John C. Ruhnka

Some hypotheses about risk in venture capital investing

Abstract Venture capital investing differs in important respects from investment decisions involving the securities of Fortune 500 companies, or decisions to purchase established companies, which are generally made in accord with widely recognized financial models. Investing in new ventures involves a high level of uncertainty as well as a high risk of failure. Venture capital investing is characterized by high variability in the outcomes of new ventures and in the performance of venture capital portfolios. Venture capital investing decisions are complicated by a general lack of quantifiable financial and market data for early-stage ventures, and investment decisions remain hostage to unanticipated competitors, market shifts, and financial cycles. Some observers have suggested that venture capital investment decisions are primarily subjective assessments. While the question of risk in venture capital investing has been addressed on an ad hoc basis in several empirical studies, there has been little effort to develop a theoretical framework of risk perceptions and risk-reduction strategies. Despite differences in investor experience, investment preferences, and tolerance for risk, venture capital managers share many common perceptions of the risks involved in investing in new ventures and the distribution of those risks over the venture-capital-funded phase of development. Venture capital managers also utilize many common behaviors and strategies in adapting to these risks. These perceptions and reactions to risk in investing, and strategies for controlling risk can, in theory, be used to construct a behavioral framework that can predict how venture capital managers will behave in choosing between various investment opportunities in order to minimize risk and to maximize potential returns. In an attempt to begin to identify various elements of such a behavioral framework of venture capital reactions to risk, the authors have drawn upon psychological risk theory of decision-making under uncertainty, including classic expected utility theory, later modifications to that theory by Kahneman and Tversky (1979). and Coombs and Huangs (1970) “portfolio approach” to risk, that are applicable to venture capital investing. These expected behaviors to risk have been used in conjunction with empirical studies of venture capital investment and portfolio outcomes, distributions of investments within portfolios, and venture capitalist perceptions of risk, to propose nine hypotheses about how venture capital managers behave in making investment decisions. These hypotheses include differences in variation and magnitude of returns for early-stage versus later-stage ventures, explanations of how risk distributions change over the stagewise development of new ventures, differences in the behavior of “aggressive” versus “conservative” investors in screening investment prospects, and strategies utilizing a lower “ideal level of risk” to reduce the chances of achieving negative or sub-normal final portfolio returns.

A venture capital model of the development process for new ventures

Abstract For years, researchers have hypothesized that new ventures develop in a fairly predictable chronological process by evolving through various functional and strategic developmental stages. However, cross-comparable longitudinal data from large numbers of ventures are still not available to validate these “stages of development” hypotheses. The study sought to determine whether venture capital firms, which have extensive experience with the longitudinal development of new ventures, operate in accord with a common theory about how this process operates. These findings also represent a first step toward empirically validating various elements of “stages of development” theories. The study analyzed the perceptions of the CEO or managing partner of 73 U.S. venture capital firms about key features of the development process for new businesses. Venture capital firms were asked whether they differentiated stages in the development process. For each such stage information was elicited on what the stage was called, distinguishing characteristics of ventures in that stage, key developmental goals or benchmarks typically accomplished in that stage, and the major risks involved. Sufficient consensus was found on these aspects of the development process for a “venture capital model” of this process to be constructed. The model consists of five sequential stages: 1) “seed” ; 2) “start-up” ; 3) “second stage” ; 4) “third stage” ; and 5) “exit stage.” Strong consensus was found on distinguishing characteristics of ventures in early stages of development, key developmental goals or benchmarks in various stages, and major developmental risks associated with each stage. Consensus on developmental characteristics diminished somewhat in later stages, presumably because of differential rates of development among investees, as well as differing degrees of success in accomplishing earlier objectives. Nevertheless, sufficient differences in functional characteristics remained to clearly distinguish later stage investees from early stage investees, and to enable differentiations in maturity between “third stage” and “exit stage” investees. The venture capital developmental model exhibits both similarities and differences from “stages of development” paradigms. First, the venture capital model is primarily strategic and market-oriented in focus. It gives lesser emphasis to the elements of organizational structure, management style, and management specialization than some “stages of development” theories, although these elements are identified by venture capitalists as potential areas of risk should problems arise. Second, like “stages of development” paradigms, the venture capital model is universal and not venture specific. Venture capital firms appear to view all potentially feasible business concepts, despite differences in product, organizational complexity, rate of development, or ultimate size, as passing through the same process sequence, albeit at different speeds and with varying degrees of success. Third, the model, while reflecting the financial objectives of venture capital investors, is primarily shaped by the naturally occurring functional development of investees. It does not represent arbitrary requirements imposed on investees to segment the developmental process into steps that would not otherwise occur. The development of venture capital investees is influenced by the strategic and financial objectives of venture capital firms. Thus the model does not necessarily mirror the strategic and dynamic elements of the development process for firms that are not intended by their founders to grow rapidly and then go public or be acquired by a larger corporation, or for ventures that must depend upon internally generated funds or bank loans to finance development. The venture capital model, representing perceptions of 73 venture capital firms derived from longitudinal data for many hundreds of new ventures, appears to empirically confirm the concept of an evolutionary progression through key functional and strategic steps, which is a central element of most “stages-of-development” hypotheses. The study did not go into sufficient depth, however, to provide detail on the influence of factors such as organizational structure and management styles and control systems on development. These factors are central elements in several “stages of development” theories, and are arguably of critical importance in the growth, survival, and financial success of new ventures.

Governmental Incentives for Corporate Self Regulation

This article presents an overview of traditional legal and regulatory incentives directed at achieving lawful corporate behavior, together with examples of more recent governmental incentives aimed at encouraging self regulation activities by corporations. These incentives have been differentiated into ’positive‘ incentives that benefit corporations for actions that encourage or assist lawful behavior, and ‘punitive’ incentives that only punish corporations for violations of legal or regulatory standards. This analysis indicates that traditional legal and regulatory incentives for lawful corporate behavior are overwhelmingly punitive in their intended effects, while more recent governmental incentives to encourage voluntary corporate self regulation are much more positive in their intended effects.A prototype private compliance system containing typical features specified in governmental incentives for corporate self regulation was then analyzed applying the same positive/punitive analysis that was performed with the governmental incentives. This analysis suggests that corporate compliance programs that are structured to comply with Department of Defense regulations for defense contractors or the new Federal Organizational Sentencing Guidelines will reflect the same overwhelmingly ‘punitive’ balance of incentives for lawful and ethical employee conduct as do the traditional legal and regulatory incentive systems for lawful corporate behavior.Finally, the question of whether governmental incentives for corporate self regulation are succeeding was investigated by examining the behavior of the Fortune 1000 companies in enacting or revising corporate codes of conduct, an essential feature of every governmental-encouraged system for corporate self regulation, during the period 1960 to 1994. This data indicates a dramatic growth in the enactment of voluntary corporate codes of conduct by the Fortune 1000 companies in the period 1985–1994 that broadly parallels the growth in positive governmental incentives for such programs. In addition, several dramatic increases in code enactment and revision activity that occurred, coincide with specific governmental incentives for private compliance programs offered during that period.

The Ethical Implications of Corporate Records Management Practices and Some Suggested Ethical Values for Decisions

While the ethical implications of corporate actions have received increasing attention, one important area overlooked by both researchers and corporate codes of ethics is the significant ethical implications of corporate records management practices. This article discusses the operational and strategic purposes of modern corporate records management programs—including “scorched earth” programs which seek to reduce exposure to potential liability by eliminating documentary evidence from corporate files that could be used to establish culpability in future governmental investigations or in litigation by persons injured by corporate actions. As a first step toward developing relevant ethical guidelines and decision criteria for socially-responsible records management practices, the ethical values of freedom of choice and avoidance of harm are applied to various corporate decisions as to (1) which information should be retained as records and for how long, (2) subsequent disclosure or non-disclosure of that information and to whom, and (3) decisions as to when information in corporate records may properly be destroyed.

Development and Delivery of Coursework: The Legal/Regulatory/Policy Environment of Cyberforensics

This paper describes a cyber-forensics course that integrates important public policy and legal issues as well as relevant forensic techniques. Cyber-forensics refers to the amalgam of multi-disciplinary activities involved in the identification, gathering, handling, custody, use and security of electronic files and records, involving expertise from the forensic domain, and which produces evidence useful in the proof of facts for both commercial and legal activities. The legal and regulatory environment in which electronic discovery takes place is of critical importance to cyber-forensics experts because the legal process imposes both constraints and opportunities for the effective use of evidence gathered through cyber-forensic techniques. This paper discusses different pedagogies that can be used (including project teams, research and writing assignments, student presentations, case analyses, class activities and participation and examinations), evaluation methods, problem-based learning approaches and critical thinking analysis. A survey and evaluation is provided of the growing body of applicable print and online materials that can be utilized. Target populations for such a course includes students with majors, minors or supporting elective coursework in law, information sciences, information technology, computer science, computer engineering, financial fraud, security and information assurance, forensic aspects of cyber security, privacy, and electronic commerce.

Electronic Data Discovery: Integrating Due Process into Cyber Forensic Practice

Most organizations and government agencies regularly become engaged in litigation with suppliers, customers, clients, employees, competitors, shareholders, prosecutors or regulatory agencies that nearly assures the need to organize, retain, find and produce business records and correspondence, e-mails, accounting records or other data relevant to disputed issues. This article discusses some high visibility cases that constrain how metadata and content is routinely made available to opposing parties in civil litigation, to prosecutors in criminal prosecutions and to agency staff in regulatory enforcement litigation. Public policy, as implemented in the rules of evidence and pretrial discovery, restrict electronic data discovery (EDD) as it becomes a predominant and potentially costly pre-trial activity pivotal to modern litigation. This article discusses these constraints while identifying opportunities for the interdisciplinary activities among litigators, forensic experts and information technology professionals.