‘If the Facts Don't Fit the Theory … ’: The Security Design Puzzle in Venture Finance

Abstract

When confronting theory with evidence, divergent results surface with reference to the optimal securities that should be adopted in venture capital (VC) finance. The vast majority of the theoretical models on VC consistently predict that convertible securities, especially in the form of convertible preferred stocks, represent the optimal form of finance. While the theoretical literature seems to be supported by empirical studies in the US, the evidence outside the US shows the opposite results. Puzzling patterns emerge, especially when comparing the evidence from the US, Canada and Europe, and an intensive academic debate is under way. The evidence becomes even more challenging when considering the contrasting financing behaviour of US venture capitalists (VCs) investing in Canada. It has been documented that US VCs investing in Canada adopt a wide range of securities other than convertible stocks. If convertible securities truly represent the optimal form of VC finance, why would US VCs use different types of securities when investing in Canada? At present, researchers are still arguing about which factors would have the most significant impact on explaining the different financing behaviour of VCs around the world. The purpose of this paper is to shed some light on the ongoing international debate on the optimal security design and contracting behaviour in venture finance. With this review, the authors intend to contribute to the VC literature by identifying current trends, explanations and determinants underlying the puzzling empirical evidence on the financing structure adopted by VCs around the world.

Institutional Determinants of Venture Capital Activity: An Empirically Driven Literature Review and a Research Agenda

“…One of the first examples includes Gompers and Lerner (2001), then followed by Gompers (2007). The immense scientific work on VC contracts has triggered surveys of literature on the same topic, one conducted by Tykvová (2007) and the other from Zambelli (2014). Jääskeläinen (2012) clusters literature on syndication, one of the most integral components of VC activity.…”

Barbarians at the Gate of the Middle Kingdom: The International Mobility of Financing Contract and Governance

“…(2017) propose the notion of international mobility of corporate governance. This literature suggests that these factors could explain different financing behaviors of PE investors around the world: varying legal conditions (Cumming & Johan, 2008; Cumming, Schmidt, & Walz, 2010), an investor’s learning over time (Cumming, 2005), learning from PE syndicates (Meuleman & Wright, 2011), and an investor’s adaptation to local institution (Zambelli, 2014). Rooted (very often implicitly) in the tradition of the studies in neo-institutional economics (North & Thomas, 1970; Pacheco, York, Dean, & Sarasvathy, 2010), this literature primarily focuses on structural relations such as home country creditor and shareholder rights versus abnormal returns after cross-border acquisitions (Ellis et al., 2017; Renneboog, Szilagyi, & Vansteenkiste, 2017), foreign independent directors versus returns on assets (Miletkov, Poulsen, & Wintoki, 2017), and foreign political connections versus firm value (Sojli & Tham, 2017).…”

“…Agency theory then identifies the role of a PE investor as a principal in structuring financial contracts, screening deals, and monitoring the venture (Cendrowski & Wadecki, 2012; Cumming & Johan, 2014). Meanwhile, PE investors also act as “coaches” to professionalize privately held firms, provide value-added services such as introducing stock option plans, hiring a vice president of sales and marketing, formulating human resource policies (Hellmann & Puri, 2002), and even appointing a member outside the founding family as the CEO (Hellmann, 1998; Zambelli, 2014). PE is often an accelerator for successful initial public offerings (IPOs) into advanced stock markets (Cumming, Siegel, & Wright, 2007).…”

Due Diligence and Investee Performance

“…13 The results reported in Tables A2-A3 are consistent with our main findings discussed in the previous sections and further reinforce the results reported in Tables 4-5. 14 12 For a recent review of the control and veto rights held by PE investors, see Zambelli (2014). 13 The number of employees was not available for all companies.…”

“…For the purpose of this paper, we adopt the term ‘private equity’ to refer to the later stage financing of existing firms, in line with the definition provided by the Italian Venture Capital Association (AIFI), Capizzi (), and Heed (), among others. This definition, which differs from the one typically adopted in USA (see, e.g., Gompers and Lerner, ), excludes the funding of start‐up and early stage firms (venture capital investments) and includes: a) development or expansion financing, b) leveraged buyout (LBO) deals, and c) replacement and turnaround financing (see, e.g., Zambelli, ; ). Historically, the PE sector has dominated the Italian alternative financing industry, while early stage investments have always represented a minority (see AIFI Statistics Reports from 1999 onwards, Caselli et al ., ).…”