Staging Venture Capital: Empirical Evidence On The Differential Roles Of Early Versus Late Rounds

Antonio Davila Graduate School of Business Stanford University Stanford, CA 94305-5015 Tel: (650) 724 50 60 Fax: (650) 725 04 68 Email: adavila@stanford.edu George Foster Graduate School of Business Stanford University Stanford, CA 94305-5015 Tel: (650) 723 28 21 Fax: (650) 725 04 68 Email: ffoster@gsb.stanford.edu Mahendra Gupta John M. Olin School of Business Washington University Campus Box 1133 One Brookings Drive St. Louis, MI 63130-4899 Tel: (314) 935 45 65 Fax: (314) 935 63 59 Email: guptam@olin.wustl.edu February, 2003

The assistance of Trinet and VentureOne for this research is gratefully appreciated. We are grateful for the comments of participants in the Stanford University research workshop. Financial support is from The Center for Entrepreneurial Studies at the Graduate School of Business, Stanford University and Morgridge Fellowship. Research assistance was provided by Nicole Ang, Jiangyun Liu, Barbara Lubben and Jakub Wilsz.

Staging Venture Capital: Empirical Evidence On The Differential Roles Of Early Versus Late Rounds Abstract A characteristic feature of venture capital funding is its staged structure. Startup firms do not receive all the funding they need to achieve profitability in their first round of venture funding. Rather venture capitalists invest in stages and their investment today does not commit them to future funding. The theoretical literature has examined this feature of venture capital investments beyond its signaling value. An important theoretical prediction is that the first round of funding has a different role compared with follow-up rounds. The objective of the first round is to provide capital to a cash-constrained entrepreneur. After this first round, an agency relationship is established between the entrepreneur and the investor or between inside and outside investors. Follow-up rounds are intended to mitigate the agency costs associated with this relationship. While these agency costs may arise for different reasons, in all models these follow-up rounds happen before the startup firm hits its cash constraint. Objectives other than removing a cash constraint take precedence in follow up rounds. The results in this paper provide evidence consistent with this differential empirical prediction. Finally, the paper also examines whether funding rounds have different signaling value within the firm.

Staging Venture Capital: Empirical Evidence On The Differential Roles Of Early Versus Late Rounds The fundamental need for funding in startup firms comes from the entrepreneurs wealth constraints. The entrepreneur needs funds to finance the firm from inception until it

becomes cash flow positive. Venture capitalists provide the funds required to overcome cash limitations during the initial stages of a firms life, before the uncertainty of the venture is reduced and alternative sources of funding become available. The relevance of venture capital funding events is reflected in their signaling value. While wealth constraints explain the initial funding of a start up firm, they do not explain the need for staged funding. Staged funding is a salient characteristic of venture capital investing. Rather than committing their funding upfront, stage funding allows venture capitalists to periodically update their information about the firm, monitor its progress, review its prospects, and evaluate whether to provide additional funding or abandon the project. Staged financing provides venture capital with a real option. This option can be exercised or abandoned over time as the uncertainty about the startup firm is reduced. Staged financing is also advocated as a control mechanismtheoretical models explain this financing structure as a governance mechanism to reduce the agency costs implicit in venture-backed startups. These theoretical models are important to understand the unique nature of venture financing. However, the empirical literature on entrepreneurial finance has limited evidence on the validity of these arguments. This paper provides empirical evidence informative to these theoretical predictions. It examines two questions related to staged funding in venture-backed startups: (1) Do cash constraints more severely limit growth in early funding rounds than in later rounds? (2) Is

the signaling value of these funding events larger in early rounds compared with later rounds? The first question addresses the issue of access to capital, which is central to our understanding of entrepreneurship (Evans and Jovanovic 1989). The answer to this question is informative for several reasons. First, recent theoretical work (Bergemann and Hege 1998; Neher 1999; Wang and Zhou 2002) predicts that cash constraints not only have a role in the growth of firms but also within the staged funding structure that underlies the governance of venture-backed firms. Second, an uninformed examination of funding

rounds may suggest that all funding rounds serve the same purposeto provide cash to a cash-constrained firm. However, theoretical models of staged financing based on rational expectations predict differences in the role of cash constraints over funding stages. Early rounds provide the funding that startup firms need to begin to grow. They remove cash constraints that hold back the development of the firm. Follow-up rounds are intended to govern the agency relationship established after the first funding round. Thus the cash that flows to the startup firm in these later rounds provides the leverage required to exercise control over the firm. In particular, the threat of hitting cash constraints disciplines the agency relationship, even if in equilibrium these constraints are not binding. Third, models of staged venture capital predict the need for successive rounds of funding, but they do not speak to the role of the amount of funding. Our empirical results indicate that the amount of funding is associated with the growth of startup firms for late funding events (but not for early funding events). Our second question empirically investigates whether the signaling value of rounds of finance differs between early and late stages of the startups lifecycles. The asymmetric

information associated with startup firms enhances the value of credible signals about the quality of the firm. Venture capital provides one such powerful signal. However, a real option framework suggests that uncertainty is resolved over time and the value of these signals may decrease as uncertainty and the associated information asymmetry decreases. This paper utilizes a unique dataset that combines employee-level information on the hiring date, firing date, and monthly cash salary with firm-level information including the date of venture funding and the amount of funding received. A sample of 170 startup firms and 268 funding events provides a detailed picture of the evolution of these firms around these events. The results confirm the predictions of agency-based staged funding models beyond the signaling value associated with these events. We find that early and late rounds fulfill different roles in the venture capital firm-startup relationship. Removing cash

constraints that impede the growth of startup firms is a fundamental role of early rounds. Growth in early rounds is delayed until funds are available whereas in later rounds growth occurs before and after the financing round date. Average salaries significantly increase after the firm receives new funds in early rounds but not later rounds. One empirical finding that current theory does not address involves the amount of funding. The amount of funding significantly explains growth patterns around later but not early funding rounds. Consistent with decreasing information asymmetry as uncertainty is reduced, the signaling value of a venture capital round to explain employee turnover is more significant in early rounds than in later rounds. The next section of this paper presents the literature on the staged structure of venture capital financing and the hypotheses. Section 2 describes the research design. Section 3 presents the results and Section 4 concludes.

1. THE STAGED STRUCTURE OF VENTURE CAPITAL FINANCING 1.1 Venture Capital Venture capital firms are financial intermediaries focused on providing capital to small, fast-growth startup companies that are typically high risk and not amenable to more traditional financing alternatives. These venture capital firms have some unique

characteristics that separate them from traditional sources of funds. First, their investments (startup firms) involve higher levels of uncertainty, asymmetric information, and typically higher intangible assets and growth opportunities (Gompers 1995). Second, venture

capitalists take an equity position in the company and play an active role in the governance of the firm (Sapienza and Gupta 1994). They typically sit in the board of directors and regularly monitor performance (Sahlman 1990; Lerner 1995; Robie, Wright et al. 1997). This monitoring goes beyond what a traditional financing institution would do and includes spending time at the companies, frequent meetings with managers, and being involved in the definition of the companies strategies, hiring decisions (Hellmann and Puri 2001), and top management compensation (Kaplan and Stromberg 2000). In addition, venture capitalists bring their experience in evaluating the prospects of startups through their screening of potential investments (Hall and Hofer 1993), their collaboration with other startups, their understanding of the solutions to the problems that these firms may face, and when startups are best positioned to raise money (Gompers and Lerner 1999). They also assist with their reputation in the capital (Meggison and Weiss 1991) and product markets. Finally, they provide access to a strategic network including potential clients or suppliers, management talent (Bygrave and Timmons 1992), additional funding (Gorman and Shalman 1989),

strategic partners (Baum, Calabrese et al. 2000), and infrastructure providers like accounting firms, law firms, and public relations firms. 1.2 Rounds of Financing A salient characteristic of venture capital investing is its staging structure through sequential financing rounds. At each round of financing, a venture capital firm supplies new financial resources to the startup in exchange for a percentage of the equity of the company. These rounds of financing are discrete events staged over the life of the company as a private entity. Rounds of funding are critical in the relationship between venture capitalists and the startups that they invest in. They are not a mere transfer of financial resources; they also involve the redefinition of the governance structure of the firm and provide a signal about its prospects. This new ownership structure affects the control structure of the

company as well as the payoffs of a future liquidity event (whether it is a public offering or a trade sale). Several theory papers explore the optimality of staged funding. A common starting assumption is a wealth-constrained entrepreneur who wishes to retain higher rather than lower equity in the firm for a given growth path. The first round of funding releases the cash constraint binding the growth of the firm. Previous empirical research has documented the significant role of cash constraints in the decision to engage in entrepreneurial work as well as the size of the investment in the startup endeavor (Holtz-Eakin, Joulfaian et al. 1994a). This empirical observation is a starting assumption for the agency-based models of staged venture funding where the first stage of the venture capital investment process removes this cash constraint. The question that emerges is: why does the investor stage additional funding rather than providing all the capital upfront?

One explanation consistent with staged venture funding relies on real options. Each funding round provides enough capital to reach the next milestone where investors, in light of new information, decide whether to fund the next stage or to exercise their abandonment option. The staged structure gives the investor the option of not further investing in a project with a negative outcome. Such an option does not exist when all funding happens upfront. (Sahlman 1990). Bergemann and Hege (1998) provide a more elaborate model of the real option argument where they include a moral hazard problem. In their model, a wealth-constrained entrepreneur receives funding from an external investor. The

entrepreneur has private information about how he allocates his effort between generating information about the project and private consumption. The investor updates his beliefs about the success of the project at the end of each period and decides whether to fund the next round. This staging of investment reduces the induced moral hazard problem. Neher (1999) studies the superiority of staged funding over up-front funding in a perfect certainty, full information setting (thus without a real option). A wealth-constrained entrepreneur establishes an agency relationship with an investor who provides the funds required to start the business. The investment that the entrepreneur makes is partly sunk, thus the relationship is open to the hold-up problem associated with the entrepreneur renegotiating the contract after the investment has been made. Staging the investment can reduce this hold-up problem if the value of the ventures assets without the entrepreneur increases over time as the entrepreneurs specific knowledge is embedded in the assets of the firm. The cash constraints associated with follow-up rounds, while never binding in equilibrium, provide the bargaining power that the investor needs to reduce the costs associated with the hold-up problem.

Wang and Zhou (2002) derive the superiority of staged funding over upfront financing in a setting where there is no information asymmetry between the investor and the entrepreneur, the entrepreneur provides effort, new information becomes available over time and only the final output is contractible. In the staged funding solution, the investor keeps the option of abandoning the project if the new information is not attractive. Staged funding provides two benefits. First, it reduces the cost associated with the risk of bad information becoming available. And second, it decreases the costs of the moral hazard problem that emerges from the agency relationship established when the first investment occurs. The initial funding provides the resources that the wealth constrained entrepreneur needs. In contrast, follow up funding relies on the threat that the entrepreneur runs out of resources to curve down moral hazard, even if in equilibrium this threat is never carried out. Kockensen and Ozerturk (2002) adopt an incomplete contracting framework to endogenously derive the optimality of staged venture capital funding. Their model assumes a wealth-constrained entrepreneur and an initial investor who provides a first round of funding, but does not commit to further funding. Before the second round funding decision, new information becomes available. This information is available to both the entrepreneur and the inside investor but not to potential outside investors. Consequently, the inside investor has an informational advantage that allows him to offer better terms if the project remains attractive as well as capture a surplus associated with the private information. Staged funding provides the inside investor with a surplus that otherwise he would not capture. As in previous models, the first round removes the initial cash constraint and allows the entrepreneur to grow its venture. The second round gives the venture capitalist bargaining power to extract additional rents. The cash constraint implicit in the second

round is the threat that strengthens the venture capitalist bargaining position even if rational expectations ensure that it is never carried out. These models separate an initial stage where the cash-constrained entrepreneur receives funding and where an agency relationship is established from follow-up rounds. These follow-up rounds rely on the threat to the entrepreneur of hitting his cash constraint to reduce agency costs. 1.3 Signaling Our second research question examines the differential signaling value of funding events. A large literature has studied the role of signaling in multiple settings and industries as a mechanism to reduce uncertainty (Akerlof 1970; Spence 1974; Kreps 1990; Heil and Robertson 1991). Venture capital firms funding decisions act as such a signaling mechanism. Before each round of financing, venture capitalists perform a thorough analysis of the company they are intending to fund (Hall and Hofer 1993). They access information internal to the company and match this information with their experience and knowledge of the industry to evaluate its prospects.1 Internally a round of financing complements existing employees priors about the quality of the company and its attractiveness as a workplace. The financing event indicates that outside experts, having access to different and probably richer information than employees have, find the company attractive to invest. The value of this signal may decrease over the life of the venture as uncertainty decreases. The shaper prior beliefs that

Admati and Pfleiderer (1994) exogenously impose stage financing and examine in a setting with asymmetric information between inside and outside investors a robust financial contracting over the funding stages. Their solution, where the insider maintains a fixed fraction of the equity of the firm, relies on the signaling value that the insiders decision has on outside investors. 8

employees have in later rounds of funding suggest that the signal associated with later funding events will have lower value. 1.4 Hypothesis Tested The first hypothesis is that cash constrains growth of startups more severely in early rounds than in later rounds. We use both headcount data and average salary data to probe this hypothesis.2 Our second hypothesis is that the signaling value of funding rounds is higher in early rounds compared to later rounds. We test this hypothesis using employee turnover as a measure of the value of the signal within the organization. Employees are one of the best-informed players. If the uncertainty about the future of the firm is large, the updating of employees beliefs associated with the early funding rounds may be significant enough to affect their decisions to remain in the firm. As uncertainty decreases, the

relevance of the signal to employees decision to remain in the firm will decrease and the impact upon turnover less significant. 2. RESEARCH METHOD 2.1 Sample selection To examine the hypothesized relationships, we contacted a Professional Employer Organization (PEO). The company specializes in providing outsourced human resource services to small firms mainly in the San Francisco Bay Area but also throughout the United States. Over time, it has developed a strong relationship with venture capital firms and is perceived as a cost effective full-service solution for the human resources needs of small companies. Companies using its services outsource all their human resources needs.

Davila, Foster and Gupta (2003) documents a positive association between headcount growth of startups and change in pre-money valuation in sequential rounds of venture-capital financing. 9

Outsourcing non-core activities like payroll is perceived as a way to focus scarce management attention on more high-value added activities. The database provides both the number of employees in each of its clients per month as well as their monthly cash compensation. Thus, the database provides a unique source of startup firms information. The database includes information about 606 venture backed and non-venture backed entities that were in the system at some point between January 1994 and December 1999. For those entities, we collected payroll information from January 1994 through May 2000. The database grows over time as the PEO, itself also a startup, grew over this time period. To identify those firms in the sample that received venture funding, we matched the names of the firms against two proprietary databases that follow the venture capital industry: VentureOne and Venture Economics. We found 194 firms that were both in the PEO database and at least in one of the venture capital databases. From Venture One and Venture Economics we gathered data on the dates of rounds of financing (or IPO), the amount of funding, as well as information regarding the age of the company. Because firms disclose the information in these databases on a voluntary basis not all information is available. In particular, the date of founding is available for 170 firms. In total, the sample includes 4,155 firm-months observations with 268 of these firm-months having a financing event. Several caveats regarding the sample are relevant. The sample is not a random sample of venture-backed startups. Only companies that choose to outsource their human resources needs are included. The sample includes mostly technology companies. Given the location of the PEO firm, it is biased towards Silicon Valley based companies. Finally, the time period examined may be unique in that venture capital investments were particularly large.

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Startups leave the database for different reasons. A total of 85 venture-backed firms left the database during the observation period. One reason is that the company goes out of business. Another reason is that the PEOs value proposition is no longer viewed as cost effectiveeither because they changed their human resource strategy or because they outgrew the services provided by the PEO. An analysis of companies exiting indicates that these companies are relatively smaller or had stayed relatively longer in the database. This exit pattern apparently reflects two types of startups. One type is smaller companies. The other is older companies that is consistent with the probability of bringing human resource management inside increasing with age (Baron, Burton et al. 1996). The loss of smaller companies may bias our sample towards more successful startups, while the loss of older ones may introduce a bias towards companies in the early stages of their lives. However, neither of these two effects is expected to affect the behavior around the rounds of funding. 2.2 Dependent variables We use two different proxies for cash constraintsemployee growth and cash salary. Startup firms that are cash constrained are unable to grow their headcount until funds become available. Even if the likelihood of a funding round is credible enough for new employees to be willing to join the company, the lack of funds precludes growth until funds are received. This scenario is consistent with our hypothesis of delayed hiring for early rounds of venture funding. In contrast, startups that do not face cash constraints can fund their growth as soon as the signal associated with the funding event becomes credible. This scenario is consistent with later rounds of funding. At this stage in the life of the startup, cash constraints are used in the bargaining process to reduce agency costs but under rational expectations are not binding.

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Employee growth is constructed as follows. For each month we count the number of employees in each company in the sample. We use this count to estimate the change in the number of employees. A limitation of this measure is that it does not include outside consultants and contractors. We do not have hard data to evaluate the potential impact of this limitation. However, the PEO management believes that the startups in their database do not use these outside contractors significantly. We expect the pattern of employee growth to be different for early versus late funding rounds. For early rounds, due to binding cash constraints, we do not expect any increase in employee headcount before the funding round and expect any increase only after the funding round. In contrast, for later rounds growth cash constraints are non-binding in equilibrium, and hence there should an increase in employee headcount around the funding event (both before and after the funding event) as soon as the likelihood of a funding becomes credible. Our second measure of cash constraint is average cash-equivalent pay. Cash constraints may translate into lower average cash salaries. Firms in early stages have limited access to funds and their chance of success depends on minimizing cash outflows. Only when the cash constraints are removed, can the company increase cash salaries. We measure cash salary as follows. The database reports up to ten different payments per employee. Net pay (the actual cash payments to the employee) can vary across

employees because of differences in their pay status, their health plan or retirement plan choices. We choose gross pay to proxy for cash-equivalent pay. Compared to the net pay, gross pay does not reflect variance that may be due to differences in the personal tax status of employees. It also avoids problems with differences in health plan or retirement pension

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choices. Gross pay has its own limitations because companies offer different packages in terms of contributions to employees retirement or health plan. However, differences in such benefit packages across startups are not as pronounced as in larger companies. Companies working with this particular PEO do have choices in terms of benefits other than gross pay, but the needs and offers of these companies tend to be similar. For our cross-sectional analyses, we calculate the average cash-equivalent pay as the total payroll in a month divided by the headcount that month. We expect the average employee salary levels to be below the sample average due to cash constraints before the early round of funding. A startups ability to secure venture funds sends a strong signal about the prospects of the startup to both the external and internal constituents in the organization. The signal can compensate for the uncertainty and risk of the job in the minds of the employees of the startup and provides a rational for them to stay with the firm. We use employee turnover as a measure of the signaling value of venture funding Turnover is measured as follows. The database has information at the employee level and allows us to track when a particular person left a company. To estimate turnover in a specific month the number of people that left the company during that month is divided by the headcount at the end of the previous month. This is computed for each month on a company-by-company basis. We expect the value of this signal to decrease from early to late rounds as uncertainty about the prospects of the firm is reduced and thus to have a lower impact on the employees decisions to stay or leave the firm. 2.3 Additional variables

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The timing of each funding round provides the event date to anchor the evolution of our dependent variables. For each company, the date of each financing round (including IPO and merger and acquisition events) and in most cases the amount of financing is available. We classify the various rounds of financing as early or late rounds of financing. Early rounds are seed and first rounds. Second, third, and fourth rounds are classified as late rounds. This classification is similar to VentureOnes classification. A small number of companies go through a fifth and sixth round (12 observations). We separate these rounds because they may be used for different purposes compared to early and late rounds. In particular, they may be used as a mezzanine round before the initial public offering. Alternatively, they may be an interim stage due to the IPO environment not being viewed as friendly. We do not include these rounds in our hypotheses or in our reported results.3 We also include the following control variables: size of the company measured using the same headcount number used to estimate employee growth and turnover; age of the company calculated as the time elapsed since its founding (in months); and industry.4 3. ANALYSIS AND RESULTS 3.1 Summary information and descriptive statistics Table 1 presents descriptive statistics for the sample of firms used in the study. Panel A presents the industry composition of the sample. The sample is heavily biased towards high technology industries. This is consistent with the focus of venture capital investing that

The final database includes company-month observations with information on headcount, salary, and turnover as well as funding. If a company joined the PEO system after several rounds of funding, we do not have headcount information for the months when these early rounds happened. However, we identify whether a funding event happen right before the company joined PEO and we can identify the first months of headcount, salary, and turnover information as being post-funding event months. Similarly, we do not have information for companies that had funding rounds after they left the headcount database; but if a funding event happened just after the company dropped out of the database, we can flag the last months in the database as pre-funding event months. 4 Industry dummies are included in the tests but not reported. 14

concentrates on technology-intensive firms with significant uncertainty and where specialized knowledge can be leveraged. Insert Table 1 around here Panel B summarizes the average number of rounds for the venture-backed companies founded in different time periods. The median number of rounds is two. Companies founded in later periods have fewer rounds in part due to being in existence for a shorter period. Panel C presents round of financing statistics. First rounds and second rounds are the most frequent. The amount of funds raised increases from $1.40 (median $1.23) for seed rounds to $24.68 (median $23.50) for fifth rounds. Early rounds funding amounts is comparable to Gompers (1995), while the amount of funding for later rounds is larger in the current sample than in Gompers sample. Changes in technology that require larger

investments in later stages or particularities of the time period of our study may account for this difference. The post-money valuation increases from $3.34 (median $3.00) for seed rounds to $347.84 (median $347.84) for sixth rounds. The companies in the sample had 468 financing events, 222 early round events, 226 late rounds and 20 fifth and sixth rounds. Panel D provides timelines on the database. We have headcount growth information for 268 venture funding events (for the rest of events companies had not signed up for the human resources outsourcing service). Panel A in Table 2 describes the distribution of these events; 79 correspond to early rounds (seed and first round), 165 are late rounds (second, third, and fourth) and 12 are fifth and sixth rounds. An additional 12 events correspond to companies in the sample that went public but remained in the sample. We have an additional 3,887 firm-month observations with no funding event.

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Panel B presents descriptive statistics on the variables used in the study.5 Venturebacked companies have 31 employees on average with an average monthly growth of 1.80 employees. Insert Table 2 around here Panel C presents the correlation among the variables in the research. Growth is

positively correlated with lower turnover suggesting that growth may proxy for success and thus employee retention. Growth is also correlated with size but negatively with age. The average salary is also negatively correlated with turnover indicating progression in the salary levels with tenure of employees in startups. Turnover as well as size increases with the age of the company. 3.2 The differential role of cash constraints over funding rounds The analysis in this section uses an event study design centered on the months with a round of funding. We examine the path of employee growth and average salary in the months prior and subsequent to the funding event, using the following pooled regression specification: Dependent_variablej,t = +

i=-3,3

i Early_Roundj,t * Month_Dummyi,j,t +

i=-3,3

Late_Roundj,t * Month_Dummyi,j,t + i Control_Variablesj,t + For each of the 268 venture-capital financing events in our sample we identify the month in which the event happened (termed month 0). We restrict our study to month 0 and the six months surrounding this event month (prior three months and subsequent three months)

The descriptive statistics in Panel B are based on the sample after removing the top and bottom 0.5% observations. The observations removed include negative monthly salaries and monthly salaries that reached in one extreme case $2.3 million. These observations are probably due to unusual events or coding mistakes.

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when we expect the impact of funding to be most significant to the startup. The three months prior to the financing event are designated months -3, -2, -1, and the three months after the event as months +1, +2, +3. Monthly dummies take a value of one for company j if month t is i months away from the funding month (where i takes seven values from 3 to 3), zero otherwise. We also use a different dummy variable to distinguish the two types of rounds (and control for other financing events). Early round is a dummy variable that takes a value of one if the financing round is a seed or a first round and zero otherwise. Late round is defined in a similar way for rounds two, three and four. We also use a different dummy for fifth and sixth rounds as well as IPOs and include them as controls. The dependent variable is growth in number of employees and average salary for company j in month t. When using change in headcount, we use absolute rather than relative growth because of the small size of the companies involved mostly for early rounds; we include a size variable in the regressions to control for the potential effect of size. From our previous discussion, firms that receive early rounds of funding should reveal a pattern consistent with the release of the cash constraint. The coefficients for the three months prior to the funding round should be negative or/and the coefficients for the three months subsequent to the funding round should be positive. Negative coefficients for the months prior to the funding round would indicate that cash constraints limit growth and/or average salary. Positive coefficients for the months subsequent to the funding round would indicate that cash constraints have been released to allow growth to happen and or average salaries to increase. The reference point against which the coefficients in the regression model are gauged is growth (average salary) for months outside the [-3, +3] time window around the funding events.

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We also include age, size, and industry (not reported) as additional controls. Larger firms may experience larger absolute growth or offer larger salaries. Holding size constant, older firms may be less successful and grow at a lower rate. Finally, growth and salaries may vary across industries. Insert Table 3 around here Table 3 presents the results. Model 1 has employee growth as its independent variable, while Model 2 has average salary. The results are consistent with theory-based predictions indicating that early rounds release cash constraints that limit the growth of startup firms, while later rounds serve as monitoring or real option mechanisms where cash constraints are not binding in equilibrium. Growth around early round events only happens after funds are received but not before. The coefficients for the months prior to the event are not significant, but the coefficients for the months subsequent to the event are positive and significant. On average, compared to the growth in non-funding months, companies in our sample grew by 0.60, 1.21, 1.15 and 0.83 people per month in the zero, first, second, and third month after an early round funding event. Also consistent with predictions, the average cash salary before an early The

round is significantly smaller than the average salary in non-funding months.

coefficients vary between -$925 and -$630 for the three months before an early round that approximately represent over 10% of the average monthly salary of $7,310 (Panel B, Table 2). This difference ceases to be significant the month after the funding event. In late rounds we observe a strikingly different pattern. Reinforcing the idea that cash constraints play less of a role in these later rounds, employee growth is significant before as well as after the funding event for each month during the event window [-3.3]. Moreover,

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the growth rate in later rounds is higher than the growth rate in earlier rounds. Differences in patterns between early and late rounds are also present for average salaries. None of the average salary coefficients of the late round dummies is significant suggesting that the later rounds funding event itself does not impact average salary. There is no significant shortfall in salary before the later funding rounds and no significant increase in salary after the funding rounds. This pattern is consistent with non-binding cash constraint in late rounds enabling the startup to be at the average salary levels.6 3.3 The differential signaling value of funding events Table 4 uses the same event study research approach to examine turnover centered on the month when a funding event happens (month 0). The dependent variable is employee turnover. The signaling value of funding events is reflected in the increased attractiveness of remaining in the firm as the signal becomes credible while outside options remain the same. As uncertainty about prospects of the startup decreases over time, the value of the signal is expected to decrease. Table 4 presents the results. Insert Table 4 around here Turnover is generally lower around the early funding rounds. Five out of the seven months bracketing an early funding event are significant. This observation is consistent with the signaling value of a funding event being more valuable early in the life of the firm. If the uncertainty of a startup firm decreases over its life, as assumed in real option models of venture funding and as argued in the field-based research literature, the value of an external signal is more valuable early on. Initially, employees may assign a significant

We also examined whether this salary increase holds for all employees in the company (consistent with an agency problem) or rather it is associated with new employees only (indicating that the increase in average salary is associated with hiring more expensive human capital). A means comparison indicates no significant difference in the average salaries between new and existing employees. 19

value to the decisions of external investors; at this stage, uncertainty is large and any piece of information from players with access to different information has a significant impact on the employees updating of the firm prospects. However, the value of an additional signal is less relevant in updating employees beliefs when the uncertainty is lower. We performed several robustness checks on Tables 3 and 4. (1) We controlled for the possibility of a momentum where past growth fuels future growth as argued in the practitioners literature (Cox and Camp 1999) running an alternative model including employee growth in the previous month. We use an instrumental variable approach to proxy for the lagged dependent variable (Kennedy 1997), we also control for autocorrelation in the residuals using an AR(1) model and use a Prais-Winsten estimator (Greene 2000). (2) We also used percentage growth rather than absolute growth. In all cases results were comparable. We also controlled for the potential effect that the amount of funding may have. Larger amounts of funding may be associated with higher growth for several reasons. First, venture capitalists may affect the growth of the firm through the amount of funds that they make available to the firm. Larger amounts of funding permit growth strategies not available if the funding amount is smaller. Second, firms that receive larger amount of funds may use the free cash flow to grow faster or increase salaries. Finally, previous research has found that entrepreneurs that receive higher cash flowsthrough inheritancesalso achieve higher top line growth (Holtz-Eakin, Joulfaian et al. 1994b). We control for the funding amount interacting the month dummy variables around the funding event with the amount of funds received. Table 5 presents the results. Insert Table 5 around here

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The pattern for early rounds is similar to Table 3. In early rounds, employee growth and average salary are mostly independent of the amount of funding received. The effect of the amount of funds received is only significant for the funding month (month 0 with a coefficient of 0.057, t=1.97). The pattern for the relevance of the funding amount in later rounds contrasts sharply with early rounds. The significance of the event itself disappears and we observe a significant association between the amount of funding and both growth and average salary. The growth compared to non-funding months ranges between 0.063 and 0.238 people per additional million dollars in funding.7 This pattern is consistent with various explanations such as free cash flow problems associated with larger funds or an expanded growth strategy set that allows more aggressive growth. The results for turnover are also consistent with earlier rounds having a stronger signaling value. In terms of the relevance of the funding amount, only the coefficient for the month of a late funding round is negative and significant. Thus, it provides some evidence that the amount of funding rather than the funding event itself may have signaling value in later rounds. 4. CONCLUSIONS This paper addresses the role of cash constraints over the staged funding structure of venture capital investments. Cash constraints are an important topic in entrepreneurship finance because of their role in inhibiting new ventures growth. While this effect is important in early rounds of venture-backed companies, staged funding theory assigns a different role to these constraints in later rounds of funding. Consistent with theory

predictions, we find very different patterns between early rounds and late rounds of venture funding. The behavior of employee growth and average salary in early rounds is consistent

An increase in the month following the funding event could be driven by a bonus linked to it. However, we observe this pattern throughout a six-month period. 21

with the role of external funding as releasing cash constraints. The event itself significantly impacts growth and average salary but the amount of funding does not. The pattern in later rounds indicates a different role. Here, cash constraints are part of the bargaining between the various playersentrepreneur, existing investors and external investorsbut in equilibrium they are not binding. We find that the amount of funding is significantly associated growth and average salaries in these later rounds. Several explanations are consistent with this pattern including agency costs associated with free cash flows. Alternatively, the larger variance in the amount of funding that exists in these later rounds may allow an expanded set of growth strategies that does not exist in early rounds. We also document that the signaling value of a funding event is significant in early rounds of funding when uncertainty about the prospects of the firm is larger. In later rounds, we find some evidence that the amount of funding has signaling value but not the event itself. The focus of this paper is the funding rounds of companies that did one or more venture rounds. Here there is an observable eventa funding round with a date and an amount. A related study would be to examine the impact of non-funding events (i.e., unsuccessful funding rounds) on variables such as headcount, average salary and turnover. A key

challenge here is that there rarely is an observable event. Startups do not announce that they have been unsuccessful in raising money. Typically they approach multiple parties and continue to seek money at ever more unfavorable terms as their cash balance approaches zero. Some of these companies eventually shut down with the resultant observable effect on headcount, average salary and turnover. Some continue to struggle along with a dramatically reduced scale of operations. Others are acquired, sometimes as a distress sale.

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The sample studied in this paper is not a random sample. It includes companies that were successful in obtaining one of more rounds of venture funding. This is an important sample in and of itself because it matches the on-going concern assumption underlying the arguments put forward in the theoretical models. Thus, the sample provides an ideal setting to test some of their predictions. However, our results need not be generalizable to the broader set of firms seeking venture funding. The timing of the study is characterized by a favorable investment environment. When this environment is harsher, the distinct behavior between early and later rounds may become less pronounced. In the extreme, where the venture community abandons the notion of a pre-commitment to sub-sequent rounds, the results we report for early rounds may be descriptive for later rounds. An extension of our research would be to examine the robustness of our results to periods where venture funding for later rounds is extremely difficult.

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BIBLIOGRAPHY Admati, A. R. and P. Pfleiderer (1994). Robust financial contracting and the role of venture capitalists. The Journal of Finance 49: 371-402. Akerlof, G. A. (1970). The market for "lemons":Quality uncertainty and the market mechanisms. Quarterly Journal of Economics 84: 488-500. Baron, J. N., D. M. Burton, and M. T. Hannan. (1996). The road taken: origins and evolution of employment systems in emerging companies. Industrial and Corporate Change 5: 239-275. Baum, J. A. C., T. Calabrese, and B. S. Siverman (2000). Don't go it alone: Alliance network composition and startups' performance in Canadian biotechnology. Strategic Management Journal 21: 267-294. Bergemann, D. and U. Hege (1998). Venture capital, moral hazard, and learning. Journal of Banking and Finance 22: 703-735. Bygrave, W. and J. Timmons (1992). Venture capital at the crossroads. Boston, MA, Harvard Business School Press. Cox, L. W. and S. M. Camp (1999). Survey of innovative practices. Kansas City, Kauffman Center for Entrepreneurial Leadership. Davila, A., G. Foster, and M. Gupta. (2003 forthcoming). Venture capital financing and the growth of startup firms. Journal of Business Venturing. Evans, D. S. and B. Jovanovic (1989). An estimated model of entrepreneurial choice under liquidity constraints. Journal of Political Economy 97(4): 808-827. Gompers, P. A. (1995). Optimal investment, monitoring, and the staging of venture capital. The Journal of Finance 50: 1461-1489. Gompers, P. A. and J. Lerner (1999). The venture capital cycle. Cambridge, Ma, MIT Press. Gorman, M. and W. A. Shalman (1989). What do venture capitalists do? Journal of Business Venturing 4: 231-248. Greene, W. H. (2000). Econometric analysis. Upper Saddle River, NJ, Prentice Hall. Hall, J. and C. W. Hofer (1993). Venture capitalists' decision criteria in new venture evaluation. Journal of Business Venturing 8: 25-43.

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Heil, O. and T. S. Robertson (1991). Toward a theory of competitive market signaling: A research. Strategic Management Journal 12: 403-419. Hellmann, T. and M. Puri (2001). Venture capital and the professionalization of start-up firms: empirical evidence. Journal of Finance forthcoming. Holtz-Eakin, D., D. Joulfaian, and H. S. Rosen (1994a). Entrepreneurial decisions and liquidity constraints. RAND Journal of Economics 25(2): 334-347. Holtz-Eakin, D., D. Joulfaian, and H. S. Rosen (1994b). Sticking it out: Entrepreneurial survival and liquidity constraints. Journal of Political Economy 102(1): 53-75. Kennedy, P. (1997). A guide to econometrics. Cambridge, Ma, MIT Press. Kockesen, L. and S. Ozerturk (2002). Staged financing and endogenous lock-in: A model of start-up finance. Working paper, Columbia University. Kreps, D. M. (1990). A course in microeconomic theory. Princeton, N.J., Princeton University Press. Lerner, J. (1995). Venture capitalists and the oversight of private firms. The Journal of Finance 50: 301-319. Meggison, W. L. and K. A. Weiss (1991). Venture capital certification in initial public offerings. Jounral of Finance 46. Neher, D. V. (1999). Staged financing: An agency perspective. Review of Economic Studies 66: 255-274. Robie, K. M., M. Wright, et al. (1997). The monitoring of venture capital firms. Entrepreneurship Theory and Practice: 9-27. Sahlman, W. A. (1990). The structure and governance of venture-capital organizations. Business Economics 29: 35-37. Sapienza, H. J. and A. K. Gupta (1994). Impact of agency risks and task uncertainty on venture capitalists-CEO interaction. Academy of Management Journal(37): 1618-1632. Spence, M. A. (1974). Market signaling: Information transfer in hiring and related screening processes. Cambridge, Ma, Harvard University Press. Wang, S. and H. Zhou (2002). Staged financing in venture capital: Moral hazard and risks. Journal of Corporate Finance forthcoming.

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TABLE 1 Descriptive statistics for firms in the sample Panel A: Industry statistics
Venture-backed firms Communications and networking Electronics & Computer Hardware Semiconductors Software Information Services Healthcare & Biotechnology Business & Consumer Services and Products Total 28 8 8 51 35 19 21 170

Panel B: Number of financing rounds for companies in the sample

Founded Before 1994 1994-95 1996-97 1998-99 Total Mean 3.10 3.41 3.00 1.93 2.75 Median 3 3.5 3 2 2 Min. 1 1 1 1 1 Max. 6 6 6 5 6 St. Dev. 1.97 1.28 1.49 0.93 1.47 # of Companies 20 34 62 54 170

Panel C: Valuation amounts for companies in the sample

Rounds of financing Early rounds Seed 1 Late rounds 2 3 4 Other rounds 5 6 Overall Amount raised (in millions of dollars) Mean $1.40 5.65 9.80 14.48 16.43 24.68 18.61 $9.08 Median $1.23 4.00 7.50 9.28 11.00 23.50 12.13 $5.00 St. Dev. $0.99 7.48 8.73 16.82 19.31 19.02 22.66 $12.35 Post-money valuation (in millions of dollars) Mean $3.34 13.70 47.07 57.00 112.40 147.70 347.84 $46.31 Median $3.00 10.50 30.00 49.00 66.00 135.37 347.84 $20.00 St. Dev. $1.70 13.86 50.78 44.90 149.16 70.06 172.76 $74.40 60 162 122 67 37 16 4 468 Number of Rounds

Panel D: Evolution of the database over time

Year Venture-backed firms year end Number of employees Bi-monthly data points 1994 19 389 5,400 1995 29 832 11,446 1996 64 1,832 23,264 1997 47 3,755 51,798 1998 98 5,426 74,980 1999 109 9,371 116,120 2000 101 6,477 49,270 Total 194 27,193 585,497

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TABLE 2 Descriptive statistics for research variables Panel A: Events in the sample Number of months Number of months with financing event Number of early round events (rounds zero and one) Number of late round events (rounds two, three, and four) Number of other rounds (round five and six) Number of IPO 4,155 268 79 165 12 12

Panel B: Growth, turnover and average salary for venture-backed startups

Mean Standard deviation 3.75 33.89 0.063 2,732 15.0 Minimum Maximum Median

Employee growth (per month) Number of employees Turnover Average salary (in $) Time in the sample (in months)

1.80 31.19 0.032 7,310 18.5

-14 1 0 1,672 1

27 336 0.739 30,394 77

1 21 0 6,935 14

Panel C: Correlation table

Average salary Growth Average salary Turnover Ln (size) 0.05*** Turnover -0.29*** -0.04*** Ln (size) 0.27*** -0.02 0.05
***

Ln (age) -0.12*** -0.02 0.16*** 0.39***

Correlations are all significant at 1% level except for the correlation between average salary and Ln (size) and Ln (age) that are not significant.

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TABLE 3 Rounds of funding and changes in startup firms

Model 1 Employee Growthj,t Coefficient Constant Ln (Size)j,t-1 Ln (Age)j,t Early Roundmonthj,-3 Early Roundmonthj,-2 Early Roundmonthj,-1 Early Roundmonthj,0 Early Roundmonthj,+1 Early Roundmonthj,+2 Early Roundmonthj,+3 Late Roundmonthj,-3 Late Roundmonthj,-2 Late Roundmonthj,-1 Late Roundmonthj,0 Late Roundmonthj,+1 Late Roundmonthj,+2 Late Roundmonthj,+3 Adjusted R-squared # of observations 1.61 1.17** -0.99** 0.09 0.26 0.45 0.60* 1.21** 1.15** 0.83** 0.65* 0.84** 0.49 1.23** 2.06** 1.59** 1.52** 0.17 4,132
**

Model 2 Average salaryj,t Coefficient 6,983 -80 -113

**

t-statistic 5.46 13.05 -12.27 0.34 0.90 1.38 2.52 3.35 3.79 2.85 2.26 2.74 1.72 3.64 5.91 4.23 3.94

t-statistic 27.52 -1.12 -1.68 -2.92 -2.63 -2.16 -1.31 -0.26 -0.30 -0.32 -1.61 -0.13 1.06 0.49 1.08 0.27 1.50

-925** -776** -630* -372 -84 -80 -70 -279 -22 -185 102 221 50 237 0.08 4,131

Early Roundmonthj, i, and Late Roundmonthj, i are dummy variables that take value of one if month t is i months before/after a month when the company received external funding (where i takes values of 3 to 3). Control dummies for the months around fifth and sixth rounds as well as for industry are included but not reported. The reference industry is business and consumer services and products. To avoid the influence of outliers, we delete the top and bottom 0.5% observations for the dependent variables. Standard errors are White-adjusted. *, or ** indicate that the coefficient is significant at the 5%, 1% level (2-tailed).

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TABLE 4 Rounds of financing and employee turnover

Turnoverj,t Constant Ln (Size)j,t-1 Ln (Age)j,t Early Roundmonthj,-3 Early Roundmonthj,-2 Early Roundmonthj,-1 Early Roundmonthj,0 Early Roundmonthj,+1 Early Roundmonthj,+2 Early Roundmonthj,+3 Late Roundmonthj,-3 Late Roundmonthj,-2 Late Roundmonthj,-1 Late Roundmonthj,0 Late Roundmonthj,+1 Late Roundmonthj,+2 Late Roundmonthj,+3 Adjusted R-squared # of observations Coefficient 0.011 -0.002 0.012** -0.012* -0.010 -0.013* -0.012* -0.005 -0.013** -0.011** -0.003 -0.005 -0.006 0.004 -0.008* -0.008** -0.005 0.04 4,151 t-statistic 1.96 -1.46 7.81 -1.96 -1.43 -2.44 -2.36 -0.65 -3.59 -2.87 -0.65 -1.12 -1.69 0.78 -2.28 -2.57 -1.34

Early Roundmonthj, i, and Late Roundmonthj, i are dummy variables that take value of one if month t is i months before/after a month when the company received external funding (where i takes values of 3 to 3). Control dummies for the months around sixth and seventh rounds as well as for industry are included but not reported. The reference industry is business and consumer services and products. To avoid the influence of outliers, we delete the top and bottom 0.5% observations for the dependent variables. Standard errors are White-adjusted. *, or ** indicate that the coefficient is significant at the 5%, 1% level (2-tailed).

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TABLE 5 Rounds of financing and funding amount

Model 1 Employee Growthj,t Coefficient Constant Ln (Size)j,t-1 Ln (Age)j,t Early Roundmonthj,-3 Early Roundmonthj,-2 Early Roundmonthj,-1 Early Roundmonthj,0 Early Roundmonthj,+1 Early Roundmonthj,+2 Early Roundmonthj,+3 Late Roundmonthj,-3 Late Roundmonthj,-2 Late Roundmonthj,-1 Late Roundmonthj,0 Late Roundmonthj,+1 Late Roundmonthj,+2 Late Roundmonthj,+3 Early Round j,-3 * Amount Early Round j,-2 * Amount Early Round j,-1 * Amount Early Round j,0 * Amount Early Round j,1 * Amount Early Round j,2 * Amount Early Round j,3 * Amount Late Round j,-3 * Amount Late Round j,-2 * Amount Late Round j,-1 * Amount Late Round j,0 * Amount Late Round j,1 * Amount Late Round j,2 * Amount Late Round j,3 * Amount Adjusted R-squared # of observations 1.88** 0.98** -0.86** 0.06 0.14 0.20 0.25 0.77* 1.13** 0.65* 0.23 -0.59 -0.10 -0.64 0.59 -0.52 -0.84 -0.008 0.009 0.033 0.057* 0.089 0.000 0.060 0.044 0.142** 0.063* 0.186** 0.146** 0.213** 0.238** 0.21 4,132 t-statistic 6.44 11.20 -11.23 0.17 0.47 0.65 0.92 2.32 3.10 2.09 0.5 -1.09 -0.22 -1.36 1.20 -0.98 -1.57 -0.30 0.50 0.83 1.97 1.23 0.01 1.14 1.09 2.82 1.81 4.54 3.22 3.73 4.08 Model 2 Average salaryj,t Coefficient 6,996** -108 -78 -802** -718* -583* -563 -34 -54 -114 -746 -393 -64 -400 235 -313 -256 -21 -9 -8 38 -9 -2 21 46** 37** 26 50** 1 38 49** 0.10 4,131 t-statistic 27.32 -1.48 -1.14 -2.99 -2.08 -2.02 -1.76 -0.09 -0.18 -0.46 -3.06 -1.72 -0.27 -1.36 0.70 -1.17 -1.13 -0.99 -0.44 -0.28 0.86 -0.24 -0.08 0.64 3.60 2.74 1.66 2.71 0.07 1.92 3.17 Model 3 Turnoverj,t Coefficient 0.010 -0.002 0.116** -0.015* -0.009 -0.012 -0.096 -0.005 -0.012** -0.010* -0.003 -0.001 -0.004 0.010 -0.009 -0.006 -0.000 0.001 -0.0002 -0.0001 -0.0005 0.0002 -0.0004 -0.0004 0.000 -0.0004 -0.0001 -0.0007* 0.000 -0.0002 -0.0004 0.04 4,151 t-statistic 1.85 -1.23 7.49 -1.98 -1.19 -1.92 -1.44 -0.56 -2.90 -2.20 -0.40 -0.11 -0.76 1.51 -1.72 -1.17 -0.03 0.44 -0.19 -0.18 -0.97 0.27 -0.85 -0.84 -0.01 -0.15 -0.48 -2.18 0.34 -0.83 -1.69

Early Roundmonthj, i, and Late Roundmonthj, i are dummy variables that take value of one if month t is i months before/after a month when the company received external funding (where i takes values of 3 to 3). Control dummies for the months around fifth and sixth rounds as well as for industry are included but not reported. The reference industry is business and consumer services and products. To avoid the influence of outliers, we delete the top and bottom 0.5% observations for the dependent variables. Standard errors are White-adjusted. *, or ** indicate that the coefficient is significant at the 5%, 1% level (2-tailed).

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