Venture Capital Special Issue || The Syndication of Venture Capital Investments

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  • The Syndication of Venture Capital InvestmentsAuthor(s): Joshua LernerSource: Financial Management, Vol. 23, No. 3, Venture Capital Special Issue (Autumn, 1994),pp. 16-27Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665618 .Accessed: 21/06/2014 09:01

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  • The Syndication of Venture Capital Investments

    Joshua Lerner

    Joshua Lerner is Assistant Professor of Business Administration at Harvard Business School, Boston, Massachusetts.

    Abstract: 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.

    M Cooperation among financial institutions is an enduring feature of the equity issuance process. Syndicated underwrit-

    ings in the U.S. date back at least as far as an 1870 offering by Pennsylvania Railroad. By the 1920s, separate syndicates in many cases handled intricate arrangements for the pur- chase, inventory, and sale of securities (Galston (1925)). Co-managed offerings and selling syndicates continue to be

    prominent in equity issues to this day. Despite its persistence, syndication has been little

    scrutinized in the corporate finance literature. The reason

    may lie in the difficulty of analyzing syndication patterns empirically and the complexity of motives behind

    syndication. The syndication of venture capital investments in

    privately held firms differs in two ways from public sale of

    registered securities. First, the process through which private firms sell securities is little regulated by the Securities and

    Exchange Commission. Thus, financial intermediaries are bound by few constraints against working together.

    Second, privately issued securities are purchased directly by the venture capital fund and must be held for at least a

    two-year period (Blumenthal (1993)). By contrast, underwriters take on relatively limited risks in a public

    security issue; they ascertain the demand schedule for the

    security before the price is determined. These differences suggest that securities sales by private

    firms provide an attractive arena in which to study the economics of syndication. I explore three hypotheses. The first two suggest that syndication may be a mechanism

    through which venture capitalists resolve informational uncertainties about potential investments:

    1. Syndicating first-round venture investments may lead to better decisions about whether to invest in firms. Sah and Stiglitz (1986) show that hierarchical organizations, in which investments are made only if several independent observers agree, may be superior to ones where projects are funded after one affirmative decision. Another venture

    capitalist's willingness to invest in a potentially promising firm may be an important factor in the lead venture capitalist's decision to invest.

    2. Admati and Pfleiderer (1994) develop a rationale for

    syndication in later venture rounds that is based on informational asymmetries between the initial venture investor and other potential investors. A venture capitalist who is involved in the firm's

    daily operations may exploit this informational

    advantage, overstating the proper price for the securities in the next financing round. The only way to avoid this opportunistic behavior is if the lead venture capitalist maintains a constant share of the firm's equity. This implies that later-round financings must be syndicated.

    The author thanks for their suggestions Chris Barry, Joetta Forsyth, Ken Froot, Paul Gompers, Lisa Meulbroek, William Sahiman, Peter Tufano, several practitioners, and two anonymous referees. Assistance in obtaining data was provided by Jesse Reyes of Venture Economics and Mark Edwards of Recombinant Capital, and is gratefully acknowledged. Financial support was provided by the Division of Research, Harvard Business School. All errors and omissions are the author's.

    Financial Management, Vol. 23, No. 3, Autumn 1994, pages 16-27.

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  • LERNER / THE SYNDICATION OF VENTURE CAPITAL INVESTMENTS 17

    The third hypothesis is different in emphasis. Syndication may also be a mechanism through which venture capitalists exploit informational asymmetries and collude to overstate their performance to potential investors:

    3. Lakonishok, Shleifer, Thaler, and Vishny (1991) suggest that pension funds " window dress." Because institutional investors may examine not

    only quarterly returns but also end-of-period holdings, money managers 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 in marketing documents as investors in these firms.

    While these three hypotheses do not exhaust the rationales for syndication, they lend themselves to empirical examination.

    I examine these concepts using a sample of 651 investment rounds prior to going public at 271 biotechnology firms. 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 both to 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 (i.e., its valuation has increased since the prior venture round). Finally, the

    ownership stake of venture capitalists frequently stays constant in later venture rounds. I interpret these results as

    supporting the three hypotheses. While industrial organization has long focused on

    incumbent-entrant relationships, corporate finance has devoted little attention to such interactions. Yet with its

    ability to measure interactions and returns, finance is a natural testing ground. This paper joins the relatively few studies of the relationship between incumbent and entrant financial institutions.1

    I. Rationales for Syndication I focus my analysis on three hypotheses. First, syndication

    may lead to a superior selection of investments. Sah and Stiglitz (1986) contrast decision-making in hierarchies and polyarchies: that is, settings in which projects are undertaken

    only if two reviewers agree that the project is worthy and those in which the approval of either is sufficient. The authors show that it may be more efficient to undertake only those projects approved by two reviewers.

    Venture capitalists, upon finding a promising firm, typically do not make a binding commitment to provide financing. Rather, they send the proposal to other investors for their review. Another venture capitalist's willingness to invest in the firm may be an important factor in the lead venture investor's decision to invest (Pence (1982)).

    This motivation for syndication is often emphasized by practitioners:

    Venture capitalists prefer syndicating most deals for a

    simple reason-it means that they have a chance to check out their own thinking against other knowledgeable sources. If two or three other funds whose thinking you respect agree to go along, that is a double check to your own thinking. (George Middlemas of Inco Securities in Perez (1986))

    Most financing involves a syndicate of two or more venture groups, providing more capital availability for current and follow-on cash needs. Syndication also

    spreads the risk and brings together more expertise and support. These benefits pertain only to start-up financing requiring the venture capitalist's first investment deci- sion. There are different strategies and motivations for syndication in follow-on financing. (Robert J. Kunze of Hambrecht and Quist (1990))

    If opinions of others are an important motivation for syndication, venture organizations should be careful in their choice of first-round syndication partners. Established firms are unlikely to involve either new funds or small, unsuccessful organizations as co-investors. The choice of

    syndication partners should be less critical in later rounds.

    Having decided to provide capital to a firm, venture capitalists should be much less concerned about confirming their judgment. This suggests that (i) experienced venture

    capitalists are likely to invest with one another in the first round and (ii) seasoned venture capitalists should invest with both experienced and inexperienced investors in later rounds.2

    Admati and Pfleiderer (1994) argue that syndication in later rounds should occur even when venture capitalists are

    Examples are Beatty and Ritter (1986), Hayes, Spence, and Marks (1983), Lakonishok, Shleifer, and Vishny (1992), and Sirri and Tufano (1992).

    2Another hypothesis that would generate a similar empirical pattern is Welch's (1992) model of" cascades" in equity sales. While Welch focuses on the sale of equity in initial public offerings (IPOs), the same pattern could appear in private financings: upon observing the decision of early venture capitalists to invest in the firm, less sophisticated venture investors rush in to invest in later rounds.

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  • 18 FINANCIAL MANAGEMENT / AUTUMN 1994

    risk-neutral and under no capital constraints. Suppose informed entrepreneurs raise funds from outside investors

    directly. In keeping with Brennan and Kraus (1987), entrepreneurs can communicate all their private information with a set of contingent claims. If an unforeseen state of the world can occur, however, the signaling equilibrium breaks down. As a result, the entrepreneur may be unable to raise the full amount needed.

    Lead venture capitalists who become involved in the firm's operations can solve this information problem. Other less well-informed investors will invest if this lead one does. Venture capitalists, however, may exploit their informational advantage and overstate the proper price for the securities in the firm's financings. Under the assumptions of the Admati and Pfleiderer model, the only way to insure optimal behavior in this circumstance is for lead venture capitalists to maintain a constant equity stake.

    Suppose a lead venture capitalist obtains one-half of a

    company's two million shares in the first round. (The entrepreneur retains the other 50%.) If the second round involves the issuance of another million shares, the venture capitalist should buy only one-half of these. The remaining half-million shares should be purchased by other venture capitalists. This model provides a rationale for syndication in later rounds and suggests that venture capitalists will hold a constant equity stake across rounds.

    Lakonishok, Shleifer, Thaler, and Vishny's (1991) discussion of money manager "window dressing" suggests a third rationale for venture syndication. Pension funds, which typically evaluate money managers once a quarter, examine performance in several ways. Because market-adjusted performance is a noisy indicator of a money manager's skill, plan sponsors also examine the portfolio of securities held at the end of the quarter. Anticipating this, money managers may adjust their portfolios just before the

    quarter's end. They may buy firms that have performed particularly well in that quarter or sell "mistakes" that incurred losses.

    Venture capital funds may behave the same way. In their

    private placement memoranda for new funds, venture

    organizations discuss the performance of their previous funds. The performance data are often difficult for outsiders to confirm. In computing historical returns, venture

    capitalists may make generous assumptions about the valuation of securities.3 Thus, potential investors may also

    examine venture organizations' prior investments. Offering documents also discuss successful past investments, often not clarifying whether the venture organization was an early or late investor.

    Investment in a promising firm shortly before it goes public may consequently benefit a venture organization, even if the financial return is low. Early venture investors

    may curry favor with their colleagues by permitting them to invest in later-round financings of promising firms. The early-round investors may do so in the hope that the

    syndication partners will in turn offer them opportunities to invest in later rounds of their deals.

    This hypothesis suggests that venture capitalists should offer shares in the best deals to those firms most able to

    reciprocate: well-established venture firms. Venture capitalists should be less likely to offer such opportunities to less established venture organizations.

    A final rationale for syndication that I do not examine is risk avoidance through risk sharing (Wilson (1968)). Venture capitalists have much at stake in the performance of their funds. First, they typically receive as compensation between 20% and 30% o...

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