venture capital special issue || the syndication of venture capital investments

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

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserveand extend access to Financial Management.

http://www.jstor.org

This content downloaded from 62.122.73.86 on Sat, 21 Jun 2014 09:01:50 AMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=black

http://www.jstor.org/action/showPublisher?publisherCode=fma

http://www.jstor.org/stable/3665618?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


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 purchase, 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.



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 decision. 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.



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% of fund profits. Fund performance also affects the ability to raise new funds. Venture capitalists may consequently diversify their holdings to insure that they do not conspicuously underperform their peers. Many contracts establishing venture capital partnerships explicitly prohibit investing in other venture funds (Gompers and Lerner (1994)). By investing in many syndicated investments, however, a venture fund can achieve much the same effect.

It is unclear whether risk aversion will lead to a greater tendency to syndicate by less or more established funds. A new venture organization may believe that a follow-on fund is difficult to raise unless it performs very well (Gompers (1993a)). The fund may make high-risk solo investments. Alternatively, an established venture organization may believe that its reputation will allow it to raise a later fund even after a disastrous performance. Its fund may thus be willing to invest alone in risky but promising projects. To

analyze empirically the relationship between risk aversion and syndication, we would need to know about the utility functions of the venture capitalists, the status of their current funds, and their future fund-raising plans.4

3Venture funds frequently do not sell shares of firms that have gone public, but rather, they distribute them to their limited partners. (Limited partners usually include tax-exempt and tax-paying entities, which may have different preferences regarding the timing of sales.) The transfer of the securities from the venture capitalist to the limited partners may take several weeks. During this period, the firm's share price may fall sharply, either because the venture capitalists themselves sell their shares of the thinly traded

security or because the market anticipates forthcoming sales by the limited partners. In calculating returns, venture funds may employ not the price on the date that the shares reached the limited partners, but rather the price on the date that the distribution was announced ("Stock Distributions-Fact, Opinion and Comment" (1987)).

4One test is to examine funds that specialize in start-ups, traditionally the most risky of venture investments. These venture capitalists, it might be anticipated, have relatively little risk aversion. Using a t-test, I compare the number of syndication partners (by round of investment) for these funds and




II. The Data I examine financings between 1978 and 1989 by privately

held biotechnology firms that received venture capital before

going public. Here I summarize the construction of the data set and examine the implications of using an industry sample. (For a fuller description of the data, see Lerner (1994a, 1994b).)

I base the analysis on the records of the consulting firm, Venture Economics. Its Venture Intelligence database records the size of and participants in each funding round. Venture Economics obtains these data from individual and institutional investors in venture funds. The Venture Economics data are very comprehensive but have a

significant bias (see Lerner (1994a)). Single venture rounds, particularly in more mature firms, are often recorded as several observations.

This may happen for three reasons. First, a contract between a company and its venture financiers may call for the staged distribution of the funds in a single venture round, which may then appear in the database as several distinct venture rounds.

Second, staggered disbursements arise without design. Venture capital funds typically do not keep large cash balances but, rather, draw down funds from their limited

partners as needed. Limited partners will have between two weeks and several months to provide the funds. As several venture funds normally participate in a financing round, investments may be received over the course of several months and thus be recorded in the database as several rounds.

Finally, Venture Economics aggregates information about venture investments from reports by pension fund

managers, individual investors, and investment managers. If the date of the investment differs in these records, a single investment round may be recorded as two or more events. While data accuracy has increased over time and Venture Economics has recently improved its data collection

methodology to limit such problems in the future, the

over-reporting of rounds is a significant factor in the historical Venture Economics data.

Thus, I confirm (and, if necessary, combine and correct) the observations. I use the data of a second consulting firm, Recombinant Capital (Valuation Histories for Private Biotechnology Companies (1992) and Valuation Histories for Public and Acquired Biotechnology Companies (1993)).

This firm gathers its information from public documents and

company and venture capital contacts. For firms not tracked by Recombinant Capital that had

gone public, I corroborate the Venture Economics data using the "Certain Transactions" and "Financial Statements" sections of the IPO prospectuses. If these are ambiguous, I use the "Recent Sales of Non-Registered Securities" section of the S-1 or S- 18 statements. (I also use these statements for

companies that withdrew proposed IPOs.) I find financial statements of acquired private firms in the acquirers' proxy statements, 10-K, 10-Q, or registration statements. I attempt to corroborate the remaining cases through telephone contacts with companies and venture capitalists.

In all, I identify 651 financing rounds at 271 firms.5 I determine the age and size of venture organizations using the publications of Venture Economics and other organizations, including these reports: Pratt's Guide to Venture Capital Sources (1991), The Venture Capital Report Guide to Venture Capital in the U.K. (Clay (1987)), Corporate Finance Sourcebook (1991), Guide to European Venture Capital Sources (1988, 1991).

While the use of an industry sample allows me to use other data sources to verify and correct the data set, it raises the concern that the investment patterns here are not representative of venture capital as a whole. In other work (Lerner (1994a,1994b)), I show that the IPOs of firms in this

sample closely resemble the 433 venture-backed IPOs examined by Barry, Muscarella, Peavy, and Vetsuypens (1990) in several critical respects. These include the inflation-adjusted IPO size, the length of venture capitalist involvement with the firm, and the number of venture

capitalists serving as directors of the firm. Moreover, in the cross-sectional sample of

venture-backed firms developed by Gompers (1993b), the cumulative venture funding that biotechnology firms receive is near the mean. The average funding for these firms is more than for computer software and medical device companies but considerably less than for computer and electronic

component manufacturers.

III. The Syndication of Venture Investments

Table 1 describes the sample. Even in the first round, there is extensive syndication. In each later venture round, two or

all others. I identify the specialist funds using a database assembled by Venture Economics (described in Gompers and Lerner (1994)). I find that, while these funds have slightly fewer syndication partners, the differences are not statistically significant.

5I employ in my sample all rounds in which external financiers provided a significant amount of capital ($100,000 or above) in exchange for equity (almost universally preferred stock) or convertible debt. The practical effect of my definition is to eliminate (i) company formations, where founders contributed a small amount of funds (typically under $20,000) in exchange for a considerable amount of common stock and (ii) bridge loans by venture capital providers in the months prior to an initial public offering and due immediately after the IPO.




Table 1. Description of the Sample

The sample consists of 651 financing rounds of privately held biotechnology firms between 1978 and 1989. The table indicates the number of observations, the mean number of venture and non-venture investors, and the mean number of such investors investing in the firm for the first time. The table also reports the mean amount invested by venture and non-venture investors, in millions of nominal dollars.

Round of External Financing #1 #2 #3+

Number of Observations 269 184 198

Mean Number of Investors in Each Round

Venture Investors 2.2 3.3 4.2

Non-Venture Investors 0.5 0.9 1.1

Mean Number of New Investors in Each Round

Venture Investors 2.2 1.5 1.3


Amount Invested per Investor ($ mil) Venture Investors 0.5 0.6 0.6


Because some early-round investors do not invest in subsequent rounds, the number of investors in a given round is often less than the sum of the investors in the previous round and the new investors.

more new investors typically invest in the firm. The mean number of investors rises from 2.7 (including non-venture investors) to 5.3.6 Because some early-round investors do not invest in subsequent rounds, the number of investors in a given round is often less than the sum of the number of investors in the previous round and the number of new investors.

The amount invested per venture and non-venture investor is quite stable. Consistent with Sahlman (1990), the size of each financing round increases (on an absolute and

per investor basis) as the firm matures. This reflects the

growing number of investors and the increasing representation of non-venture investors.

A. Syndication Partners in First and Later Rounds

I examine the choice of syndication partners in the

sample. I expect that established venture capitalists will

disproportionately syndicate first-round investments with other established firms. In later rounds, they should be much

more willing to syndicate investments with less seasoned firms.7

There is not an obvious way, however, to distinguish between established and marginal venture capital organizations. While many influential venture capital organizations, such as Greylock and TA Associates, date back to the 1960s, others of today's leading venture

capitalists did not close their first fund until the 1980s, including Technology Venture Investors and Burr, Egan, Deleage. Furthermore, a substantial number of venture

organizations have operated for some time without ever

becoming major factors in the industry. I thus do not characterize venture capitalists simply by age, but also by the relative size of the organization's fund.

More established venture organizations should be able to access capital from investors for larger and more frequent funds. Venture capitalists generally prefer larger funds because of the substantial economies of scale in operating a

large venture fund (or several large funds). I express the

organization's size as a percentage of the total venture capital pool because venture capital expanded dramatically between

6I define venture investors as either (i) traditional limited partnerships where general partners invest the limited partners' capital and oversee these investments or (ii) corporate venture capital programs that are established enough to be listed in Pratt's Guide to Venture Capital Sources (1991). I include as non-venture investments private placements by other corpora- tions or financial institutions, as well as by partnerships established solely to invest in a single firm. Investments that are made by an agent and marketed to retail investors are also designated as non-venture investments.

7One question suggested by this analysis is which firms do not syndicate at all. I compare the age and size of venture organizations investing alone to those organizations investing jointly. I find that larger and older venture organizations are only slightly more likely to invest alone than others. The t-tests comparing syndicating and solo investors are statistically insignificant and not reported in the tables.




1978 and 1989; it is relative rather than absolute size that measures relative experience.8

Table 2 divides all venture capitalists into quintiles based on size. I compute the ratio of a venture organization's committed capital (the total amount provided by investors) to the total venture pool in the year of investment. Venture organizations typically operate several funds (i.e., partnerships) at any given time. All funds sponsored by a venture capital organization are aggregated for the purpose of the analysis. I use the committed capital rather than the value of assets because venture capitalists follow divergent practices as to when they write up or write off their investments.

I examine the syndication partners in each size quintile of venture organizations, considering first-, second-, and later-round investments separately. If funds were equally likely to syndicate with a venture organization of any size, each cell would be equal: 20% of the syndications would be with the largest quintile of organizations, 20% with the middle quintile, and so on.

I present the analysis in Figure 1 and Table 2. There are uneven numbers of observations for each quintile, so the tabulations are not symmetric around the diagonal axis. For instance, there are 44 syndicated first-round investments between venture capitalists in the largest quintile and those in the middle quintile. The number of syndicated investments

involving the largest quintile of organizations is slightly larger than the number involving the middle quintile. Thus, co-investments with middle-quintile firms make up 20% of the joint investments by the largest quintile of organizations. These 44 transactions with the largest quintile comprise 22% of the co-investments by middle-quintile venture capitalists.

Venture capitalists in the smallest quintile are disproportionately likely to undertake early-round transactions with each other. The bottom quintile of venture organizations syndicate 43% of their first-round investments with other bottom-quintile venture capitalists. With each subsequent round, this pattern becomes less pronounced. In second and later rounds, the percentages are 32% and 24%.

Some patterns, however, are less clear. It is not obvious, for instance, why top-tier firms syndicate first-round investments more frequently with second-quintile organizations (35%) than with other top-quintile firms (14%).

Table 3 examines the statistical significance of these patterns. I test the null hypothesis that the probability of each cell is 20%, using a Pearson X2-test. For the size analysis reported in Table 2, I reject the null hypothesis at the 0.01 level of confidence in the first round. In the other rounds, I cannot reject the null hypothesis at conventional confidence levels.

Similar results appear when venture organizations are

Figure 1. Syndication Partners in Venture Financings of Privately Held Biotechnology Firms

First-Round Investments Second-Round Investments Later-Round Investments

50% 50% 50%

40% 40% 40%

30%-

30% 30%

20% 20% 20%

10% 5 10% 10%

5

0%4 0% 4 0% 4

2 Size Quintile of 2 2 Size Quintile

of 2 2 Size Quintle

of

3 1 Syndication Partner 3 1 Syndication Partner 3 1 Syndication Partner

Venture Capital Size Quintile 5 Venture Capital Size Quintile Ventre Capital Size Quinte 5

The sample consists of 651 financing rounds between 1978 and 1989. Venture organizations are divided into quintiles on the basis of committed capital, relative to all venture organizations active in biotechnology in the year of the investment. The quintile of the largest venture capital firms is denoted as 1; the smallest as 5. First-, second-, and later-round investments are considered separately. The vertical axis indicates, for each size quintile, the percentage of syndication partners in each of the five quintiles.

8Neither age nor relative size provides an indication of industry expertise. One might expect certain venture capitalists to develop special expertise in a complex industry such as biotechnology. If early-round investments involve specialists, it is not obvious that such specialists will be particularly likely to co-invest with each other. In many cases, early-round syndications between two established venture organizations will pair one group with

industry-specific experience and another without such experience, which is expected to contribute general management and financial expertise. Estab- lished venture organizations can be expected to be involved as syndication partners, even when they do not have specialized industry expertise (Kunze (1990)).




Table 2. Syndication Partners in Venture Financings of Privately Held Biotechnology Firms

The sample consists of 651 financing rounds between 1978 and 1989. Venture organizations are divided into quintiles on the basis of committed capital, relative to all venture organizations active in biotechnology in the year of the investment. Each row of the table indicates, for one size quintile, the distribution of syndication partners (i.e., the percentage of syndication partners in each size quintile). First-, second-, and later-round investments are considered separately.

First-Round Financings

Size Quintile of Syndication Partner Venture Capital Size Quintiles Largest (%) 2nd (%) Middle (%) 4th (%) Smallest (%)

Largest Quintile 14 35 20 17 14

2nd Quintile 27 25 14 19 16

Middle Quintile 22 20 20 23 16

4th Quintile 18 25 21 16 20

Smallest Quintile 12 17 12 16 43

Second-Round Financings

Size Quintile of Syndication Partner

Venture Capital Size Quintiles Largest (%) 2nd (%) Middle (%) 4th (%) Smallest (%)


2nd Quintile 25 22 20 15 17


4th Quintile 22 18 23 21 18


Later-Round Financings

Size Quintile of Syndication Partner

Venture Capital Size Quintiles Largest (%) 2nd (%) Middle (%) 4th (%) Smallest (%)


2nd Quintile 20 20 25 21 17


4th Quintile 17 21 25 20 17


Rows may not add to 100%, due to rounding. Because certain size quintiles undertook more or fewer syndicated investments, the tables are not symmetric along the diagonal axis.

segmented by age. Of the first-round syndication partners of the quintile of youngest firms, 36% are also in the youngest quintile. Although I do not report the full results for age as I do for size in Table 2, the pattern is similar. I test for deviations from the equally likely distribution in Table 3. I again reject the null hypothesis of equal probabilities (at the 0.05 level of confidence) in the first round. In later rounds, I cannot reject the null hypothesis.

The analyses reported in Tables 2 and 3 using the age and

size proxies suggest sharp divisions between more and less established venture capitalists. If the unwillingness of

experienced venture capitalists to invest with smaller and younger organizations in the first round stems from a mistrust of inexperienced investors' judgment, then a second

pattern should appear as well. Experienced venture capitalists should be reluctant to invest in the later rounds of deals begun by their less-seasoned counterparts. Inexperienced venture investors should be brought into




Table 3. Tests of the Randomness of the Distribution of Syndication Partners in Venture Financings of Privately Held Biotechnology Firms The sample consists of 651 financing rounds between 1978 and 1989. Venture organizations are divided into quintiles on the basis of committed capital and age, relative to all venture organizations active in biotechnology in the year of the investment. The table indicates the test statistic and significance level for a Pearson X2-test, whose null hypothesis is that 20% of the observations are in each cell. Separate tests are performed for the first-, second-, and later-investment rounds.

Firms Divided into Quintiles by Venture Organization:

Size Age

First-Round Financings

Pearson X2-statistic 48.08 26.87

p-value 0.000 0.043

Second-Round Financings


p-value 0.273 0.954 Later-Round Financings


p-value 0.983 0.448

later-round financings by experienced organizations, but not vice versa.

To assess this possibility, I examine venture organizations investing for the first time in the second or later venture rounds. I contrast the characteristics of the new investors with those of the venture organizations that invested

previously in the firm. I compare funds along three dimensions of experience: size of the venture capital organization (committed capital in the year of the investment as a percentage of the total committed capital in the venture

pool), age of the venture organization (in years), and number of biotechnology firms in which the organization had invested before this transaction.

I expect that the later-round venture investors would be less experienced than the previous investors. Table 4

compares the characteristics of the new investors to those of the previous venture financiers and presents the p-values from t-tests comparing these firms. The results are consistent with the hypothesis and are significant at the 0.01 confidence level. The typical later-round syndication involves

less-experienced venture capitalists investing in a deal begun by established organizations.

Table 4. The Experience of Venture Capitalists Investing in the Second and Later Rounds

The sample consists of 651 financing rounds between 1978 and 1989. For each venture organization investing in a firm for the first time in the second or later round, I compare its experience level to the experience level of previous venture investors in the firm. Venture organizations are compared on the basis of size (committed capital in the year of the investment as a percentage of the total pool of venture capital), age (in years), and the number of biotechnology firms in which the organization had previously invested. The differences are expressed as the experience level of the new investor minus that of the previous investor.

Average Difference, Experience of New p-value, t-test

Measures of Venture Investor and of No Experience Previous Investor Difference

Venture Organization -0.12% 0.008 Size as Percentage of Total Pool

Age of Venture -1.42 0.006 Organization (years) Prior Biotech -0.76 0.001 Investments by Venture Organization

B. Changes in Equity Holdings Across Venture Rounds

I next examine an empirical prediction of Admati and Pfleiderer's model-that the stakes held by venture

capitalists will be relatively constant across venture rounds. Table 5 examines investors' aggregate equity holdings

and their equity purchases in financing rounds. In the second round, first-round investors purchase 30% of the shares sold. New investors buy the remaining shares. The existing investors' purchase corresponds quite closely to their

previous ownership position of 34% prior to the round. In the third round, when previous investors hold 51% of the

equity, existing shareholders purchase about half the shares. In later rounds, current shareholders purchase over half the shares. These results confirm the prediction of Admati and Pfleiderer that venture shareholders strive to maintain a constant equity share.

Similarly, the equity ownership of individual venture organizations shows relatively little variation. Table 6 shows the change in equity held by each venture investor before and after each venture round. I compute:

(Stake After Round - Stake Before Round)(1) Stake Before Round

In 21% of the cases, the share of the firm held by the




Table 5. Equity Stakes in Privately Held Venture-backed Biotechnology Firms

The sample consists of 332 financing rounds between 1978 and 1989 where the size of the ownership stake for each investor can be determined. The table indicates the mean percentage of the firm's equity held by outside investors after each venture round, as well as the percentage of the equity sold in the round purchased by previous investors in the firm.

Round of External Financing #1 (%) #2 (%) #3+ (%)

Total Stake Held by 33.9 51.1 57.0 Outside Investors after Investment Round

Share of Equity Sold in 30.0 52.7 Round Purchased by Previous Investors

In computing the equity stake, all preferred shares are converted to common shares at the conversion ratios then in force. (These are typically stipulated in the amended bylaws prepared after each venture round.) Outstanding warrants and options are counted only if their exercise price is below the per-share price of the venture round.

venture capitalist changes by less than 5% after the venture round. In 70.5% of the cases, the change is less than 25%. 9

C. Later-Round Syndications of Investments in Promising Firms

I finally examine suggestions of "window dressing" in the syndication of venture investments. An empirical implication of the hypothesis is that experienced venture

capitalists will invest in the later rounds of deals particularly likely to go public.

I use as observations each second- and later-round venture investment. I run a pair of probit regressions using the same

independent variables, but different dependent variables:

(INVEST?)1i =

O•Q + (AVALUE)i O•i

+ (VCSIZE)ia 2i + E i (2) The dependent variables are dummy variables indicating

whether (i) one or more experienced venture capitalists invested in the firm for the first time in the round and (ii) one or more inexperienced venture capitalists invested for the first time. In both cases, I code the dependent variable as 1.0 when a new investor is present. I define experienced and

inexperienced firms as those above and below the median size of those venture organizations investing in

Table 6. Changes in Venture Equity Stakes in Privately Held Biotechnology Firms

The sample consists of 188 second or later financing rounds between 1978 and 1989 where the size of the ownership stake of each venture capitalist before and after the venture round can be determined. The table indicates the change in the equity ownership of each venture organization around each financing round: the difference between the new and old stakes divided by the old stake (a total of 871 observations). All funds of a given venture organization are considered together.

Change in Number of Ownership (%) Observations Percentage (%)

<-25 72 8.3

<-5 and >-25 298 34.2

<5 and >-5 183 21.0

<25 and >5 134 15.3

<50 and >25 94 11.1

<75 and >50 23 2.6

<100 and >75 27 3.1

>100 40 4.6

In computing the equity stake, all preferred shares are converted to common shares at the conversion ratios then in force. (These are typically stipulated in the amended bylaws prepared after each venture round.) Outstanding warrants and options are counted only if their exercise price is below the per-share price of the venture round.

biotechnology in that year, using the amount of capital committed to the venture organization as a measure of size.

I use two independent variables. To identify the most

promising deals, I examine the change in the per share valuation of the firm between the current and previous venture rounds. I anticipate that the firms whose valuations increase sharply are superior performers and those most

likely subsequently to go public (Sahlman (1990)). I include the size of the largest previous venture investor as an

independent variable. In this way, I control for the reluctance of established firms to invest in deals begun by less established firms.

My partition of venture capitalists into experienced and

inexperienced is crude; I here disregard much of the information about their characteristics. In unreported regressions, I repeat the analysis, using specifications that

capture more detail. First, I run four separate regressions, examining whether venture capitalists in each of four size

quartiles invested for the first time in the transaction. Then, I employ a Poisson specification, where my dependent variable is the number of new venture capitalists in each size

9That is, in 70.5% of the cases, a venture capitalist with a 10% stake in a

company before a venture round would have an equity stake of between 7.5% and 12.5% thereafter.




quartile who invested in the firm. The results are robust to these changes.

I also examine the robustness of the analysis to the use of venture organization age rather than relative size. I regress:

(INVEST?)ij =1oj + (AVALUE)i~lj + (VCAGE)i2j +ij (3)

As before, I use two dependent variables, indicating whether an experienced or an inexperienced venture capitalist joined as a new investor. I now define experienced and inexperienced firms as those above or below the median age of those venture organizations investing in biotechnology in that

year. Instead of size, I use the age of the oldest previous investor as an independent variable.

The results in Table 7 support suggestions of "window

dressing." The coefficients 0.14 and 0.15 in the first and third

regressions show that established venture capitalists are

significantly more likely to invest for the first time in later rounds when valuations have increased sharply.10 Valuation

changes are insignificant (and actually negative) in

explaining the probability of investments by less established firms.

IV. Discussion In my sample of private investments in the biotechnology

industry, I show that in the first round, established venture

capitalists tend to syndicate with one another. Later rounds involve less established venture organizations. These results are consistent with the view that syndication allows

Table 7. The Probability of Venture Capitalists Investing for the First Time in a Second or Later Financing Round

The sample consists of 199 second or later financings of privately-held biotechnology companies between 1978 and 1989 in which the valuations of the firm in the current and previous rounds are available. The dependent variable is a dummy variable indicating if one or more venture investors above or below the median size or age of venture organizations active in biotechnology in that year were first-time investors in this round. (Rounds with new investors are coded as 1.0.) The independent variables are the percentage change in the valuation of the firm from the previous to the current venture round, the age (or size) of the most experienced venture organization that had previously invested in the firm, and a constant. A probit regression is employed (absolute t-statistics in parentheses).

Dependent Variable

Organization Above Organization Below Organization Above Organization Below Median Size Invested Median Size Invested Median Age Invested Median Age Invested

Percentage Change in Valuation 0.14 (2.21) -0.04 (0.83) 0.15 (2.67) -0.03 (0.57) between Previous and Current Round

Size of Oldest Previous Investor 21.86 (2.12) 12.33 (1.50) (percentage of total venture pool)

Age of Oldest Previous Investor (years) 0.03 (2.15) 0.02 (2.66)

Constant 0.33 (1.85) -0.49 (3.15) 0.41 (1.12) -0.62 (3.58)

Log Likelihood -101.9 -128.2 -110.6 -128.4

X_ statistic 8.86 2.86 6.99 7.79

p-value 0.01 0.24 0.03 0.02

Number of Observations 199 199 199 199

The change in the firm value is computed using the price per share in the previous venture round and the price per share in the current round. I correct for any stock splits, reverse splits, or stock dividends.

1?While it could be argued that the price per share increases because other experienced venture capitalists invested in the firm, there are strong argu- ments to the contrary. Venture capital partnership agreements frequently specify that new venture investors be involved in situations where venture capitalists may be tempted to price investments at too high a valuation. An example is when a venture fund makes a later-round investment in a company already held by the venture capitalist's earlier fund (1992 Terms and Conditions of Venture Capital Partnerships (1992)). The venture

capitalist may be tempted to undertake a follow-on financing at a high valuation. This is because the value of the first fund's investment can then be written up in the hopes of impressing potential investors in a third fund. (The potential investors will find it difficult to assess the value of the privately held firm.) The investors in the second fund demand a co-investment by another venture capitalist who does not stand to benefit from the write-up of current holdings because they expect that this investor will demand a lower valuation.




established venture capitalists to obtain information in order to decide whether to invest in risky firms. When established funds join as new investors in later rounds, the firm's valuation has often increased sharply prior to the investment. This pattern supports suggestions of "window dressing" in the syndication of later-round investments. I also present evidence consistent with Admati and Pfleiderer's constant equity share hypothesis.

Results of this study of syndication in one particular environment may be more broadly applicable. We see many of these behaviors in public security issuances. For instance, decisions regarding IPOs of firms specializing in complex technologies are often taken in consultation with co-lead investment bankers. Decision-sharing is an important motivation in many of these co-managed offerings. (See, for instance, the description of Microsoft's IPO in Wallace and Erickson (1992).)

This analysis does not exhaust the important questions concerning syndication. One issue that I have acknowledged but not addressed is how reputation affects the risk aversion

of venture capitalists and their consequent willingness to

syndicate. For instance, more established venture

organizations may be willing to accept lower returns as long as the variance is lower. They may thus participate in many syndicated deals.

A second research question, suggested by the industrial

organization literature, is the response to entrants. The 1980s saw the entry of many new firms into venture capital, just as in the leveraged buy-out business. While a few entrants

participated in many syndicated first-round transactions, many more were relegated to later-round syndications. The

process through which some of the entrants joined the core of established venture organizations remains unclear. Nor is it clear whether the syndication of later-round investments

by established venture capitalists helped establish the stature of the new organizations. (One of the empirical examinations of entry in the finance literature is Beatty and Ritter (1986).) Thus, several aspects of the syndication of both public and

private securities would reward further scrutiny. M

References Admati, A.R. and P. Pfleiderer, 1994, "Robust Financial Contracting and

the Role of Venture Capitalists," Journal of Finance (June), 371-402.

Barry, C.B., C.J. Muscarella, J.W. Peavy III, and M.R. Vetsuypens, 1990, "The Role of Venture Capital in the Creation of Public Companies: Evidence from the Going Public Process," Journal of Financial Economics (October), 447-471.

Beatty, R.P. and J.R. Ritter, 1986, "Investment Banking, Reputation, and the Underpricing of Initial Public Offerings," Journal of Financial Economics (January/February), 213-232.

Blumenthal, H.S., 1993, Going Public and the Public Corporation, New York, Clark Boardman Callaghan.

Brennan, M.J. and A. Kraus, 1987, " Efficient Financing Under Asymmetric Information," Journal of Finance (December), 1225-1243.

Clay, L., 1987 and earlier years, The Venture Capital Report Guide to Venture Capital in the U.K., Bristol, U.K, Venture Capital Report.

Corporate Finance Sourcebook, 1991 and earlier years, Wilmette, IL, National Register Publishing Co.

Galston, A., 1925, Security Syndicate Operations: Organization, Management and Accounting, New York, Roland Press.

Gompers, P.A., 1993a, "Grandstanding in the Venture Capital Industry," University of Chicago Working Paper.

Gompers, P.A., 1993b, "The Structure of Venture Capital Investment," University of Chicago Working Paper.

Gompers, P.A. and J. Lerner, 1994, "The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements," University of Chicago and Harvard University Working Paper.

Guide to European Venture Capital Sources, 1988 and earlier years, London, Venture Economics, Ltd.

Hayes, S.L., A.M. Spence, and D. Van Praag Marks, 1983, Competition in thelnvestment Banking Industry, Cambridge, MA, Harvard University Press.

Kunze, R.J., 1990, Nothing Ventured: The Perils and Payoffs of the Great American Venture Capital Game, New York, HarperCollins.

Lakonishok, J., A. Shleifer, R. Thaler, and R. Vishny, 1991, "Window Dressing by Pension Fund Managers," American Economic Review: Papers and Proceedings (May), 227-231.

Lakonishok, J., A. Shleifer, and R. Vishny, 1992, "The Structure and Performance of the Tax-Exempt Money Management Industry," Brookings Papers on Economic Activity: Microeconomics, 331-391.

Lerner, J., 1994a, "Venture Capitalists and the Oversight of Private Firms," Journal of Finance (forthcoming).

Lerner, J., 1994b, "Venture Capitalists and the Decision to Go Public," Journal of Financial Economics (June), 293-316.

1992 Terms and Conditions of Venture Capital Partnerships, 1992, Boston, Venture Economics.

Pence, C.C., 1982, How Venture Capitalists Make Investment Decisions, Ann Arbor, MI, UMI Research Press.

Perez, R.C., 1986, Inside Venture Capital: Past, Present, and Future, New York, Praeger.

Pratt's Guide to Venture Capital Sources, 1991 and earlier years, Boston, Venture Economics.




Sah, R.K., and J.E. Stiglitz, 1986, "The Architecture of Economic Systems: Hierarchies and Polyarchies," American Economic Review (September), 716-727.

Sahlman, W.A., 1990, "The Structure and Governance of Venture Capital Organizations," Journal of Financial Economics (October), 473-521.

Sirri, E.R., and P. Tufano, 1992, "Competition in the Mutual Fund Industry," Harvard University Working Paper.

"Stock Distributions-Fact, Opinion and Comment," 1987, Venture Capital Journal (August), 8-14.

Valuation Histories for Private Biotechnology Companies, 1992, San Francisco, Recombinant Capital.

Valuation Histories for Public and Acquired Biotechnology Companies, 1993, San Francisco, Recombinant Capital.

Wallace, J. and J. Erickson, 1992, Hard Drive: Bill Gates and the Making of the Microsoft Empire, New York, John Wiley & Sons.

Welch, I., 1992, "Sequential Sales, Learning, and Cascades," Journal of Finance (June), 695-732.

Wilson, R., 1968, "The Theory of Syndicates," Econometrica (January), 119-132.



venture capital special issue || the syndication of venture capital investments

Documents