More than Money: Venture Capitalists on Board

Natee Amornsiripanitch is a Ph.D. Student at Yale University; Paul A. Gompers is the Eugene Holman Professor of Business Administration at Harvard Business School; and Yuhai Xuan is Dean’s Professor of Finance at The Paul Merage School of Business at the University of California, Irvine. This post is based on their recent article, forthcoming in the Journal of Law, Economics, and Organization. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups (discussed on the Forum here) and Do Founders Control Start-Up Firms that Go Public? (discussed on the Forum here), both by Jesse Fried and Brian Broughman.

There exists a large literature on boards of public companies. However, research on boards of private companies is limited because of data limitations. To fill this gap in the literature, we employ a large data set of private venture capital-backed companies in the United States and abroad to explore the structure and functions of these boards.

In our article, we begin by documenting key features of board structure. We find that venture capital-backed boards of directors are small and are mostly composed of venture capitalists and independent outsiders. The median number of board members is five. As financing rounds progress, board size increases. As board size grows, the number of venture capitalists and independent outsider board members increases, while the number of insider board members remains small.

Next, we explore the determinants of board membership. We find that lead investor status, prior investor-founder relationship, geographical proximity, the venture capital firm’s track record, and the size of the venture capital firm’s network of outsider board members and managers are all positively correlated with board membership. On average, venture capitalists receive a board seat 43.9% of the time. Being a lead investor in the investment round increases the venture capital firm’s probability of board membership to 61.5% while non-lead investors serve on the board only 35% of the time. The probability of receiving a board seat is higher in earlier rounds for both lead and non-lead investors. Furthermore, independent venture capital investors receive board seats far more often than corporate venture capitalists in young startups. In regression analysis, we show that having a prior relationship with founders also increases the venture capital firm’s probability of board membership by almost 10%. In addition, having a large network of managers and outsider board members from which to recruit is as important as having a successful track record. All of these factors are plausibly related to the value that venture capitalists can provide to portfolio companies and, hence, are positively related to getting a board seat.

The second part of the article explores actions that venture capitalists take as board members. The debate on how venture capitalists generate returns on their investments still rages on the in the literature. One view is that venture capitalists mainly generate returns from picking good companies to invest in, while the opposing view argues that venture capitalists actively add value to their portfolio companies. We seek to add to this debate by empirically identifying specific actions that venture capitalists perform as board members.

The first set of actions that we focus on is management and board member recruiting. Survey results show that manager quality is a key determinant of success for early stage ventures. Furthermore, venture capitalists say that they recruit managers and outsider board members for their portfolio companies. In our analysis, we find that venture capitalists recruit managers from their networks into their portfolio companies. Furthermore, most of the hiring activities were performed by successful and well-connected venture capitalists. Although these findings are simple correlations, they suggest that management recruiting could be a key driver of venture capital investment success.

For outside board member recruiting, the regression results show that this activity is not mediated by board membership. Our regressions suffer from selection bias, which likely mitigates the effect of board membership on outside recruiting. In some sense, a venture capitalist may be more likely to appoint an outside director from her network when she chooses not to join the board. Monitoring is an important aspect of board membership so she might hire a related outsider board member to monitor the company for her in her absence.

The last area of service that we study is exit facilitation. Prior research shows that M&A announcement returns are higher when the acquirer and the target received venture financing from the same venture capital firm. Motivated by this work, we explore whether venture capitalists use their board membership status to facilitate these potentially productive unions. We find that this is the case. Portfolio companies are more likely to be acquired by companies that were backed by a venture capitalist who serves on their current board. Again, we find that these relationship-based acquisitions are mostly performed by successful and well-connected venture capitalists on the board. Tying this finding to our results for determinants of board membership, we see indirect evidence that these activities are valuable for portfolio companies. We show that successful and well-connected venture capitalists are more likely to obtain board membership upon investment and that these venture capitalists are the most active investors in terms of relationship-based recruiting and acquisitions.

Overall, we interpret our results as suggestive evidence that successful and well-connected venture capitalists bring value to the companies in which they invest and serve as directors. This interpretation, however, comes with caveats. While we demonstrate that venture capitalists who serve on the boards are likely to get involved in portfolio companies and use their connections through their network for recruiting and exiting, the article does not provide evidence on returns to the venture capitalists or performance of the portfolio companies conditional on whether venture capitalists serve on the boards or not. Thus, our interpretation is based on the assumption that actions such as related recruiting and related acquisition exits are valuable, which may not be true for all cases. We hope that future research will verify this assumption and relate these actions to investment outcomes and venture capital fund performance.

The complete article is available here.

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