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

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

A. What Do Venture Capitalists Do?

Gorman and Sahlman (1989) surveyed venture capitalists and asked how they spend their time. They found that venture capitalists spend roughly half of their time monitoring an average of nine portfolio companies. They spend an average of 110 hours per year working with each portfolio firm, and their most frequent activity is assisting the firm in raising additional funds. Typical respondents said that they had replaced three chief executive officers in portfolio companies during their careers as venture capitalists. This finding is consistent with the broad view that key activities of venture capitalists are identifying and recruiting members to the management team of portfolio companies. Those same venture capitalists identified weak management as the dominant cause of failure among their portfolio companies, so it is natural that considerable emphasis would be placed on management ability.

Venture capitalists typically specialize by emphasizing a particular industry, such as biotechnology, or by emphasizing a particular stage of development, such as startup companies or companies in the expansion stage. A number of papers describe the specialization of venture capitalists (see, for example, Gupta and Sapienza (1992), Norton and Tenenbaum (1993), and Ruhnka and Young (1991)); some suggest that the specialization of venture capitalists makes it prudent for the venture capital investor to diversify across venture capitalists to eliminate the diversifiable risk inherent in specialization. Barry, Muscarella, Peavy, and Vetsuypens (BMPV) (1990) provide a table showing the industry specialization of venture-backed IPOs and suggest that specialization aids in the monitoring process. A number of papers by Lerner (1994a, 1994b, and 1994c) focus specifically on biotechnology ventures and provide details of the functioning of venture capital within that industry.

Other papers have examined the activities of venture capitalists in evaluating new opportunities. Most notable has been the work of Tyebjee and Bruno (TB) (1984), who examined 90 deals made by 41 venture capitalists. They point out five principal activities carried out by the venture capitalists:

1. Deal origination 2. Deal screening 3. Deal evaluation 4. Deal structuring 5. Post-investment activities

Recent research on venture capital in the finance literature has focused on steps four and five. A body of literature also exists that focuses on steps two and three (for example, see Roberts (1991) and MacMillan, Zemann, and Subbanarasimha (1987)).

In this issue of Financial Management, Fried and Hisrich (1994) present results of field studies and interviews with venture capitalists to understand their activities better, specifically their decision to invest. They show that, in the average investment made by the 18 venture capitalists in their sample, the venture capitalists spent three weeks of full-time effort in evaluating and closing the deal and that nearly 100 days elapse during this process. Fried and Hisrich examine the investment decision-making process in order to identify the activities venture capitalists undertake to avoid the adverse selection problem described by Amit, Glosten, and Muller (1990). They argue that an intensive screening and evaluation process allows the venture capitalists to gather substantial amounts of information prior to investing and that this information reduces the adverse selection problem.