Venture capital is independently managed, dedicated capital focusing on equity or equity-linked investments in privately held, high-growth companies. Research into venture capital has focused on the structure and financing of venture partnerships, the financial and operational interactions of venture capitalists with portfolio firms, and the exiting of venture capital investments. Major areas needed further research include the internationalization of venture capital, the impact of public policy, and the real economic effects of these funds.
KeywordsAgency conflicts Asymmetric information Capital gains taxation Corporate governance Covenants Entrepreneurship Financial intermediaries High-risk assets Initial public offerings Investment Limited liability Limited partnerships Liquidity constraints Maximum likelihood Monitoring Patents Pay-for-performance incentives Reputation Research and development Venture capital
Venture capital is independently managed, dedicated capital focusing on equity or equity-linked investments in privately held, high-growth companies. The first venture firm, American Research and Development, was formed in 1946 and invested in companies commercializing technology developed during the Second World War. Because institutions were reluctant to invest, it was structured as a publicly traded closed-end fund and marketed mostly to individuals, a structure emulated by its successors.
By 1978 limited partnerships had become the dominant investment structure. Limited partnerships have an important advantage: capital gains taxes are not paid by the limited partnership. Instead, only the taxable investors in the fund pay taxes. Venture partnerships have predetermined, finite lifetimes. To maintain limited liability, investors must not become involved in the management of the fund.
Activity in the venture industry increased dramatically in early 1980s. Much of the growth stemmed from the US Department of Labor’s clarification of Employee Retirement Income Security Act’s ‘prudent man’ rule in 1979, which had prohibited pension funds from investing substantial amounts of money into venture capital or high-risk asset classes. The rule clarification explicitly allowed pension managers to invest in high-risk assets, including venture capital.
The subsequent years saw both very good and trying times for venture capitalists. Venture capitalists backed many successful companies, including Apple Computer, Cisco, Genentech, Google, Netscape, Starbucks, and Yahoo! But commitments to the venture capital industry were very uneven, creating a great deal of instability. The annual flow of money into venture funds increased by a factor of ten during the early 1980s. From 1987 through 1991, however, fund-raising steadily declined as returns fell. Between 1996 and 2003, this pattern was repeated.
Venture capital investing can be viewed as a cycle. In this article, I follow the cycle of venture capital activity. I begin with the formation of venture funds. I then consider the process by which such capital is invested in portfolio firms, and the exiting of such investments. I end with a discussion of open research questions, including those relating to internationalization and the real effects of venture activity.
Research into the formation of venture funds has focused on two topics. First, the commitments to the venture capital industry have been highly variable since the mid-1970s. Understanding the determinants of this variability has been a topic of continuing interest to researchers. Second, the structure of venture partnerships has attracted increasing attention.
First, Poterba (1987, 1989) notes that the fluctuations could arise from changes in either the supply of or the demand for venture capital. It is very likely, he argues, that decreases in capital gains tax rates increase commitments to venture funds, even though the bulk of the funds are from tax-exempt investors. The drop in the tax rate may spur corporate employees to become entrepreneurs, thereby increasing the need for venture capital. The increase in demand due to greater entrepreneurial activity leads to more venture fund-raising.
Gompers and Lerner (1998b) find empirical support for Poterba’s claim: lower capital gains taxes have particularly strong effects on venture capital supplied by tax- exempt investors. This suggests that the primary mechanism by which capital gains tax cuts affect venture fund-raising is the higher demand of entrepreneurs for capital. The authors also find that a number of other factors influence venture fund-raising, such as regulatory changes and the returns of venture funds.
A second line of research has examined the contracts that govern the relationship between investors (limited partners) and the venture capitalist (general partner). Gompers and Lerner (1999) find that compensation for older and larger venture capital organizations is more sensitive to performance than that of other venture groups. Also, the cross-sectional variation in compensation terms for younger, smaller venture organizations is considerably lower. The fixed component of compensation is higher for smaller, younger funds and funds focusing on high-technology or early stage investments. Finally, Gompers and Lerner do not find any relationship between the incentive compensation and performance.
The authors argue that these results are consistent with a learning model in which neither the venture capitalist nor the investor knows the venture capitalist’s ability. With his early funds, the venture capitalist will work hard even without explicit pay-for-performance incentives: if he can establish a good reputation, he can raise subsequent funds. These reputation concerns lead to lower pay for performance for smaller and younger venture organizations. Once a reputation has been established, explicit incentive compensation is needed to induce the proper effort.
Covenants also play an important role in limiting conflicts in venture partnerships. Their use may be explained by two hypotheses. First, because negotiating and monitoring covenants are costly, they will be employed when monitoring is easier and the potential for opportunistic behaviour is greater. Second, in the short run the supply of venture capital services may be fixed, with a modest number of funds of carefully limited size raised each year. Increases in demand may lead to higher prices when contracts are written. Higher prices may include not only increases in monetary compensation, but also greater consumption of private benefits through fewer covenants.
Gompers and Lerner (1996) show that both supply and demand conditions and costly contracting are important in determining contractual provisions. Fewer restrictions are found in funds established during years with greater capital inflows and funds, when general partners enjoy higher compensation. The evidence illustrates the importance of general market conditions on the restrictiveness of venture partnerships. In periods when venture capitalists have relatively more bargaining power, the venture capitalists are able to raise money with fewer stings attached.
Lerner and Schoar (2004) examine rationales for constraints on liquidity. Venture groups often impose severe restrictions on transfers of partnership interests beyond what is required by securities law. They argue that these curbs allow general partners to screen for long-term investors. A limited partner who expects many liquidity shocks would find these restrictions especially onerous. Thus, the limited partners investing will be highly liquid, facilitating fund-raising in follow-on funds. The authors show that restrictions on liquidity are less common in later funds organized by the same venture group, when information problems are presumably less severe.
A second broad area of research has focused on the ties between venture capitalists and the firms in which they invest.
This literature emphasizes the informational asymmetries that characterize young firms, particularly in high-technology industries. These problems make it difficult for investors to assess firms, and permit opportunistic behaviour by entrepreneurs after finance is received. Specialized financial intermediaries, such as venture capitalists, address these problems by intensively scrutinizing firms before providing capital and monitoring them afterwards.
Economic theory examines the role that venture capitalists play in mitigating agency conflicts between entrepreneurs and investors. The improvement in efficiency might be due to the active monitoring and advice that is provided (Cornelli and Yosha 2003; Hellmann 1998; Marx 1994), the screening mechanisms employed (Chan 1983), the incentives to exit (Berglöf 1994), the proper syndication of the investment (Admati and Pfleiderer 1994), or investment staging (Bergemann and Hege 1998; Sahlman 1990).
Staged capital infusion is the most potent control mechanism a venture capitalist can employ. The shorter the duration of an individual round of financing, the more frequently the venture capitalist monitors the entrepreneur’s progress. The duration of funding should decline and the frequency of re-evaluation increase when the venture capitalist believes that conflicts with the entrepreneur are likely.
If monitoring and information gathering are important – as models such as those of Amit et al. (1990) and Chan (1983) suggest – venture capitalists should invest in firms where asymmetric problems are likely, such as early stage and high-technology firms with intangible assets. The capital constraints faced by these companies will be large and these investors will address them.
Gompers (1995) shows that venture capitalists concentrate investments in early stage companies and high-technology industries where informational asymmetries are significant and monitoring is valuable. He finds that early stage firms receive significantly less money per round. Increases in asset tangibility are associated with longer financing duration and reduce monitoring intensity.
In a related paper, Kaplan and Strömberg (2003) document how venture capitalists allocate control and ownership rights contingent on financial and non- financial performance. If a portfolio company performs poorly, venture capitalists obtain full control. As performance improves, the entrepreneur obtains more control. If the firm does well, the venture capitalists relinquish most of their control rights but retain their equity stake.
Related evidence comes from Hsu (2004), who studies the price entrepreneurs pay to be associated with reputable venture capitalists. He analyses firms which received financing offers from multiple venture capitalists. Hsu shows that high investor experience is associated with a substantial discount in firm valuation.
Venture capitalists usually make investments with peers. The lead venture firm involves other venture firms. One critical rationale for syndication in the venture industry is that peers provide a second opinion on the investment opportunity and limit the danger of funding bad deals.
Lerner (1994a) finds that in the early investment rounds experienced venture capitalists tend to syndicate only with venture firms that have similar experience. He argues that, if a venture capitalist were looking for a second opinion, then he would want to get one from someone of similar or greater ability, certainly not from someone of lesser ability.
The advice and support provided by venture capitalists is often embodied in their role on the firm’s board of directors. Lerner (1995) examines whether venture capitalists’ representation on the boards of the private firms in their portfolios is greater when the need for oversight is larger, looking at changes in board membership around the replacement of CEOs. He finds that an average of 1.75 venture capitalists are added to the board between financing rounds when a firm’s CEO is replaced in the interval; between other rounds 0.24 venture directors are added. No differences are found in the addition of other outside directors.
Hochberg (2005) studies the influence of venture capitalists on the governance of a firm following its initial public offering (IPO). Venture-backed firms manage earnings less in the IPO year, as measured by discretionary accounting accruals. Venture-backed firms also experience a stronger wealth effect when they adopt a poison pill, which implies that investors are less worried that the poison pill will entrench management at the expense of shareholders. Finally, venture-backed firms more frequently have independent boards and audit and compensation committees, as well as separate CEOs and chairmen.
It is natural to ask why other financial intermediaries (such as banks) cannot duplicate these features of the venture capitalists, and undertake the same sort of monitoring. Economists have suggested several explanations for the apparent superiority of venture funds in this regard. First, because regulations limit banks’ ability to hold shares, they cannot freely use equity. Second, banks may not have the necessary skills to evaluate projects with few collateralizable assets and significant uncertainty. Finally, venture funds’ high-powered compensation schemes give venture capitalists incentives to monitor firms closely. Banks sponsoring venture funds without high-powered incentives have found it difficult to retain personnel.
So far, this section has highlighted the ways in which venture capitalists can successfully address agency problems in portfolio firms. During periods when the amount of money flowing into the industry grows dramatically, however, competition between venture groups can introduce distortions.
Gompers and Lerner (2000) examine the relation between the valuation of venture deals and inflows into venture funds. Doubling inflows leads to a 7–21 per cent increase in valuation levels. But success rates don’t differ significantly between investments made during periods of low inflows and valuations on the one hand and those made in booms on the other. The results indicate that the price increases reflect increasing competition for investment.
A third major area of research has been the process whereby venture funds exit investments. This topic is important because, in order to make money on their investments, venture capitalists must sell their equity stakes.
Initial research into the exiting of venture investments focused on IPOs. This reflects the fact that typically the most profitable exit opportunity is an IPO. Barry et al. (1990) and Megginson and Weiss (1991) document that venture capitalists hold significant equity stakes and board positions in the firms they take public, which they continue to hold a year after the IPO. They argue that this pattern reflects the certification they provide to investors that the firms they bring to market are not overvalued. Moreover, they show that venture-backed IPOs have less of a positive return on their first trading day, a finding that has been subsequently challenged (Lee and Wahal 2004; Kraus 2002). The authors suggest that investors need a smaller discount because the venture capitalist has certified the offering’s quality.
Subsequent research has examined the timing of the exit decision. Several potential factors affect when venture capitalists choose to bring firms public. Lerner (1994b) examines how the valuation of public securities affects when venture capitalists choose to finance companies in another private round in preference to taking the firm public. He shows that investors take firms public when market values are high, relying on private financings when valuations are lower. Seasoned venture capitalists appear more proficient at timing IPOs.
Another consideration may be the venture capitalist’s reputation. Gompers (1996) argues that young venture firms have incentives to ‘grandstand’, or take actions that signal their ability to potential investors. Specifically, young venture firms bring companies public earlier than older one to establish a reputation and successfully raise new funds. Gompers shows that the effect of recent IPOs on the amount of capital raised is stronger for young venture firms, providing them with greater incentives to bring companies public earlier.
Lee and Wahal (2004) propose a variant of the ‘grandstanding’ hypothesis: they posit that venture firms have an incentive to underprice IPOs. The publicity surrounding a successful offering will enable the venture group to raise more capital than it could otherwise. Lee and Wahal confirm this hypothesis by showing a positive relationship between first-day returns and subsequent fund-raising by venture firms.
The typical venture firm, however, does not sell its equity at the time of the IPO. After some time, venture capitalists usually return money to their limited partners by distributing their shares. Gompers and Lerner (1998a) examine distributions. After significant increases in stock prices prior to distribution, abnormal returns around the distribution are negative. Cumulative excess returns for the 12 months following the distribution also appear to be negative. While the overall level of venture capital returns does not exhibit abnormal returns relative to the market (Brav and Gompers 1997), there is a distinct rise and fall around the time of the stock distribution. The results are consistent with venture capitalists possessing inside information and with the (partial) adjustment of the market to that information.
A related research area is venture-fund performance. Kaplan and Schoar (2005) show substantial persistence across consecutive venture funds. General partners that outperform the industry in one fund are likely to outperform in the next fund, while those who underperform in one fund are likely to underperform with the next fund. These results contrast with those of mutual funds, where persistence is difficult to identify.
Cochrane (2005) estimates the returns of venture capital investments. He notes that many analyses of returns focus only on investments that go public, get acquired, or go out of business. Such calculations may produce biased returns by concentrating only on the portfolio’s ‘winners’ and outright failures. Cochrane develops a maximum likelihood estimate that uses existing data, but adjusts for these selection biases. While these papers – as well as Gompers and Lerner (1997) and Jones and Rhodes-Kropf (2003) – represent a first step towards understanding these issues, much more work remains to be done.
While financial economists know much more about venture capital than they did a decade ago, there are many unresolved issues. I highlight here three promising areas.
The rapid growth in the US venture capital market has led institutional investors to look abroad. In a pioneering study, Jeng and Wells (2000) examine the factors that influence venture fund-raising internationally. They find that the strength of the IPO market is an important determinant of venture commitments, supporting Black and Gilson’s (1998) hypothesis that the key to a successful venture industry is the existence of robust IPO markets. Jeng and Wells find, however, that the IPO market does not influence commitments to early-stage funds as much as those to later-stage ones. Much more remains to be explored regarding the internationalization of venture capital.
One provocative finding from Jeng and Wells’s analysis is that government policy can dramatically affect the health of the venture sector. Researchers have only begun to examine the ways in which policymakers can catalyse the growth of venture capital and the companies in which they invest (Irwin and Klenow 1996; Lerner 1999; Wallsten 2000). Clearly, much more needs to be done in this arena.
A final area is the thorniest: the impact of venture capital on the economy. Demonstrating a causal relationship between innovation, job growth and venture activity is a challenging empirical problem. Kortum and Lerner (2000) examine the influence of venture capital on patented inventions in the United States over three decades, finding that increases in venture capital activity in an industry are associated with significantly higher patenting rates. One dollar of venture capital, they suggest, is three times more likely than one dollar of corporate R&D to stimulate patenting. (Hellmann and Puri 2000, also explore the impact of venture capital on innovation.) Many research opportunities remain in this arena.
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