A recent book by Josh Lerner and a recent article in the Journal of Public Economics has asserted that government venture capital programs in Europe have displaced or crowded out private venture capital. The result of work such as this has been to place pressure on government bodies around the world to remove or replace their existing governmental programs. In the aftermath of the financial crisis, venture capital markets around the world themselves have been in crisis. So, it is particularly timely to address the issue of whether or not government venture capital programs in regions such as Europe really have in fact crowded out private venture capital programs.

As pointed out in this Economist article and in my recent commentary and my review article, the idea that government programs crowding out private venture capital in Josh Lerner’s book and in the Journal of Public Economics is based on empirical measures that are completely flawed. The empirical tests supporting crowding out are based on methodologies that rank the Austrian and Hungarian venture capital markets as being the best in the Europe, and the U.K. venture capital market as being the worst in Europe (I am not kidding).

…continue reading: Measuring the Effectiveness of Public Policy Towards Venture Capital

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

In our recent NBER working paper, Private Equity Performance: What Do We Know?, my co-authors (Tim Jenkinson of the University of Oxford and Robert Harris of the University of Virginia) and I use a new research-quality data set of private equity fund-level cash flows from Burgiss. We refer to private equity as the asset class that includes buyout funds and venture capital (VC) funds. We analyze the two types of funds separately. The data set has a number of attractive features that we describe in detail later. A key attribute is that the data are derived entirely from institutional investors (the limited partners or LPs) for whom Burgiss’ systems provide recordkeeping and performance monitoring services. This results in detailed, verified and crosschecked investment histories for nearly 1400 private equity funds derived from the holdings of over 200 institutional investors. Using these data we reassess the performance of private equity funds, in absolute terms and relative to public markets. Our results are markedly more positive for buyout funds than have previously been documented.

…continue reading: Private Equity Performance

In the paper, Does Reputation Limit Opportunistic Behavior in the VC Industry? Evidence from Litigation against VCs, forthcoming in the Journal of Finance, we use a hand-collected database of lawsuits filed against U.S. venture capitalists (VCs) to examine the role of reputation in limiting opportunism in the VC industry. The lawsuits in our sample serve as a proxy for alleged opportunistic behavior by the defendant VCs. Based on the lawsuit plaintiff, we further identify whether the defendant VCs allegedly behaved opportunistically against founders, limited partners, other VCs, buyers of VC-backed startups, or other parties (angels, creditors, employees, etc.).

We choose proxies for VC reputation (or alternatively the intensity of VC relationships) with each of the four main types of plaintiffs as follows. First, the number of deals that a VCs invests in serves as proxy for the VC’s reputation with founders. Second, we use the amount of funds under management to proxy for the VC’s reputation with limited partners. Third, the VC’s network centrality, defined as the scaled number of relationships that a VC has with other VCs, serves as proxy for the VC’s reputation with other VCs. Last, we use the percentage of companies in the VC’s portfolio that go public to proxy for the VC’s reputation with buyers of VC-backed startups.

…continue reading: Reputation and Opportunistic Behavior in the VC Industry

In the paper, Management Quality, Venture Capital Backing, and Initial Public Offerings, which was recently made publicly available on SSRN, we use hand-collected data on the quality and reputation of the management teams of a large sample of 3,240 entrepreneurial firms going public during 1993-2004 to conduct the first large-sample study of the relationship between VC-backing and management quality and the effect of these two variables on a firm’s IPO characteristics and valuation, post-IPO financial policies, and post-IPO operating performance. We hypothesize that VC-backing positively affects the quality of a firm’s management team, and that both management quality and VC-backing play a certifying role in conveying a firm’s intrinsic value to the financial market, reducing the information asymmetry faced by it.

Our empirical findings are as follows. First, we find that overall VC-backed firms have higher quality management teams compared to non-VC-backed firms. In particular, VC-backed firms have a greater percentage of management team members with MBA degrees, a greater percentage of managers with prior managerial experience, a greater percentage of managers in core functional areas (operations and production, sales and marketing, R&D, and finance), and larger management teams compared to non-VC-backed firms. At the same time, VC-backed firms have lower percentages of management team members who are CPAs and who have prior managerial experience at law and accounting firms; further, their managers have shorter average tenures and smaller heterogeneity in these tenures.

…continue reading: Management Quality, Venture Capital Backing, and Initial Public Offerings

Background

Wilson Sonsini Goodrich & Rosati recently surveyed various corporate governance and disclosure practices of venture-backed companies incorporated in the United States and involved in U.S. initial public offerings (IPOs) from January 2010 through June 2011. A copy of the report is available here. We believe that this is the first such survey specifically relating to venture-backed companies.

We examined the 50 companies involved in the largest IPOs measured by deal size over those 18 months. By deal size, measured by gross proceeds, the IPOs examined ranged from $56 million to $352.8 million, with an average deal size of $123.3 million and a median deal size of $90.1 million.

Nineteen of the companies examined were headquartered in the San Francisco Bay Area; six in southern California; five in Texas; three each in Georgia and Massachusetts; and the remainder in 11 other states and one foreign country.

Forty-eight of the companies examined were incorporated in Delaware; one in California; and one in Maryland.

Twenty of the companies examined were listed on The NASDAQ Global Market; 17 on the New York Stock Exchange; and 13 on The NASDAQ Global Select Market.

…continue reading: Governance and Disclosure Practices of Venture-Backed IPOs

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

In our paper, Are Busy Boards Detrimental?, which was recently made publicly available on SSRN, we attempt to measure effects of busy directors serving on the boards of venture-backed IPO firms, and by so doing, address concerns that busy boards are detrimental and that multiple directorships should be limited. The issue of busy boards has received considerable attention in the academic literature and popular press. Yet, even though the academic literature has long recognized that venture capitalists are active on the boards of IPO firms in which they have invested, it is silent on the effects, or even the existence, of busy directors on IPO firms’ boards.

A recent Wall Street Journal article, “Start-Ups Grumble About Directors Too Busy To Help” (7/29/2010), discusses this very issue of the costs and benefits of busy directors among young firms. Focusing on the negative aspects of busy boards, the Wall Street Journal article articulates entrepreneurs’ concerns that venture capitalist directors are juggling too many companies and that the hands-on guidance they can provide to their portfolio companies becomes diluted. Consistent with evidence presented in this paper, however, a number of associated commentaries by executives of private companies with busy boards on the WSJ.com website emphasize that busy directors also provide substantial benefits to the companies on which they serve. The following quote from executive Marcie Black of BandGap, Inc. incorporates the sentiments of several executives’ posts: “The article focuses heavily on the amount of attention a board member offers, but it’s the quality of attention that matters. Many abilities of a mentor improve as they sit on more boards—experience, breadth of network, personal skills, and sense of perspective. No matter the issue that we’re confronting, Forest [board member at BandGap Inc. who also serves on 19 other Boards] has seen it before and usually more than once. The clarity I get from a 20 minute conversation is worth hours from a less experienced mentor.” The executive commentaries to the WSJ article are consistent with our evidence that busy directors can provide strong benefits to young firms’ boards.

…continue reading: Are Busy Boards Detrimental?

In our paper, Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley, recently made publicly available on SSRN, Brian Broughman and I examine the role of inside financing rounds in VC-backed firms.

VCs typically invest through several rounds of financing. Each round is separately negotiated and priced. A subsequent (“follow-on”) round of financing could be provided by either (a) the firm’s existing VC investors exclusively (an inside round) or (b) a group led by a VC fund that did not invest in the startup’s earlier rounds (an outside round). Historically, most follow-on financings were structured as outside rounds, in part to mitigate conflict between the entrepreneur and existing VCs over the value of the firm. In recent years, however, more than half of follow-on rounds have been structured as inside rounds.

…continue reading: Do VCs Use Inside Rounds to Dilute Founders?