(Editor’s Note: This post comes to us from Professors Carsten Bienz and Julia Hirsch).

In our paper “The Dynamics of Venture Capital Contracts” published in the Review of Finance (a working paper version is available on SSRN), we explore the different ways staging can be implemented. The standard view of staging that we have has been shaped by the fact that we cannot easily observe milestones – in contrast to rounds – without knowing the actual financing contracts. We show, however, that milestone financing is an important characteristic of venture capital contracts. Even more though, milestones have a unique feature that rounds lack: they give the VC the ability to commit to provide new funds to the entrepreneur. Our results indicate that the contracting parties are aware of this difference. Milestones appear to be used more frequently  when entrepreneurs must fear that VCs might use the lack of commitment inherent in rounds to their advantage. This situation arises out of the fact that VCs may secure extremely favourable financing conditions in later financing rounds if they are the only investors who are informed about a firm’s real prospects. The paper shows that this threat is particularly relevant when there is one single VC financing the portfolio firm.

This post comes to us from Jay Ritter, Xiaohui Gao, and Zhongyan Zhu. It summarizes their paper, Where Have All the IPO’s Gone?, now publicly available on SSRN.

During 1980-2000, an average of 311 companies per year went public in the U.S. Since the technology bubble burst in 2000, the average has been only 102 initial public offerings (IPOs) per year, with the drop especially precipitous among small firms. Many have blamed the Sarbanes-Oxley Act of 2002 and the 2003 Global Settlement’s effects on analyst coverage for the decline in U.S. IPO activity.

We offer an alternative explanation. We posit that the advantages of selling out to a larger organization, which can speed a product to market and realize economies of scope, have increased relative to the benefits of remaining as a small independent firm.

Consistent with this changing product market hypothesis (as opposed to a changing financial markets explanation), we document that there has been a decline in the profitability of small company IPOs, and that small company IPOs have provided public market investors with low returns throughout the last three decades. Defining IPOs as small or large companies on the basis of whether the pre-IPO annual sales were less than or greater than $50 million (in dollars of 2009 purchasing power), the fraction of small company IPOs with nonnegative EPS in the three years after going public has declined from 42% for IPOs from 1980-2000 to 27% for those from 2001-2009. The fraction of large company IPOs with nonnegative EPS has barely changed, declining from 77% to 76%. In terms of long-run stock returns, measured by the buy-and-hold market-adjusted returns in the three years after going public (not including the first day of trading), small company IPOs from 1980-2009 have underperformed the market by an average of 35%, whereas large company IPOs have underperformed by only 4%. For IPOs from 2001-2009, the underperformance of small company IPOs has continued, but large company IPOs have actually outperformed the broader market.

Venture capitalists have been increasingly exiting their investments with trade sales rather than IPOs, and an increasing fraction of firms that have gone public have been involved in acquisitions, either by being acquired or by making acquisitions themselves. The increase in M&A activity actually started in the early 1990s. The increase in M&A activity is consistent with our hypothesis that small firms in many industries need to get large quickly in order to prosper, and many firms do so by making acquisitions or by being acquired, rather than relying exclusively on organic growth.

Our analysis suggests that IPO volume will not return to the levels of the 1980s and 1990s even with regulatory changes. Although there have been changes in financial markets that adversely affect IPOs (SOX and the decline of bid-ask spreads, which reduces the ability of analysts to get indirectly compensated for covering a firm), our analysis suggests that the bigger problem is the change in product markets. We posit that the decline of IPO activity, especially for small companies, is not so much a private company vs. public company issue as it is a small company vs. big company issue.

Our analysis also suggests that it is rational for a venture capitalist to pursue a “build to sell” model rather than a “build to take public” model. Trade sales can generate higher returns not because the IPO market is broken, but because the future cash flows of the business will be higher as part of a larger organization that can realize economies of scope and speed products to market.

A copy of the original study is available here.

This post comes to us from Richard Blake at Wilson Sonsini Goodrich & Rosati, LLP. It summarizes their report, Corporate Governance and Disclosure Practices of Venture-Backed Companies in U.S. Initial Public Offerings.

Wilson Sonsini Goodrich & Rosati examined the 50 companies involved in the largest IPOs measured by deal size in the 18-month period from Jan. 1, 2010 through June 30, 2011, and reviewed practices and trends in a number of areas, including those related to directors and independence, board committees and policies, stock plans, key metrics and non-GAAP measures, and defensive measures.

We noted the following key findings in our survey:

•       Directors and Independence

-     Even though newly public companies have phase-in periods within which to comply with stock exchange requirements regarding majority board independence, each company surveyed had a majority of independent directors on its board, and most companies were substantially independent, at the time of the IPO.

-       Of the companies surveyed, slightly more companies separated the chairman and CEO roles than combined them.

•       Board Committees

-       Even though newly public companies have phase-in periods within which to comply with stock exchange requirements regarding fully independent board committees, almost all of the companies surveyed had board committees that were substantially comprised of independent members at the time of the IPO.

-       Frequently, board committees of the companies surveyed included members who were venture capitalists affiliated with venture funds that had invested in the companies, and frequently the venture capitalists were determined to be independent directors, notwithstanding their share ownership.

•       Board Policies

-       Nearly all the companies surveyed had adopted, or planned to adopt, key corporate governance board policies in connection with the IPO, such as corporate governance guidelines, codes of business conduct, and related party transactions policies or procedures.

•       Stock Plans

-       Nearly all the companies surveyed adopted a new equity compensation plan in connection with the IPO, frequently with “evergreen” provisions, which allow shares automatically to be added to the available pool annually.

-       Less than a majority of the companies surveyed adopted an employee stock purchase plan in connection with the IPO, but those that adopted one frequently included an evergreen provision.

•       Key Metrics and Non-GAAP Financial Measures

-       A significant minority of companies surveyed disclosed non-financial key metrics (e.g., subscribers or registered members for Internet companies) in addition to financial metrics.

-       Half of the companies surveyed disclosed non-GAAP financial measures (frequently, adjusted EBITDA).

•       Defensive Measures

-       None of the companies surveyed adopted a shareholder rights plan, or “poison pill,” in connection with the IPO, although other defensive measures were liberally adopted.

(Editor’s Note: This post comes to us from Yael V. Hochberg, Assistant Professor of Finance, Northwestern University – Kellogg School of Management, NBER, Laura Anne Lindsey, Assistant Professor, Arizona State University (ASU) – Finance Department, and Mark M. Westerfield, Assistant Professor, University of Southern California – Marshall School of Business – Finance and Business Economics Department.)

The venture capital industry is characterized by strong inter-organizational networks that have been shown to affect VC firm performance and the competitive supply of capital for entrepreneurs. In the paper, “Economic Ties: Evidence from Venture Capital Networks,” we examine how VC firms’ observable resources are related to tie formation, and thus how networks facilitate the distribution and combination of resources across organizations. Unlike the social networks literature, we find little evidence of homophily (that is, similarity or likeness between entities) as a motive for network ties among VC firms. Rather, VC firms tend to form ties with the best available partner in terms of investment scope and network access, but form ties in an anti-homophilous fashion on experience. VCs also use network ties to trade experience, access and investment scope for access to capital by partnering with other VC firms that have ample available capital but few other resources that might foster successful investment.

In our paper, Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley, recently made publicly available on SSRN, Brian Broughman and I examine the role of inside financing rounds in VC-backed firms.

VCs typically invest through several rounds of financing.  Each round is separately negotiated and priced.  A subsequent (“follow-on”) round of financing could be provided by either (a) the firm’s existing VC investors exclusively (an inside round) or (b) a group led by a VC fund that did not invest in the startup’s earlier rounds (an outside round).  Historically, most follow-on financings were structured as outside rounds, in part to mitigate conflict between the entrepreneur and existing VCs over the value of the firm.
In recent years, however, more than half of follow-on rounds have been structured as inside rounds.

A number of commentators have suggested that VCs with sufficient control over the startup may use inside rounds to sell themselves cheap stock.  In fact, while litigation by founders against VCs is rare, many of the lawsuits that are filed allege that VCs used an inside round to dilute the firm’s founders.  Alternatively, VCs may use inside rounds as a form of “backstop” financing: when outside VCs refuse to invest in the firm on acceptable terms (or at all), current VCs may be forced to resort to inside financing to keep the firm going. Unfortunately, there has been no empirical study on whether VCs frequently use inside financing rounds to dilute founders or for other purposes.

To shed light on the purpose and effect of inside rounds, we collected data on 90 follow-on financing rounds from 45 Silicon Valley firms that were sold in 2003 or 2004.  Our data covers the lifespan of each firm and includes, for each round of financing, (1) the identity of the VC investors, the (2) terms of financing, and (3) the economic returns generated from the sale of the firm.  We also collected qualitative assessments from the founders on the circumstances surrounding each of the 90 financing rounds.

We find that inside rounds are more likely to occur in firms where VCs lose money. Consistent with backstop financing, we also find that inside rounds increase when market conditions deteriorate. The picture that emerges is confirmed by the founders’ own accounts of their firms’ fundraising efforts. According to almost every founder in our sample, VCs consistently sought outside financing, and resorted to inside rounds only when outside financing was not available.

Even if VCs do not conduct inside rounds by choice, they may still use inside rounds to dilute founders by setting the valuation too low.  To address this possibility. we compare the valuations used in inside rounds to those used in outside rounds. For each firm, we determine the relative valuation of the last financing round by comparing the assigned valuation to the best available proxy of what the firm was actually worth at the time: its eventual sale price. If VCs use inside rounds to dilute founders, we would expect the relative valuations of inside rounds to be lower than the relative valuations of outside rounds.  In fact, the relative valuations of inside rounds are higher than in outside rounds, and in various regression models the difference is both economically and statistically significant.  We perform various robustness checks on these results and reach the same results: inside rounds are overvalued relative to (and yield lower returns than) outside rounds. We also find evidence consistent with valuations being driven by litigation considerations.

All in all, we find little evidence of the use of inside rounds to engage in dilutive financing.  Instead, we find that inside rounds are generally used for backstop financing – to support marginal firms that cannot attract outside investors, and when VCs conduct inside rounds they tend to use relatively high valuations, perhaps to reduce litigation risk.

The full paper is available for download here.

Fenwick and West has recently released the results of its 2011 First Quarter Venture Capital Survey.  The survey, which is updated quarterly, summarizes deal terms for recent financings in the Silicon Valley.  The latest edition can be found here.

(Editor’s Note: This post comes to us from Vladimir I. Ivanov, Economic Fellow, US Securities & Exchange Commission.)

In the paper, “Corporate Venture Capital and Corporate Governance in Newly Public Firms: Evidence from Venture Backed IPOs,” we investigate the corporate governance of venture capital (VC) backed IPO firms that enter into strategic alliances. Startups often have alliances with outside strategic partners and with parents of corporate VCs (CVCs), who primarily invest in startups for strategic reasons. Both CVCs and outside strategic alliance partners can influence an IPO firm’s corporate governance. We find that firms with strategic alliances have greater independent director representation, more staggered boards and forced CEO turnovers and smaller percentage of new shares and secondary share sales. Comparing the governance of IPO firm with strategically oriented CVCs backing to IPO firms with outside strategic alliance partners, we find significantly stronger effects in firms backed by CVCs.

(Editor’s Note: This post comes to us from Salim Chahine, Associate Professor of Finance, American University of Beirut – School of Business, and Marc Goergen, Professor of Finance, Cardiff University – Cardiff Business School; European Corporate Governance Institute (ECGI).)

In the paper, “VC Board Representation and Performance of US IPOs,” we  study the impact of five dimensions of venture capitalist (VC) power on the likelihood of the board representation of VCs in their portfolio firms at the initial public offering (IPO) as well as the effect of the latter on IPO performance. The dimensions of VC power are based on Finkelstein’s (1992) four dimensions of power which are ownership power, structural power (i.e., the VC’s rank within the firm’s financial hierarchy), expert power (i.e., VC industry specialization), and prestige power (i.e., the number of IPOs the VC has been involved with so far). We add controlling power (i.e., how pivotal the VC is to the voted decision) to these four dimensions. We find that all five dimensions of power have a significantly positive impact on the likelihood of VC board membership. While controlling for the possible endogeneity of the latter, underpricing and the IPO premium are higher if there is VC board membership, which is consistent with both the grandstanding and management support hypotheses. Our results suggest that VCs improve IPO performance and that they do not just maintain a strong presence in better performing companies after the IPO.

(Editor’s Note: This post comes to us from Gregory F. Udell, Indiana University Bloomington – Department of Finance, Xuan Tian Assistant Professor of Finance, Indiana University – Kelley School of Business, Xiaoyun Yu, Indiana University Bloomington – Department of Finance, China Academy of Financial Research (CAFR).)

Information-based theories of financial intermediation focus on delegated monitoring. However, there is little evidence on how markets discipline financial intermediaries who fail at this function. This paper, “Disciplining Delegated Monitors: Evidence from Venture Capital,” uses the venture capital (VC) market to address this gap in the empirical literature by looking at how VC’s reputations are affected when they fail in their monitoring role to prevent fraud by their portfolio firms. We find that VCs who fail to prevent fraud experience greater difficulty in taking future portfolio firms public, and that the negative effect prevails over ten years after the fraud surfaces. In addition, reputation-damaged VCs interact differently in the future with their limited partners, other VCs in the community, and their IPO underwriters because they are perceived by these groups as inefficient monitors.

(Editor’s Note: This post comes to us from Thomas F Hellmann, Associate Professor, University of British Columbia – Sauder School of Business, and Noam Wasserman, Associate Professor, Harvard University – Harvard Business School.)

In the paper, “The First Deal: The Division of Founder Equity in New Ventures,” we examine the division of founder shares in entrepreneurial ventures, focusing on the decision of whether or not to divide the shares equally among all founders. To motivate the empirical analysis we develop a simple theory of costly bargaining, where founders trade off the simplicity of accepting an equal split, with the costs of negotiating a differentiated allocation of founder equity. We test the predictions of the theory on a proprietary dataset comprised of 1,476 founders in 511 entrepreneurial ventures. The empirical analysis consists of three main steps. First we consider determinants of equal splitting. We identify three founder characteristics – idea generation, prior entrepreneurial experience and founder capital contributions – regarding which greater team heterogeneity reduces the likelihood of equal splitting. Second, we show that these same founder characteristics also significantly affect the share premium in teams that split the equity unequally. Third, we show that equal splitting is associated with lower pre-money valuations in first financing rounds. Further econometric tests suggest that, as predicted by the theory, this effect is driven by unobservable heterogeneity, and it is more pronounced in teams that make quick decisions about founder share allocations. In addition we perform some counterfactual calculations that estimate the amount of money ‘left on the table’ by stronger founders who agree to an equal split. We estimate that, at the time of the raising of the initial round of financing, the value at stake is approximately 10% of the firm equity, 25% of the average founder stake, or $450K in net present value.