Venture capital investment duration in Canada and the United States

Journal of Multinational Financial Management 11 (2001) 445– 463 www.elsevier.com/locate/econbase

Venture capital investment duration in Canada and the United States Douglas J. Cumming a,*, Jeffrey G. MacIntosh b b

a School of Business, Uni6ersity of Alberta, Edmonton, Alberta, Canada T6G 2R6 Faculty of Law, Uni6ersity of Toronto, 78 Queen’s Park, Toronto, Ontario, Canada M5S 2C5

Received 15 July 2000; accepted 26 February 2001

Abstract This paper considers efficient venture capital investment duration for different types of entrepreneurial firms so that on exit, information asymmetries between the venture capitalist (as seller) and the new owners of the investment are minimized and capital gains maximized. We hypothesize that a number of factors are likely to affect investment duration, and our empirical tests confirm the statistical significance of some of these variables (stage of firm at first investment, capital available to the venture capital industry, whether the exit was preplanned, whether the exit was made in response to an unsolicited offer). However, the fit between our theoretical model and the data is stronger in the United States than in Canada, offering evidence in support of the view that institutional factors have distorted investment duration in Canada. © 2001 Elsevier Science B.V. All rights reserved. JEL classification: G24; G28; G32; G38; K22 Keywords: Exit strategy; Investment duration; Regulation; Venture capital

1. Introduction Venture capitalists (‘VCs’) are financial intermediaries that are in essence a kind of specialized mutual fund. They receive capital contributions from institutional investors (particularly pension funds), high net worth individuals and, in Canada, * Corresponding author. Tel.: +1-780-4920678; fax: +1-780-4923325. E-mail addresses: [email protected] (D.J. Cumming), [email protected] (J.G. MacIntosh). 1042-444X/01/$ - see front matter © 2001 Elsevier Science B.V. All rights reserved. PII: S 1 0 4 2 - 4 4 4 X ( 0 1 ) 0 0 0 3 4 - 2

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individuals from across the economic spectrum, and invest the pooled deposits in small, private, and mainly high-technology businesses with potentially high growth (which we refer to throughout as ‘entrepreneurial firms’, or ‘EFs’). VC managers are highly specialized investors; they create value by closely monitoring the EF’s managers and participating in strategic decision-making. They also offer EFs the benefit of a web of contacts that are useful in sourcing legal, accounting, marketing, investment banking and other business and professional services, and help identify other potential sources of financing. VCs play an active role in identifying and hiring managers with appropriate entrepreneurial, marketing, and financial management skills (Sahlman, 1990). Since rapid growth firms do not usually pay dividends, VC managers make profits by generating capital gains. Thus, the ability to make a profitable ‘exit’ (i.e. sale of the investment) lies at the heart of VC investing. There are a variety of different exit strategies that the VC might select, the five principle strategies being (MacIntosh, 1997; Cumming and MacIntosh, 2000a): an initial public offering (‘IPO’), in which a significant portion of the firm is sold into the public market; an acquisition exit, in which the entire firm is bought by a third party (typically a strategic acquiror); a secondary sale, in which only the VC’s shares are sold to a third party (again, typically a strategic acquiror); a buyback, in which the VC’s shares are repurchased by the EF; and a write-off, in which the VC walks away from the investment. In this paper, we examine the relationship between the duration of venture capital investments and exit strategy. The main motivating principle is that different exit strategies involve the sale of the VC’s interest to a variety of different buyers (the ‘new owners’) with varying abilities to resolve information asymmetries between EF insiders and outsiders. Because of these differences, the new owners of the VC’s interest in the EF firm will have varying abilities to correctly value the EF and to monitor for agency costs post-purchase. We hypothesize that a longer duration of VC investment reduces information asymmetry between insiders and outsiders, resulting in different probabilities of observing different exit strategies. We draw inspiration from the abundant literature suggesting that the structure of venture capital investments is designed to mitigate information asymmetries and agency costs between the VC and the EF (e.g. Sahlman, 1990; Hellmann, 1998; Trester, 1998; Gompers and Lerner, 1999a; Cumming, 2000; Kaplan and Stro¨ mberg, 2000 among others). We also draw inspiration from a number of other papers examining the duration of various aspects of VC investment behaviour. In particular, Megginson and Weiss (1991) find that a longer duration of investment is associated with a lower degree of short-term underpricing in IPOs, suggesting that a longer duration reduces information asymmetry. Gompers (1995) analyses the duration of staged investment rounds; Hellmann and Puri (2000) investigate the time to VC interventions in the management of start-up firms; Cochrane (2001) considers duration in the context of measuring the relative risk and return of IPOs, acquisitions, and investments that remain private. In this paper, we analyse the factors that affect total venture capital investment duration across all the types of venture capital exit enumerated above. In addition, in the spirit of Black and Gilson

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(1998) and Jeng and Wells (2000), we provide a comparison of evidence across Canada and the US to highlight the impact of legal and institutional features on the relation between private and public equity markets. This paper is organized as follows. Section 2 sets up a theoretical framework and presents the testable hypotheses. Institutional and legal differences between Canada and the US are addressed in Section 3. The empirics are presented in Section 4. Concluding remarks follow. 2. Efficient venture capital investment duration

2.1. Basic analytical framework We begin with a basic analytical framework that makes assumptions that are relaxed in subsequent sections. We assume first that the VC has a unique ability, as an active investor, to add value to the enterprise (i.e. there are no other value-added investors). We also assume that at any given point in time, the VC’s investment in the firm can be sold to a third party for a price that represents the best estimate of the true value of the firm (i.e. there is no information asymmetry). We further assume that the fund has an infinite life span, so that a looming wind-down will not affect the VC’s exit decision. At this broad level of generality, the VC’s maximization problem can be represented mathematically as follows, where PVA is the projected value added, PC is projected cost, and the VC chooses effort [e] and total investment duration [time 0 to time T]: Max PVA(e(T),x(T),T) − PC(e(T),z(T),T). e,T

By ‘effort’, we mean all of those things that VCs can do to add value to an enterprise. We note that since VCs invest in firms with the potential for rapid growth, and rapid growth firms tend not to pay dividends, PVA will largely be a function of the investment’s purchase cost and its anticipated exit value. By ‘projected cost’, we mean all the direct and overhead costs associated with creating value, as well as the opportunity cost associated with alternative deployments of capital. By ‘projected’, we mean to suggest that the VC will take into account not merely present cost and effort, but a summation of all expected future costs and efforts. By ‘measurement interval’, we mean those points in time (whether quarterly, yearly, or otherwise) at which the VC formally or informally reassesses its continued commitment to an investment. As elaborated below, the vectors x(T) and z(T) reflect the array of internal and external factors that may randomly generate shifts in the PVA and PC functions. At the point of optimality, a VC will exit from an investment when the projected marginal value added as a result of the VC’s efforts [PMVA], at any given measurement interval, is less than or equal to the projected marginal cost [PMC] of these efforts1: 1

Strict equality is not imposed, as the VC does not continually re-evaluate an investment. Re-evaluation is done at measurement intervals, discussed above.

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PMVA(e(T*), x(T*),T*) 5PMC(e(T*), z(T*),T*). The duration of venture capital investment will thus be the interval from the time of initial investment until the above condition is satisfied. If the PMVA is less than the PMC, the VC will be better off selling the investment, so that it can reinvest the proceeds in a new enterprise and maximally exploit its comparative advantage — creating value by actively managing EFs. The relationship between PMVA and PMC is depicted in Fig. 1. We expect that the VC’s PMVA will be large at the start of the investment and will diminish over time (possibly becoming negative) as the firm matures. At the time of initial investment, many key strategic decisions will not have been made (e.g. the selection of senior managers, the identification of product development and marketing strategies), and the firm’s network of advisors (e.g. legal, accounting, investment banking) and business contacts (e.g. suppliers, independent contractors, customers) will be rudimentary. All of these matters are at the core of the VC’s expertise; hence, potential value-added is significant. Further down the road, however, the firm’s web of advisors and business contacts will be in place, and the likelihood that key decisions will have to be made that engage the VC’s expertise will decline2.

Fig. 1. Venture capital investment duration and comparative statics. 2

We do not mean to suggest that the development of a business involves a hierarchical disposition of key strategic decisions followed strictly by less important decisions. We suggest only that the probability that decisions will have to be taken that engage VC expertise will decline over time.

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The PMC function, like the PMVA function, will tend to decline over the course of the investment, reflecting the greater intensity of VC effort in the early stages of the investment. As this effort diminishes, so will the PMC. We hypothesize, however, that at some point, the PMC will begin to decline more slowly than the PMVA. This is because maintenance costs, like due diligence costs, contain significant fixed cost elements (MacIntosh, 1994). As effort diminishes, total costs will asymptotically approach fixed costs, leveling the slope of the cost function. Both the PMVA and PMC functions will be subject to discontinuities, based on both internal and external factors. For example, the VC may re-draw the PMVA function based on new information about the entrepreneurial team, or a stock market crash. Similarly, the PMC function may be re-drawn if the entrepreneur turns out to be difficult to deal with (requiring the expenditures of additional time). Fig. 1 depicts the effect of shifts in the PMVA and PMC functions. In the following subsections, we relax the assumptions in the basic analytical framework and examine the factors that may affect the PMVA and PMC functions.

2.2. Relaxing the assumption of no information asymmetry In every case in which the VC sells its interest in the EF to a third party, there will be some degree of information asymmetry between the VC and the third party buyer. However, the greater the degree of information asymmetry, the greater the risk that a third party purchaser will incorrectly value the EF. This will adversely affect the buyer’s willingness to pay for the investment, and thus also adversely affect the exit price. Similarly, prospective agency (i.e. moral hazard) costs post-acquisition are higher for firms with a greater degree of information asymmetry between the buyer and the investee firm’s management (Sahlman, 1990; MacIntosh, 1994; Gompers and Lerner, 1999a). The prospect of higher agency costs will also lower the buyer’s willingness to pay. If information asymmetries are sufficiently large that the VC is unable to sell the investment for a price close to its true worth, this will induce the VC to retain the investment until at least some measure of the information asymmetry is resolved. We thus hypothesize that the greater the degree of information asymmetry between the VC and the buyer, the longer the duration of investment.

2.2.1. High-technology firms and information asymmetry We hypothesize that high-technology firms will be characterized by a greater information asymmetry than non-technology firms. The more sophisticated or innovative the technology, the fewer will be the potential buyers with the ability to understand, and hence correctly value the technology (and monitor managers post-acquisition). The risk associated with mis-assessment is high, since technology firms are typically characterized by high asset specificity and, should the technology fail, low asset salvage value (Wynant and Hatch, 1991). Further, the assets of such

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firms are predominantly intangible, especially in early stages of development, and more difficult to value (Hart and Moore, 1994; Noe and Rebello, 1996). Our null hypothesis is therefore that technology firms, with greater information asymmetry, will be associated with a longer duration of investment (i.e. the PMVA function will be shifted to the right for technology firms: see Fig. 1). Two factors, however, give rise to some ambiguity in this theoretical prediction. First, it may be that technology firms exhibit greater complementarities to the technologies possessed by strategic acquirors, creating a richer universe of potential new owners and shortening the duration of investment (see Section 2.5 below). Second, the investment duration necessary to bring a particular technology to fruition will vary considerably across the technology spectrum (e.g. while computer software development may be completed in a few months, developing a new drug may take many years). Thus, our test of the null hypothesis in Section 4 is a test of whether the investment-lengthening effect of information asymmetry dominates these offsetting effects.

2.2.2. Stage of de6elopment at first in6estment and information asymmetry The following categories are commonly used to describe the stages of venture capital investment: seed, start-up, early stage, expansion, buyout, and turnaround. We adopt the definitions habitually employed in annual industry reports in Canada and the US (Canadian Venture Capital Association, 1993– 1996; Venture Economics, 1993– 1996). The seed stage is the earliest stage of financing, followed by start-up, early stage (sometimes called first stage expansion financing), expansion financing, and buyout and turnaround financing. How does investment stage affect the degree of information asymmetry? VC participation in an enterprise certifies the quality of an investment to outsiders (Sahlman, 1990; Gompers and Lerner, 1999a). In addition, we anticipate that the longer the VC’s specialized monitoring and disciplinary skills are brought to bear, the greater will be the increase in firm value, just as the longer a force is applied to an inert body, the greater will be the speed it will attain. Hence, the longer the duration, the greater the value of the certification effect (Barry et al., 1990; Megginson and Weiss, 1991). This suggests that heightened degrees of information asymmetry will be associated with a longer investment duration, as the VC attempts to maximally exploit the value of duration as a signal of quality. And, since the degree of information asymmetry will vary inversely with the firm’s stage of development, we expect that the earlier the stage of investment, the longer the investment duration. Another factor suggests an inverse relationship. Fig. 1 suggests that the largest value-added for VC investors occurs at the start of any given investment. We suggest in addition that the difference between the PMVA and the PMC will be at its maximum (among investments arrayed by stage of investment) for early stage investments. Thus, it will take longer for the PMVC and PMC functions to converge and satisfy the exit condition. This is simply another way of saying that the VC retains its comparative advantage (as an investor) over other investors for a longer period of time for early stage ventures.

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At periodic intervals, however, a VC will re-evaluate an investment and exit if the investment shows a negative net present value investment. This process, whether formal or informal, may take place quarterly, yearly, at staging intervals, or on an ad hoc basis. We refer to this re-evaluative dynamic as the ‘culling’ process. The existence of culling suggests a positive relationship between stage of development and investment duration for three primary reasons. First, VCs make the bulk of their profits from the few ‘home runs’ in their portfolios (MacIntosh, 1997; Gompers and Lerner, 1999a), which are likely to constitute approximately 10% of portfolio investments. A further 20% will be profitable, but significantly less so than home runs. Approximately 10– 30% of investments will be written off, and the remainder will fall into the category of the ‘living dead’; i.e. investments that generate sufficient profit to support the entrepreneur, but not enough to generate more than nominal returns for VC investors. It is to the VC’s advantage to engage in significant culling of its portfolio early on in the investment process, in order to focus the VC’s talents and resources on prospective home runs. Second, early stage firms are characterized by a much wider dispersion of possible (and realized) outcomes. This heightened dispersion is a function of enhanced information asymmetry. For example, the quality of management and the soundness of the firm’s product or technology will be untested at the seed stage. Even at the end of the start-up stage, most firms will not yet have turned a profit. Despite the VC’s expertise at resolving information asymmetries, it seems inevitable that valuation error will be greater for early stage investments, and hence that a larger proportion of such investments will be found to be wanting and quickly exited. Third, there will be a comparatively rapid reduction in information asymmetry between the VC and the EF at the start of the investment. The degree of uncertainty will narrow sharply as the VC rapidly acquires an understanding of various aspects of the EF’s quality (e.g. of management, technology). For all these reasons, an abundance of relatively poor investments will be discarded relatively early in the investment cycle. The existence of a culling process encapsulates the VC’s oft-repeated homily that ‘the lemons ripen quickly, while the plums take time to mature’. We therefore adopt as our working hypothesis the view that duration will be shorter the earlier the stage of investment (i.e. that the culling effect dominates the effects of information asymmetry and comparative advantage).

2.2.3. Information asymmetry and exit strategy Both in this paper and elsewhere (Cumming and MacIntosh, 2000a), we hypothesize that the exit vehicle is chosen, in part, to minimize the degree of information asymmetry between firm insiders and outsiders (and in particular, between the VC and the investment’s new owners) in the interest of maximizing exit proceeds. The ability of the new owners to resolve information asymmetry depends on their identity. Buy-backs, which are effected by the EF (hence, in effect, by the entrepreneur), are characterized by the least degree of information asymmetry, followed by acquisition exits, secondary sales, and IPOs (Cumming and MacIntosh, 2000a). We thus hypothesize that the longer the VC investment duration, ceteris paribus, the greater the likelihood of an IPO exit, followed by a secondary sale, an acquisition, and a buyback.

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2.2.4. Information asymmetry and the extent of exit Exit strategy encompasses the choice of making a ‘full exit’, or a ‘partial exit’. In relation to IPOs, a partial exit means that the VC retains at least part of its securities for a period longer than a year following the date of the IPO. A partial acquisition exit involves the receipt of securities in the acquiror instead of cash3. A partial secondary sale and buyback involves sale of part of the VC’s holdings. A partial write-off is a write-down of the book value of investment. Following Leland and Pyle (1977) and Cumming and MacIntosh (2000b), we hypothesize that a partial exit will typically be made when information asymmetry is high, and the VC wishes to signal the quality of the investment by means of partial ownership retention4. Information asymmetry, and hence the need for VC certification through a partial exit, will be greater, the shorter the duration of investment; thus in general, we posit that the direction of causality is from duration of investment to the extent of exit5. 2.3. Entrepreneurial firm quality Given the existence of a culling process that weeds out bad investments in the early stages, there should be a positive relationship between EF quality and investment duration. Higher-quality firms will make it through the early stage culling process and continue to be nurtured for some period of time. The existence of a positive relationship will be mitigated to the extent that younger VC firms engage in grandstanding (Gompers, 1996), i.e. prematurely bringing promising investments to the IPO market in order to generate a track record that will assist in raising further capital. Although the extent of grandstanding in our data sample is unknown, we nonetheless hypothesize that higher EF firm quality will give rise to longer total VC investment duration6. This null hypothesis is tested in Section 4 below. 3 As indicated in Cumming and MacIntosh (2000b), this form of exit is broadly analogous to a partial sale of the VC’s shares, since the securities it receives in consideration for its holding may be highly marketable. 4 When VCs dispose of all of their securities at the time of a public offering, outside investors may view this as a signal of a lack of confidence in the firm. This will result in an inferior exit price (Bygrave and Timmons, 1992: 175; Leland and Pyle, 1977). Evidence of this arises in the common practice of underwriters, in connection with IPOs, to insist (even where regulatory hold and escrow requirements do not apply) that key shareholders (including VCs) sign a lock-in arrangement (i.e. a negotiated escrow) forbidding such shareholders from selling into the secondary market for a stipulated period of time (in the US, usually 6 months) following the IPO. 5 The choice of the extent of exit may, on its face, impact on the VC’s choice of investment duration. The desire to make a partial exit will reduce the period of time during which it is necessary to hold the investment (or part thereof), because the partial exit will signal the firm’s quality and mitigate information asymmetry. But the more plausible direction of causality is from duration to extent of exit; VCs have few reasons for wishing to partially exit an investment save to signal the quality of the firm and enhance the proceeds of sale (Cumming and MacIntosh, 2000b). The causality issue is assessed in the empirics below. 6 In the empirical tests (Section 4), we proxy firm quality by the ratio of the firm’s market value (the price received by the VC from the sale of its interest in the investment) to the book value (what the VC paid for the investment). This proxy gives rise to the potential for endogeneity as active VC participation over a longer duration may increase the project’s value. The empirical analysis in Section 4 considers this endogeneity issue.

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2.4. Venture capital fundraising VCs are intensely active investors. Hence, each VC manager will monitor only a small number of investments. Gorman and Sahlman (1989), for example, find that VC managers spend about half their time monitoring an average of nine EFs. The expertise of VC managers is accumulated over a period of time. The greater the experience of the manager, the greater the ability to guide fledgling enterprises through difficult stages in the growth process, and to help the firm put in place business and advisory contacts. Because VC managing depends on experience, in the short-run, VC management expertise is inelastic. VCs take the bulk of their reward in the form of a percentage (typically 20%) of the increase in the value of the investment portfolio (Sahlman, 1990; Gompers and Lerner, 1999a). Thus, VC firms have a strong incentive to expand the pool of capital under administration. However, should a fresh supply of capital become available (e.g. from changes in tax rates, interest rates, or other economic conditions; see Gompers and Lerner, 1999b; Jeng and Wells, 2000), the VC will be constrained in its ability to launch new funds given the short-run inelasticity in the supply of VC managers. It may thus be in the interest of a VC fund to exit old investments in order to free up managerial resources and launch a new fund. Thus, our null hypothesis is that duration will be shorter when there is an increase in capital available for investment7.

2.5. Existence of other 6alue-added in6estors In our general theory, we made the simplifying assumption that VCs are the only value-added investors. However, it is clear that there are other value-added investors, the most important of which is the strategic acquiror (‘SA’). A SA will usually be a company in the same or a similar business as the purchased firm, either as competitor, supplier, or customer (see e.g. Venture Economics, 1996). A SA will often integrate the company’s technology with its own following the acquisition, although sometimes the target firm will be left as a wholly owned subsidiary in order to avoid breaking up the managerial and entrepreneurial team whose talents first made the firm an attractive target. SAs will sometimes have an ability to add value over and above that of even a skilled VC. Because the SA and the investee firm are usually in the same or closely related businesses, SAs are well positioned to resolve information asymmetries between insiders and outsiders. This enables an SA to evaluate the firm’s potential, monitor managers post-acquisition, and make strategic decisions about how best to deploy the firm’s product or technology. Because the SA will usually own the entire firm post-acquisition, it will possess the control it needs (unfettered by obstreperous minority shareholders) to implement desired changes.

7 Additional factors that may bear relevance to this hypothesis are considered in an extended version of this paper on file with the authors. See also Gompers (1996).

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The existence of valued-added investors other than the VC creates a potential opportunity cost for every VC investor; at any given time, there may be another value-added investor for whom the present value of the project is higher than for the VC. If so, the VC is better off selling the investment to that investor rather than retaining and developing the project itself. The existence of SAs and other value-added investors would appear to be a factor that causes a shorter duration of investment (especially for technology firms, which are likely to possess technologies exhibiting complementarities with those possessed by potential SAs; see Section 2.2.1). However, the thrust of our argument thus far has been that causation runs in the opposite direction, i.e. that duration affects the degree of information asymmetry between insiders and outsiders of the EF, and hence affects the probability of observing different forms of exit (see Cumming and MacIntosh (2000a) for empirical tests, and support for the proposition that causation is from duration to choice of exit vehicle). Nonetheless, in recognition of the inherent ambiguity in the direction of causation, in our regressions, we include a dummy variable for cases in which an exit was prompted by an unsolicited offer (which will typically be made by a SA). We hypothesize that an unsolicited offer will be associated with a shorter duration of investment. In general, we expect that when an unsolicited offer is made, a sale will occur if the purchase offer exceeds the VC’s assessment of the difference between its PMVA and PMC (and if the VC believes that there are no alternative purchasers with a greater willingness to pay).

2.6. Exits that are pre-planned or inspired by market conditions Our data also disclose cases in which the exit strategy was pre-planned at the time of initial investment, or made in response to market conditions. A pre-planned exit will typically be contemplated only when the anticipated duration of investment is short. Thus, we hypothesize that pre-planned exits will be made over a shorter duration. Our null hypothesis is that VC exits inspired by ‘market conditions’ will not systematically be associated with either a shorter or longer duration. A VC might as easily postpone an exit because market conditions are unfavourable, as exit earlier than anticipated because conditions are favourable.

3. Institutional and legal differences between Canada and the United States In related work (MacIntosh, 1994, 1997; Cumming and MacIntosh, 2000a,b) we present evidence that there are significant institutional and legal differences between Canadian and US venture capital markets. The effect of these differences can be summarized as follows: (1) more onerous hold period and escrow requirements applicable to Canadian VCs, and lower liquidity in Canadian secondary markets, suggest that investment duration will be longer in Canada than in the US, particularly for IPOs; (2) government sponsorship of venture capital through the vehicle of the ‘Labour Sponsored Venture Capital Corporation’ distorts investment

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and exit behaviour, introducing noise into exit behaviour and making it less likely that the theoretical model of investment duration will hold; (3) VC managers in Canada are less skilled than their US counterparts, again introducing noise into the Canadian exits data and making it less likely that the theoretical model will hold in Canada. Taken together, these factors suggest that it is better to treat the Canadian and US data as distinct sub-samples than to pool the data. Nonetheless, in our empirical tests below, we both segregate and pool the data.

4. Empirical evidence

4.1. Sur6ey data and summary statistics The hypotheses developed in Section 2 are empirically tested herein using survey data. The survey data comprise exits from 112 portfolio companies from 13 VC firms in the US and 134 portfolio companies from 22 VC firms in Canada between 1992 and 19958. For each portfolio company, the survey data include information respecting the amount invested by the VC (book value), the year of investment, the stage of the firm’s development when the investment was made, the exit value (market value), the exit vehicle used (IPO, acquisition, secondary sale, buyback, write-off, or other/unknown), the extent of exit (partial or full), whether the company is technology-intensive, and the reason for exit (pre-planned, market conditions, unsolicited offer, or other). Summary statistics for the US and Canadian data are presented in Tables 1 and 2, respectively. The definition of partial exit for each exit vehicle is provided in Section 2.2.4. Tables 1 and 2 present data for both full and partial exits. The results in Section 4.2 below are for all the exits (i.e. both full and partial), but were similar for the sub-samples of full and partial exits. In Canada, the duration was longest for acquisition exits (average of 6.94 years) and shortest for secondary sale exits (average of 3.08 years). In the US, the duration was longest for secondary sale exits (average 6.33 years) and shortest for buy-back exits (average of 4.00 years) and other/unknown exits (average of 2.75 years). On average, the costs of investment, exit values, and real returns were greater in the US than in Canada. In Canada, the average duration for IPO exits was 5.86 years; in the US, it was 4.70 years.

8 Collection of the survey data was done in conjunction with MacDonald & Associates (1996) in Canada and Venture Economics in the US. The data represent approximately 10% of US VC exits and 32% of Canadian VC exits over the period (as recorded by the respective associations in the two countries). The sample of exits from Venture Economics and the CVCA were collected, based on the willingness of the venture capitalists to disclose private information. Factors that may induce self-selection reporting bias across Canada and the US are likely to be the same in the two countries. Thus, self-selection bias, if it exists, is not expected to affect the comparative cross-country results. Complete industry exits data are available neither from Venture Economics (1993 – 1996) nor from the Canadian Venture Capital Association (1993 –1996). Nonetheless, comparing our data sample to the available data from various annual reports did not reveal any obvious statistical discrepancies.

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Exit vehicle

Number of portfolio companies

Average duration (years)

Technology industry

No

Yes

Extent of exit

Full sample including partial exits

Partial

Full

Average Average investmentb exit valueb

Sample excluding partial exits

Average gross real return (%)

Average annual real return (%)

Variance in real return (%)

Average Average investmenta exit valueb

Average gross real return (%)

Average annual real return (%)

Variance in real return (%)

IPO Acquisition

30 30

4.7000 5.1667

12 9

18 21

8 6

22 24

2 035 036 1 720 349

12 565 880 3 859 077

464.6397 143.0386

54.9152 57.8286

51.1517 754.7467

2 052 934 1 640 617

13 058 260 3 017 889

506.1595 119.8723

44.4932 67.2604

14.9276 943.0674

Secondary sale Buy-back Write-off Other Total

9

6.3333

2

7

3

6

519 931

1 005 871

54.8768

−7.5650

6.6850

428 671

242 123

−42.3940

−9.7570

4.3797

6 33 4 112

4.0000 4.3636 2.7500 4.7500

5 15 2 45

1 18 2 67

5 2 1 25

1 31 3 87

784 397 1 984 068 1 112 445 1 714 030

2 687 449 92 500 1 539 990 4 706 597

145.0423 −97.8450 35.2761 147.3815

24.7910 −90.0070 34.0191 5.6416

3.2665 4.8772 83.9444 256.6047

2 634 352 2 032 191 1 355 079 1 588 089

10 265 360 98 468 1 712 773 3 796 201

289.6732 −97.7050 −8.1910 109.9431

40.4996 −89.3620 −9.8670 −2.5835

0.0000 5.1315 10.3594 304.8443

a

Source: Venture Economics. Real US dollars (base year =1990). CPI data source: International Financial Statistics, Label 11/64; available at www.chass.utoronto.ca. Partial exit market values are adjusted to reflect full values. Real returns are calculated assuming investment at the beginning of the year, and exit at the end of the year, reflecting the lowest possible estimate. b

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Table 1 United States venture capital investment duration data summarized by exit vehiclea

Exit vehicle

Number of portfolio companies

Average duration (years)

Technology industry

Extent of exit

Full sample including partial exits

Sample excluding partial exits

No

Yes

Partial

Full

Average Average investmentb exit valueb

Average gross real return (%)

Average annual real return (%)

Variance in real return (%)

Average Average investmenta exit valueb

Average gross real return (%)

Average annual real return (%)

Variance in real return (%)

IPO Acquisition

36 16

5.8611 6.9375

3 9

33 7

20 1

16 15

1 464 087 1 945 386

5 170 185 3 271 514

1385.8530 84.5848

27.8282 13.3089

9.8247 2.9498

1 520 666 1 998 818

3 536 233 3 353 662

187.5823 85.0041

21.5102 13.7993

8.6706 3.1193

Secondary sale Buy-back Write-off Other Total

12

3.0833

0

12

5

7

402 144

968 181

165.6950

54.8972

90.2764

304 109

581 065

157.8125

18.0877

8.0910

41 27 2 134

6.3415 4.0741 6.0000 5.5299

30 18 2 62

11 9 0 72

7 1 1 35

34 26 1 99

668 245 332 038 2 412 731 969 012

808 686 3 821 3 687 627 2 169 579

66.9712 −97.1010 60.1537 399.0807

3.8207 −92.0440 9.5346 −3.2530

1.5041 4.3792 0.1692 33.8738

729 096 338 780 2 766 431 937 431

879 255 3 968 3 492 890 1 459 018

41.7198 −96.9890 42.1686 43.6362

2.5680 −91.7380 12.4435 −16.2390

1.5212 4.5280 0.0000 24.9186

a

Source: Canadian Venture Capital Association. Real Canadian Dollars (base year =1990) converted to US dollars. CPI data source: CANSIM, Label P700000; available at www.chass.utoronto.ca. Foreign exchange rates from CANSIM, label B3400. Values expressed in US dollars for comparative purposes only. Returns were computed in Canadian dollars and do not reflect exchange rate changes. Partial exit market values are adjusted to reflect full values. Real returns are calculated assuming investment at the beginning of the year, and exit at the end of the year, reflecting the lowest possible estimate. b

D.J. Cumming, J.G. MacIntosh / J. of Multi. Fin. Manag. 11 (2001) 445–463

Table 2 Canadian venture capital investment duration data summarized by exit vehiclea

457

458

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Statistical tests of the equality of means in investment duration across Canada and the United States were performed9, resulting in two notable statistical differences. The test for the difference in means for the duration of IPO exits in Canada versus the US is equal to 1.66709 (the two-sided P-value is 0.0954), suggesting that the duration is longer for IPO exits in Canada. The test for the difference in means for the duration of all exits in Canada and the US is equal to 2.0745 (the two-sided P-value is 0.0380), indicating that the duration is longer in Canada than in the US for all exits taken together. Average investment duration is also statistically longer in Canada than in the U.S. for each firm development stage at first VC investment. The statistics are consistent with hypothesized differences in the Canadian and US legal and institutional environments. For example, lower VC skill in Canada and/or less liquid Canadian markets might account for the longer duration of investment.

4.2. Hazard model of total in6estment duration In order to analyse the significance of various factors that may influence the duration of a VC’s investment, we employ Cox’s semi-parametric proportional hazards model. The advantage of this duration model is that it involves minimal distributional assumptions10. The formal proportional hazards model is based on the hazard rate, h( t) = ho(t)e i%X, where ho(t)=t 1/(| − 1) is the baseline hazard function. The probability that a venture capital exits one of its portfolio companies is e i%Xj/(SjmRie i%Xj). Note that the baseline hazard is eliminated in the conditioning. Because there are no censored observations in our data set, and more than one portfolio company is exited in each of the exit years in our data set (1992– 1995), the partial loglikelihood is ln L=_ = 1[b%_jmTiXj − mi ln _jmRie i%Xj] (Cox, 1975). Newton’s method was employed to maximize this log-likelihood function. The dependent variable is the duration of investment, measured in years. The matrix of independent variables (X) encompasses the value of the VC’s securities upon exit and total capital in the industry. In addition, dummy variables are employed for the following: preplanned exits, unsolicited offers, exits inspired by market conditions, seed investments, start-up investments, early stage investments, expansion investments, buy-out investments and technology Efs (for a number of different industries)11. A constant is not included in the model because the model is homogeneous of degree zero in X; therefore, inclusion of a constant would lead to a singular Hessian matrix during Newton iterations. Information criteria statistics 9 The test statistic for the equality of means is given by: (DurationCanada −DurationUS)/ (Var(DurationCanada)/NCanada + Var(DurationUS)/NUS)1/2, where DurationCanada and DurationUS are the mean durations for exits in Canada and the US, respectively; Var(DurationCanada) and Var(DurationUS) are the variances of the responses for durations in Canada and the US, respectively; NCanada and NUS are the number of exits in Canada and the US, respectively. See Newbold (1988). 10 Cox (1972). Because the model only assumes a basic form for the hazard function, it is semiparametric. 11 Turnaround investments in Canada and secondary purchases in the United States were not included to avoid perfect collinearity (note that these variables were suppressed because there were no turnaround stage investments in the US, and there were no secondary purchase stage investments in Canada). Suppressing other stage of investment variables did materially affect the results.

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were used to infer the appropriateness of the included right-hand-side variables. Durbin – Wu – Hausman (DWH) tests12 did not indicate significant endogeneity problems with these variables. The DWH tests also indicated that causality generally runs from investment duration to choice of exit and extent of exit; therefore, choice of exit and extent of exit are not included as right-hand side variables. The Canadian and US estimates, as well as the estimates for the full sample combining the Canadian and US data are presented in Table 3.

4.3. Empirical results We hypothesized that the higher the quality of the firm (as proxied by the market/book ratio), the longer the investment duration (due to the hypothesized investment culling process). However, none of the results in the Canadian, US and combined samples are significant. With respect to the firm’s stage of development at the time of the VC’s initial investment, our working hypothesis was that there is a positive relationship between stage of development and duration. In the US, at the 1% level of significance, earlier stage investments are likely to be held for a shorter period of time than later stage investments. This is evidence that there is significant culling of early stage investments13. Curiously, however, despite the statistically strong results in the US, there is only one statistically significant variable in Canada. This suggests that we are correct in assuming that Canadian and US venture capital markets are far from perfectly integrated, and that our theoretical framework is less likely to hold in Canada than in the US. Contrary to expectation, duration generally appears to be unaffected by whether or not the investee is a high-technology firm. Many of the technology coefficients in Canada and the US were positive, as expected (Section 2.2.1), but insignificant. Breaking technology firms down into constitute industry sectors did not materially affect the empirical results, with the exception of medical technology EFs, where the coefficients in the Canadian sample and combined Canadian and US sample are significant. This is consistent with anecdotal evidence suggesting that medical products take longer to develop (although we expected the same to be true of biotechnology EFs, and in our data, this is not the case). As hypothesized, the greater the amount of VC fundraising, the shorter the duration of investment, although, again, this result is significant only in the US14. 12 The DWH tests are available in an extended version of the paper on file with the authors; see also Cumming and MacIntosh (2000a). For details regarding DWH tests, see Davidson and MacKinnon (1993) (pp. 237 –242, 389 –395). 13 Eliminating write-off exits from our sample does not change the qualitative interpretations in the empirical analysis. We control for write-offs with the variable for firm quality (market/book). 14 We do not include an interest rate variable, as it is collinear with the fundraising variable, and its coefficient is insignificant. This is not surprising, given that interest rates are a determinant of venture capital fundraising; see Gompers and Lerner (1999b). The inclusion of an interest rate variable does not materially change the statistical significance of any coefficients for other variables in Canada and the US, with one exception: it does make insignificant the coefficient for fundraising in the US regression (due to collinearity across the fundraising and interest rate variables).

460

Dependent variable: duration of investment United States

Canada

Combined United States–Canadian sample

Independent variables

Coefficient

t-ratio

Coefficient

t-ratio

Coefficient

t-ratio

Market I book value Preplanned exits Market conditions Unsolicited offers Venture capital fundraising Seed firms Start-up firms Early-stage firms Expansion firms Buyout firms Multimedia industries Computer hardware Computer software Manufacturing Consumer products Agricultural and biotechnology Recycling Industrial equipment and mining Medical

−0.0266 −0.2123 −0.2707 −0.2296 −0.0002 −2.4544 −1.9434 −1.9671 −2.3444 −1.0378 0.4509 −0.1098 −0.0573 0.8105 −0.2621 0.4173 0.3741 −1.0036 0.2807

−0.9204 −0.7132 −0.9809 −0.5323 −2.2210** −3.0559*** −2.4332** −2.4166** −2.9405*** −0.9903 0.7753 −0.2477 −0.1454 1.3892 −0.6437 0.5175 0.4614 −0.9207 0.6652

−0.0003 −0.3719 0.2186 −0.3460 −0.0004 −0.3539 −0.4773 −1.0717 −0.2848 −0.9255 0.2550 −0.1306 0.1422 0.2652 0.4836 0.5039 0.7448 0.0448 0.9105

−0.1170 −1.3339 0.7566 −1.2285 −1.4767 −0.5719 −0.9844 −2.0071** −0.5919 −1.2334 0.5773 −0.3307 0.3351 0.7850 1.3276 1.0429 0.9492 0.0861 2.4811**

−0.0015 −0.4725 −0.0865 −0.4897 0.00004 −0.6407 −0.5736 −0.7732 −0.5338 −0.8623 0.3699 0.0763 0.0816 0.1762 0.2488 0.4592 0.6879 0.2675 0.5277

−0.5311 −2.5969*** −0.4806 −2.1728** 0.6979 −1.6768* −1.5852 −2.0161** −1.5187 −1.5158 1.0527 0.2626 0.2855 0.6169 0.9116 1.2592 1.2419 0.6239 1.8919*

* , **, ***Significant at the 10, 5, and 1% level, respectively (two-sided tests).

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Table 3 Proportional hazard model estimates of Canadian and US venture capital investment duration

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This evidence supports the view that in the shorter term, the limited supply of managerial talent operates as a constraint on the ability to launch new funds (Section 2.4). It also supports Ho¨ lmstrom and Milgrom’s (1991) multitask principal-agent perspective. When VCs’ opportunity costs increase, there is greater scope for VCs to act against the interests of their existing EFs and capital contributors: exit from existing investments is sooner than that which would otherwise have been optimal, similar to Gomper’s evidence of grandstanding among young VC firms (Gompers, 1996). There is evidence that when exit is preplanned (Section 2.6), the duration of investment is shorter. However, this result is significant only in the combined sample and not in either the US or Canadian sub-samples. Exits prompted by market conditions (Section 2.6) did not systematically affect investment duration in either the US or Canada. As expected (Section 2.5), the coefficient accompanying unsolicited offers is negative in the US and Canada, as well as in the combined sample. However, this coefficient is significant only in the combined sample.

5. Conclusion In the US, firms in the early stages of development at the date of the VC’s first investment have a shorter average duration. This offers support to the view that a culling process occurs in early stages of the investment cycle, with ‘lemons’ quickly discarded and ‘plums’ maintained in the VC’s portfolio. We also found statistically significant evidence in the US data that the availability of capital to the venture capital industry affects the average duration of investment, with greater capital resulting in a shorter duration. This supports the view that managerial talent is constrained in the short run, resulting in re-deployment of managerial resources from old to new investments in order to allow for the creation of new funds. In periods of rapid expansion in available capital, VCs appear to exit their existing investments in order to attract new investors and increase their total compensation. This is consistent with Gompers’ explanation of grandstanding (Gompers, 1996). However, we have provided an additional reason why VCs — and not merely younger VC firms seeking to establish a track record — may choose to exit their investments prematurely if contemplating the establishment of a new fund. Our explanation suggests that these premature exits may be taken via any of the exit strategies available to VCs, and not merely by IPOs. Only two of the factors that, we hypothesized, would influence investment duration were statistically significant in the Canadian sub-sample, while several were significant in the US sub-sample. This is in keeping with the hypothesis that our theoretical framework will achieve a better fit with the US data, given distortions in exit behaviour introduced by the lower liquidity of secondary trading markets, Canadian legislation establishing LSVCCs, and onerous escrow and hold period requirements (MacIntosh, 1994). It is also consistent with the view that the average skill level of Canadian VC managers is lower than their American counterparts, introducing a random factor into Canadian exit behaviour.

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