the staging of venture capital investmentssfb649.wiwi.hu-berlin.de/fedc/events/motzen10/the...

Venture Capital FrameworkMotivations for Staging

Costs of StagingReferences

The Staging of Venture Capital Investments

Tobias Scheinert

Humboldt Universität zu Berlin

June 4, 2010

Tobias Scheinert The Staging of Venture Capital Investments

Outline

1 Venture Capital Framework

2 Motivations for StagingProject Characteristic vs. Real OptionsInformation GenerationAgency Problems

Moral HazardHold-UpAdverse Selection

Diversi�cation vs. Specialization

3 Costs of StagingWindow DressingProject Delay

The Venture Capital Framework

Two players: Entrepreneur (E) and Venture Capitalist (VC)

The entrepreneur (he) is cash constrainedThe venture capitalist (she) provides the funding in return fora claim on the ventures returnCompetitive Market, thus various VCs are competing forlucrative investments

(Un-)certainty about the venture's quality, the entrepreneur'squality, and/or the general market development

Complete information vs. information asymmetries

Decision faced by the VC: How to organize the investment intothe entrepreneur's �rm (staged �nancing vs. lump-sum�nancing, if stages how to structure them)

The entrepreneur (he) is cash constrained

The venture capitalist (she) provides the funding in return fora claim on the ventures returnCompetitive Market, thus various VCs are competing forlucrative investments

The entrepreneur (he) is cash constrainedThe venture capitalist (she) provides the funding in return fora claim on the ventures return

Competitive Market, thus various VCs are competing forlucrative investments

Project Characteristic vs. Real OptionsInformation GenerationAgency ProblemsDiversi�cation vs. Specialization

Outline

Project Characteristic vs. Real Options

Staging is the outcome of the project's nature

Project stages might be deterministicFinancing stages simply mimic the development process of theproject

Alternatively, projects consist of a sequence of real options

There is uncertainty about the state of nature and thus aboutthe success probability of the projectVC holds an option (or a sequence of options) to wait

Observe the state of nature (e.g. market demand for a certainproduct)Financing is only provided if certain thresholds are reached

Project stages might be deterministic

Financing stages simply mimic the development process of theproject

There is uncertainty about the state of nature and thus aboutthe success probability of the project

VC holds an option (or a sequence of options) to wait

Observe the state of nature (e.g. market demand for a certainproduct)

Financing is only provided if certain thresholds are reached

Empirical Evidence

Kaplan and Strömberg (2004)

External risk is associated with [...] tighter staging, inthe sense of a shorter period between �nancing rounds.

Li (2008)

... the portfolio company will receive the staged�nancing much later when there is a higher level ofmarket uncertainty.

Empirical Evidence

Li (2008)

Empirical Evidence

Li (2008)

Empirical Evidence

Li (2008)

Empirical Evidence

Li (2008)

Information Generation

There is not only exogenous uncertainty, the venture alsoentails endogenous uncertainty

Waiting is not valuable since the uncertainty does notautomatically clears up over time

Investment can produce valuable information about thepro�tability of a project

However, if all the funding is provided up-front, then thegenerated information cannot be used in the negotiation oflater �nancing round

Thus, staging the investment can balance this trade-o�

Theoretical Modeling

Pindyck (1993)Roberts and Weitzman (1981)

Pindyck (1993)

Roberts and Weitzman (1981)

Pindyck (1993)Roberts and Weitzman (1981)

Empirical Evidence

Kaplan and Stromberg (2003)

[...] ex ante staging is more common in earlier rounds.

Li (2008)

The funding duration for a Seed/Startup-stagecompany is 10% shorter than that for an expansion- orlate-stage company.

Further evidence: Sahlman (1990)

Empirical Evidence

Li (2008)

Empirical Evidence

Li (2008)

Empirical Evidence

Li (2008)

Empirical Evidence

Li (2008)

Empirical Evidence

Li (2008)

Agency Problems - Moral Hazard

E and VC do likely have di�erent objective functions

If there is an information asymmetry between both parties, Emight choose to perform actions which are not in the interestof the VC

In order to reduce this information asymmetry, the VC canmonitor E

If the VC could monitor costlessly, she would monitor andinvest continuouslyIn reality, however, VCs face monitoring costsThus the trade-o� between agency costs and monitoring costsmeans that funding will be provided in a staged manner

Financing can also be made contingent on reached milestones

If the VC could monitor costlessly, she would monitor andinvest continuously

In reality, however, VCs face monitoring costsThus the trade-o� between agency costs and monitoring costsmeans that funding will be provided in a staged manner

If the VC could monitor costlessly, she would monitor andinvest continuouslyIn reality, however, VCs face monitoring costs

Thus the trade-o� between agency costs and monitoring costsmeans that funding will be provided in a staged manner

1 If the VC holds a claim on the portfolio �rm that is senior toE's claim then there is a asset substitution problem

E could increase the riskiness of the project, and thus increasethe value of his claimStaging could be used to incentivize E not to take excessiverisk

2 Since E obtains also private bene�ts from running the �rm hemight want to choose risk below the value maximizing level

If you view staged �nancing as a compounded option, it can beshown that the chance to obtain funding in later rounds(exercise of one of the compounded options) is higher athigher risk levelsThus, staging can help to mitigate the agency issue that Ewant's to take overly conservative actions

E could increase the riskiness of the project, and thus increasethe value of his claim

Staging could be used to incentivize E not to take excessiverisk

If you view staged �nancing as a compounded option, it can beshown that the chance to obtain funding in later rounds(exercise of one of the compounded options) is higher athigher risk levels

Thus, staging can help to mitigate the agency issue that Ewant's to take overly conservative actions

Bergemann and Hege (1998)Wang and Zhou (2004)Hsu (2008)

Bergemann and Hege (1998)

Wang and Zhou (2004)Hsu (2008)

Bergemann and Hege (1998)Wang and Zhou (2004)

Hsu (2008)

Bergemann and Hege (1998)Wang and Zhou (2004)Hsu (2008)

Empirical Evidence

Gompers (1995)

Venture capitalists weigh potential agency andmonitoring costs when determining how frequently theyshould reevaluate projects and supply capital.

Ex ante staging using explicit milestones is related tointernal risk.

Further evidence: Kaplan and Stromberg (2003), Hege et al.(2003), Krohmer et al. (2009), Li (2008), and Sahlman (1990)

Empirical Evidence

Gompers (1995)

Empirical Evidence

Gompers (1995)

Empirical Evidence

Gompers (1995)

Empirical Evidence

Gompers (1995)

Empirical Evidence

Gompers (1995)

Agency Problems - Hold-Up

Entrepreneur is crucial for the success of the venture

VC faces hold-up after the initial investment is sunk

E could try to repudiate and renegotiate new contract termsCould prevent �nancing of actually pro�table projects ex ante

Staging could mitigate the hold-up problem

Smaller initial investment results in smaller claim on theventure's returns and is less susceptible of being renegotiateddownEarly �nancing rounds generate collateral that can supportlater rounds

E could try to repudiate and renegotiate new contract terms

Could prevent �nancing of actually pro�table projects ex ante

Smaller initial investment results in smaller claim on theventure's returns and is less susceptible of being renegotiateddown

Early �nancing rounds generate collateral that can supportlater rounds

Neher (1999)

Empirical Evidence

Sahlman (1990)

Further evidence: Kaplan and Strömberg (2004), Kaplan andStrömberg (2004)

Empirical Evidence

Sahlman (1990)

Empirical Evidence

Sahlman (1990)

Agency Problems - Adverse Selection

There are good and bad entrepreneurs / projects

Staging can be used as a screening device to distinguishbetween both types

Since the entrepreneur faces the risk of project abandonmentby the VC following bad news, bad managers are less likely toselect a staged contract

Diamond (1991)For the decision to �nance with short-term or long-term debt

Empirical Evidence

Ex ante staging using explicit milestones is related tointernal risk. This is consistent with ex ante staging beinga way for good �rms to signal their type (or for VCs toscreen out bad �rms), similar to the way short-term debtis used [...]

Hege et al. (2003)

US VCs have better screening skills [...] than theirEuropean counterparts.

Empirical Evidence

Hege et al. (2003)

Empirical Evidence

Hege et al. (2003)

Empirical Evidence

Hege et al. (2003)

Empirical Evidence

Hege et al. (2003)

1 Diversi�cation

Staging can be used to hold a portfolio of investments that arediversi�ed across stages which may give better risk/returncharacteristicsSince funds should be disbursed quickly and due to the limitedlifetime of a VC fund, it is not possible to achievediversi�cation across stages by investing in ventures thatmature at di�erent ratesAchieving diversi�cation via selling stakes in later-stageprojects could also be problematic since this sends a negativemarket signal and valuable information, which VCs acquireover time would be lost during a transfer of ownership.

1 Diversi�cation

Staging can be used to hold a portfolio of investments that arediversi�ed across stages which may give better risk/returncharacteristics

Since funds should be disbursed quickly and due to the limitedlifetime of a VC fund, it is not possible to achievediversi�cation across stages by investing in ventures thatmature at di�erent ratesAchieving diversi�cation via selling stakes in later-stageprojects could also be problematic since this sends a negativemarket signal and valuable information, which VCs acquireover time would be lost during a transfer of ownership.

1 Diversi�cation

Staging can be used to hold a portfolio of investments that arediversi�ed across stages which may give better risk/returncharacteristicsSince funds should be disbursed quickly and due to the limitedlifetime of a VC fund, it is not possible to achievediversi�cation across stages by investing in ventures thatmature at di�erent rates

Achieving diversi�cation via selling stakes in later-stageprojects could also be problematic since this sends a negativemarket signal and valuable information, which VCs acquireover time would be lost during a transfer of ownership.

1 Diversi�cation

Staging can be used to hold a portfolio of investments that arediversi�ed across stages which may give better risk/returncharacteristicsSince funds should be disbursed quickly and due to the limitedlifetime of a VC fund, it is not possible to achievediversi�cation across stages by investing in ventures thatmature at di�erent ratesAchieving diversi�cation via selling stakes in later-stageprojects could also be problematic since this sends a negativemarket signal and valuable information, which VCs acquireover time would be lost during a transfer of ownership.

2 Specialization

Financing stages are usually linked to important steps in theventure's development process (e.g. design completion,development of a patent or a prototype, development of theproduct to a marketable stage, marketing activities, etc.)If, besides providing capital, VCs do also provide advice andservices, they might specialize in stages where they have acompetitive advantage.Thus staged �nancing occurs because of the specialization ofVCs on certain stages in the venture's life cycle

2 Specialization

Financing stages are usually linked to important steps in theventure's development process (e.g. design completion,development of a patent or a prototype, development of theproduct to a marketable stage, marketing activities, etc.)

If, besides providing capital, VCs do also provide advice andservices, they might specialize in stages where they have acompetitive advantage.Thus staged �nancing occurs because of the specialization ofVCs on certain stages in the venture's life cycle

2 Specialization

Financing stages are usually linked to important steps in theventure's development process (e.g. design completion,development of a patent or a prototype, development of theproduct to a marketable stage, marketing activities, etc.)If, besides providing capital, VCs do also provide advice andservices, they might specialize in stages where they have acompetitive advantage.

Thus staged �nancing occurs because of the specialization ofVCs on certain stages in the venture's life cycle

2 Specialization

Financing stages are usually linked to important steps in theventure's development process (e.g. design completion,development of a patent or a prototype, development of theproduct to a marketable stage, marketing activities, etc.)If, besides providing capital, VCs do also provide advice andservices, they might specialize in stages where they have acompetitive advantage.Thus staged �nancing occurs because of the specialization ofVCs on certain stages in the venture's life cycle

Empirical Evidence

Gorman and Sahlman (1989)

It seems likely that venture capitalists [...] tend tospecialize in terms of the stage at which they invest [...]

Sahlman (1990)

Venture-capital �rms tend to specialize by industry orstage of investment.

Empirical Evidence

Sahlman (1990)

Empirical Evidence

Sahlman (1990)

Empirical Evidence

Sahlman (1990)

Empirical Evidence

Sahlman (1990)

Empirical Evidence

Dean and Giglierano (1990)

... VCs do not specialize, but, rather, create uniqueportfolio strategies.

Hege et al. (2003)

[...] �relationship �nancing� (measured by earlycontinuity, average continuity, and the presence of at leastone VC in all rounds) is signi�cantly more important inEurope than in the United Stages [...]

Empirical Evidence

Hege et al. (2003)

Empirical Evidence

Hege et al. (2003)

Empirical Evidence

Hege et al. (2003)

Empirical Evidence

Hege et al. (2003)

Window DressingProject Delay

Outline

Window Dressing

Staged �nancing can induce the entrepreneur to manipulateinterim results in order to signal positive information and toincrease the chance of obtaining additional funds by the VC

The VC can be hurt in two ways:

Window dressing likely sacri�ces long term pro�t for a goodshort term signalWindow dressing also reduces the information content of thesignal that is used by the VC to determine whether or not todisburse additional funding

Window Dressing

Window dressing likely sacri�ces long term pro�t for a goodshort term signal

Window dressing also reduces the information content of thesignal that is used by the VC to determine whether or not todisburse additional funding

Window Dressing

Cornelli and Yosha (2003)

Window Dressing

Cornelli and Yosha (2003)

Window Dressing

Empirical Evidence

Krohmer et al. (2009)

[...] fund managers may be �window dressing� theirportfolio to impress sponsors, injecting just enough cashto keep losing projects a�oat.

Window Dressing

Empirical Evidence

Window Dressing

Empirical Evidence

Project Delay

Withholding funds might delay the growth of the venture asthe entrepreneur needs to �waste� his time assemblinginformation used in the �nancing process

This would be especially costly if there is strong competition

Project Delay

Withholding funds might delay the growth of the venture asthe entrepreneur needs to �waste� his time assemblinginformation used in the �nancing process

This would be especially costly if there is strong competition

Project Delay

Empirical Evidence

Li (2008)

[...] the portfolio company will receive the staged�nancing much sooner when a larger number of VC �rmscompete in the same industry.

[...] 25% reported a delay in the introduction of thenew product tht was due to delay or failure in �nding�nancing.

Project Delay

Empirical Evidence

Li (2008)

Project Delay

Empirical Evidence

Li (2008)

Project Delay

Empirical Evidence

Li (2008)

Project Delay

Empirical Evidence

Li (2008)

Thank you for your attention

References I

Bergemann, D. and U. Hege (1998). Venture capital �nancing, moral hazard, andlearning. Journal of Banking & Finance 22(6-8), 703�735.

Cornelli, F. and O. Yosha (2003). Stage �nancing and the role of convertiblesecurities. The Review of Economic Studies 70(1), 1�32.

Dean, B. V. and J. J. Giglierano (1990). Multistage �nancing of technical start-upcompanies in silicon valley. Journal of Business Venturing 5(6), 375�389.

Diamond, D. W. (1991, August). Debt maturity structure and liquidity risk. TheQuarterly Journal of Economics 106(3), 709�737.

Gompers, P. A. (1995). Optimal investment, monitoring, and the staging of venturecapital. The Journal of Finance 50(5), 1461�1489.

Gorman, M. and W. A. Sahlman (1989, July). What do venture capitalists do?Journal of Business Venturing 4(4), 231�248.

Hege, U., F. Palomino, and A. Schwienbacher (2003, November). Dereminants ofventure capital performance:europe and the united states. Technical Report 3, LSEWorking Paper.

Hsu, Y.-W. (2008, November). Staging of venture capital investment: a real optionsanalysis. Small Business Economics.

References II

Kaplan, S. N. and P. Strömberg (2004, October). Characteristics, contracts, andactions: Evidence from venture capitalist analyses. Journal of Finance 59(5),2177�2210.

Kaplan, S. N. and P. Stromberg (2003, April). Financial contracting theory meets thereal world: An empirical analysis of venture capital contracts. Review of EconomicStudies 70(2), 281�315.

Krohmer, P., R. Lauterbach, and V. Calanog (2009). The bright and dark side ofstaging: Investment performance and the varying motivations of private equity�rms. Journal of Banking & Finance 33(9), 1597�1609.

Li, Y. (2008). Duration analysis of venture capital staging: A real options perspective.Journal of Business Venturing 23(5), 497�512.

Neher, D. V. (1999). Staged �nancing: An agency perspective. The Review ofEconomic Studies 66(2), 255�274.

Pindyck, R. S. (1993, August). Investments of uncertain cost. Journal of FinancialEconomics 34(1), 53�76.

Roberts, K. and M. L. Weitzman (1981, September). Funding criteria for research,development, and exploration projects. Econometrica 49(5), 1261�1288.

References III

Sahlman, W. A. (1990). The structure and governance of venture-capitalorganizations. Journal of Financial Economics 27(2), 473�521.

Wang, S. and H. Zhou (2004). Staged �nancing in venture capital: moral hazard andrisks. Journal of Corporate Finance 10(1), 131�155.

Venture Capital FrameworkMotivations for StagingProject Characteristic vs. Real OptionsInformation GenerationAgency ProblemsDiversification vs. Specialization

Costs of StagingWindow DressingProject Delay

References

the staging of venture capital investmentssfb649.wiwi.hu-berlin.de/fedc/events/motzen10/the...

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