New directions in research on venture capital finance - Venture Capital Special Issue

Financial Management (Financial Management Association), Autumn, 1994 by Christopher B. Barry

The investment of venture capital funds in growing enterprises is a remarkable feat of financial engineering. Investors in private venture capital funds place their money for long periods of time in the hands of venture capitalists of uncertain ability and who have committed only small amounts of their own funds. The venture capitalists seek out promising ventures, eventually placing money in risky ventures managed by entrepreneurs whose skills are unknown and whose future efforts are not predictable. Such investments are often made in firms that have not yet registered one single dollar of revenues; have no products in existence at the time of investment, only unproven and untested ideas; and do not have a complete, experienced management team. The entrepreneurs have information not possessed by the venture capitalists. The venture capitalists not only commit money to these entrepreneurs, but they also commit weeks of their time assisting them. Despite the extensive monitoring, more than one-third of the investments made by venture capitalists result in losses, and a sizable fraction results in loss of the entire original investment, often after years of waiting and after countless hours of handholding by the venture capitalists. Venture capital is an area of finance in which issues we encounter to a lesser degree in public companies can take on extreme importance.

And yet venture capital survives. Hellman (1993) estimates that $2.5 billion of venture capital investments were made in 1992 from a pool of $33 billion in capital committed to the venture capital industry. In the first half of 1994, $1.7 billion of new capital was committed to private venture capital funds (Private Equity Analyst (1994)). The mere fact that venture capital exists bears testimony to the adaptability of financial systems. Because problems encountered in venture capital investing are so challenging, the uncertainty so high, the asymmetries of information so great, and the opportunities so outstanding, venture capital finance gives us an opportunity to study modern financial theory in a setting of extremes. In such a setting, some of the issues often assumed away in other circumstances cannot be ignored. Thus, we have the opportunity and the necessity in venture capital to leam more about risk, uncertainty, and contracting technology.

In spite of the intriguing issues in venture capital finance, relatively little has been published on this subject in the most influential finance journals. Why? Probably for two reasons. First, the theoretical problems are complex, many-faceted, and difficult to solve. Second, the very nature of venture capital creates difficulties for the empiricist because data on private investment by private firms are not easily obtained.

Nevertheless, significant progress has been made recently toward understanding the problems of venture capital finance. New theories have been formulated and new databases have been tapped or developed, shedding new light on issues about which we knew very little as recently as the 1980s. The door has been opened, and opportunities abound for new work on venture capital finance.

The purpose of this paper is to provide a selective survey and synthesis of recent findings in venture capital research and to put them into perspective, suggesting new avenues for study. The goal of the paper is not to survey exhaustively all published work on venture capital finance. Two recent papers, taken together, provide a more comprehensive overview of the field. One is Sahlman's (1990) paper that explains venture capital and its organizational setting. A second is Norton's (1993) survey paper, which takes a more managerial orientation than does Sahlman's paper. The two papers contain 147 references on venture capital. In addition to those papers, Gompers (1994b) provides an updated history and an interesting analysis of the venture capital industry.

The present paper begins with an introduction to venture capital in the first section. The second section discusses recent findings and current controversies in a variety of topics on venture capital finance. The third section points to unanswered questions and offers suggestions for further research.

I. Introduction to Venture Capital

In most Spanish-speaking nations, there is no explicit term for venture capital; instead, the term "capital de riesgo," or risk capital, is used. That term captures an important dimension of venture capital--it is capital invested in highly risky ventures. But there is more to venture capital than making high-risk investments. Venture capital also entails an active and motivated working relationship in which the venture capitalists take on important roles within their portfolio firms in which they have invested. Venture capitalists, acting on behalf of third parties, actively monitor the investments and sometimes assume important managerial roles within the firm. Warne (1988) characterizes venture capital as the combination of capital and consulting. In brief, venture capital entails the investment of risk capital within a firm in substantial blocks coupled with the close monitoring of that investment.