Richard Brown and Dr. James C. Brau, Business Management
Venture capital funding of young and high-risk companies is a topic of great interest to both finance practitioners and researchers. A venture capitalist gives funds to privately held companies in hopes of earning a high return on the investment. Venture capitalists also provide more than money: they are viewed as sources of expert advice, both in the industry that the new firm is in, and in the various stages of developing a company. In return for their services, venture capitalists receive equity positions in the monitored firm that potentially offer enormous monetary rewards.
Venture capital is an intriguing matter for empirical research for several reasons. Informational asymmetry is high in the entrepreneur-venture capital relationship, and uncertainty and potential rewards are enormous for the venture capitalist. These factors are even more prominent in a small business setting.
Researchers have pointed out several benefits that venture capitalists may confer on a firm they chose to fund. Venture capitalists may play a certification role in the marketplace, minimizing informational asymmetry (Megginson, 1991). Also, the monitoring and funding they offer should increase the firm’s performance. However, others point to factors that suggest that venture capital backed firms should not fare better than non-venture capital backed firms, as venture capitalists suffer from an adverse selection problem. The high cost of venture capital funds drives away the most skilled entrepreneurs who can obtain less expensive financing from other sources, leaving venture capitalists with only lemon entrepreneurs.
The purpose of this study was to determine if venture capitalists add value to the going public process for small businesses. We analyzed only small manufacturing firms (less than 500 employees), avoiding the recent market fad of dotcom firms whose sole business purpose was to go public. IPOs occurring between 1990 and 1996 were studied, allowing for a three-year cumulative return to be computed. We examined underpricing, three-year sales growth, and three-year cumulative returns between VC and non-VC backed IPO’s. Control variables included size of the firm, flotation size, market to book equity ratio to control for growth opportunities, high-tech dummy variable to control for high-tech effects, and the Carter- Manaster underwriter measure to control for underwriter effects. The general model estimated is:
Success variable = á i + â VCi + ã Ci + å I
where success variable in Model 1 is underpricing, in Model 2 is three-year sales growth, and in
Model 3 is three-year stock return;
i represents an individual IPO firm;
á is the intercept of the model;
â is the coefficient on VC, a variable that equals one when an IPO is VC backed and zero
otherwise;
ã is a vector of coefficients;
C is a vector of control variables; and
å is a random error term.
In all models, the coefficient for the VC backed indicator is statistically equal to zero. We conclude that there is no meaningful difference between the underpricing, three-year sales growth, and three-year stock returns between VC and non-VC backed IPOs.
Having determined that the presence of venture capital is not a critical factor in the performance of the firms we observed, the study was expanded to determine if performance differences could be explained by differing degrees of venture capital involvement, as the amount of venture capital involvement varied considerably from firm to firm. Various measures of venture capital presence were constructed, such as number of rounds of funding and time between funding rounds. Using models similar to those used to test venture capital versus non-venture capital backed IPOs, we were again unable to detect any significant differences in underpricing, sales growth, or stock returns based on the amount of venture capital involvement.
One area of difference venture capital backed IPOs and non-venture capital backed IPOs is the rate at which the firms delist. In our sample, 16 out of 133 non-venture capital backed firms stopped trading. Nine of the delistings were due to a violation of exchange rules. Ten out of 126 venture capital backed delisted, with only four delisting for inability meeting exchange requirements. The difference in means is not statistically significant, but the cause of the delistings suggests that venture capital backed firms have some advantages in survivorship.
While the results of the study do not support the hypothesis that venture capitalists add value to the going public process for small firms, we do not have conclusive evidence of an adverse selection problem. Non-venture capital backed firms do not outperform venture capital backed firms using any of the measures in the empirical analysis.
Furthermore, this paper does not comment on the value that venture capitalists may provide in simply bringing a company public. A venture capital backed firm may have a greater chance of going public than a non venture capital backed firm. A linear probability model with IPO as the dependent variable could capture such a relationship. This question is a logical starting point for further research in venture capital funding.
References
- Megginson, William L. and Kathleen A. Weiss. (1991) “Venture Capitalist Certification in Initial Public Offers,” Journal of Finance 46 (3), 879-903.