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Venture Capital and Private Equity Contracting
Hypothesis 20.6: Venture capital investments in the seed or early stages of development are more likely to be write-off exits due to the greater risks at the earlier stage of investment, while expansion-stage investments are less likely to be written off. Hypothesis 20.7: Larger investments are more likely to go public, as there are minimum capital requirements for listing.
Further, we may expect entrepreneurs residing in the same province as their venture capital fund to be more likely to have better exit success (in terms of an IPO or acquisition). Lerner (1995), for example, shows that venture capital funds that are geographically closer to their investee entrepreneurial firms are more likely to serve on the firm’s board of directors. Geographic proximity gives rise to improved due diligence (lower adverse selection costs) and greater valueadded facilitated by regional proximity (lower moral hazard costs). Geographic proximity therefore should be positively correlated with exit success.6 Hypothesis 20.8: Investors and entrepreneurs residing in the same province are less likely to have secondary sale, buyback, and write-off exits, since proximity enhances due diligence and adverse selection problems, and venture capital fund value-added is facilitated by regional proximity.
20.2.3 Venture Capitalist-Entrepreneur Contracts An important difference between IPOs and acquisitions arises from the fact that an entrepreneur may have a nonpecuniary preference for an IPO over an acquisition if the entrepreneur seeks to be the CEO of a publicly traded firm. The entrepreneur’s nonpecuniary preference for an IPO may be viewed as an agency cost, since at times of poorly performing IPO markets, the entrepreneur may not always be interested in maximizing the financial return to the venture. In an acquisition exit, the founding entrepreneur often leaves the merged organization, which is frequently viewed as a negative and emotional event for the entrepreneur (Petty et al., 1999; see also Black and Gilson, 1998). Hence, exit outcomes may be influenced by the allocation of control rights between the venture capital fund and entrepreneur. When IPO markets are in a slump and an acquisition is comparatively more profitable but the entrepreneur still prefers an IPO due to the nonpecuniary benefits, then IPOs are more likely when the entrepreneur has control rights over exit but acquisitions are more likely when the venture capital funds have control rights. When IPO markets are “hot” and both the entrepreneur and venture capital fund prefer an IPO exit, then the allocation of control rights would not affect the exit outcome. 6
Location choice is not random. For example, Sorenson and Stuart (2001) show the likelihood of a venture capital fund investing in an entrepreneurial firm increases the greater degree of proximity between the investor and entrepreneurial firm. Location is therefore not completely exogenous to exit outcomes. We consider endogeneity for this variable, among others, in the empirical assessment in this chapter.