Convertible Securities and Venture Capital Finance

This paper offers a new explanation for the prevalent use of convertible securities in venture capital finance. Convertible securities can be used to endogenously allocate cash‐flow rights as a function of the state of the world and the entrepreneur's effort. This property can be used to induce the entrepreneur and the venture capitalist to invest efficiently into the project. The result is robust to renegotiation and to changes in the timing of investments and information flows. The model is consistent with the observations that conversion is often automatic and that convertible securities are rarely used by outside investors.     

FINANCIAL CONTRACTING BETWEEN MANAGERS AND VENTURE CAPITALISTS: THE ROLE OF VALUE‐ADDED SERVICES,REPUTATION SEEKING,AND BARGAINING POWER

I analyze manager and venture capitalist bargaining over the financial contract in the face of double‐sided moral hazard problems. The allocation of cash flows depends on the combined effects of value‐added services, reputation seeking, and bargaining power. Welfare is maximized when the venture capitalist has high value‐adding capabilities, the market for reputation is informationally efficient, and the manager has bargaining power. Furthermore, I consider the effect of exit strategies on the financial agreement. I also consider bidding between venture capitalists of differing abilities. Generally, the superior venture capitalist wins with a lower bid, but in some cases the inferior venture capitalist can win.     

Investor protection and convertible debt design

An important issue that firms consider when designing convertible debt is to specify security features such as conversion ratio, maturity date and call period. Following Lewis et al. [Lewis, M., Rogalski, R., Seward, J., 2003. Industry conditions, growth opportunities and market reactions to convertible debt financing decisions. Journal of Banking and Finance 27, 153–181], we employ a single measure that simultaneously considers all of these features: the expected probability (measured at issue date) that the convertible will be converted to equity at maturity. We find that firms in countries with stronger shareholder rights issue convertible debt with a higher expected probability of converting to equity. The positive association between the expected probability of conversion and shareholder rights is less pronounced in firms for which ownership structures create potentially high managerial agency costs. Specifically, in countries with stronger shareholder rights, firms with higher separation of control rights and cash flow rights tend to issue convertibles with lower probability of conversion. Furthermore, we find that large non-management block ownership strengthens the likelihood of issuing convertible debt with higher probability of conversion in countries with stronger shareholder rights. In contrast, firms in countries with stronger creditor rights issue convertibles with lower probability of conversion. We also document that the negative association between creditor rights and probability of conversion is more pronounced in firms with higher separation of control rights and cash flow rights.     

Liquidity Risk and Venture Capital Finance

This article provides theory and evidence in support of the proposition that venture capitalists adjust their investment decisions according to liquidity conditions on IPO exit markets. We refer to technological risk as a choice variable in terms of the characteristics of the entrepreneurial firm in which the venture capitalist invests, and liquidity risk as the current and expected future external exit market conditions. We show that in times of expected illiquidity of exit markets (high liquidity risk), venture capitalists invest proportionately more in new high-tech and early-stage projects (high technology risk) in order to postpone exit requirements. When exit markets are liquid, venture capitalists rush to exit by investing more in later-stage projects. We further provide complementary evidence that shows that conditions of low liquidity risk give rise to less syndication. Our theory and supporting empirical results facilitate a unifying theme that links related research on illiquidity in private equity.     

我国风险投资退出方式的选择

风险投资在现代经济中具有举足轻重的作用,选择合适的方式退出是风险投资成功的关键。本文结合目前我国风险资本的退出现状,分析中国风险投资退出的主要障碍在于相关法律法规不健全、中介服务不成熟、风险企业在国内主板上市难度大,指出了在我国目前的国情下,可供选择的风险投资退出方式有收购与兼并、买壳或借壳上市、境外二板上市或国内中小企业板上市、股份回购、通过区域性产权交易市场退出等。     

Renegotiation of cash flow rights in the sale of VC-backed firms

Incomplete contracting theory suggests that venture capitalist (VC) cash flow rights, including liquidation preferences, could be subject to renegotiation. Using a hand-collected data set of sales of Silicon Valley firms, we find common shareholders do sometimes receive payment before VCs’ liquidation preferences are satisfied. However, such deviations from VCs' cash flow rights tend to be small. We also find that renegotiation is more likely when governance arrangements, including the firm's choice of corporate law, give common shareholders more power to impede the sale. Our study provides support for incomplete contracting theory, improves understanding of VC exits, and suggests that choice of corporate law matters in private firms.     

IPOs,trade sales and liquidations: Modelling venture capital exits using survival analysis

This paper examines the dynamics of exit options for US venture capital funds. Using a sample of more than 20,000 investment rounds, we analyze the time to ‘IPO’, ‘trade sale’ and ‘liquidation’ for 6000 VC-backed firms. We model these exit times using competing risks models, which allow for a joint analysis of exit type and exit timing. The hazard rate for IPOs are clearly non-monotonic with respect to time. As time flows, VC-backed firms first exhibit an increased likelihood of exiting to an IPO. However, after having reached a plateau, non-exited investments have fewer possibilities of IPO exits as time increases. This sharply contrasts with trade sale exits, where the hazard rate is less time-varying. We further provide evidence on the impact of economic factors such as syndicate size and composition, geographical location and VC value adding, on exit outcomes.     

Financing decisions: The case of convertible bonds

Research studying firms' motivations to issue convertible bonds remains far from complete. This paper aims to provide further understanding of firms' motives behind issuing convertible bonds. We propose a theoretical model that explains issuers' choice between convertibles and equity when raising a required amount of capital by comparing the cash flow streams of both alternatives in order to maximize the firm's value for the current shareholders. We derive a closed form solution of our theoretical model both in absence and presence of default risk. Our model suggests that issuing convertible bonds is preferred to a direct stock issuance if the expected return of convertible bonds is lower than the expected return of common stocks. Empirical findings confirm our theoretical predictions.     

Why do firms issue private equity repeatedly? On the motives and information content of multiple PIPE offerings

This study examines why private equity issues tend to be a repeated source of financing for public firms. We test the recent operational needs theory of public equity issuance within the context of repeated private equity issues. We find that repeated PIPE issuers burn through cash quickly and do not reach the standards of information transparency or profitability needed for a successful public equity offering. This has implications for investor composition and the market response to a PIPE. Initial PIPE offerings are characterized by substantial diversity in investor type. In successive transactions firms increasingly rely upon hedge funds, who extract greater price discounts and more often require cash flow rights as opposed to control rights. As firms select a path of repeated PIPEs to raise funds, successive issues become uninformative to the market. We conclude that, for small public firms, the same motive underlies public equity offerings and repeated private equity offerings—an acute need for cash.     

Should I stay,or should I go? – How fund dynamics influence venture capital exit decisions

We investigate the determinants of venture capital (VC) exit behavior after the lockup expiry in initial public offerings (IPOs) by considering insights from prospect theory and behavioral finance for the first time. Hereby, the paper concentrates on the under-researched relationship between fund managers and the limited partners investing in these funds. The results from a proprietary dataset of 292 U.S. VC-backed IPOs from 1991 to 2008 imply that VC firm characteristics and fund dynamics have a significant influence on the exit extent after the lockup expiry and may not always be in line with limited partners' interests, hinting at the relevance of behavior grounded in prospect theory. In particular, first-time funds keep their shares longer after an IPO, whereas funds satisfied with current fund performance cash out soon after the end of the lockup period.     

Stock reaction to dividend savings of convertible preferred calls: Free cash flow or price pressure effects?

Calls of in-the-money convertible preferred stock typically induce dividend savings for the firm, since preferred dividends exceed common stock dividends. Prior research finds that these savings are negatively related to stock returns at call announcement and argues that the market expects managers to abuse the increased free cash flow. This paper finds that dividend savings are closely related to call size, suggesting other explanations. Larger calls experience a more negative announcement reaction. Consistent with temporary liquidity effects, there is a price reversal during the conversion period, which is greater for larger calls.     

Share repurchases of initial public offerings: motives,valuation effects,and the impact of market regulation

This study investigates the motives and valuation effects of share repurchase announcements of German firms during the 1998–2008 period, addressing the question why initial public offering (IPO) firms repurchase shares soon after going public. While our focus is on IPO firms, we also examine the impact of firm size by differentiating between IPO and established DAX/MDAX firms and by analyzing the source of surplus cash holdings, that is, either from equity issuances or from operating cash flows. We further explore the impact of the regulatory environment. Our empirical analysis reveals significant differences between the IPO and DAX/MDAX subsamples regarding their repurchase motives, stock price performance, and explanatory factors. Standard corporate payout theories are essential in explaining the different valuation effects. Our empirical analysis suggests agency costs of free cash flow as the main reason for the observed valuation effects of both IPO and DAX/MDAX firms, yet for different reasons. While DAX/MDAX firms continuously generate high operating cash flows before and after repurchasing shares, IPO firms exhibit low operating cash flows during the entire period but large surplus cash holdings due to the mandatory equity issuance at their public offering. Overall, the repurchase decisions of IPO firms are best explained by the agency costs of cash holdings and the unique rules and regulations of the German stock exchange.     

Venture capital funds and the public equity market

This paper considers the relationship between the public equity market and the returns to venture investing using a dataset which is derived from the records of two large limited partners who have been investing in venture capital for almost 30 years. Evidence is found to suggest that market conditions over the investment cycle, and exit conditions at the time of exit in particular, are an important determinant. This paper also investigates whether any other aspects of the venture investment process respond to events in the broader market. While general trends are evident in the venture investment cycle, only the intensity of the investment process is found to respond to events in the public equity market.     

Convertible securities in merger transactions

This paper provides a rationale for the use of convertible securities as the medium of exchange in corporate change-of-control transactions. We argue that convertible securities can resolve the information asymmetry about the bidder’s value while at the same time mitigating the information asymmetry about the target’s value. In contrast, deals with cash or stock can only address one information asymmetry or the other but not both. Empirically, we find that a bidder is more likely to offer convertible securities, rather than all cash or all stock, when both the bidder and its target face large asymmetric information problems. We also find that both bidders and targets in convertible deals enjoy positive abnormal stock returns around takeover announcements. These findings provide empirical support for the use of convertible securities to resolve the double-sided asymmetric information problem. Finally, we find that bidder returns in convertible deals are larger than in all-cash and all-stock deals, but that target returns in convertible deals are smaller than in all-cash and all-stock deals.     

Valuation and Control in Venture Finance

This paper presents the model of a relationship between a venture capitalist and an entrepreneur engaged in the formation of a new firm. I assume that the entrepreneur derives private nonpecuniary benefits from having some control over the firm. I show that to separate the entrepreneur's value of control from the firm's expected payoff, the venture capitalist demands disproportionately highercontrol rights than the size of his equity investment. The entrepreneur is compensated for a greater loss of control through better terms of financing, ability to extract higher rents from asymmetric information, and improved risk sharing.     

Convertible bond arbitrage,liquidity externalities,and stock prices

In the context of convertible bond issuance, we examine the impact of arbitrage activity on underlying equity markets. In particular, we use changes in equity short interest following convertible bond issuance to identify convertible bond arbitrage activity and analyze its impact on stock market liquidity and prices for the period 1993 to 2006. There is considerable evidence of arbitrage-induced short selling resulting from issuance. Moreover, we find strong evidence that this activity is systematically related to liquidity improvements in the stock. These results are robust to controlling for the potential endogeneity of arbitrage activity.     

Convertible securities and optimal exit decisions in venture capital finance

We study the interaction between exit decisions and contract design in venture capital finance. One of the main characteristics of venture capital funds is that they need to divest their holdings in the portfolio firms after a limited period of time. However, venture capitalists and entrepreneurs often have diverging interests with respect to different exit solutions (e.g., IPOs or trade sales). We show that with convertible securities, the ex-ante agreed optimal exit policy can be implemented. Thereby, we give an explanation for the widespread use of convertible securities in venture capital finance.     

Agency Problems and the Performance of Venture-backed IPOs in Germany: Exit Strategies,Lock-up Periods,and Bank Ownership

Abstract

The agency problems for initial public offerings are well documented in the literature. The objective of this research is to investigate the potential conflicts of interest for the ‘Neuer Markt’ in Germany. Of special interest are venture-backed IPOs and those in which banks acted as venture capitalist, underwriter, and provided analyst recommendations. High initial returns and outperformance are observed over the first 6 months of trading, which decreases significantly over the subsequent 18 months. The individual performance depends on the VC's underwriter and bank affiliation, exit behaviour, and lock-up commitment. Venture capitalists, and especially banks, timed their exit well. This indicates some serious agency problems in the German IPO market.     

Politician as venture capitalist: Politically-connected VCs and IPO activity in China

This study examines the impact of venture capitalists' (VC) political connections on their portfolio companies. Specifically, we use a manually-collected dataset of VCs' political connection to investigate the potential benefits and costs that politically-connected VCs bring to their portfolio companies. On the benefit side, we find that companies backed by politically-connected VCs are more likely to obtain IPO approval from the Chinese Securities Regulatory Commission (CSRC, China's counterpart to the SEC in the US). On the other hand, these VCs are more likely to acquire equity in the company at a significant discount and to invest shortly before the IPO application. In addition, we find that politically-connected VC-backed companies do not experience greater improvements in financial performance, corporate governance, or innovation output subsequent to receiving venture financing. Our results further show that companies backed by VCs with political connections are less mature and experience more underpricing at their IPO than non-politically-connected VC-backed companies. Finally, we find that, compared to non-politically-connected VCs, politically-connected VCs exit earlier after a company's IPO and that their portfolio companies experience greater post-IPO underperformance and performance volatility.     

The two sides of CEO option grants at the IPO

This paper examines the impact of CEO IPO option grants on IPO underpricing. Contrary to Lowry and Murphy (2007) who do not find a relationship between the two, this paper finds such a relationship when board independence, the power of the CEO and venture capitalists (VCs) are taken into account. The results are threefold. First, powerful CEOs are able to reap substantial gains from IPO options, to the detriment of the shareholders. Second, young, powerful VCs use IPO option grants to bribe the CEO to agree to an early IPO which will leave more of the existing shareholders' money on the table. Finally, IPO options only work as a value-enhancing incentive in the presence of strong boards.