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Venture Capital and Private Equity Investing
Cumming & Johan (2013, Chapter 10)
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© Cumming & Johan (2013)
Venture Capital Investing
Figure 1.1. Venture Capital Financial
Intermediation
Investors
Returns
Capital
Part II:
Chapters 4-9
Venture Capitalist
Equity, Debt,
Warrants, etc.
Capital
Part III:
Chapters 10-13
Entrepreneurial Firm
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Chapter Objectives
•
This chapter overviews issues considered in Chapters 10-14, and provides supplementary
issues dealing with venture capital and private equity investment activities
1.
2.
Due diligence (screening potential investee firms)
Selecting the stage of entrepreneurial firm development at which to invest (the various
stages were indicated in Chapter 1) and industry in which to invest (e.g., biotech,
computers, etc.)
Staging (number of financing rounds)
Valuation
Syndication (number of investors)
Board seats
Contracts between the fund and its investee firms, which includes decisions over matters
that include, but are not limited to:
3.
4.
5.
6.
7.
a.
b.
c.
Security (debt, preferred equity, common equity, etc.)
Control rights (such as the right to replace the founding entrepreneur as the CEO, among other
rights)
Veto rights (such as over asset sales and purchases)
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
1. Due Diligence: How do VC’s choose investments?
Kaplan and Stromberg (2004 Journal of Finance)
“Characteristics, Actions and Analyses: Evidence from Venture Capital”
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
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Contract Terms
Summary
Data
• 67 Investments from 11 U.S. limited
partnerships
• Specific details introduced here that have
previously been ‘unknown’ outside the
venture capital funds themselves
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
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Contract Terms
Summary
Criteria for Deciding to Invest
A. Opportunity: Market Conditions, Product,
Strategy and Competition
• Large market size and growth
• Attractive product and/or technology
• Attractive business strategy/model
• High likelihood of customer adoption
• Favourable competitive position
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Criteria (continued)
B. Management: Quality and Previous
Experience
6. Quality of management
7. Favourable performance to date
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Criteria (continued)
C. Deal Terms: Valuation, Contractual
Structure, syndicate and portfolio
considerations
8. Low valuation
9. Contractual structure that limits risk
10. Positive influence of other investors
11. Good fit in VC investment portfolio
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Criteria (continued)
D. Financial and Exit Conditions
12. Financial market conditions and exit
opportunities
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
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Contract Terms
Summary
Large Market Size and Growth
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Examples:
Two very important and visible market opportunities, which should both be over
$1B with an few years
Large market amenable to rapid growth
Very large market in which incumbents can earn high profit margins
Virtually unlimited market potential in the long run
Large and growing market with favourable demographic and privatization trends
Company could dramatically impact the evolution of the computer industry
Dramatic shifts in business favour the company’s product
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Attractive Product and/or Technology
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Examples:
Late stages of product development (first product launch planned in 15 – 18
months)
Superior technology with large market potential
Revolutionary new technology
Has developed excellent product
Has built a robust, scalable system that can meet the current market demands
Best product on the market
Well tested technology/product
Early stage company with post-beta product with competent/experienced
technology team
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Attractive Business Strategy/Model
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Examples:
Company significant reduces costs while maintaining quality
Compelling business strategy. Presence or likelihood of validating corporate
alliances
Attractive and demonstrated profitability of business model
Excellent new concept
Dinstictive strategy
High value-added, high margin strategy for very little upfront capital
“Lean and mean” operation with few employees and good customer focus
Pure play / focused
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
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Contract Terms
Summary
High Likelihood of Customer Adoption
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Examples:
Conceptual acceptance by professional community
Beta arrangements with large customers
Solid base of customers who regularly renew
Increasing popularity of approach among customers
Company has very interesting beta sites, who have been enthusiastic about
product
Major corporations are customers and are positive regarding the capabilities of
the product and the management team
Attractive customer value proposition
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Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Favorable Competitive Position
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Examples:
Company has intellectual property rights to all significant research findings using this
technology, not very threatening competitors
Company is targeting a significant segment that is underserved by incumbents
Early mover advantages from being pioneer of this concept and largest player
Highly fragmented industry, which makes the industry ripe for consolidation
No competitors
Early entrant
Very few effective alternatives available, and none currently targeting all three target
segments
First-mover advantage, similar to Amazon and AOL
Given the large market, there is more than enough room for several competitors
Strong proprietary and patent position
Potential for large market share with early penetration – meeting clearly unaddressed needs
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
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Summary
Quality of Management
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Examples:
Comfortable with the management team
Management team is of the highest quality in the industry
Experienced management team which is critical driver of success
VC is investing because of quality of management team, who is believed to be
good in science, and at raising and conserving money
Experienced, proven and high-profile CEO competing in a market where execution
is key
Very good CFO just hired
Known CEO for a long time
CEO / founder is one of the few managers in the industry capable of attracting
necessary employees. Has developed excellent product while consuming only
modest amounts of capital.
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
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Summary
Quality of Management (continued)
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Examples (continued):
Experienced managers out of successful venture backed company
Strong CEO/founder with very high marks from existing investors
Current management team has extensive internet and website management
experience
Key members of management team has industry experience. Team is wellbalanced, young and aggressive
Highly sought-after entrepreneur/founder, who co-founded successful company
that subsequently went public. Strong board
Excellent CEO joining company
CEO is frugral and will not spend capital unwisely
Executive team has acquired a significant level of penetration an relationships in a
fairly short time.
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Favorable Performance to Date
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Examples:
Attractive and demonstrated profitability of business model
Rapid growth: over 40% last four years
Company has a manageable cash burn rate and is expected to be cash-flow break-even with
12 months
Company has good reputation in industry
Company has been successful to date and has made substantial improvements during last
two years
Significant sales growth momentum
Has developed product, well positioned to achieve revenue target
Company is operationally break-even
Year one sales of $3.2M, profitabe so far
Cash flow positive
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Low Valuation
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Examples:
Low valuation 5-year IRR of 46% in conservative case
Very profitable unit model (60% IRR over 10 years)
Valuation is attractive and should give high returns if successful
Exit multiples are shooting up
VC only has to invest $1m at a $2m pre-money valuation
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Contractual Structure that Limits Risk
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Examples:
The participating preferred should protect the VC in the case of mediocre performances
Unique investment structure: only have to put in money if milestones are met; combination
of cumulative non-convertible preferred stock and regular convertible preferred has benefit
that VC will be paid back most of investment out of IPO proceeds
Equipment can be funded with debt
Gives investors ability to control growth
Successfully structured investment to minimize downside, by only providing limited funds
until milestones met
VC commitment will be invested over time. If initial (Chicago) launch no successful, VC has
option to cut back
Cash-efficient early stage thanks to future company acquisitions with stock
New investor has the benefit of reduction in VC pro rata investment if more funds needed
Limited risk for VC: will only own 4.4% of company
Can take company to leading industry position with minimum amount of capital
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Positive Influence of Other Investors
•
•
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•
Examples:
Investing partners include investors who previously invested in some extremely
successful companies
Former CEO of US industry involved as active chairman and interim CEO, as well as
investor
Main reason that VC is investing is that it is required to get a new individual
investor which has the benefit of (1) reduction in VC pro rata investment if more
funds needed, and (2) the skills of the investor and the interim “turnaround” CEO
that he is getting company
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Good Fit in VC Investment Portfolio
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Examples:
Adds additional breadth to VC portfolio with this market segment
VC is strong in this geographic region
Participation in the rapidly growing market
Good strategic fit with VC
VC has board seat on company in complementary business, with which VC could
facilitate marketing partnership
Represents new market segment for the funds, which should stimulate some
additional opportunities (assuming a positive outcome)
Potential for )Non-California) VC to lead a Silicon Valley deal
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Financial Market Conditions and Exit Opportunities
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Examples:
If successful, possibility for early exit or acquisition
Expect to have access to both debt and equity in public markets in attractive terms
Quick flip potential for the investment
Many strategic buyers available
Recent public market enthusiasm for e-commerce companies might enable public
equity financing to mitigate future financing risks
Given the size of the market opportunity and company’s strategy, capital markets
will be receptive given that company achieves business plan. Also, a consolidation
trend should emerge in industry as more companies enter market
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
NDAs?
• Non-disclosure agreements
• Rarely considered by VCs
• Why?!
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Diversification?
• Venture capital funds typically have around
10 investees in their portfolio.
• Why not more investments (diversify risk)?
• This issue is studied further in Chapter 18
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
2. Stage of Development
Cumming, Fleming and Schwienbacher (2005 Financial
Management) “Liquidity Risk and Venture Capital Finance”
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Exit Conditions in Stock Markets Affect VC/PE Markets
•
Relationship between IPOs and Early Stage
Investments
•
Inverse relation… early stage investments take a
while to bring to fruition (Chapter 19)
•
Can delay exit requirements by investing early
stage, hence early stage activity is counter cyclical
relative to IPO market conditions
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© Cumming & Johan (2013)
Venture Capital Investing
4.5
700
4
600
500
3.5
400
3
300
2.5
200
2
100
Relative Importance of New Early-Stage
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
0
1985
1.5
IPO Volume
Figure 10.1: Importance of New Early-Stage Investments and IPO Volume in the United
States from 1985 to 2004. The bold line (with left-hand Y-axis) gives the ratio of new earlystage investments over all new expansion-stage and later-stage investments in each year. The
IPO volume (right-hand Y-axis) is shown by the dashed line and represents the number of initial
public offerings (IPOs) as reported by Ritter and Welch (2002). It refers to IPOs on the
NASDAQ, NYSE and AMEX. Source: Cumming et al. (2005b).
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
3. Venture Capital Staging
Gompers (1995 Journal of Finance)
"Optimal Investment, Monitoring, and the Staging of
Venture Capital"
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Tradeoff
• Agency Costs versus Monitoring Costs
• This tradeoff enables us to make
predictions regarding the duration and size
of venture capital investments
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Typical Monitoring
• Gorman and Sahlman (1989)
 Monitoring is costly and can’t be done continuously
 Between financing rounds, on average inside VCs visit the
entrepreneurial firm once per month and spend 4-5 hours at
the firm per visit
 On average outside VCs visit the firm once a quarter for an
average of 2-3 hours
 Checks between financing are designed to limit opportunistic
behaviour by entrepreneurs between performance evaluations
for new capital commitments
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Value of Staging
• Gather information about the firm
Reduce informational asymmetry between
entrepreneur and venture capitalist
• Monitor the progress of the firm
• Maintain the option to abandon financing
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Monitoring Costs
• Opportunity costs of generating reports for
the VC and entrepreneur
• Opportunity costs of visiting an
entrepreneurial firm
• Contracting costs (legal, negotiating, and
other incidental costs) associated with each
new financing round
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Factors that affect agency costs
1. Asset intangibility and R&D
2. Growth options
 Increase in market to book ratios  increasing role of
investment opportunities in firm value
3. Asset specificity
4. Firm development stage
• No agency costs  irrelevance of financing structure
(similar to MM proposition)
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Asset Intangibility
• Agency costs of debt
 E.g., Risk-shifting, under-investment, asset stripping
• Value of leverage
 Increases with liquidation values and asset tangibility
• Asset characteristics that increase the agency costs of
debt reduce the value of leverage and make monitoring
more valuable
 Should also shorten funding duration in staged venture capital
investments
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Growth Options
• Growth options  more scope for the entrepreneur to
act in his or her own interest against the interest of the
VC(s)
• Market to book ratios are indicative of growth options
• Shorter investment durations when higher market to
book options
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Asset Specificity
• Assets with high industry-specific and firmspecific value have smaller liquidation
values
• Greater asset specificity  reduced
liquidation values  shorter investment
duration  more monitoring
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Firm Development Stage
• Which firms (start-up, expansion,
turnaround, buyout) should be staged and
which should have shorter investment
durations?
37
© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Investment and Liquidity
• When more capital is available for
investment, will VCs invest more or less per
round and more or less frequently in the
firms they finance?
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Importance of Exit
• Do firms that are exited by means of an IPO
receive more or fewer rounds of financing
and more or less total financing than their
counterparts that are exited by an
acquisition, secondary sale, buyback or
writeoff?
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Examples of Staging
• Federal Express
 $12,250,000 September 1973 $204.17 / share
 $6,400,000 March 1974 $7.34 per share
 $3,800,000 September 1974 $0.63 per share
 Firm went public in 1978 at $6 per share
• Apple Computer
 $518,000 January 1978 $0.09 / share
 $704,000 September 1978 $0.28 / share
 $2,331,000 December 1980 $0.97 / share
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
What If No Staging?
• Entrepreneurs may pursue personally
beneficial strategies at expense of VC
Examples:
Risk-shifting
Fame as opposed to fortune
• Entrepreneur may invest in negative expected
NPV venture
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Gompers Data
• 794 firms that received VC financing between 1961 and
1992 in the US
• Received 2143 rounds of venture capital financing (15%
of all VC over the period)
• Industry focus (min 70% of annual investments) on
high-tech firms (communication, computers,
electronics, biotechnology, medical/health)
• VCs specialize in investments in which asymmetric
information and agency costs are most pronounced
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Info on Exits in the Sample
•
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•
•
22.5% IPO
23.8% merger / acquisition
15.6% writeoff
38.1% remain private
• Useful contrasts relative to Chapters 20 and
21
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
The Duration & Size of Financing Rounds (1/2)
• Duration of financing rounds declines for late stage
companies
• The average amount of financing per round generally
rises for late stage companies
• Asymmetric information and agency costs decline as
investment stage is later
• Rate of cash utilization increases as investment stage is
later (rate of working capital utilization and investment
increases with investment stage)
44
© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Independent Variables (2/2)
•
•
•
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•
•
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Dummy variable for stage of financing
Firm age at time of financing (+)
(Tangible assets) / (Total assets) (+)
Size of financing round (insignificant)
Market-to-book ratio (-)
R&D / Sales (also: R&D / Assets) (-)
Amount of $ in VC industry (-)
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Regression Analysis Total Financing & # Financing Rounds
• Independent variables:
Exit types (IPO +)
(Tangible assets) / (total assets) (insignificant)
Market to book ratio (+)
R&D / Sales (insignificant)
R&D / Assets (insignificant)
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Supplementary Issues in Staging
• What else may explain the results?
– Monitoring costs are not measured
• Also, relevant to consider cyclicality of new
investments versus follow-on staged
investments (next slide)
47
© Cumming & Johan (2013)
Venture Capital Investing
0.35
700
600
0.3
500
0.25
400
0.2
300
200
0.15
100
Proportion of New Investments
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
0
1985
0.1
IPO Volume
Figure 10.2: Importance of New Investments Compared to Follow-On Investments. The
bold line (left-hand Y-axis) gives the proportion of new investments from all investments (new
and follow-on) in each year. The dashed line (right-hand Y-axis) gives again the number of IPOs
in each given year (IPO volume), as in Figure 2. Source: Cumming et al. (2005b Financial
Management).
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
4. Valuation in VC relative to Public Markets
Gompers & Lerner (2000, Journal of Financial Economics)
"Money Chasing Deals?: The Impact of Fund Inflows on
the Valuation of Private Equity Investments
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Valuation Issues
• How does fund inflows into the VC market
affect the pricing of deals?
• Is the relation driven by demand pressures
or is it related to an improvement in deal
prospects?
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
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Valuation
Syndication
Board Seats
Contract Terms
Summary
Data
• 4000 venture investments between 1987
and 1995
• Data from VentureOne (a US consulting
firm)
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
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Valuation
Syndication
Board Seats
Contract Terms
Summary
Findings (1/2)
1. Strong positive relation between venture
capital valuations and capital inflows
•
•
A doubling of the fund inflows into venture
capital funds causes an increase in valuations
by 7-21%
A doubling of public market values causes an
increase in value of private equity by 15-35%
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© Cumming & Johan (2013)
Venture Capital Investing
Due Diligence
Stage of Development
Staging
Valuation
Syndication
Board Seats
Contract Terms
Summary
Findings (2/2)
2. The results are consistent with the demand
pressure interpretation – high values are
higher because of money flowing into the VC
market and not due to an improvement in
investment opportunities
•
Success rates (IPO or acquisition) did not differ
from early 1990s (bad market) and late 1980s
(hot market)
53
© Cumming & Johan (2013)
Venture Capital Investing
Figure 10.3. Relation between Pre-Money Valuation and Annual Fund Inflows
into Venture Capital. Source: Gompers and Lerner (2000)
1.2
35
30
1
25
0.8
20
0.6
15
0.4
10
0.2
5
0
0
Annual Inflow into Venture Funds (1987=1)
Average Pre-Money Valuation
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Venture Capital Investing
Due Diligence
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Syndication
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Contract Terms
Summary
Additional Issues
•
Additional valuation issues were
considered in Chapter 4
•
Valuation considered further in Chapter
22
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Summary
5. Syndication
Lerner (1994 Financial Management) “The
Syndication of Venture Capital Investments”
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Syndication
Board Seats
Contract Terms
Summary
Syndication = More than 1 investor per investee
Venture Capitalist 1
Venture Capitalist 2
Entrepreneur
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Summary
Reasons for Syndication
1. Sah and Stiglitz (1986)
• VCs make better decisions about whether
to invest
• Prediction: syndicated investments perform
better
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Reasons (Con’t)
2. Lakonishok, Shleifer, Thaler, and Vishny
(1991)
• VCs collude and overstate the value of the
entrepreneurial investment upon exit
• Prediction: VCs offer best deals to those
that can reciprocate (well-established VC
firms)
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Summary
Reasons (Con’t)
3. Admati and Pfleiderer (1994)
• Inside versus outside VCs
• Inside VCs have an informational advantage over
outside VCs
• Inside VCs will overstate performance at each staged
financing round
• Solution (a testable prediction): inside VC has a fixed
share of equity
• As such, necessarily must have outside VCs
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Summary
Question
• Can you think of a possible problem with
Admati and Pfleiderer’s theory?
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Rationales (Con’t)
4. Wilson (1968)
• Diversification through risk sharing
• (Don’t want to underperform your peers
and risk not attracting new capital for
investment)
• Not a testable proposition with Gompers &
Lerner’s data
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Summary
Rationales (Con’t)
5. Hold-up
• Testable?
• With the Gompers and Lerner data, not
empirically distinguishable from the 1st
rationale
• Will be able to test when return to forms of
finance
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Summary
Lerner’s Empirical Evidence
• 271 biotechnology firms; 651 investment rounds 78-89
• Support for the three rationales for syndication
• Mean # of VC investors (Table 9.1 p.191)
 Round 1: 2.2
 Round 2: 3.3
 Round 3: 4.2
• Mean # of new VC investors in each round
 Round 1: 2.2
 Round 2: 1.5
 Round 3: 1.3
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Summary
Evidence (Con’t)
• Experienced VCs don’t invest with
inexperienced VCs in the first round
• Experienced VCs don’t invest with
inexperienced VCs in later rounds where
the inexperienced VC initiated the 1st round
financing
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Board Seats
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Summary
Evidence (Con’t)
• Equity holdings are relatively constant
across investment rounds
• Later-round syndications of investments in
promising firms (collusion; overstate value
of portfolio of investments)
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Summary
Question
• Relate the issue of “moral hazard” among
syndicated VCs to Admati and Pfleiderer’s theory of
syndication
• Can you see a problem with Admati and Pfleiderer’s
theory?
• This question is considered in detail in the Appendix
to Chapter 11
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4.5
700
600
4
500
3.5
400
3
300
200
2.5
100
Syndicate Size
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
0
1985
2
IPO Volume
Figure 10.4: Syndicate Size for New (First-Round) Investments and IPO Volume in the
United States from 1985 to 2004. The bold line (left-hand Y-axis) gives the average number of
syndicate partners involved in new investments in each year. The dashed line (right-hand Y-axis)
gives again the number of IPOs in each given year (IPO volume). Source: Cumming et al.
(2005b).
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Summary
6. Board Seats
Lerner (1995 Journal of Finance) Venture
Capitalists and the Oversight of Private Firms”
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Summary
Monitoring and Assistance
• VCs are active investors
• Being active involves costs
• Implications:
Successful investments
Regional development
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Summary
Lerner’s Data
• 271 biotechnology firms 1978 – 1989 US
• Table 8.2 p.175
• VC board membership generally increases
with each financing round
• (but so does membership from other
outsiders and other insiders)
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Board Membership
• Composition of the board determined by
need for oversight
• When may the firm’s managers deviate
from value maximizing decisions?
• Increased presence of VCs when likelihood
for deviations is greatest
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Board Membership & CEO Turnover
• Why care about CEO turnover?
Uncertainty about new CEO
Problems in a firm that fired the old CEO
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Summary
Evidence
• Increase in VC board membership around
time of CEO turnover
• No significant change in number of other
outsiders on board around CEO turnover
• Nonparametric evidence Table 8.3
• Parametric evidence Table 8.4
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Summary
Board Membership & Geographic Proximity
• >50% have a VC director within 60 miles of
headquarters
• >25% have a VC director with 7 miles
• Prob (VC director within 5 miles) = 22%
• Control factors:
 Stake held by VC in firm
 Size of VC fund
 Age of venture organization
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Questions
• What does this imply about venture capital
fundraising?
• What does this imply about regional
development?
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Summary
7. Contract Terms
• Contracts between the fund and its investee firms, which
includes decisions over matters that include, but are not limited
to:
– Security (debt, preferred equity, common equity, etc.)
• Focus of Chapters 11-13
– Control rights (such as the right to replace the founding
entrepreneur as the CEO, among other rights)
– Veto rights (such as over asset sales and purchases)
• Focus of Chapter 14
• Samples: Term Sheet, Shareholder Agreement and Subscription
Agreement are available at
http://venturecapitalprivateequitycontracting.com/
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Summary
8. Summary
• Many interrelated issues in venture capital investment decisions
• Easier to understand in context of agency theory (Chapter 2)
• Focus in Chapters 11-13 on financial contracting
• Thereafter Chapters 14-18 consider impact of investing on
effort
• Lastly Chapters 19-22 consider exits and returns
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