Abdou, Varela

2009 Bartling, Park

2009 Batnini, Khalfallah

—

VC-backed IPOs

Theory

IPO data

What determines the level of IPO gross spreads? Underwriter profits and the costs of going public Performance of new equity issuers, VC and auditor’s reputation ENKEL ABSTRACT BESCHIKBAAR

319 defunct U.S. VC-backed IPOs and 319 healthy VC-backed IPOs

Post-IPO survival



(Continued)

Is there a puzzle in the failure of VC-backed portfolio companies?

Title

Table 5.2.

How does audit firms’ reputation impact the IPOs of VC-funded firms?

Signaling

Probability of bankruptcy after IPO

Experience and reputation

UP, gross spreads

Time to bankruptcy after IPO

Dependent variable

Research question

(Continued)

VC investors try to strengthen their reputation through very reputed auditors in order to reduce underpricing.

Superiorly informed VC-backed firms impose smaller spreads but face larger UP than non-VC-backed firms.

Experience and reputation of VC extend time from IPO to bankruptcy, but does not differentiate between survival and bankruptcy.

VC-backed and non-VC-backed IPOs. Affiliation with (prestigious) underwriters enhances screening, monitoring and certification.

Findings


Journal Journal of Economics and Business

Entrepreneurship Theory and Practice

European Finance Journal

Year Authors

2010 Boulton

2009 Bruton, Chahine, Filatotchev

2009 Coakley, Hadass, Wood

Founders, private equity investors, and underpricing in entrepreneurial IPOs UK IPOs underpricing and VC

VC and the incorporation decisions of IPO firms

Title 2,052 U.S. VC-backed and 2745 non-VCbacked IPOs

275 U.K. entrepreneurial IPOs, LSE, and AIM 591 U.K. VC- and non-VCbacked IPOs

IPO data

IPO data

UP

UP

Signaling, agency theory

Certification versus Spinning

VC-backed IPO firms are more likely to be incorporated in acquisition-friendly states.

Geographic location Acquisition probability

In which U.S. states are firms incorporated, depending on antitakeover laws?

Liquidity, strong governance mechanisms increase value

(Continued)

UP of VC-backed IPOs is lower pre- and post-bubble years. During dotcom bubble, UP increased while operating performance of IPO firms decreased; experienced VCs and underwriters are associated with highest UP (spinning: take advantage of market exuberance).

VC has no impact on underpricing, but business angels reduce underpricing.

Firms incorporated in acquisition-friendly states have a higher probability of being taken over five years after IPO.

Findings

Dependent variable

Research question


(Continued)

IPO data


Table 5.2.


511

Journal


Journal of Economics and Business

2010 Bruton, Filatotchev, Chahine, Wright

2010 Elston, Yang

2010 Arikawa, Journal of Imad’EddineEconomics and Business

Year Authors

Neither VC ownership (dummy and equity %) nor additional info disclosure have impact on UP.

UP

131 VC-backed and 189 non-VCbacked Neuer Markt IPOs

IPO data

VC, ownership structure, accounting standards and IPO UP: Evidence from Germany

(Continued)

Concentrated ownership improves IPO performance. BAs have a value increasing effect, especially in France. VCs have a positive effect on performance in the U.K.

Stock market performance

Multiple agency theory, ownership concentration; Institutional context

112 U.K. and 112 French VC-backed IPOs

IPO data

Governance, ownership structure and performance of IPO firms: The impact of different types of PE investors and institutional environments ROA

UP is lower when VC is subsidiary of lead underwriter and when directly invested in IPO firm (rather than through fund).

Findings

UP

Agency problem between IPO firm and underwriter

463 Japanese IPOs, of which 269 VC-backed

Dependent variable

IPO data

Research question

VC affiliation with underwriters and the UP of IOPs in Japan

Title


(Continued)


Table 5.2.


Journal Journal of Corporate Finance

Year Authors

2011 Lee, Masulis

US IPO Do more data reputable financial institutions reduce earnings management by IPO issuers?

Title


Table 5.2.

Reputation of financial intermediaries


(Continued) Dependent variable

Do financial Earnings manageintermediment aries restrain earnings management around IPOs?

Research question

There is no evidence that VCs as a group restrain EM by IPO issuers. However, more reputable VCs are associated with significantly less EM. Moreover, a stronger reduction in EM is found when more reputable investment banks are matched with more reputable VCs, which indicates that VC and IB reputation are complements rather than substitutes.

Findings


513

514


firms compared to non-VC-backed firms. Megginson and Weiss (1991) attribute this to the certification effect of VC investors: as VCs often bring companies to the market, they cannot afford to bring low-quality firms to the market. When a VC-backed company does an IPO, it is hence thought to be of higher quality compared to non-VC-backed companies on average. Comparable outcomes are found on the Singapore stock market: despite the fact that VC-backed IPOs are younger compared to non-VC-backed IPOs, they are less underpriced and have higher quality underwriters, but no lower IPO costs (Wang et al., 2003). Studying later time periods, however, the difference in underpricing between VC-backed and non-VC-backed IPOs has disappeared in the U.S.A. (Bradley and Jordan, 2002), in Australia (da Silva Rosa et al., 2003), in the U.K. (Bruton et al., 2009), and in Germany (Elston and Yang, 2010). This is attributed to the fact that whether or not a company is backed by a VC is public information, and this information is now incorporated into the price (Bradley and Jordan, 2002). Further, Australian VC firms might provide lower certification to their portfolio companies (da Silva Rosa et al., 2003). Lee and Wahal (2004) even find higher underpricing for U.S. VC-backed firms compared to non-VC-backed firms when controlling for the endogeneity in applying for and receiving venture capital, which is in line with the theoretical predictions of Bartling and Park (2009). This hints that matching procedures used in earlier studies to compose samples of non-VC-backed firms might not fully account for pre-investment differences in VC- and non-VC-backed firms. Further, underpricing is higher if VCs have a seat on the Board of Directors (Chahine and Goergen, 2011). Interestingly, early studies showed that IPO is not a pure exit strategy for VC investors, as they typically maintain their shareholdings after an IPO (Megginson and Weiss, 1991). This serves as a credible signal used by VCs to decrease information asymmetries (Neus and Walz, 2005). Liu and Ritter (2011) document that the higher underpricing of U.S. VC-backed IPOs is largely attributable to those that receive coverage from an all-star analyst, which will help sustain the price in the long run when they exit. The behavior and impact of VC investors in other parts of the world are not fully comparable to what happens in the U.S.A. Kutsuna et al.


515

(2002), for example, showed that half of VC investors fully divest at IPO on the Japanese Stock Market, while the remainder tend to sell a significant fraction of their shareholdings. Further studies have tried to bring more nuance to or explanation of findings in more detail. While there is (mixed) evidence that VC investors lower the costs and underpricing of IPOs of their portfolio companies, not all VC investors induce the same effect. Barry et al. (1990) showed that underpricing is especially reduced if more and more experienced VC investors have board seats and higher equity stakes. They attribute this to the stronger monitoring exerted by experienced investors. This might also be an effect of the lower earnings management around IPOs of companies backed by more reputable VCs (Krishnan et al., 2011). Interestingly, Coakley et al. (2009) in the U.K. and Tykvov´ a and Walz (2007) in Germany showed that IPOs backed by more reputable or experienced VC investors, experienced higher levels of underpricing during the dotcom bubble and this despite the finding that IPOs backed by high quality VCs typically use significantly more equity-based compensation (Campbell and Frye, 2009). Underpricing for U.K. IPOs increased during the dotcom bubble, while the operating performance of IPO firms decreased. Coakley et al. (2009) explain this as spinning behavior: experienced intermediaries such as VCs and underwriters take advantage of market exuberance, which might indicate an agency risk vis-` a-vis their portfolio companies. Gompers (1996) advanced another explanation, namely that young (less experienced) VCs tend to “grandstand” when bringing their portfolio companies to the market. For the VCs themselves, reputation may be important because it gives great market power in their ability to close attractive deals, as entrepreneurs of start-up companies are more likely to accept a financing offer made by a VC with a high reputation, even at lower valuations (Hsu, 2004; Seppa, 2002). Reputation also provides the VC with the ability to raise new funds and to certify ventures to third parties (Gompers, 1996) and to syndicate with other respected investors (Wright and Lockett, 2003). The consequences of losing a good reputation can therefore be significant. For example, in the aftermath of the market crash in 2001, a number of well-established VCs damaged their reputation by overinvesting in marginal ventures,

516


and subsequently were unable to raise new funds and were forced out of business (Lerner and Gompers, 2001). Furthermore, because VC reputation is highly valued by the market, VCs attempt to gain reputations as soon as possible. A primary vehicle for building reputation is taking a portfolio company public because an IPO may serve as a visible (if somewhat imperfect) signal of the VCs’ prowess in selecting, developing, and cashing out of high potential ventures (Stuart et al., 1999). Companies, backed by young VC investors or VC investors with fewer IPOs, are younger and smaller at IPO (Gompers, 1996; Lee and Wahal, 2000), their VCs have been on the board for a shorter period of time and they hold smaller equity stakes (Gompers, 1996). VCs leading IPOs with greater underpricing time the IPO to coincide or precede raising money, and therefore are even willing to bring younger, lower quality portfolio companies to the market (Gompers, 1996). This pays off, as Lee and Wahal (2004) showed that this leads to larger future inflows of capital. These studies strongly support the notion that VC firms use IPOs of their portfolio companies to build up their reputation vis-à-vis their investors (Neus and Walz, 2005). This constitutes an agency risk for entrepreneurs, as their firms might be taken prematurely to an IPO. VC reputation hence serves as a credible commitment to the accurate pricing of IPOs (Neus and Walz, 2005). VC affiliation also impacts what happens at IPO. In a study of IPOs on the Singapore stock exchange, Wang et al. (2002b) document that IPOs backed by independent VC investors have lower underpricing compared to comparable IPOs backed by finance-related VC investors and have higher short-term market performance, although no such difference was found for IPOs on Germany’s Neuer Markt (Tykvov´ a and Walz, 2007). For bank-related VCs, the financial institution to which a venture capital investor belongs may also be the underwriter of the IPO. When the lead VC investor is also the lead underwriter in the U.K. or in Japan, this leads to higher underpricing, indicating conflicts of interest (Espenlaub et al., 2000; Hamao et al., 2000), but the opposite is found in France (Chahine and Filatotchev, 2008) and in a later time period in Japan (Arikawa and Imad’eddine, 2010). These conflicting findings in different countries suggest that the institutional context is

5.4 Post-Initial Public Offering Performance and Venture Capital

517

important in understanding the relationship between VC backing and IPO performance.

5.4

Post-Initial Public Offering Performance and Venture Capital

Another stream of research has focused on the long-run performance of VC-backed IPOs in order to understand whether the better shortterm performance of VC-backed IPOs is sustained in the long term. Brav and Gompers (1997) showed that the market returns of VCbacked IPOs outperform those of non-VC-backed IPOs, but only in an equally weighted portfolio. When taking the relative value of each IPO into account, this difference disappears. In the same vein, the long-run market performance of VC-backed IPOs on the Japanese or Singaporean stock market are comparable with that of non-VC-backed IPOs (Hamao et al., 2000; Wang et al., 2003). Jain and Kini (1995) showed that U.S. VC-backed IPOs have initially higher market-to-book and price–earnings ratios compared to non-VC-backed IPOs, suggesting that VC-backed IPOs are valued higher. These differences, however, disappear over time, consistent with the idea that the monitoring and value-adding that VC firms provide are most valuable during the earlystages of the issuers’ transition to a public corporation (Jain and Kini, 1995). Nevertheless, having more reputable VC investors leads to higher long-run post-IPO performance of the portfolio firm, even controlling for their superior selection skills (Krishnan et al., 2011). This is explained by their more active post-IPO involvement in the corporate governance of their portfolio firms. Interestingly, the long-run stock performance of IPOs backed by more experienced and independent VCs, as well as foreign VCs, is higher than that of other VC-backed IPOs, both in Japan (Hamao et al., 2000) and in Germany (Tykvov´ a and Walz, 2007). This might be a consequence of the fact that especially more experienced VC investors tend to invest abroad. Further, the performance of Japanese, U.K., and French IPOs is higher with higher VC ownership after IPO (Kutsuna et al., 2002; Bruton et al., 2010). VCs investing in public equity (PIPEs)

518


also convey positive signals about growth opportunities (Janney and Folta, 2003), leading to higher short-term returns upon announcement and higher long-term performance. The latter is attributed to a certification effect, rather than a monitoring effect (Dai, 2007). The post-IPO operating performance of U.S. VC-backed firms remains higher than that of non-VC-backed IPOs, as measured in terms of return on assets, cash flow margins, and sales growth, despite equally strong levels of capital expenditure (Jain and Kini, 1995). The authors attribute this positive effect to the long-lasting influence of the valueadded and monitoring that VC investors provide. In contrast, the postIPO operating performance of VC-backed IPOs on the Singapore stock market is lower and declines faster compared to non-VC-backed IPOs, which might be interpreted as a further indication of grandstanding by Singaporean VCs (Wang et al., 2003). Post-IPO performance is dependent on VC characteristics. It is higher when more VCs (Jain and Kini, 1995) or more reputable VCs (Tykvov´ a and Walz, 2007) invested in the company or act as a board member, which support the monitoring and certification effects of VCs (Jain and Kini, 1995; Jain, 2001). Tykvov´ a and Walz (2007) showed that institutional affiliation of the VC firm is important in explaining the long-run performance of IPOs on the German Neuer Markt. IPOs backed by independent VCs outperform, while IPOs backed by public VCs underperform (Tykvov´ a and Walz, 2007). Further, French IPOs backed by VCs affiliated with lead underwriters have higher post-IPO performance compared to nonaffiliated VC-backed IPOs and non-VCbacked IPOs (Chahine and Filatotchev, 2008). Rather than leading to conflicts of interests, affiliation of VCs with underwriters enhances screening, monitoring, and certification in France. VC-backed IPOs have a slightly higher survival rate compared to non-VC-backed IPOs (Baker and Gompers, 2003). Studying survival after IPO, the time from IPO to bankruptcy, is longer if the VC investor is more experienced, but findings relating to the impact of VC experience and reputation on post-IPO survival are mixed (Abdoua and Varela, 2009; Chou et al., 2011). Bruton et al. (2010) adopt a multiple agency perspective and argue that the impact of VCs’ retained ownership on IPO performance should

5.4 Post-Initial Public Offering Performance and Venture Capital

519

be negative since VCs’ greater agency role toward their institutional investors reduces their willingness to put pressure on underwriters or to protect the longer-term interests of the IPO firm by monitoring it on behalf of the more diffuse body of shareholders introduced during the IPO. In addition, Arthurs et al. (2008) argue that, to maintain their reputation with underwriters VCs need to signal that they are not walking away from poor or uncertain performers. Retained ownership by VCs may not mitigate the potential of agency problems, since they do not focus on monitoring the firm after the IPO which can lead to a negative impact of their retained ownership on performance. The extent of the multiple agency problem associated with VCs at the time of IPO has been found to be different in the U.K. compared to France (Bruton et al., 2010). In addition to the differences in VC monitoring between the U.K. and France, as VCs in France are more likely to be captive firms, the salience of the multiple agency conflict is likely to be higher than in the U.K. where more VCs are independent or semi-captive with aligned more closely with interests of fund investors. These factors combined may further limit the certification and monitoring abilities of VCs in France compared to the U.K. Again, the institutional context is important in understanding venture capital investors’ behavior and impact.


In this chapter we first outline the different elements of the returns that VCs generate from their activities. We then examine the evidence related to returns to VCs at the fund level.

6.1

Dimensions of Venture Capital Fund Returns

Independent and semi-independent VC firms generally raise a limited life fund, usually with a ten-year life with a possibility of extension subject to penalty payments to the investors in the fund. In the typical independent VC fund, fund managers receive a fee for the management of the funds and a share in the profits of the fund (Gilligan and Wright, 2010). During the investment phase, the management fee will typically be 1.5%–2.0% of the committed fund size (Metrick and Yasuda, 2010). Funds providers (Limited Partners) adopt a variety of measures to judge the performance of VC funds, but independent limited life funds tend to be set target IRRs expressed either as raw returns or percentage outperformance above other asset classes (Robbie et al., 1997). VC fund

520

6.2 Venture Capital Returns and Risk

521

managers also receive a share of the capital gains (“carried interest” or “carry”), typically 20% once the investors have received an agreed minimum hurdle rate return (currently around 5%, but variable from fund to fund), less fees received. The management fee earned varies with fund size, the deal stage, whether the focus is on high-tech deals (Gompers and Lerner, 1997), and likely reflects the bargaining power arising from previous fund performance. Metrick and Yasuda (2010) find that over half of their sample had management fees of less than 2%, while 8% had fees above 2% and that management fees decline significantly during the life of the fund. Fees for monitoring and/or for nonexecutives may be payable to the VC-fund or to the manager, or split between them in a predetermined proportion. Fund managers may also charge an arrangement fee of up to 3% of the equity invested to the investee company.

6.2

Venture Capital Returns and Risk

While national Venture Capital Associations publish reports on returns to venture capital funds, these typical are limited in the adjustments made for risk, unrealized investments, fees, and other factors that may distort the apparent success of investing in VC. Such adjustments aside, returns on early-stage investments for funds are generally very low and in comparison with stock market indices relating to smaller companies, even for top quartile funds. This mirrors the low returns earned on entrepreneurial investments in private companies (Moskowitz and Vissing-Jorgensen, 2002). There is now a long history of detailed academic studies of the rates of return to VC investments (Table 6.1). Early evidence (Bygrave, 1994) showed that VC fund returns were generally well below the levels typically sought on individual deals (Wright and Robbie, 1996; Manigart et al., 2002a,b). This early evidence indicated that returns peaked in the early 1980s and that early-stage funds generated higher returns than later stage funds. Investment stage specialist funds also generated higher returns (Manigart et al., 1993). From earliest studies it has, however, been recognized that the bulk of returns are earned by the top decile or top quartile of funds (Huntsman and Hoban, 1980).

What is the risk reduction effect of investing in a portfolio of VC funds?

12 publicly traded U.S. VC funds, 1981–1985


1988 Brophy, Guthner

Publicly traded VC funds: Implications for institutional “fund of funds” investors

Compared to mutual funds and S&P 500

11 publicly traded U.S. VC funds, 1974–1979

An Analysis of the performance of publicly traded VC companies

Research question



1983 Martin, Petty

Data source Sample 110 U.S. VC investments by three VC firms, 1960–1975

Title

Venture capital returns.

Private Investment in new enterprise: Some empirical observations on risk, return and market structure

Journal

Table 6.1.

1980 Huntsman, Financial Hoban Management

Year Authors

Panel A: Venture Capital Return and Risk

Annual IRR, St. Dev. Sharpe ratio

Measure

(Continued)

Portfolio of VC funds has very low beta (0.73–0.87), hence investing in a portfolio of VC funds produces superior risk-adjusted returns.

More of the individual VC funds dominated S&P index than individual mutual funds, and by larger margins.

Superior returns are generated when investing in a portfolio of VC funds (18.5–23.8%) compared to market indices.

VC funds outperform mutual funds on a risk/return basis (Sharpe ratio), but two VC firms ranked among the worst.

VC firms are riskier.

Bulk of the return is earned by the top decile or quartile. Average investment holding period = 5 years.

Annual IRR of 18.9%.

Findings


Journal of Private Equity Journal of Financial economics

1997 Gompers, Lerner

2000 Gompers, Lerner

Money chasing deals? The impact of fund inflows on private equity valuations

Risks and rewards in private equity

The performance of publicly traded European venture capital companies

Journal of Small Business Finance

1994 Manigart, Joos, De Vos

Title Risk/Return profile of VC

Journal

1989 Chiampou, Journal of Kallett Business Venturing

Year Authors

Venture One

4,069 investment rounds of U.S. VC firms

40 European quoted VC firms

Stock market data

Warburg Pincus investment data

55 U.S. privately held VC funds (partnerships), 1978–1987

Competition, increased opportunities

Illiquidity, specialization


(Continued)

LPs

Data source Sample


Mature VC funds generate return higher than expected return given risk.

Dispersion of returns is not greater than that of small stocks.

35 VC funds > 6 year generate annual return of 24.4%, Std. dev. 51%.

Findings

Marked-tomarket risk and return

(Continued)

Investments made during periods of high funds inflow have higher valuations, but do not generate greater success, suggesting that greater competition is driving higher valuations during boom periods.

beta = 1.27, size effect.

RiskFew listed VC firms adjusted outperform the market. return, beta Investment stage specialist VC funds generate higher returns on a risk-adjusted basis than generalist VC funds.

Measure


523

Journal of Portfolio Management

2002 Chen, Baierl, Kaplan

2003 Sarin, Das, Jagannathan

2003 Ljungqvist, Richardson

Journal of Investment Management

2002 Moskowitz, American VissingEconomic Jorgensen Review

Journal

Year Authors

The private equity discount: An empirical examination of the exit of VC-backed companies

The returns to entrepreneurial investment: A private equity premium puzzle?

73 PE funds of one institutional investor, 1981–1993

2,000 VC and buyout funds, 23,208 unique firms

VX

Asset pricing theory, diversification

4,000 U.S. households

NBER Working Paper

Proprietary data, Survey of Consumer Finance

risk/return profile of VC investments


(Continued)

148 U.S. VC Funds

Data source Sample

VC and its role VE (only in strategic nonasset allocation liquidated funds)

Title


Time to exit, exit multiple

Probability of exit

Annual arithmetic return Std. dev.

Measure

(Continued)

Valuation multiple and expected investment gain depend on industry, firm stage, financing

Probability of IPO is 20–25%; acquisition = 10–20% (the latter higher for later stage).

beta = 1.1 (VC + LBO).

IRR increase with fund size, decrease with money raised in fund’s vintage year.

19.8% IRR; 5–6% risk premium above expected return given beta.

Entrepreneurial investments in non-public companies, whose distribution resembles that of private equity funds, have relatively low performance. Returns to household private equity are equal to returns to public equity, hence do not compensate for the additional risk.

Correlation with quoted firms = 0.04.

Annual compounded return = 13.4%; Std. dev. = 115.6%.

Findings


Gross IRR Asset pricing, hybrid repeat sales approach

Sandhill Econometrics

An index for venture capital, 1987–2003

Contributions to Economic Analysis and Policy

2005 Hwang, Quigley, Woodward

50,734 funding events of 9092 PE firms

Mean, Std. dev., alpha, beta

Illiquidity, diversification, monitoring

Quarterly returns to GPs, based on valuation estimates

VentureOne, 7,765 U.S. VC-backed SDC firms Platinum

VE

The risk and return of venture capital

WP Columbia University


Measure

2005 Cochrane

Research question

NIET GEVONDEN


2004 Jones, RhodesKnopf

Data source Sample

Journal

Title

(Continued)

Year Authors

Table 6.1.

(Continued)

Net returns are lower than those reported by Cochrane, accounting for missing data. Gross out-of-fee performance slightly above that of S&P 500.

Return distribution is equal to small Nasdaq stocks.

Individual investments have beta of 1.7; risk of later stage is lower than that of early-stage. Alpha is 32% (gross of fees, taking selection into account); average beta = 0.6.

beta = 1.8 for VC and 0.66 for LBO; alpha = 4.68% annually for VC, 0.72% for LBO.

Expected multiple = 21 for early-stage with IPO, 10 for early-stage with M&A.

Expected multiple = 1.12 for later stage and 5.12 for early-stage.

amount, valuation at entry and market sentiment.

Findings


525

Journal Journal of Finance

Year Authors

2005 Kaplan, Schoar

PE performance: Returns, persistence and cash flows

Title VE, institutional investors data


(Continued)

746 liquidated VC/PE funds > $5 million

Data source Sample


Net returns of LBOs are lower than S&P, net VC returns are higher than S&P on value-weighted basis.

IRR Public market equivalent

(Continued)

VC funds voluntarily limit their fund size and pass excess return to LPs, because they have unobservable info on GPs abilities or on their investment strategy.

Fund returns are persistent (up to second following fund).

Returns are larger for larger funds and funds that raised higher amounts in previous funds. Fund returns (and market entry) are procyclical; established funds are less sensitive to cycles than new entrants.

IRR = 17% (approximately the same for VC and PE, for value weighted and equal weighted). PME < 1 for equal weighted, > 1 value weighted; beta = 1.07.

Findings

Measure


2009 Phalippou, Review of Gottschalg Financial Studies

The performance of private equity funds

Venture capital VE performance in Europe and the US: A comparative analysis

Revue Finance

2009 Hege, Palomino, Schwienbacher

147 European VC-backed firms and 234 U.S. VC-backed firms

Portfolio allocation of 20 GPs, returns of 1,398 VC funds

VC returns in U.S.A. are higher than in Europe, but U.S. venture firms investing in Europe do not outperform their peers. Differences in contracting behavior do not explain the performance gap. European IPOs yield similar returns as U.S. IPOs. Gross IRR based on reported valuations

What are obstacles to the emergence of a VC industry?

(Continued)

Previously reported Net profitability performance measures are overstated due to sample index selection biases and overstated accounting valuations. Average VC funds underperform compared to S&P 500. Previous expertise leads to higher performance.

Large differences in skills exist among investors, significantly affecting performance. The average performance of one investor hence greatly differs from the average performance of the industry. Endowments have the highest performance.

IRR

Why do different classes of investors in PE have different returns?

Investment styles

Asset pricing

Findings

Measure

Research question


(Continued)

VE, institu- 1,579 tional mature PE investors funds data

Institutional investors, Asset Alternative, VE, PE performance monitor

Smart institutions, foolish choices? The limited partner performance puzzle

Journal of Finance

Data source Sample

2007 Lerner, Schoar, Wong

Title

Journal

Year Authors

Table 6.1.


527


Institutional 203 U.S. investor in Partnership PE agreements

The economics of private equity funds

2010 Metrick, Yasuda

Dynamic selection problem

1,934 U.S. companies

SandHill Econometrics (= VX + VentureOne)

Risk and return characteristics of VC-backed entrepreneurial companies

2010 Korteweg, Review of Sorenson Financial Studies

Info available when fund was formed cannot predict performance


348 mainly U.S. funds

Data source Sample

(Continued)

VE

Title VC funds: Flowperformance relationships and performance persistence

Journal

2010 Phalippou Journal of Banking and Finance

Year Authors

Table 6.1.

What is the impact of contract features on PE returns?

What explains persistence in performance, and relationship with follow-on fund size?

Research question

(Continued)

Slight adjustments in fee contracts lead to significant changes in total costs for investors. More experienced funds collect higher fees per partner by raising larger funds, not by charging a higher cost per dollar managed.

Post-2001 alphas are negative.

Average beta = 2.8 and is consistently above 2.2.

Persistence in VC fund return is mainly driven by unsophisticated investors underperforming. There is no performance persistence for VC firms whose performance is above median. Better performing funds can raise more funds, poor performance funds have no flow–performance relationship.

Soft information holdup

Beta corrected for Fama– French, selection, etc. estimated using valuations of VC companies

Findings

Measure


Journal Journal of Business Venturing



Year Authors

2007 Hand

2009 Gompers, Kovner, Lerner

2009 Diller, Kaserer

11,297 U.S. portfolio companies

200 mature European PE and VC funds

Venture Source

VE

Specialization and success: Evidence from venture capital

What drives PE returns? Fund inflows, skilled GPs, and/or risk?

203 U.S. IPO-ed biotech companies, 1992–2001

IPO files

Data source Sample Growth options


(Continued)

Determinants of the round-to-round returns to pre-IPO VC investments in U.S. biotechnology companies

Title

Panel B: Drivers of Venture Capital Returns

Table 6.1.

How does VC firm and GP specialization affect performance?

Research question

Positive relationship between specialization of individual VC GPs as a firm and its success.

Rate of IPO or M&A

(Continued)

Correlation with market returns is very low.

VC and PE fund returns are driven by fund inflow (stronger effect for VC and PE), GP’s skills, and portfolio company risk.

Poorer performance by generalists is driven by inefficient allocation of funding across industries and poor selection within industries.

Larger book-to-market and smaller firm size is associated with higher returns.

Findings

Round-toround returns

Measure


529

Journal

2010 Cumming, Journal of Walz International Business Studies

Year Authors Private equity returns and disclosure around the world

Title Center of Private Equity Research

221 PE funds

Data source Sample

Table 6.1. Theoretical framework

(Continued)

How does the institutional context impacts how PEs report to their investors?

Research question Measure

Fund size and syndication is positively related to performance, but not fund sequence. More monitoring, more advice, more legal protection, and the use of convertible securities are associated with higher performance. Less stringent accounting rules and weak legal system facilitate overvaluation.

Findings



531

More recent debate surrounding the question of whether VC funds outperform the stock market or not have attempted to control for various factors that might otherwise lead to misleading interpretations. An important key issue concerns whether VC funds outperform the stock market net or gross of fees. Ljungqvist and Richardson (2003), after taking into account portfolio company risk and the timing of investments, find that mature VC funds started covering the period 1981–1993 generated IRRs above S&P 500 returns net of fees. For a slightly later period, Kaplan and Schoar (2005) show that net of fees returns are overall in line with returns on the S&P 500. One problem with assessing funds returns concerns the effects of missing data on funding rounds, which could lead to apparent returns being biased upward. Cochrane’s (2005) study found that the gross returns of VC firms were high but after addressing missing data issues in the Cochrane dataset, Phalippou (2007) and Hwang et al. (2005) find that gross of fees returns were lower. Ljungqvist and Richardson (2003) used data from an LP in order to access fund-level data that are not normally available. As a result their findings may be biased as the single LP providing the data invested in a disproportionately high share of (larger) buyout funds. More generally, proprietary datasets from LPs or funds of funds may involve potential selection bias as the VC funds included may be better than those not covered. After adjusting for this problem by using the fraction of a fund’s successful exits as a proxy for performance, Phalippou and Gottschalg (2009) find that average fund performance in the Kaplan and Schoar (2005) study changes from slight overperformance to underperformance compared to the S&P 500. In addition to the evidence on VC returns at the fund level it is also important to consider risk aspects. A number of studies have examined risk factors and generally concluded that betas are relatively low, suggesting that there is a beneficial effect offered from the diversification provided by investing in a portfolio of VC investments (Manigart et al., 1994). Early evidence from returns to funds of funds investment strategies (Brophy and Guthner, 1988) found that VC portfolios showed systematic risk below the S&P 500 and mutual funds and higher returns than both benchmarks, suggesting that diversification

532

Venture Capital Returns

contributes to reducing firm-specific risk. Other evidence also indicates that the correlation between VC funds returns and returns on listed corporations is low (Chen et al., 2002; Diller and Kaserer, 2009), that few listed VC firms outperform the market (Manigart et al., 1994) and that the dispersion of VC fund returns is not greater than that for small stocks (Chiampou and Kallett, 1989). As might be expected, where studies have made comparisons, the betas on leveraged buyout (LBO) funds are lower than for VC funds (Jones and Rhodes-Knopf, 2004). Using firm-level data, studies also suggest that investments in later investment rounds are steadily less risky (Cochrane, 2003, 2005). There are also some suggestions from more recent studies that VC investments are becoming riskier and less profitable (Korteweg and Sorensen, 2010). Studies have also compared VC funds returns with buyout fund returns after adjusting for risk factors. Comparing VC funds and buyout funds, Kaplan and Schoar (2005) show that on a weighted capital basis U.S. VC funds, but not buyout funds, outperform the S&P 500. However, on an equal weighted basis, VC funds returns are lower than the S&P 500. Lerner et al. (2007) also find that early and later stage funds have higher returns than buyout funds for funds raised during 1991–1998. While buyout fund managers earn lower revenue per managed dollar than managers of VC funds, because buyout managers build on prior experience to raise larger funds, they have significantly higher revenue per partner (Metrick and Yasuda, 2010).

6.3

Determinants of Venture Capital Return and Risk

Institutional context is important in returns generation. Both VC and buyout funds in common law countries result in higher returns than in other institutional environments (Lerner and Schoar, 2005). However, less stringent accounting rules and weak legal systems are associated with systematic biases in reporting unrealized IRRs, although Hege et al. (2009) did not find the legal context important for driving differences in VC returns between U.S.A. and Europe. VC fund-level studies have suggested that the buildup of expertise through learning from past performance contributes to higher returns, in contrast to studies of mutual funds (Kaplan and Schoar, 2005;

6.3 Determinants of Venture Capital Return and Risk

533

Phalippou and Gottschalg, 2009). Examining persistence in VC fund returns more closely, Phalippou (2010) finds that this is mainly driven by unsophisticated investors who underperform. This is consistent with Lerner et al. (2007), who find wide variation in returns by type of institution. The presence of unsophisticated performance-insensitive LPs allows poorly performing GPs to raise new funds. Evidence on influence of the nature of competition in the market on fund returns is somewhat inconclusive. Gompers and Lerner (2000) find that investments made during periods of high funds inflow do not generate greater success, except for VC firms with deep industry knowledge (Gompers et al., 2008). In their analysis, Ljungqvist and Richardson (2003) find that competition for deal flow reduces VC fund performance and higher demand increases performance while higher supply decreases it. Demand may be driven by experienced VC firms who may be able to pay more as they have developed the ability to find better deals and add more value. The positive relationship between fund inflows and performance shown by Cumming and Walz (2010) is identified after correcting for sample selection bias. Using evidence from Europe, Diller and Kaserer (2009) find that while both VC and later stage PE fund returns are driven by fund inflow, the effect is stronger for VC funds. Prior experience helps VC firms to increase investments when deal opportunities improve, leading to improved exit performance (Gompers et al., 2005). While studies have investigated the relationship between more qualitative VC characteristics, such as human or social capital, on exit performance, to our knowledge no studies to date have linked these to VC return and risk.

7 Conclusions and Future Research

Our review of the venture capital past-investment literature has shown that there has been a considerable increase in research attention to this subject. Early interest in VC was predominantly in the entrepreneurship journals but more recently finance and economics journals have become more prevalent. Although in part due to the different topics addressed by different fields, the asymmetry of crossreferencing between fields is striking. While articles in entrepreneurship and management journals frequently cite finance journals, the reverse is less evident. In this section, we put forward areas where major research questions remain unanswered. We first focus on VC activity, syndication and returns, and end with VC exits. In each of these domains, the impact of VC firm characteristics, portfolio company and deal characteristics, and environmental characteristics may be further explored. Major VC firm characteristics include experience, reputation, country of origin, sources of knowledge, and source of funds. Important portfolio company and deal characteristics include the industry, resource endowments, stage of development, corporate governance, distance to the VC, and contract. Important environmental characteristics include the institutional and legal environment, and industry competition. 534

7.1 The Nature and Processes of Venture Capital Activity

7.1

535

The Nature and Processes of Venture Capital Activity

Although there is increasing recognition and analysis of the influence of the extent and nature of VC firm expertise on the performance of portfolio companies, this research remains limited in two principal ways. First, further more fine-grained understanding is needed for the relationship between the nature of VCs human capital and performance. For example, further research could consider more the nature of VCs’ prior business experience rather than simply whether they have prior business experience. Similarly, more fine-grained analysis of how the external networks brought by the VC impact portfolio company performance is needed. Research on these aspects may also help to shed further light upon the factors that generate greater effects of VC involvement in particular industry sectors. Additional research might usefully be focused on the nature of the human and social capital resources VC firms bring to foreign markets that can enable them to enhance performance in those markets and overcome the liability of foreignness. More generally, there is a need to analyze to what extent the human and social capital of venture capital firm executives is mobile across institutional boundaries. Analysis is also needed of the modes for entry into foreign markets adopted by venture capital firms, such as investing from the VC home country or establishing foreign subsidiaries, and the rationale for using different modes of entry in terms of accessing the human and social capital required to identify attractive deals. There is some evidence that VCs adapt when they enter foreign markets in terms of their information, valuation, and monitoring behavior (Wright et al., 2005), but there is an absence of evidence regarding the relative success of foreign VCs in, for example, aiding firms to internationalize. Second, research on the processes both by which VC firms orchestrate their own resources and capabilities and how they do so in portfolio companies is limited. The strategic entrepreneurship perspective emphasizes the need to select and structure human, social/network, financial, and technological resources in order to exploit opportunities and gain competitive advantage, achieve growth, and create value (Ireland et al., 2003). Recent developments in the resource-based

536

Conclusions and Future Research

theory of the firm have demonstrated the need for firms to be able to orchestrate or better coordinate their resources and capabilities (Barney et al., 2011; Sirmon et al., 2007, 2011; Maritan and Peteraf, 2011). Success along these dimensions is not only about being in possession of the requisite resources and capabilities but also about knowing how to accumulate, bundle, and leverage them to generate sustainable returns. Sirmon et al. (2011) argue that resource orchestration is contingent upon three dimensions: the different phases of the firm’s life cycle; firm breadth in terms of different strategies; and the depth in terms of the different levels of the firm. We envision opportunities to adopt the strategic entrepreneurship perspective to examine the role of VC firms. For example, research might consider the role of VC firms in resource orchestration as their portfolio companies develop across different rounds of investment and different life cycle phases. Studies might also examine how VC firms work with entrepreneurs to adopt product market or technology market strategies and orchestrate the resources needed to develop these strategies. To what extent does the VC provide network links to enable entrepreneurs to recruit the people they need to commercialize their products? How does the VC help in developing executive and advisory boards that have the capabilities to assembly the necessary resources for the firm to develop? Interesting process issues concern the nature of any conflicts between the VC and the entrepreneur that relate to these resource orchestration decisions. For example, the appropriate champion of the new venture’s development may need to be someone other than the founder, as (s)he may not have the capabilities or networks to access and orchestrate the necessary resources to exploit opportunities. This raises issues not only to do with the replacement decision but in terms of the process of founder removal and identifying suitable replacements who have the necessary capabilities. Studies have documented that VCs often replace founders but the process of doing this successfully is not well understood. Although it is recognized that venture capital involves multiple rounds of investment, the process by which these rounds are undertaken have not been thoroughly examined. For example, issues relating to the timing of investment rounds, the amounts of funding involved,

7.1 The Nature and Processes of Venture Capital Activity

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the pricing of investment rounds, and the selection of new partners could be interesting directions for further analysis. Further, the impact of different investment rounds upon portfolio firm performance and returns to funds providers is an area that we know little about. While individual portfolio firms are free-standing with their own financing structure and board, to the extent that VCs specialize in certain sectors there may be benefits to be achieved from encouraging and exploiting interactions between portfolio firms. For example, there may be synergies through the promotion by VCs of alliances, mergers, and other forms of trading relationships. There may also be learning benefits to be had from seeing how other portfolio firms have met similar challenges. The extent and nature of these interactions has not been investigated. Further, most studies focus on independent new ventures. The role and impact of VC on spin-offs from corporates or universities might be different, however, given the different resource endowments the latter are able to draw upon. A deeper understanding of these differences is hence warranted. Finally, a source of heterogeneity in VC, the source of VC funds, has not been fully taken into account, although the differences in goals and legal framework of different types of VCs might have important impacts. For example, investing from an independent VC fund in a dual VC firm/VC fund structure entails different processes compared to investing as a corporate VC from the balance sheet of a corporate, or investing family money within a captive VC structure. Further, government- or university-related VC funds may have different approaches leading to different outcomes. Finally, some VC firms or VC funds are themselves quoted on stock exchanges; the impact thereof is not fully understood yet. Comparative analysis of the different investment behaviors of private and publicly listed VC funds and firms is needed. To what extent do these different forms of ownership impact the risk-taking behavior and the time horizon of investing? For example, are publicly listed VC more risk averse and looking for quicker returns because they are monitored quarterly by analysts? Alternatively, because they are not under the pressure of a limited life fund, are they able to hold investments for longer?

538


7.2

Syndication

Despite the explosive growth of studies on venture capital syndication, important questions remain. There is a need to examine which partners VC firms select to join a syndicate, particular in respect of new, less familiar partners. Further work is needed relating to the paradox of relational embeddedness in VC partner selection. Under what conditions will firms syndicate with less relationally embedded partners and how stable are these relationships? This further relates to the dynamics of syndication arrangements, which have been neglected empirically. This is an important omission in venture capital investing, given the changes that occur over the rounds of investment in terms of the changes in equity stakes of existing syndicate member, and the selection and integration of new syndicate members. A further issue relating to the dynamics of syndication concerns what happens when syndicated investments become distressed and require restructuring. How does this affect the injection of new funds? A further dimension of the dynamics of syndication research concerns the evolving relationship between formal venture capital firms and business angels. For example, business angels may have been earlystage investors before the entry of formal venture capital firms and may play a role in the selection of venture capital firms. What form does this role take? Do formal venture capital firms seek to buy out business angels or do business angels have a continuing role in the development of the firm? Differences in goals, professionalism, and legal structures may engender conflicts between different investor types. To what extent are there conflicts between business angels and formal venture capital firms and how are these resolved? Further, interaction between debt (senior and subordinated) and equity providers has received limited attention. How important is debt financing in venture capital-backed companies? To what extent are there repeats patterns of investment between the same equity and debt providers, how are these relationships formed, and how do they evolve? Evidence relating to the financial distress of syndicated deals is limited but has assumed greater importance since the onset of the financial

7.2 Syndication

539

crisis from 2008. A more thorough understanding of how these are handled is important. If it is considered at all, most research has focused upon the role of lead investors in syndicates. The available studies to date have tended to adopt a principal–principal approach (Wright and Lockett, 2003). However, VCs in syndicates will also experience multiple agency challenges (Arthurs et al., 2008; Bruton et al., 2010). More research is needed regarding the role of non-lead investors and their interactions with lead investors, portfolio companies, debt providers, and their limited partners. The relationships involving these different partners highlight more complex multiple principal, multiple agency issues relationships. Further qualitative work is needed to examine the processes involved in these relationships. For example, studies might consider the ways in which agency relationships affect the operation of contractual drag along and come along provisions between lead and non-lead syndicate members. Further work is also needed on the role that non-lead partners play in early-stage VC deals versus late-stage VC deals, especially in the context of distressed deals. Despite the presence of ‘drag along’ and similar provisions, coordination may be problematical when restructuring of distressed deals is required. As bankruptcy regimes vary across institutional environments (Armour and Cumming, 2006), the problems of coordinating distress cross-border syndicated deals may pose notable challenges. Studies are needed that examine the distress resolution process in failed VC deal transactions and how these are particularly dealt with in cross-border syndicates. More generally in a cross-border context, there is an absence of empirical work that examines the extent to which VC firms seek to exploit or augment their resources when they syndicate with domestic VC firms in a foreign country. The relative importance of resource exploitation or augmentation may vary between different VC firms, markets, and investees, but at present systematic understanding is limited. Despite the development of global datasets, few VC studies have explicitly analyzed the relationship between different institutional

540


contexts across the world and the involvement of VC firms together with their impact in portfolio companies. Different institutional contexts present different opportunity sets, different information availability, etc. that need to be taken into account.

7.3

Returns to Venture Capital

Although recent studies have attempted to adjust for some of the problems that may distort apparent VC fund returns and risk, more needs to be done. Most studies have focused on proprietary datasets relating to independent VC funds. Accessing performance data on captive and public sector funds is generally lacking but may be more problematical to obtain. The absence of studies of these other types of VC firms may mean that there is a bias in apparent VC returns and risk. Further, while some insights have been generated as to how investment experience affects VC returns and risk, little is known as to how differences in human and social capital, in investment strategy, or in legal form are related to risk and return. If there is a learning effect in the VC industry over time, do returns increase over time or are these competed away through increased competition for deals? Are the returns on funds raised in the boom period up to 2007 likely to be lower than in previous periods? How does experience relate to VC risk? Further analysis may be required for the motives of LPs to invest in first time funds if experienced funds generate greater returns. Na¨ıve LPs may invest in first time funds to gain experience, and a shortage of allocation from established funds may mean that new entrants cannot gain access to established funds. However, it is important to distinguish between first time funds that are managed by inexperienced managers and those that are managed by experienced executives who have spunout of established funds. Heterogeneity in the nature of self-reported information may make comparisons of performance between VC funds difficult. An important issue concerns the methodology used to arrive at a fair valuation of an unexited portfolio company, given its subjective nature. There is some tendency for more developed capital markets to use valuation methods

7.4 Exit

541

that are more in line with standard corporate finance theory but even here, informational restrictions limited the extent to which the most sophisticated DCF or options methods were used, with other methods such as P/E multiples and comparator transaction prices or industry benchmarks being used either alongside or instead of these methods (Wright and Robbie, 1996; Manigart et al., 1997, 2002a, 2002b). Studies are also needed that take into account the difference between committed and drawn down funds in comparing returns with market benchmarks. Further academic studies of funds returns are also needed to consider the influence of the actual life of the funds and the variation over time. While there has been extensive examination of the returns to venture capital firms, there is little attention to whether venture capital investment is worth it in terms of the returns to entrepreneurs. Particular issues that need to be considered relate to the returns to entrepreneurs whose equity stakes are diluted due to failure to achieve performance targets. This issue also introduces the need to examine how entrepreneurs continue to be motivated to perform. For example, the impact of good leaver/bad leaver provisions on the returns to entrepreneurs needs to be examined. Similarly, while the focus of attention in venture capital research has been on the founder, the impact on returns to other team members warrants further analysis.

7.4

Exit

The dominant theory used to explain exits up to now has been agency theory based upon information asymmetries between venture capital investors, entrepreneurs, and outsiders/buyers. Besides information asymmetries, the exit process is prone to strong goal incongruencies between investors and entrepreneurs, giving rise to another type of agency problem. On the one hand, entrepreneurs might be willing to hold on longer to their venture, or might oppose selling to a specific buyer for personal reasons. Alternatively, a VC investor might push for an exit because the VC fund is at the end of its lifetime, or because it is in fundraising mode. The impact of these issues has not been widely explored to date. Further, as the venture capital process does impact

542


the development of portfolio companies, it is worthwhile investigating the relationship between the venture capital process and exit. For example, how does trust or conflicts between venture capital investors and entrepreneurs impact exit timing and exit type? While some insights have been gained in the processes of IPOs and bankruptcies, much less is known to date about trade sale exits, (preplanned) buy-backs, or secondary sales to other venture capital investors. As we have noted, most exit analysis has focused upon IPOs, but more recent attention has been devoted to strategic sales to corporations. However, there has been little attention to exit through the sale of earlier stage venture capital investments to later stage private equity firms although this exit type has become increasingly important. The phenomenon of secondary buyouts involving the sale of later stage buyout deals between investors is well recognized in the private equity literature, but the sale from early-stage to late-stage investors may be especially interesting as it raises issues about the changing nature of involvement resulting from the ownership transfer. Analysis of the processes involved and the changes in investor involvement is needed. Differences in lock-up periods adopted by venture capital firms in different deals have been analyzed but there may also be variations in the length of lock-up periods between venture capital investors, entrepreneurs, and other investors. The rationale for and impact of these differences in lock-up period have not been analyzed. For example, to what extent are differences in underpricing observed where there are differences in the lock-up periods adopted by different categories of shareholder? How do stock prices react to the expiration of the different back-up periods? In trade sales, buyers often put a part of the agreed-upon price in escrow accounts, that VC firms can only access after a specified period of time and if certain conditions are met. This is broadly comparable with lock-ups in IPOs. To the best of our knowledge, no analysis hereof has been performed, although it may strongly affect VC returns. Few studies to date consider VC characteristics in exit types other than IPOs. The proximity of one VC investor in the syndicate makes a trade sale more likely (Giot and Schwienbacher, 2007). Clearly, more research is needed on this subject. For example, one might expect that

7.4 Exit

543

VC partners with industry experience facilitate trade sales thanks to their deep individual industry knowledge or to their strong industry networks. Further, VC firms having exited more portfolio firms in a specific industry or geographic region may have built a reputation in that area, again facilitating trade sales. These hypotheses are worth further analysis. While more research is now being devoted to the analysis of trade sale as well as IPO exit mechanisms, there remains little systematic evidence on the processes engaged in by VCs to prepare portfolio companies for exit. For example, how are portfolio companies prepared for an exit? How do VCs choose between different exit types? How are trade buyers selected? What happens when VC firms do not exit (fully) at IPO or during the trade sale process? What is the impact of the current widespread use of auctions in trade sales or secondary sales? What are the wealth effects for both entrepreneurs and venture capital investors? An important aspect of preparing a firm for exit via IPO is the development of boards of directors and related control systems. VC firms may be skilled at developing and using boards in ways that enable their portfolio companies to gain advantages over their rivals (Barney et al., 2001). Selecting the right mix of directors with unique and useful skills or connections can improve ventures’ competitive advantage. Knowing how to organize the board and ensure effective decision-making processes is another source of advantage. Boards in growing ventures may be more effective when skilled directors have been recruited to help the firm fully realize its potential for generating economic rents, rather than simply to monitor the accountability of managers (Zahra et al., 2009). VC investors may play an important role in appointing nonexecutive directors with experience in developing and listing high-tech firms onto the spin-off board whose role is to professionalize management. The processes through which VCs undertake this task are not generally understood. The literature relating to VCs is vast. Even focusing upon the subset of the literature relating to the involvement of VCs in their portfolio companies, we have reviewed a considerable number of papers. These papers stem from a number of literatures. Considerable progress

544


has been made over time, but the general lack of cross-fertilization between finance and economics on the one hand, and management and entrepreneurship on the other, have led to duplication and constrained progress. The extensive agenda for future research that we have identified may be facilitated by greater integration between these disciplines. After all, VC involvement in their portfolio companies is as much about strategy as it is about finance.

Acknowledgments

Financial support from Gimv Private Equity Chair, Equistone European Partners and Ernst & Young is gratefully acknowledged.

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