Yearly Archives: 2009

Stock Option Manipulation

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, August 20, 2009
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This post comes to us from David Cicero of the University of Delaware.

 

In my forthcoming Journal of Finance paper The Manipulation of Executive Stock Option Exercise Strategies: Information Timing and Backdating, I identify three common option exercise strategies, and analyze executives’ incentives for manipulating the exercise of options to maximize their payoffs under each strategy.

In the first strategy, executives exercise options and immediately sell the shares to a third party (the “Stock Sale Subsample”). This strategy encompasses about two-thirds of executives’ option exercises. As executives clearly reduce their exposure to their company through these transactions, the incentive is to exercise when future returns are expected to be poor. Consistent with this hypothesis, I find that exercises in the Stock Sale Subsample are followed by abnormal returns of approximately -2% over a 120-day trading period.

The second strategy involves exercising options with cash and holding the acquired shares (the “No Disposition Subsample”). Executives engage in this exercise-and-hold strategy about one-fifth of the time. This strategy is thought to be employed for tax reasons. When executives exercise options, they pay ordinary income taxes on the spread between the exercise price and the stock price, but they pay capital gains taxes on any subsequent appreciation when they eventually dispose of the shares. Given these tax rules, if an executive expects his stock to perform well in the future, he has an incentive to exercise the options and hold the shares instead of holding the unexercised options: in doing so, the executive can minimize the amount that is taxed as income at the time of exercise, and cause the subsequent appreciation to be taxed as capital gains when he sells the shares. Consistent with executives manipulating option exercises to maximize their returns under this strategy, I find that exercises in the No Disposition Subsample are preceded by negative abnormal returns over the 20-day trading period prior to exercise of approximately -1.5%, and are followed by positive abnormal returns over the 20-day trading period after exercise of approximately 3%, which continue to increase to approximately 5% over a 120-day trading window.

The third strategy involves either delivering previously held stock to the company or having some shares withheld to cover the exercise costs (the Company Disposition Subsample). These “stock swap” transactions constitute about one-tenth of executive option exercises. I show that executives benefit from executing stock swap exercises when the stock price is high, but, given that they continue to hold many of the shares, they also benefit from higher future stock prices. The return patterns are consistent with executives manipulating these exercises to maximize their returns. Abnormal returns are approximately -0.5% over the two months following exercise, and turn insignificant but positive thereafter.

My three samples generate much stronger evidence of option exercise manipulation than has been previously discovered. In particular, I find strong evidence that executives timed option exercises relative to private information to enhance the returns from each of the three exercise strategies in both the pre- and post-Sarbanes-Oxley (SOX) periods. In additional tests, I also find considerable evidence that before SOX executives sometimes backdated exercises to correspond with more favorable exercise prices when employing the two exercise strategies where the only counterparty is the executive’s own company (the No Disposition and Company Disposition Subsamples). Finally, I find that companies where executives likely backdated option exercises were also more likely to subsequently report weaknesses in internal controls over financial reporting.

The full paper is available for download here.

Beware the Idolatry of Numbers

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, August 19, 2009

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(Editor’s Note: This post by Ben Heineman recently appeared in The Atlantic.)

In early August, The New York Times ran a front page story that statisticians–rather than “dronish number nerds”–are increasingly in demand, “even cool.” With reams of data generated in the computer age and new realms to explore for purposes as broad as protecting national security or creating financial products, statisticians, says the Times , are only a small part of an army of “data sleuths…from backgrounds like economics, computer science and mathematics.”

An important question raised by the story–and, of course, the broader, deeper trend of using mathematics and systems analysis to “understand” complex human behavior–is whether, before they have deleterious effects, emerging theories and products and ideas can be advanced with a strong measure of humility and put in the context of complex human society, where some key factors exist that cannot be quantified. Will the already potent but ever-emerging “numbers” class have the broad education and training to understand the “benefits” but also the “limits” of all this numbers crunching?

I raise this question of the potential effects of rigid application of mathematical and systems techniques because two of the most serious problems to beset this country–the Vietnam War and the financial meltdown–stemmed, in important ways, from overconfidence, indeed even cult-like behavior. These two problems are at the front of my mind due to two books that received attention in June and July that dealt with how the false idolatry of numbers and systems can lead people, institutions and nations far astray–with catastrophic results.

The first is former Defense Secretary Robert S. McNamara’s, In Retrospect: The Tragedy and Lessons of Vietnam. It was published in 1995, nearly 30 years after he left the Defense Department in 1968, but received much attention when McNamara died, at 93, in early July. As is well known, McNamara was a part of a World War II “systems analysis” team at Defense, led by Tex Thornton, a “whiz kid” who rose to the top of Ford Motor and a civilian technocrat who brought a powerful systems orientation to the Pentagon in the early 60s. While this approach certainly had relevant application to an attempt to rationalize the Pentagon’s corpulent competition between the Army, Navy and Air Force, it became famous in the Vietnam War when numbers like body counts, targets hit, enemy forces captured, weapons seized, tons of bombs dropped, and hamlets protected were used to argue that the war was being prosecuted successfully. The origins of the war were not in systems theories (rather, to take one strand, a belief that monolithic Russian-Chinese Communism would overrun Southeast Asia). But those theories played an important part in convincing McNamara and President Johnson that the war could be won and, therefore, in deepening our involvement, resulting in tragedy both for the U.S. and for Vietnam.

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SEC Resolves Empty Voting Action Involving King-Mylan Merger

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, August 19, 2009
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Editor’s Note: This post is by Steven M. Haas of Hunton & Williams LLP.

On July 21, 2009, the Securities and Exchange Commission (“SEC”) announced a settlement agreement with Perry Corp. (“Perry”) stemming from the hedge fund’s alleged failure to disclose its accumulation of nearly 10% of an issuer’s voting shares with the intent of influencing a merger vote. Those shares were also hedged through swap transactions in order to eliminate Perry’s economic exposure if the share price declined. The SEC argued that Perry should have promptly disclosed its 10% position on a Schedule 13D, which must be filed within ten days after initially obtaining 5% ownership, rather than on a Schedule 13G, which may be filed 45 days after the end of the calendar year. The SEC’s order is available here.

The Perry settlement arose from the failed attempt by Mylan Laboratories, Inc. to acquire King Pharmaceuticals, Inc. in 2004. Perry had a significant ownership stake in King and stood to benefit from the merger, which offered King stockholders a 61% premium. Once the merger was announced, Perry also shorted Mylan shares, betting that Mylan’s stock price would decline as the merger became more likely.

The King-Mylan merger was conditioned on Mylan’s stockholders’ approval. When Carl Icahn emerged as a large Mylan stockholder vocally opposed to the merger, Perry began accumulating up to 10% of Mylan’s outstanding voting stock with the intent to vote it in favor of the merger. The purchases were done after US markets closed in a manner that avoided public volume-reporting. Perry then entered into swap transactions that hedged risk from any potential drop in Mylan’s share price. As a result, Perry could vote the Mylan shares without any potential economic downside facing other Mylan stockholders in order to realize value from the merger as a King stockholder.

While the King-Mylan merger was never consummated, the SEC brought an enforcement action alleging that Perry should have disclosed its ownership on a Schedule 13D once it acquired 5% of Mylan’s stock. Perry argued that the purchases were made in the “ordinary course of business” and therefore could be disclosed after the end of the calendar year on a Schedule 13G. The SEC took the position that:

When institutional investors, such as Perry, acquire ownership of securities for the purpose of influencing … the outcome of a transaction—such as acquiring shares for the primary purpose of voting those shares in a contemplated merger—the acquisition is not made… in the “ordinary course” of business….

Pursuant to the settlement, Perry paid a $150,000 fine without admitting any wrongdoing.

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Comment Letter of Eighty Professors of Law, Business, Economics, or Finance in Favor of Facilitating Shareholder Director Nominations

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, August 18, 2009
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This post is by Lucian Bebchuk of Harvard Law School.

I submitted to the SEC yesterday a comment letter on behalf of a bi-partisan group of eighty professors of law, business, economics, or finance in favor of facilitating shareholder director nominations. The submitting professors are affiliated with forty-seven universities around the United States, and they differ in their view on many corporate governance matters. However, they all support the SEC’s “proxy access” proposals to remove impediments to shareholders’ ability to nominate directors and to place proposals regarding nomination and election procedures on the corporate ballot. The submitting professors urge the SEC to adopt a final rule based on the SEC’s current proposals, and to do so without adopting modifications that could dilute the value of the rule to public investors.

A copy of the comment letter filed with the SEC is available here. Below is the text of the main part of the comment letter followed by the list of the eighty professors.

TEXT OF MAIN PART OF COMMENT LETTER:

This comment letter is submitted on behalf of a bi-partisan group of eighty professors of law, business, economics, or finance whose names appear below (the “Submitting Professors”). The Submitting Professors are affiliated with forty-seven universities around the United States. All of the Submitting Professors have research or professional interests relating to how publicly traded firms are run and how their affairs are governed by corporate and securities laws. The Submitting Professors welcome the opportunity to provide comments to the Securities and Exchange Commission (the “SEC”) on its proposed rule Facilitating Shareholder Director Nominations (the “Proposed Rule”).

There is substantial variance among the views of the Submitting Professors on many corporate governance matters. However, all of the Submitting Professors support the SEC’s proposals to remove impediments to the exercise of shareholders’ rights to nominate and elect directors and to enable shareholders to place proposals regarding nomination and election procedures on the corporate ballot. All of the Submitting Professors urge the SEC to adopt a final rule based on the SEC’s current proposals, and to do so without adopting modifications that could dilute the value of the rule to public investors. While all of the Submitting Professors share the views expressed in this paragraph, each individual professor may not endorse each and every statement below.

The ability of shareholders to replace directors is supposed to play a key role in the governance structure of public companies. However, shareholders seeking to replace directors face considerable impediments. One significant impediment to replacing directors is incumbents’ control of the company’s proxy card – the corporate ballot sent by the company at its expense to all shareholders. We believe that providing shareholders with rights to place director candidates on the company’s proxy card, as the SEC proposes doing, would improve director accountability.

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Law Firms Comment on SEC’s Proposed Proxy Access Rules

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, August 17, 2009
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(Editor’s Note: This post is by Theodore Mirvis of Wachtell, Lipton, Rosen & Katz. In addition to participating in the comment letter discussed in this post, Wachtell, Lipton, Rosen & Katz also filed its own comment letter, which is available here.)

Seven major law firms — Cravath, Swaine & Moore LLP, Davis Polk & Wardwell LLP, Latham & Watkins, LLP, Simpson Thacher & Bartlett LLP, Skadden, Arps, Slate, Meagher & Flom LLP, Sullivan & Cromwell LLP and Wachtell, Lipton, Rosen & Katz — collaborated on a 40-page comment letter that was submitted to the SEC today on its proposed proxy access rules. The joint 7 Firm letter recommends:

  • The SEC should amend Rule 14a-8(i)(8) to permit stockholders to utilize Rule 14a-8 for proxy access proposals.
  • The SEC should not adopt Rule 14a-11 until there has been sufficient experience with private ordering of proxy access under amended Rule 14a-8 to permit the SEC to make a more informed decision as to whether a prescriptive rule governing proxy access is necessary and desirable.
  • If the SEC disagrees with the firms’ view, the SEC should not adopt a prescriptive proxy access rule any earlier than the 2011 proxy season.
  • Finally, any prescriptive proxy access regime should permit private ordering under state law so as to permit stockholders to modify the SEC’s proxy access regime as they see fit, including by opting out entirely.

The letter includes detailed discussion and recommendations regarding the workability issues raised by the SEC’s proposed proxy access rules.

The complete comment letter can be downloaded here.

Corporate Political Contributions and Stock Returns

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, August 17, 2009
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This post comes to us from Michael J. Cooper of The University of Utah, Huseyin Gulen of Purdue University, and Alexei V. Ovtchinnikov of Vanderbilt University.

 

In our paper Corporate Political Contributions and Stock Returns, which was recently accepted for publication in the Journal of Finance, we study whether there is a robust relation between firm contributions and contributing firm returns. Using data from the U.S. Federal Election Commission (FEC), we create a new and comprehensive database of publicly traded firms’ political action committee (PAC) contributions to political campaigns in the U.S. from 1979 to 2004. After merging the FEC contributions data with CRSP/Compustat data, we have approximately 819,000 contributions made by 1,930 firms over the past twenty five years or so – thus, we have a remarkably rich dataset to test for systematic contribution/return effects arising from publicly traded firms’ involvement in the U.S. political process. Our sample captures over 70% of the total dollar volume of all hard-money corporate contributions and represents on average 60% of the market value-weighted capitalization of all publicly traded firms in the U.S.

We develop a simple measure to describe firms’ political contribution practices that takes advantage of the comprehensive nature of the FEC data. We view each firm as supporting a portfolio of candidates and simply sum up, over a rolling multiyear window, the number of candidates that each firm supports. We find that the average firm participating in the political donation process contributes to 73 candidates over any five-year period, 53 of whom go on to win their elections. There is substantial variability across firms in the number of supported candidates, with a standard deviation of approximately 96 candidates.

We perform panel regressions of annual abnormal returns on the lagged number of supported candidates and other control variables. We find that the number of supported candidates has a statistically significant positive relation with future abnormal returns for firms which contribute to political candidates. The relation is evident in univariate regressions of abnormal returns on the number of supported candidates as well as in multivariate regressions after controlling for other established predictors of returns such as book-to-market, firm capitalization, and momentum, measured by lagged 12-month buy-and-hold returns. We find that our results are robust to three alternative contribution definitions: the total strength of the relationships between candidates and the contributing firm (as measured by the length of the firm-candidate relationship), the ability of the candidates to help the firm (as measured by the home state of the firm and the candidate), and the power of the candidates (as measured by a candidate’s committee ranking). We document especially strong effects for a measure related to the ability of the candidate to help the donating firm. Thus, the contribution effect appears to increase for firms that have longer relationships with candidates, support more home candidates, and support more powerful candidates.

We further break the contributions data up into House and Senate categories. We find that there is an incremental House effect after controlling for the Senate effect, although contributions to both branches of government result in positive economic effects for the contributing firms. Our finding of an incremental effect for firms supporting House candidates may be related to the constitutional provision that revenue and appropriations bills must originate in the House. Thus, firms may find that it is more expedient to support House members, where potential firm value increasing actions may be more suitably created. We also split our sample along political party lines. The FEC data show that Republican candidates typically receive higher total dollar contributions than do Democrats and that Republican candidates’ contributions come from a larger number of supporting firms than do Democrat candidates’ contributions. However, despite the fact that Republicans receive more contributions than Democrats, we find an incremental contribution effect for Democrats after controlling for Republican effect, but do not find an incremental Republican effect after controlling for the Democrat effect.

The full paper is available for download here.

Impact of the Credit Crunch on Acquisition Agreements

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, August 16, 2009
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(Editor’s Note: This post by John G. Finley is based on a Simpson Thacher & Bartlett memorandum, which first appeared as an article in the New York Law Journal.)

This post was written together with Simpson Thacher & Bartlett associate Salvatore Gagliardi.

While the pace of M&A activity has been subdued, the significance of contractual developments in dealmaking has been pronounced. Over the past year, the difficulty of the credit markets has resulted in significant developments in how practitioners draft cash acquisition agreements for strategic buyers (e.g., corporate buyers seeking to further their strategic objectives). These developments have resulted in such buyers having greater flexibility in deciding not to close, particularly if the reason is financing related. These changes have been especially pronounced in multi-billion dollar transactions where the buyer is dependent on third party financing to effect the proposed transaction. This trend began with strategic buyers utilizing the termination provisions used in private equity deals under which a seller’s only remedy if a buyer were to fail to close were a fixed fee from the buyer (i.e., a reverse break fee). In such cases, this reverse break fee structure was analogized to an option or referred to as providing the buyer with “optionality.” The practice has, however, now developed beyond the use of the reverse break fee model as utilized in private equity deals. Although there are variations in the benefits of these provisions to prospective buyers, a common element is that they mitigate the risk to a buyer from failing to close due to a financing failure.

Private Equity Precedent

The optionality used in recent strategic deals was based on a structure used in private equity deals that developed after 2005. Prior to 2005, private equity transactions were structured with the private equity firm forming a shell company that entered into the acquisition agreement and undertook the obligations contained therein. There was no risk to the private equity firm, as distinguished from the shell company, other than reputational risk and the theoretical possibility of piercing the corporate veil (i.e., disregarding the corporate entity and treating obligations of the shell company as obligations of shareholder/owner). Further, the acquisition agreement was typically conditioned on the availability of financing (although the shell company often agreed to be subject to the remedy of specific performance pursuant to which it could be required to use its reasonable best efforts to obtain financing). Given that the shell company was without resources, sellers were put in the position of relying on the reputational risk to the private equity firm if its wholly owned shell company breached its obligations as well as the possibility of veil piercing. This latter risk was viewed as remote but the consequences were grave if realized.

Beginning in 2005, the private equity structure utilizing financing conditions as described above was superseded by a reverse break fee structure. This structure arose out of a desire by sellers to eliminate the financing condition and reduce the reliance on the reputational risk to the buyer arising from a breach. Under this structure, a break fee of roughly 3 percent was payable by the shell company for a failure to close, which fee was guaranteed by the private equity firm. This created significant optionality for the private equity firm as it guaranteed the payment of a fixed fee, but the firm was no longer subject to the in terrorem risk of veil piercing or any other liability. Moreover, although there were exceptions, the norm that developed was that even the shell company was not subject to specific performance. This meant that there was no risk that the shell company would sue the private equity firm under the equity commitments or lenders under the debt commitments. Some deals sought to increase the cost to the buyer of failing to close by providing that the private equity firm could be subject to, in addition to the reverse break fee, the payment of damages in excess of a break fee for a willful breach. Those deals were, however, a small minority.

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What does a non-executive chairman do anyway?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Saturday, August 15, 2009
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(Editor’s Note: This post by Francis H. Byrd first appeared as a Governance & Proxy Review Update.)

With the introduction of Senator Schumer’s Shareholder Bill of Rights there has been a great deal of discussion surrounding the role of the Non-Executive Chairman (NEC) versus that of the CEO. Discussion of this concept in the media would lead one to believe that the role of the NEC is to serve as a supervisor of the Chief Executive. Nothing could be further from the truth. In fact, it appears that this misconception of the role is the rationale behind Senator Schumer’s bill requiring mandatory NECs for all companies. Companies will lose not only the right to make decisions about their leadership structure but would then be forced to subscribe to a flawed notion of the NEC-CEO relationship that could lead to serious problems for the board and company.

U.S. companies, who have separated the positions of chair and CEO, are usually hoping to achieve three specific and important goals: (1) allow the CEO to focus exclusively on managing the enterprise; (2) create a director leadership position with a focus on board administration and communications between the independent directors; and (3) craft a defined director leadership position, codified within the firm’s governance guidelines, possessing the procedural authority to lead the board during an unexpected or forced CEO transition. Many firms utilizing this structure provide for a recombination of the roles when the board deems it appropriate.

In these instances the NEC is likely to be a director of long tenure with experience and understanding of the company. The NEC would be likely to maintain an office at the company, and spend more time with the CEO than other board members. His/her primary function would be to insure robust communications between and amongst board committee chairs and as needed with individual directors. Under this board leadership model, the CEO is relieved of the tasks of managing the intra-board relationship and can focus more attention on the competitive and regulatory and risk challenges facing the company. Leading the full board meetings, the important executive sessions of independent directors, and involvement in board, committee and director evaluations are key elements of the NEC role.

Mentor to the CEO, not manager of the Chief Executive

A common misconception that I fear is firing the call for change, is the belief that the NEC will or should serve as a supervisor of the CEO. That the NEC, who under this faulty scenario possesses industry knowledge equal to or greater than the CEO, is the Admiral to the Chief Executive’s captain, prepared at any moment to order a change of course or trim of sail. A relationship designed to these parameters would create serious disruptions for the board and confusion in the senior management ranks as to who is in charge.

In actuality, the split roles need to be handled with care. Done right, the NEC serves as a mentor and sounding board for the CEO on issues to be presented to the board, on feedback from the executive sessions of the independent directors, and on issues facing the enterprise. The CEO looks to the NEC for feedback and counsel on the board’s concerns, whether strategic planning or risk mitigation. The relationship is more Mentor to CEO than supervisor to manager – it can’t work any other way. If a company faces an unexpected CEO transition (due to death or resignation), a board with an NEC (or strong, active Lead Director) might be better positioned to act swiftly and deftly.

Given the sensitive nature of the NEC role, the selection, ability and willingness of the director who undertakes the position and the CEO who must work within this leadership structure are all of prime importance–which is why boards need to be free to choose the leadership structu re that works best for them, and not have it mandated by Washington.

SEC Enforcement Director Discusses Enforcement Initiatives

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, August 14, 2009
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(Editor’s Note: This post below is a transcript of remarks by Robert Khuzami, Director of the Division of Enforcement of the Securities and Exchange Commission, to The Association of the Bar of the City of New York last week.)

I. Introduction
Thank you, Pat, for that kind introduction. It’s great to be back in New York. And I am grateful to the New York City Bar for providing me with this opportunity to talk about the Enforcement Division. There is lots to talk about.

As I was thinking about this speech, a colleague mentioned that I had been with the Commission approximately 100 days. Aside from making me wonder why my colleagues are counting, it caused me to pause and reflect – how did my 100-day accomplishments compare with those of others? That often over-weighted yardstick of accomplishment – did I measure up?

Franklin Roosevelt set the bar pretty high. In his first 100 days in office, he reopened failed banks under Treasury supervision; he established the FDIC; and he created extensive farm subsidy and federal jobs programs.

More recently, President Obama has also achieved impressive accomplishments in his first 100 days. First off, President Obama appointed a brilliant, experienced, and transformative leader of the SEC … and I’m not just saying that because Chairman Schapiro might read this speech. After that, President Obama passed the economic stimulus plan, funded stem cell research, took on the health care crisis and crafted a plan to withdraw troops from Iraq.

All that being said, I’m pretty proud of my own 100-day accomplishments. So how have things changed? Before I joined the Division in March, the Dow was struggling around 6500 points. Now the Dow is over 9200. So am I really responsible for a 41% increase in the Dow? I am, and I’d explain it, but it’s very complicated. It involves algorithms, and calculus, and a black box and other … stuff. Now, when I ran this speech by my wife, she looked (kind of like some of you out there) a little incredulous. She said, ―you’re not claiming credit for the stock market, are you? While you’re at it, are you also taking credit for the mild hurricane season or the sharp decrease in lethal shark attacks world-wide. Well I am, and I’d explain it, but it’s very complicated. It involves algorithms, and calculus, and a black box and other … stuff.

Jokes aside, the Enforcement Division has accomplished much in the 100 days. This reflects a dedicated and talented staff as well as a reinvigoration of our core mission of investor protection. Before I describe some of these accomplishments, I need to make an important disclaimer – my views are my own and do not necessarily reflect the views of the Securities and Exchange Commission or any member of the Commission staff.

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Networking Barriers to Venture Capital

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, August 14, 2009
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This post comes to us from Yael V. Hochberg of the Kellogg School of Management, Northwestern University, Alexander Ljungqvist of the Stern School of Business, New York University, ECGI, and CEPR, and Yang Lu of Barclays Capital.

 

In our paper Networking as a Barrier to Entry and the Competitive Supply of Venture Capital, which was recently accepted for publication in the Journal of Finance, we examine whether strong networks among incumbent venture capitalists in local markets help restrict entry by outside VCs, thus improving incumbents’ bargaining power over entrepreneurs.

Our results are consistent with the hypothesis that networking among VCs reduces entry. First, we find that there is less entry in VC markets in which incumbents are more tightly networked with each other, as evidenced by their past syndication patterns. The magnitude of the effect is large: Controlling for other likely determinants of entry, a one-standard deviation increase in the extent to which incumbents are networked (using measures borrowed from economic sociology) reduces the number of entrants in the median market by around a third.

The networking patterns we observe in the data may not be exogenous; rather, they may reflect omitted variables affecting both networking and entry. For example, unobserved variation in the cost of doing business in a given industry or location could induce networking (say, to economize on information costs) and independently reduce entry. To correct for this potential endogeneity problem, we follow two approaches. First, we use instrumental variables motivated by non-strategic and mechanical determinants of syndication decisions. This strengthens our results. Second, we exploit the three-way panel structure of our data (which span time, location, and industry) to identify omitted time-varying factors that are either location-specific or industry-specific. This produces results that are very similar to the IV estimates.

Our second test focuses on the determinants of an individual VC firm’s entry decision. Strong networks among the incumbents in the target market reduce the likelihood of entry. But not every potential entrant is deterred. Controlling for industry experience and geographic proximity to the market (which each double the likelihood of entry), we find that a VC firm is significantly more likely to enter if it has previously established ties to incumbents by inviting them into syndicates in its own home market. Moreover, it is with these very same incumbents that the entrant does business in the target market. In the context of the entry deterrence game sketched out above, this suggests that incumbents deviate from the strategy of non-cooperation with entrants when the gain from deviating – reciprocal access to the entrant’s home market – is sufficiently tempting. The cost of deviation is punishment, in the form of reduced syndication opportunities with fellow incumbents. We show that after doing business with a potential entrant, an incumbent’s probability of being invited into fellow incumbents’ syndicates decreases considerably and significantly, for up to five years after the event. This effect is concentrated in markets with a small number of incumbents, consistent with the notion that a small number of players can more easily prevent free-riding when called upon to execute a punishment strategy.

Finally, we examine the price effect of reduced entry by comparing the valuations of companies receiving VC funding in relatively more protected and relatively more open markets. Controlling as best we can for other value drivers, we find significantly lower valuations in more densely networked markets: A one-standard deviation increase in our networking measures is associated with a 10% decrease in valuation, from the mean of $25.6 million. This suggests that incumbent VCs benefit from reduced entry by paying lower prices for their deals. On the other hand, the more market share entrants capture, the higher are valuations in the following year, suggesting that entry is pro-competitive and, at least in that sense, benefits entrepreneurs. An unanswered question is whether networks provide offsetting benefits to entrepreneurs. We leave an examination of the overall welfare effects of networking to future research.

The full paper is available for download here.

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