Why do venture capital firms exist? theory and canadian evidence

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Abstract

This paper investigates the role of venture capitalists. We view their “raison d’être” as their ability to reduce the cost of informational asymmetries. Our theoretical framework focuses on two major forms of asymmetric information: “hidden information” (leading to adverse selection) and “hidden action” (leading to moral hazard). Our theoretical analysis suggests four empirical predictions.

1. Venture capitalists operate in environments where their relative efficiency in selecting and monitoring investments gives them a comparative advantage over other investors. This suggests strong industry effects in venture capital investments. Venture capitalists should be prominent in industries where informational concerns are important, such as biotechnology, computer software, etc., rather than in “routine” start-ups such as restaurants, retail outlets, etc. The latter are risky, in that returns show high variance, but they are relatively easy to monitor by conventional financial intermediaries.

2. Within the class of projects where venture capitalists have an advantage, they will still prefer projects where monitoring and selection costs are relatively low or where the costs of informational asymmetry are less severe. Thus, within a given industry where venture capitalists would be expected to focus, we would also expect venture capitalists to favor firms with some track records over pure start-ups. To clarify the distinction between point 1 and point 2, note that point 1 states that if we look across investors, we will see that venture capitalists will be more concentrated in areas characterized by significant informational asymmetry. Point 2 says that if we look across investment opportunities, venture capitalists will still favor those situations which provide better information (as will all other investors). Thus venture capitalists perceive informational asymmetries as costly, but they perceive them as less costly than do other investors.

3. If informational asymmetries are important, then the ability of the venture capitalist to “exit” may be significantly affected. Ideally, venture capitalists will sell off their share in the venture after it “goes public” on a stock exchange. If, however, venture investments are made in situations where informational asymmetries are important, it may be difficult to sell shares in a public market where most investors are relatively uninformed. This concern invokes two natural reactions. One is that many “exits” would take place through sales to informed investors, such as to other firms in the same industry or to the venture’s own management or owners. A second reaction is that venture capitalists might try to acquire reputations for presenting good quality ventures in public offerings. Therefore, we might expect that the exits that occur in initial public offerings would be drawn from the better-performing ventures.

4. Finally, informational asymmetries suggest that owner-managers will perform best when they have a large stake in the venture. Therefore, we can expect entrepreneurial firms in which venture capitalists own a large share to perform less well than other ventures. This is moral hazard problem, as higher values of a venture capitalist’s share reduce the incentives of the entrepreneur to provide effort. Nevertheless, it might still be best in a given situation for the venture capitalist to take on a high ownership share, since this might be the only way of getting sufficient financial capital into the firm. However, we would still expect a negative correlation between the venture capital ownership share and firm performance.

Our empirical examination of Canadian venture capital shows that these predictions are consistent with the data. In particular, there are significant industry effects in the data, with venture capitalists having disproportionate representation in industries that are thought to have high levels of informational asymmetry. Secondly, venture capitalists favor later stage investment to start-up investment. Third, most exit is through “insider” sales, particularly management buyouts, acquisitions by third parties, rather than IPOs. However, IPOs have higher returns than other forms of exit. In addition, the data exhibit the negative relationship between the extent of venture capital ownership and firm performance predicted by our analysis.

Introduction

In both Canada and the United States, venture capital finance is a significant form of financial intermediation. There is no strict regulatory definition of the venture capital industry, unlike commercial banking or insurance but, generally speaking, venture capital firms provide privately held “entrepreneurial” firms with equity, debt, or hybrid forms of financing, often in conjunction with managerial expertise. In Canada these firms are playing an increasingly important role. As reported in Macdonald & Associates (1996), between the end of 1991 and the end of 1995, the amount of capital under management by Canadian venture capital firms grew from C$3.2 billion (or about $3.8 billion in 1995 dollars) to C$6 billion, implying an annualized real growth rate of about 12% per year. The rate of new investment by venture capital firms grew even more rapidly, rising from C$290 million in 1991 (or C$306 million 1995 dollars) to C$669 million in 1995, which corresponds to real growth of more than 20% per year.

Despite its growing importance, the venture capital industry has received much less academic scrutiny than other parts of the financial sector.1 This applies both to theory and to empirical investigation. At the theoretical level, perhaps the most fundamental question to ask about the venture capital industry is why it exists at all. Why have a set of specialized firms that focus on financing the entrepreneurial sector? Even if there were no dedicated venture capital firms, a combination of commercial banks, investment banks, private investors, and stock exchanges providing the necessary intermediation could still be imagined. In fact, among entrepreneurial firms, most finance is provided by banks and private investors (including family members), and many young entrepreneurial firms “go public” on stock exchanges without first seeking venture capital finance. In seeking to understand venture capital finance, it therefore seems important to ask what exactly is the niche filled by venture capital firms.

The primary objective of this paper is to present a theory explaining the existence of the venture capital industry and investigate the consistency of this theory with empirical observations. Our basic hypothesis is that informational asymmetries are the key to understanding the venture capital industry. Previous papers have focused on the importance of asymmetric information in venture capital markets, and several authors have suggested that a central distinction between venture capitalists and other financial intermediaries is that venture capitalists operate in situations where asymmetric information is particularly significant. In this paper we provide a simple formal model that distinguishes venture capitalists from other potential investors on the basis of their ability to deal with informational asymmetries. This model is also used to draw inferences about how venture capital financing would be expected to work. These predictions are then compared with the actual pattern of venture capital investment in Canada. This link between theory and empirical evidence is the main contribution of the paper.

There are two major forms of informational asymmetry. One type, sometimes referred to as “hidden information,” occurs when one party to a transaction knows relevant information that is not known to the other party. For example, an entrepreneur developing a new product may have a much better idea about whether the product will actually work than does the venture capitalist who may finance the venture. The problem arises because the informed party typically has an incentive to misrepresent the information. The entrepreneur, for example, may have an incentive to overstate the likelihood of successful product development. Furthermore, the market may become crowded with “low-quality” projects, precisely because it is hard for investors to distinguish between good-quality and poor-quality projects. This phenomenon is called adverse selection. Potential investors understand that adverse selection exists and may therefore be wary of funding such entrepreneurial endeavours.2

The other type of informational asymmetry is often described as “hidden action.” In this situation one party to a transaction cannot observe relevant actions taken by the other party (or at last cannot legally verify these actions). For example, an investor in an entrepreneurial firm might not be able to observe whether the entrepreneur is working hard and making sensible decisions, or whether the entrepreneur is planning to “take the money and run.” This problem leads to what is called “moral hazard.” The informed party then has an incentive to act out of self interest, even if such actions impose high costs on the other party.

Both adverse selection and moral hazard may arise in any investment environment, but they seem particularly acute in entrepreneurial finance. With large established firms, investments are made safer by the use of existing assets as collateral, and the development of reputation. Collateral and reputation effects can mitigate the negative effects of both adverse selection and moral hazard. Because entrepreneurial firms lack assets to provide as collateral, and because they lack the “track record” necessary to establish their reputation, the effects of informational market failures are more severe in entrepreneurial finance than in financing established firms.

Our central hypothesis is that venture capitalists emerge because they develop specialized abilities in selecting and monitoring entrepreneurial projects. In other words, venture capitalists are financial intermediaries with a comparative advantage in working in environments where informational asymmetries are important. This is their niche.3

The next section of our paper provides a brief review of relevant literature, followed by a section that sets out a formal model of venture capital finance with associated empirical predictions. The fourth section describes the data set obtained from Macdonald & Associates, and the fifth section compares the theoretical predictions with the data. The final section contains concluding remarks.

Section snippets

Literature review

Akerlof (1970) is normally taken as the starting point of the formal analysis of informational asymmetry. Akerlof describes a situation where sellers of used cars have private information about the quality of their cars, but buyers cannot discern quality differences before purchase. In this setting, low-quality cars or “lemons” dominate the market, thus the market “selects” adversely. Akerlof showed that this adverse selection is inefficient in that potentially efficient (i.e.,

A theory of venture capital finance

An entrepreneur has a potential project and seeks potential investors. To keep the analysis simple we assume that the project requires fixed financial input I from an investor. The expected cash flow from the project, net of production costs, is denoted R (for “net operating revenue”). This expected net operating revenue depends in part on the effort, e, provided by the entrepreneur and it depends in part on the underlying project quality, q. In addition, the outcome depends on a random

The data set

The data used for this study were collected by Macdonald & Associates Ltd. and made available to us on a confidential and anonymous basis. In addition, no individual firm-specific information is reported or discussed in our analysis. The data are derived from two surveys. The first survey, referred to as the “investment survey,” began as an annual survey in 1991 and became quarterly in 1994. It asks just over 100 Canadian venture capital firms to identify their investees and provide some

Investment practices of canadian venture capitalists

We now present some empirical evidence that addresses the predictions of the theoretical framework outlined in section 3. Some of this data, together with other empirical information on the Canadian venture capital industry is provided by Amit, Brander, and Zott (1997). Before considering the implications of informational asymmetries, we provide a general characterization of important financial variables in the data, as shown in Table 1. All relevant table entries are in thousands of 1995

Concluding remarks

The theoretical framework we offer focuses on informational issues. Specifically, we view asymmetric information as the central feature of venture capital investment. Both major forms of asymmetric information, “hidden information” (leading to adverse selection) and “hidden action” (leading to moral hazard) are included in our analysis. While the model abstracts from some important elements of the venture investment process (such as bargaining, syndication, etc.), we believe that the

Acknowledgements

We thank two anonymous referees and the editor for very helpful comments. We also thank Paul Gompers, who served as the discussant on the paper at the Economic Foundations of Venture Capital Conference held at Stanford University in March 1997. In addition, we owe a substantial debt to Mary Macdonald and Ted Liu of Macdonald & Associates Ltd. for providing access to the data. (Individual data records were provided on an anonymous basis.) We gratefully acknowledge financial support from Social

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