Exit Behavior in Venture Capital

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CONTRACTS AND EXITS IN VENTURE CAPITAL FINANCE*

Douglas J. Cumming

Assistant Professor of Finance, Economics & Law

University of Alberta School of BusinessEdmonton, Alberta, Canada T6G 2R6

Telephone: (780) 492-0678Fax: (780) 492-3325

E-mail: [email protected]

Web: http://www.bus.ualberta.ca/dcumming/

First Draft: March 1, 2002

This Draft: April 22, 2002

* Comments welcome! I owe special thanks to the venture capital funds for providing the

data, and to Jan Peter Kooiman, Enrico Perotti, Ibolya Schindele, and Robert Westenberg for theirhelpful support. I received helpful comments and suggestions from the seminar participants at

the Aarhus Business School (March 2002), Copenhagen Business School (March 2002), the ABN

AMRO Bank Conference on Venture Capital Exit Strategies, Amsterdam (March 2002), and theUniversity of Alberta (April 2002). This paper is scheduled for presentation at the Tilburg

University Conference on Regulatory Competition in Corporate and Security Law in Europe(September 2002), The Tinbergin Institute at the University of Amsterdam (September 2002) and

the American Finance Association Annual Conference, Washington DC (January 2003).Collection of the data was made possible with the generous assistance of the ABN AMRO BankCorporate Finance Department, the University of Amsterdam Department of Financial

Management, and a University of Alberta Pearson Fellowship. I have also greatly benefited fromworking with Jeff MacIntosh on related research. Any errors and/or omissions are my own.

mailto:[email protected]:[email protected]:[email protected]://www.bus.ualberta.ca/dcumming/Default.htmhttp://www.bus.ualberta.ca/dcumming/Default.htmhttp://www.bus.ualberta.ca/dcumming/Default.htmmailto:[email protected]


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CONTRACTS AND EXITS IN VENTURE CAPITAL FINANCE

First Draft: March 1, 2002

This Draft: April 22, 2002

Abstract

Contracts and exits from a sample of 179 investment rounds in 132 entrepreneurial firms by 17 European venture capital (VC) funds are analyzed. The data indicate the financial contractsare quite heterogeneous in terms of both the cash flow and control rights. The use of differentsecurities by European VC funds does not depend on the definition of venture capital, and thesecurities used are not functional equivalents. A normative empirical analysis of exit shows the

likelihood of different types of exit vehicles (IPO, acquisition, and liquidation) and the returns toventure capital depend on not only firm specific characteristics but also the allocation of cashflow and control rights.

Keywords: Venture Capital, Financial Contracting, Exit, IPO, Acquisition

JEL Classification: G24, G28, G31, G32, G35


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1. Introduction

Venture capital1 contracts are heterogeneous: there exist differences across contracts in

the selected securities, control rights, veto rights, provisions for different contingencies, among

other things, depending on the characteristics of the transacting parties. Venture capital exitdecisions are also heterogeneous: a disposition may involve an initial public offering (IPO), or an

acquisition (i.e., a trade sale, where both the entrepreneur and venture capitalist sell their interest),and venture capital contracts typically specify which party has control over the exit decision.

2

It is widely recognized that a venture capitalist’s decision to invest in an entrepreneurialfirm is based on exit potential. While previous research in venture capital has identifiedinternational differences in financial contracts and international differences in exit strategies, the

precise interaction between these two activities has not been empirically studied. This paperintroduces a new European venture capital dataset to provide new insights into the ways in which

contracting and exit are interrelated. This paper provides a positive empirical analysis of thetypes of contracts used by venture capitalists, and a normative empirical analysis of the resulting

exit process associated with different contracts and different types of entrepreneurial investments.

In the first of the two main parts of this paper, a positive analysis of functionaldifferences in financial contracts is provided. We expand the scope of evidence on securitiesused in venture capital finance. While venture capitalists in the United States almost always use

convertible preferred equity to finance entrepreneurial firms, venture capitalists in every othercountry (at least those where data are available) use a variety of forms of finance (see section 2

below for details). In the European venture capital data herein, we observe common equity usedmost frequently, but there are a wide variety of securities used in venture capital transactions. Werelate the use of different securities to the type of entrepreneurial firm (e.g., stage of development,

industry), board seats, specific contingencies, veto rights and other control rights. Previousresearch has not considered the allocation of control rights when securities other than convertible

preferred equity are used.

The second of the two main parts of this paper provides a normative analysis of the performance of the different investments – in terms of the selected exit vehicle (IPO, acquisition,write-off

3) and the IRR. This part of the analysis is based on previous research on venture capital

exits (MacIntosh, 1997; Black and Gilson, 1998; Cumming and MacIntosh, 1999;Schweinbacher, 2001; Smith, 2001; Fleming, 2002). We extend previous research by considering,among other things, how control rights and cash flow rights among different securities affects the

selection of the exit vehicle. Our data are the first European dataset that enables and investment-

1 The term ‘venture capital’ is defined differently across countries. In this paper we employ the definition used by the

European Venture Capital Association (www.evca.com), which is inclusive of seed, early, expansion, mezzanine(late), turnaround and buyout transactions. This broad definition is also used in other jurisdictions such as Canada

(www.cvca.ca). Regardless, the main results in this paper are not contingent on the particular definition of venture

capital. As well, all of the (self-described) venture capital funds in the data herein consider financing different types ofentrepreneurial firms.

2 Venture capitalists may also dispose of their investments via a secondary sale (where the venture capitalist sells to athird party, but the entrepreneur retains his or her interest), a buyback (where the entrepreneur repurchases the venture

capitalist’s interest), or a write-off (liquidation); see MacIntosh (1997). Partial dispositions through each exit vehicleare also possible (Cumming and MacIntosh, 2002).

3 The term ‘acquisition’ generally refers to trade sales to other investors as well as other strategic acquirors.

Acquisitions pertain to strategic acquirors in the data herein.


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by-investment analysis of the selected exit vehicle,4 and the first dataset (anywhere) that enables anormative analysis of which financial structure is ‘best’ in venture capital finance.

This paper analyzes a hand-collected dataset involving 179 investment rounds in 132

entrepreneurial firms from 17 European venture capital funds. Coincidentally, the data are quitesimilar in scope to other hand-collected datasets in academic venture capital research. For

example, Kaplan and Strömberg (2002) analyze 213 investment rounds in 119 portfoliocompanies by 14 U.S. venture capital funds. Papers by Gompers (1997) and Hellmann and Puri(2000, 2001) also use data of similar scope.

In a nutshell, the data herein indicate the following. First, different securities are notfunctional equivalents in venture capital contracts. That contracts other than convertible

preferred equity are used is not dependent on the definition of venture capital. Second, theallocation of control rights, board seats, etc., depends on the allocation of cash flow rights

through the use of different securities. Third, the selected exit vehicle and the returns to venturecapital significantly depend on the allocation of cash flow and control rights in specific venture

capitalist investments. The results are interpreted within the institutional context from which thedata are derived, and suggest avenues for further theoretical and empirical research.

This paper is organized as follows. Section 2 outlines previous research. The data aredescribed in section 3. Section 4 considers the determinants of contractual terms. Section 5

evaluates the performance of the investments under different contracts, and the likelihood ofdifferent exit outcomes. Limitations are discussed in section 6, and avenues for future theoreticaland empirical research are discussed. Concluding remarks follow.

2. Previous Research

Our research is based on a number of earlier papers that have provided the foundation forunderstanding venture capital (VC) investing and exit decisions. Previous VC contracting andexit papers may be categorized into seven groups:5

(1) Empirical research indicating the prevalent use of convertible preferred equity,

staging, syndication, and various control rights, etc. (Sahlman, 1990; Lerner, 1994;Gompers, 1995, 1997; Bergmann and Hege, 1998; Gompers and Lerner, 1999;Kaplan and Strömberg, 2002);

(2) Theoretical research explaining the optimality of convertible preferred equity in

venture capital based on the U.S. evidence, and the allocation of various controlrights (Sahlman, 1990; Chan, et al., 1990; Berglöf, 1994; Cornelli and Yosha, 1997;Hellmann, 1998; Marx, 1998; Trester, 1998; Bergmann and Hege, 1998; Repullo and

Suarez, 1998; Bascha and Walz, 2001a; Houben, 2001; Kirilenko, 2001; Schmidt,2001; among others);

4 Schweinbacher (2002) considers VC exits in Europe, but the data are averaged at the VC fund level (no investmentspecific data were collected).

5 This list omits papers pertaining to VC fundraising and fund structure (see, e.g., Jeng and Wells, 2000; Gompers and

Lerner, 1996, 1998, 1999). Please advise the author as to missing citations.


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(3) Research indicating the role of U.S. tax law in biasing the selected security in theU.S. towards convertible preferred equity for U.S. entrepreneurial firms (Gilson and

Schizer, 2001), but not in other jurisdictions such as Canada (Sandler, 2001);

(4) Empirical research showing the use of a variety of different securities in jurisdictionsother than the United States, including Canada (Cumming, 2000), Germany (Bascha

and Walz, 2001b), Finland (Parhankangas and Smith, 2000), Taiwan (Songtao,2000), Australia (Australian Bureau of Statistics, 2000), as well as in cases of cross-

border U.S. VC investments in Canadian entrepreneurial firms (Cumming, 2001),

and for different types of venture capital funds (not only limited partnerships, butalso corporate VCs, government VCs, etc.; Cumming, 2000);6

(5) Theoretical research on the optimality of convertible preferred equity in ensuring anefficient exit (Berglöf, 1994; Black and Gilson, 1998; Bascha and Walz, 2001;

Hellmann, 2001; Smith, 2001; Schweinbacher, 2001);

(6) Empirical research examining the performance of venture-backed IPOs (Barry et al.,1990; Megginson and Weiss, 1991, Lin and Smith, 1997; Gompers and Lerner, 1999;

Ljungqvist, 1999; Franzke, 2001; among others);

(7) Empirical research examining the complete choice of different venture capital exit

vehicles (IPOs, acquisitions, secondary sales, buybacks, and write-offs) based on thecharacteristics of the entrepreneurial firms and venture capital funds (MacIntosh,1997; Black and Gilson, 1998; Cumming and MacIntosh, 1999; Schweinbacher,2002; Flemming, 2002), and related empirical research explaining the risk and returnto venture capital (Cochrane, 2001; Smith and Smith, 2000; Manignart et al., 2000).

Previous venture capital research has not considered the allocation of control rights whensecurities other than convertible preferred equity are employed. In addition, previous researchhas not fully analyzed which types of investments and contracts typically lead to ‘superior’

results, in terms of the selected exit vehicle as well as the internal rate of return (IRR). Thefollowing sections provide an analysis of a new dataset that shed light on these issues, andsuggest avenues for further research.

3. Data

3.1. Description of the Data

We consider the contracts and exits from a hand-collected sample of 17 European venturecapital funds. The data comprise 179 investment rounds in 132 entrepreneurial firms (portfoliosize ranges from 2 – 20 entrepreneurial firms per fund). The VC funds are based in Austria (1

fund), Belgium (1), Czech Republic (1), Denmark (1), France (1), Germany (4), Italy (2), Poland

(1), Switzerland (1) and The Netherlands (4). As with U.S.-based research with data of similarscope (Gompers, 1997; Kaplan and Strömberg, 2002), as well as European research (Maginart etal., 2000; Schweinbacher, 2002), the funds were selected based on their willingness to disclose

6 U.S. based research on this issue has only considered limited partnerships. It is the author’s hope that future researchin the U.S. will consider other types of venture capital funds as well. In addition, future theoretical research mayattempt to explain forms of finance other than convertible preferred equity, in light of the fact that the only evidencethat convertible preferred equity is used most frequently is from U.S. data. Some recent theoretical paper provides

guidance as to the use of different securities by venture capitalists; see Garmaise (2000) and Schindele (2002).


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CFS Working Paper No. 2002/07

Exit Timing of Venture Capitalists in the Course of anInitial Public Offering

Werner Neus* and Uwe Walz**

June 2002***

Abstract:

We analyze the desinvestment decision of venture capitalists in the course of an IPO of their portfolio firms. The capital market learns of the project quality only in the period followingthe IPO. Venture capitalists with high-quality firms face a trade-off between immediately

selling their stake in the venture at a price below the true value and having to wait until thetrue value is revealed. We show that the dilemma may be resolved via a reputation-acquiring

mechanism in a repeated game set-up. Thereby, we can explain, e.g., the advent of “hot-issuemarket behavior” involving early disinvestments and a high degree of price uncertainty.Furthermore, we provide a new rationale for underpricing. Young venture capitalists may use

underpricing as a device for credibly committing themselves to acquiring reputation.

JEL Classification: G24, G14, D82

Keywords: Exit Decisions, Venture Capital, IPO, Underpricing

* Werner Neus, University of Tübingen, Department of Banking, Mohlstr. 36, D-72074 Tübingen,

email: [email protected].** Uwe Walz, University of Tübingen, Department of Economics, Mohlstr. 36, D-72074 Tübingen,

email: [email protected], CEPR, London, UK, and Center for Financial Studies,

Taunusanlage 6, D-60329 Frankfurt am Main.*** We would like to thank seminar participants at the Universities of Frankfurt and Bonn for suggestions and

comments. We are also grateful to an anonymous referee for the very helpful and constructive commentson an earlier version of the paper.


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I. Introduction

One of the key issues in venture capital finance is the exiting process (cf. Gompers and

Lerner, 2000). Due to the structure of the venture capital industry (often closed-end

funds are used) and due to their comparative advantage in start-up finance, venture capi-

tal firms are engaged in their portfolio firms for only a limited period of time. Unwind-

ing the engagement in the portfolio firm in the course of the exit process is therefore one

of the most important aspects of success for venture capital firms. Of the different exit

channels, the initial public offering (IPO) of shares of the portfolio firms is often re-

garded as the most essential one in terms of its contribution to a venture capitalist’s re-

turn. Therefore, IPOs play a decisive role in venture capital investments (see, e.g., Black

and Gilson, 1998). It is, however, quite surprising to observe that venture capitalists are

by no means disposed to sell (all) their shares at the time of the IPO (see Barry et al.

1990).

This observation is the starting point of the present paper. We analyze the disin-

vestment decision of venture capital firms (VCs) in the course of an IPO. We isolate the

determinants of the VCs’ decision to unwind their investment at the time of the IPO and

explore potential motives for postponing the disinvestment to a later period. In contrast

to the analysis by Gompers (1996), who considers the timing of the IPO, we take the

date of the IPO as given and analyze the optimal disinvestment time period (i.e. at the

time of the IPO or later). We thereby take into account the fact that VCs, as inside in-

vestors, are typically better informed, at least for some period of time, about the quality

of their portfolio firms than are outside investors in the capital market. That is, whereas

informational asymmetries do exist at the time of the IPO, they vanish over time. There-

fore, VCs wanting to disinvest a single high-quality portfolio firm face the following


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trade-off. On the one hand, late disinvestments are associated with large opportunity

costs; on the other hand, they may help to overcome informational costs (i.e. a low price

for such ventures).

By extending our basic set-up of a single-issue case to a repeated set-up, we take

into account that venture capitalists are identifiable, repeated players in the IPO market.

We show that such a repeated-game set-up allows venture capitalists to establish a repu-

tation as honest players in the IPO market, i.e. for not selling overvalued shares. As we

are less interested in a subtle game-theoretic model than in economic consequences, we

model reputation as simple as possible and use an infinitely repeated game with a per-

fectly observable deviant behavior. In models like this (e.g. Klein and Leffler, 1981),

reputation is the trust outside investors have with respect to the correctness of a VC’s

announcement of project quality, implicitly given by the pricing of a venture. Therefore,

reputation is a binary variable: VCs may or may not have a reputation for a correct pric-

ing.

This kind of reputation (as well as any other, more differentiated kind) allows

VCs to overcome the costs associated with the informational asymmetries in the IPO

market. Within such a reputational equilibrium market inefficiencies can be resolved.

This corresponds to the more general “certification hypothesis” on the role of invest-

ment bankers in the process of issuing shares in public offerings (e.g. Beatty and Ritter,

1986; Booth and Smith, 1986). The importance of reputation is stressed in many theo-

retical as well as empirical studies into venture capital (see, e.g., Amit et al. 1998).

Here, reputation serves as a credible commitment to a correct pricing of issues. We ask

under which circumstances such a reputational equilibrium will emerge. VCs may differ

in their experience, their market share, and the composition of their portfolio. We inves-


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tigate which types of venture capitalists are most likely to be able to establish a reputa-

tion for credible announcements of the (high) quality of portfolio firms in the course of

the IPO. This kind of reputation will enable VCs to sell their venture at the time of the

IPO at the “correct” price. We show that seasoned venture capitalists with a high market

share are those signaling the quality of their firms best. This conforms with empirical

research on the timing of disinvestment in the course of an IPO (see Lin and Smith,

1998).

In a second step, we extend our basic model by allowing for the possibility of in-

vesting in the quality of portfolio firms via advisory services and management support

for an additional period. This is a matter of importance, as the provision of managerial

resources belongs to the essential tasks of venture capitalists (see Hellmann, 1998).

Once again, we isolate the types of VCs willing to invest for an additional period in

their portfolio firms and analyze the impact of this option on the distribution of disin-

vestment timings. In a third step, we introduce underpricing as an additional device for

acquiring reputation in the IPO market that involves not selling overvalued firms. We

show that particularly young and unseasoned venture capitalists may be led to under-

price their high-quality firms in order to acquire one of the most-sought-after goods in

the venture capital market: reputation. By underpricing, young VCs are able to over-

come (at least partially) the inefficiencies in the IPO market.

There are a number of studies which are related to our study. Gompers (1996)

investigates the timing of the IPO of venture-backed firms and provides arguments that

VCs force their firms to go public too early. In an empirical paper, Gompers and Lerner

(1998) investigate one very prominent way for VCs to liquidate the positions in their


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portfolios, namely via the distribution of shares (rather than cash) to their investors. In

so doing, VCs delegate the task of selling shares to their investors.

Our paper complements the empirical study of Lin and Smith (1998), who analyze

the disinvestment decision of VCs using US data. However, their study lacks a theoreti-

cal framework in which the disinvestment decisions can be analyzed in detail.

Underpricing is one of the most prominent features in the IPO literature, often

viewed as a signal for project quality (e.g. Grinblatt and Hwang, 1989; Allen and Faul-

haber, 1989). Alternatively, underpricing may be a compensation for a winner’s curse in

a set-up where some of the outside investors have superior information on the value of

the firm (Rock, 1986). Furthermore, underpricing may emerge as the result of moral-

hazard problems between the investment banker (as the agent) and their client (Baron,

1982). We present an additional rationale for underpricing: Particularly for young VCs,

underpricing may serve as a credible commitment to building up a reputation for the

correct pricing of issues.

Finally, there is some relation between our paper and Stocken (2000), who exam-

ines the credibility of a manager’s disclosure of privately obtained information to inves-

tors in a repeated-game set-up. In his model, sufficiently patient managers almost al-

ways report truthfully, whereas in our paper the credibility of the VCs depends on cer-

tain attributes.

The paper is organized as follows. In the next section, we present the basic struc-

ture of our model and outline the equilibria emerging for a one-shot game, i.e. for a sin-

gle issue. The second part of this section contains a detailed analysis of potential reputa-

tional equilibria. In sections three and four, we analyze straightforward extensions of

our basic setting. In section three, we allow for the option of value-enhancing invest-


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tential cost of cheating is less pronounced in this case, thus necessitating a high level of

underpricing.

The (young) VCs’ incentive to underprice may have obvious repercussions on the

investment process of this particular class of VCs. Good-type firms could anticipate the

incentive of the VC and hence would require compensation for this, since underpricing

reduces its expected revenue from the IPO. This would, given that potential portfolio

firms anticipate this correctly and can observe the characteristics of VCs, impose an ad-

ditional cost on (young) VCs without affecting, however, our line of argument.

V. Concluding remarks

The purpose of the present analysis was to investigate the disinvestment decision of

venture capital firms in the course of an initial public offering. Due to informational

asymmetries product quality is only revealed after the IPO period. Using a repeated

game framework we asked whether (and if so, how) expected sanctions in future periods

can force VCs who might otherwise falsely report the quality of their venture to report

them correctly and allow for disinvestment in the IPO period at the true project values.

This avoids the welfare costs associated with disinvestment decisions in the course of an

IPO.

In addition, we investigated under which circumstances VCs may have an incen-

tive to engage themselves in their ventures even after the IPO period. We went on to

provide a previously unexplored reason for underpricing in the course of a venture capi-

tal-backed IPO. In our setting, underpricing serves as a device for young VCs to credi-

bly invest in the building up of reputation, which especially for first time funds is so of-

ten urgently needed.


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Our analysis provides a number of explanations for stylized facts and hypotheses

which can be directly tested by using available data for venture and non-venture backed

IPOs.

First, we provide an explanation for a number of characteristics associated with a

“hot-issue” market. With a “hot-issue” market (i.e., with a low ß) what emerges is a

pooling equilibrium with early disinvestments associated with a high degree of price

uncertainty. This is reminiscent of the grandstanding hypothesis for early disinvest-

ments put forward by Gompers (1996). But in contrast to him we do not focus on the

timing of the IPO, but rather on the disinvestment decision of the VC. In addition, and

in contrast to his argument, with us early selling does not have any informational con-

tent (i.e. does not send a signal to potential investors) but rather results from a high de-

gree of uncertainty.

Second, we find that a high market share on the part of an individual VC (i.e., a

high d) facilitates the building up of reputation, together with a high degree of credibil-

ity and low price uncertainty. We should therefore expect that experienced VCs with a

high market share build up reputation, disinvest early, and are able to sell even their

high-quality ventures at close to their true value. This is in line with Lin and Smith

(1998), who find with US data that only VCs that sell during the IPO have well-

established reputations. It can also be interpreted as explaining the empirical observa-

tion that markets react favorably to the presence of (seasoned) venture capital financing

at the time of an IPO (see Barry et al. 1990; Megginson and Weiss, 1991).

Third, we show that a careful selection of ventures on the one hand, and late-stage

investment in the value of the portfolio firms via intense management support on the

other hand, constitute clear substitutes. In our model, VCs with an expected


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preponderance of high-quality firms (i.e., a high a) have little incentive to undertake

investments in the improvement of firm value via intense management support in late

stages. This suggests the formation of clientele groups. Typical venture capitalists who

are highly specialized in active investment (i.e., providing intense management support)

will disinvest late and provide very little price uncertainty. They will sell “mature”

firms. More conventional financiers, who have little competitive edge in the area of “ac-

tive” investment, will disinvest early and provide for a higher degree of price uncer-

tainty.

Fourth, VCs engaged in high-risk ventures (i.e., with a high ? ) have a higher in-

centive to establish a reputation for selling high-quality ventures at their true value and

not reporting falsely on the quality of their ventures. Hence, for them the credible

building up of reputation should be facilitated, leading to early disinvestments and little

price uncertainty. A final hypothesis emerging from our analysis is that especially un-

seasoned VCs have an incentive to engage in underpricing, whereas seasoned VCs do

not need to underprice. This hypothesis is in line with empirical findings on the US

market (see Muscarella and Vetsuypens, 1989; Gompers, 1996 for VCs; Johnson and

Miller, 1988, Carter and Manaster, 1990 for investment bankers in general).


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Investment, Duration, and Exit Strategies for Corporate and

Independent Venture Capital-backed Start-ups

Bing Guo

Universidad Carlos I II de Madrid, Business and Administration Department

Calle Madrid 126, Getafe 28903, Spain

[email protected]

Yun Lou

HEC Paris, Accounting Department

1 Rue de La Liberation, Jouy-en-Josas, Paris, France

[email protected]

David Pérez-Castrillo

Universitat Autònoma de Barcelona and Barcelona GSE, Facultat de Ciències Econòmiques

Edifici B, Bellaterra 08193, Barcelona, Spain

Ph: (+34) 935811405, fax: (+34) 935812012, [email protected]

Abstract

We propose a model of investment, duration, and exit strategies for start-ups backed by

venture capital (VC) funds that accounts for the high level of uncertainty, the asymmetry of

information between insiders and outsiders, and the discount rate. Our analysis predicts that

start-ups backed by corporate VC funds remain for a longer period of time before exiting and

receive larger investment amounts than those financed by independent VC funds. Although a

longer duration leads to a higher likelihood of an exit through an acquisition, a larger investment

increases the probability of an IPO exit. These predictions find strong empirical support.

JEL Classification: G24, G32, G34.

Keywords: Venture Capital Funds, Start-ups, IPO, Acquisition.

1


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1 Introduction

Entrepreneurs and venture capitalists make investment decisions and choose the length of their

involvement in a start-up to maximize the chances of success and the value of their ventures. They

also look ahead and develop strategies to cash in on their companies. In particular, these strategies

allow venture capitalists to liquidate their shares. Planning an exit strategy is as important as

deciding how to start the enterprise.

There are two main exit routes for a successful start-up. The company can go through an Initial

Public Offering (IPO) or can be sold to an existing firm via an acquisition. 1 Under an IPO, the

venture obtains a stock market listing, which enables the company to receive additional financing

for its projects and enables the insiders to eventually sell their shares to the public. If the start-up

is acquired, the insiders obtain immediate cash in return for their shares.

The optimal exit route for start-ups depends on multiple factors, such as the expected prof-

itability of the venture, the level of uncertainty, the asymmetry of information between the insidersand outsiders (e.g., potential buyers and new investors),2 the possible conflicts of interest among

insiders,3 the financial market conditions at the time of the exit, and the characteristics of the

venture capitalists. Some of these factors are affected by the partners’ investment and duration

decisions. Understanding the main trade-offs faced by start-ups at the exit stage is crucial because

this understanding not only allows one to determine how venture capitalists and entrepreneurs

divest their companies but also how the decisions are taken at the onset of the venture.

One important determinant of a start-up’s investment, duration and exit route is the charac-

teristics of the venture capital funds that are involved. Whether the start-up receives financing

from Corporate Venture Capital (CVC) funds or receives financing only from Independent Venture

Capital (IVC) funds is particularly important. In this paper, we explore the differences in invest-

ment, duration, and exit strategies of the start-ups depending on the nature of the venture capital

funds.

Unlike traditional IVC funds, which are limited partnerships, CVC funds are private equity

funds in which large corporations invest (i.e., CVC funds are subsidiaries of corporations) (Chem-

manur, Loutskina, and Tian, 2011). Several differences exist between the two types of funds.

First, whereas the sole objective of an IVC fund is to actualize a financial return on capital, CVC

programs also care about strategic returns, such as the development of new, related business (see

Sykes, 1990; Yost and Devlin, 1993; Dushnitsky and Lenox, 2006; Hellmann, Lindsey, and Puri,

2008). Second, because of the presence of the corporate parent, CVC funds can provide more

industry-related knowledge and support to start-ups than IVC funds (Riyanto and Schwienbacher,

2006; Chemmanur, Loutskina, and Tian, 2011). Third, CVC managers are likely to be less con-

cerned with immediate financial returns from their portfolio firms than IVC managers (Manso 2011;

1Two other exit routes that are not as commonly used are Management Buy-out and Refinancing (or secondarysales); see Schwienbacher (2009).

2See Cumming and MacIntosh (2003) for a discussion about the information asymmetries between sellers and the

potential buyers of start-ups.3See, for instance, Gompers (1995); Kaplan and Strömberg (2003); De Bettiguies (2008); and Macho-Stadler andPérez-Castrillo (2010).

2


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Chemmanur, Loutskina, and Tian 2011) because of several reasons. CVC investors have more un-

used resources, such as technology and marketing resources (Sahaym, Steensma, and Barden, 2010;

Basu, Phelps, and Kotha, 2011; Da Gbadji, Gailly, and Schwienbacher, 2011). Moreover, IVC man-

agers’ payments are performance-based, whereas managers of CVC programs usually have fixed

salaries and receive corporate bonuses. Finally, the IVC managers’ abilities to raise additionalfunds depend on their reputations, which are influenced by their history of success (Gompers,

1996; Dushnitsky and Shapira, 2010). As a result of these differences, IVC fund managers are

more concerned about quick exits than CVC fund managers.

We focus on the fact that CVC funds are more patient than IVC funds in realizing finan-

cial returns from their investments in start-ups, and we analyze how this difference influences the

strategies of the start-ups. We propose a simple model that accounts for the high level of uncer-

tainty regarding the returns from an investment in a start-up, the existence of private information

in the hands of insiders, and the discount rates of the partners in the start-ups. We choose to

study a rather parsimonious model in which we abstract from possible internal conflicts among

insiders and some of the dynamic interactions between investment and duration. Our objective

is to build a model that encompasses three crucial decisions in the lives of start-ups (investment,

duration, and exit) rather than focusing on other, albeit interesting, aspects that appear at par-

ticular moments in time. This modeling strategy allows us to obtain theoretical results concerning

the aforementioned decisions, which we test using data from U.S. start-ups. Our empirical results

confirm the theoretical predictions.

In our model, the amount of capital invested in a start-up influences the start-up’s expected

value. We assume that a higher investment leads to a more favorable distribution of the set of potential values. Furthermore, the decision regarding the duration of the start-up (i.e., the length

of the relationship between the entrepreneur and the VCs until the exit of the start-up), affects the

market information about the probability of the venture’s success. We assume that the potential

value of the venture at the time of its exit will be known to every market participant. Nevertheless,

insiders have more precise information about the expected profitability of a start-up because they

know the probability of its success. Whether outsiders are informed of this probability depends on

how long the start-up remains in the market before exiting.

We show that the ventures with a higher probability of success are more likely to attempt an

IPO, whereas those with lower probabilities prefer to seek an acquirer. Moreover, the likelihood of

exiting through an IPO increases with the potential value of the start-up as long as that value is

positive. In contrast, start-ups with negative potential value are liquidated.

We link a start-up’s exit strategy with the investment decision and with the market level of

information. We show that a higher investment level induces a greater likelihood of a successful

exit. Of the successful exits, the higher the investment level is, the higher the likelihood of an IPO

exit. Moreover, the IPO exit rate is lower if outsiders receive more precise information, that is,

if the duration of the venture is longer. Finally, we analyze the optimal investment and duration

decisions of the start-up. In particular, we show that both the level of investment and the duration

of the venture decrease with the discount rate of the venture capital.

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The theoretical and empirical academic research on venture capital is growing. There are

plenty of studies on the effect of VC funds (v.s. non-VC funds) on the exit strategy of the start-

ups. However, the impact of the type of VC funds (i.e., CVC funds v.s. IVC funds) on the

investment, on the exit and, in particular, on the duration strategy of start-ups has not received

much attention in the previous literature.4

We discuss briefly the contributions that are mostrelevant to our paper.

With regard to the influence of VC fund characteristics on the level of investment for a start-up,

the theoretical model of Hellmann (2002) and the empirical analyses of Gompers and Lerner (2000)

and Masulis and Nahata (2009) also find that start-ups receive higher investment amounts from

CVC funds than from IVC funds. Concerning the choice of an exit route (i.e., IPO vs. acquisition),

most papers suggest that because of the CVC funds’ strategic returns, CVC-backed start-ups are

more likely to exit through an acquisition than IVC-backed start-ups. This argument has been

put forward by theoretical studies (Hellmann, 2002; Riyanto and Schwienbacher, 2006) and has

received empirical support from a study using a European dataset (Cumming, 2008). Based on

survey evidence, Siegel, Siegel, and MacMillan (1988) and Sykes (1990) also find that the percentage

of acquired CVC-backed start-ups is higher than the percentage of acquired IVC-backed ventures.

However, this result is challenged by Gompers and Lerner (2000) and Chemmanur and Loutskina

(2008), who find that CVC-backed start-ups exit more frequently through the IPO market than

IVC-backed start-ups do. Moreover, few start-ups appear to be acquired by the parent companies of

the CVC funds that financed these ventures. In the ThomsonOne and the Securities Data Company

Global New Issues databases that we use, only 5% of the start-ups with CVC financing that exit

via acquisitions are bought by the parent company of the CVC fund. Maula and Murrey (2001)find a similar result. Our paper introduces the duration strategy as an important determinant

of the exit choice. In this way, we provide an explanation for the disagreement in the empirical

results regarding the exit choices made by CVC- and IVC-backed start-ups.

2 The Mo del

We propose a model to analyze the optimal investment and duration decisions, as well as exit

strategy of a start-up (S ). As mentioned in the Introduction, we abstract from possible internal

conflicts among venture capitalists and managers/founders of the start-up. Therefore, the decisions

made by the start-up at any stage aim to maximize its expected discounted profits, that is, expected

income minus costs (including investment costs).5

In our model, the start-up takes decisions at two moments. First, it decides on the level and

the length of the investment. While we acknowledge that the financing of a start-up is a dynamic

process where, at each period, the information on the current development of the start-up is used to

decide about the next investments, we simplify this process and assume that the total investment

4See Da Rin, Hellmann, and Puri, forthcoming, for a survey of the academic work on venture capital and, in

particular, for a review of the papers that examine the structures and strategies of VC funds.5In Section 6, we discuss the implications of the nature of the VC on the objective function of the start-up.

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Speed and consequences of venture capitalist post-IPO exit

Imants Paeglis⁎, Parianen Veeren

John Mols on School of Bu siness, Concordia Univers ity, 1450 Guy Street, Montreal, Quebec H1H 1L8, Canada

a r t i c l e i n f o a b s t r a c t

Article history:

Received 13 April 2011Received in revised form 16 April 2013

Accepted 19 April 2013

Available online 28 April 2013

We examine the determinants of the speed at which venture capitalists exit a firm after its IPOand

theinfluence of their exit on firm value.We hypothesizethat thespeedof VC exit will be influencedby founder ownership, which both impedes liquidity of a firm'sstock and significantly influences its

post-exit value.Our results suggest that thisis indeedthe case. In particular, we find that firms with

intermediate levels of founder ownership have the fastest speed of VC exit. Also, such firms

experience the largest decline in firm value around the VC exit. Overall, our results suggest that

speed and consequences of VC exit are significantly related to a firm's ownership structure.

© 2013 Elsevier B.V. All rights reserved.

JEL Clas sification:

G24

G32

Keywords:

Venture capitalists (VC)

Exit

Ownership

1. Introduction

Venture capitalists (VC) are specialized, limited-term investors. Because of the limited life-span of their investments, the

planning and implementation of exits are an important part of their overall investment strategy. 1 The existing literature on VC

exits has largely treated the IPO itself as an exit event.2 In practice, however, it may take several years after the IPO for the VCs to

fully exit their portfolio companies. Further, the continued presence of VCs in a newly public firm is costly both in terms of capital

and time commitments. In particular, capital could be distributed to the limited partners who can then use it to fund new startups.

The venture capitalist himself could focus on monitoring and advising the new portfolio companies which have a greater need of

his expertise. Yet, despite this significance, we know very little about the determinants of the speed at which VCs exit their most

successful investments (for notable exceptions, see Gompers and Lerner, 1998; Lin and Smith, 1998; Luo, 2005).

In this paper, we examine the determinants and consequences of the venture capitalist post-IPO exit. We argue that the speed

at which venture capitalists exit a firm after its IPO and the influence their exit has on firm value will be an outcome of interaction

between the following two factors: (1) the firm's post-exit ownership structure and (2) the liquidity of its stock. Both of thesefactors are significantly influenced by the ownership stake held by the firm's founder. The founder is by far the most significant

individual blockholder in the newly public firm and has been shown to have a distinct influence on firm value.3

In particular, we hypothesize that founder ownership will influence the two aforementioned factors in the following manner.

First, upon the exit of venture capitalist, a major monitoring agent, the founder is likely to become the largest shareholder of the

Journal of Corporate Finance 22 (20 13) 10 4–123

⁎ Corresponding author. Tel.: +1 514 848 2424x2904; fax: +1 514 848 4500.

E-mail addresses: [email protected] (I. Paeglis), [email protected] (P. Veeren).1 See Gompers and Lerner (2002) and Smith (2005) for discussions on the importance of VC exits from the nance and law perspectives, respectively.2 See, e.g., Cumming (2008).3 While there are other individual blockholders present in the newly public rms, they are less likely to inuence the speed of VC exit (due to their, on average,

smaller ownership stakes and shorter term commitments to the rm). Later in the paper we examine the robustness of our results to the presence and ownership

of non-founder individual blockholders and show that our results are unique to founders.

0929-1199/$ –

see front matter © 2013 Elsevier B.V. All rights reserved.http://dx.doi.org/10.1016/j.jcorpn.2013.04.005

Contents lists available at SciVerse ScienceDirect

Journal of Corporate Finance

j o u r n a l h o m e p a g e : w w w . e l s e v i e r . c o m / l o c a t e / j c o r p f i n

http://dx.doi.org/10.1016/j.jcorpfin.2013.04.005http://dx.doi.org/10.1016/j.jcorpfin.2013.04.005http://dx.doi.org/10.1016/j.jcorpfin.2013.04.005mailto:[email protected]:[email protected]://dx.doi.org/10.1016/j.jcorpfin.2013.04.005http://dx.doi.org/10.1016/j.jcorpfin.2013.04.005http://dx.doi.org/10.1016/j.jcorpfin.2013.04.005http://www.sciencedirect.com/science/journal/09291199http://crossmark.crossref.org/dialog/?doi=10.1016/j.jcorpfin.2013.04.005&domain=pdfhttp://www.sciencedirect.com/science/journal/09291199http://dx.doi.org/10.1016/j.jcorpfin.2013.04.005mailto:[email protected]:[email protected]://dx.doi.org/10.1016/j.jcorpfin.2013.04.005


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firm with more unconstrained control. The influence of the changes in founder's control on firm value (from now on, we will refer

to this influence as the incentive effect ) depends upon the level of founder ownership. In particular, VC exit will be most

detrimental for firms with intermediate levels of founder ownership.4 The ownership stake of such founders will be high enough

to ensure control over the firm and yet too low to ensure his incentives are aligned with those of minority shareholders. This

suggests the highest potential for entrenchment of such founders.5 The VC exit will leave them with a free reign over the firm and

will therefore result in a decrease in firm value. In other words, firms with intermediate levels of founder ownership will have the

most negative incentive effect. The incentive effect for firms with low levels of founder ownership will be smaller, because the

market for corporate control will take over monitoring of the founder from the departing VCs. For firms with high levels of

founder ownership the incentive effect will be small as well since the VC exit will not significantly change the firm's ownership

structure (i.e., the founder will remain the controlling shareholder of the firm as before in the presence of venture capitalists).

Second, founder ownership is likely to have a negative influence on liquidity of a firm's stock (see Brockman et al., 2009, who

find that blockholders impede liquidity). In addition, venture capitalist ownership is also likely to impede liquidity. While the

source of the impediment will differ for various levels of founder ownership, the liquidity (illiquidity) is likely to remain relatively

stable over the entire founder ownership range.6 Given these impediments to liquidity, to avoid selling their shares at a discount,

the venture capitalists are better off selling their blocks in pieces. Therefore, staged exits (i.e., selling in pieces over a longer period

of time) will be the preferred exit strategy for VCs.

Moreover, the VC exit is likely to increase the liquidity of a firm's stock. This increase in liquidity, in turn, leads to a decrease in

the liquidity premium and expected return, and to an increase in the stock price. From now onward, we will refer to the increase

in firm value resulting from improved liquidity as the liquidity effect . The presence of a positive liquidity effect suggests a second

potential benefit to VC from staging the exit: selling each additional piece of ownership stake at a higher price allows him to

maximize the proceeds from his sales. Since a negative incentive effect leads to a lower price increase (if not a decrease) for firms

with intermediate levels of founder ownership, this second benefit from staging is likely to be significantly lower (or altogether

absent) for such firms. Consequently, VCs of such firms will be less likely to stage their exits (as compared to firms with low and

high levels of founder ownership). This implies that the speed of venture capitalist exit will be a concave function of founder

ownership.

Finally, the above discussion also implies that changes in firm value around the VC exit (i.e., the sum of the incentive and

liquidity effects) will be lowest for firms with intermediate levels of founder ownership (as compared to firms with low and high

levels of founder ownership). Thus, we expect the impact of VC exit on firm value to be a convex function of founder ownership.

We test the above hypotheses using all US venture-backed IPOs between 1993 and 2004. Our results can be summarized as

follows. First, we find a concave relationship between founder ownership and the speed of VC exit. Our findings imply that VCs

exit firms with intermediate levels of founder ownership faster than they do those with either low or high levels of ownership.

Second, we find that firms with intermediate levels of founder ownership experience the largest decrease in firm value around

the VC exit. Third, we find a concave relationship between founder ownership and liquidity of a firm's stock. Fourth, we present

three additional pieces of evidence consistent with entrenchment of founders with intermediate levels of ownership: firms with

such founders attract lower interest from institutional blockholders, have a lower percentage of outside directors on their boards,

and issue a lower fraction of shares in their IPOs. Fifth, we show that the impact of founder ownership on the speed of VC exit (and

the resulting changes in firm value) is unique to founders and is not observed for individual blockholders in general. Finally, we

discuss implications of our results for market rationality and venture capitalist reputation concerns.

The rest of the paper is organized as follows. Section 2 reviews the relevant literature. Section 3 develops the hypotheses that

will serve as the basis for our empirical tests. Section 4 describes our sample. Section 5 describes testing methodology and reports

the results. Section 6 concludes.

2. Literature review

Our paper is related and contributes to several areas of research. First and foremost, we contribute to the broader literature on

venture capitalists and their exits. Venture capitalists are specialized, limited-term investors. Their expertise and competitive

advantage lies in the nurturing of startup firms. As the firm matures, the VC's competitive advantage (and therefore the benefitsfrom their presence in the firm) gradually disappears. This effect becomes even more pronounced after the firm goes public. In

other words, venture capitalists are not interested in being shareholders in a public firm. The limited-term nature of venture

capitalist investments is already reflected at the time of the establishment of a VC fund — they are structured as limited

partnerships with a finite life span (see, e.g., Sahlman, 1990). As documented by Bartlett (1994), VC contracts also include

4 For the ease of exposition, from now on we will refer to three distinct ranges of founder ownership. High founder ownership will refer to ownership above a

“controlling stake”. Intermediate (low) founder ownership will refer to cases where the founder holds a (less than a) “controlling stake”. A “controlling stake” is

dened as the level of ownership necessary to maintain control of the rm. While there has been a signicant debate in the nance literature about this level of

ownership, no consensus has been reached. The empirical estimates of the controlling stake vary signicantly from study to study (see, e.g., Hermalin and

Weisbach, 1991; McConnell and Servaes, 1990; Morck et al., 1988 ).5 As discussed in more detail in Section 3, evidence consistent with this is provided by, among others, Slovin and Sushka (1993), Chahine (2007), Alavi et al.

(2008), and Basu et al. (2009).6 Founder (VC) ownership is the main source of liquidity impediment in rms with high (low) levels of founder ownership. In rms with intermediate levels of

founder ownership both the founder and the venture capitalist impede liquidity. This is because of the negative relationship between founder and VC ownershipat the time of IPO (i.e., at this time, any increase in venture capitalist ownership comes at the expense of founder ownership).

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provisions regarding exits. Finally, successful exits also have implication for the fundraising and investment of subsequent funds

(see, e.g., Gompers and Lerner, 2002).

Most of the literature on VC exits has focused on the determinants of the choice between various exit options, such as an IPO,

an acquisition, or a write-off (see, e.g., Cumming, 2008; Cumming et al., 2006). The implicit assumption in this literature is that

IPO itself is a VC exit event. Due to lockups and other considerations, however, it may take several years after the IPO for the VCs to

fully exit their portfolio companies. Perhaps because of this implicit assumption, as stated by Da Rin et al. (2013) in their recent

survey of venture capitalist research, “relative little is known about the role of VCs in their companies after going public, and the

impact that their ultimate withdrawal has [on] these companies” (p. 604).

The continued presence of VCs in newly public firms is costly since the capital and human resources are not put to their best

uses. First, capital can be distributed to the limited partners who can then invest it in new startups. Second, general partners are

likely to be actively involved in the monitoring and advising of the portfolio companies of the follow-on funds.7 Due to the nature

of their expertise, the benefits from involvement in such companies will be larger compared to those from monitoring and

advising newly public firms. For these reasons, venture capitalists would like to exit from their portfolio companies as soon as

possible. We are, however, aware of only two studies that have explicitly examined the speed at which venture capitalists exit

their portfolio companies after the IPO. Lin and Smith (1998) study the VC selling decision at the time of the IPO (i.e., the inclusion

of secondary shares in the IPO). Luo (2005) examines the relationship between the likelihood of a VC exit immediately after the

lockup expiration (before the first proxy statement after the lockup expiration) and earnings management at the time of IPO. We

contribute to this literature by examining the influence of a firm's ownership structure and liquidity of its stock on the speed of VC

exit within five years of IPO.

The second stream of research has examined the influence of VC exit on the price and trading volume of the firm's stock, either

at the time of lockup expiration (see, e.g., Brav and Gompers, 2003; Field and Hanka, 2001) or at the time of the distributions by

venture capital funds (Gompers and Lerner, 1998). We contribute to this literature by showing that changes in firm value around

the VC exit vary significantly, depending on the level of founder ownership.

The third stream of research has examined the influence of founder ownership on firm value (see, e.g., Anderson and Reeb,

2003; Villalonga and Amit, 2006, who examine this influence in large and index-listed firms). We contribute to this literature in

two ways. First, we examine the influence of founder ownership on firm value in the newly public firms, which has not been

extensively studied so far. Second, we contribute to this literature by highlighting the influence of an activist investor on the

observed founder ownership–firm value relationship. In particular, we show that departure of a monitoring shareholder has a

significant influence on the firm value.

3. Hypothesis development

Consider a venture capitalist deciding on the speed of exit from his equity position in a portfolio company. The speed of his exit

(and its impact on firm value) will be an outcome of the interaction between the following two factors. First, the VC exit willinfluence a firm's ownership structure (and, consequently, the incentives of its founder), which, in turn, will influence the

post-exit firm value. Second, the liquidity of a firm's stock will influence the VC's ability to sell his shares and therefore the speed

of his exit. In addition, the increase in liquidity resulting from the VC exit will also influence firm value. Finally, the interaction

between the two factors will significantly influence the speed of VC exit. Below, we discuss these two effects and subsequently

examine the interaction between them.

3.1. Changes in founder's incentives

Venture capitalist exit will influence the incentives of a firm's founder. In particular, the departure of the VC is likely to leave

the founder as the major shareholder. The founder's willingness and ability to use this status for his own benefit will largely

depend on the level of his ownership. The large literature on the relationship between ownership and firm value has contended

that a higher level of ownership can have two opposing effects on the latter. First, it can make the founder insensitive to the

market for corporate control (i.e., to entrench him) and thus allow him to increase his consumption of private benefits of control

(see, e.g., Stulz, 1988). Second, it can also better align the founder's incentives with those of minority shareholders ( Jensen and

Meckling, 1976). In particular, at a higher level of founder ownership a larger fraction of the costs of private benefits is borne by

him, reducing his incentives to engage in perquisite consumption. Despite a large empirical literature on the matter, there is no

consensus about the dominance of the entrenchment effect over the incentive effect (or vice versa) over a particular ownership

range.

Consider three distinct ranges of founder ownership. The exit of a VC from a firm with a high level of founder ownership will

not change the founder's status since he has been the major shareholder of the firm even in the presence of the VC. Therefore, we

expect a negligible loss of value, due to the VC exit from such firms.

VC exit is likely to have a significantly negative influence on the value of firms with intermediate levels of founder ownership.

In such firms, the ownership stake of the founder will be high enough to ensure him control over the firm and yet too low to align

his incentives with those of minority shareholders. The evidence consistent with this conjecture is provided by Slovin and Sushka

7 Gorman and Sahlman (1989) report that venture capitalists spend about half of their time monitoring and assisting portfolio companies.

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(1993). They report a significant increase in the corporate control activity after the death of a blockholder. This indicates that

before his death a blockholder's ownership stake represented a certain degree of hindrance to outside bidders. Slovin and Sushka

(1993) report that the increase in corporate control activity is especially pronounced for firms in which the blockholder's

ownership stake was between 20% and 30% of shares outstanding. In addition, they find that the market reaction upon the

announcement of a blockholder's death is a concave function of his ownership stake and “that firm value reaches a minimum

when insider ownership is 40%” (p. 1304). Additional evidence, consistent with entrenchment of shareholders with intermediate

levels of ownership, in the context of IPOs, is also provided by Chahine (2007), Alavi et al. (2008), and Basu et al. (2009).8 This

evidence suggests the highest potential for entrenchment of founders with intermediate levels of ownership. Further, the

potential entrenchment will become especially pronounced after the venture capitalist exit, when such founders will be isolated

from the market for corporate control and will have a free and unconstrained reign over their firms. 9

Finally, in firms with low levels of ownership, the market for corporate control will take over monitoring of founders from the

departing VCs. More specifically, the founder's ownership stake will be too low to ensure him (an unconditional) control of the

firm, allowing for effective monitoring by the market for corporate control. 10 Therefore, for such firms, the venture capitalist exit

will not have a significant detrimental influence on firm value.

3.2. Liquidity considerations

The liquidity of a firm's stock is another crucial factor to be considered by a venture capitalist when deciding on the speed of

his exit. Brockman et al. (2009) find that liquidity of a firm's stock is influenced by the presence of blockholders. 11 At the time of

IPO, there are two main types of blockholders present in a firm: founders and venture capitalists. Thus, before the lockup

expiration, liquidity is likely to be a function of ownership stakes of both the founder and VC.In particular, the relationship between founder ownership and liquidity can be described as follows. At high levels, it is

founder ownership that impedes liquidity. As founder ownership decreases, VC ownership is likely to increase.12 Therefore, at low

levels of founder ownership, VC ownership is likely to be the biggest impediment to liquidity. Overall, liquidity should remain

relatively constant over the entire founder ownership range.13

The negative influence of venture capitalist ownership on liquidity, however, lasts only until exit. In other words, VC exit will

increase a stock's liquidity.14 As argued by Amihud and Mendelson (1986), illiquid stocks have higher expected returns due to a

liquidity premium. Higher expected returns, in turn, imply a lower price for illiquid stocks. As sales by venture capitalists increase

liquidity, a stock's liquidity premium and expected return will decrease, leading to an increase in its price. Thus, ceteris paribus, VC

exit will be associated with stock price increases.

The above discussion has two implications for the speed of VC exit. First, to sell a large block of shares in an illiquid market, the

venture capitalist has to face a “liquidity discount” (i.e. the liquidation value of the block will be lower than the market price

prevailing before his trade).15 In such a setting, the optimal response for the venture capitalist is to sell his block in pieces (i.e., to

stage his exit). Given the impediments to liquidity described above, staged exits are likely to be the preferred way for VCs to exittheir investments.

Second, as suggested by Subramaniam and Yarrow (2001), by staging his exit (and therefore by selling each additional piece of

ownership stake at a higher price), the VC may be able to maximize proceeds from the sale of his position. The VC's ability to reap

such benefits from staging (from now on, we will refer to these as price appreciation benefits) depends upon the sum of liquidity

and incentive effects. In particular, the presence of a negative incentive effect will limit the stock price increase (or lead to its

decrease). This, in turn, will reduce the price appreciation benefits and make a staged exit less attractive.

8 Chahine (2007) nds that post-IPO performance in France is a cubic function of founder ownership with the (rst) minimum at 30.7% ownership stake. Alavi

et al. (2008) nd that the oat of Australian IPOs is a convex function of insider ownership, consistent with the desire of insiders with intermediate levels of

ownership to keep control. Basu et al. (2009) nd evidence consistent with a convex relationship between family ownership and rm value in newly public US

rms in the absence of venture capitalists.9 It can be argued that, since the VC exit is expected, its impact on rm value should already be reected in the stock price before the exit and that there should

be no change in rm value at the time of exit. Signicant transaction costs in the post-IPO stock market (such as short sale constraints), however, may prevent all

publicly available information from being re

ected in the stock price. In particular, Duf

e et al. (2002) argue that in the presence of short sale constraints (and theresulting high lending fees), the stock price will be determined by only the most optimistic investors and therefore will not re ect expectations of all investors.

Empirical evidence on a perfectly predictable post-IPO event associated with a persistent and signicantly negative market reaction is provided by the literature

on lockup expiration (e.g., Brav and Gompers, 2003; Field and Hanka, 2001). We will have more to say on this issue later in the paper (Section 5.5.2).10 Bethel et al. (1998) nd that rms in which more than 5% of equity are held by insiders and founding families are less likely to experience activist block share

purchases (i.e., be subject to the monitoring by the market for partial corporate control).11 Brockman et al. (2009) nd a negative relationship between the level of blockholder ownership and liquidity of a rm’s stock. They show that this

relationship is driven primarily by the lack of trading rather than by the threat of informed trading.12 This increase, however, is not one-to-one because of the presence of other shareholders in the rm.13 The exact relationship between founder ownership and liquidity depends upon the rm’s ownership structure (such as the presence and number of minority

(non-block) shareholders) and therefore is an empirical matter.14 An increase in the liquidity of a rm’s stock upon lockup expiration, the rst time venture capitalists can sell their shares after the IPO, has been documented

by Brav and Gompers (2003) and Field and Hanka (2001), among others. They nd that the increase in liquidity is signicantly higher for venture-backed rms,

indicative of selling by VCs.15 For the ease of exposition, from now on we are assuming that the venture capitalist himself is selling the block of shares in the open market. In practice, as

reported by Gompers and Lerner (1998), in a majority of cases the VC distributes his shares to the limited partners who then decide on the sale of these shares. As

long as the limited partners sell soon after the distribution of shares by the VC, the in uence of such sales on liquidity and stock price discussed below should notbe signicantly different from that observed in the case of VC selling.

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IPOs or Acquisitions? A Theory of the Choice of Exit Strategy by

Entrepreneurs and Venture Capitalists

Abstract

We develop the first theoretical analysis of a private firm’s choice of exit mechanism between IPOsand acquisitions in the literature. We consider an entrepreneur managing a private firm backed bya venture capitalist. The entrepreneur and venture capitalist desire to exit partially from the firm,motivated either by the desire to satisfy their liquidity demands or to raise external financing forthe firm (or both). Five important ingredients drive the firm’s equilibrium choice between IPOs andacquisitions in our model. First, the success probability in product market competition may differacross firms: later stage (“higher type”) firms with a dominant product may be more viable againstentry by competitors relative to earlier stage (“lower type”) firms with untested products. Second,while firm insiders have private information about this success probability, this information asymmetrymay vary across exit mechanisms: while insiders’ information advantage over IPO market investorsis likely to be large, this information asymmetry relative to potential acquirers is likely to be small.Third, while a stand-alone firm has to fend for itself in product market competition after going public,an acquirer may be able to help increase the private firm’s success probability in product marketcompetition (“synergy”). Fourth, while the IPO market would value the firm’s equity competitively,acquirers will have considerable bargaining power, allowing them to extract some of the firm’s netpresent value from firm insiders. Fifth, while the entrepreneur derives benefits of control (as well ascash flow benefits) from managing the firm (and will lose these in the event of an acquisition), theventure capitalist will make the exit choice based on financial considerations alone. In this setting,we derive a number of testable predictions regarding a firm’s equilibrium choice between IPOs andacquisitions. We also provide a resolution to the empirical finding that many firms which are able toobtain higher valuations in the IPO market never the less choose to be acquired (the “IPO valuationpremium puzzle”).


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IPOs or Acquisitions? A Theory of the Choice of Exit Strategy by

Entrepreneurs and Venture Capitalists

1 Introduction

It is well known that taking their firm public through an initial public offering or IPO is an important

pathway for entrepreneurs and venture capitalists to diversify their equity holdings in the firm and

exit (at least partially), while simultaneously allowing the firm to raise external financing for new

investment. This “going public” decision has been extensively studied in the literature both theoret-

ically (see, e.g., Boot, Gopalan, and Thakor (2006), Chemmanur and Fulghieri (1999), Maksimovic

and Pichler (2001), or Pagano and Roell (1998)) and empirically (see, e.g., Lerner (1994), Pagano,Panetta, Zingales (1998), Helwege and Packer (2003), or Chemmanur, He, and Nandy (2003)). How-

ever, an equally (if not more) important pathway for private firms to accomplish the same objectives

is agreeing to be acquired by another firm: in fact, over the last decade, a private firm was much

more likely to have been acquired than to go public. 1 Surprisingly, private firm acquisitions, and the

determinants of a firm’s choice between IPOs and acquisitions have been relatively unexplored in the

literature. While the empirical literature has recently started to explore this choice (see, e.g., Brau,

Francis, and Kohers (2003), Poulsen and Stegemoller (2006)), there has been no theoretical analysis

so far of a firm’s choice between IPOs and acquisitions. The objective of this paper is therefore to

develop the first such theoretical analysis in the literature.

Developing a rigorous theoretical analysis of the factors determining a firm’s choice between IPOs

and acquisitions is important for several reasons. First, the exit decision is one of the most important

decisions in the life of a firm, since it typically allows the firm to access the public capital markets for

the first time (either as a stand-alone firm, in the case of an IPO, or as part of a large publicly traded

firm, if it is acquired by such a firm). Further, it is the first significant opportunity for the entrepreneur

and venture capitalist (as well as other private investors) to liquidate some of their holdings in the

1According to the National Venture Capital Association (NVCA), there were more exits by venture capitalists throughacquisitions than by IPOs in eight of the last ten years. The NVCA reports that acquisitions constituted 76% of thevalue of exits of venture backed firms in 2006: while acquisitions of venture backed firms accounted for $16.6 billion invalue, IPOs of venture backed firms accounted for only $5.3 billion. See also the empirical studies of Brau, Francis, andKohers (2003), Poulsen and Stegemoller (2006) and Nahata (2003), who document a much greater proportion of exitsby acquisitions than IPOs in both venture backed and non-venture backed firms.

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firm. Therefore, understanding the factors determining the choice between these two exit mechanisms

is crucial not only for entrepreneurs, but also for venture capitalists, as well as for investment banks

and other financial intermediaries involved in facilitating a firm’s IPO or its acquisition. Second, the

ratio of acquisitions to IPOs among private firm exits have increased dramatically in recent years;

further, the proportion of firms withdrawing their offerings after filing to make IPOs and choosing

to be acquired instead has also risen steadily in the last five years. 2 These trends indicate that the

costs to private firms of going public rather being acquired has risen significantly in recent years, a

trend blamed by investment bankers and other practitioners on the recent spate of scandals involving

analysts, which has reduced the number of analysts and therefore the post-IPO coverage of small

firms, and the Sarbanes-Oxley Act, which, they argue, has increased the cost of complying with

disclosure and governance regulations after an IPO.3 An understanding of the factors driving a firm’s

choice between IPOs and acquisitions is therefore also important for policy makers in deciding what

corrective actions (if any) to take to ensure that entrepreneurs and venture capitalists have adequate

exit opportunities available to them.

Third, recent empirical research on IPOs versus acquisitions, while still in its infancy, has also raised

several interesting questions which highlights the need for a better understanding of a firm’s choice

between these two exit mechanisms. A stylized fact emerging from this literature is that IPOs are

characterized by significantly higher valuations than acquisitions: Brau, Francis, and Kohers (2003)

document a “valuation premium” of 22% for IPOs over acquisitions. While an average valuation

premium of IPOs over acquisitions is not, by itself, surprising (since IPO firms also tend to be higher

growth firms: see Poulsen and Stegemoller (2006)), the above finding would be quite puzzling if the

IPO valuation premium persists even after carefully controlling for all firm quality variables: why

would an entrepreneur choose to do an acquisition if he could exit with a much higher payoff through

an IPO? Our theoretical analysis is able to explain this “IPO valuation premium puzzle”, and other

findings of the empirical literature, and also generate hypotheses for further empirical research.

2The Wall Street Journal reports that the proportion of stock offers that were withdrawn because issuers begandiscussions to be acquired instead was 33% in 2005 (so far), against 18% in 2004 and 16% in 2003 ( Wall Street Journal ,February 21, 2005, “More Companies Pulling Deals to be Acquired”).

3See again (Wall Street Journal , February 21, 2005, “More Companies Pulling Deals to be Acquired.”): ”From theperspective of a small company readying itself to go public, getting acquired also avoids an after-market expense: thecost of complying with the Sarbanes-Oxley Act, which requires public companies to audit their internal controls, frominventory tracking to the security of their competitive systems...”.

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Finally, a theoretical analysis of a firm’s choice between IPOs and acquisitions would also allow

us to explore many related phenomena. The first of these are post-IPO acquisitions, where a firm is

acquired within two or three years of an IPO. A question that naturally arises here is why, given the

significant costs of going public, a firm would choose to do an IPO only to be acquired so soon after.

In an empirical study of such “double-exits”, Dai (2005) finds that these are more common in venture

backed rather than in non-venture backed firms, a result indicating that these are not corrections of

a “mistaken” IPO, given that venture capitalists are repeat investors experienced in the exit process.

Our analysis indicates that such post-IPO acquisitions may indeed arise in equilibrium. Our analysis

is also able to suggest possible sources of value in the reverse phenomenon, namely, post-acquisition

IPOs, where an acquirer takes a firm public within one to three years after an acquisition. Finally,

our theoretical analysis can also shed light on a private firm’s choice (given that it has decided to be

acquired) between strategic acquisitions (where the acquirer is a firm with strategic, product market

motivation for the acquisition) and financial acquisitions (where the acquirer is a private buy-out group

driven only by financial considerations, and with no product market motivation for the acquisition).

We study the situation of an entrepreneur managing a private firm backed by a venture capitalist.

The entrepreneur and the venture capitalist wish to exit partially from the firm, motivated either

by a desire to satisfy their personal liquidity demands, or by the need to raise external financing for

investment in the firm’s growth opportunity (project), or both. They can accomplish this in one of

two ways. They can either take the firm public in an IPO, selling some of their equity holdings in the

firm to satisfy their respective liquidity demands, and issuing new equity to raise the required amount

for the firm, with the entrepreneur continuing to manage the firm after the IPO. Alternatively, they

can sell their private firm to an acquirer, in which case they divest their entire equity holdings in the

firm, with the entrepreneur giving up the control of the firm to the acquirer. We analyze the firm’s

choice between the two above alternatives, and study three polar cases: first, the case where the choice

of exit is made by the entrepreneur alone (“entrepreneur controlled firm”), either because the venture

capitalist’s equity holdings in the firm are very small, or because his financial contract with the firm

does not give him enough power to block any exit decision made by the entrepreneur; second, the

other extreme case, where the venture capitalist is so powerful that, while the entrepreneur manages

the firm, the exit choice is made by the venture capitalist (“VC controlled firm”); third, a scenario

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midway between the above two extremes, where the exit decision is made by the entrepreneur, but

where the venture capitalist has veto power over any exit choice (“jointly controlled firm”), so that the

exit decision is negotiated between the entrepreneur and the venture capitalist, with transfers (side

payments) made by the entrepreneur to the venture capitalist in case the latter disagrees with an exit

choice made by the former.4

Five important ingredients drive a private firm’s choice between IPOs and acquisitions in our

model. First, firm insiders may have private information about how viable their business model

(and the firm itself) is against future (post-exit) competition in the product market: clearly, more

mature (later stage) firms with a dominant product (“higher type” firms in our model) would be

more viable against entry by competitors relative to early stage firms with products untested against

competition (“lower type” firms) and the entrepreneur and the venture capitalist can be expected to

have private information about this viability. Further, the extent of information advantage possessed

by firm insiders will be different across the two exit alternatives: while insiders’ information advantage

against IPO market investors can be expected to be considerable, this information advantage may be

low (or even non-existent) against potential acquirers, who can be expected to be well informed by

virtue of their industry expertise about the viability of alternative business models in the product

market.5 Second, while a stand-alone firm has to tend for itself after going public, an acquirer may be

4Non-venture backed firms (or firms where venture capitalists have only an insignificant amount of investment)approximate the entrepreneur controlled firms in our model, since in these firms, the exit decisions reflect primarilythe incentives of the entrepreneur. Venture backed firms, on the other hand, lie somewhere on a continuum betweenthe entrepreneur controlled and VC controlled firms in our model: whether such firms are closer to b eing entrepreneurcontrolled or VC controlled depends on how much control venture capitalists have in its governance, which, in turndepends on the extent of venture capitalists’ investment in the firm, and the terms of this investment: e.g., extent of board representation held by venture capitalists and the stringency of the contractual provisions in their financial contractswith the firm. When the venture capitalist invests in the firm using convertible preferred equity (as is common in theU.S.), one contractual provision which gives him considerable power over the private firm’s exit decision is AutomaticConversion provision of the term sheet. The automatic conversion provision reads something like: “The Series [A]Preferred shall be automatically converted into Common Stock, at the then applicable conversion price, (i) in the eventthat the holders of at least two thirds of the outstanding Series A Preferred consent to such conversion or (ii) upon theclosing of a firmly underwritten public offering of shares of Common Stock of the Company at a per share price not less

than x times the Original Purchase Price per share and for a total offering with net proceeds to the Company of notless than $y million (a “Qualified IPO”).” Note that x, “the number of times the original purchase price of the preferredstock will automatically convert into common and facilitate a public offering,” and y, “the amount of money that willqualify an IPO as acceptable to the preferred,” determine the stringency of this provision: the larger the numbers x andy, the greater the venture capitalist’s power over the exit decision.

5Unlike acquirers, who can rely on their own industry expertise, the primary source of information for IPO marketinvestors about the viability of alternative business models are financial analysts. To quote the technology industrynewsletter LA Vox (“Are M&As the new IPOs?”, January 21, 2003, www.larta.org): “Bankers have relied for years onthe expertise of analysts about what business models are working,....the number of analysts on Wall Street is droppingsignificantly and the number of companies covered is dropping significantly. That makes it difficult to get companiespublic and support them once they are public. Until it reverses, we’ll not have public markets for new offerings.”

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able to provide considerable support (“synergy”) to the firm in the product market, thus increasing

its chances of succeeding against competitors and establishing itself in the product market. 6 7 Third,

while the IPO market would price the firm’s equity competitively (so that insiders can retain the entire

net present value of their firm’s project), acquirers will have considerable bargaining power, allowing

them to extract some of this net present value from firm insiders. Fourth, an entrepreneur managing a

private firm may derive personal benefits from continuing to manage it long term (“private benefits of

control”), which he is likely to lose after an acquisition 8 This may motivate an entrepreneur to prefer

an IPO

Exit Behavior in Venture Capital

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