Thomas J. Chemmanur

How Does Venture Capital Financing Improve Efficiency in Private Firms? A Look Beneath the Surface

Using a unique sample from the Longitudinal Research Database (LRD) of the U.S. Census Bureau, we study several related questions regarding the efficiency gains generated by venture capital (VC) investment in private firms. First, does VC backing improve the efficiency (total factor productivity, TFP) of private firms, and are certain kinds of VCs (higher reputation versus lower reputation) better at generating such efficiency gains than others? Second, how are such efficiency gains generated: Do venture capitalists invest in more efficient firms to begin with (screening) or do they improve efficiency after investment (monitoring)? Third, how are these efficiency gains spread out over rounds subsequent to VC investment? Fourth, what are the channels through which such efficiency gains are generated: increases in product market performance (sales) or reductions in various costs (labor, materials, total production costs)? Finally, how do such efficiency gains affect the probability of a successful exit (IPO or acquisition)? Our main findings are as follows. First, the overall efficiency of VC backed firms is higher than that of non-VC backed firms. Second, this efficiency advantage of VC backed firms arises from both screening and monitoring: the efficiency of VC backed firms prior to receiving financing is higher than that of non-VC backed firms and further, the growth in efficiency subsequent to receiving VC financing is greater for such firms relative to non-VC backed firms. Third, the above increase in efficiency of VC backed firms relative to non-VC backed firms increases over the first two rounds of VC financing, and remains at the higher level till exit. Fourth, while the TFP of firms prior to VC financing is lower for higher reputation VC backed firms, the increase in TFP subsequent to financing is significantly higher for the former firms, consistent with higher reputation VCs having greater monitoring ability. Fifth, the efficiency gains generated by VC backing arise primarily from improvement in product market performance (sales); however for higher reputation VCs, the additional efficiency gains arise from both an additional improvement in product market performance as well as from reductions in various input costs. Finally, both the level of TFP of VC backed firms prior to receiving financing and the growth in TFP subsequent to VC financing positively affect the probability of a successful exit (IPO or acquisition).

Corporate Venture Capital, Value Creation, and Innovation

We analyze how corporate venture capitalists (CVCs) differ from independent venture capitalists (IVCs) in nurturing innovation in entrepreneurial firms. Using the NBER Patent Citation database, we find that CVCs help their portfolio firms achieve a higher degree of innovation productivity, as measured by their patenting, although these firms are younger, riskier, less profitable, and go public earlier compared to the entrepreneurial firms backed by IVCs. To establish causality, we use both an instrumental variable approach and a difference-in-difference approach, and show that the above baseline results are unlikely to be driven by the better selection ability on the part of CVCs. While our baseline results are based on VC-backed firms that eventually go public, we develop additional robustness tests using the entire universe of VC-backed private firms and show that our results are not driven by CVCs bringing their most innovative firms public: CVC-backed firms are more innovative regardless of their eventual exit outcomes or current investment status. Finally, we develop a simple theoretical model to analyze the mechanisms through which CVCs nurture innovation to a greater extent than IVCs, and test the implications of this model. Our analysis suggests that two possible mechanisms are CVCs’ greater tolerance for failure and greater industry specific knowledge arising from the strategic fit between the CVCs’ parent firms and the entrepreneurial firms they invest in.

IPOs versus Acquisitions and the Valuation Premium Puzzle: A Theory of Exit Choice by Entrepreneurs and Venture Capitalists

We analyze a private firm’s choice of exit mechanism between initial public offerings (IPOs) and acquisitions, and we provide a resolution to the “IPO valuation premium puzzle.” The private firm is run by an entrepreneur and a venture capitalist (VC) (insiders) who desire to exit partially from the firm. A crucial factor driving their exit choice is competition in the product market: While a stand-alone firm has to fend for itself after going public, an acquirer is able to provide considerable support to the firm in product market competition. A second factor is the difference in information asymmetry characterizing the two exit mechanisms. Finally, the private benefits of control accruing to the entrepreneur post-exit and the bargaining power of outside investors versus firm insiders are also different across the two mechanisms. We analyze two situations: the first, where the entrepreneur can make the exit choice alone (independent of the VC), and the second, where the entrepreneur can make the exit choice only with the concurrence of the VC. We derive a number of testable implications regarding insiders’ exit choice between IPOs and acquisitions and about the IPO valuation premium puzzle.

Why Include Warrants in New Equity Issues? A Theory of Unit IPOs

We develop a theory of unit IPOs in which the firm going public issues a package of equity with warrants. We model an equity market where insiders have private information about the riskiness as well as the expected value of their firms future cash flows. We demonstrate that, in equilibrium, high risk firms issue underpriced “units” of equity and warrants; lower risk firms, on the other hand, issue underpriced equity alone. In contrast to the existing literature, underpricing arises as a signal in our model in the context of a one-shot equity offering. Though developed in the context of IPOs, our model can also explain the issuance of seasoned equity offerings packaged with warrants. Further, the intuition behind the model generalizes readily to provide a new rationale for packaging call-option-like claims with risky securities other than equity, including convertible debt and debt with warrants.

Do Anti-Takeover Provisions Spur Corporate Innovation? A Regression Discontinuity Analysis

We study the effect of antitakeover provisions (ATPs) on innovation. To establish causality, we use a regression discontinuity approach that relies on locally exogenous variation generated by shareholder proposal votes. We find a positive, causal effect of ATPs on innovation. This positive effect is more pronounced in firms that are subject to a larger degree of information asymmetry and operate in more competitive product markets. The evidence suggests that ATPs help nurture innovation by insulating managers from short-term pressures arising from equity markets. Finally, the number of ATPs contributes positively to firm value for firms involved in intensive innovation activities.

Venture Capitalists Versus Angels: The Dynamics of Private Firm Financing Contracts

We consider a setting in which an entrepreneur chooses between angel and venture capital financing to fund his investment project. The entrepreneur may raise the required external financing over several rounds, though a certain minimum amount needs to be raised initially. There are four key ingredients driving the entrepreneur’s choice between the above two sources of private equity financing in our model. First, venture capitalists are to able add value to some of the firms they finance, while angels are not able to add significant value. Second, the entrepreneur has private information regarding the nature of his own firm. Further, the extent of this private information evolves over time, since a financier who has financed the firm in prior rounds will know more about it than a new financier. Third, since the venture capitalist has to engage in privately costly effort to add value to the firm, the financial contract between the two has to provide him with the right incentives to maximize this value-addition. Finally, the entrepreneurs effort is also required to ensure project success. In the above setting, we derive: (i) The equilibrium financing path of the firm, including its choice between angel and venture capital financing over different financing rounds, and the amounts raised in these rounds; (ii) The equilibrium design of financial contracts between the entrepreneur and the angel or venture capitalist, with implications for the differences between angel and venture capital contracts; (iii) The dynamic evolution of venture capital contracts over financing rounds; (iv) The differences in the composition of projects financed by venture capitalists and angels and the structure of their holdings in these projects; (v) The effect of an announcement by any firm of a successful venture capital or angel financing upon other private equity investors assessment of its value. Angels, Venture Capitalists, and Entrepreneurs: A Dynamic Model of Private Equity Financing

Management Quality, Financial and Investment Policies, and Asymmetric Information

We develop measures of the management quality of firms and make use of a unique sample of hand-collected data to examine the relationship between the reputation and quality of a firm’s management and its financial and investment policies, a relationship that has so far received little attention in the literature. We hypothesize that better and more reputable managers are able to convey the intrinsic value of their firm more credibly to outsiders, thus reducing the information asymmetry facing their firm in the equity market. Given this, firms with better and more reputable managers will have more access to the equity market, so that we expect lower leverage ratios for these firms. In addition, they will have less need to signal using dividends, so that they will have lower dividend payout ratios. Further, since better managers are likely to select better projects (having a larger net present value (NPV) for any given scale) and to implement them more ably, higher management quality will also be associated with higher levels of investment. We present evidence consistent with the above hypotheses. Our direct tests of the relationship between management quality and asymmetric information also indicate that higher management quality leads to a reduction in the extent of information asymmetry facing a firm in the equity market.

Institutional Trading, Information Production, and the SEO Discount: A Model of Seasoned Equity Offerings

We develop a model of the seasoned equity offering (SEO) process, starting from the SEO announcement, through pre-offer trading, and ending in the offering itself. We use our model to advance a new rationale for the existence of the SEO discount and SEO underpricing, and to analyze the role of institutional investors in SEOs. We show that the SEO discount is positively related to the extent of information asymmetry a firm faces, and SEOs with greater pre-offer net buying by institutional investors have higher institutional allocations, greater oversubscription, and lower SEO discounts. Furthermore, our model predicts a positive link between the pre-offer net buying by institutional investors and the magnitude of SEO underpricing and the long-run post-SEO operating performance.

Antitakeover provisions in corporate spin-offs.

We analyze the relation between antitakeover provisions (ATPs) and the performance of spin-off firms. We find that firms protected by more ATPs before spin-offs have higher abnormal announcement returns and greater improvements in post-spin-off operating performance than firms with fewer ATPs. Further, firms that reduce the number of ATPs after spin-offs have greater improvements in operating performance than firms that do not reduce the number of ATPs. Finally, CEOs of pre-spin-off firms tend to retain more ATPs in parent firms and assign fewer ATPs to the spun-off units if they remain as the CEOs of the parents but not the spun-off units. Overall, our results indicate a positive relation between ATPs and the value gains to spin-offs. 2009 Elsevier B.V. All rights reserved.

'Preparing' the Equity Market for Adverse Corporate Events: A Theoretical Analysis of Firms Cutting Dividends

This paper presents the first theoretical analysis of the choice of firms between “preparing” and not preparing the equity market in advance of a possible dividend cut. In our model, insiders have private information about their firm’s intermediate cash flow as well as about the net present value of its growth opportunity. We show that, in equilibrium, firms in temporary financial difficulties but with good long-term growth prospects are more likely to prepare the market in advance of dividend cuts, while those with permanently declining earnings are less likely to prepare the market. Our model generates several new testable predictions.