Money chasing hot industries? Investor attention and valuation of venture capital backed firms

This study analyzes how investor attention to industries affects firm valuations in the venture capital market. Relying on aggregate search frequency in Baidu, we construct a direct measure of investor attention to industries (ASVI). Our results show that an increase in ASVI predicts higher firm valuations. We prove that the price increase is an attention-induced result rather than an information-based fundamental premium, which is due to the evidence of a long-run reversal of firm valuations and worse performance of VC investments. Our findings continue to hold across a wide range of robustness checks, including sample selection, endogeneity, alternative measures of ASVI. We also find that syndicated investments and involvement of experienced venture capitalists attenuate the effect of ASVI on firm valuations, further supporting the attention-induced view.     

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.     

Venture capital investment cycles: The impact of public markets

It is well documented that the venture capital industry is highly volatile and that much of this volatility is associated with shifting valuations and activity in public equity markets. This paper examines how changes in public market signals affected venture capital investing between 1975 and 1998. We find that venture capitalists with the most industry experience increase their investments the most when public market signals become more favorable. Their reaction to an increase is greater than the reaction of venture capital organizations with relatively little industry experience and those with considerable experience but in other industries. The increase in investment rates does not affect the success of these transactions adversely to a significant extent. These findings are consistent with the view that venture capitalists rationally respond to attractive investment opportunities signaled by public market shifts.     

Venture Capital Backing and Overvaluation: Evidence from the High‐Tech Bubble

We investigate the association between venture capital (VC) backing and the likelihood of firm overvaluation in the high‐tech bubble period. We find strong evidence that a VC‐backed firm is more likely than a non‐VC‐backed firm to be overvalued during the bubble period. A further investigation suggests that such an association exists only for VC‐backed firms that have gone public recently and VC‐backed firms over which venture capitalists (VCs) have high ownership or control. But outside the bubble period, all the differences in overvaluation between VC‐backed and non‐VC‐backed firms disappear. Our findings provide additional evidence supporting VC opportunism in boom periods.     

Venture capital funds: Flow-performance relationship and performance persistence

This paper finds that venture capital funds that are expected to be backed by more skilled investors show no performance persistence but a significant flow-performance relationship. In contrast, funds that are expected to be backed by less skilled investors show performance predictability and have a non-significant flow-performance relationship. These results suggest that only skilled investors use all available information to adjust their capital allocation and, as a result, eliminate performance predictability as argued theoretically by Berk and Green (2004). Results also show that Kaplan and Schoar (2005) overstate the persistence in fund performance by not using an ex ante measure of the performance of earlier funds. Whether or not an ex ante measure is used, however, the persistence is largely due to unsophisticated investors. When investors are sophisticated, the performance of earlier funds, sequence and fund size do not help predict the performance of the focal fund.     

The potential for expropriation through joint ventures

We examine the potential expropriation of a firm's intellectual capital that results from joint venture agreements when a firm's joint venture partner becomes the target of an acquisition attempt. We find that: (1) non-targeted joint venture partners often suffer losses in value upon the announcement of the acquisition; (2) the magnitude of the loss increases with the R&D intensity of the non-targeted joint venture partner; and (3) average bidder returns are less negative for acquirers if the affected joint venture partners report R&D spending and are in the same line of business as the acquirer. Our estimate of the average loss is $843 million per firm, roughly 3% of the non-targeted firm's pre-announcement equity value. Our evidence suggests a previously unrecognized merger motive in that joint ventures expose a firm's intellectual capital to the risk of expropriation.     

Syndication in Venture Capital Financing

We examine syndication in venture capital (VC) investments between 1980 and 2005. We argue that VC firms syndicate investments to mitigate human capital and financial constraints within individual VC firms and to reduce uncertainty about firm value. Our results are consistent with those arguments. We find that syndication is more likely for firms in the earliest stage of development and firms in the last stage of development as private firms (when human capital investments are greatest), for firms requiring the largest amounts of financial capital, and for firms with greater growth opportunities (those that are most difficult to value).     

Entrepreneurial finance: Banks versus venture capital

We analyze how entrepreneurial firms choose between two funding institution: banks, which monitor less intensively and face liquidity demands from their own investors, and venture capitalists, who can monitor more intensively but face a higher cost of capital because of the liquidity constraints that they impose on their own investors. Because the firm's manager prefers continuing the firm over liquidating it and aggressive (risky) continuation strategies over conservative (safe) continuation strategies, the institution must monitor the firm and exercise some control over its decisions. Bank finance takes the form of debt, whereas venture capital finance often resembles convertible debt. Venture capital finance is optimal only when the aggressive continuation strategy is not too profitable, ex ante; the uncertainty associated with the risky continuation strategy (strategic uncertainty) is high; and the firm's cash flow distribution is highly risky and positively skewed, with low probability of success, low liquidation value, and high returns if successful. A decrease in venture capitalists’ cost of capital encourages firms to switch from safe strategies and bank finance to riskier strategies and venture capital finance, increasing the average risk of firms in the economy.     

Legality and venture capital exits

This paper introduces an analysis of the impact of Legality on the exiting of venture capital investments. We consider a sample of 468 venture-backed companies from 12 Asia-Pacific countries, and these countries' venture capitalists' investments in US-based entrepreneurial firms. The data indicate IPOs are more likely in countries with a higher Legality index. This core result is robust to controls for country-specific stock market capitalization, MSCI market conditions, venture capitalist fund manager skill and fund characteristics, and entrepreneurial firm and transaction characteristics. Although Black and Gilson (1998) [Black, B.S., Gilson, R.J., 1998. Venture capital and the structure of capital markets: banks versus stock markets. Journal of Financial Economics 47, 243–77] speculate on a central connection between active stock markets and active venture capital markets, our data in fact indicate the quality of a country's legal system is much more directly connected to facilitating VC-backed IPO exits than the size of a country's stock market. The data indicate Legality is a central mechanism which mitigates agency problems between outside shareholders and entrepreneurs, thereby fostering the mutual development of IPO markets and venture capital markets.     

Predicting success in entrepreneurial finance research

We study the relationship between buyout and venture capital (VC) funds’ returns, and more typically available proxies—exits via M&A or IPO. We further explore the effects of filters on the selection of M&As and IPOs (to emphasize successes), on the relationship. We show that some of these filters can reduce the count of exits by as much as 80% without significantly improving the correlation between exits and fund returns. We also show that for venture capital funds, counting acquisitions that are at least twice the amount of funding raised results in the best correlation between exits via an acquisition and fund returns. Finally, when the sample comprises young startups – that are perhaps not yet ready for any form of exit – follow-on funding, employment, website ranking, and patent activity can be used as proxies for exits in place of IPOs or acquisitions.     

The causes and consequences of venture capital stage financing

This paper examines the causes and consequences of venture capital (VC) stage financing. Using information about the physical location of an entrepreneurial firm and the geographic distance between the VC investor and the firm, I show that VC investors located farther away from an entrepreneurial firm tend to finance the firm using a larger number of financing rounds, shorter durations between successive rounds, and investing a smaller amount in each round. However, VC investors' propensity to stage is independent of whether the firm is located in a close-knit community. I also find that VC staging positively affects the entrepreneurial firm's propensity to go public, operating performance in the initial public offering (IPO) year, and post-IPO survival rate, but only if the firm is located far away from the VC investor. However, the effect of VC staging on entrepreneurial firm's performance is independent of whether it is located in a close-knit community. The findings are robust to a variety of alternative proximity measures, instrumental variables, and econometric approaches for dealing with endogeneity problems.     

Staged venture capital contracting with ratchets and liquidation rights

This paper uses real options analysis to study later round financing in the presence of two standard venture capital contracting provisions: anti-dilution (ratchet) and liquidation preference. We argue that such provisions can preclude financing of a positive NPV venture in the case of a large follow-on financing relative to firm value. Liquidation preference contracting at multiples greater than one is not feasible in the later round if the financing is small relative to firm value. We highlight an interaction effect between the two provisions: increasing the liquidation multiple can help to avoid dilution and the need for the prior venture capitalist to waive ratchet provisions.     

What drives the valuation premium in IPOs versus acquisitions? An empirical analysis

Using a hand-collected data set of private firm acquisitions and IPOs, this paper develops the first empirical analysis in the literature of the “IPO valuation premium puzzle,” which refers to a situation where many private firms choose to be acquired rather than to go public at higher valuations. We also test several new hypotheses regarding a private firm's choice between IPOs and acquisitions. Our analysis of private firm valuations in IPOs and acquisitions indicates that IPO valuation premia disappear for larger VC backed firms after controlling for various observable factors affecting a firm's propensity to choose IPOs over acquisitions. Further, after controlling for the long-run component of the expected payoff to firm insiders from an IPO exit, we find that the IPO valuation premium vanishes even for larger non-VC backed firms and shrinks substantially for smaller firms as well. Our Heckman-style treatment effects regression analysis demonstrates that the above results are robust to controlling for the selection of exit mechanism by firm insiders based on unobservables. Our findings on private firms' choice between IPOs and acquisitions can be summarized as follows. First, firms operating in industries characterized by the absence of a dominant market player (and therefore more viable against product market competition) are more likely to go public rather than to be acquired. Second, more capital intensive firms, those operating in industries characterized by greater private benefits of control, and those which are harder to value by IPO market investors are more likely to go public rather than to be acquired. Third, the likelihood of an IPO over an acquisition is greater for venture backed firms and those characterized by higher pre-exit sales growth.     

On the relationship between concentration of prospect theory/mental accounting investors,cointegration, and momentum

We examine the role of cointegration between stock prices and their estimated fundamental values in return momentum. We find that the positive relationship between capital gains overhang and future stock returns in Grinblatt and Han (2005) is significantly stronger among the “non-cointegrated” group of stocks as compared with the “cointegrated” group of stocks. Further, for the cointegrated stocks, the slower the speed of adjustment to the cointegrating equilibrium, the greater (smaller) is the future return of stocks with unrealized capital gains (losses). These findings are robust to various firm characteristics including firm size, book-to-market ratio, past returns, idiosyncratic volatility, dispersion in analysts’ earnings forecasts, turnover, individual investor ownership, and industry returns.     

Do venture capitalists imitate portfolio size?

Venture capitalists face the challenge of determining how many entrepreneurial ventures they should invest in. Kanniainen and Keuschnigg (J Corp Finance 9:521–534, 2003) develop a theoretical model based on economic factors that shows how a venture capital fund should set its portfolio size in order to achieve optimal returns. Determining the required economic inputs to this model is difficult in practice however, given the informational asymmetries, uncertainties and ambiguities present in the decision-making environment of venture capitalists. Hence, we contend that general partners of venture capital funds also use their prior venture capital fund management experience, which we refer to as social capital, to overcome the difficulties they face in solving the above optimization problem. Our results support our hypotheses that portfolio size is explained by the interplay of economic and social factors.      

VC Fund Financial Performance: The Relative Importance of IPO and M&A Exits and Exercise of Abandonment Options

By combining data from two sources, we are able to examine how fund financial performance is related to fund outcomes (initial public offering [IPO] and merger & acquisition (M&A) percentages) and abandonment practices. We also are able to relate fund performance to the track record of the venture capital firm. Our primary findings include: 1) fund IPO and M&A outcomes are statistically significantly related to financial performance, 2) M&A success is around 60% to 80% as important as IPO success in explaining performance, 3) except among the top performers, funds with aggressive exercise of abandonment options outperform those that continue to support a large percentage of their initial investments, and 4) prior performance of the firm, in terms of success percentages and abandonment practices, is significantly related to fund performance. Results are robust to controlling for selection bias of the reporting entities, as well as biases related to looking back at the performance of earlier funds survivorship, and attrition. Quantile regression estimates establish that our results hold across the full range of realized performance levels.     

Information asymmetry,information dissemination and the effect of regulation FD on the cost of capital

This paper considers the impact of Regulation Fair Disclosure (FD) on firms’ information environments and costs of capital. For NYSE/Amex firms we find little evidence of a change in the cost of capital attributable to Regulation FD. For Nasdaq firms we find that Regulation FD increased firms’ costs of capital by 10–19 basis points per annum though the statistical significance of this change is modest for some of our models. We also show substantial cross-sectional variation in the cost of capital changes. We find that cost of capital changes were negatively related to both pre-regulation firm size and PIN. In addition to the findings regarding Regulation FD, this research contributes to a growing literature that documents links between firms’ information environments and their costs of capital.     

Size and performance of Chinese mutual funds: The role of economy of scale and liquidity

Using a detailed stockholding for a comprehensive sample of Chinese open-end equity mutual funds from 2004 to the first half of 2010, we investigated the effect of economy of scale and liquidity on the relationship between fund size and performance. We find that an inverted U-shape relationship exists between fund size and performance as measured by various performance benchmarks. Both economy of scale and liquidity play important roles in Chinese mutual funds. Furthermore, their combined effect explains the inverted U-shape relationship of size and performance reasonably well.     

Are small firms less vulnerable to overpriced stock offers?

We show an inverted-U relation between targetiveness (probability of being targeted) and firm size. However, this pattern describes stock offers and is more pronounced during hot markets characterized by higher stock valuations. For cash offers we find a negative and monotonic relation. These contrasting patterns suggest that small firms (in the bottom NYSE size quartile) are less vulnerable to overpriced stock offers. In addition, we find that the stock acquirers of small targets are less overvalued than those of large targets, and that the announcement returns are less negative for stock acquirers of small targets than for those of large targets.     

The Roles of Performance Measures and Monitoring in Annual Governance Decisions in Entrepreneurial Firms

This paper analyzes annual corporate governance decisions at firms making initial public offerings (IPOs) of common stock between 1996 and 1999. Our objective is to examine relations between firms' corporate governance decisions and the informativeness of available measures of managerial performance. We consider financial measures such as earnings and stock return, as well as direct monitoring. We collect a sample of IPO firms from the manufacturing, Internet, and technology (non-Internet) industries, and examine how the use of various performance measures in annual compensation grants and turnover decisions varies with the information environment of the firm and with the extent of venture capital influence. Consistent with prior research that finds earnings are of limited usefulness in firm valuation for Internet firms, we find Internet firms place less importance on earnings and greater importance on stock returns in determining compensation grants than do non-Internet firms. We also find that compensation grants of firms with little or no venture capital influence display significantly stronger association with accounting and stock performance measures than those of firms with more intense monitoring by venture capitalists. This result is consistent with direct monitoring and the use of explicit performance measures acting as substitute governance mechanisms.