David J. Brophy

A Finance Perspective on Entrepreneurship Research

Entrepreneurship has been studied from numerous perspectives, most notably psychology, management, and marketing. Few studies, however, have utilized finance theory and methodology. Several finance based theories are explored as possible models for studying entrepreneurship, categorized as valuation and capital structure. Valuation theories and applications include such approaches as portfolio theory, capital asset pricing, efficient markets, and option pricing. The primary concepts of valuation theory are examined -- e.g., emphases on risk/return and time value of money -- as are the potential problems associated with the use of valuation theory. A second proposed approach is capital structure theory, which considers each of the following factors: leverage, taxes, and bankruptcy; agency costs; and information asymmetries. Potential limitations and implications of utilizing capital structure theory to examine entrepreneurial success are discussed, including the influence of factors like venture capital and the early stage growth/liquidity crisis. The implementation of chaos theory in studying entrepreneurship may also offer a different, valuable perspective. Overlapping areas of study for finance and entrepreneurship are identified as areas of opportunity for future research. (AKP)

Publicly traded venture capital funds: implications for institutional “fund of funds” investors

Abstract Institutional investors supply the bulk of the funds which are used by venture capital investment firms in financing emerging growth companies. These investors typically place their funds in a number of venture capital firms, thus achieving diversification across a range of investment philosophy, geography, management, industry, investment life cycle stage and type of security. Essentially, each institutional investor manages a “fund of funds,” attempting through the principles of portfolio theory to reduce the risk of participating in the venture capital business while retaining the up-side potential which was the original source of attraction to the business. Because most venture capital investment firms are privately held limited partnerships, it is very difficult to measure risk adjusted rates of return on these funds on a continuous basis. In this paper, we use the set of twelve publicly traded venture capital firms as a proxy to develop insight regarding the risk reduction effect of investment in a portfolio of venture capital funds, i.e., a fund of funds. Measurements of weekly total returns for the shares of these funds are compared with similar returns on a set of comparably sized “maximum capital gain” mutual funds and the daily return of the S&P 500 Index. A comparison of returns on an individual fund basis, as well as a correlation of daily returns of these individual funds, were made. In order to adjust for any systematic bias resulting from the “thin market” characteristic of the securities of the firms being observed, the Scholes-Williams beta estimation technique was used to reduce the effects of nonsynchronous trading. The results indicate that superior returns are realized on such portfolios when compared with portfolios of growth-oriented mutual funds and with the S&P 500 Index. This is the case whether the portfolios are equally weighted (i.e., “naive”) or constructed to be mean-variant efficient, ex ante, according to the capital asset pricing model. When compared individually, more of the venture funds dominated the S&P Market Index than did the mutual funds and by much larger margins. When combined in portfolios, the venture capital funds demonstrated very low beta coefficients and very low covariance of returns among portfolio components when compared with portfolios of mutual funds. To aid in interpreting these results, we analyzed the discounts and premia from net asset value on the funds involved and compared them to Thompsons findings regarding the contribution of such differences to abnormal returns. We found that observed excess returns greatly exceed the level which would be explained by these differences. The implications of these results for the practitioner are significant. They essentially tell us that, while investment in individual venture capital deals is considered to have high risk relative to potential return, combinations of deals (i.e., venture capital portfolios) were shown to produce superior risk adjusted returns in the market place. Further, these results show that further combining these portfolios into larger portfolios (i.e., “funds of funds”) provides even greater excess returns over the market index, thus plausibly explaining the “fund of funds” approach to venture capital investment taken by many institutional investors. While the funds studied are relatively small and are either small business investment companies or business development companies, they serve as a useful proxy for the organized venture capital industry, despite the fact that the bulk of the funds in the industry are institutionally funded, private, closely held limited partnerships which do not trade continuously in an open market. These results demonstrate to investors the magnitude of the differences in risk adjusted total return between publicly traded venture capital funds and growth oriented mutual funds on an individual fund basis. They also demonstrate to investors the power of the “fund of funds” approach to institutional involvement in the venture capital business. Because such an approach produces better risk adjusted investment results for the institutional investor, it seems to justify a greater flow of capital into the business from more risk averse institutional investment sources. This may mean greater access to institutional funds for those seeking to form new venture capital funds. For entrepreneurs seeking venture capital funds for their young companies, it may also mean a lower potential cost of capital for the financing of business venturing. From the viewpoint of public policy makers interested in facilitating the funding of business venturing, it may provide insight regarding regulatory issues surrounding taxation and the barriers and incentives which affect venture capital investment.

Financial Factors Which Stimulate Innovation

Because Innovation requires the commitment of resources to a development with highly uncertain net returns, the methodology of financial economics Is useful In understanding innovation, even to the point of suggesting a relationship between the Incidence and rate of Innovation and the state of key financial factors. Our model posits such a relationship, grouping the key financial factors under the headings of investment valuation and financing: the fundamental components of financial economics. The model argues that the incidence and rate of innovation are related to both valuation and financing factors as well as the Interactions between them. We present a structure for this model and suggest a LISREL methodology for empirically testing these financial factors.