Venture Capital and Private Equity Contracting: An International Perspective

edition.

Preface

This book is intended for advanced undergraduate and graduate students in business, economics, law, and management. This book is also directed at practitioners with an interest in the venture capital and private equity industry. We consider a number of different countries in this book. The terms venture capital and private equity may differ in different countries, therefore in this book we generally refer to venture capital as risk capital for small private entrepreneurial firms and private equity as encompassing a broader array of investors, entrepreneurial firms and transactions, including later stage investments, turnaround investments, and buyout transactions.

Financial contracting is the common theme that links the topics covered in this book. This book explains the ways in which these contracts differ across different types of venture capital and private equity funds, different types of institutional investors, different entrepreneurial firms, and differ across countries and over time. This book will show when and how financial contracts are material to the allocation of risks, incentives, and rewards for investors and investees alike. This book will further show when and how financial contracts have a significant relationship with actual investment outcomes and success.

Why should we care about financial contracting? Venture capital and private equity funds are financial intermediaries between sources of capital and entrepreneurial firms. Sources of capital typically include large institutional investors including pension funds, banks, insurance companies, and endowments. These and other sources of capital do not have the time or expertise to invest directly in entrepreneurial firms, particularly high-growth firms in high-tech industries. As such, specialized venture capital and private equity funds facilitate the investment process, at a price of course. These funds are for all intents and purposes organizations that are established, capitalized, and operated under specific contractual terms and obligations agreed between the investors and the venture capital and private equity funds. Another different type of financial contract governs the relationship between venture capital and private equity funds and their investee entrepreneurial firms, how such firms are capitalized and how they are in turn operated. It is obvious therefore that financial contracting is not something that venture capital and private equity funds do, it is also in essence what they are.

Broadly framed questions addressed in this book include, but are not limited to, the following:

• What covenants and compensation terms are used in limited partnership contracts?

• In what ways are limited partnership contracts related to market conditions and fund manager characteristics, and how do these contracts differ across countries?

• What are the cash flow and control rights that are typically assigned in venture capital and private equity contracts with investee firms, and when do fund managers demand more contractual rights?

• Do different contractual rights assigned to different parties influence the effort provided by the investor(s)?

• In what ways are different financial contracts related to the success of venture capital and private equity investments?

By considering venture capital and private equity contracting in an international setting, this book offers an understanding of why venture capital and private equity markets differ with respect to

• Fund governance

• Investee firm governance

• Investee firm performance

In this book, we provide examples of actual contracts that have been used in practice, including a limited partnership agreement, a term sheet, a shareholder agreement, and a subscription agreement. In addition, we provide datasets of venture capital and private equity that include details on a large number of actual contracts. It is important and relevant to review data to show real investment contracts from actual transactions, and explain how financial contracts are central to actual investment decisions and investment outcomes. Without analyzing data, we would at best be limited to our best guesses, which is not the intention here. The data considered in this book are international in scope, with a focus on Canada, Europe, and the United States. It is important to consider data from a multitude of countries to understand how and why venture capital and private equity markets differ around the world. As well, idiosyncratic features of certain countries may distort our understanding of how venture capital and private equity contracts work in practice.

In short, by considering international datasets, and not data from just one country such as the United States, we are able to gain a significant amount of insight into how venture capital and private equity funds operate in relation to their legal and institutional environment. Each chapter in this book, where possible and appropriate, will refer to and analyze data. Note however that venture capital and private equity funds are not compelled to publicly report data, nor are they willing to do so. As such, there is always more data that can be collected. It is the authors’ hope that this book will not only provide an understanding of how venture capital and private equity funds operate through financial contracts, but also that it will inspire further empirical work in the field so that we may better understand the nature and evolution of venture capital and private equity markets in years to come.

A Brief Note on Organization and Data

Part I of this book comprises three chapters. Chapter 1 briefly refers to aggregate industry statistics on venture capital and private equity markets around the world to compare the size of the markets in different countries. Chapter 2 describes agency problems in venture capital and private equity investment. Chapter 2 is the only chapter that does not consider data. The intention in Chapter 2 is to provide a framework for understanding agency problems. Chapter 3 provides an overview of the empirical methods considered in this book. The description of the statistical and econometric techniques used is intended to be user friendly so that all readers can follow along each of the chapters regardless of background. As well, Chapter 3 provides an overview of the institutional and legal settings in the countries considered in the different chapters. A central theme in this book is that differences in venture capital and private equity markets, including but not limited to contracting practices, are attributable to international differences in legal and institutional settings.

Part II of this book (Chapters 4–9) considers venture capital and private equity fundraising and the structure of limited partnerships (Chapters 4–7), as well as listed private equity (Chapter 8), and public policy toward fundraising and fund structure (Chapter 9). In order to understand the contractual structure of limited partnerships, we do not exclusively focus on contracts themselves, but rather provide a context in which to understand the contracts by providing evidence on motivations underlying institutional investment in venture capital and private equity. We provide some country-specific data (Chapters 4 and 7) from the United States and The Netherlands, as well as data from a multitude of countries (Chapters 4–6, 8, and 9). We start with the perspective of institutional investors in Chapter 4 to understand the motivations underlying the source of capital—institutional investors. Outside the United States, institutional investors have comparatively less experience with venture capital and private equity investment. Chapter 4 examines recent data from institutional investors from The Netherlands to study a market somewhat less developed than that in the United States, but nevertheless with significant commitments to venture capital and private equity funds, commitments to funds both domestic and international, as well as commitments in niche areas such as the socially responsible investment class. Also, regulatory changes to make The Netherlands particularly interesting to study from the perspective of institutional investors. In the United States, many institutional investors have longstanding relationships with venture capital and private equity fund managers that span multiple decades. In Chapter 7, we examine data from the United States pertinent to the issue of style drift, which refers to situations in which fund managers deviate from stated objectives in limited partnership contracts. Chapters 5 and 6 provide a broader perspective with data from venture capital and private equity funds from a multitude of countries (Belgium, Brazil, Canada, Cayman Islands, Finland, Germany, Italy, Luxembourg, Malaysia, Netherland Antilles, The Netherlands, New Zealand, Philippines, South Africa, Switzerland, the United Kingdom, and the United States). This international comparative evidence highlights the role of legal and institutional differences around the world and the impact on fund governance. Likewise, the data introduced in Chapter 8 on listed private equity and Chapter 9 on the role of government and public policy are from a variety of countries.

While Part II focuses on fund structure and governance, the subsequent sections of this book highlight a role of financial contracts with entrepreneurs (Part III), governance provided to investees (Part IV), and the divestment process (Part V).

Part III (Chapters 10–13) covers material pertaining to financial contracting with entrepreneurs. Chapter 10 first summarizes evidence on investment activities in a number of studies from the United States. Chapter 11 considers evidence from financial contracting from United States and Canadian venture capitalists, with a focus on security design. Chapter 12 considers evidence on financial contracting from Europe, and Chapter 13 provides evidence from an even broader set of countries around the world. It is worthwhile to compare evidence on financial contracts from the United States, Canada, and Europe to understand how laws and regulations, among other things, influence the design of financial contracts and venture capital governance more generally.

Part IV (Chapters 14–18) relates financial contracts and other investment mechanisms to the governance provided to the investee firm. Chapter 14 provides a survey of all of the factors that might influence investee governance. Chapter 15 considers the relation between contracts and actual investor effort in terms of advice and monitoring, as well as disagreement between investors and investees. Chapters 16–18 consider noncontractual factors that influence investor effort, particularly the role of geographic proximity (Chapter 16), portfolio size (Chapter 17), and fund size (Chapter 18).

Part V (Chapters 19–22) studies the exit outcomes of venture capital and private equity-backed companies. Because investees typically do not have cash flows to pay interest on debt or dividends on equity, venture capital and private equity investors invest with a view toward capital gain in an exit event. Chapter 19 provides an overview of the exit decision and summarizes evidence on exits from Australasia, Canada, Europe, and the United States. Chapters 20 and 21 show exits are significantly related to the governance of the fund (as considered in Chapters 4–9) and contracts between investors and investees (as considered in Chapters 10–14) and the effort provided (Chapters 15–18). Exit outcomes are considered with reference to extensive data from Canada (Chapter 20) and Europe (Chapter 21). Thereafter, Chapter 22 provides evidence on the financial returns to venture capital investment from 39 countries around the world from North and South America, Europe, Africa, and Australasia. The data indicate financial structures and governance are significantly related to returns. As well, Chapter 22 discusses evidence on reporting biases of the performance of unexited institutional investors for companies that have not yet had an exit event.

Selected chapters in this book are based on previously published material, as summarized below:

Chapter 4:

Cumming, D., and S.A. Johan, 2007. Regulatory Harmonization and the Development of Private Equity Markets Journal of Banking and Finance, 31, 3218–3250.

Cumming, D., and S.A. Johan, 2007. Socially Responsible Institutional Investment in Private Equity Journal of Business Ethics 75, 395–416.

Chapter 5:

Cumming, D., and S.A. Johan, 2006. Is it the Law or the Lawyers? Investment Covenants around the World European Financial Management 12, 553–574.

Chapter 6:

Cumming, D., and S.A. Johan, 2009. Legality and Venture Capital Fund Manager Compensation Venture Capital: An International Journal of Entrepreneurial Finance 11, 23–54.

Chapter 7:

Cumming, D.J., G. Fleming and A. Schwienbacher, 2009. Style Drift in Private Equity Journal of Business Finance and Accounting 36(5–6), 645–678.

Chapter 8:

Cumming, D.J., G. Fleming and S.A. Johan, 2011. Institutional Investment in Listed Private Equity European Financial Management 17(3), 594–618.

Chapter 9:

Cumming, D., 2007. Government Policy Towards Entrepreneurial Finance in Canada: Proposals to Move from Labour Sponsored Venture Capital Corporations to More Effective Public Policy CD Howe Institute Commentary No 247.

Chapter 11:

Cumming, D., 2005. Agency Costs, Institutions, Learning and Taxation in Venture Capital Contracting Journal of Business Venturing 20, 573–622.

Chapter 12:

Cumming, D., and S.A. Johan, 2008. Preplanned Exit Strategies in Venture Capital European Economic Review 52, 1209–1241.

Chapter 13:

Cumming, D.J., D. Schmidt and U. Walz, 2010. Legality and Venture Capital Governance Around the World Journal of Business Venturing 25, 54–72.

Chapter 15:

Cumming, D., and S.A. Johan, 2007. Advice and Monitoring in Venture Capital Finance Financial Markets and Portfolio Management 21, 3–43.

Chapter 16:

Cumming, D.J., and N. Dai, 2010. Local Bias in Venture Capital Journal of Empirical Finance 17, 362–380.

Chapter 17:

Cumming, D., 2006. The Determinants of Venture Capital Portfolio Size: Empirical Evidence Journal of Business 79, 1083–1126.

Chapter 18:

Cumming, D.J., and N. Dai, 2011. Limited Attention, Fund Size and the Valuation of Venture Capital Backed Companies Journal of Empirical Finance 18(1), 2–15.

Chapter 20:

Cumming, D.J., and S.A. Johan, 2010. Venture Capital Investment Duration Journal of Small Business Management 48, 228–257.

Chapter 21:

Cumming, D., 2008. Contracts and Exits in Venture Capital Finance Review of Financial Studies 21, 1947–1982.

Chapter 22:

Cumming, D.J., and U. Walz, 2010. Private Equity Returns and Disclosure Around the World Journal of International Business Studies 41(4), 727–754.

We are indebted to Na Dai, Grant Fleming, Armin Schwienbacher, Daniel Schmidt, and Uwe Walz for the generosity in allowing us to use some of the material upon which Chapters 7, 8, 13, 16, 18, and 22 are based, as that work was developed jointly with these excellent coauthors.

Each chapter of the book has been adapted in a way that begins with a list of learning objectives. As well, each chapter ends with a list of key terms and a number of discussion questions. PowerPoint lecture slides for each chapter and online Appendices 1–4 are available online at http://www.venturecapitalprivateequitycontracting.com/ and http://booksite.elsevier.com/9780124095373/.

Part One

Introduction

Outline

1 Introduction and Overview

2 Overview of Agency Theory, Empirical Methods, and Institutional Contexts

3 Overview of Institutional Contexts and Empirical Methods

1

Introduction and Overview

This chapter provides an overview of the topics covered in the book entitled Venture Capital and Private Equity Contracting: An International Perspective. Broadly framed questions addressed in this book include, but are not limited to, the following: What covenants and compensation terms are used in limited partnership contracts? In what ways are limited partnership contracts related to market conditions and fund manager characteristics, and how do these contracts differ across countries? What are the cash flow and control rights that are typically assigned in venture capital and private equity contracts with investee firms, and when do fund managers demand more contractual rights? Do different contractual rights assigned to different parties influence the effort provided by the investor(s)? In what ways are different financial contracts related to the success of venture capital and private equity investments? By considering venture capital and private equity contracting in an international setting, this book offers an understanding of why venture capital and private equity markets differ with respect to fund governance, investee firm governance, and investee firm performance.

Keywords

Venture capital; private equity; financial contracting

These days it is difficult to not have heard of the terms venture capital and private equity. The venture capital and private equity markets are frequently discussed in popular media and typically referred to as scorching in the popular press, at least in boom times. The market has direct relevance for entrepreneurs who want to raise money, investors who want to make money from financing entrepreneurs, and individuals who want to work for a fund or set up their own fund. Also, venture capital and private equity is of significant interest to the public sector, as government bodies around the world strive to find ways to promote entrepreneurship and entrepreneurial finance. It is widely believed that venture capital and private equity funds facilitate more innovative activities and thereby improve the well being of nations. It is thought of as a critical aspect of national growth in the twenty-first century.

In the next 23 chapters, which are divided into 4 parts, we will provide an analysis of the issues that venture capital and private equity market participants face during the fund-raising process (Part II), investment process (Part III), and divestment process (Part IV). A common theme across all issues involves agency costs, and hence agency theory is reviewed after this introductory chapter in Chapter 2 (Part I). All the issues addressed in this book are analyzed from an empirical law and finance perspective, with a focus on financial contracting. Financial contracts are central to the establishment of the relationship between venture capital and private equity funds and their investors. Financial contracts also govern the relationship between venture capital and private equity funds and their investee entrepreneurial firms, as well as determine the efficacy of the divestment process. In most chapters we refer to datasets to grasp the real-world aspects of the venture capital and private equity process. Further, it is important to consider international evidence to grasp the impact of laws and institutions on the respective venture capital and private equity markets. The empirical methods and legal and institutional settings in this book are overviewed in Chapter 3.

1.1 What is Venture Capital and Private Equity?

At the outset, it is important to discuss what is meant by the terms venture capital and private equity. Venture capital and private equity funds are financial intermediaries between sources of funds (typically institutional investors) and high-growth and high-tech entrepreneurial firms. Funds are typically established as limited partnerships, but as discussed herein, there are other types of funds. A limited partnership is in essence a contract between institutional investors who become limited partners (pension funds, banks, life insurance companies, and endowments who have rights as partners but trade management rights over the fund for limited liability) and the fund manager who is designated the general partner (the partner that takes on the responsibility of the day-to-day operations and management of the fund and assumes total liability in return for negligible buyin). Chapter 5 examines in detail the structure of limited partnerships and limited partnership contracts. The basic intermediation structure of venture capital and private equity funds is graphically summarized in Figure 1.1.

Figure 1.1 Venture capital financial intermediation.

Venture capital funds are typically set up with at least US$50 million in capital committed from institutional investors and often exceed US$100 million. Some of the larger private equity funds raised more than US$10 billion in 2006.¹ Fund managers typically receive compensation in the form of a management fee (often 1–2% of committed capital, depending on the fund size) and a performance fee or carried interest (20% of capital gains). Chapter 6 discusses factors related to fund manager compensation. Venture capital funds invest in start-up entrepreneurial firms that typically require at least US$1 million and up to US$20 million in capital. Private equity funds invest in more established firms, as discussed further below.

Venture capital is often referred to as the money of invention (see, e.g., Black and Gilson, 1998; Gompers and Lerner, 1999, 2001; Kortum and Lerner, 2000) and venture capital fund managers as those that provide value-added resources to entrepreneurial firms. Venture capital fund managers play a significant role in enhancing the value of their entrepreneurial investments as they provide financial, administrative, marketing, and strategic advice to entrepreneurial firms, as well as facilitate a network of support for an entrepreneurial firm with access to accountants, lawyers, investment bankers, and organizations specific to the industry in which the entrepreneurial firm operates (Gompers and Lerner, 1999; Leleux and Surlemount, 2003; Manigart et al., 2002a, b; Sahlman, 1990; Sapienza et al., 1996; Wright and Lockett, 2003). Academic studies have shown us that venture capital-backed entrepreneurial firms are on average significantly more successful than nonventure capital-backed entrepreneurial firms in terms of innovativeness (Kortum and Lerner, 2000), profitability, and share price performance upon going public (Gompers and Lerner, 1999, 2001).

Venture capital and private equity investments carried out by a fund typically last over a period of 2–7 years. A venture capital limited partnership envisages this extended investment horizon and hence is structured over a 10-year horizon (with an option to continue for an additional 3 years) so that the fund manager can select investments over the first few years and then bring those investments to fruition over the remaining life of the fund. Investments are made with a view toward capital gains upon an exit event (a sale transaction), as entrepreneurial firms typically are not able to pay interest on debt or dividends on equity. The terms of the investment often give the venture capital fund significant cash flow rights in the form of equity and priority in the event of liquidation. As well, the venture capital fund typically receives significant veto and control rights over decisions made by the management of the entrepreneurial firm.

The terms venture capital and private equity differ primarily with respect to the stage of development of the entrepreneurial firm in which they invest. Venture capital refers to investments in earlier-stage firms (seed or start-up firms), whereas private equity is a broader term that also encompasses later-stage investments as well as buyouts and turnaround investments. In this book, unless explicitly stated otherwise, for ease of exposition we use the term private equity to encompass all private investment stages including venture capital. The various financing stages are defined as follows.

• Seed

− Financing provided to entrepreneurs to research, assess, and develop an initial concept before a business has reached the start-up phase.

• Start-up

− Financing provided to firms for product development and initial marketing. Firms may be in the process of being set up or may have been in business for a short time but have not sold their product commercially.

• Other early stage

− Financing to firms that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet be generating a profit.

• Expansion

− Financing provided for the growth and expansion of a firm which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital.

• Bridge financing

− Financing made available to a firm in the period of transition from being privately owned to being publicly quoted.

• Secondary purchase/replacement capital

− Purchase of existing shares in a firm from another private equity investment organization or from another shareholder or shareholders.

• Rescue/turnaround

− Financing made available to an existing firm which has experienced trading difficulties (firm is not earning its cost of capital (WACC)), with a view to reestablishing prosperity.

• Refinancing bank debt

− To reduce a firm’s level of gearing.

• Management buyout

− Financing provided to enable current operating management and investors to acquire an existing product line or business.

• Management buyin

− Financing provided to enable a manager or group of managers from outside the firm to buyin to the firm with the support of private equity investors.

• Venture purchase of quoted shares

− Purchase of quoted shares with the purpose of delisting the firm.

• Other purchase of quoted shares

− Purchase of shares on a public stock market.

In practice, sometimes broader categories are used. For example,

• Start-up: sometimes used in practice to refer to start-up and other early stage

• Expansion: sometimes used in practice to refer to expansion, bridge financing, and rescue/turnaround.

• Replacement capital: sometimes used in practice to refer to secondary purchase/replacement capital and refinancing bank debt.

• Buyouts: sometimes used in practice to refer to management buyout, management buyin, and venture purchase of quoted shares.

Precise definitions of terms vary somewhat depending on the norms in a particular country and the specific individuals surveyed. As the chapters in this book make use of data from different countries, we will define and explain the use of terms like these, as well as others, in their specific contexts in each chapter.

Definitions of stages of development in venture capital and private equity are perhaps usefully viewed in the context of a diagram. A common picture used in practice is shown in Figure 1.2. In this figure, venture capital finance is placed in a broader context of other sources of finance. Prior to seeking and obtaining venture capital finance, entrepreneurs who are just starting their venture often obtain capital from friends, family, and "fools (known as the 3 Fs or FFF). The term fools refers to the high risk associated with investment in nascent stage firms and the valley of death depicted in Figure 1.2 where firms require significant capital inflows but show little or no revenues until subsequent years. Professional individual investors known as angel" investors are a common source of capital for entrepreneurs prior to obtaining more formal institutionalized venture capital finance (Wong, 2002). Many angel investors are successful entrepreneurs who have, through their experience, specialized abilities to recognize talent in other entrepreneurs and their new ventures. A classic example is Andy Bechtolsheim who cofounded Sun Microsystems. He gave US$100,000 to the founders of Google, who could not even cash the check as they had not yet established Google as a legal entity. A limitation in the study of the market for angel investment, however, is the lack of systematic data.² This book will not be considering angel investment.

Figure 1.2 Stages of entrepreneurial firm development.

In Figure 1.2, the term mezzanine refers to investment in late-stage firms that are close to an initial public offering (IPO). An IPO is the first time a firm sells its shares for sale in the public market (i.e., lists or floats on a stock exchange). A seasoned equity offering involves additional capital-raising efforts by firms already trading on a stock exchange. The latter part of this book (Chapters 19–23) will consider issues involved with the exit of venture capital investments through IPOs, mergers and acquisitions, and other exit vehicles.

1.2 How Does Venture Capital and Private Equity Differ from Alternative Sources of Capital?

A salient point about raising capital for entrepreneurial firms is that there are many different sources of capital. This book considers venture capital and private equity only. But it is worth mentioning at the outset some general characteristics about this type of financing relative to other sources of financing. Table 1.1 provides a helpful, albeit oversimplified, overview of typical characteristics of alternative fund providers for entrepreneurial firms.³ It shows where venture capital and private equity fit in within the financing spectrum.

Table 1.1

Greatly Oversimplified Typical Characteristics of Funds Providers

The range of sources of capital enumerated in Table 1.1 is broader than that shown in Figure 1.2. Figure 1.2 presented financing sources for start-up firms on a high-growth trajectory. But the variety of sources of capital available to firms is much broader than that indicated in Figure 1.2.

Firms may finance their operations internally from reinvestment of their profits. Alternatively, for firms that do not have internal finance or sufficient internal finance, they must seek external capital. A well-established literature in finance has established a pecking order of firms’ preferences for raising capital. Theoretical and empirical work has shown that firms prefer to finance their growth internally by reinvesting their profits because it is less costly than seeking external finance (Myers and Majluf, 1984; see also Myers, 2000). External capital comes at a cost. The cost of debt finance is the interest payments and the risk of being forced into bankruptcy in the event of nonpayment. The cost of equity finance is the dilution in ownership share associated with the equity sold. Where investors do not provide significant value added to the entrepreneurial firm, equity tends to be a more costly form of finance than debt.⁴ In an empirical study of nonpublicly traded entrepreneurial firms raising external capital, Cosh et al. (2009) find evidence that is highly consistent with this pecking order.

Different sources of external capital for entrepreneurs include banks, venture capital and private equity funds, leasing firms, factoring firms (that buy your accounts receivable or A/R), trade customers and suppliers, partners and working shareholders, angel investors, government agencies, and public stock markets. Cosh et al. (2009) find that firms’ ability to access capital from different sources depends primarily on the degree of information asymmetry faced by the investors and their ability to do due diligence to mitigate such information asymmetry. Information asymmetry refers to the fact that the entrepreneur knows more about the project than the external investor. Information asymmetry is a risk and cost to the external investor, and it explains why a firms’ own profits is a cheaper source of external capital than external debt or equity finance. With internal finance there is no price to pay in terms of compensating a bank or equity investor for carrying out a due diligence review to assess the quality of the firm before investment and for taking on a risk if the investment is carried out. Internal finance also has the advantage that it is nondilutive in that the entrepreneur does not have to give up equity ownership to an external investor.

Apart from the founding entrepreneur’s (or entrepreneurs’) savings, family, friends, and fools (the 3 Fs mentioned earlier) are a common source of capital for the earliest stage entrepreneurial firms. An entrepreneur without a track record typically has an easier time raising this type of capital because these investors will have known the entrepreneur for a long time and possibly for the entrepreneur’s entire life. In other words, information asymmetries faced by the 3 Fs are lower than that faced by other sources of external capital. As mentioned, angel investors do finance early-stage entrepreneurial firms but in general do not have a prior relationship with the entrepreneur. Angel investors typically look for entrepreneurs with their own skin the game (personal wealth invested), as well as that of the 3 Fs, as a way to ensure that the entrepreneur is committed to the venture and to make sure that those who know the entrepreneur believe in his or her abilities.

Venture capital funds tend to finance entrepreneurial firms with significant information asymmetries in terms of not having a lengthy operating history and in high-tech industries with hard-to-value intangible assets. Venture capital funds typically require an equity stake in the firms in which they invest.⁵ Venture capital fund managers are specialized investors with the ability to carry out extensive due diligence of suitable projects in which to invest. One explanation for the very existence of venture capital funds is in fact the pronounced information problems associated with financing high-tech start-up entrepreneurial firms (Amit et al., 1998). As venture capital funds are intermediaries between institutional investors and entrepreneurial firms (Figure 1.1) and there are minimum fund sizes that make the costs of establishing this type of financial intermediary viable, venture capital funds rarely consider projects that require less than US$1 million and almost never consider projects that require less than US$500,000.

There are a variety of sources of external debt capital. Perhaps the most well-known source is the typical commercial banks. Most commercial bank loans require significant collateral and prefer to finance low-risk projects, and bank managers invest with a view solely to ensure the loan is repaid on time and with interest. Riskier projects such as that considered by venture capital funds typically will not receive bank finance. Some banks, however, do have a strategy of making loans to venture capital-backed entrepreneurial firms. Silicon Valley Bank, which is part of SVB Financial Group, is one well-known example of this type of bank. Other specialized merchant banks undertake riskier projects with terms that compensate for the risk taken.

Bridge funds provide quick short-term sources of capital to firms with significant collateral. Leasing companies, factors (firms that buy your A/R), and asset lenders provide terms that are typically less favorable than a typical commercial bank loan but often used by entrepreneurial firms that need to ensure cash flow to continue to pay salaries and other ongoing expenses.

Entrepreneurial firms may receive capital from partner firms (such as major suppliers or customers). Costs and benefits depend on relative bargaining power of the two organizations and the potential for strategic alliances.

Few studies have compared the relative importance of different sources of entrepreneurial capital. Perhaps the most informative data are provided by Cosh et al. (2009), which are based on a sample of 2520 private firms in the United Kingdom for capital-raising decisions in 1996–1997. There were 37.8% (952 of 2520) firms in their data that did seek external finance in the 1996–1997 period. The average amount of external finance sought was £467,667, and the median amount sought was £100,000. The average amount obtained was almost 81% of that which was sought, and the median percentage obtained was 100%. Overall, therefore, the data do not suggest a shortage of external capital for firms that make more than a trivial effort in applying for capital. Table 1.2 reports the number of firms in their data that did seek external finance by the type of source of finance, as well as the percentage of all their external capital obtained from the source. Among the firms that did seek external finance, 775 approached banks, 474 approached leasing firms, 151 approached factoring/invoice discounting firms, 138 approached partners/working shareholders, 87 approached venture capital funds, 83 approached private individuals, 53 approached trade customers/suppliers, and 67 approached other sources. It is of interest that outright rejection rates were highest among venture capital funds (46% rejection) and much higher than that for banks (17% outright rejection). The lowest rejection rate was among leasing firms (5%). Banks comprised the median and mean highest percentage of outside finance in terms of which type of source was approached and which type of source provided the finance. In fact, banks comprised the only type of source for which the median percentage of a firm’s total external capital was greater than 0% (for banks, the median percentage is 34%; see Table 1.2).

Table 1.2

Relative Importance of Specific Sources of External Capital in the UK

Source: Cosh et al. (2009).

The Cosh et al. (2009) data indicate that there is not a substantial capital gap for the majority of firms seeking entrepreneurial finance; rather, firms seeking capital are able to secure their requisite financing from at least one of the many different available sources. There are, however, differences in firms’ ability to obtain finance in the form that they would like. Even after controlling for selection effects, Cosh et al. find that banks are more likely to provide the desired amount of capital to larger firms with more assets. Leasing firms, factor discounting/invoicing firms, trade customers/suppliers, and partners/working shareholders are more likely to provide the desired capital to firms with higher profit margins. Profit margins are not statistically relevant to venture capital funds and private individual investors; smaller firms are more likely to obtain finance from private individuals, whereas young innovative firms seek external capital from venture capital funds.

Apart from private sources of capital, a variety of different types of government support programs exist to enable access to entrepreneurial finance. The nature and scope of programs varies greatly across different countries. Some of the programs related to venture capital are detailed in Chapter 9.

Finally, entrepreneurial firms may access external capital by listing their firm on a stock exchange in an IPO. This is one of a variety of different ways in which venture capital and private equity funds exit their investments. Part V of this book considers why venture capital and private equity funds exit by IPO versus other forms of exit. Also, Part V provides evidence on factors that influence the performance of IPOs.

1.3 How Large Is the Market for Venture Capital and Private Equity?

The market for venture capital and private equity varies significantly in different countries around the world. Data on the amount of venture capital and private equity per GDP for 28 countries is presented in Figure 1.3. Similar data over a longer time horizon is presented in Figure 1.4 and Table 1.3. Figure 1.4 and Table 1.3 also include information pertaining to the value of exit transactions (sales of investments) and fundraising from institutional and other investors. More recent data up to 2011 are discussed immediately thereafter.

Figure 1.3 Venture capital investment by stages as a percentage of GDP, 1998–2001. Source: OECD.

Figure 1.4 Size of venture capital and private equity markets across countries. Source: Armour and Cumming (2006).

Table 1.3

Size of Venture Capital and Private Equity Markets Across Countries

The size of the early stage, expansion stage, total private equity (including early, expansion, late, buyout, and turnaround stages), fundraising and dispositions (exits) expressed as a fraction of GDP are presented. Values are averaged for the 1990–2003 period.

Source: Armour and Cumming (2006).

The venture capital industry in the United States is the largest in the world in terms of total capital under management. As of 2003, there was over US$100 billion in capital under management by more than 1000 funds. Funds in the United States are predominantly set up as limited partnerships and are typically very specialized in terms of stage of development and industry focus. There is significant geographic concentration of investment activity. Route 128 in Boston has a high concentration of biotechnology investments, whereas Silicon Valley in California has a high concentration of electronics and computer-related investments.⁶

In Canada, there were around 130 funds in 2003, with US$20 billion in capital under management and approximately 50% of this capital managed by tax-subsidized labor-sponsored venture capital corporations (LSVCCs).⁷ LSVCCs are tantamount to a mutual funds that invest in private equity and have individual retail-based investors, not institutional investors (discussed further in Chapter 9; see also Cumming and MacIntosh, 2006, 2007). Relative to their US counterparts, funds in Canada tend to be less specialized in terms of stage of development, industry, and geographic focus.

In Australia, there was approximately US$3 billion in capital under management across 174 funds in 2003.⁸ Many funds in Australia are quite small, as they are organized as pooled investment vehicles and not traditional limited partnership funds (Cumming, 2007; Cumming et al., 2005). There was comparatively little early-stage investment activity until 1997 when the Government of Australia established the Innovation Investment Fund (IIF) program, which effectively led the government to be a limited partner in specialized early-stage funds alongside other institutional investors that received more favorable terms (Cumming, 2007).⁹

In Hong Kong, there were 177 funds in 2003 that collectively managed US$26 billion in committed capital.¹⁰ In Europe, there were approximately 700 funds in 2003 that collectively managed a little more than US$50 billion capital under management.¹¹

A number of studies have sought to explain international differences in the size of venture capital and private equity markets. Leleux and Surlemount (2003) focus on differences across Europe and the effect of direct government investment programs in terms of whether they seed or crowd out (displace) private investment. They find little effect of direct government investment programs. Jeng and Wells (2000) find evidence that favorable legal regimes that encourage pension investment and tax friendly environments are more likely to stimulate venture capital across countries (consistent with US-based evidence from Poterba (1989) and Gompers and Lerner (1998)). Black and Gilson (1998), Cumming et al. (2006), and Armour and Cumming (2006) present evidence that public stock markets are important for venture capital markets, particularly as they offer an exit vehicle for venture capital funds to sell their investments. Based on the set of countries in Table 1.3, Amour and Cumming (2006) show laws are as important and may even be more important and show that the more successful venture capital and private equity markets are attributable to entrepreneur-friendly bankruptcy laws, legal environments that have clearly delineated shareholder rights, and low capital gains taxes (the latter finding is consistent with empirical work in Poterba (1989), Gompers and Lerner (1998), Jeng and Wells (2000) and is consistent with theoretical studies of Keuschnigg (2003a,b, 2004a,b), and Keuschnigg and Nielsen (2001, 2003a,b,c, 2004a,b)). Armour and Cumming (2006) find direct government expenditure programs that create government-subsidized venture capital funds do not play a more pronounced role in stimulating the size of a venture capital market, and may even crowd out private investment, particularly in the case of Canada (as discussed by Cumming and MacIntosh, 2006, 2007). A primary problem with the Canadian initiative has been the statutory covenants (essentially a statutory financial contract) governing the operations, or rather hampering the operations, of the LSVCCs. Chapter 9 considers in more detail the relative success of different government initiatives for stimulating venture capital and private equity markets in different countries.

Alternative benchmarks other than GDP for comparing the size of venture capital markets across countries have been proposed in various research papers, including population and late-stage private equity investments. To highlight the differences in select country rankings with these measures, in Figures 1.5 and 1.6 we present annual venture capital data from the European Venture Capital Association (EVCA) spanning the years 1989–2011 for the following western European countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom. Figure 1.5 shows amounts of venture capital scaled by total private equity, GDP, and population. Figure 1.6 presents a similar graph with the numbers of venture capital investments scaled by numbers of private equity investment, GDP, and population.

Figure 1.5 Comparison of VC amounts by total PE versus GDP and population.

This figure shows the differences across countries in terms of amounts of early-stage VC/total PE, early-stage VC/GDP, and early-stage VC/population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989–2011.

Figure 1.6 Comparison of the number of VC investments by total PE versus GDP and population in Europe.

This figure shows the differences across countries in terms of numbers of early-stage VC investment/total PE, early-stage VC/GDP, and early-stage VC/population. Amounts are scaled as indicated to enable direct comparisons and show how country rankings for VC amounts change depending on the benchmark used to compare countries. Data are averaged by country for the period 1989–2011.

Figures 1.5 and 1.6 highlight the differences in country rankings of early-stage venture capital when the denominator is changed. In Figure 1.5, the best countries based on the ratio of venture capital to private equity are Ireland, Portugal, and Austria, whereas the worst is the United Kingdom. In Figure 1.5, the best countries based on both venture capital/GDP and venture capital/population are the United Kingdom, the Netherlands, and Sweden, whereas the worst is Austria. Similar differences in rankings arise from the use of number of investments in Figure 1.6. Simply put the use of ratios of venture capital to private equity for measuring the success of a venture capital market gives rise to bizarre country rankings. Very similar bizarre country rankings were reported by a working paper version of the Da Rin et al. (2006) paper, as explicitly detailed Cumming (2011a,b, 2013).¹² In turn, Da Rin et al.’s (2006) public policy estimates on the effectiveness of public policy are completely incorrect, as discussed further in Cumming (2011a,b, 2013).¹³

1.4 State of the Venture Capital Market Pre- and Postfinancial Crisis

It is widely recognized that the venture capital industry is subject to massive booms and busts, but since the start of the financial crisis in August 2007, venture capital has been in particularly hard times, as documented in Block et al. (2012), among others. To follow up-to-date specific market trends in venture capital, it is possible to access publicly available aggregated datasets such as Pitchbook or to purchase deal-specific data from vendors such as Pitchbook, Thompson SDC, or Zephyr DBV. To illustrate the massive boom and bust in recent times, we present data from Pitchbook that shows the current state of the venture capital industry in the United States. We also present data from Thompson SDC to provide an international perspective in the following.

Definitions of venture capital and private equity have differed over time and across countries. Worldwide, the term private equity generally refers to the asset class of equity securities in companies that are not publicly traded on a stock exchange. Both private equity funds and venture capital funds invest in private equity, the difference being venture capital funds invest in earlier-stage private investments. Venture capital funds often style drift into other types of private equity investments such as late-stage and buyout deals (discussed in this book in Chapter 7), and some venture capital funds invest in publicly traded companies (Chapter 22), and even other funds are themselves publicly listed (Chapter 8). A common characteristic of most stages of venture capital investments is that although investee companies require financing, they do not have cash flows to pay interest on debt or dividends on equity. The more nascent the company, the more unlikely that the venture capital investor will be able to recoup investment amounts. Investments are made by venture capitalists with a view toward capital gain on exit. The most sought after exit routes are an IPO, where a company lists on a stock exchange for the first time to obtain additional financing, and an acquisition exit (trade sale), where the company is sold in entirety to another company. Venture capitalists may also exit by secondary sales, where the entrepreneur retains his or her share but the venture capitalists sell to another company or another investor, by buybacks, where the entrepreneur repurchases the venture capitalists’ interests, and by write-offs or liquidations (Chapters 19–21).

It can be said therefore that if the industry is indeed in crisis, then essentially it is a crisis for critical growth of new technology companies. Not only is there less capital to be invested in high-growth companies, but also whatever capital there is to be invested may not be advanced to the companies that need the capital most. Also, as venture capital investors are increasingly challenged to obtain liquidity through preferred, most profitable exit routes, they are increasingly wary of investing in the asset class, thus further reducing the amount of venture capital available.

Figure 1.7A shows the slowdown in venture capital fundraising and the growth in the overhang of uninvested capital or capital that is being held by venture capital funds but have yet to be invested in high-growth companies. In 2010, there was US$81.66 billion in uninvested venture capital. For private equity funds, in 2010 there was US$485 uninvested private equity (Figure 1.7B). The drop-off in venture capital shown in Figure 1.7A is not as dramatic in recent years for venture capital as it is for private equity shown in Figure 1.7B. The reasons are twofold. First, private equity deals have a greater reliance on the use of debt and the credit crisis obviously curtailed credit markets. Second, venture capital investments tend to be more counter-cyclical relative to private equity investments insofar as there are relatively more venture capital deals when IPO markets are weak. Venture capital deals take a longer time to bring to fruition and as such investors invest more heavily in venture deals with the expectation that they will be ready to exit when IPO markets are at a peak (Cumming et al., 2005).

Figure 1.7 (A) Capital overhang for venture capital funds raised by US investors and (B) capital overhang for private equity funds raised by US investors. Source: Pitchbook.

Figure 1.8A and B may explain why venture capital fundraising has slowed down, albeit not as dramatically as private equity fundraising. Figure 1.8A and B shows venture capital funds have not performed very well in the past decade and have been outperformed in many years by private equity funds of the same vintage year. For recent years, one would hope that the J-curve kicks in for subsequent years; that is, one would hope that despite the current low-performance figures, returns will increase dramatically in upcoming years. Figure 1.8A and B shows DPI, which refers to distributions to paid in capital, a measure of the cumulative distributions’ returns to limited partners as a proportion of the cumulative paid in capital. The DPI measure reflects the funds realized return or the cash-on-cash return; it does not reflect valuations of unexited portfolio companies, which at times can be inflated relative to actual subsequent investment outcomes (see Chapter 22). Figure 1.8A and B also shows the RVPI, or the residual value to paid in capital, which measures how much of a fund investor’s capital is tied up as equity in the fund (not yet realized) relative to paid in capital. That is, while DPI measures the realized return on investment, RVPI measures the unrealized return on investment.

Figure 1.8 (A) Average venture capital return multiples by vintage year and (B) average private equity return multiples by vintage year. Source: Pitchbook.

Figure 1.8A and B also shows the TVPI, or total value to paid in capital, which is the sum of DPI and RVPI. DPI, RVPI, and TVPI are measured net of fees and carried interest. Typically, venture capital funds have a 2% fixed management fee and a 20% carried interest performance fee (Chapter 6). There has been a striking increase in the RVPI component of TVPI relative to the DPI component of TVPI in recent years for both venture capital (Figure 1.8A) and private equity (Figure 1.8B), but the comparatively lower DPI for venture capital is particularly noteworthy.

It is important to note that there are wide discrepancies in reported returns to venture capital and private equity. For example, in Table 1.4 we report return statistics presented by Thompson Financial in 2006. These statistics differ from Figure 1.8A and B due to the reporting by vintage year versus calendar year and differences in the treatment of RVPI. Reporting issues in venture capital and private equity are discussed further in Chapters 4 and 22.

Table 1.4

Thomson Financials’ US Private Equity Performance Index (PEPI)

The PEPI is based on the latest quarterly statistics from Thomson Financials’ Private Equity performance database analyzing the cash flows and returns for over 1860 US venture capital and private equity partnerships with a capitalization of US$678 billion. Sources are financial documents and schedules from limited partners investors and general partners. All returns are calculated by Thomson Financial from the underlying financial cash flows. Returns are net to investors after management fees and carried interest. Buyout funds sizes are defined as the following: small: US$0–250 million, medium: US$250–500 million, large: US$500–1000 million, mega: US$1 billion+.

Source: Thomson Financial/National Venture Capital Association.

Figures 1.9 and 1.10 show venture capital fund IRRs by different fund sizes and horizons. There is a growing body of work that shows that venture capital and private equity funds exhibit diseconomies of scale, and lower returns and worse exit results as a result of limited attention (Chapters 15, 17 and 18).

Figure 1.9 Venture capital horizon IRR by fund size. Source: Pitchbook.

Figure 1.10 IRR quartiles by fund size for mature venture capital funds. Source: Pitchbook.

Figure 1.11 shows that for median 1-year rolling horizon IRRs by fund type, venture capital has not performed as well as private equity or other comparable asset classes in recent years.

Figure 1.11 Median 1-year rolling horizon IRR by fund type. Source: Pitchbook.

Figure 1.12 presents a similar picture showing private equity horizon IRRs (based on long-term index holdings) outperform venture capital (for 1-, 3- and 5-year horizons) and the Russell 3000 index (for the 3- and 5-year horizons).

Figure 1.12 Horizon IRR—private equity, venture capital, and public index. Source: Pitchbook.

Clearly, the state of the venture capital industry in the United States does not appear to be terribly optimistic or attractive, at least on average, to investors as at 2010 based on performance over the past decade. Nevertheless, there is massive performance persistence in venture capital and private equity as top quartile funds (top 25% of performing funds) have a significant likelihood of remaining in the top quartile over time (Figure 1.13; see also Kaplan and Schoar, 2005). Institutional investors into established venture capital and private equity fund managers therefore typically have longstanding relationships, and those without such relationships typically have difficulty accessing such fund managers.

Figure 1.13 US buyout returns by vintage year median, upper, and lower quartiles as of December 2006. Source: Kaplan (2007), Venture Economics.

1.4.1 The Effect of the Crisis on a Venture Capital Industry Already in Distress

Indubitably, during the crisis, venture capital activity slowed down. In Block et al. (2012), the authors found that the crisis led to a decrease in the number of funding rounds. This decrease occurred within all industries and is larger for first rounds than for later rounds. The authors observed that venture capital funds were more reluctant to provide first-round investments toward new start-ups during the crisis than during the precrisis period, especially in the Biotechnology, Internet, and Medical/Health Care industries. Within these industries the percentage decrease in first-round investments was approximately four times larger than the decrease in later-round investments.

The slowdown of venture capital activity due to the crisis has been found to be more severe in the United States than elsewhere. Block et al. (2012) not only show that the decrease in the number of funding rounds per month is more pronounced within than outside the United States, but also that the difference is particularly strong for first-round investments in nearly all industries in the United States. This difference in US versus non-US investments is confirmed by the Thompson SDC presented in Figure 1.14.

Figure 1.14 US versus non-US venture capital investment by fund vintage year. Source: Thompson SDC.

1.4.2 Crisis Leading to Opportunities?

In addition to weakening in fundraising and weakening of performance, venture capitalists are finding it increasingly difficult to exit from their investments. Looking at Figure 1.15, it is clear that not only have the number of IPO exits for venture capital funds in the United States drastically declined since 2002, but this drop has also been more severe in the United States than outside the United States.

Figure 1.15 US versus non-US venture capital IPO exits by fund vintage year. Source: Thompson SDC.

This decline in IPOs may not necessarily be attributed to the crisis as the numbers have been declining since the bursting of the tech bubble and even more so after the introduction of the Sarbanes Oxley Act of 2002 as companies found the more onerous operational and disclosure requirements too costly to implement. It is essentially too expensive for nascent companies to seek listing and as such it is taking longer for these companies to go public. As these companies take longer to initiate an IPO, venture capital fund managers are unable to provide their fund investors with the sought after profits by the time the fund life ends, traditionally 10 years from fund establishment. It may be the case that the traditional life of a fund has to be extended to 15 years, and while this may deter fund investors who do not wish to be locked into an investment for that duration, the extension will enable venture capitalists to dedicate both the financial and value-added resources to ensure that their investee companies are more than ready to initiate an IPO (see also Metrick and Yasuda, 2010).

In addition to increased difficulties to exit from their investments through IPOs and particularly since the global financial crisis, there has been a growing market in secondary private fund interests whereby fund investors transfer their limited partner interests to secondaries. The market for secondaries represents an important way for many investors to achieve liquidity, particularly since most funds are closed ended with the 10-year lifespan and do not offer early redemption rights. Most of these secondaries to date have been buyout fund portfolios, often held by banks, although there is increasing interest in venture capital by secondaries. For the secondaries in the buyout market, it has been reported that sellers routinely achieve 90% of a portfolio’s net asset value. With a growing secondaries market, it is possible that more investors may reevaluate their view of venture capital, and even when new fund structures with increased life spans are introduced, such investments may still be attractive to potential fund investors. And for the sake of nascent companies, it is crucial that venture capital remains an attractive investment class.

Finally, in view of the weak performance of venture capital, it is also possible to question the compensation structures currently in place for industry participants. It has been suggested by Mulcahy et al. (2012), among others, that the model of paying a 2% annual management fee and 20% carried interest or performance fee may not be sufficiently incentivising fund managers to seek the most profitable investments, as it may just be easier to rely on the management fees, especially when the funds are large enough.

1.4.3 Summary

This overview of the market showed the impact of the financial crisis on the venture capital and private equity in the United States with some international comparisons. These statistics provide insight into changes the industry will likely face in coming years in respect to fundraising and fund structures.

The recent financial crisis cannot totally be blamed for the marked drops in venture capital fundraising, reduced venture investment, and the hindrance of successful exits around the world, but it may have exacerbated the existing problems. Poor returns over the past decade indicate most fund managers do not earn their fees and investors have been increasingly wary of taking on added risk without getting the reward. Structural changes appear to be inevitable to the venture capital marketplace to preserve an essential source of funding for nascent high-growth companies.

1.5 What Issues Are Relevant to the Study of Venture Capital and Private Equity?

1.5.1 Information Asymmetries and Agency Problems

As mentioned earlier,¹⁴ problems of information asymmetries and agency costs are two of the paramount explanations for the existence of venture capital and private equity funds. If there are no agency costs or information asymmetries, then entrepreneurial firms can simply raise capital from banks or other sources of debt finance. Agency costs and information asymmetries play a central role in shaping the contracts used to set up limited partnerships. Also, agency problems are the primary reason why venture capital and private equity funds use detailed contracts with their