Paul A. Gompers

Grandstanding in the venture capital industry

Abstract I develop and test the hypothesis that young venture capital firms take companies pubic earlier than older venture capital firms in order to establish a reputation and successfully raise capital for new funds. Evidence from a sample of 433 IPOs suggests that companies backed by young venture capital firms are younger and more underpriced at their IPO than those of established venture capital firms. Moreover, young venture capital firms have been on the board of directors a shorter period of time at the IPO, hold smaller equity stakes, and time the IPO to precede or coincide with raising money for follow-on funds.

An Analysis of Compensation in the U.S. Venture Capital Partnership

In this paper, we analyze the structure of compensation in US venture capital partnerships. We contrast a learning model that extends Gibbons and Murphy (1992) to a situation in which a venture capitalist and an investor split the expected gains from investment with a signalling alternative. Empirical evidence from 419 U.S. venture capital partnerships formed between January 1978 and December 1992 is generally consistent with the four primary predictions of the learning model. Compensation is bunched, with 81 percent of the sample funds sharing between 20 and 21 percent of the profit. The compensation of new and smaller funds shows considerably less variation than older and larger funds. Compensation of older and larger funds is significantly more sensitive to performance than compensation of newer and smaller funds. Finally, funds that focus on early-stage and high-technology investments have higher base compensation, consistent with the greater effort required to monitor these projects.

The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements

This article examines covenants in 140 partnership agreements establishing venture capital funds. Despite the similar objectives and structures of these funds and the relatively limited number of contracting parties, the agreements are quite heterogenous in their inclusion of covenants. We examine two complementary hypotheses that suggest when covenants will be used. Covenant use may be determined by the extent of potential agency problems: because covenants are costly to negotiate and monitor, they will be employed only when these problems are severe. Alternatively, covenant use may reflect the supply and demand conditions in the venture capital industry. The price of venture capital services may shift if the demand for venture funds changes while the supply of fund managers remains fixed in the short run. The evidence suggests that both factors are important. This is in contrast to previous studies which have either focused exclusively on costly contracting or provided only weak support for the effects of supply and demand on contracts.

Institutions, Capital Constraints and Entrepreneurial Firm Dynamics: Evidence from Europe

We explore the impact of the institutional environment on the nature of entrepreneurial activity across Europe. Political, legal, and regulatory variables that have been shown to impact capital market development influence entrepreneurial activity in the emerging markets of Europe, but not in the more mature economies of Europe. Greater fairness and greater protection of property rights increase entry rates, reduce exit rates, and lower average firm size. Additionally, these same factors also associated with increased industrial vintage a size-weighted measure of age and reduced skewness in firm-size distributions. The results suggest that capital constraints induced by these institutional factors impact both entry and the ability of firms to transition and grow, particularly in lesser-developed markets.

Venture capital distributions: Short-run and long-run reactions

Venture capital distributions, a legal form of insider trading, provides an ideal arena for examining the share price impact of transactions by informed parties. These sales, which occur after substantial run-ups in share value, generate a substantial price reaction immediately around the event. In the months after distribution, returns apparently continue to be negative. When the short- and long-run reactions are decomposed, they are consistent with the view that venture capitalists use inside information to time stock distributions: Distributions of firms brought public by lower quality underwriters and of less seasoned firms have more negative price reactions. Copyright The American Finance Association 1998.

Specialization and Success: Evidence from Venture Capital

This paper examines how organizational structure affects behavior and outcomes, studying the performance of different types of venture capital organizations. We find a strong positive relationship between the degree of specialization by individual venture capitalists at a firm and its success. When the individual investment professionals are highly specialized themselves, the marginal effect of increasing overall firm specialization is much weaker. The poorer performance by generalists appears to be due to both an inefficient allocation of funding across industries and poor selection of investments within industries. Venture capital organizations with more experience tend to outperform those with less experience.

Risk and Reward in Private Equity Investments: The Challenge of Performance Assessment

D espite advances during the past decades in the pricing and risk adjustment of return in public markets, the measurement of risk and return in private equity has advanced relatively little. This is surprising, given the importance of return measurements for both fund managers and private equity investors. Private equity organizations need to document the performance of their earlier investments when raising new funds. The benchmark chosen to measure performance is critical in an institutional investor’s decision to allocate funds across various asset classes, as well as the choice of individual managers within an asset class. Universities and foundations that spend a certain percentage of their endowments must be able to calculate the change in valuation of their private equity portfolios from year to year. Investment officers at pension funds whose bonuses are tied to thle performance of their portfolios must similarly be able to accurately measure how well these funds are performing on a risk-adjusted basis in a timely manner. At the same time, the relatively slow pace of innovation in assessing riskiness and returns for private equity investments i s understandable. Firms receiving capital from private equity hnds very often remain privately held for a number of years after the initial investment. These firms have no observable market price. In order to present a conservative assessment of the portfolio valuation, private equity managers often refrain from marking portfolio firm values to market, preferring to maintain the investments at book value. Thus, the stated returns of private equity funds may not accurately reflect the true evolution of value. The problem is severe for both venture capital and buyout investments. In fact, current practices may substantially understate the true volatility of buyouts because they rarely have follow-on investments when the firm can be revalued. This article describes our efforts to address this issue. In particular, we outline a method for addressing this problem by “marking to market” the returns of a private equity group. We next discuss the calculation of riskadjusted returns. We then apply these concepts in an illustrative calculation of the returns of a private equity group that has been an active investor over the past three decades. The analysis and methodology used here represents a substantial improvement in the measurement of risk and return in private equity. The tool is potentially useful for addressing portfolio allocation and fund assessment in a rigorous and coherent manner.

Venture capital growing pains: Should the market diet?

Abstract This paper examines recent trends in the venture capital market and current research that explores the impact of these trends. High returns in the venture capital industry caused by the surging market for venture-backed initial public offerings and recent reductions in the capital gains tax rate have led to dramatic increases in venture capital commitments. This rise in fundraising has had dramatic effects on various segments of the venture capital market which may indicate overheating. The terms and conditions of venture capital limited partnerships have changed reflecting the growth in demand for venture capital services. The share of profits retained by venture capitalists has increased while the restrictiveness of the partnership agreements has eased. Venture firms are raising substantially larger funds with increasing pressure to find investments, thereby moving to later stage investments. The price of investments has also responded to the growing desire to increase investment. Finally, institutional investors are increasingly looking internationally for new investment opportunities in venture capital to avoid potential market excesses.

Extreme Governance: An Analysis of Dual-Class Companies in the United States

Dual-class common stock allows for the separation of voting rights and cash flow rights across the different classes of equity. We construct a large sample of dual-class firms in the United States and analyze the relationships of insider’s cash flow rights and voting rights with firm value, performance, and investment behavior. We find that relationship of firm value to cash flow rights is positive and concave and the relationship to voting rights is negative and convex. Identical quadratic relationships are found for the respective ownership variables with sales growth, capital expenditures, and the combination of R&D and advertising. Our evidence is consistent with an entrenchment effect of voting control that leads managers to underinvest and an incentive effect of cash flow ownership that induces managers to pursue more aggressive strategies.

Short-Term America Revisited? Boom and Bust in the Venture Capital Industry and the Impact on Innovation

This chapter seeks to understand the implications of the recent decline in venture activity for innovation. It argues that the situation may not be as grim as it initially appears. While there are many reasons for believing that on average venture capital has a powerful effect on innovation, the effect is far from uniform. During boom periods, the prevalence of overfunding of particular sectors can lead to a sharp decline in the effectiveness of venture funds. While prolonged downturns may eventually lead to good companies going unfunded, many of the dire predictions today seem overstated.