venture capital special issue || executive summaries

Executive SummariesSource: Financial Management, Vol. 23, No. 3, Venture Capital Special Issue (Autumn, 1994),pp. 75-81Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665624 .

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Executive Summaries

New Directions in Research on Venture Capital Finance Venture capital is risk capital in which the providers of

capital actively participate in the enterprise that receives financing. It has seen phenomenal investment successes, but it has also experienced colossal failures. The purpose of this

paper is to describe the lessons we have learned recently about venture capital and to indicate areas in which more needs to be learned.

New findings in venture capital are important to a broader audience because venture capital shows us finance at the extremes. Risky ventures are such that the possible outcomes of a given investment can be extraordinary, but in either direction: A sizable fraction of venture capital investments result in total losses. The level of uncertainty is extreme. Not only is venture capital often invested in new technologies about which little is known, but the entrepreneurs are often unproven. They have information not possessed by investors, and they may have incentives to disclose imperfectly. Thus, venture capitalists have learned how to design contracts, how to provide the incentives, and how to screen out unfavorable projects. Those same issues are present in settings other than venture capital as well.

Relative to other fields of finance, little is known about venture capital. The private nature of venture capital investment makes empirical research difficult, and theory is limited by the complexity and dynamic features of venture capital decision making. Nevertheless, much has been learned recently.

Venture capitalists commonly invest through a process known as staged financing, usually with convertible debt or preferred stock. Such a process puts entrepreneurs on a relatively short leash, and the abandonment option becomes valuable. Further, entrepreneurs willing to accept such financing reveal their confidence in the project. Reluctance to accept such a form of financing can be informative by itself. Venture capitalists also subject themselves to staged financing by the manner in which they raise funds from

private investors. In fact, limited partnerships are the principal organizational form for venture capital, and recent

findings shed light on how such organizations function. Venture capitalists reduce the adverse selection problem

by performing due diligence, by investing with other venture

capitalists via syndicates, and by offering contracts that reveal the beliefs of the entrepreneurs. Many of the activities of venture capitalists are essentially designed to avoid investing in ventures that will fail.

Recent studies examine venture capital's role in the process of going public, and we have learned how venture

capitalists work with management and how they give advice. Recent evidence indicates an ability of venture capitalists to pick market peaks for making initial public offerings. On the other hand, one recent paper shows that less experienced venture capitalists have incentives to take companies public prematurely, i.e., at a time that does not maximize the value of the IPO firm but that enhances the venture capitalist's appeal to potential funding sources.

A serious problem in risky ventures is that insiders have information not possessed by outsiders. In screening projects, venture capitalists take many steps to deal with the risk created thereby. However, once venture capitalists have made an investment and have ownership in a venture, they too have inside information, and they have incentives to attract other investors to the venture. The additional capital can help them realize a return from their own investment. Recent results show that the adverse selection created thereby can be resolved with a particular type of investing pattern on the part of the original venture capitalists. New empirical evidence indicates that venture capital investments do indeed follow such patterns.

In addition to describing the new findings in venture capital, the paper suggests areas in which further research is needed. For example, "angel" investing involves greater amounts of capital than does venture capital investing, yet we know little of how it compares or how it functions. Also, we do not know how or if venture capitalists in fact create value within an organization. Is that created value worth the costs of having venture capital involved? We are unsure how the various organizational forms in which venture capital operates affect the behavior and performance of venture capital. We also are unsure how venture capitalists select among alternative exit strategies and whether or not those choices are ideal. Venture capitalists face relationships "upstream" with the providers of capital, "horizontally" with other venture capitalists and financial professionals, and "downstream" with their portfolio firms. How do the multiple relationships affect decision making and performance? Are there conflicts of interest created thereby? Are they resolved? If so, how, and in whose favor? Finally, is venture capital a superior form of investment? Do the returns outweigh the high risks? Performance studies to date have been mixed and time-period dependent. These open issues are identified and discussed in the paper in hopes that we will see new findings in the near future to address them.

Christopher B. Barry

Financial Management, Vol. 23, No. 3, Autumn 1994, pages 3-15.

75



76 FINANCIAL MANAGEMENT / AUTUMN 1994

The Syndication of Venture Capital Investments Cooperation among financial institutions is an enduring

feature of the equity issuance process, dating in the U.S. back to at least 1870. Yet the questions of why and how these institutions syndicate are little addressed in either academic studies or practitioner discussions. The neglect may be due to the complex motives for these arrangements, as well as the difficulty of analyzing these patterns. An understanding of the motives for syndication should be helpful both to managers of financial intermediaries and managers at firms that rely upon financiers for access to equity capital.

This paper empirically examines the syndication of venture capital investments. Private equity sales are an attractive arena for the study of syndication because of the ways they differ from public sales of registered securities. First, minimal regulation by the Securities and Exchange Commission puts few limits on the ability of these financial intermediaries to work together. Second, venture capitalists are typically required to hold shares for at least a two years after purchasing the unregistered securities. Thus, syndications of private equity investments are in an arena where there are few constraints on the ability to syndicate and where the risks to financial intermediaries are great.

I focus on three rationales for the syndication of venture capital investments. First, established venture funds may offer potential first-round investments to other experienced venture organizations as part of the screening process. Sah and Stiglitz (1986) show that hierarchical organizations, in which investments are made only if several independent observers agree, may be superior to ones in which projects are funded after one affirmative decision. In this case, the other investors' willingness to invest in a potentially promising firm may be an important factor in the lead venture capitalist's decision to invest. Second, in keeping with a theoretical model by Admati and Pfleiderer (1994), venture funds may syndicate later-round investments to maintain a constant share of the firm's equity in each round. Admati and Pfleiderer show that, by following such a syndication strategy, venture capitalists can limit their ability to exploit informational advantages. (Without such limitations on

opportunistic behavior, they might find it difficult to attract other investors.) Finally, venture capitalists may offer stakes in later-round investments in successful firms to their established peers in a manner seemingly akin to "window dressing" by mutual funds documented by Lakonishok, Shleifer, Thaler, and Vishny (1991). Because institutional investors may examine not only quarterly returns but also end-of-period holdings, money mangers may adjust their portfolios at the end of the quarter by buying firms whose shares have appreciated and selling "mistakes." Venture capitalists may similarly make investments in the late rounds of promising firms, even if the financial returns are low. This strategy allows them to represent themselves as investors in these firms when marketing subsequent venture funds to institutional investors.

Examination of these three hypotheses shows that venture capitalists' motives for syndicating investments are complex and multi-layered. I use a sample of 651 investment rounds at 271 privately-held venture-backed biotechnology firms based in the U.S. I determine the amount invested in these firms by each venture partnership using information from Venture Economics, Recombinant Capital, SEC filings, and contacts with companies and venture capitalists. I find that 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, and the investors may be engaging in a form of "window dressing." Finally, syndication often insures that the ownership stake of venture capitalists stays constant in later venture rounds, a result consistent with Admati and Pfleiderer's hypothesis that syndication is used to limit opportunistic behavior.

Joshua Lerner




FM EXECUTIVE SUMMARIES 77

Toward A Model of Venture Capital Investment Decision Making Venture capitalists are important financial intermediaries

in any economy developing new technology. Venture

capitalists aid suppliers of capital by generating information and by acting on that information to make decisions that reduce the risk in an investment. They benefit users of capital by providing equity capital and business advice.

This empirical study identifies generic criteria that VCs use to make decisions and presents a six-stage decision

process model. The fifteen criteria common to

decision-making processes in all the investments studied can be grouped into three categories: concept, management, and returns. The concept must: (1) present significant potential for earnings growth, (2) involve a business idea (new product, service, retail concept) that either already works or can be brought to market within two to three years, (3) offer a substantial competitive advantage or be in a relatively non-competitive industry, and (4) have reasonable overall

capital requirements. A venture's management must: (1) display personal integrity, (2) have done well at prior jobs, (3) be realistic, (4) be hardworking, (5) be flexible, (6) have a thorough understanding of the business, (7) exhibit

leadership, and (8) have general management experience. Returns criteria require that the investment: (1) provide an exit opportunity, (2) offer the potential for a high rate of return, and (3) offer the potential for a high absolute return.

The decision-making process can be modeled in six stages. The first stage, origination, refers to the way the investment proposal comes to the venture capitalist. Most are referrals.

Once an investment proposal is received, a venture capital firm-specific screen is applied. This second stage eliminates

proposals that do not meet a variety of specific individual criteria, such as type of industry, investment size, stage of financing, or geographic location.

In the third stage, the generic screen, proposals are analyzed for acceptance in terms of the generic criteria. Most deals that pass through the firm-specific screen are rejected at the generic screen based upon reading of the project's business plan.

Investment proposals passing through the generic screen flow into the first-phase evaluation stage where additional information is obtained by meeting with the principals of the company seeking financing; assessing management's capabilities and references; contacting existing and potential customers, suppliers, and distributors; and analyzing the financial statements. Sometimes formal marketing or technical studies are conducted.

At some point the venture capitalist develops an emotional commitment to the proposal, which marks the start of the fifth stage, second-phase evaluation. Venture capitalists like to have a rough understanding about the structure of the deal, including price, before entering this phase. Evaluation activities continue, but the amount of time spent increases dramatically. Now the venture capitalist determines if there are obstacles to the investment.

The final stage, closing, involves developing details of an agreement and preparing the legal documents before concluding the financing.

An investment proposal can be rejected at any stage in the decision process, which is time-consuming and labor-intensive. It takes about 97 days and requires about 130 hours of venture capitalists' time for a proposal to receive funding. This decision-making process produces both supply- and demand-side benefits to the market.

Vance H. Fried and Robert D. Hisrich





Managerial Ownership, Debt Policy, and the Impact of Institutional Holdings: An Agency Perspective

Academia widely discusses agency problems in large modem corporations. The separation of ownership from control is at the crux of the agency conflicts in firms. Managers who own only a fraction of the firm's ownership claims may have a tendency to take actions that serve their best interests as opposed to the maximization of shareholder wealth. Extensive research on this agency issue has identified mechanisms that have the potential of mitigating the conflicts between managers and owners of corporations. A large body of literature suggests that, in addition to other factors, managerial stock ownership and external debt help in aligning the interests of managers with those of external stockholders. The literature also indicates that institutional investors are important external monitoring agents; however, there is no thorough explanation regarding the interrelationships between institutional ownership and other financial policy variables that may help to reduce agency costs. This paper adds to the literature by examining the relationships among institutional holdings of common stock, debt policy, and managerial ownership in an agency framework.

In this paper, we argue that managerial equity ownership, debt financing, and institutional ownership are inter-related in resolving agency costs in firms. Although these agency-conflict-reducing mechanisms offer potential benefits in mitigating agency problems, they are not entirely without cost. Managerial equity holdings may resolve the problems of excessive perquisite consumption, shirking, and expense preference behavior of managers. However, very high levels of managerial equity ownership may induce entrenchment problems and expose managers to suboptimal non-diversification risks. Debt financing may help to discipline the manager by "bonding" the firm to meet the commitments of periodic interest and principal payments. However, excessive debt financing may escalate the firm's bankruptcy potential and increase the debt induced agency problems, such as risk shifting and underinvestment. Institutional investors may provide monitoring benefits through their investing and divesting activities, voting of corporate governance proposals, acting to change board composition, and forming of shareholder advisory committees. However, the literature contains arguments that institutional ownership increases stock price volatility and induces short-term myopia in management.

Recognizing the interrelationships among these agency cost control mechanisms, managers are likely to optimize the usage of each mechanism in order to minimize the total agency costs in the firm. Of the three mechanisms, managers have the ability to adjust the levels of their equity holdings and debt financing depending on the relative costs and benefits of each. They have, however, little control over the institutional holdings of common stock. Therefore, we

expect the managers to optimize the usage of inside equity and external debt given the proportion of institutional ownership and other firm specific characteristics. Consequently, we hypothesize that institutional equity holdings are inversely related to the levels of debt and managerial ownership.

To test our hypothesis, we estimate a simultaneous system of two regression equations with managerial equity ownership and the debt ratio as the endogenous variables. The estimation procedure employs a two-stage least squares methodology to overcome the potential for a simultaneous bias between the endogenous variables. The proportion of institutional equity holdings appears as an exogenous variable in both equations. We predict a negative coefficient estimate for the institutional holdings variable in each equation. Each equation contains the other endogenous variable as a regressor (managerial equity ownership in the debt ratio equation and vice-versa) and control variables relevant to the respective equations. The sample consists of a cross-section of 516 firms trading on the New York Stock Exchange, the American Stock Exchange, and the over-the-counter market (OTC).

Important empirical findings are as follows: The regression coefficient for institutional equity holdings is negative and statistically significant in each equation. This finding is consistent with our argument that firms with greater monitoring by institutional investors may find it optimal to employ less debt and managerial ownership to control agency conflicts in the firm. There is a negative relationship between financial leverage and managerial equity ownership in the debt ratio equation. This suggests a possible trade-off between debt financing and managerial equity ownership in resolving agency conflicts in firms.

Additionally, we use interaction terms between the major agency variables and a dummy variable for OTC firms. We find a more pronounced inverse relationship between institutional holdings and the endogenous variables for OTC firms relative to listed firms. Perhaps this suggests that the monitoring by institutions plays a more significant role for smaller firms, which typically trade in the OTC market.

This study provides empirical support for the view that cross-sectional variations in agency cost control devices are systematic and not random. Given this evidence in addition to the costs and benefits associated with different agency cost control mechanisms, the firm's management can possibly minimize the agency costs of the firm by optimizing the usage of different mechanisms. For example, the monitoring benefits of increased institutional holdings may enable managers to employ less debt financing or inside equity.

Chenchuramaiah T. Bathala, Kenneth P. Moon, and Ramesh P. Rao





The Role of Medium of Exchange in Merger Offers: Examination of Terminated Merger Proposals

Previous research has revealed that, around the announcement of a merger proposal, significantly higher valuation effects accompany cash offers for both target and

bidding firms than the valuation effects accompanying stock offers (Asquith, Bruner, and Mullins (1983), Wansley, Lane, and Yang (1983), Huang and Walkling (1987), Travlos (1987), Franks and Harris (1989), Murphy and Nathan (1989), and Eckbo, Giammarino, and Heinkel (1990)). We

explore whether the difference in merger gains that is

dependent on the offer medium can be explained by synergy, tax code incentives, or the presence of a financing or investment signal. The empirical support for the tax and the

financing signal explanations has been based on reactions in the market at the time of the initial announcement of the

merger offer. A study of terminated merger proposals provides an avenue for investigation of further explanations.

For terminated merger proposals, Bradley, Desai, and Kim (1983), Fabozzi, Ferri, Fabozzi, and Tucker (1988), and Davidson, Dutia, and Cheng (1989) attribute any target firm revaluation to anticipation of a subsequent offer, not to takeover type or terminating party. However, these studies do not consider the possibility of permanent revaluation related to different offer medium. In this study, we examine the relation between the medium of exchange (cash or stock) and valuation effects associated with terminated merger proposals.

We find that merger premiums are higher for target shares at the initial announcement when cash rather than stock is

offered. This difference continues after the offer is terminated, even when there is no subsequent bid, indicating a permanent revaluation of target share value. These results

persist even after we control for variables shown in previous studies to influence target and bidding firms' wealth effects around merger announcements. This suggests that findings of Bradley, Desai, and Kim (1983) and Davidson, Dutia, and

Cheng (1989) indicating zero overall returns for target firms not involved in subsequent bids occur because researchers combine a sample of stock offers that have negative returns and a sample of cash offers that have positive returns.

In conclusion, our results are consistent with the investment and synergy hypotheses, which state that private information related to a target firm's stand-alone value or

synergy potential is revealed to the market through the offer medium associated with a merger proposal. These findings do not rule out the chance that a tax explanation of differential valuation effects may occur simultaneously with the investment and/or synergy explanations. The absence of valuation effects for bidding firm shares provides evidence

contrary to the predicted response of the financing explanation, suggesting that offer medium does not signal private information of bidding firm value.

Michael J. Sullivan, Marlin R.H. Jensen, and Carl D. Hudson





Timing the Disclosure of Information: Management's View of Earnings Announcements

Anecdotal evidence suggests that some corporate managers choose an optimal disclosure time to release information. However, the effectiveness of such a strategy for a highly regular and predictable event such as an earning announcement is questionable. In an efficient market, the " timing" per se can not affect security prices. Nevertheless, some empirical studies suggest that corporate practices are not always consistent with market efficiency. Managers may delay announcements containing bad news until the close of a trading day. Late announcements are preceded by a general decline in stock prices when the market expects bad news to be delivered late. Practitioners, however, find that firms disclose bad news early.

The fact that corporations do change information release schedules prompts several interesting questions. If the market anticipates most of the good or bad news, why do companies change their information release schedules? Is changing reporting schedules a widespread practice? Are managers' practices consistent with empirical findings? To address these questions, we surveyed managers about their corporate earnings announcement policy.

The questionnaire sent to the chief financial officers of 3,090 companies with 1991 sales greater than $100 million included both descriptive and policy questions. Respondents operated in several different industrial categories: manufacturing (the most frequent response), banking and finance, distribution, health care, transportation, and utilities. Approximately 53% of the responding companies traded on the New York Stock Exchange, 7% on the American Stock Exchange, and 36% on the NASDAQ.

About 50% of the firms responding maintain a fixed earnings announcement schedule. Firms that vary announcement timing report that earnings levels that are unexpected have the most impact on the timing decision. Pending release of economic information by the public sector and abrupt changes in the stock market have little effect on decisions about earnings announcement timing. Approximately one-third of the firms that vary their announcement schedule believe that lower-than-expected earnings by itself warrants a change in the announcement date. The percentage for higher-than-expected earnings is lower-25.8%. This is consistent with the claim that firms see lower-than-expected earnings as a more significant event. Answers provided to our open-ended questions suggest that firms release bad information earlier. Preliminary earnings announcement is a common practice. While this finding contradicts most of the results found in prior empirical studies, it is consistent with practitioners' reports.

We partitioned the respondents by firm size and location of stock trading. Statistical tests indicate that small firms are more likely to change the date and time of their announcement than larger firms. Also, firms that are traded on the NASDAQ are more likely to change announcement date and time than firms traded on the NYSE.

Carl R. Chen and Nancy J. Mohan





A Simple Approximation of Tobin's q Although perhaps unknown to many business executives,

Tobin's q ratio has recently been advanced as a powerful analytical tool. Defined as the ratio of the market value of a firm to the replacement cost of its assets, q has been shown to be a significant determinant of a number of diverse

corporate phenomena, including (but by no means limited to) investment and diversification decisions, the relationship between managerial equity ownership and firm value, the

relationship between managerial performance and tender offer gains, investment opportunities and tender offer

responses, and financing, dividend, and compensation policies. Thus, information on a firm's q ratio can provide financial analysts and their top-level managers with

important insights into the likely performance of the firm (as well as that of its competitors) under various alternative scenarios prior to actual implementation.

Unfortunately, despite its influence over many important aspects of corporation behavior, discussions with several senior financial managers suggest little, if any, reliance upon q in real-world decision analysis. We believe that much of the reason for this managerial shunning of such a potentially powerful analytical tool is due both to an unfamiliarity with

q on the part of most financial analysts as well as the fact that the availability of timely and accurate q data is severely limited when compared to other important financial variables, such as beta. The present study, by confirming the

accuracy of a simple approximation of q using basic financial and accounting information, is intended to correct this latter limitation.

The algorithms typically employed in the calculation of Tobin's q are costly both in terms of their data requirements and computational effort. Approximate q, on the other hand, is extremely conservative on both counts and is simply defined as follows:

Approximate q = (MVE + PS + DEBT)/TA,

where MVE is the market value of the firm's common shares, PS is the market value of the firm's outstanding preferred stock, DEBT is the value of the firm's short-term liabilities net of its short-term assets, plus the value of the firm's

long-term debt, and TA is the book value of the total assets of the firm. Many financial executives will no doubt recog- nize the similarity between approximate q and the MVA (market value added) and EVA (economic value added) concepts discussed in recent issues of several popular business publications. (See, for example, Fortune, December 27, 1993, page 64.) Approximate q, while similar to MVA, has one important difference. Approximate q, by virtue of its ratio composition, is a standardized measure of wealth crea- tion. It is not subject to the scale biases inherent in simple differences such as MVA.

Comparisons of q values obtained via the approximation procedure outlined above with those obtained via a more

theoretically correct formula suggest few significant differences. Indeed, simple linear regressions between the two data series indicate that at least 96.6% of the variability of Tobin's q is explained by approximate q. Mean, median, and maximum absolute deviations between the two series for 40 randomly selected firms were 6.8, 6.2, and 18.0%, respectively. All of these errors compare very favorably with the estimation errors typically observed in other areas of financial analysis, such as capital budgeting.

Although the actual application of Tobin's (or approximate) q to specific areas of financial analysis is

beyond the scope of this article, a number of important references concerning these issues are provided in the study.

Kee H. Chung and Stephen W. Pruitt




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