Determinants of the round-to-round returns to pre-IPO venture capital investments in U.S. biotechnology companies

I propose that pre-IPO venture-backed biotech companies offer a useful new setting through which to evaluate the relative merits of theories for why firm size and book-to-market explain variation in stock returns. This is because pre-IPO biotech firms have large and rapidly evolving growth options relative to assets-in-place. Such attributes align closely with the key features of the model by Berk et al. Berk, J.B., Green, R.C., Naik, V., 1999. Optimal investment, growth options, and security returns. Journal of Finance 54 (5), 1553–1607] of the endogenous relations between growth options, optimal investment actions and expected equity returns, where firm size and book-to-market emerge as sufficient statistics for the aggregate risk of a firm's assets-in-place. Using venture capital investments in pre-IPO U.S. biotech companies during 1992–2001, I find that equity returns between financing rounds (‘round-to-round’ returns) are reliably negatively related to firm size and positively related to book-to-market ratios. I interpret these results as being most consistent with the theory of Berk et al., and less consistent with alternative explanations such as financial distress, behaviorally biased investors or data snooping.