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

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

Lerner (1994b) finds another way in which venture capitalists reduce the adverse selection problem: They tend to syndicate their investments, i.e., venture capitalists tend to invest with other venture capitalists. Lerner investigated 651 rounds of investment in 271 biotechnology firms. He found that syndication is common from the first investment round of investing, a fact that he argues is a part of the screening process: Venture capitalists are more comfortable with a deal when other venture capitalists of similar experience are willing to invest as well.

The post-investment activities of venture capitalists are also extensive. BMPV (1990) examined venture capitalists' activities by studying prospectuses of IPOs by venture-backed firms. They found that the average venture-backed IPO had three venture capital investors holding 34% of the pre-IPO equity in the firm. The average IPO had two venture capitalists serving as members of the board of directors, and an average of 1.8 venture capitalists remained on the board a full year after the IPO. Surprisingly few venture capitalists sold any of their shares in the IPO, even though participating in the IPO is viewed as a key exit strategy for the venture capitalists.

Lerner (1994a) examined the activities of venture capitalists in providing oversight of their portfolio companies. Lerner studied the association between the venture capitalists' degree of involvement and the need for monitoring. In particular, he found that venture capitalist representation on boards of directors increased by 44% for firms in which the chief executive officer (CEO) had no prior experience in running an entrepreneurial firm. Lerner also examined the impact of a change in CEO. He refers to CEO replacement as an instance of "organizational crisis" and as an indication of a need for more intense monitoring. He found that on average venture capital investors added 1.75 board members between financing rounds when the CEO was replaced, versus an average increase of only 0.24 board members between rounds in which the CEO was not replaced. Thus, the monitoring activities of venture capitalists appear to intensify as the need dictates.

B.How Successful Are Venture Capitalists?

Venture capitalists manage other people's money to achieve high returns. In order to do so, they invest in risky investment opportunities. An important indicator of the success of venture capital, therefore, is the realized rate of return in relation to riskiness of investments in venture capital funds: Have venture capitalists provided returns adequate to compensate for the risk incurred?

Huntsman and Hoban (1980) examined 110 investments by three venture capital firms over the period 1960-1975. They showed that venture capital returns depend on outliers. While the average return over the period was 18.9%, eliminating the top 10% of investments resulted in an average return of -0.28%. In other words, venture capital success is highly dependent on finding a few outstanding investments, and diversification is vital. Huntsman and Hoban provide no formal tests of the superiority or inferiority of their returns with respect to a formal model of returns.