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

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

The analysis of venture capital performance indicates that venture capitalists take on high risks that appear to be rewarded on average. Those risks tend to be unsystematic, so that portfolios constructed by investing in a variety of venture capital funds will have much lower risk than will investment in a single fund. The evidence regarding the performance of those investments is mixed, so it remains to be seen whether venture capital is a superior form of investment.

C. Venture Capital and the Going-public Process

One way to find data on venture capital activities is to identify IPOs in which venture capitalists have been investors in the offering firm. For example, using IPO listings from Venture Economics, the major provider of data on the venture capital industry, BMPV developed an exhaustive set of initial public offerings (IPOs) by venture-backed companies over the period 1978-1987. BMPV examined whether the presence of experienced venture capitalists on the board of a firm going public affects the results of the offering. Evidence indicated that the market recognized the quality of the venture capitalists because IPO underpricing was lower when the firm had more experienced venture capitalists who had been investors.

The reputation and certification role of venture capital was also confirmed in a study by Megginson and Weiss (1991). Their findings are consistent with a recognized role for the venture capitalists as monitors. Megginson and Weiss used a matched sample of IPOs with venture backing and IPOs without venture backing. They found significantly less underpricing in those issues with venture capital backing, which is similar to other studies' findings that the quality of the underwriter or auditor can influence IPO pricing.

Lin and Smith (1994) developed a series of hypotheses to describe the role of venture capital in the IPO process. Because the venture capitalist is likely to return to the IPO market with future offerings of portfolio companies, the venture capitalist has reputational capital to protect, a factor that may influence whether, when, and at what price the company will go public. Lin and Smith argue that firms with venture capital will be able to come to the market earlier in their development, backed by the relationship with venture capital. Gompers (1994a) notes, however, that the venture capitalist may in fact choose to bring the portfolio firm public earlier than would be optimal for the entrepreneur in order to attract new investment funds. Gompers calls that phenomenon "grandstanding."

Lin and Smith go on to argue that the venture capitalist's IPO selling decision will depend on the venture capitalist's reputation, the reputation of the underwriter, and the degree of underpricing. In particular, high-quality venture capitalists making offerings via high-quality underwriters will be more likely to sell in an underpriced IPO, but unlikely to sell in cases in which the IPO is overpriced. Lin and Smith find empirical support for all of these hypotheses.