Venture Capital 2.0

Joseph A. McCahery is Professor of International Economic Law at Tilburg University Law School, TILEC and ECGI; and Erik P.M. Vermeulen in Professor of Business Law and Finance at Tilburg University Law School and TILEC, and Vice President of Philips Lighting. This post is based on a recent paper by Professors McCahery and Vermeulen. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, by Jesse Fried and Brian Broughman (discussed on the Forum here) and Delaware Law as Lingua Franca: Evidence from VC-Backed Startups, by Jesse Fried, Brian Broughman, and Darian Ibrahim (discussed on the Forum here).

Over the last decade, a wide consensus has emerged regarding the changing structure of the venture capital industry. For example, with a few notable exceptions, most traditionally structured venture capital firms have delivered uninspiring returns. This has not only led to a significant decrease in the number of venture capital funds, but also has steered many funds toward the less risky and growth stage companies. Declining expectations stimulated remaining funds to focus on companies founded by serial entrepreneurs with considerable track records. While this trend resulted in a significant increase in the returns to investors, it also created a “funding gap” in the development of early to mid-stage companies. According to this perspective, the solution to the funding, investment and liquidity gaps is for new sources of capital—be they government, corporate or crowd—to provide founder-entrepreneurs with capital, capacities and connections that allows them to start, scale and grow their businesses. In our paper, Venture Capital 2.0: From Venturing to Partnering, which was recently made publicly available on SSRN, we evaluate the likely impact of each of the different financing options to young and high growth companies and whether they can, with greater network resources, improve access to follow-on funding in later stages of a start-up’s development.

So what can we expect from crowdfunding? Crowdfunding makes it possible for early-stage start-up companies to raise “venture capital” from a large group of individuals, sidestepping the traditional fundraising process that includes lengthy due diligence and tough negotiations over pre-money valuations and contractual terms. Analysts expect that the number of equity-based crowdfunding platforms will increase in the near future as we increasingly observe several regulatory initiatives that are intended to give a boost to equity crowdfunding (by increasingly allowing nonprofessional investors to participate in deals). However, despite its popularity, equity crowdfunding faces several challenges. For example, crowdfunding may lack connectivity to follow on investors, key stakeholders and other advisors. High potential growth companies, particularly in capital intensive sectors, must be able to attract follow on funding from later stage investors. In fact, the crowdfunding investors that typically follow a “spray and pray strategy,” when it comes to making investment decisions, have fewer resources or incentives to assist portfolio companies in securing the next stage of financing. We suggest that a related problem is that this strategy may be exacerbated by the fact that companies that pitch for crowdfunding are more likely to end up with a multitude of investors. Further, the crowdfunding provisions of the JOBS Act that require start-up companies to have public accounting firms audit their financial will arguably have a deterrent effect on the use of equity crowdfunding in the United States. Current research suggests that firms are more likely to consider crowdfunding to showcase their products.

Our estimates show that corporate venture capital (CVC) may have the potential to contribute significantly to the growth of young and high growth companies, and also create more liquidity in the venture capital cycle. Many mature corporations have established CVC units seeking competitively advantageous innovations while capitalizing on their own ability to provide a broad range of strategic benefits from industry partnerships, distribution opportunities and product development insights. Despite its growth and financial benefits, the corporate finance literature has identified a number of problems with CVC from mixed strategies with difficult to determine objectives to a lack of expertise and inefficient compensation structure for CVC managers. Clearly, the problems that surround CVC investments have an impact on the management, operation and activities of CVC funds themselves. Consistent with this idea, we show that nearly half of the CVC programs established after the financial crisis are either idle or had not made a successful investment before the end of 2014. To be sure, there are notable exceptions of CVC units that successfully managed their relationships, such as Google and Intel, which led the 2015 Global Corporate Venturing league table by number of transactions and Tencent and Alibaba, which are the leaders if we look at total dollars invested. Overall, the evidence shows that CVC-backed firms are more innovative despite their age and high level of risk, but perform less well compared with traditional VCs (Chemmanur, Loutskina and Tian, 2014).

Third, our study shows that there are a number of reasons why government backed funds and their syndicated activities may have a positive effect on the entrepreneurial firms in which they invest. Prior research has looked, for example, at Australian government funds that operate as public-private partnership. The funds are managed by private sector fund managers who are not only in a better position to pick “winners,” but also to ensure that the funds are connected to the venture capital industry. Unlike most government development funds, the Australian program is designed to attract and incentivize private investors. Our analysis of wide range of government venture capital funds suggests that properly structured public-private partnerships—that build on ingredients already available in the market—are probably one of the strongest tools to develop a sustainable venture capital industry.

We conclude by acknowledging that a vibrant venture capital industry also needs access to an online marketplace where the fragmented and disorganized stakeholders of the venture capital ecosystem—such as entrepreneurs, venture capital funds, angel investors, and other investors and stakeholders, could connect and exchange investment and exit opportunities.

The full paper is available for download here.

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