Venture capitalists (VCs) play a significant role in the financing of high-risk, technology-based business ventures. VC exits usually take one of three forms: an initial public offering (IPO) of a portfolio company’s shares, followed by the sale of the VC’s shares into the public market; a “trade sale” of the company to another firm; or dissolution and liquidation of the company.

Of these three types of exits, IPOs have received the most scrutiny. This attention is not surprising. IPO exits tend to involve the largest and most visible VC-backed firms. And, perhaps just as importantly, the IPO process triggers public-disclosure requirements under the securities laws, making data on IPO exits easily accessible to researchers.

But trade sales are actually much more common than IPOs and, in aggregate, are more financially important to VCs. Unlike IPOs, however, trade sales do not trigger the intense public-disclosure requirements of the securities laws; they take place in the shadows. Thus, although trade sales play a critical role in the venture capital cycle, relatively little is known about them.

In our paper, Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups recently made public on SSRN, Brian Broughman and I seek to shine more light on intra-firm dynamics around trade sales. In particular, we investigate how VCs induce the “entrepreneurial team” – the founder, other executives, and common shareholders – to go along with a trade sale that they might have an incentive to resist.

…continue reading: Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups

Delaware dominates the corporate chartering market in the U.S—it is the only state that attracts a significant number of out-of-state incorporations. As a result, incorporation decisions are “bimodal,” with public and private firms typically choosing between home-state and Delaware incorporation.

Much ink has been spilled in the debate over whether Delaware’s dominance arose because it offers high-quality or low-quality corporate law. Under the “race-to-the-top” view, Delaware has prevailed because its law maximizes firm value. Under the “race-to-the-bottom” view, Delaware has won by offering corporate law that favors insiders at other parties’ expense.

But a firm today may choose Delaware law not solely because of its inherent features but rather because, after decades of Delaware’s dominance, business parties—including investors and their lawyers—are now simply more familiar with Delaware law than the laws of other states. Indeed, the bimodal pattern of domiciling is itself strong evidence that business parties are familiar only with their home states’ corporate law and Delaware’s.

In our paper, Delaware Law as Lingua Franca: Evidence from VC-Backed Startups, recently made public on SSRN, Brian Broughman, Darian Ibrahim, and I show, for the first time, that familiarity does in fact affect firms’ decisions to domicile in Delaware rather in their home states.

…continue reading: Delaware Law as Lingua Franca: Evidence from VC-Backed Startups

For a number of years, as the new year approached, I have prepared a one-page list of the key issues for boards of directors that are newly emerging or will be especially important in the coming year. Each year, the legal rules and aspirational best practices for corporate governance matters, as well as the demands of activist shareholders seeking to influence boards of directors, have increased. So too have the demands of the public with respect to health, safety, environmental and other socio-political issues. In The Spotlight on Boards, I have published a list of the roles and responsibilities that boards today are expected to fulfill. Looking forward to 2012, it is clear that in addition to satisfying these expectations, the key issues that boards will need to address include:

• 1. Working with management to navigate the dramatic changes in the domestic and world-wide economic, social and political conditions, in order to remain competitive and successful.
• 2. Coping with the increase in regulations and changes in the general perception of business that have followed the financial crisis. Once it was said, “The business of America is business.” Today, it could be said, “The business of America is government, and a dysfunctional government at that.”

…continue reading: Key Issues for Directors 2012

Over the past year a record number of governments in Sub-Saharan Africa changed their economy’s regulatory environment to make it easier for domestic firms to start up and operate. In a region where relatively little attention was paid to the regulatory environment only 8 years ago, regulatory reforms making it easier to do business were implemented in 36 of 46 economies between June 2010 and May 2011. That represents 78% of economies in the region, compared with an average of 56% over the previous 6 years.

Worldwide, regulatory reforms aimed at streamlining such processes as starting a business, registering property or dealing with construction permits are still the most common. But more and more economies are focusing their reform efforts on strengthening legal institutions such as courts and insolvency regimes and enhancing legal protections of investors and property rights. This shift has been particularly pronounced in low- and lower-middle-income economies, where 43% of all reforms recorded by Doing Business in 2010/11 focused on aspects captured by the getting credit, protecting investors, enforcing contracts and resolving insolvency indicators.

…continue reading: Comparing Regulation for Domestic Firms in Different Countries

In our paper, Investment Cycles and Startup Innovation, which was recently made publicly available on SSRN, we examine how the environment in which a new venture was first funded relates to their ultimate outcome. New firms that surround the creation and commercialization of new technologies have the potential to have profound effects on the economy. The creation of these new firms and their funding is highly cyclical (Gompers et al. (2008)). Conventional wisdom associates the top of these cycles with negative attributes. In this view, an excess supply of capital is associated with money chasing deals, a lower discipline of external finance, and a belief that this leads to worse ventures receiving funding in hot markets.

However, the evidence in our paper suggests another, possibly simultaneous, phenomenon. We find that firms that are funded in “hot” times are more likely to fail but create more value if they succeed. This pattern could arise if in “hot” times more novel firms are funded. Our results provide a new but intuitive way to think about the differences in project choice across the cycle. Since the financial results we present cannot distinguish between more innovative versus simply riskier investments, we also present direct evidence on the quantity and quality of patents produced by firms funded at different times in the cycle. Our results suggest that firms funded at the top of the market produce more patents and receive more citations than firms funded in less heady times. This indicates that a more innovative firm is funded during “hot” markets.

…continue reading: Investment Cycles and Startup Innovation

On October 9, 2011, California Governor Jerry Brown signed into law competing bills that create two new corporate forms in California — a “flexible purpose corporation” and a “benefit corporation” — intended to allow entrepreneurs and investors the choice of organizing companies that can pursue both economic and social objectives. The new corporate forms differ from traditional for-profit corporations that are organized to pursue profit (and not social purposes) and non-profit corporations that must be used solely to promote social benefits. These laws will take effect on January 1, 2012.

The flexible purpose corporation is created by California Senate Bill 201 (“SB 201″), which adds Division 1.5 to Title 1 of the California Corporations Code (the “Code”) and amends other related sections of the Code, and the benefit corporation is created by California Assembly Bill 361 (“AB 361″), which adds Part 13 to Division 3 of Title 1 of the Code. State Senator Mark DeSaulnier authored SB 201, and a full copy is available here. AB 361 was authored by Assemblyman Jared Huffman, and a full copy is available here. Both new laws take effect January 1, 2012.

…continue reading: Two New Corporate Forms to Advance Social Benefits in California

In the paper, The Consequences of Entrepreneurial Finance: A Regression Discontinuity Analysis, which was recently made publicly available on SSRN, my co-authors (William Kerr and Antoinette Schoar) and I document the role of angel funding for the growth, survival, and access to follow-on funding of high-growth start-up firms. We use a regression discontinuity approach to control for unobserved heterogeneity between firms that obtain funding and those that do not. This technique exploits that a small change in the collective interest levels of the angels can lead to a discrete change in the probability of funding for otherwise comparable ventures.

The results of this study and our border analysis in particular, suggest that angel investments improve entrepreneurial success. By looking above and below the discontinuity in a restricted sample, we remove the most worrisome endogeneity problems and the sorting between ventures and investors. We find that the localized increases in interest by angels at break points, which are clearly linked to obtaining critical mass for funding, are associated with discrete jumps in future outcomes like survival and stronger web traffic performance.

…continue reading: The Consequences of Entrepreneurial Finance

Entrepreneurial activity is risky and poorly diversified. Most economic models would suggest that the high degree of entrepreneurial risk should be compensated by premium returns, but this is not borne out by the empirical evidence. Several hypotheses based on the idea that entrepreneurs have a different set of preferences or beliefs (e.g. risk tolerance or over-optimism) have been offered to explain this anomaly. In our forthcoming American Economic Review paper, Risk Taking by Entrepreneurs, we provide an alternative theory of endogenous entrepreneurial risk taking that does not rely on individual heterogeneity of preferences or beliefs.

The key ingredients in our theory are borrowing constraints, the existence of an outside opportunity and endogenous risk choice. A self-financed entrepreneur chooses every period how much to invest in a project, which is chosen from a set of alternatives. All available projects offer the same expected return but a different variance. After returns are realized, the entrepreneur decides whether to exit and take the outside opportunity (e.g. become a worker) or to stay in business. The possibility of exit creates a non-concavity in the entrepreneurs’ continuation value: for values of wealth below a certain threshold, the outside opportunity gives higher utility; for higher wealth levels, entrepreneurial activity is preferred.

Risky projects provide lotteries over future wealth that eliminate this non-concavity and are particularly valuable to entrepreneurs with wealth levels close to this threshold. As the level of wealth increases, entrepreneurs invest in less risky projects. In order to stress the role of risk taking, our model allows entrepreneurs to choose completely safe projects with the same expected return. All exits occur precisely because low wealth entrepreneurs purposively choose risk. If risky projects were not available, no entrepreneurs would ever exit from business. It is the relatively poor entrepreneurs that decide to take more risk. At the same time, due to self-financing, they invest less in their projects than richer entrepreneurs. Correspondingly, the model implies that survival rates of the business are positively correlated with business size. Moreover, if agents enter entrepreneurship with relatively low wealth levels (as occurs in the case with endogenous entry that we study), our model also implies that young businesses exhibit lower survival rates. It also appears that, conditional on survival, small (younger) firms grow faster than larger (older) ones.

One of the main contributions of our work is that we actually provide a very intuitive interpretation for lotteries—entrepreneurial project risk choice. This enables us to relate the implications of our model not only to the firm dynamics stylized facts, but also to the broad empirical evidence on entrepreneurial risk taking and the private equity premium puzzle. In addition, by incorporating the project risk choice in an occupational choice model with exogenous borrowing constraints, we are also able to illustrate how lotteries might lead to expected gains in lifetime consumption and can be used to relax the borrowing constraints.

The full paper is available for download here.

An entrepreneur’s primary incentive is ownership of a substantial share of the enterprise that commercializes the entrepreneur’s ideas. An inescapable consequence of this incentive is the entrepreneur’s exposure to the idiosyncratic risk of the enterprise. Diversification or insurance to ameliorate the risk would necessarily weaken the incentives for success. In our forthcoming American Economic Review paper, The Burden of the Nondiversifiable Risk of Entrepreneurship, we study this issue in the case of startup companies backed by venture capital.

We make use of a rich body of data, which we believe is not a sample, but close to the universe of companies receiving venture funding from 1987 to the present. Standard venture deals involve three parties: entrepreneurs, general partners, and limited partners. The entrepreneurs have leveraged positions; that is, they receive no payoff until other claimants have received prescribed payoffs. The general partners, who arrange financing and supervise the startup company by holding board seats, are compensated in proportion to the amount invested and the capital gains on the investment. The limited partners are passive investors who hold debt and equity claims on the startup. General partners are somewhat diversified across investments and the limited partners are highly diversified. The burden of specialization falls mainly on the entrepreneurs.

We focus on the joint distribution of the duration of the entrepreneur’s involvement in a startup what we call the venture lifetime and the value that the entrepreneur receives when the company exits the venture portfolio. Exits take three forms: (1) an initial public offering, in which the entrepreneur receives liquid publicly-traded shares or cash (if she sells her own shares at the IPO or soon after) and has the opportunity to diversify; (2) the sale of the company to an acquirer, in which the entrepreneur receives cash or publicly-traded shares in the acquiring company and has the opportunity to diversify; and (3) shutdown or other determination that the entrepreneur’s equity interest has essentially no value. Most IPOs return substantial value to an entrepreneur. Some acquisitions also return substantial value, while others may deliver a meager or zero value to the entrepreneur. The joint distribution shows a distinct negative correlation between exit value and venture lifetime. Highly successful products tend to result in IPOs or acquisitions at high values relatively quickly.

In addition, we develop a unified analysis of the factors affecting the entrepreneur’s risk-adjusted payoff, based on a dynamic program. The analysis takes account of the joint distribution of exit value and venture lifetime and of salary and compensation income. We use it to calculate the certainty-equivalent value of the entrepreneurial opportunity the amount that a prospective entrepreneur would be willing to pay to become a founder of a venture-backed startup. For a risk-neutral individual, the certainty-equivalent is $3.6 million. With mild risk aversion and savings of $100,000, however, the amount is only $0.7 million and with normal risk aversion and that amount of savings, the certainty-equivalent is slightly negative.

Our most important finding is that the reward to the entrepreneurs who provide the ideas and long hours of hard work in these startups is zero in almost three quarters of the outcomes, and small on average once idiosyncratic risk is taken into consideration.

The full paper is available for download here.

In my paper Inheritance Law and Investment in Family Firms (co-written with Andrew Ellul and Marco Pagano) which I recently presented at the Law, Economics and Organizations Seminar at Harvard Law School, my co-authors and I investigate whether inheritance laws reduce investment and growth in family firms. Inheritance laws may constrain entrepreneurs to bequeath a minimal stake to non-controlling heirs. The larger the portion of the founder’s assets to be assigned to non-controlling heirs, the lower the fraction left to the heir designated to remain at the helm of the firm. Absent any friction in capital markets, a lower wealth of the controlling heir would not affect the family firm’ ability to borrow and invest. But in the presence of capital market imperfections, it may hinder the firm’s investment.

In the context of a stylized model of succession in a family firm, we show that larger legal claims by non-controlling heirs on the founder’s estate lead to lower investment by family firms, as they reduce the firm’s ability to pledge future income streams to external financiers. To perform empirical tests, we collect data on inheritance law for 62 countries, mainly via questionnaires sent to law firms that are part of the Lex Mundi project. We measure the “permissiveness of the inheritance law” of each country as the maximum share of a testator’s estate that can be bequeathed to a single child, depending on the presence or absence of a spouse and the total number of children. We then merge this indicator with measures of investor protection and with data for 10,245 firms from 32 countries for the period 1990-2006.

We find that indeed the strictness of inheritance law is associated with lower investment and growth in family firms, while it leaves investment unaffected in non-family firms. Moreover, the negative effect of strict inheritance law on family firms’ investment is exacerbated by poor investor protection, which is also in accordance with the model. We also find that the results are mostly driven by family firms that experience succession in our sample period. It is precisely around and after succession that the effects of inheritance laws are mostly felt, because it is at this time that the decision on who is appointed as the controlling heir and his/her stake is determined. Indeed we find that during and after succession family firms experience a decrease in investment that is more severe for firms located in countries with stricter inheritance law. Also in this case, poor investor protection is found to exacerbate the effect of strict inheritance law, as well as having a direct negative effect on investment. Our results are robust to the use of different specifications of the investment equation, to the inclusion of inheritance taxes (which have no statistically significant effect on family firms’ investments), to different definitions of family firms and different measures of financial dependence.

The full paper is available for download here.