Venture Capital Exits in Canada and the United States*
Douglas J. CummingSchool of Business, University of Alberta
Edmonton, Alberta, Canada T6G 2R6
Tel: (780) 492-0678
Fax: (780) 492-3325
E-mail: [email protected]://www.bus.ualberta.ca/dcummingJeffrey G. MacIntosh
Toronto Stock Exchange Professor of Capital Markets
Faculty of Law, University of Toronto
78 Queens Park
Toronto, Ontario, Canada M5S 2C5
Tel: (416) 978-5785
Fax: (416) 978-6020
E-mail: [email protected] Draft: September 1997
This Draft: February 2002 *Cumming: University of Alberta School of Business; B.Com. (Hons.) McGill University; M.A. Queens University; J.D./Ph.D., University of Toronto. MacIntosh: Toronto Stock Exchange Professor of Capital Markets, University of Toronto Faculty of Law; B.Sc., MIT; LL.B., University of Toronto; LL.M., Harvard Law School. The authors thank Varouj Aivazian, Paul Halpern, Vijay Jog, Aditya Kaul, Frank Mathewson, Vikas Mehrotra, Michael Patry, Tom Ross, Corrine Sellars, and especially Ralph A. Winter for helpful comments and suggestions. We are also grateful for comments from the seminar participants at the ABN AMRO International Conference on Initial Public Offerings (2000, Amsterdam), ASA Conference at the University of Western Ontario (2001, London), Australasian Banking and Finance Conference (2001, Sydney), Canadian Law and Economics Association (1998, Toronto), Center for Financial Studies at the University of Frankfurt (2001), Eastern Finance Association (2001, Charleston), Financial Management Association (2001, Toronto), Law & Entrepreneurship Research Conference Sponsored by the Northwestern School of Law of Lewis & Clark College (2000, Portland), Multinational Finance Society (2001, Garda, Italy), Northern Finance Association (2000, Waterloo), University of Alberta Finance Workshop (1999, Edmonton), University of Hamburg Law and Economics Workshop (2001), and the University of Toronto Institute for Policy Analysis (1997). This paper is scheduled for presentation at the Babson Conference on Entrepreneurship (2002, Colorado).
Venture Capital Exits in Canada and the United StatesAbstract
Venture capital exit vehicles enable, to different degrees, mitigation of informational asymmetries and agency costs between the entrepreneurial venture and the new owners of the firm. Different exit vehicles also affect the amount of new capital for the entrepreneurial firm. Based on these factors, we conjecture the efficient pattern of exits depending on the quality of the entrepreneurial venture, the nature of its assets, and the duration of venture capital investment. We empirically assess the significance of these factors using a multinomial logit model. Our comparative results between Canada and the U.S. provide insight into the impact of different institutional and legal constraints, and suggest such constraints have distorted the efficient pattern of exits in Canada.
I. Exit Vehicles...6
II. A General Theory of Venture Capital Exits.8
III. Exceptions to the General Theory: Factors Affecting the Venture Capitalists Timing of Exit and Choice of Exit Vehicle .12
A. Ability of the New Owners to Resolve Information Asymmetry and Value the Firm...13
B. Ability of New Owners to Monitor the Investment Post-Exit and Discipline the Managers.20
C. Black and Gilsons Implicit Contract Theory29
D. The Transaction Costs of Effecting a Sale of the VCs Interest....29
E. Ongoing Costs of Operating as a Public, As Opposed to a Private Firm...34
F. Liquidity of Investment to Buyer...35
G. The Liquidity of the Consideration Received by the VC: The VCs Cash Preference.....36
H. Managerial Incentives42
1. Incentive compensation and Stock Ownership as Managerial Motivators...42
2. The Corporate Control Market..46
I. Transaction Synergies....47
J. Capital Raised, Scale of Acquisition, and Ability to Meet Future Capital Requirements.51
K. Risk Bearing Considerations..56
L. Common Exit Strategies as a Factor in Promoting Teamwork..58
M. The Cyclicality of Valuations in IPO Markets...62
N. The Life Cycle of a Venture Capital Fund: The Fire Sale Problem.. 64
O. Reputational Incentives..65
P. Agency Costs of Debt.67
Q. Public Profile..69
R. Governance Mechanisms69
S. A Rank Ordering of Exit Preference by Investee Firm Quality.70
IV. Testable Hypotheses73
A. Firm Quality...74
B. Investment Duration and Exit Strategy..75
C. Exit Strategies for High-Technology Firms...77
V. Legal and Institutional Factors79
A. Type of Venture Capital Fund79
B. Tax Factors.83
C. Securities Regulation..83
D. Market Liquidity.88
E. Underwriting Support for IPOs..89
VI. Empirical Evidence...90
B. Multinomial Logit Analysis...94
Venture capital investing is primarily equity investing. Many entrepreneurial firms (EFs) are young firms lacking the cash flow and profitability that would enable them to pay interest or dividends. Thus, most of the venture capitalist's return arises in the form of capital gains. For this reason, understanding the means by which venture capitalists (VCs) exit (i.e., dispose of) their investments is vital to an understanding of the venture capital process. Indeed, there is evidence that the prospective suitability of the various exit vehicles (initial public offering, acquisition, company buyback, secondary sale, and write-off, each defined below) is considered by VCs to be an important factor in deciding whether to invest in a firm.
In addition, once an investment is taken on, the VC will structure its deal with the entrepreneur to maximize the probability of exiting on favourable terms. Various common features of the typical VC/entrepreneur deal, such as piggyback rights, go-along (or carry-along) rights, and put options are inserted with a view to facilitating exit.
While previous research has explored the role of venture capitalists (VCs) in the going-public process, the complete class of venture capital exits (IPOs, acquisitions, secondary sales, buybacks, and write-offs) has not previously been the subject of theoretical or empirical investigation.
Previous research has dealt extensively with agency problems that arise in venture capital investing. As initially identified by Sahlman, three types of agency relationships have been the focus of discussion. First, venture capital firms have incentives to favour their interests over those of their investors, and thus can be viewed as agents of the investors. Second, the entrepreneur has an incentive to favour her interests over those of the VC, and hence can be considered to be an agent of the VC. Third, a venture capital firm sometimes has the incentive to act at odds with the best interests of the entrepreneur, and thus may be characterized as an agent of the entrepreneur.
In this paper, we suggest that there is a fourth type of agency problem that has received scant attention. When the VC exits its investments, agency issues arise as between the sellers of the firm's equity (the VC and other investors in the EF) and the purchasers. We hypothesize that the choice of exit vehicle and the timing of exit are strongly influenced by a desire to minimize these agency problems (in addition to a variety of other hypothesized factors). The theme that unifies the paper is that the VCs goal is to maximize the proceeds resulting from the exit of its investments. We identify a variety of factors that influence the exit price associated with various forms of exit, and hence the VCs choice of exit vehicle.
Not all of these factors are empirically testable, either because it would be difficult to devise an appropriate empirical test, or because of limitations in our data set. For this reason, in our empirical tests, a variety of factors are subsumed under the rubric of a variable that we simply style firm quality, which is proxied by the ratio of the proceeds of exit to the cost of investment. We hypothesize that, when arrayed by quality (from high to low), VC investments will be exited by, in rank order, IPOs, acquisitions, secondary sales, buybacks, and write-offs (Hypothesis 1).
We also hypothesize that the longer the duration of the VCs investment, the less the degree of information asymmetry between firm insiders (including the selling VC) and outsiders (i.e. potential purchasers of the VCs interest). We posit a rank ordering of exits arrayed by investment duration (from high to low) in the following order: IPOs, secondary sales, acquisitions, buybacks, and write-offs (Hypothesis 2).
Finally, we hypothesize that technology investments (when compared to non-technology investments) will be associated with greater information asymmetry between insiders and outsiders, a greater likelihood of moral hazard problems, higher growth potential, and a greater likelihood that transaction synergies can be generated by combining the EF with another firm. We posit a rank ordering of preferred exit vehicles for technology investments as follows: IPOs and acquisitions, secondary sales, buybacks, write-offs (Hypothesis 3).
We test these hypothesized relationships using multinomial logit methodology, on data derived from a survey sent to Canadian and U.S. VCs. In our results, we find little support for Hypothesis 2, more support for Hypothesis 3, and perhaps the strongest support for the central hypothesis of the paper, Hypothe