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Economic Downturn and Financing Innovative Startup Companies
Abstract
This study examines how fluctuations in the amount of capital flowing into venture funds affect the financing of innovative startup companies and how economic downturns affect such financing. We argue that the nature of the economic downturn can cause differential effects on the investment pattern. We find that venture capital firms invest more in early-stage companies than in later-stage companies when the amount of capital flowing into the market increases. We also find that venture capital firms invest less in early-stage companies than in later-stage companies during an economic downturn associated with the real sector and that they invest more in early-stage companies than in later-stage companies during an economic downturn associated with the financial sector. This study contributes to the entrepreneurship literature by demonstrating how macroeconomic factors affect venture capital investment decisions. The study also delineates the implications of seeking market entry via venture capital financing by entrepreneurial companies.
... Indeed, economic downturns successively associated with the financial and real sector profoundly affect investment projects. Early stage financing becomes riskier and exit via initial public offerings (IPOs) or mergers and acquisitions (M&A) appears unfavourable (Paik and Woo, 2014). ...
Using an industrial organisation (I/O) approach, this study considers venture capital (VC) and aims to explain the scale of investments made by fund management companies by the basic conditions of this industry. Thus, within the market structure-conduct-performance paradigm, we focus on the relationship between basic conditions and VC firms' conduct. The basic conditions are analysed from the point of view of supply, (corresponding to the fund management companies that raise capital from investors), and demand, (referring to the firms in which the capital available can be invested). Macroeconomic, institutional, exit and entrepreneurial characteristics form the VC environment, and one and the same element can constitute a basic condition on both the supply and demand side. The econometric study, based on a sample of 18 European countries over the period 2002-2009, highlights the influence of the interest rate, tax and legal framework, exit context and innovation dynamics.
... Researches on innovative start-ups are very recent: In fact, they are "new" start-ups, that is start-ups born about 5 years ago. Paik and Woo (2013) examined how fluctuations in the amount of capital flowing into venture funds affect the financing of innovative startup companies and how economic downturns affect such financing. ...
The purpose of this paper is to analyze the energy innovative start-ups currently existing in Italy. An investigation on whether those firms are able to implement a knowledge-based strategy (KS) is described: in particular, it is a strategy based on a high investment in qualified human resources and, in general, this is reflected in the fact that the company adopting a KS pays its employees more than the average of other companies belonging to the same sector. Furthermore the ability to generate a return on the investment in knowledge is analyzed. A methodology already proposed in other papers by the same authors was applied in order to identify firms that adopt a KS understanding also the sustainability of such kind of strategy. A discussion on how firms that do not implement a profitable knowledge-based strategy can improve and consolidate their position in terms of knowledge is proposed.Keywords: Energy innovative start-ups, knowledge-based strategy, human capital efficiency, value creationJEL Classifications: M13, M20, M41, O32, O34DOI: https://doi.org/10.32479/ijeep.7926
... A large proportion of these data is generated daily by users who connect to social networks and who use their mobile applications to express opinions on products or services, or on any specific topic (Regmi et al. 2015; Rathore et al. 2016). In today's increasingly connected world, users obtain information on the Internet through search engines, such as Google, Yahoo!, Bing, Baidu, among others (Paik and Woo, 2014;Thiel et al., 2014). ...
In the present study, we analyzed User Generated Content (UGC) to measure the importance of Search Engine Optimization (SEO) for early-state startups. Several social media analytics techniques were used to derive insights from Twitter-based UGC. Data visualization and topic-modeling algorithms were applied to a dataset of tweets (n = 67,126). Specifically, hashtag analysis, polarity and emotion analysis, word analysis, topic modeling, and other relevant approaches were used. In addition, we also performed a qualitative case study on an early-state startup to validate our findings. The results helped us identify the communities in Twitter about SEO for early-stage startups and the main optimization indicators according to the feelings expressed in tweets (positive, negative and neutral). Our results also demonstrated that SEO is not the most relevant strategy of positioning of digital marketing for early-state startups and that, although this strategy is used by the early-state startups, it is predominantly negatively perceived by Twitter users. Due to using novel approaches to data analysis, our findings provide meaningful implications for both practitioners and academic researchers.
... Joshi and Subramanya (2015) detailed that in India, foreign VC firms refrain from earlystage company investments because of the risk propensity. Paik and Woo (2014) demonstrated a slightly different pattern for local U.S. VCs. Leveraging more than two decades of data from the Thomson Financial Venture Economics database, the authors demonstrated that VCs invest more in early-stage firms during economic booms. ...
... Joshi and Subramanya (2015) detailed that in India, foreign VC firms refrain from earlystage company investments because of the risk propensity. Paik and Woo (2014) demonstrated a slightly different pattern for local U.S. VCs. Leveraging more than two decades of data from the Thomson Financial Venture Economics database, the authors demonstrated that VCs invest more in early-stage firms during economic booms. ...
Undercapitalization is a major impediment for the growth and survival of Canadian life sciences firms. Proficient management teams are the “sine qua non” criteria in the venture capital decision-making processes. The purpose of this multicase study was to explore strategies successful venture capitalists use to improve their evaluation processes of life sciences management teams’ drug development capabilities. The conceptual framework for this study was based on business process management. The purposeful sample consisted of 10 venture capitalists located in the United States and Canada who had expertise evaluating life sciences management teams. The data were triangulated from semistructured interviews, annual reports, company websites, and articles. Collected data were coded to identify underlying themes. Several themes emerged from the analysis process: begin with the exit in mind, collapse learning timelines, conduct systematic due diligence, and cultivate and critique one’s drug development expertise. The findings may provide venture capitalists and other investors such as angel investors with a refined framework for improving investment decisions. Life sciences management teams may also attract more private equity financing by understanding the vicissitudes of investor expectations. Increased investment and venture capital support for life sciences companies may revitalize the development of new therapies and effect social change by improving patient lives and investment outcomes.
... The concept of cluster as a social institution, based on the harmonization of interests and cooperation of different agents (Paik and Woo, 2014), not just on their competition, mergers and acquisitions, is opposed to competitive individualist paradigm in modern economics. The cluster as a social institution compensates for growing in the conditions of globalization the level of uncertainty of social processes, creates a specific information space, which forms the economic agents with new motivations, developing multi-dimensional economic space. ...
Transition of the Russian Federation’s policy to the innovative way of economic and social development is indispensable imperative to ensure its output to a leading position in the modern globalized world. Among the wide range of means, methods, forms, the mechanisms by which it is possible sharp acceleration of the process of formation of an innovative economy in our country, a special place belongs to the cluster approach. International scientific community is justified, and the practice of developed countries proved that the cluster approach to the structuring of the national economy and regional systems are an important source to improve production efficiency, increase its competitiveness, and increase public welfare. Questions of cluster formation and management of the development of the Russian economy in recent years, becomes the subject of numerous studies by Russian scientists - economists. Cluster policies are becoming increasingly recognized in public authorities. Moreover, there are already official documents, which examine the content and direction of the cluster policy.
... Indeed, economic downturns successively associated with the financial and real sector profoundly affect investment projects. Early stage financing becomes riskier and exit via initial public offerings (IPOs) or mergers and acquisitions (M&A) appears unfavourable (Paik and Woo, 2014). ...
Using an industrial organisation (I/O) approach, this study considers venture capital (VC) and aims to explain the scale of investments made by fund management companies by the basic conditions of this industry. Thus, within the market structure-conduct-performance paradigm, we focus on the relationship between basic conditions and VC firms' conduct. The basic conditions are analysed from the point of view of supply, (corresponding to the fund management companies that raise capital from investors), and demand, (referring to the firms in which the capital available can be invested). Macroeconomic, institutional, exit and entrepreneurial characteristics form the VC environment, and one and the same element can constitute a basic condition on both the supply and demand side. The econometric study, based on a sample of 18 European countries over the period 2002-2009, highlights the influence of the interest rate, tax and legal framework, exit context and innovation dynamics.
Human Resource Management is undergoing a transformation. It's not just about following the rules and regulations; for sustainable development it's also about getting the most out of your employees and fostering a positive work environment. Starting a business takes time but learning and implementing HR practices for startups may help the process go more smoothly. The researchers attempted to shed light on the necessity, role, obstacles, and solutions for overcoming the challenges of human resource management in start-ups through this research article.HR solutions for startups, address problems by changing and adapting as the company grows. Innovative hiring, attracting good people, promoting teamwork, recognizing milestones, and rewarding employees for their efforts are all ways that your HR department may help you overcome HR difficulties in startups and provide you an advantage.
It is widely recognized by researchers, practitioners and policy makers that for a tech startup adequate financial capital is an essential resource in order to emerge, survive and grow over its lifecycle. However, there is a lack of understanding on what are the various needs for financing, what factors drive these needs and how do they vary over a startup's lifecycle. This study makes a key contribution to the literature by investigating the financial requirements for a tech startup and their determinants based on primary data gathered from 93 tech startups in Bangalore. Our findings suggest that, out of the three major categories of financial requirements, namely, Human Capital (HC), Research Capital (RC) and Social Capital (SC), financial requirements for HC and SC vary with a startup's lifecycle stage while financial requirement to acquire RC does not. With these results, we assert that, while all the three resources are essential, RC is the most critical financial requirement for a tech startup as it assumes predominance throughout a tech startup's lifecycle and acts as oxygen for its growth and sustainable competitive advantage.
Explaining how entrepreneurs overcome information asymmetry between themselves and potential investors to obtain financing is an important issue for entrepreneurship research. Our premise is that economic explanations for venture finance, which do not consider how social ties influence this process, are undersocialized and incomplete. However, we also argue that organization theoretic arguments, which draw on the concept of social obligation, are oversocialized. Drawing on the organizational theory literature, and in-depth fieldwork with 50 high-technology ventures, we examine the effects of direct and indirect ties between entrepreneurs and 202 seed-stage investors on venture finance decisions. We show that these ties influence the selection of ventures to fund through a process of information transfer.
The purpose of this work is two-fold. The first is to stimulate an interest in modeling the management of venture capital funds. The second is to provide entrepreneurs with insights which can help in their dealings with venture capitalists. With respect to the first objective, the value of the study may perhaps be as much in what it did not achieve as in what it did achieve. A five-step model of the activities of venture capitalists has been developed. The model, however, is highly descriptive and lacks a theoretical basis. Moreover, the model is admittedly simplistic. The second objective is to provide potential entrepreneurs with insight into the way venture capitalists manage their funds. These insights are also valuable to managers in large companies who wish to improve their allocation of resources to internal ventures competing for new business development funds.
Prior work on the commercialization of innovation is motivated by competitive dynamics between startup and incumbent firms and has looked at the determinants of innovator commercialization mode. We contribute to the literature by examining variation in performance resulting from the choice of whether to innovate technologically in new ventures. The institutional and business environment conditions which strategies lead to higher performance for start-up innovators. In contrast to the factors shown to determine commercialization mode, we show that the team characteristics and economic environment play a stronger role in predicting an innovator's entrepreneurial firm performance. Using unique data from a novel survey of entrepreneurial firms founded over five decades and across diverse industries, we show the conditions when technology focused vs. functionally diverse founding teams outperform. In addition, we show that in certain environments firms with more highly original innovations and innovating firms founded during a recession have higher performance.
Considering significant reasons why some newventures are more likely than others to receive capital from external sources,it isargued that new venture finance follows a pattern of multistage selection over time. Using a sample of the life stories of 221 of new Swedish ventures in 1998, the venture financing process is analyzed from the perspectives of the business founder and of the financier. Founders seek external funding based on their perceptions about business opportunity, including anticipated market growth, market competition,employment growth, and price competitiveness. Financiers, on the other hand, make their funding decisions based on objective verifiable indicators of venture development. Other control covariates of the study include start-up experience, industry experience, completed business plan, venture age, industry sales growth, number of firms in an industry, and average firm age in theindustry. The study offers several contributions by: (1) indicating that the financingof new ventures follows an evolutionary selection process; (2) examining empirically the role of founders in the process of new venture finance; (3) providing evidence about new venture finance that can be generalized to thetypical new venture; and (4) overcoming the problems of selection bias. (CBS)
We consider the financing of a research project under uncertainty about the time of completion and the probability of eventual success. We distinguish between two financing modes, namely relationship financing, where the allocation decision of the entrepreneur is observable, and arm's-length financing, where it is unobservable. We find that equilibrium funding stops altogether too early relative to the efficient stopping time in both financing modes. The rate at which funding is released becomes tighter over time under relationship financing, and looser under arm's-length financing. The tradeoff in the choice of financing modes is between lack of commitment with relationship financing and information rents with arm's-length financing. Ordering information: This article can be ordered from https://pubs3.rand.org/cgi-bin/rje/pdf.cgi .
We examine the influence of venture capital on patented inventions in the United States across twenty industries over three decades. We address concerns about causality in several ways, including exploiting a 1979 policy shift that spurred venture capital fundraising. We find that increases in venture capital activity in an industry are associated with significantly higher patenting rates. While the ratio of venture capital to R&D averaged less than 3% from 1983-1992, our estimates suggest that venture capital may have accounted for 8% of industrial innovations in that period.
Venture capitalists often hold extensive control rights over entrepreneurial companies, including the right to fire entrepreneurs. This article examines why, and under what circumstances, entrepreneurs would voluntarily relinquish control. Control rights protect the venture capitalists from hold-up by the entrepreneurs. This provides the correct incentives for the venture capitalists to search for a superior management team. Wealth-constrained entrepreneurs may give up control even if the change in management imposes a greater loss of private benefit to them than a monetary gain to the company. The model also explains why entrepreneurs accept vesting of their stock and low severance.
The article discusses a study that investigates the impact of venture capital backing on the commercialization of technology-based start up companies. The article looks at what extent venture capital-backed start-ups use cooperative commercialization strategies and how that compares to other start-ups. The article states that after analyzing the cooperative activity in 701 start-ups, there is a substantial increase in such activity for venture capital-based firms. The study hypothesizes that venture capitalists differ in reputation and that start-ups affiliated with those with a higher reputation forge more cooperative outcome alliances.
This paper explores the conditions under which firms are likely to pursue equity investment in new ventures as a way to source innovative ideas. We find that both industry-level and firm-level factors drive firms to invest more in new ventures. These results have important implications for the organization of R&D.
We find that venture capital-backed startups receiving their initial investment in hot markets are more likely to go bankrupt, but conditional on going public, are valued higher on the day of their initial public offering, have more patents, and have more citations to their patents. Our results suggest that VCs invest in riskier and more innovative startups in hot markets (rather than just worse firms). This is particularly true for the most experienced VCs. Furthermore, our results suggest that increased capital in hot times plays a causal role in shifting investments to more novel startups by lowering the cost of experimentation for early stage investors and allowing them to make riskier, more novel, investments.
This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the 'separation and control' issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears the costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem.
This study empirically evaluates the certification and value-added roles of reputable venture capitalists (VCs). Using a novel sample of entrepreneurial start-ups with multiple financing offers, I analyze financing offers made by competing VCs at the first professional round of start-up funding, holding characteristics of the start-up fixed. Offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire start-up equity at a 10-14% discount. The evidence suggests that VCs' ''extra-financial" value may be more distinctive than their functionally equivalent financial capital. These extra-financial services can have financial consequences.
In this paper we draw on recent progress in the theory of (1) property rights, (2) agency, and (3) finance to develop a theory of ownership structure for the firm.1 In addition to tying together elements of the theory of each of these three areas, our analysis casts new light on and has implications for a variety of issues in the professional and popular literature, such as the definition of the firm, the “separation of ownership and control,” the “social responsibility” of business, the definition of a “corporate objective function,” the determination of an optimal capital structure, the specification of the content of credit agreements, the theory of organizations, and the supply side of the completeness-of-markets problem.
This paper examines three rationales for the syndication of venture capital investments, using a sample of 271 private biotechnology firms. Syndication is commonplace, even in the first-round investments. Experienced venture capitalists primarily syndicate first-round investments to venture investors with similar levels of experience. In later rounds, established venture capitalists syndicate investments to both their peers and to less experienced capital providers. When experienced venture capitalists invest for the first time in later rounds, the firm is usually doing well. Syndication also often insures that the ownership stake of the venture capitalist stays constant in later venture rounds. I argue that the results are consistent with the proposed explanations.
Venture capital financing is widely believed to be influential for new innovative companies. We provide empirical evidence that venture capital financing is related to product market strategies and outcomes of start-ups. Using a unique hand-collected database of Silicon Valley high-tech start-ups. Using a unique hand-collected database of Silicon Valley high-tech start-ups we find that innovator firms are more likely to obtain venture capital than imitator firms. Venture capital is also associated with a significant reduction in the time to bring a product to market, especially for innovators. Our results suggest significant interrelations between investor types and product market dimensions, and a role of venture capital for innovative companies.
The global financial crisis has made it painfully clear that powerful psychological forces are imperiling the wealth of nations today. From blind faith in ever-rising housing prices to plummeting confidence in capital markets, "animal spirits" are driving financial events worldwide. In this book, acclaimed economists George Akerlof and Robert Shiller challenge the economic wisdom that got us into this mess, and put forward a bold new vision that will transform economics and restore prosperity. Akerlof and Shiller reassert the necessity of an active government role in economic policymaking by recovering the idea of animal spirits, a term John Maynard Keynes used to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery. Like Keynes, Akerlof and Shiller know that managing these animal spirits requires the steady hand of government--simply allowing markets to work won't do it. In rebuilding the case for a more robust, behaviorally informed Keynesianism, they detail the most pervasive effects of animal spirits in contemporary economic life--such as confidence, fear, bad faith, corruption, a concern for fairness, and the stories we tell ourselves about our economic fortunes--and show how Reaganomics, Thatcherism, and the rational expectations revolution failed to account for them.
This paper relates quality and uncertainty. The existence of goods of many grades poses interesting and important problems for the theory of markets. On the one hand, the interaction of quality differences and uncertainty may explain important institutions of the labor market. On the other hand, this paper presents a struggling attempt to give structure to the statement: “Business in under-developed countries is difficult”; in particular, a structure is given for determining the economic costs of dishonesty. Additional applications of the theory include comments on the structure of money markets, on the notion of “insurability,” on the liquidity of durables, and on brand-name goods.
We provide a model of investment in new ventures that demonstrates why some places, times, and industries should be associated with a greater degree of experimentation by investors. Investors respond to financing risk, a forecast of limited future funding, by modifying their focus to finance less innovative firms. In equilibrium, financing risk disproportionately impacts innovative ventures with the greatest real option value by creating a trade-off between protecting the firm from financing risk and maximizing its real option value. We propose that extremely novel technologies may need “hot” financial markets to get through the initial period of discovery or diffusion.
This paper was accepted by Gustavo Manso, finance.
We find that VC-backed firms receiving their initial investment in hot markets are more likely to go bankrupt, but conditional on going public are valued higher on the day of their IPO, have more patents and have more citations to their patents. Our results suggest that VCs invest in riskier and more innovative startups in hot markets (rather than just worse firms). This is particularly true for the most experienced VCs. Furthermore, our results suggest that the flood of capital in hot markets also plays a causal role in shifting investments to more novel startups – by lowering the cost of experimentation for early stage investors and allowing them to make riskier, more novel, investments.
Three principal aspects of venture capital (VC) are empirically explored: fundraising, investing, and exiting those investments. Despite the recent attention to VC, misconceptions abound that the authors attempt to correct. Throughout, the discussions are based on examinations of a large sample of firms, VC funds, and investments. Three themes are elaborated in the volume: (1) The great incentive and information problems venture capitalists must overcome; (2) the interrelatedness of each aspect of the VC process and how it proceeds through cycles; and that (3) the VC industry adjusts slowly to shifts in the supply of capital or the demand for financing. The VC partnership is the intermediary between investors and high-tech start-ups. The fundraising aspect is examined in terms of its structure, means of compensation, and the importance of the structure of the limited partnership form used by most VC funds. The need to provide incentives and shifts in relative negotiating power impact the terms of VC limited partnerships. Covenants and compensation align the incentives of VC funds with those of investors; covenants and restrictions limit conflicts among investors and venture capitalists. Supply and demand and costs of contracting determine contractual provisions. VC contracting may not always be efficient. During periods of high demand and capital flows, partners negotiate compensation premiums. The investing aspect is discussed in terms of why investments are staged, how VC firms oversee firms, and why VC firms syndicate investments. Four factors limit access to capital for firms: uncertainty, asymmetric information, nature of firm assets, and conditions in the financial and product markets. These factors determine a firm's financing choices. Asymmetries may persist longer in high-tech firms, thus increasing the value of delaying investment decisions. Exiting VC investments is examined, in regard to the market conditions that affect the decision to go public, whether reputation affects the decision to go public, why venture capitalists distribute shares, the performance of VC-backed firms, and the future of the VC cycle. Exiting investments affects every aspect of the investment cycle. Venture capitalists add value to the firms in which they invest. The VC cycle is a solution to information and inventive problems. (TNM)
The venture capital market is characterized by personal interactions between VC firms and the startups they finance. Yet we have little systematic evidence of how startup founders get matched with partners at VC firms. By assembling data at the individual partner and founder level, we compare personal similarity-based rationale with resource complementarity-based reasons explaining the likelihood of an investment match. We find that a match is more likely if the two parties share a common ethnicity or have both attended a top ranked university, and particularly so when information problems are more severe. With such similarities, the VC’s investment also represents a larger fraction of her total investments. We interpret personal similarity as reducing transactions costs in VC matching rather than proxying quality-based matching. Matching based on VC partner’s professional expertise appears to be less determined by their complementarity with the founder’s background and more by the current lifecycle stage of the startup. In particular, VC partners with finance or operational capabilities are more likely to match with mature ventures. Our findings shed new light on how personal characteristics and professional expertise can be important in financing situations where informational frictions are severe and investors are actively involved with their borrowers.
Many strategic investments require firms to make upfront outlays to generate profits at a later date. When firms have limited access to external capital, they have to rely on internally generated funds for these investments. In this case, their strategic investments are constrained by cash flow. I predict that by geographically diversifying sales (i.e., exporting), firms can relax this constraint because exporting signals more stable expected cash flows and firm quality, which can increase external capital providers' willingness to fund investments. Examining a representative sample of Spanish manufacturers from 1990 to 1998, I find support that exporting mitigates investment liquidity constraints allowing firms to make strategic investments they would not otherwise be able to make. This highlights how diversification can be a strategy to create and maintain competitive advantage. Copyright © 2011 John Wiley & Sons, Ltd.
We explore the conditions under which firms are likely to pursue equity investment in new ventures as a way to source innovative ideas. We find that firms invest more in new ventures—commonly referred to as ‘corporate venture capital’—in industries with weak intellectual property protection and, to some extent, in industries with high technological ferment and where complementary distribution capability is important. Furthermore, we find that the greater a firm's cash flow and absorptive capacity, the more likely it is to invest. Our results suggest that in Schumpeterian environments incumbents may supplement their innovative efforts by tapping into the knowledge generated by new ventures. Copyright © 2005 John Wiley & Sons, Ltd.
Entrepreneurs in high-technology industries often have prior experience at incumbent firms, but we know little about how knowledge obtained at the prior employer impacts entrepreneurial performance. Drawing on previous work from strategy, economics, and organizational sociology, I assess the impact of industry experience on entrepreneurial performance and innovation in medical device start-ups. I find that spawns (ventures started by former employees of incumbent firms) perform better than other new entrants. Interestingly, my findings suggest that this superior performance is not driven by technological spillovers from parent to spawn, but rather by nontechnical knowledge related to regulatory strategy and marketing. Copyright © 2008 John Wiley & Sons, Ltd.
This paper examines the impact venture capital can have on the development of new firms. Using a hand-collected data set on Silicon Valley start-ups, we find that venture capital is related to a variety of professionalization measures, such as human resource policies, the adoption of stock option plans, and the hiring of a marketing VP. Venture-capital-backed companies are also more likely and faster to replace the founder with an outside CEO, both in situations that appear adversarial and those mutually agreed to. The evidence suggests that venture capitalists play roles over and beyond those of traditional financial intermediaries.
The question of how initial resource endowments-the stocks of resources that entrepreneurs contribute to their new ventures at the time of founding-affect organizational life chances is one of significant interest in organizational ecology, evolutionary theory, and entrepreneurship research. Using data on the life histories of all 134 firms founded to exploit MIT-assigned inventions during the 1980-1996 period, the study analyzes how resource endowments affect the likelihood of three critical outcomes: that new ventures attract venture capital financing, experience initial public offerings, and fail. Our analysis focuses on the role of founders' social capital as a determinant of these outcomes. Event history analyses show that new ventures with founders having direct and indirect relationships with venture investors are most likely to receive venture funding and are less likely to fail. In turn, receiving venture funding is the single most important determinant of the likelihood of IPO. We conclude that the social capital of company founders represents an important endowment for early-stage organizations.
This study investigates whether VCs' assessment policies of new venture survival are consistent with those arising from the strategy literature (using two established strategy perspectives). Strategy scholars suggest the nature of the markets, competition, and decisions made by the management team affect a new venture's survival chances. The findings demonstrate that VCs' assessment policies are predominantly consistent with those proposed by strategy scholars---providing insight into why VCs consider certain criteria in their assessment of new venture survival as well as why some criteria are more important in their assessment than others. Through this increased understanding of venture capitalists' decision making, entrepreneurs seeking capital may be better able to address their requests for funding to those criteria venture capitalists find most critical to the survival of a new venture. Venture capitalists may use these findings to better understand their own decision making process, which, in turn, provides the opportunity to increase evaluation efficiency.
A number of issues that relate to the desirability and implications of new venture financing are examined within a principal-agent framework that captures the essence of the relationship between entrepreneurs and venture capitalists. The model suggests: (1) As long as the skill levels of entrepreneurs are common knowledge, all will choose to involve venture capital investors, since the risk sharing provided by outside participation dominates the agency relationship that is created. (2) The less able entrepreneurs will choose to involve venture capitalists, whereas the more profitable ventures will be developed without external participation because of the adverse selection problem associated with asymmetric information. (3) If a costly signal is available that conveys the entrepreneur's ability, some entrepreneurs will invest in such a signal and then sell to investors; these entrepreneurs, however, need not be the more able ones. The implications for new venture financing of these and other findings are discussed and illustrated by example.
This paper presents evidence of performance persistence in entrepreneurship. We show that entrepreneurs with a track record of success are much more likely to succeed than first-time entrepreneurs and those who have previously failed. In particular, they exhibit persistence in selecting the right industry and time to start new ventures. Entrepreneurs with demonstrated market timing skill are also more likely to outperform industry peers in their subsequent ventures. This is consistent with the view that if suppliers and customers perceive the entrepreneur to have market timing skill, and is therefore more likely to succeed, they will be more willing to commit resources to the firm. In this way, success breeds success and strengthens performance persistence.
It is well documented that the venture capital industry is highly volatile and that much of this volatility is associated with shifting valuations and activity in public equity markets. This paper examines how changes in public market signals affected venture capital investing between 1975 and 1998. We find that venture capitalists with the most industry experience increase their investments the most when public market signals become more favorable. Their reaction to an increase is greater than the reaction of venture capital organizations with relatively little industry experience and those with considerable experience but in other industries. The increase in investment rates does not affect the success of these transactions adversely to a significant extent. These findings are consistent with the view that venture capitalists rationally respond to attractive investment opportunities signaled by public market shifts.
This paper provides a new explanation for the use of convertible securities in venture capital. A key property of convertible preferred equity is that it allocates different cash flow rights, depending on whether exit occurs by acquisition or IPO. The paper builds a model with double moral hazard, where both the entrepreneur and the venture capitalist provide value-adding effort. The optimal contract gives the venture capitalist more cash flow rights in acquisitions than IPOs. This explains the use of convertible preferred equity, including automatic conversion at IPO. Contingent control rights are also important for achieving efficient exit decisions.
We show that inflows of capital into venture funds increase the valuation of these funds’ new investments. This effect is robust to (i) controlling for firm characteristics and public market valuations, (ii) examining first differences, and (iii) using inflows into leveraged buyout funds as an instrumental variable. Interaction terms suggest that the impact of venture capital inflows on prices is greatest in states with the most venture capital activity. Changes in valuations do not appear related to the ultimate success of these firms. The findings are consistent with competition for a limited number of attractive investments being responsible for rising prices.
This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears these costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem.The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.Adam Smith, The Wealth of Nations, 1776, Cannan Edition(Modern Library, New York, 1937) p. 700.
Venture-capital organizations raise money from individuals and institutions for investment in early-stage businesses that offer high potential but high risk. This paper describes and analyzes the structure of venture-capital organizations, focusing on the relationship between investors and venture capitalists and between venture-capital firms and the ventures in which they invest. The agency problems in these organizations and to the contracts and operating procedures that have evolved in response are emphasized. Venture-capital organizations are contrasted with large, publicly traded corporations and with leveraged buyout organizations.
A questionnaire was administered to one hundred venture capitalists to determine the most important criteria that they use to decide on funding new ventures. Perhaps the most important finding from the study is direct confirmation of the frequently iterated position taken by the venture capital community that above all it is the quality of the entrepreneur that ultimately determines the funding decision. Five of the top ten most important criteria had to do with the entrepreneur's experience or personality. There is no question that irrespective of the horse (product), horse race (market), or odds (financial criteria), it is the jockey (entrepreneur) who fundamentally determines whether the venture capitalist will place a bet at all.
Determines the extent to which venture capital-backedstartups engage in cooperative commercialization strategies and identifiespossible consequences of those strategies. After a review of the literature onthe extra-financial effects of venture capital (VC) on startups, a number ofhypotheses are presented. Two of these hypotheses predict that VC funding is associated with boosts instartup cooperative behavior and positively associated with a startup's initialpublic offering (IPO). The next two suggest that startups affiliated with morereputable VCs forge more cooperative outcomes and are more likely to achieve anIPO. According to the last hypothesis, VC-backed startups that go public have amore reputable IPO underwriter. Data containing information on 696 firms, some of which were VC-backed andsome of which were supported by the Small Business Innovative Research (SBIR)program, are used to test these hypotheses. Analysis of the data reveals thatthe hypotheses are viable. Several potential explanations for the findings areoffered. (SAA)
This paper is about financial contracting choices for the entrepreneur. In an incomplete contracts model, the entrepreneur can design contracts contingent on three possible control right allocations: entrepreneur-control, investor-control, and joint control, with each allocation inducing different effort levels by both the entrepreneur and the investor. Several contracts resembling financial instruments commonly used in practice, such as common stock, straight and convertible preferred equity, and secured and unsecured debt, emerge as potentially optimal. Contractual optimality is shown to depend on entrepreneur/investor input complementarity, and investors' opportunity cost of capital. The results of the model are consistent with, and propose an explanations for, empirical regularities such as a) the prevalence of equity-type contracts in high-growth ventures and of debt-type contracts in lifestyle ventures; b) geographical and temporal differences in equity-type instruments used to finance high-growth ventures.
We analyze incomplete long-term financial contracts between an entrepreneur with no initial wealth and a wealthy investor. Both agents have potentially conflicting objectives since the entrepreneur cares about both pecuniary and non-pecuniary returns from the project while the investor is only concerned about monetary returns. We address the questions of (i) whether and how the initial contract can be structured in such a way as to bring about a perfect coincidence of objectives between both agents (ii) when the initial contract cannot achieve this coincidence of objectives how should control rights be allocated to achieve efficiency? One of the main results of our analysis concerns the optimality properties of the (contingent) control allocation induced by standard debt financing.
I. Introduction, 488. — II. The model with automobiles as an example, 489. — III. Examples and applications, 492. — IV. Counteracting
institutions, 499. — V. Conclusion, 500.
This paper shows how the optimal financial structure of a firm complements incentive schemes to discipline managers, and how the securities' return streams determine the claimholders' incentives to intervene in management. The theory rationalizes (1) the multiplicity of securities, (2) the observed correlation between return streams and control rights of securities, and (3) the partial congruence between managerial and equityholder preferences over policy choices and monetary rewards as well as the low level of interference of equity in management. The theory also offers new prospects for a reappraisal of the earlier corporate finance literature. Copyright 1994, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
We present a dynamic model of venture capital financing, described as a sequential investment problem with uncertain outcome. Each venture has a critical, but unknown threshold beyond which it cannot progress. If the threshold is reached before the completion of the project, then the project fails, otherwise it succeeds. The investors decide sequentially about the speed of the investment and the optimal path of staged investments. We derive the dynamically optimal funding policy in response to the arrival of information during the development of the venture. We develop three types of predictions from our theoretical model and test these predictions in a large sample of venture capital investments in the U.S. for the period of 1987-2002.First, the investment flow starts low if the failure risk is high and accelerates as the projects mature. Second, the investment flow reacts positively to information that arrives while the project is developed. We find that the investment decisions are more sensitive to the information received during the development than to the information held prior to the project launch. Third, investors distribute their investments over more funding rounds if the failure risk is larger.
Venture capital financing is widely believed to be influential for new innovative companies. We provide empirical evidence that venture capital financing is related to product market strategies and outcomes of start-ups. Using a unique hand-collected database of Silicon Valley high-tech start-ups we find that innovator firms are more likely to obtain venture capital than imitator firms. Venture capital is also associated with a significant reduction in the time to bring a product to market, especially for innovators. Our results suggest significant interrelations between investor types and product market dimensions, and a role of venture capital for innovative companies. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
Venture capital financing is characterized by extensive use of convertible securities and stage financing. In a model where
a venture capitalist provides staged financing for a project, we illustrate an advantage of convertible debt (or warrants)
over a mixture of debt and equity. Essentially, when the venture capitalist retains the option to abandon the project, the
entrepreneur has an incentive to engage in window dressing and bias positively the short-term performance of the project,
reducing the probability that it will be liquidated. An appropriately designed convertible security prevents such behaviour
because window dressing also increases the probability that the venture capitalist will exercise the conversion option becoming
the owner of a substantial fraction of the project's equity.
We analyze incomplete long-term financial contracts between an entrepreneur with no initial wealth and a wealthy investor.
Both agents have potentially conflicting objectives since the entrepreneur cares about both pecuniary and non-pecuniary returns
from the project while the investor is only concerned about monetary returns. We address the questions of (i) whether and
how the initial contract can be structured in such a way as to bring about a perfect coincidence of objectives between both
agents (ii) when the initial contract cannot achieve this coincidence of objectives how should control rights be allocated
to achieve efficiency? One of the main results of our analysis concerns the optimality properties of the (contingent) control
allocation induced by standard debt financing.