Venture Capital Exits in Canada and the United States*

Douglas J. CummingSchool of Business, University of Alberta

Edmonton, Alberta, Canada T6G 2R6Tel: (780) 492-0678Fax: (780) 492-3325

E-mail: Douglas.Cumming@ualberta.ca Http://www.bus.ualberta.ca/dcumming

Jeffrey G. MacIntoshToronto Stock Exchange Professor of Capital Markets

Faculty of Law, University of Toronto78 Queen’s Park

Toronto, Ontario, Canada M5S 2C5Tel: (416) 978-5785Fax: (416) 978-6020

E-mail: j.macintosh@utoronto.ca

First Draft: September 1997This Draft: February 2002

* Cumming: University of Alberta School of Business; B.Com. (Hons.) McGill University; M.A. Queen’s University; J.D./Ph.D., University of Toronto. MacIntosh: Toronto Stock Exchange Professor of Capital Markets, University of Toronto Faculty of Law; B.Sc., MIT; LL.B., University of Toronto; LL.M., Harvard Law School. The authors thank Varouj Aivazian, Paul Halpern, Vijay Jog, Aditya Kaul, Frank Mathewson, Vikas Mehrotra, Michael Patry, Tom Ross, Corrine Sellars, and especially Ralph A. Winter for helpful comments and suggestions. We are also grateful for comments from the seminar participants at the ABN AMRO International Conference on Initial Public Offerings (2000, Amsterdam), ASA Conference at the University of Western Ontario (2001, London), Australasian Banking and Finance Conference (2001, Sydney), Canadian Law and Economics Association (1998, Toronto), Center for Financial Studies at the University of Frankfurt (2001), Eastern Finance Association (2001, Charleston), Financial Management Association (2001, Toronto), Law & Entrepreneurship Research Conference Sponsored by the Northwestern School of Law of Lewis & Clark College (2000, Portland), Multinational Finance Society (2001, Garda, Italy), Northern Finance Association (2000, Waterloo), University of Alberta Finance Workshop (1999, Edmonton), University of Hamburg Law and Economics Workshop (2001), and the University of Toronto Institute for Policy Analysis (1997). This paper is scheduled for presentation at the Babson Conference on Entrepreneurship (2002, Colorado).

Venture Capital Exits in Canada and the United States

Abstract

Venture capital exit vehicles enable, to different degrees, mitigation of informational asymmetries

and agency costs between the entrepreneurial venture and the new owners of the firm. Different exit

vehicles also affect the amount of new capital for the entrepreneurial firm. Based on these factors, we

conjecture the efficient pattern of exits depending on the quality of the entrepreneurial venture, the nature of

its assets, and the duration of venture capital investment. We empirically assess the significance of these

factors using a multinomial logit model. Our comparative results between Canada and the U.S. provide

insight into the impact of different institutional and legal constraints, and suggest such constraints have

distorted the efficient pattern of exits in Canada.

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CONTENTS

INTRODUCTION……………………………………………………………………………………………..3

I. EXIT VEHICLES…………………………………………………………………………………………...6II. A GENERAL THEORY OF VENTURE CAPITAL EXITS…………………………………………………….8

III. EXCEPTIONS TO THE GENERAL THEORY: FACTORS AFFECTING THE VENTURE CAPITALIST’S TIMING OF EXIT AND CHOICE OF EXIT VEHICLE ………………………………………………………………….12A. Ability of the New Owners to Resolve Information Asymmetry and Value the Firm……...……13B. Ability of New Owners to Monitor the Investment Post-Exit and Discipline the Managers…….20C. Black and Gilson’s Implicit Contract Theory……………………………………………………29D. The Transaction Costs of Effecting a Sale of the VC’s Interest……………...………………….29E. Ongoing Costs of Operating as a Public, As Opposed to a Private Firm……………………..….34F. Liquidity of Investment to Buyer………………………………………………………………...35G. The Liquidity of the Consideration Received by the VC: The VC’s Cash Preference………..…...36 H. Managerial Incentives……………………………………………………………………………421. Incentive compensation and Stock Ownership as Managerial Motivators……………...422. The Corporate Control Market…………………………………………………………..46I. Transaction Synergies..…………………………………………………………………………..47J. Capital Raised, Scale of Acquisition, and Ability to Meet Future Capital Requirements……….51K. Risk Bearing Considerations……………………………………………………………………..56L. Common Exit Strategies as a Factor in Promoting Teamwork………………………..…………58M. The Cyclicality of Valuations in IPO Markets………………………….……………………..…62N. The Life Cycle of a Venture Capital Fund: The Fire Sale Problem…….. ………………………64O. Reputational Incentives…………………………………………………………………………..65P. Agency Costs of Debt…………………………………………………………………………….67Q. Public Profile……………………………………………………………………………………..69R. Governance Mechanisms…………………………………………………………………………69S. A Rank Ordering of Exit Preference by Investee Firm Quality………………………………….70

IV. TESTABLE HYPOTHESES………………………………………………………………………………73A. Firm Quality……………………………………………………………………………………...74B. Investment Duration and Exit Strategy…………………………………………………………..75C. Exit Strategies for High-Technology Firms……………………………………………………...77

V. LEGAL AND INSTITUTIONAL FACTORS…………………………………………………………………79A. Type of Venture Capital Fund……………………………………………………………………79B. Tax Factors……………………………………………………………………………………….83C. Securities Regulation…………………………………………………….……………………….83D. Market Liquidity………………………………………………………………………………….88E. Underwriting Support for IPOs…………………………………………………………………..89

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VI. EMPIRICAL EVIDENCE………………………………………………………………………………...90A. Data………………………………………………………………………………………………90B. Multinomial Logit Analysis……………………………………………………………………...94

CONCLUSION………………………………………………………………………………………………97APPENDIX…………………………………………………………………………………………………99INTRODUCTION

Venture capital investing is primarily equity investing. Many entrepreneurial firms (“EFs”) are

young firms lacking the cash flow and profitability that would enable them to pay interest or dividends.

Thus, most of the venture capitalist's return arises in the form of capital gains. For this reason,

understanding the means by which venture capitalists (VCs) exit (i.e., dispose of) their investments is vital

to an understanding of the venture capital process. Indeed, there is evidence that the prospective suitability

of the various exit vehicles (initial public offering, acquisition, company buyback, secondary sale, and

write-off, each defined below) is considered by VCs to be an important factor in deciding whether to invest

in a firm.1

In addition, once an investment is taken on, the VC will structure its deal with the entrepreneur to

maximize the probability of exiting on favourable terms. Various common features of the typical

VC/entrepreneur deal, such as “piggyback” rights,2 “go-along” (or “carry-along”) rights,3 and put options

are inserted with a view to facilitating exit.4

1 ? Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks versus Stock Markets, 47 J. FIN. ECON. 243 (1998); J. WILLIAM PETTY, JOHN D. MARTIN, AND JOHN W. KENSINGER, HARVESTING INVESTMENTS IN PRIVATE COMPANIES (1999); Ian C. MacMillan, Robin Siegel & P.N. Subba Narashimba, Criteria Used by VCs to Evaluate New Venture Proposals, 1 J. BUS. VENTURING 119 (1985); Richard B. Carter & Howard E. Van Auken, Venture Capital Firms' Preferences for Projects in Particular Stages of Development, 32 J. SMALL BUS. MGMT. 60 (1994); Arshad M. Kahn, Assessing Venture Capital Investments with Non-Compensatory Behavioral Decision Models, 2 J. BUS. VENTURING 193 (1987); Albert Bruno & Tyzoon Tyebjee, The Entrepreneur's Search for Capital, 1 J. BUS. VENTURING 61 (1985).

2 ? A piggyback right enables the holder to require that she be bought out at the same time and on the same terms as another shareholder. Where there is such a right, it helps the ensure that the parties work toward a common exit, since neither party can unilaterally exit.

3 ? The holder of a go-along right can insist that the other owner(s) subject to the right sell her shares at the same time and on the same terms as the holder of the right. The venture capitalist will typically hold the right, which is designed to enable the VC to deliver one hundred percent of the EF’s shares to an acquiror.

4 ? PAUL A. GOMPERS & JOSH LERNER, THE VENTURE CAPITAL CYCLE (1999); William A. Sahlman, The Structure and Governance of Venture Capital Organizations, 27 J. FIN. ECON. 473 (1990).

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While previous research has explored the role of venture capitalists (“VCs”) in the going-public

process,5 the complete class of venture capital exits (IPOs, acquisitions, secondary sales, buybacks, and

write-offs) has not previously been the subject of theoretical or empirical investigation.6

Previous research has dealt extensively with agency problems that arise in venture capital

investing.7 As initially identified by Sahlman, three types of agency relationships have been the focus of

discussion.8 First, venture capital firms have incentives to favour their interests over those of their

5

? Gompers & Lerner, Id.; Paul A. Gompers & Josh Lerner, Conflict of Interest in the Issuance of Public Securities: Evidence from Venture Capital, 42 J. LAW & ECON. 1 (1999); William C. Megginson & Kathleen A. Weiss, Venture Capital Certification in Initial Public Offerings, 46 J. FIN. 879 (1991); Christopher Barry, Chris Muscarella, John Peavy & Michael Vetsuypens, The Role of Venture Capital in the Creation of Public Companies: Evidence from the Going Public Process, 27 J. FIN. ECON. 447 (1990).

6 ? Black & Gilson, supra note 1, convincingly argue that IPOs are a superior form of exit to the alternatives, and that an active IPO market is strongly correlated with the health of the venture capital industry in different countries. They also put forth an implicit contract theory discussed infra section III.C. They do not, however, rigorously explore alternative forms of exit. Petty et al., supra note 1, provide an analysis of case studies on harvesting venture capital investments. D. Gordon Smith, Control Over Exit in Venture Capitalist Relationships, Northwestern School of Law of Lewis and Clark College, mimeo (2000), considers whether the entrepreneur or venture capitalist should have control over the exit decision. Thomas Hellmann, IPOs, Acquisitions and the Use of Convertible Securities in Venture Capital, Stanford University, mimeo (2001), considers control over exit in the choice of IPOs versus acquisitions. A new paper by Armin Schweinbacher, An Empirical Analysis of Venture Capital Exits in Europe and in the United States, mimeo (February 2002), considers similar tests introduced in our paper with data from Europe and the United States. Schweinbacher’s tests are based on our paper, and the results are similar: exit patterns are most efficient in the United States. In contrast to our data (see infra section VI), however, Schweinbacher’s data uses averages exit frequency across funds and does not provide a project specific investment-by-investment analysis of exits.

7 ? William A. Sahlman, The Structure and Governance of Venture Capital Organizations, 27 J. FIN. ECON. 473 (1990); Josh Lerner, The Syndication of Venture Capital Investments, 23 FIN. MGMT. 16 (1994a); Josh Lerner, Venture Capitalists and the Decision to Go Public, 35 J. FIN. ECON. 293 (1994b); Anat R. Admati & Paul Pfleiderer, Robust Financial Contracting and the Role of Venture Capitalists, 49 J. FIN. 371 (1994); Eric Berglöf, A Control Theory of Venture Capital Finance, 10 J. LAW, ECON. & ORG. 247 (1994); Francesca Cornelli & Oved Yosha, Stage Financing and the Role of Convertible Debt, London Business School Working Paper No.253-1997 (1997); Dirk Bergmann & Ulrich Hege, Venture Capital Financing, Moral Hazard, and Learning, 22 J. BANKING & FIN. 703 (1998); Jeffrey J. Trester, Venture Capital Contracting Under Asymmetric Information, 22 J. BANKING & FIN. 675 (1998); Thomas Hellmann, The Allocation of Control Rights in Venture Capital Contracts, 29 RAND J. ECON. 57 (1998); Gompers & Lerner, supra note 4; Paul A. Gompers, Grandstanding in the Venture Capital Industry, 42 J. FIN. ECON. 133 (1996); Raphael Amit, James Brander and Christoph Zott, Why do Venture Capital Firms Exist? Theory and Canadian Evidence, 13 J. BUS. VENTURING 441; Paul A. Gompers, Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments, Harvard University, mimeo (1997); Douglas J. Cumming, The Convertible Preferred Equity Puzzle in Canadian Venture Capital Finance, University of Alberta, mimeo (2000); Mark Garmaise, Informed Investors and the Financing of Entrepreneurial Projects, University of Chicago Graduate School of Business, mimeo (2000); Steven N. Kaplan & Per Strömberg, Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts, University of Chicago Graduate School of Business, mimeo (1999).

8 ? Sahlman, Id.

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investors, and thus can be viewed as agents of the investors. Second, the entrepreneur has an incentive to

favour her interests over those of the VC, and hence can be considered to be an agent of the VC. Third, a

venture capital firm sometimes has the incentive to act at odds with the best interests of the entrepreneur,

and thus may be characterized as an agent of the entrepreneur.

In this paper, we suggest that there is a fourth type of agency problem that has received scant

attention. When the VC exits its investments, agency issues arise as between the sellers of the firm's equity

(the VC and other investors in the EF) and the purchasers. We hypothesize that the choice of exit vehicle

and the timing of exit are strongly influenced by a desire to minimize these agency problems (in addition to a

variety of other hypothesized factors). The theme that unifies the paper is that the VC’s goal is to maximize

the proceeds resulting from the exit of its investments. We identify a variety of factors that influence the

exit price associated with various forms of exit, and hence the VC’s choice of exit vehicle.

Not all of these factors are empirically testable, either because it would be difficult to devise an

appropriate empirical test, or because of limitations in our data set. For this reason, in our empirical tests, a

variety of factors are subsumed under the rubric of a variable that we simply style firm “quality”, which is

proxied by the ratio of the proceeds of exit to the cost of investment. We hypothesize that, when arrayed by

quality (from high to low), VC investments will be exited by, in rank order, IPOs, acquisitions, secondary

sales, buybacks, and write-offs (Hypothesis 1).

We also hypothesize that the longer the duration of the VC’s investment, the less the degree of

information asymmetry between firm insiders (including the selling VC) and outsiders (i.e. potential

purchasers of the VC’s interest). We posit a rank ordering of exits arrayed by investment duration (from

high to low) in the following order: IPOs, secondary sales, acquisitions, buybacks, and write-offs

(Hypothesis 2).

Finally, we hypothesize that technology investments (when compared to non-technology

investments) will be associated with greater information asymmetry between insiders and outsiders, a

greater likelihood of moral hazard problems, higher growth potential, and a greater likelihood that

transaction synergies can be generated by combining the EF with another firm. We posit a rank ordering of

preferred exit vehicles for technology investments as follows: IPOs and acquisitions, secondary sales,

buybacks, write-offs (Hypothesis 3).

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We test these hypothesized relationships using multinomial logit methodology, on data derived

from a survey sent to Canadian and U.S. VCs. In our results, we find little support for Hypothesis 2, more

support for Hypothesis 3, and perhaps the strongest support for the central hypothesis of the paper,

Hypothesis 1.

We find evidence that exit preferences differ as between Canada and the United States. In

particular, our theoretical framework appears to have more predictive power in the United States. We

suggest that this is due to economic, legal and institutional factors that distort the efficient pattern of exits in

Canada. We also suggest that these various constraints have led to a lower level of VC skill in Canada,

introducing noise into our Canadian data, as well as lower returns to venture capital investing in Canada

relative to the United States.

The paper is organized as follows. In section I we begin with a basic description of alternative exit

vehicles. Section II summarizes a general theory of venture capital exits derived from related work.

Section III enumerates and discusses factors that push toward or away from particular exit choices. This

section supplies the theoretical core of the paper. In section IV we generate the three hypotheses that link

firm quality, investment duration, and the nature of the firm's assets to choice of exit vehicle. Section V

discusses legal, institutional and economic differences that arise between the U.S. and Canadian markets

that impact on the choice of exit. In Section VI, we empirically test the three hypotheses using survey data

collected from Canadian and U.S. VCs. Section VII is the conclusion.

I. EXIT VEHICLES

In general, VCs will exit their investments by one of the following five methods: initial public

offering (IPO), acquisition, buyback, secondary sale, or write-off. In an IPO, the firm embarks upon a sale

of its shares to public investors. The VC will typically not sell all (or even a part of) its shares into the

public market at the date of the public offering, for reasons discussed below. Rather, securities will be sold

into the market (or distributed to investors) over a period of months or even years following the public

offering. Whether the VC sells at the time of the IPO or later, by common convention we denominate IPOs

as a form of exit, since it will precipitate an exit at some point in the future.

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Sometimes a VC will exit via an acquisition exit in which the entire firm is purchased by a third

party. There are a variety of means for effecting an acquisition exit, including a sale of shares, a merger, and

sale of the firm’s assets. However the transaction is effected, potential buyers in a strategic acquisition can

assume a variety of identities. In some cases, the purchaser will be another VC. A sale from one VC to

another can be motivated by the relative skill sets of the selling and purchasing VC. The purchaser may be

more familiar with the firm’s technology or markets, for example, than the seller. Such a sale might also be

motivated by differences in the confidence of the two VCs in the future of the firm’s product or technology.

In the majority of cases, however, the purchaser will be a strategic acquiror. A strategic acquiror is a

business entity that is in a business that is the same as, or similar to that of the target firm.

It may be a competitor of the target firm, or a supplier or customer.9 It is typically larger, and often much

larger than the target firm. Following the acquisition, it may leave the target firm as a wholly owned

subsidiary or a separate division, in order to preserve the management/entrepreneurial team responsible for

the firm’s past success. Alternatively, it may integrate the company's technology with its own following the

acquisition. In either case, a major motivation for the transaction will often be to meld the target’s products

and/or technology with its own, in order to produce synergistic gains.

This is not to say that a strategic fit exists in every case. Gompers and Lerner’s investigations of

corporate VC funds, for example, demonstrate that the closeness of fit between the corporation’s business

and the target firm varies substantially.10 Corporate VC funds that lack a strategic focus do comparatively

poorly and tend to be wound up sooner than funds with a strong strategic focus. It would be surprising if

the same was not also true for corporate acquirors acquiring other than through an in-house VC fund.

Although references below to strategic acquirors should be understood to encompass variation in closeness

of fit, for analytical purposes we deal mainly with the case of a strategic acquiror with a close fit with the

target’s technology.

In an exit effected by way of secondary sale, the VC sells its shares to a third party – again

typically a strategic acquiror, and in some cases another VC. A secondary sale differs from an acquisition

exit in that only the VC sells to a third party; the entrepreneur and other investors retain their investments.

Where the purchaser is a strategic acquiror, it will usually be seeking a window on the firm’s technology,

9

? See, e.g., VENTURE ECONOMICS, EXITING VENTURE CAPITAL INVESTMENTS (1988).

10 ? Gompers and Lerner, supra note 4, 95-123.

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with a view to possibly effecting a 100% acquisition of the firm at some point in the future.

In a buyback, the entrepreneur and/or firm managers or the company (collectively referred to

simply as "the entrepreneur" below) will repurchase the shares held by the VC. In many cases, the buyback

will be triggered by the exercise of contractual rights taken by the VC at the time of initial investment.

Such rights will often include, for example, the ability to “put” its shares to the entrepreneur after the elapse

of stated periods of time, such as two or five years, the failure to achieve performance targets, or the failure

to go public.

A write-off occurs where the VC walks away from its investment. While a write-off will often

involve the failure of the company, the VC may continue to hold shares in a non-viable or barely profitable

enterprise.

II. A GENERAL THEORY OF VENTURE CAPITAL EXITS

Elsewhere, we provide a general theory of VC exits.11 This theory builds on research into the nature

of venture capital investing, which may be summarized as follows. The VC’s special skill set as an investor

is engaged in all three phases of an investment: entry (i.e. investment), building value with a view to exit,

and exit.12 At the point of entry, the VC exercises expert judgment in winnowing the wheat from the chaff.

During the build up phase, the VC is an active, or value-added, or relational investor. The VC intensively

monitors managers and participates in strategic decision-making (including hiring and firing managers).

During this phase, the VC also provides ancillary services to the entrepreneurial EF, such as providing advice

on legal and accounting assistance, identifying other sources of financing or arranging financing, identifying

suppliers and customers, etc. Finally, the VC exercises expert judgment in relation to the exit decision,

determining when and by what means and for what consideration the investment will be exited. In the

build-up (second) and exit (third) stages, the VC lends its reputational capital to the EF. This makes it easier,

for example, for the firm to source high quality professional assistance, source high quality suppliers, and

11 ? Douglas J. Cumming & Jeffrey G. MacIntosh, Venture Capital Investment Duration in Canada and the United States, 11 J. MULTI. FIN. MGMT. 445 (2001); see also Douglas J. Cumming & Jeffrey G. MacIntosh, Economic and Institutional Determinants of Venture Capital Investment Duration , in Gary Libecap, ed., ADVANCES IN THE STUDY OF ENTREPRENEURSHIP, INNOVATION AND ECONOMIC GROWTH, Vol.13 forthcoming (2002).

12 ? See generally Black & Gilson, supra note 1, at 252-255.

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locate customers. In all three phases (at least with respect to relatively early stage companies), the VC’s

skills are sui generis,13 and are not – at least in the development stages at which VCs invest - replicated by

other types of investors.14

Our general theory begins with a theory of venture capital duration. This theory contains a

number of admittedly unrealistic assumptions and assumes away any differences in the types of exits that the

VC might choose, in order to isolate those elements of the choice of exit that are endogenous to VC

investing (and not influenced, for example, by information asymmetries that arise on exit between the VC

and potential buyers of its interest). Once these elements are identified, we relax our assumptions and bring

a variety of “real world” constraints on VC exit to bear, to gain a fuller understanding of the range of

dynamics that drive VC exit choice.

The theory of duration thus assumes that the investment has been made and focuses on the second

element in the VC’s skill set – the ability to add value to the EF by offering managerial and strategic

guidance in addition to a variety of ancillary services. The general insight is that as the duration of the VC’s

investment increases, its ability to add value to the enterprise diminishes. The starting assumptions are:

1. The VC has a unique ability to add value to the enterprise by functioning as an active

investor (i.e. there are no other value-added investors).

2. At any given point in time, the VC’s investment in the firm can be sold to a third party for a

price which represents the best estimate of the true value of the firm (i.e. there is no

information asymmetry).

13 ? See Black & Gilson, supra note 1; Michael Gorman and William Sahlman, What Do Venture Capitalists Do? (1989) J. BUS. VENTURING 231 (1989); WILLIAM D. BYGRAVE & JEFFREY A. TIMMONS, VENTURE CAPITAL AT THE CROSSROADS (1992); Josh Lerner, Venture Capitalists and the Oversight of Private Firms, 50 J. FIN. 301 (1995); Thomas Hellmann & Manju Puri, Venture Capital and the Professionalization of Start-up Firms: Empirical Evidence, J. FIN. (forthcoming 2002).

14 ? The skill sets of merchant bankers and mezzanine financiers overlap those of VCs, but these financiers typically finance firms in more mature stages of development, and focus more of their efforts on MBO and LBO financing. They also provide a range of advisory and other services not offered by venture capital firms. The skill set of angel investors also overlaps with that of VCs, but angels have historically invested prior to VC involvement. VCs typically will not invest below certain thresholds (e.g. in Canada, typically $500,000 or $1,000,000 per investment) because there is a significant fixed cost element to investigating new investment possibilities, generating economies of scale in VC investing. See Jeffrey G. MacIntosh, Venture Capital Exits in Canada and the United States, in PAUL J.N. HALPERN, ED., FINANCING GROWTH IN CANADA, 279-356 (1997).

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3. The exit price is thus not dependent upon the form of exit.

4. The fund has an infinite life span, so that the VC’s choice of when to exit is made

independently of any need to exit investments in order to return both invested capital and

profits to the fund’s investors.

5. The VC can freely re-deploy capital harvested from one investment into other investments.

Under these assumptions (which are relaxed in the analysis and discussion that follows), a VC will

exit from an investment when the projected marginal value added (PMVA) resulting from its stewardship

efforts, at any given point in time, is less than the projected marginal cost (PMC) of these efforts. By

"effort" we mean all of those things that VCs can do to add value to an enterprise. By "cost" we mean all the

direct and overhead costs associated with creating value, as well as the opportunity cost associated with

alternative deployments of capital. By "projected" we mean to suggest that the VC will take into account not

merely present cost and effort, but a summation of all future costs and efforts. By "point in time", we refer

to all of those points in time at which the VC formally or informally reassesses its continued commitment to

an investment, whether quarterly, yearly, or otherwise. We refer to the projected marginal costs of

maintaining the investment as the “maintenance costs”. These relationships are illustrated in Figure I.

[FIGURE I ABOUT HERE]

If, at any given time the maintenance costs exceed the marginal value generated, then the VC will be

better off selling the investment to a third party (or parties). That way, it can maximally exploit its

comparative advantage over other investors – i.e. its ability to create value by actively managing each firm

within its portfolio.

In this general theory of investment duration, we suggest that an exit will generally be precipitated

by one of three different types of events.

1. The marginal value and maintenance cost curves cross: the exhaustion of the VC’s skill set

We posit that VC value added will decline over time until it is equal to or less than maintenance

costs. VC value added will be greatest at the start of the investment relationship, when the VC is most likely

10

to be able to bring managerial and financial discipline to the enterprise, help identify and implement product

development strategies, identify legal, accounting and marketing expertise, and so on. However, the ability to

add value will decline over time as the firm matures, management becomes more seasoned, the most

pressing product development and marketing issues have been worked out, and the firm’s various business

contacts (including legal, accounting, investment banking, marketing channels, suppliers, and customers)

have been put in place.

We also posit that maintenance costs will decrease over time. That is, the effort expended by the

VC will be front-end loaded, for the reasons given in the preceding paragraph.

Finally, we posit that maintenance costs contain a significant fixed cost element, since the VC must

perform some baseline level of monitoring in respect of each of its investments, whether in need of active

management or not. Thus, the maintenance costs curve will decline more slowly than the marginal value

curve. Thus, at some point in time the two functions will cross, at which point the VC will be unable to add

further value to the enterprise, and will exit the investment.

2. Internal or external shocks change the location of the marginal value added and/or

maintenance cost curves

A variety of internal or external shocks (both systematic and unsystematic in nature) can shift either

the marginal value added curve, the maintenance costs curve, or both, causing the exit criterion to be

satisfied. For example, if the firm’s technology proves unworkable, this will presumably relocate the

marginal value added curve. Other events that might relocate either or both of the curves include: the

firm’s technology is rendered obsolete by external technological developments; the firm’s product is

displaced in the market by those of competitors; a recession dries up demand for the firm’s product;

complementary technological developments in the marketplace greatly increase the value of the firm’s

technology, etc.

3. The VC receives new information about the location of the marginal value or maintenance

cost curves

Upon entering into an investment, the VC will, at least at an intuitive level, draw marginal value

added and maintenance cost curves. These curves may subsequently be revealed to have been drawn

11

incorrectly. For example, the maintenance cost curve may have to be re-drawn because the entrepreneur

turns out to be far more difficult to work with than originally forecast. Once re-drawn, the curves may

intersect at a new location, causing the exit condition to be satisfied. The effect of re-drawing either or both

curves is illustrated in Figure I.

III. Exceptions to the General Theory: Factors Affecting the Venture Capitalist’s Timing of Exit and

Choice of Exit Vehicle

The general theory of venture capital exits described above is based on a number of unrealistic

assumptions. For example, at any given point in time, it is likely that there will be a host of potential value-

added investors other than the VC. Foremost among these is the strategic acquiror. A strategic acquiror – a

firm in the same or similar business – will often have unique abilities to resolve information asymmetries

between managers and investors, and to monitor the investment. If so, that strategic acquiror will place a

higher value on the assets than the VC.15 In such a case, maintaining the investment rather than selling it to

the strategic acquiror results in an opportunity cost for the VC. Acting rationally, the VC will sell the

investment, even if the value-added that the VC can generate exceeds the investment’s maintenance costs.

Similarly, severe information asymmetries arise at the time of exit, as between the selling VC and

whomever purchases the VC’s interest. These information asymmetries will affect the timing of exit, the

choice of exit vehicle, and the proceeds that result from exit.

Thus, the general theory must yield to a set of exceptions (based on real world constraints) that we

posit are the key determinants of the VC’s choice of when, and by what means, it will exit a particular

investment. These are enumerated and discussed in this section, and summarized in Table I.

These exceptions are all tied together by a single thread. All of them impact in one way or another

on the VC’s exit value. Under the assumption that the VC will generally choose the timing and form of exit

that will maximize the proceeds of exit, examination of the exceptions helps to illuminate why VCs exit their

investments as they do.

15

? Research by Gompers & Lerner supports the view that strategic acquirors are better able to select investments and to provide value-added services. They find that corporate VC funds with a strong strategic focus (which are in essence a type of strategic acquiror) perform both the screening and monitoring functions better than private funds. See Gompers & Lerner, supra note 4, at 95-123.

12

[TABLE I ABOUT HERE]

A. Ability of the New Owners to Resolve Information Asymmetry and Value the Firm

When the time comes for the VC to exit, the degree of information asymmetry between firm

insiders and outsiders will be less severe than when the VC initially invested in the firm. Older firms

that have benefited from VC guidance will tend to have a proven product, an established market,

relatively experienced management, and more elaborate internal control and information systems than

when the VC's first investment was made. This will attenuate many of the risks that confront investors in

the earlier stages of the firm's existence.16

Nonetheless, the degree of information asymmetry may still be significant, especially when

compared with that of a typical public company. A public company will have a lengthier operating history,

resulting in the production of a stream of publicly available issuer-specific information. In addition to the

beefier information record resulting from mandatory disclosure, public companies attract the private

information gathering activities of both buy-side (i.e. institutional) and sell-side (i.e. brokerage) analysts.

Even if held privately, this information will work its way into the share price, reducing the risk that buyers

will make investment mistakes.17 Lacking the informational base resulting from the operation of mandatory

disclosure and private information gathering activities, the securities or private firms are inherently subject to

an information discount reflecting the comparative paucity of information.

The severity of the information asymmetry confronting the firm will be a factor in the choice of exit,

because it will influence the willingness of a variety of potential buyers to pay for the VC’s interest. In

investing, what you don’t know can hurt you. The lower the quantum and quality of information concerning

the EF, the higher the information discount.

This means that those potential buyers (“new owners”) who are best able to overcome these

16 ? Sahlman, supra note 7. See also Jeffrey G. MacIntosh, Legal and Institutional Barriers to Financing Innovative Enterprise in Canada, monograph prepared for the Government and Competitiveness Project, School of Policy Studies, Queen's University, Discussion Paper 94-10 (1994).

17 ? See generally Ronald J. Gilson and Reinier J. Kraakman, The Mechanisms of Market Efficiency, 70 VA. L. REV. 549 (1984); Avner Arbel, Giraffes, Institutions, and Neglected Firms, F. ANAL. J. 57 (May-June 1983).

13

information asymmetries will tend to be the highest valuing purchasers. Since different forms of exit result

in sales to a heterogeneous variety of buyers possessing differing abilities to resolve information

asymmetries, the existence and magnitude of information asymmetry associated with the EF will influence

the VC’s choice of exit.

IPOs

IPOs involve the sale of shares of a company to public investors, typically (but not always)

accompanied by a listing on a stock exchange. We hypothesize that this form of exit will be

accompanied by the greatest information asymmetry between the firm and its new owners. Historically,

about three-quarters of all VC investments have been in high technology companies, and this has risen to

about 90% in recent years.18 High technology firms are the most likely to be characterized by severe

information asymmetries, particularly when the firm’s technology is novel.19 There will thus be a

significant difference in willingness to pay between sophisticated investors (i.e. those with the ability to

resolve information asymmetries) and unsophisticated investors.

We posit that public investors are relatively unsophisticated.20 While all but the smallest IPOs are

sold mainly to institutional investors, institutional money managers do not possess a high degree of

expertise in evaluating any particular technology. Moreover, public buyers suffer from well-known

collective action problems resulting from the relatively high degree of dispersion of share holdings.

Because share ownership is atomized, each owner has an incentive to allow other shareholders to gather

information.21 Attempts to spread the cost of information gathering by pooling resources are also

characterized by free rider problems. By contrast, as discussed below, exits via acquisitions, secondary

sales, and buybacks all result in considerable concentration in post-exit shareholdings, mitigating free rider

18 ? CANADIAN VENTURE CAPITAL ASSOCIATION, VENTURE CAPITAL IN CANADA: ANNUAL STATISTICAL REVIEWS 1993-2001; VENTURE ECONOMICS, VENTURE CAPITAL ANNUAL REVIEWS 1993-1996; Gompers & Lerner, supra note 4.

19 ? See infra, Part IV, C.

20 ? Thomas Chemmanur & Paolo Fulghieri, Information Production, Private Equity Financing, and the Going Public Decision, Columbia University, mimeo (1994).

21 ? ADOLF A. BERLE & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY, revised edition (New York: Harcourt, Brace and World, Inc., 1967); Bernard S. Black, The Value of Institutional Investor Monitoring: The Empirical Evidence, 39 U.C.L.A. LAW REV. 986 (1992)

14

problems.

The standard answer to the comparative lack of sophistication of public buyers is that the skill and

knowledge deficit is abridged by investment bankers, lawyers, accountants, and other market professionals.

These individuals gather and process information concerning the IPO firm and ensure that the new issue is

correctly priced. Because they are repeat players in capital markets, their reputations are at stake with

respect to every new issue brought to market. Thus, they have an incentive to price new issues

appropriately.

The certification role played by investment intermediaries has been empirically documented. The

more reputable the investment banker associated with a new issue, for example, the lower the degree of

short-term underpricing of the issue (i.e. the more potent the signal of quality, hence the lesser the need to

underprice to attract purchasers).22 Similarly, the better the reputation of the firm’s accountants, the lower

the degree of underpricing.23

The certification role extends to VCs as well. VC-backed firms (i.e. those that have had VC

involvement prior to going public) also exhibit a lesser degree of short-term underpricing.24 VCs are able to

bring firms to the public market sooner than non-VC-backed firms,25 with lower ratios of revenues to

assets,26 and with less established earnings records.27 Moreover, the older the VC firm, and hence the

greater its reputation, the lower the degree of short-term underpricing.28 This evidence is all consistent with

the certificatory role played by VCs in public market offerings, and the proposition that the better the VC’s

reputation, the more potent the signal of quality.

22 ? Megginson & Weiss, supra note 5.

23 ? See, e.g., Richard B. Carter, Frederick H. Dark, and Alan K. Singh, Underwriter Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks, 53 J. FIN. 285 (1998).

24 ? Megginson & Weiss, supra note 5.

25 ? Megginson & Weiss, Id.; Timothy H. Lin and Richard L. Smith. Insider Reputation and Selling Decisions: The Unwinding of Venture Capital Investments During Equity IPOs, 4 J. CORP. FIN. 241 (1998).

26 ? Megginson & Weiss, Id.; Lin & Smith, Id.

27 ? Barry et al., supra note 5.

28 ? Gompers, Grandstanding in the Venture Capital Industry, supra note 7.

15

Problems of information asymmetry are also partly addressed by VC ownership retention. As

explored further in Part III F, VCs do not typically sell their shares at the time of the IPO. Ownership

retention conveys a signal of quality to the market in addition to providing an assurance that the VC will

continue to monitor management post-IPO. Ownership retention and VC reputation are at least partly

substitutable, so that sales by VCs with established reputations do not affect the offering price as adversely

as sales by VCs lacking good reputations.29

Despite this evidence, we hew to our assertion that information asymmetry is highest in the case of

IPOs. Buyers in IPOs mostly rely on market intermediaries to price a new issue appropriately. By contrast,

in an acquisition exit, a secondary sale, or a buyback, the purchaser will have direct access to firm

information in addition to a degree of sophistication at least matching that of the most sophisticated market

intermediaries. In an acquisition exit or a secondary sale, the new owner will typically be a strategic

acquiror - a firm in the same or a similar line of business that will often seek to meld the firm’s

technology with its own. It will possess a keen understanding of the firm’s technology and its potential

marketability. In a buyback, the purchaser will be the entrepreneur, who is obviously well situated to

resolve information asymmetries (although will perhaps lack the ability of the strategic acquiror to

evaluate the information30).

We also note that, while investment bankers clearly play an important role in accurately pricing a

new issue, like institutional money managers, they tend to be generalists (although in the U.S. there are a

variety of highly specialized technology underwriters).31 Because of this, they rely heavily on their

technology analysts both in determining whether to underwrite a particular offering and in pricing the

offering. Despite their specialized skills, these analysts are unlikely to be able to replicate the knowledge

and experience of a strategic acquiror or the firm’s insiders.

29 ? Lin & Smith, supra note 25.

30 ? See infra, note 36 and accompany text.31

? Almost all underwriters in Canada are generalists. Even Yorkton securities, the investment banker with perhaps the best claim to be a technology boutique, still does approximately 30% of its business in traditional industries. Moreover, it does not specialize in any one segment of the technology market. By contrast, in the United States, boutique underwriters such as Hambrecht and Quist and Robertson, Stephens and Co. focus entirely on technology offerings, and even particular types of firms in the technology spectrum.

16

Even an experienced VC may lack the acumen of a strategic acquiror in valuing the firm, although

it may possess an evaluative capability superior to the entrepreneur effecting a buyback. Daines and

Klausner present direct evidence that VCs fail to maximize the value of the firm when it goes public.32 The

find that firms with VC involvement are just are likely to adopt value-reducing anti-takeover provisions as

firms without VC involvement.

Moreover, evidence relating to the reduction of short-term underpricing in the presence of reputable

market intermediaries (including VCs) is not evidence that information asymmetries are fully resolved.

Short-term underpricing is the market’s reaction to information asymmetry. While the presence of

reputable market intermediaries reduces IPO underpricing, it does not eliminate it. While admittedly we

cannot directly observe (and hence compare) discounting in private companies to reflect information risk,

underpricing even with expert intermediaries remains substantial.33

For this reason, in Table 1 we rank the comparative ability of public markets to resolve information

asymmetries as somewhat disfavouring an exit via a public offering.

Acquisitions

As noted, in a sale of the entire firm to a third party, the buyer will often be a strategic acquiror. A

strategic acquiror will usually be a large company in the same or similar business as the purchased firm,

either as competitor, supplier, or customer, and will often integrate the company's technology with its own

following the acquisition.34 That strategic acquirors are usually the same or a closely related business to the

acquired firm is not merely accidental. Just as VCs are specialists at resolving information asymmetries in

the earlier stages of investing, so strategic acquirors, by virtue of their understanding of the firm’s market

sector and their ability to evaluate the firm’s technology, are expert evaluators of the firm’s business.

Because of its bargaining power, a strategic acquiror will be able to demand and receive access to inside

information about the firm (and better access than in connection with a secondary sale). Thus, in Table 1,

we rank the ability of strategic acquirors to resolve information asymmetries as strongly favouring the

32 ? Robert Daines and Michael Klausner, Do IPO Charters Maximize Firm Value? Antitakeover Provisions in IPOs, J, LAW, ECON., & ORG. (forthcoming) (2002).

33 ? Megginson & Weiss, supra note 5.

34 ? Supra, note 9 and accompanying text.

17

acquisition exit.

Secondary Sales

Purchasers in secondary sales are usually strategic acquirors. However, the purchaser of a secondary

block will usually lack the bargaining power of a 100% acquiror to obtain inside information. Clearly, there

will be a great deal of fact-dependency. If the vendor is selling a majority or controlling block, it will usually

have access to inside information that can be provided to potential purchasers. If a minority is being sold,

the situation is more parlous; the VC may not be able to count on the support of the board in obtaining and

using corporate information to sell its interest. More than likely, however, no secondary purchaser would

consider buying into an enterprise without the support of the entrepreneur and the other owners. Where this

is the case, the information flow may be comparable to a situation in which a controlling interest is being

sold.

Nonetheless, because there will be cases in which access to information will be restricted, the

comparative inability of a secondary purchaser to resolve information asymmetries and value the firm is

ranked as slightly disfavouring a secondary sale.

Buybacks

Whether the corporation or a group of insiders actually purchase the VC's shares, the entrepreneur-

insiders are the true buyers. For obvious reasons, the problem of access to information disappears. The

insiders know as much or more about the enterprise than anyone else. They clearly have better knowledge of

their own activities (and proclivities) than anyone else.

It is more than simply access to information that is important in valuing an enterprise, however.

Evaluative skill is also important. Because of lack of business savvy, experience, financial acumen, or

market knowledge, the entrepreneur may not be as capable of evaluating information as a VC or even

knowledgeable outsiders. For this reason, the problem of information asymmetry may persist even in the

face of unfettered access to firm information. Nonetheless, we suggest that the entrepreneur’s access to

information greatly attenuates the problem of information asymmetry, substantially reducing valuation risk.

18

A complete analysis of the ability to overcome information asymmetries cannot, however, ignore a

constituent that will usually play a major “ownership” role following a buyback –the firm’s lenders. A

buyback will typically involve substantial borrowing to retire the VC’s shares. The post-buyout firm will

thus be re-capitalized with a much higher level of debt than prior to the VC exit. The effect of information

asymmetry on the debt holders will be substantial. Banking officers who oversee the administration of

commercial lending facilities are generalists who rarely possess the ability to effectively evaluate high

technology (and/or high growth) companies.35 Perhaps more importantly, lending officers have evaluative

abilities that are grossly inferior to those of VCs. Acting rationally, they will discount their ability to place

an accurate valuation of the enterprise. The result will either be that credit is made unavailable, or made

available only at premium prices.

Moreover, commercial lending has traditionally been based on the ability to take security over

tangible assets, which are often scarce in high tech businesses.36 It is true that a few banks have focused on

lending to high growth companies (sometimes, as in the case of the Silicon Valley Bank, in partnership with

VCs). Some mainstream banks have opened specialty-lending branches that cater to technology

businesses.37 These banks are willing to lend against receivables, and do not require tangible assets.

Nonetheless, in many geographic locales such cutting-edge lending is not available. Even when it is, it will

be restricted to firms with sufficiently generous cash flow to service regular interest payments and periodic

repayments of principal. If a firm does not have such cash flow, then the likelihood of securing debt

financing to retire the VC’s shares will be remote.

Merchant bankers, mezzanine financiers, and leveraged buyout specialists clearly possess a much

higher level of sophistication in evaluating and monitoring their investments. However, such lenders favour

companies both with cash flow and at least moderate growth prospects. They are very unlikely to lend to

living dead or lifestyle investments, which we argue elsewhere in this paper make up the great bulk of share

35 ? Jeffrey G. MacIntosh, The Banks and Innovative Enterprise: Opportunities and Constraints, in RICHARD J. BRAUDO AND JEFFREY G. MACINTOSH, EDS., COMPETITIVE INDUSTRIAL DEVELOPMENT IN THE AGE OF INFORMATION (1999).

36 ? Id.

37 ? See Paul A. Toriel, The Role of Banks in the Financing of Knowledge-based SMEs, in RICHARD J. BRAUDO AND JEFFREY G. MACINTOSH, EDS., COMPETITIVE INDUSTRIAL DEVELOPMENT IN THE AGE OF INFORMATION (1999) at 156. Banks like the Silicon Valley Bank of California, which essentially partner with a VC to overcome these evaluatory deficiencies, are still the exception.

19

buybacks. Moreover, such lenders lack the technology focus of VCs, and will in general possess inferior

evaluative capabilities in relation to the types of firms that VCs invest in. In addition, merchant bankers,

mezzanine financiers, and leveraged buyout specialists focus their attention on companies that are much

larger than the typical buyback firm.

Even when cash flow exists, debtholders will be concerned that the concentration of equity holdings

in the hands of a small number of insiders will furnish the equity holders with a greater incentive to

appropriate wealth from the debt holders, leading to a higher agency cost of debt. 38 Agency costs are

enhanced by information asymmetry,39 leading to an even lower post-buyout firm valuation, and hence a

lower exit price.

Thus, our entry in Table 1 for the effect of information asymmetry on the ability of the new owners

to resolve information asymmetries and value the firm shows separate entries for equity and debt. The new

equity holders will be highly capable of resolving information asymmetries, while the new debt holders will

do so with great difficulty.

B. Ability of New Owners to Monitor the Investment Post-Exit and Discipline the Managers

The willingness of potential new owners to pay to acquire the VC’s interest (or the entire firm) will

depend on the degree to which the new owners are capable of mitigating managerial agency costs.40 The

higher the prospective agency costs, the lower the firm’s valuation by prospective investors,41 and the lower

the VC’s exit value.

The ability to resolve information asymmetry is closely connected with monitoring capability.

Knowledgeable buyers who can critically evaluate the information they receive from management can better

38 ? AMIR BARNEA, ROBERT A. HAUGEN AND LEMMA W. SENBET, AGENCY PROBLEMS AND FINANCIAL CONTRACTING (1985); Paul J. Halpern, Michael Trebilcock, and Stuart Turnbull, An Economic Analysis of Limited Liability in Corporation Law 30 U. TOR. L. J. 117. (1980).39

? Barnea et al., Id.

40 ? Michael H. Jensen & William H. Meckling, Theory of the Firm, Managerial Behaviour, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976).

41 ? Id.

20

determine when the managers are not performing adequately (i.e. can more readily recognize moral hazard

problems).

The ability of the buyer(s) to monitor managers will also depend not only on the identity of post-exit

shareholders and their ability to resolve information asymmetries, in addition to the post-exit configuration

of shareholdings – and in particular whether there are significant block holders and/or controlling

shareholders. In general, managers will be disciplined more effectively by a controlling (and non-

managerial) shareholder than by an unrelated group of small shareholders.42

IPOs

While information asymmetry is mitigated at the IPO stage by the certificatory force of professional

and VC participation, the involvement of these parties either terminates or is attenuated following the IPO.

The investment bank and the firm’s lawyers will conduct intensive due diligence at the time of the offering,

but, barring a major follow-on corporate transaction, will exercise a much lighter hand following the IPO.

The auditors will perform an annual audit, but this does not distinguish the IPO from any other form of exit,

given that most private companies in which VCs invest will also perform an audit.

While VCs usually retain significant post-IPO ownership interests, and often retain a board seat,43

their ability to monitor will be impaired following the IPO. The VC’s ability to supply useful monitoring is

limited by its skill set; VC investors specialize in bringing fledgling private companies to maturity, and then

exiting. The skill set associated with providing useful guidance to a public company clearly contains

overlapping elements, but is sufficiently distinct that great expertise in the former does not guarantee great

expertise in the latter.

The VC’s ability to monitor is also reduced by the disappearance of the VC’s pre-IPO contractual 42 ? Black, supra note 21; Ronald J. Gilson & Reinier J. Kraakman, Reinventing the Outside Director: An Agenda for Institutional Investors, 43 STAN. L. REV. 863 (1991); John C. Coffee, Jr., Liquidity Versus Control: The Institutional Investor as Corporate Monitor, 91 COL. L. REV. 1277 (1991); Bernard S. Black and John C. Coffee, Hail Britannia?: Institutional Investor Behaviour Under Limited Regulation, 92 Mich. L. Rev. 1997 (1994); Jeffrey G. MacIntosh, The Role of Institutional and Retail Shareholders in Canadian Capital Markets, 31 OSGOODE HALL L.J. 371 (1993); Jeffrey G. MacIntosh & Larry Schwartz, Do Institutional and Controlling Shareholders Increase Corporate Value?, in RONALD J. DANIELS & RANDALL MORCK, EDS., CORPORATE DECISION-MAKING IN CANADA (1995) 303.

43 ? Lin & Smith, supra note 25.

21

levers, such as the entitlement to be on the board of directors and a veto power over board decisions.44

The VC’s incentive to monitor on a going-forward basis will also be impaired by its reduced

shareholdings45 and the availability of a market exit option.46 This option is not available prior to an IPO –

thus enhancing the comparative attractiveness of exit over voice. The VC’s incentives to monitor will also be

reduced to the extent that stock market analysts will also supply monitoring services.47 Moreover, the VC

will not anticipate being a long-term investor (i.e. it will reduce and ultimately liquidate its holdings in the

firm, usually prior to the elapse of three years following the IPO48) reducing its incentive to participate in

long term strategic decision-making.

Thus, the impact of shareholder collective action and free rider problems will be more profound

following, than at the time of the public offering.49 These well known problems will adversely affect the

value of the enterprise at the time of the IPO, and hence the price that the public market is willing to pay for

shares in the company.

Skilful underwriters and legal counsel will create governance mechanisms that will combine

restraints and incentives to reduce managerial agency costs post-exit. These may include, for example,

providing for the election of a majority of independent directors, restricting those transactions that may be

consummated without shareholder approval, creating incentive compensation arrangements, and opting out

of anti-takeover provisions in the statute of incorporation.50 Such measures may also include not adopting

value-reducing charter restraints such as cumulative voting and other anti-takeover measures.51 However, it

44 ? Black & Gilson, supra note 1, at 261.

45 ? Id.

46 ? Id.

47 ? Id. at 260.

48 ? See Part III F.49

? See generally Lucian Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 102 HARV. L. REV. 1435 (1992).

50 ? Daines & Klausner, supra note 32.

51 ? Id.

22

is clear that none of these restraints operate seamlessly. For example, the empirical link between the

percentage of independent directors and firm value is tenuous.52 Creating charter restrictions on managerial

activity, or incorporating in states with strict fiduciary duties in order to curb opportunism may actually

reduce firm value.53 Incentive compensation schemes enhance managerial incentives, but imperfectly.54

Daines and Klausner produce empirical evidence that charter restrictions crafted at the IPO stage are

frequently sub-optimal.55 An overwhelming majority of VC-backed firms in their sample adopted some

form of anti-takeover protection (“ATP”), and many of these adopted the most virulent forms of ATP.

Daines and Klausner empirically reject possible efficiency explanations for the inclusion of ATP in IPO

firms. They also produce empirical evidence that the presence of a VC does not materially alter the

probability of that the IPO firm will adopt takeover protection.

Even with optimal charter provisions (and underlying statutory law, embodied in the corporate code

of the jurisdiction of incorporation),56 collective action and free rider problems remain. These problems are

addressed, but far from perfectly remediated by the presence of institutional investors, whose more

substantial shareholding interests create a heightened incentive to monitor.57 A variety of legal and economic

factors blunt institutional oversight, such as cooption of institutional investors by corporate managements.58

52 ? Sanjai Bhagat & Bernard Black, 2000, Board Independence and Long Term Firm Performance, Columbia Law School, The Center for Law and Economic Studies, February, 2000; download available at http://papers.ssrn.com/paper.taf?abstract_id=133808.

53 ? Roberta Romano, Law as a Product: Some Pieces of the Incorporation Puzzle , 1 J. LAW, ECON. & ORG. 225 (1985); Robert B. Daines, Does Delaware Law Improve Firm Value? J. FIN. ECON. (forthcoming) (2002).

54 ? Michael C. Jensen & Kevin J. Murphy, Performance Pay and Top Management Incentives, 98 J. POL. ECON. 225 (1990); Jeffrey G. MacIntosh, Executive Compensation: The Importance of Context, in VALUE FOR MONEY:EXECUTIVE COMPENSATION IN THE 1990s (1996).

55 ? Daines & Klausner, supra note 32.

56 ? ATPs, for example, may be found in the IPO firm’s charter, or furnished by the corporate code in the firm’s state of incorporation. Thus, ATP may be adopted by the appropriate choice of jurisdiction of incorporation. Id.

57 ? Black, supra note 21.

58 ? See Coffee, supra note 42; Black & Coffee, supra note 42, Edward Rock, The Logic and (Uncertain) Significance of Institutional Shareholder Activism, 79 GEO. L. REV. 445 (1991), and MacIntosh, supra note 42, for a theoretical and practical discussion of the shortcomings of institutional oversight.

23

The empirical link between institutional shareholder activism is still tenuous.59

Another factor tending to the remediation of agency costs is that an IPO generally involves the sale

of a minority interest to public investors,60 leaving a controlling shareholder or coalition of shareholders in

place.61 The existence of a controlling shareholder(s) will result in enhanced discipline of managers, because

the controlling parties will possess the unilateral power to discipline the managers. The extent of this

discipline, however, will depend on whether control is split between a variety of shareholders, in addition to

the identity of the controlling shareholder(s).62 Following the IPO, control will often reside not in a single

shareholder, but in a coalition of shareholders.63 The control coalition may be subject to coordination,

collective action and defection problems.

Perhaps more importantly, the managers themselves will usually form a significant part of the

controlling coalition,64 or may indeed control the firm themselves.65 This may exacerbate, rather than

ameliorate agency problems.66 While the empirical evidence is not entirely consistent, it appears that there is

no simple linear relationship between managerial share ownership and firm value. For example, one

frequently cited study suggests that as managerial ownership increases, the value of the firm rises, falls, and

59 ? Op. Cit.

60 ? Following a typical offering, only about 30 per cent of the shares will be in the public float. Gompers & Lerner, supra note 4, at 272; Daines & Klausner, supra note 32.

61 ? Barry et al., supra note 5 at 491 (Table 6), found that following an IPO, the holdings of all venture capital investors had a mean of 24.6% and a median of 22.6% of the firm’s shares. They also found that prior to the IPO, VCs in the aggregate held (on average) one-third of all board seats, and that they mostly continued to hold their board seats following the IPO. The findings of Daines & Klausner, supra note 32, are broadly similar. They find that following an IPO, VC investors had a mean of 37.5 percent of the firm’s equity, and the top five managers 18.9%. The total post-IPO director and officer holdings were 45.4%. However, Gompers & Lerner found that employees and management on average retained only between about seven and 12% of the equity of firms going public; see Gompers & Lerner, supra note 4, at 224. See also Marco Pagano, Fabio Panetta, & Luigi Zingales, Why Do Companies Go Public? An Empirical Analysis, 53 J. FIN. 27 (1998).

62 ? See infra, Part III G.

63 ? Id.64

? Supra note 38.

65 ? Id.

66 ? Id.

24

then rises again.67 Another suggests that it rises, levels off, and then decreases.68 In both cases, the studies

suggest that the enhanced alignment of managerial and shareholder interests that is created by increasing

managerial share ownership is offset by management’s ability to entrench itself in power.

In addition, a consistent finding in the finance literature is that, on average, firm profitability falls

following an IPO.69 While this finding cannot unambiguously be attributed to monitoring problems (it may

extend, for example, from reduced managerial incentives resulting from reduced managerial shareholdings70),

it is certainly suggestive. In Table 1, we thus suggest that the ability of new owners to monitor and

discipline the managers will either slightly or strongly disfavour the use of an IPO exit.

Acquisitions

In an acquisition exit, the acquiror obtains 100% of the equity of the firm. Thus, it has both the

incentive, and the ability (through its control of the board, and the ability to pass shareholder resolutions) to

monitor the managers closely. In Table 1, we thus suggest that the strategic acquiror’s heightened ability to

monitor and discipline management favours an acquisition exit.

Secondary Sales

Purchasers in secondary sales will usually be strategic acquirors (and sometimes venture capitalists).

These entities have a high level of sophistication in evaluating high growth companies. Nonetheless, they

will not have the same ability to monitor and discipline the managers as in the case of a 100% acquisition.

Very often, the vendor will be a minority shareholder. Hence the buyer will not acquire either de jure or de

facto control of the board. This removes from the acquiror’s control a variety of informational, investigative

and disciplinary tools that are available to a controlling shareholder or single owner. For example, a

67 ? Randall K. Morck, Andrei Shleifer & Robert W. Vishny, Management Ownership and Market Valuation, 20 J. FIN. ECON. 293 (1998)

68 ? John J. McConnell & Henri Servaes, Additional Evidence on Equity Ownership and Corporate Value , 27 J. FIN. ECON. 595 (1990).

69 ? Pagano et al., supra note 61; Francois Degeorge & Richard Zeckhauser, The Reverse LBO Decision and Firm Performance: Theory and Evidence, 48 J. FIN. 1323 (1993); Bharat A. Jain & Omesh Kini, The Post-Issue Operating Performance of IPO Firms, 49 J. FIN. 1699 (1994); Wayne H. Mikkelson, Megan Partch, & Ken Shah, Ownership and Operating Performance of Companies that Go Public, 44 J. FIN. ECON. 281 (1997).

70 ? An offset will be an enhanced ability to craft compensation arrangements. See infra, section III.G.1.

25

minority shareholder has no formal access to directors’ meetings or the minutes of such meetings. A

minority shareholder will have limited ability to investigate the performance of management, absent the

cooperation of the controlling shareholders. A minority shareholder will be unable, by itself, to remove

management. Depending on the size of its holding, a minority shareholder may also lack a power of

negative control; that is, the power to block resolutions requiring supra-majority confirmation.

Added to this, a non-controlling VC will have carefully nurtured a relationship with the entrepreneur

and other shareholders. In a successful venture capital investment, the VC will seldom if ever have to resort

to its formal powers as a shareholder or director; it will exercise informal powers of persuasion by virtue of

its amicable relationship with the entrepreneur. This relationship will ensure that powers not formally

granted to the VC will nonetheless be available informally, such as access to information and management’s

ear on matters of policy and management.

By contrast, the purchaser of the VC's shares will have no pre-existing relationship with the firm’s

non-selling shareholders. It will thus not - at least immediately - have the same leverage over management

as the departing VC. Even if it negotiates a contractual novation of the selling VC’s levers over management,

such as the power to veto board decisions, it will not immediately command the same informal persuasive

powers as the departing VC (although the VC may be departing either because it failed to negotiate suitable

contractual levers, or was dissatisfied with its ability to exercise informal powers of persuasion over the

entrepreneur).

These factors account for the buyer’s usual preference for a 100% acquisition rather than a secondary

purchase of the VC's shares alone. Thus, in Table 1, we suggest that monitoring and disciplinary

considerations operate to slightly or strongly disfavour a secondary sale.

Buybacks

On its face, the buyback gives the firm’s new owners both the incentive and the ability to monitor

managers, because the new equity owners are the managers. This greatly attenuates the agency costs of

equity and creates a potent incentive for the entrepreneur/managers to manage the firm’s assets profitably.

Further, the entrepreneur and/or firm will usually have to borrow money to purchase the VC'S

shares, substantially enhancing the debtload. High levels of fixed payments of interest and principal act as a

26

discipline on management.71

However, a complete analysis of the new owners’ monitoring capabilities cannot ignore a number of

additional factors. One is that the buyback jettisons a specialized monitor (the VC), and substitutes a non-

specialized and much less skilled monitor – the firm’s banker. As noted earlier, commercial banking officers

have limited skill in monitoring their debtor companies.72 This may allow the entrepreneur to indulge a taste

for leisure in a manner that she was unable to do while the VC was on board. Indeed, anecdotal evidence

accumulated from our discussions with VCs suggests that a buyback often evidences a fundamental

breakdown in the entrepreneur/VC relationship. A buyback is frequently triggered by the VC pursuant to put

rights reserved in the original deal documentation.73 It will typically exercise such rights when it is of the

view that the investment no longer has significant upside potential. The underlying cause may purely be a

function of the nature of the firm’s technology and the market in which it competes, but it may also be a

function of the differing preferences of the entrepreneur and VC. Post-buyback, the entrepreneur may be in a

position to indulge a taste for leisure in a way that she was unable to do when the company had active

minority investors. Put somewhat differently, she may be less interested in becoming fabulously wealthy

than in running a "lifestyle" company; i.e. one that furnishes profits that are adequate to pay the interest on

the firm's debt and provide a reasonable return without the extraordinary commitment generally demanded

by a VC. Needless to say, the VC’s preference is quite different; a VC seeks to groom the firm for a “home

run” – a huge upside payoff. The occurrence of a buyback is evidence that the entrepreneur’s and VC’s

objective functions have parted company, perhaps because the VC initially failed to appreciate the

entrepreneur's work/leisure preferences. If so, the managers may be less motivated after the buyout than

before.

The departure of the VC may not be the end of external monitoring, however. Other VCs may retain

their interests. There may be a variety of other active investors, including angel investors. When VCs,

angels or other active investors remain on board, the entrepreneur’s ability to indulge a leisure preference

will be constrained. Alternatively, if some active investors remain aboard, but they are less demanding than

71

? Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AMER. ECON. REV. 323 (1986).

72 ? Supra notes 35-39 and accompanying text.

73 ? Barry et al., supra note 5.

27

the departing VC, the buyback may constitute a middle ground between a VC-dominated firm (in which the

leisure preference is constrained) and an independent, management-owned firm (in which it is not).

A buyback exchanges equity for debt financing. Because the firm’s debt/equity ratio will be high

following the buyback, it is important to examine the governance properties of debt in addition to equity.

We suggested earlier that the ability of debt financiers to monitor and discipline the managers will be no

better than their ability to resolve information asymmetries and value the firm.74

Thus, we suggest in Table 1 that the governance properties of equity strongly favor a buyback,

while the governance properties of debt strongly disfavor a buyback.

Summary

Public markets are characterized by well-known collective action and free rider problems,

exacerbating agency problems. By contrast, following an acquisition exit, the purchaser possesses both

the incentive and the means to monitor and discipline management. We thus suggest in Table 1 that the

post-exit governance properties attending an acquisition exit will favor an acquisition, while slightly or

strongly disfavoring an IPO, as compared to other means of exit.

In a secondary sale, the identity of a significant blockholder changes. We suggest that, lacking

the VC’s long-standing relationship to the entrepreneur, it will be comparatively more difficult for the

buyer to use its blockholding to effectively monitor and discipline managers. We thus suggest that

governance issues slightly or strongly disfavor a secondary sale.

Buybacks present a more difficult case. A buyback essentially eliminates information

asymmetries and concentrates equity ownership in the hands of the managers, providing the managers

good incentives to lower agency costs. Moreover, the buyback typically involves adding significantly to

the firm’s debt burden, which operates as a discipline on management. However, we also suggest that

specialty lenders like merchant bankers, mezzanine financiers, and LBO specialists will be unlikely to

supply debt financing, leaving commercial banks as the most likely source of additional debt. However,

commercial lending officers are neither specialized nor highly skilled monitors. Moreover, banks are in

74 ? Id.

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the business of making low-risk loans to borrowers that have either tangible assets or receivables as

collateral, and unless the firm is a cash cow, it may be expensive or impossible to secure debt financing

to replace the VC’s equity. Added to this, the concentration of equity holdings increases the agency costs

of debt. Thus, on balance, the governance properties of a buyback neither favor nor disfavor a buyback.

C. Black and Gilson’s Implicit Contract Theory

In a very interesting paper, Black and Gilson75 show IPOs facilitate an implicit contract of

transferring control back to the entrepreneur. This is also true in the case of buybacks, where the

entrepreneur repurchases the venture capitalist’s interest. In an acquisition exits, however, the entrepreneur

does not regain control, suggesting that acquisitions may be a less attractive exit vehicle from the perspective

of an entrepreneur. Transfer of control is indeterminate in the case of secondary sale exits.

D. The Transaction Costs of Effecting a Sale of the VC’s Interest

The transaction costs of effecting a sale of the VC’s shares will be a factor that influences the exit

price. Whether the seller or the buyer bears the burden in the first instance, all transaction costs will be

passed back to the seller, since they either diminish the value of what is being sold, or increase the buyer’s

purchase price. Thus, higher transaction costs are associated with lower proceeds of sale.

In general, transaction costs will fall under some or all of the following headings: the cost of

identifying potential purchasers and marketing the shares; the cost of assembling information to enable the

buyer(s) to evaluate the purchase; the cost of negotiating contractual arrangements ancillary to the sale; the

cost of amending the firm’s constating documents to enable the sale (e.g. in order to recast governance

arrangements); the cost of changing the default law that applies to the firm by changing the jurisdiction of

incorporation; the cost of board deliberations in respect of any or all of the above or of other matters (such as

debating discretionary share transfers in the case of private corporations). At the risk of double counting,76

we also include the price discount associated with information asymmetry. Some of these costs are

unavoidable, such as negotiating a price. Other costs, such as those associated with amending the firm’s

constating documents, or reincorporation in another jurisdiction, are elective.

75 ? Supra, note 1.

76 ? See supra, Part III.A.

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Transaction Costs of Selling Following an IPO

A sale of shares in a public company entails three forms of transaction costs; the cost of brokerage,

the cost of price pressure on the price received for the shares, and the cost of any signalling effect on the

price of the shares. The sum of these costs can vary enormously. While brokerage costs are minimal, price

pressure and signalling costs can be substantial.

Price pressure results when the seller’s broker must lower the price below the posted market price to

attract enough buyers to liquidate the seller’s holdings. The likelihood of price pressure depends on the size

of the block being liquidated relative to the public float of shares. If the ratio is high, price pressure can be

substantial.77

Signalling costs arise when the market attributes informational content to a sale of shares by an

insider; i.e. the market believes that the insider is selling because it is in possession of negative information,

which lowers the price at which purchasers are willing to buy.78 These too can be substantial.79

A full enumeration of the transaction costs of a sale of public firm shares, however, must take into

consideration the transaction costs of effecting the IPO. These costs are necessarily incurred to facilitate the

post-IPO sale of the VC’s shares. They have the effect of diminishing the value of the firm, and hence the

price that the VC will receive for its shares. These costs include:

1. the underwriter’s commission, which will probably be no less than 4% of the issue

proceeds, and may be 8% or more for an IPO issuer;80

77 ? Gompers & Lerner, supra note 4, at 263-287.

78 ? Stuart C. Myers & Nicholas Majluf, Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have, 13 J. FIN. ECON. 187 (1984).

79 ? A key reason for the success of electronic trading networks is that they allow large block traders in general, and institutional traders in particular, the opportunity to unwind their positions without significant signaling effects. See generally Jonathan R. Macey & Maureen O’Hara, Regulating Exchanges and Alternative Trading Systems: A Law and Economics Perspective 28 J. LEG. STUD. 17 (1999).

80 ? There is a danger of double counting, insofar as the underwriter’s commission will reflect many of the other costs discussed infra. However, those further items noted immediately below reflect costs borne by the selling shareholder either directly, or indirectly through the cost borne by the issuing corporation. For the issuer,

30

2. the accounting costs necessary to put the firm’s information systems into a “market

ready” condition;

3. the legal, accounting, printing and other associated costs of producing the registration

statement and other documents required by securities regulators;

4. the cost of marketing the issue;

5. listing fees;

6. in Canada, the cost of translating the prospectus into French, if the offering is to be

made in Quebec.

7. the indirect cost that results from underwriter underpricing of the issue, which averages

15.3% in the U.S. and 9.3% in Canada;81

8. the set-up cost of hiring new staff to deal with public company requirements such as

compliance with continuous disclosure requirements and investor relations, etc.;

9. the opportunity cost that arises as a result of the diversion of management and other

personnel away from business matters, including time spent meeting with lawyers,

accountants, and others to assist in the preparation of the registration statement,

participating in road shows, etc.

Note that other costs associated with running a public company (as opposed to a private company), both

transactional and otherwise, are dealt with in the immediately following section.

Transaction Costs of Selling Shares in a Private Company: A Comparison

the opportunity cost resulting from diversion of management and employee talent almost certainly exceeds the direct cost. See generally MacIntosh, supra note 42.

81 ? Tim Loughran, Jay Ritter and Kristian Rydqvist, Initial Public Offerings: International Insights PACIFIC BASIN FIN. J. 165 (1994).

31

A special set of interrelated problems inheres in selling shares of private companies. Shares of

private companies are far less liquid than shares in public companies, because of the absence of a ready-made

market for the firm’s shares. This illiquidity is enhanced by virtue of the fact that share transfers in private

companies must typically be approved by the board of directors. Relatedly, small corporations are often

characterized as incorporated partnerships. That is, while nominally organized as corporations, a close

working relationship between the various shareholders – akin to a partnership - is typically important to the

success of the enterprise. This is in part a consequence of the fact that shareholder and managerial roles

overlap to a considerable degree, so that the shareholders must work together as managers. Even when this

is not the case, it is important that management and non-management shareholders share a strategic vision

for the corporation and be able to work cooperatively, failing which the enterprise may disintegrate in

acrimony and litigation. Thus, the decision of whether to admit new owners (and the decision of potential

new owners to seek admission) involves interpersonal factors that are not implicated (or implicated at a

lower level of intensity) in the case of public corporations.

The requirement for board approval of share transfers discourages trading in small lots. Thus,

investment in a private company typically involves a higher level of committed capital than investment in a

public company. Thus, the universe of potential buyers is restricted to those who are wealthy enough to be

able to fully diversify the risk of a relatively large holding. This further impairs liquidity, which is an

important component of share value.82

In addition, securities laws frequently restrict the sale of shares in private companies to designated

categories of exempt purchasers; i.e. purchasers who are permitted to buy securities without the requirement

that the issuer prepare a registration statement.83 The resale of shares in private corporations is also restricted

so as to reduce the danger of a “backdoor underwriting”, in which the issuer uses an exempt purchaser to

funnel securities to non-exempt purchasers. In the United States, resale restrictions typically extend two

years beyond the date of issuance.84 In Canada, they can be even more onerous. In Ontario, for example,

82 ? See infra parts III.E and F.

83 ? See e.g. Rule 144, 17 C.F.R. § 230.144; Securities Act (Ontario), R.S.O. 1990, c.S.5, s.72, as augmented by Ontario Securities Commission Rule 45-501 ((2001) 24 OSCB 7011) and Multilateral Instrument 45-102 ((2001) 24 OSCB 7029) (neither of the latter instruments, however, being in force in Ontario during the period covered by our data).

84 ? Rule 144, id.

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while the “hold period” for restricted shares was recently reduced to a maximum of 12 months, 85 it does not

start to run until the issuer goes public. Prior to the elapse of the pertinent hold period, securities may only

be resold to other exempt buyers. This greatly reduces the liquidity of private company shares and hence the

potential market for these shares (and the price at which they can be sold).

Overall, however, we do not believe that the transaction costs of selling an interest in a private

company will be comparable to those experienced in an IPO. Aside from liquidity factors described above,

all the elements of selling shares in a private company are replicated in the going public process – but on a

grander scale. The issuer’s and underwriter’s legal counsel, junior and senior officers, accountants, auditors

etc. will be engaged in an intensive process that will last at least several weeks and possibly several months.

Going public will generally require much more disclosure than will be required on a private sale and

extensive massaging of the company’s information systems (including preparation of historical accounting

records), and other changes to the company’s constating documents and structure that are either not required

on a private sale, or required at a lower threshold.

Moreover, once the company has been public for several months or years, the purchaser’s

information risk will be considerably lower than in respect or a private company. In the public market, share

prices reflect the heterogeneous opinions of different market traders.86 In an efficient market, the price is the

best estimate of the intrinsic value of the firm. Buyers of public firm shares thus free ride on the efforts of

other shareholders in determining value. By contrast, in a private company, the buyer must rely on its own

resources in valuing the firm. Private company valuations are thus inherently more risky.

In Table 1, we thus suggest that transaction cost considerations will favour a private sale of the VC’s

interest, rather than a public sale. We make no distinction in the transaction costs attaching to various

different forms of private sale (secondary sale and buybacks). This is not because we believe that no

material differences exist. For example, a negotiated buyback involves only one seller and one buyer, thus

raising bilateral monopoly problems that will complicate negotiations. By contrast, a secondary sale that

involves one seller but many possible buyers will not. However, we believe that the transaction costs of

various forms of private sale will be highly fact contingent, and will depend on such factors as the

85 ? Ontario Commission Rule 45-501, Multilateral Instrument 45-102, supra note 82.

86 ? Ronald J. Gilson & Reinier Kraakman, The Mechanisms of Market Efficiency, 70 VIR. L. REV. 549 (1984).

33

configuration of shareholdings, the personalities of the negotiating parties, the existing nexus of contracts

binding the various parties, and other factors. Thus, we decline to speculate on the relative transaction costs

attending different forms of private sale.

E. Ongoing Costs of Operating as a Public, as Opposed to a Private Firm

The IPO is the only form of exit that results in the company operating as a public firm. This results

in costs that are not borne by private firms. These costs will be capitalized and factored into the price at

which the firm sells its shares to the public, and will thus affect the VC’s exit value. They include:

1. the ongoing costs of regulatory compliance for public issuers, including both direct costs

(e.g. maintaining dedicated staff) and opportunity costs (e.g. diversion of managerial time);

2. loss of confidentiality as a result of regulatory requirements to disclose material

information in the registration statement, and to disclose material developments in the life

of the firm on an ongoing basis;

3. slowed decision making, especially with respect to corporate fundamental changes

requiring shareholder approval and/or stock exchange, regulatory or court approval;

4. exposure to strike suits designed to extort a settlement from the firm,87 and to other forms

of frivolous or vexatious litigation;

5. adverse changes in the firm’s opportunity set as a result of pressure from analysts and

institutional investors to achieve short-term results.88

87 ? Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 STAN. L. REV. 497 (1991). But see also Joseph A. Grundfest, Disimplying Private Rights of Action Under the Federal Securities Laws: The Commission's Authority, 107 HARV. L. REV. 961 (1994); Joel Seligman, The Merits Do Matter: A Comment on Professor Grundfest's "Disimplying Private Rights of Action Under the Federal Securities Laws: The Commission's authority" 108 HARV. L. REV. 438 (1994).

88 ? Whether pressure from analysts and institutional investors leads to management myopia is a subject of some controversy. See e.g. Ronald M. Giammarino, Patient Capital? R&D Investment in Canada, in RONALD J. DANIELS & RANDALL MORCK EDS., CORPORATE DECISION-MAKING IN CANADA (1995) 575.

34

Clearly all of these costs make the IPO a less favourable form of exit than would otherwise be the

case, when compared to a private exit.

F. The Liquidity of the Investment to the Buyer

In the strict sense, liquidity refers to the ability of a buyer or a seller to effect a sale at or near the last

transaction price.89 Immediacy refers to the ability of the buyer or seller to effect a sale quickly.90 Liquidity

is also frequently used, however, as an overarching term that embraces both liquidity, in the strict sense, and

immediacy. It is the broader sense that we use the term in this article.

Liquidity is of value to investors;91 recent empirical work confirms that it is a priced attribute of

securities.92 An exit that provides an investor with a relatively liquid investment will thus enhance the value

of the investment to the buyer, and derivatively increase the VC’s exit price.

Of the different exit techniques, only the IPO provides the new owner(s) with a high degree of

liquidity. Shares of a public firm (with some variation depending on the depth and breadth of trading) can be

freely sold into the public market at or near the last transaction price, and with speed relative to the sale of

shares of a private company. As noted in Part C above, the shares of private companies are typically illiquid

by comparison. In sum, the factor of liquidity to buyer favours sale via an IPO.

G. The Liquidity of the Consideration Received by the VC: The VC’s Cash Preference

VCs often say that "Cash is King". This homily expresses the VC's preference for an exit that yields

cash consideration. In this section, however, we use the word “cash” to refer not merely to currency, but

near-currency as well; i.e. interests that can readily be converted into currency, such as the shares of a liquid

89 ? Macey & O’Hara, supra note 78.

90 ? Id.

91 ? Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. FIN. ECON. 223 (1986); Yakov Amihud & Haim Mendelson, The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size on Stock Returns, 44 J. FIN. 479 (1989).

92 ? Michael J. Brennan, Tarun Chordia & Avanidhar Subrahmanyam, Alternative Factor Specifications, Security Characteristics, and the Cross-Section of Expected Stock Returns, 49 J. FIN. ECON. 345 (1998).

35

public company (although we note that a slightly different usage is employed in Table 1 to conform to the

manner in which our data was collected).

A cash exit is preferable for a number of reasons. When the fund termination date arrives, the

limited partners will prefer to receive their returns in a liquid form, giving them maximum flexibility in re-

deploying the proceeds of their investment (or in paying out the proceeds to their own owners).

In addition, prior to the termination of the fund, a cash exit allows the VC to re-deploy the capital.

In some circumstances (and particularly where the exit is made early in the life of the fund) re-deployment is

more attractive than holding cash, because VCs bring value to their investments by engaging in active,

hands-on management. They have no particular advantage in acting as cash custodians or in administering

purely passive investments. Once the VC's skill set has been exhausted, it makes sense to cash out and move

on to further active investments.93

Reinvestment is sometimes constrained, however, by the VC’s contract with its limited partners,

which may forbid re-investment save with the approval of the advisory board or the limited partners, or

within a restricted period of time following the fund’s inception.94 Such provisions are designed, in part, to

ensure that the VC does not re-invest late in the fund’s life cycle, with the result that the investment cannot

be harvested at the termination date and the VC has no choice but to seek an extension of the partnership, sell

the investment on disadvantageous terms, or distribute illiquid securities to its limited partners.95

IPOs

An IPO exit is generally a superior way for the VC to dispose of its interest for cash, although most

“cash” distributions following IPOs consist of distributions of shares of the public company, rather than the

93 ? Lin and Smith, supra note 25.

94 ? Gompers and Lerner, supra note 4, 39 and 43 (Table 3.1). 95 ? Gompers and Lerner provide a number of reasons why the VC might opportunistically reinvest late in the fund’s life cycle. These are: a distribution of profits might reduce VC fees by reducing capital under administration; reinvested capital may yield greater profits; extension of the limited partnership will result in the VC continuing to earn fees from the fund. Id., note 11, at 39. The first and third seem to be genuine instances of opportunistic behaviour. However, the second may in fact merely evidence an alignment of interest between the VC and the limited partners.

36

cash proceeds of sale96. The VC will not generally sell its shares at the time of the IPO97 by means of a

secondary offering qualified under the prospectus. Lin and Smith, for example, find that only slightly more

than a quarter of lead VCs sell any shares at the time of the IPO. When they do, they sell an average of

only 20.4% of their shares.98 Post-IPO, they continue to hold substantial interests in the firm. Lin and

Smith find that the average post-IPO holding of all VCs is 20.7%, and 17.7% when the lead VC sells shares

in a secondary offering at the time of the IPO.99 Other studies produce similar results.100

It is in the mutual interest of the VC and the underwriter that the VC not sell shares into the IPO.

Sale of shares might convey a signal that the VC lacks confidence in the firm’s prospects, and/or believes

that the sale price is too high.101 In addition, if the VC resiles from the firm at the time of the public market

offering, public investors will be deprived of the benefit of the VC’s continued monitoring of management.102

The VC and the underwriter will thus typically enter into a “lockup” arrangement that contractually restricts

VC sales at the time of, and for some period of time following the IPO. This contract legally enforces, and

therefore makes credible the VC’s promise not to sell. In the United States, the contractual lockup period is

typically six months following the offering, although it may be as long as two years.103

Even after the elapse of the escrow period, however, many VCs hold their shares for months or

96 ? Such distributions in kind are effected for a variety of regulatory, tax, and economic reasons. See Gompers & Lerner, supra note 4, 263 et seq. While the extent to which a share distribution mimics cash will depend on the depth and breadth of the trading in the company’s shares, an IPO will generally supply the VC (and derivatively its limited partners) with consideration that is liquid compared to other forms of exit.

97 ? Lin & Smith, supra note 25.

98 ? Id.

99 ? Id.

100 ? See supra note 61.

101 ? Lin & Smith, supra note 25; Gompers & Lerner, id. at 266; Megginson & Weiss, supra note 5; Douglas Cumming & Jeffrey MacIntosh, The Extent of Venture Capital Exits: Evidence from Canada and the United States, in JOE MCCAHERY & LUC RENNEBOOG, VENTURE CAPITAL CONTRACTING AND THE VALUATION OF HIGH TECH FIRMS (forthcoming 2002).

102 ? Barry et al., supra note 5.

103 ? Gompers & Lerner, supra note 4, at 209; Lin & Smith, supra note 25.

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years.104 Barry et al, for example, found that while the post-IPO mean holding of the VCs in their sample

was 24.6% (with a median of 22.6%, one year after the offering, the mean holding was 17.8% (and the

median 14.1%).105

In Canada, regulatory hold period and escrow requirements have historically been more restrictive

than those in the U.S., and may prevent the VC from selling its shares into the market for a period that

ranges from six months to in excess of five years, although the norm is within a range of six months to two

years.106 Anecdotal evidence suggests that regulatory approvals are often granted to permit sales prior to the

elapse of the escrow period. Because, as noted, many U.S. VCs continue to hold even after the expiry of the

escrow period, it is not clear to what extent the added layer of regulation in Canada makes it more difficult

for Canadian VCs to liquidate their investments following the IPO.107

Canadian VCs are sometimes able to do an end run around the escrow requirements by causing their

investee companies to go public via an American exchange such as NASDAQ, thus taking advantage of the

shorter escrow period. This will not, however, affect the duration of applicable hold periods, if the shares

were initially issued pursuant to an exemption from the prospectus requirement under Canadian legislation.

To the extent that an American IPO results in the issuer reincorporating in the U.S. – a factor that is said to

enhance marketability – potentially onerous tax liabilities are triggered.108 These factors limit the

attractiveness of the end run. Indeed, it would appear that the vast bulk of Canadian firms effecting IPOs do

so in Canada.109 On balance, our best guess is that the added regulatory burden in Canada results in a lower

104 ? Gompers & Lerner, id., at 266; Lin & Smith, id.; Barry et al., supra note 5; Megginson & Weiss, supra note 5.

105 ? Barry et al., id.

106 ? MacIntosh, supra note 14. The Canadian Securities Administrators, an informal body consisting of all of the provincial and territorial securities administrators, has recently agreed upon a uniform national hold period ranging from four to twelve months after (with some oversimplification) the later of the date upon which the company went public, and the say on which the exempt securities were initially sold. This has now been enacted into law in Ontario, the focal point of Canada’s capital market. See MI 45-102, supra, note 82.

107 ? Cumming & MacIntosh, supra note 100.

108 ? A reincorporation outside of Canada results in a deemed disposition of assets, resulting in the levying of capital gains taxes. See Income Tax Act (R.S.C. 1985, c. 1 (5th Supp.)), s.232.

109 ? While no precise data appears to be available on this issue, our discussions with investment bankers suggest that this is in fact the case.

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degree of liquidity for VC holdings.

Why might a VC choose to hold, even following the elapse of escrow and hold periods? If the

market for the firm’s securities is illiquid, the VC may effectively be locked in because of potentially serious

price pressure (lowering the sale price below the posted market price) should it choose to sell.110 In an illiquid

market, the market is also more likely to attribute informational content to the sale (i.e. that the seller is

selling on bad information), given that illiquid markets are characterized by relatively poor information, and

any given quantum of new information will be accorded enhanced importance by market traders.111

As noted above, even in a liquid market, reinvestment of the proceeds of sale of the VC’s shares

may be impossible under the terms of the VC-limited partner contract, attenuating the incentive to exit.112

Even in the absence of such contractual restrictions, a VC concerned to maintain a good reputation will be

concerned that reinvestment will convert a liquid asset fit for distribution into an illiquid asset unsuitable

either for exit or distribution.

Finally, the VC may simply choose to hold shares when it believes that the prospective stock market

gains outweigh the gains from reinvestment. Consider, for example, a situation in which the stock market is

rising rapidly, and the VC believes that, although stock market values are inflated and divorced from

underlying fundamentals, psychological factors will continue to drive the market higher. If the VC also

believes that the price of new investments is correspondingly inflated, then the wisest course might be to

maintain the existing investments, and attempt to sell these investments at or near the market peak.

Empirical evidence explored further below suggests that VCs are indeed good at exiting their portfolio firms

at market peaks.113

We indicated above that VCs start to unwind their interests in the first year after the IPO but

110 ? Gompers & Lerner find that distributions of shares to investors are associated with substantial drops in share prices, which they attribute to price pressure. See Gompers & Lerner, supra note 4, at 263-287.

111 ? See e.g. Avner Arbel, Generic stocks: an old product in a new package (Summer 1985) J. of Port. Man. 4 (1985); Avner Arbel, Steven Carvell and Paul Strebel, Giraffes, Institutions, and Neglected Firms, (May-June 1983) Fin. Anal. J. 57 (1983).

112 ? Supra, notes 91-92 and accompanying text. 113 ? See infra, section III.L.

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nonetheless retain substantial blocks. What happens to the VC’s ownership interests after a year? Lin and

Smith find that by three years following the IPO (or such longer period as was necessary to locate a publicly

filed proxy statement), most VCs in their sample were completely disinvested. Lead VC investors were still

listed as blockholders in proxy statements only 12.3% of the time, and in these cases they held only 1.4% of

the shares outstanding (compared to 12.1% immediately after the IPO).

Thus, while many VCs remain invested for a period of some months, or even a year or two

following the IPO, these interests will then be unwound. Initial VC ownership retention is thus not

inconsistent with the view that the IPO yields a relatively liquid exit for the VC. It merely emphasizes that

liquidity is constrained by a variety of factors, including the VC-limited partner contract, legislative

requirements, stock exchange rules, and other factors such as the life cycle of a VC fund. Thus, in Table 1

we suggest that an IPO is favoured for liquidity reasons (keeping in mind that this is in comparison to other

forms of exit).

Acquisitions

In some circumstances, an acquisition exit will supply the selling VC with liquidity that exceeds that

realized following an IPO. Consider, in particular, a case in which the acquiror pays in cash for the shares

(or the assets) of the EF, in the broad sense noted above - meaning either currency or shares of a highly

liquid public company (typically shares in the acquiror itself). In this case, the selling VC either receives

currency directly, or can readily sell the shares it receives for currency without significant price pressure

(depending on the size of its holding) or signalling impact.114 Hold periods and escrow requirements do not

typically come into play.115

The acquiror, however may not be a liquid public company, and thus unable to supply liquid shares

114 ? Since the acquiror will typically wish to acquire 100% of the EF (i.e. it will rule out VC ownership retention), it will be more difficult for the market to interpret the VC’s immediate exit as a lack of confidence in the firm. Indeed, any negative signal arising from the sale of the VC’s shares is counterbalanced by the positive signal emanating from the strategic acquiror’s purchase of the firm.

115 ? For example, in Ontario, during the period covered by our data, shares received by the VC in an acquisition effected by a merger between the acquiror and would be freely tradable as long as the acquiror had been a “reporting issuer” in Ontario for a year. OSA s.72(5). A public firm that had not filed a prospectus with Ontario regulators and was not listed on the Toronto Stock Exchange might not qualify as a reporting issuer in Ontario. However, since the shares received by the VC and other corporate insiders would not be legended, as a practical matter such shares would effectively be freely tradable.

40

as consideration. It may also be a private company without a public market for its shares. Thus, the ability

of an acquisition exit to supply cash will depend on the characteristics of the acquiror. For this reason, in

Table 1 we suggest that while an acquisition exit may provide the greatest liquidity, the ability to supply cash

is subject to considerable variation.

It is noteworthy that Canadian Labour Sponsored Venture Capital Corporations,116 which administer

approximately half of the venture capital funds in Canada, are constrained under their governing legislation

to invest only in “eligible investments”, which excludes shares in a foreign (including U.S.) corporation.

This can have the effect of reducing the VC’s exit price by forcing it to accept consideration in currency that

is less than the nominal amount of corporate shares that it might otherwise have received.

Secondary Sales

In a secondary sale, the purchaser will usually be a strategic acquiror. Thus, for the reasons explored

in the immediately preceding section, secondary sales may or may not supply cash.

Buybacks

The purpose of a buyback is to cash out the VC; definitionally, the EF will thus not offer the VC

share consideration. It will borrow money to effect the buyback, replacing equity with debt. Thus, on its

face, a buyback will yield a cash exit.

This statement must be qualified, however, given that buybacks are frequently only partial in nature;

i.e. they involve the purchase of only part of the VC’s interest.117 Moreover, payment is often staged over a

period of months or years. This again suggests that the EF is often a living dead investment, and the

entrepreneur will have limited resources (including borrowing capacity) to effect the buyback. Thus, in

reality, most buybacks promise only partial liquidity.

Summary

116 ? See infra Section V.A. for a description of Labour Sponsored Venture Capital Corporations.

117 ? Cumming & MacIntosh, supra note 100.

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In the U.S., the VC’s quest for cash points to the IPO as a preferred means of exit, although U.S.

VCs will experience greater liquidity than Canadian VCs. Acquisition exits may in some circumstances

offer even greater liquidity, if the acquiror pays cash. However, this is subject to considerable variation

depending on the nature of the acquiring firm. In both the U.S. and Canada, secondary sales are similar to

acquisition exits in their ability to yield cash. While a buyback supplies only currency, many buybacks are

only partial, and payment will occur only over a period of months of years. Thus, the reality is that

buybacks supply only partial liquidity.

H. Managerial Incentives

1. Incentive Compensation and Stock Ownership as Managerial Motivators

Another factor that a buyer will take into account in determining its willingness to pay for the VC’s

shares is the extent to which management’s incentives are aligned with shareholder interests following the

purchase. The extent of this alignment (or misalignment) will be factored into the buyer’s willingness to

pay, and hence into the VC’s exit price. In what follows, we compare the ability to craft appropriate

incentive arrangements following different types of VC exit.

It is now well understood that managerial incentives can be enhanced by incentive compensation

devices such as stock options.118 Another factor that aligns management’s interest with that of shareholders

is managerial share ownership.119 However, there is conflicting evidence on the nature of the relationship

between share ownership and managerial incentives. Morck, Schleifer and Vishny present evidence that as

managerial ownership increases, the value of the firm rises to the 5% ownership threshold, falls between 5%

and 25%, and then rises again.120 McConnell and Servaes,121 however, present evidence suggesting that the

118 ? Jensen & Murphy, supra note 54; Jeffrey G. MacIntosh, Executive Compensation: The Importance of Context, C.D. HOWE INSTITUTE, VALUE FOR MONEY: EXECUTIVE COMPENSATION IN THE 1990'S (1996), 88-123; Stephen Bryan, Lee-Seok Hwang & Steven B. Lilien, CEO Stock Option Awards: An Empirical Analysis and Synthesis of the Economic Determinants, SSRN Working paper series, abstract id 157548, March 1999.

119 ? Id.

120 ? Morck, et al., supra note 67; Karen H. Wruck, Equity Ownership Concentration and Firm Value, 23 J. FIN. ECON. 3 (1988).

121 ? John J. McConnell & Henri Servaes, Additional Evidence on Equity Ownership and Corporate Value , 27 J. FIN. ECON. 595 (1990).

42

value of the firm rises to something in excess of 50% ownership, and then falls as management ownership

increases. Whichever of these relationships holds, the non-linear relationship between management

ownership and firm value is a consequence of two opposing effects. With increasing ownership, managers’

pecuniary interests are increasingly aligned with other shareholders (the “alignment effect”). However,

increasing ownership also enhances management’s ability to ward off a hostile takeover bid, and hence to

preserve their jobs and/or indulge non-pecuniary preferences (the “entrenchment effect”). The strength of

these effects changes at differential and non-linear rates over the full range of ownership interests. Thus,

over some part of the range of ownership, the entrenchment effect will dominate. Over the other parts of the

range of ownership interests, the alignment effect will dominate.

Different forms of VC exit will tend to be associated with different post-exit managerial

shareholdings. However, without consistent evidence as to the nature of the relationship between

management ownership and share value, it is difficult to predict how ownership changes associated with the

VC's exit will affect firm value. Our comments below are thus subject to wide confidence intervals.

IPOs

The IPO is the only form of exit that allows the firm (post-exit) to pay its managers partly in share

options or other forms of compensation linked to market price. While not a perfect motivator, the use of

options and other incentive devices linked to market price enhances managerial alignment with shareholder

interests.122

On the other hand, while IPOs generally leave the existing management in place, the IPO will

significantly dilute managerial shareholdings, resulting in a diminished alignment effect. But, as the above

discussion makes clear, the IPO will also result in a diminished entrenchment effect. Thus, the effect of the

change in ownership configuration on the value of the firm cannot be predicted with precision.

Baker and Gompers suggest that VCs have the incentive to craft post-IPO compensation contracts

for CEOs that provide an appropriate trade-off between incentives and ability to consume private benefits

that might flow from control. 123 They find evidence in support of this proposition. While CEO share

122 ? See supra notes 38, 67 and accompanying text.

123 ? Malcolm Baker & Paul Gompers, Executive Ownership and Control in Newly Public Firms: The Role of Venture Capitalists, Harvard Business School, mimeo (1999).

43

ownership decreased post-IPO, incentive compensation contracts replicated the sensitivity of CEO wealth to

firm performance that prevailed prior to the IPO, while other limitations on managerial actions served to

limit manager opportunism. Thus, in Table 1 we suggest that the compensation factor strongly favours a

public company exit.

Acquisitions

Because a strategic acquisition involves the purchase of the entire firm, the managers will be left

with no direct equity interest in the EF’s assets. Nonetheless, the managers will often receive shares of

the acquiror as consideration for selling their shares in the EF, especially if the acquiror is a cash-starved

technology company.124 Thus, assuming that they stay on board, the managers will retain an indirect

share interest in the EF’s assets. Even if a new management team is hired, management can be given

shares or share options in the acquiring firm.

If the acquiror is not a public company, then it cannot use incentive compensation arrangements

based on the public market price to motivate the managers. If it is a public company, it will be able to do

so. However, a strategic acquiror is typically larger, and often much larger than the EF. Thus, whether the

purchased firm is maintained as a wholly owned subsidiary or rolled into the operations of the acquiror

company, its operations will constitute only a part – perhaps a very small part – of the acquiror’s business.

In these circumstances, there may be a tenuous link between the success of the purchased operations and that

of the firm as a whole. The ability to use the acquiror’s shares (or options) as currency to motivate

executives is thus significantly abridged, when compared to an IPO. The acquisition exit may also be

inferior in this dimension to other forms of private VC exit in which the managers retain a larger

proportional interest in the enterprise, as discussed below.

Secondary Sales

A secondary sale of the VC's interest alone will not affect managements' shareholdings, and

presumably will not affect incentive compensation contracts. Thus, it will not affect managerial incentives.

124 ? Cumming & MacIntosh, supra note 100.

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Buybacks

A buyback will not create any opportunity to put in place market-based incentive schemes, since the

firm will remain private. However, a buyback will almost always result in the insider/managers owning a

large portion (and in many cases all) of the firm. At very high levels of ownership, the alignment effect is

likely to dominate the entrenchment effect.125 Thus, on this score, a buyback is likely to enhance

management’s incentives and reduce the agency costs of equity.

In addition, because the entrepreneur and/or firm will usually resort to substantial debt financing in

order to retire the VC’s shares, the buyback will substantially enhance the entrepreneur’s or the firm’s

debtload. The higher level of fixed payments of interest and principal will act as an additional discipline on

management.126

However, after the buyback occurs, the entrepreneur will be free to pursue whatever maximand suits

her, and her pursuit of profits may be tempered by a taste for the consumption of non-pecuniary rewards,

particularly leisure. The presence of external investors will contain this leisure preference. However, the

buyback jettisons a specialized monitor (the VC) and replaces it with less effective monitor – the firm’s

lender. Indeed, as noted above, one of the objectives of the buyback, from the entrepreneur’s point of view,

may be to eliminate external monitors, in order to permit the indulgence of a taste for leisure that could not

be accommodated when the company had active external investors.

Nonetheless, lacking hard evidence that buybacks are typically motivated by the entrepreneur’s

revealed preference for leisure, we posit in Table 1 that enhanced managerial incentives favour the buyback

when compared to other forms of exit.

2. The Corporate Control Market

Public firms are subject to discipline from the market for corporate control.127 Easterbrook and

125 ? Supra notes 66-69 and accompanying text.

126 ? Jensen, supra note 71.

127 ? See e.g. Frank H. Easterbrook & Daniel Fischel, The Proper Role of a Target's Management in

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Fischel argue that the public price of a firm’s stock consists of two components. The first reflects the value

of the firm under existing management. The second reflects the value of the firm should a takeover bid

occur, with the installation of a superior management team.128 This is supported, in the case of public

corporations, by evidence that the more active the takeover market, the greater the degree of managerial

turnover and managerial discipline.129

While in theory this will also be true for private corporations, informational asymmetries between

insiders and outsiders ensure that the set of interested acquirors will be much smaller for a private

corporation than a public corporation. Moreover, a hostile takeover of a private corporation is often difficult

or impossible. The concentration in shareholdings that is typical of private corporations effectively cedes a

veto over any hostile takeover to the controller(s). Added to this, the charter of most private corporations

will require that the board approve any transfer of shares, giving the board a veto as well. Thus, the control

market is far less active for private corporations.

Thus, this factor strongly favours the IPO exit; following an IPO, the managers are subject to the

discipline of the corporate control market. The only other exit in which there is an active corporate control

market is the acquisition exit – and then only in cases in which the acquiror is a public company. Typically,

however, even in such cases the EF assets will constitute only a small part of the acquiror’s total assets, so

that if the managers use these assets inefficiently, it may not produce a hostile takeover. Thus, this factor

favours the acquisition only weakly, and with significant variation.

I. Transaction Synergies

The products or technologies or some EFs will be more likely than others to exhibit

complementarities with products or technologies owned by other firms. Thus, the possibilities for

synergistic (and value-enhancing) union with other entities will vary across the spectrum of EFs. We

hypothesize that this will affect the choice of exit.

Responding to a Tender Offer, 94 HARV. L.R. 1161 (1981).

128 ? Id.

129 ? Wayne H. Mikkelson & M. Megan Partch, The Decline of Takeovers and Disciplinary Managerial Turnover, 44 J. FIN. ECON. 205 (1997).

IPOs

In an IPO, the firm is not combined with any other entity. An IPO will thus not result in the

direct realization of transaction synergies.

By creating a public market for the firm’s shares, however, an IPO will create or enhance the

probability of a consensual merger or hostile takeover in which transaction synergies are realized.

Although following the IPO the firm will usually have a de jure or de facto controlling shareholder, 130

making a hostile takeover difficult, this controlling position will tend to disappear over time as the firm

grows (and issues more equity) and as early stage shareholders (including managers and VCs) sell off

their holdings.131 Thus, at the time of the IPO there will always be some positive probability that the firm

will be the subject of a premium takeover offer at some point in the future.132 In a market characterized

by rationale expectations, the act of going public will thus result in a takeover premium being

incorporated into the price of the shares.133

There is good empirical evidence that one of the more important reasons why acquirors pay

premia on takeovers is the expectation that the union of the acquiror and target will produce synergies.134

Thus, early stage shareholders (including VCs) selling into the public market will receive a payment that

reflects the likelihood that transaction synergies will be exploited in the future. This payment will be

incorporated into both the price at which the shares are initially sold to the public, and the market price

going forward.

Indeed, an IPO may sometimes be viewed as a strategic prelude to a synergistic merger. When

the firm is private, the universe of potential acquirors is restricted both by information asymmetries

between the firm and potential acquirors, and the firm’s lack of a public profile. By remedying these

problems, an IPO will raise the probability of a control transaction – perhaps even an auction between 130 ? Supra, note 59 and accompanying text.

131 ? Supra note 46 and accompanying text.

132 ? Supra note 112 and accompanying text. See also supra note 48 and accompanying text.

133 ? Id.

134 ? Roberta Romano, A Guide to Takeovers: Theory, Evidence, and Regulation 9 YALE J. ON REG. 119 (1992).

competing acquirors - in which shareholders will capture a share of the synergistic gains.

IPOs facilitate the potential realization of future transaction synergies not merely by facilitating

hostile acquisitions. They also facilitate acquisitions by the firm itself. Once the firm is public, its shares

can be used as currency to effect acquisitions of other firms. The ability to use the firm’s shares as

consideration in a merger or takeover bid is particularly important for the type of firms that venture

capitalists specialize in: rapid growth technology-based firms. Such firms are often cash starved, and the

ability to use shares as currency to effect acquisitions economizes on scarce cash resources. Again, in a

market characterized by rational expectations, this advantage will be reflected in the IPO price and the

market price going forward. Particularly when the EF plans to grow partly or wholly by acquisition, the IPO

thus has a significant advantage over private forms of exit.

Acquisitions

We noted earlier that not all strategic acquirors exhibit the same degree of closeness of fit between

the acquiror and the target.135 Even acknowledging this variation, the purchase of the firm by a strategic

buyer will very often result in the realization of transaction synergies. Indeed, this is frequently the whole

point of the acquisition. In some case, the decision to purchase the firm will be the outcome of a "make or

buy" decision.136 Such a decision arises where the buyer has reached a critical juncture at which it needs to

develop a specific product or technology to complete or complement an existing product line. Rather than

developing the product or technology itself, it will identify a firm that possesses what it needs and buy the

firm.

Acquisitions can also be motivated by the desire to capture the human capital of the target firm.

Since the human capital will often have its maximum value when members of the target’s entrepreneurial

group are kept together as a team, the best way to acquire the target’s human capital will be to buy the entire

firm. Again, synergistic gains can be realized by combining the target’s human capital with the acquiror’s.

Acquisitions are sometimes motivated by a desire to capture intellectual property rights held by the 135 ? Supra note 9 and accompanying text. 136 ? On the make or buy decision, see generally Oliver Hart, Norms and the Theory of the Firm, 149 UNIV. PENN. L.R. 1701 (2001); Aaron S. Edlin & Benjamin E. Hermalin, Contract Renegotiation and Options in Agency Problems, 16 J. LAW, ECON. & ORG. 395 (2000).

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target. The target may have patents, for example, that will assist it in defending intellectual property rights

against challenges from other firms - perhaps even from the target itself.

Synergies can also be realized by acquiring the target firm’s customer base, providing new

distribution channels for current and anticipated products or services.

Especially in the technology industries, strategic buyers will often place idiosyncratically high

values on the target firm. In many cases this will be due to the fact that the buyer has already spent

considerable sums of money developing similar or complementary products or technologies. Because of

this, the buyer will be uniquely positioned to bring the product or technology to market without substantial

additional investment. The buyer may also possess distribution networks that are well adapted to marketing

the seller's product or technology. In some cases, a strategic buyer will be a high valuing purchaser because it

wishes to keep the firm's technology out of the hands of competitors. Any of these factors can transform the

strategic acquiror into a high-valuing purchaser.

Clearly, the acquiror’s anticipation of the realization of transaction synergies will affect its

willingness to pay to acquire the EF. Depending on the relative bargaining strengths of the buyer and seller

and the information they possess (and in particular, the extent to which the seller is aware of the magnitude

of the synergistic gains available to the buyer), the synergistic gains will be split between the buyer and

seller.

We surmise that in this respect the acquisition exit dominates the IPO exit. In Table 1, we suggest

that the ability to exploit transaction synergies strongly favours an acquisition exit.

Secondary Sales

Transaction synergies are far less likely to be realized in the case of secondary sales than

acquisitions, primarily because the buyer will usually be unable to combine the target's assets with its own.

Under pertinent corporate law, effecting a combination of assets generally requires both directors' and

shareholders' resolutions, whether the combination is effected by way of merger, a sale of the target's assets

to the purchaser, or by other means.137 If the buyer possesses only a minority shareholding interest in the

137 ? See e.g. Canada Business Corporations Act (CBCA), R.S.C. 1975, c.C-44, as amended, Part XV (fundamental changes); Del. Code Ann. tit. 8.

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target enterprise, securing such resolutions may be difficult or impossible, particularly in Canada, where a

resolution of two-thirds of the votes cast is required.138

Even when the buyer purchases a controlling interest from the departing VC, the buyer is necessarily

taking on as many partners as there are other shareholders. Attempts to transfer assets from the target to the

buyer may result in a suit by one or more of these shareholders for breach of fiduciary duty or oppression.

However, when a strategic acquiror makes a secondary purchase, it is often as a prelude to making a

future acquisition. The occurrence of a secondary sale to a strategic acquiror thus materially raises the

probability of a future acquisition in which transaction synergies will be realized. Thus, while ranking

behind acquisitions and IPOs, secondary sales contain some possibility for the future realization of synergies.

Buybacks

A buyback results in no direct transaction synergies. Moreover, the likelihood that future synergies

will be realized in a merger or takeover seems small. Not only will the firm will remain privately held – but

loaded up with debt as a result of the borrowing necessary to effect the buyback. In addition, as noted above,

shares of private corporations are difficult to use as currency to effect acquisitions, limiting the EF’s ability

to initiate a merger or takeover transaction. Nor, because of its already high debt level, will it be able to

borrow money to effect an acquisition. Finally, the likelihood that it will be either an acquisition target or a

suitable acquiror will be small if, as we have surmised, it is a living dead investment (or “lifestyle”

company).

Summary

In summary, strategic acquisitions routinely result in the realization of transaction synergies. IPOs

incorporate some premium into the price reflecting the potential future realization of transaction synergies,

both through hostile takeovers of the EF and acquisitions by the EF itself. Secondary sales and buybacks

138 ? See e.g. CBCA, Id. Note that Rule 61-501 of the Ontario Securities Commission, which requires a valuation of the subject assets (or shares) and approval by a majority of the minority of shareholders (i.e. excluding interested parties), does not apply to corporations that are not reporting issuers in Ontario (i.e. that are private companies). See Rule 61-501, Insider Bids, Issuer Bids, Going Private Transactions and Related Party Transactions, 23 O.S.C.B. 2719 (2000).

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typically result in no direct transaction synergies, although secondary sales have a greater built-in potential

for the realization of future asset combinations that yield transaction synergies. In Table 1, we thus suggest

that this factor strongly favours the acquisition, favours the IPO, is neutral to positive with respect to

secondary sales, and strongly disfavours buybacks.

J. Capital Raised, Scale of Acquisition, and Ability to Meet Future Capital Requirements

Exit techniques differ in the extent to which they are associated with the raising of new capital for

the firm, the ability of the buyer(s) to digest the purchase, and the ability of the buyer(s) to meet future

capital requirements. These factors will all affect the choice of exit vehicle.

The purchaser will have to possess sufficient capital to effect the acquisition, whether of the VC's

shares alone or the entire company. An extraordinarily successful firm (or one with tremendous prospects of

future success) will command a high price. The buyer must have sufficient resources to pay this price.

Moreover, except in cases in which a short term “flip” is contemplated, the acquiror must be able to

anticipate that it will have sufficient capital (or the ability to bring further investors on board) to meet the

firm's future capital needs as it continues to grow.

.

IPOs

An IPO is associated with a large infusion of fresh capital. Importantly, it is the only exit technique

that invariably has this result, and this sets the IPO apart from exits that leave the corporation private. Exit

while still private involves only a secondary sale of the VCs share (or its equivalent, such as a sale of assets).

Exit via IPO involves both a secondary sale and a primary market distribution. Thus, a VC may decide to

exit while the firm is still private without the constraint of having to convince new investors that the firm

warrants a cash infusion. When exiting via IPO, the firm must be able to justify its need for new funds to the

capital market; otherwise, the IPO – and hence the exit - will fail. This will tend to restrict the availability of

an IPO to firms surpassing a hurdle growth rate. In Table 1, we record this difference in the column “Must

New Capital Be Raised?”

Moreover, access to the public market tends to be restricted to firms that surpass a hurdle size – at

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least if the firm hopes to attract a more reputable underwriter. 139 There are fixed costs associated with

marketing an issue of securities; the resulting economies of scale can be exploited by marketing only

comparatively large offerings. Thus, the most reputable underwriters tend to shy away from small offerings;

small firms may consequently either fail to gain access to the public market, or gain access only at a cost that

is unacceptable to the firm’s principals. Less reputable underwriters will be compelled to increase the degree

of IPO underpricing in order to market the issue.140

In addition, institutional funds – the primary buyers in most IPOs - are not bottom feeders. There

are fixed costs in investing institutional assets, and hence economies of scale associated with the investment

process. As a result, institutional fund managers prefer to make a smaller number of relatively large

purchases of securities, rather than a larger number of relatively small purchases.141 For this reason, they

will tend to avoid participating in small IPOs.142

An additional factor that drives institutional investors away from small IPOs is that many

institutional investors prefer to invest in relatively liquid assets. The smaller the public offering, the less the

liquidity of the offered shares, the less the degree of institutional interest, and the greater the underwriter’s

cost in marketing the issue. All of these factors support the existence of a size hurdle in IPO markets.

Pagano et al. produce direct evidence of the existence of both growth rate and size hurdles.143 They

find that firms that grow faster and are more profitable are more likely to experience an IPO. They also find

139 ? The presence of a VC mitigates the size effect to some degree. Barry et al., supra note 5, present evidence that small firms lacking VC participation effect IPOs with lower tier underwriters than similar firms with VC backing.

140 ? Megginson & Weiss, supra note 5. 141 ? Institutional investors are usually precluded under applicable legislation from making large investments in small firms, because of prohibitions against holding more than a stated percentage of a single issuer’s equity. In addition, institutional investors will typically wish to avoid ownership thresholds that trigger public reporting requirements. In the United States, the pertinent threshold is 5% (Hart-Scott-Rodino Act [cite]); in Canada, it is 10% (see e.g. Ontario Securities Act, ss.101 and 107). Finally, purchases of small firms generally preclude short-selling because of the difficulty of borrowing shares to effect a short sale; this too limits institutional interest. 142 ? Again, the presence of a VC mitigates the inclination of institutional investors to avoid small issues to a degree. See Megginson & Weiss, supra note 5.

143 ? Marco Pagano, Fabio Panetta, & Luigi Zingales, Why Do Companies Go Public? An Empirical Analysis, 53 J. FIN. 27 (1998).

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that the most important factor explaining an IPO is the market to book ratio. A high market to book ratio

suggests that the market believes that the firm will grow rapidly. The second most important factor in their

study was the firm’s size.144

Other forms of exit have neither growth nor size constraints, although buybacks will often be

available only to smaller firms, as discussed elsewhere. This creates a selection bias that suggests that the

returns associated with IPOs will exceed those associated with other forms of exit. In Table 1, we record this

difference between IPOs and other forms of exit in the column headed “Size and Growth Rate Constraints?”

While the fund raising requirement is a constraint, it is also an opportunity, in the sense that the

public market is the deepest capital well from which the company may drink. The public market has the

greatest ability to digest large-scale purchases. It also has the greatest ability to furnish additional capital if

needed in the future. This is reflected in Table 1 in the column “High Growth Firms”. IPOs are particularly

well suited to high growth firms because of the depth of the capital pool available.

Acquisitions

On the face of it, an acquisition raises no fresh capital; it merely rearranges ownership interests (i.e.

transfers the company to new owners). However, this can be misleading. A strategic acquisition is

undertaken for the purpose of realizing transaction synergies. In some cases, the target will be left as a stand-

alone entity, with a fresh capital infusion from the acquiror. In other cases, other acquiror assets will be

fused with the target firm assets – perhaps in addition to a large fresh infusion of capital.

If the acquiror is large (e.g. Microsoft, Intel, or Cisco Systems), it will usually be able to digest a

large-scale acquisition without further capital raising, and will also handily be able to meet the firm’s future

capital requirements. Even if it is not, it may nonetheless have the ability to tap into the public market for

acquisition or project financing to further develop the EF’s assets. However, because some acquirors may

not be public or may not have favourable standing in the public market, in Table 1 we suggest that an

acquisition exit may not always be as well suited as an IPO in meeting the capital needs of high growth

firms.

Secondary Sales

144 ? Id.

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A secondary market sale of shares will result in no new investment. It is also less likely than an

acquisition to presage the investment of new capital by the buyer (or the combination of the target assets and

the purchaser’s assets). This is because, as indicated above, strategic buyers often desire to obtain 100% of

the company before investing new capital.

However, even if the buyer will not immediately be investing fresh capital in the business, it will

sometimes purchase the VC's shares with a view to ultimately making an acquisition and investing new

capital. Clearly, however, a secondary sale is less likely to be well suited to rapid growth firms with good

prospects than an IPO or an acquisition exit.

Buybacks

The buyback raises no new capital. Rather, it will typically substitute debt for equity capital, in

order to finance the repurchase of the VC’s shares. In one sense, this is a benefit, since the buyback exit is

available for low growth firms that are not looking to raise new capital.

However, if the VC's investment has proven to be a winner, the corporation will have significant

value. In this situation, the company (and entrepreneur) will simply lack the resources (including borrowing

capacity) to repurchase the VC's interest. In essence, a buyback is good evidence that the entrepreneur and

VC agree that the firm lacks significant upside potential; it is a small scale “cash cow”, rather than a fast-

growing and cash-starved “gazelle”145. Thus, a buyback will support only a small scale of acquisition. In

addition, it both evidences, and adds to the EF’s comparative inability to raise present or future capital.

Summary

In summary, IPOs definitionally raise new cash for the firm. This adds a constraint to the IPO exit

decision in that the public market must be willing to support current capital raising: i.e. the firm must have

sufficiently attractive investment projects available to justify a fresh infusion of funds. This creates a

selection bias in reviewing the returns associated with VC exits, because only the most promising firms will

145 ? The terms are borrowed from Ronald J. Gilson, Evaluating Dual Class Common Stock: The Relevance of Substitutes, 73 VIRGINIA L.R. 807 (1987).

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be able to tap the IPO market. The selection bias is exacerbated by the size and growth rate hurdles that the

EF must overcome before being admitted to the public markets. However, public markets are the deepest

capital well from which the EF may drink, making the public market particularly well suited to high growth

firms.

Strategic acquisitions are also a form of exit that both accommodate large scale acquisitions (at least

if the acquiror is large) and facilitate the infusion (or raising) of new funds. Thus, acquisition exits are also

well suited to high growth firms.

Secondary sales will normally result in no fresh infusion of capital. Because only the VC sells its

shares, they are definitionally associated with a lower scale of acquisition. They are less likely than IPOs or

acquisitions to support present or future fund raising activities, although they may be a prelude to a future

acquisition by a strategic acquiror.

Buybacks merely substitute debt for equity. In general, they accommodate only small-scale

acquisitions, and do not support significant future capital raising.

K. Risk Bearing Considerations

In this section we focus on the efficiency of risk bearing by the purchaser of the VC’s interest (or, if

a corporate acquiror, its shareholders). In the Capital Asset Pricing Model, only systematic risk is priced,146

although under more sophisticated models (such as Arbitrage Pricing Theory) a variety of risk factors may be

priced.147 At the risk of oversimplification, we discuss only the cost that results from a failure to diversify

unsystematic risk.

Different forms of exit involve different classes of purchasers, and some purchasers will be better

able to diversify unsystematic risk than others. The cost of a buyer’s underdiversification will be reflected in

the buyer’s willingness to pay for the investment, and hence the VC’s proceeds of exit.

146 ? See e.g. FRANK J. FABOZZI & FRANCO MODIGLIANI, CAPITAL MARKETS: INSTITUTIONS AND INSTRUMENTS, 2d ed. (1996) at 187-214.

147 ? See, e.g., Eugene Fama, Market Efficiency, Long-Term Returns, and Behavioral Finance , 49 J. FIN. ECON. 283 (1998); Brennan et al., supra note 54; Bengt R. Hölmstrom & Jean Tirole, LAPM: A Liquidity-based Asset Pricing Model, NBER Working Paper No. W6673.

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In general, where the firm is purchased by an individual or a private corporation, the purchase may

result in underdiversification. Whether underdiversification occurs will depend on the size of the acquisition

relative to the wealth of the purchaser(s), and the degree to which the purchaser’s investment portfolio is

otherwise diversified. Bill Gates, for example, could presumably effect a billion dollar acquisition out of his

private wealth without incurring material underdiversification. Not many other individuals can make the

same claim. However, many individuals with low net worth can effect small purchases in the public market

without this leading to underdiversification.

In theory, underdiversification should not be of concern to an acquiror that is a public company (or

other tradable entity), since the entity’s owners may themselves diversify the unsystematic component of the

firm's risk by holding diversified portfolios of securities. However, as a practical matter, even managers of

public companies may have incentives to avoid high-risk investments, even if these investments have

significantly positive net present value. This will be true if the managers are underdiversified. They will be

underdiversified if their wealth is concentrated in the firm, when all sources of managerial wealth, including

remuneration, stock, stock options, and other incentive contracts are taken into account. Underdiversification

will lead the managers to avoid increasing the firm’s unsystematic risk, even though the firm’s shareholders

are indifferent to unsystematic risk (so long as the project has at least a zero net present value). 148

IPOs

IPOs spread risk better than any other form of exit save (potentially) an acquisition exit.

Institutional investors make purchases that are small relative to assets under administration, and are widely

diversified. Retail investors are obviously more prone to underdiversification, although there is no evidence

that the typical retail purchase results in underdiversification. In any case, all but the smallest IPOs are sold

mainly to institutional buyers.149 Thus, risk bearing considerations strongly favour an IPO.

Acquisitions

148

? John C. Coffee, Shareholders Versus Managers: The Strain in the Corporate Web, 85 MICHIGAN L.R. 1 (1986).

149 ? See e.g. Gompers & Lerner, supra note 4; Vijay M. Jog, The Climate for Canadian Initial Public Offerings, in PAUL J.N. HALPERN, ED., FINANCING GROWTH IN CANADA, 357-402 (1997).

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A large strategic acquiror that is a public company will be as well positioned to bear risk as a firm

effecting an IPO. Indeed, for very large public firms (particularly conglomerates) the addition of the EF’s

assets to the acquiror’s stable of assets may not materially change the managers’ exposure to risk, even if the

managers are underdiversified.150 Thus, in some cases, the acquisition will dominate the IPO with respect to

risk bearing.

Acquirors are not all large conglomerates, however. Some may be private corporations for whom

the shareholders and managers are both underdiversified. Thus, in Table 1, we suggest that risk bearing

factors will strongly favour the acquisition exit, but subject to variation.

Secondary Sales

Secondary sales may or may not result in efficient risk bearing. If the purchaser is an individual

who is underdiversified, then it will not. If it is a strategic acquiror that is a large public corporation, it will

spread risk widely. However, even in the latter case, it will not spread risk as widely as in the case of an IPO

of acquisition, since there may be other shareholders in the EF who are underdiversified. Thus, in Table 1

we list the risk bearing properties of a secondary sale as indeterminate.

Buybacks

Buybacks result in a concentration of the equity in the hands of the entrepreneur(s). Because the

manager’s income and wealth will both derive from the EF, this is almost certain to result in inefficient risk

bearing. Thus, risk bearing considerations strongly disfavour the use of a buyback exit.

Summary

Risk bearing considerations favour IPO and acquisition exits. The larger the firm and hence the

greater the scale of the exit, the greater the comparative advantage of IPOs and acquisitions in spreading risk.

Acquisitions are subject to variation, however, because the identity of the acquiror will vary. Secondary

sales have an ambiguous affect on risk bearing, while buybacks will usually result in inefficient risk bearing.

150 ? This is not to say that conglomerate enterprise is efficient; the evidence suggests otherwise. See e.g. Edward M. Miller, Why the Break-up of Conglomerate Business Enterprises Often Increases Value , 20 J. OF SOC. POL’T AND ECON. STUD. 317 (1995).

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L. Common Exit Strategies as a Factor in Promoting Teamwork

In this section, we make two important distinctions. The first is between forms of exit that are

common, and those that are not. The second is between exit strategies that are common (at the time of the

VC’s first investment), and those that are not. The first is illustrated by an acquisition exit, which, as

discussed further below, represents a common form of exit. The second is illustrated by a buyback. A

buyback is a common form of exit, but is unlikely to form a common exit strategy, in the sense that neither

the entrepreneur nor the VC will aim to effect a buyback exit at the outset of the investment.

A venture capital investment is virtually by definition a relational investment, and a strong and

amicable working relationship between the VC and the entrepreneur is what distinguishes a successful from

an unsuccessful investment.151 We posit that the strategy of working toward a common form of exit tends to

cement the VC-entrepreneur relationship and prevent various forms of VC or entrepreneur opportunism.

Consider, for example, a situation in which the entrepreneur and the VC are at one in pursuing either

an IPO or an acquisition exit. In this case, they will work cooperatively to effect that result. If, however, the

entrepreneur anticipates that the VC will make a unilateral exit via a buyback, she has incentives to depress

the value of the enterprise in order to pay the VC as little as possible when it is cashed out. This she may do

by shirking, deliberately refraining from adopting value-added strategies (which can be implemented once

the buyback has been effected), or by misrepresenting the state of the firm to the VC (thereby depriving the

VC of knowledge not merely as to an appropriate exit value, but also regarding an appropriate set of policies

that will maximize the value of the firm).

There is growing evidence in the literature of opportunistic forms of exit. Gompers, for example,

produces evidence of VC opportunism by young venture capital firms in prematurely exiting their

investments via IPOs in order to generate a track record for subsequent fund raising (a phenomenon that he

christens “grandstanding”).152 We produce evidence in related work that when abundant funds are available

to VCs, they will sometimes opportunistically effect an exit from some of their investments in order to re-

151 ? Sahlman, supra note 7; Gompers & Lerner, supra note 4.

152 ? Gompers, supra note 7.

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deploy their managers into new investment opportunities.153 The entrepreneur’s interest is clearly to avoid

opportunistic exits, whether taken unilaterally (as in a secondary sale) or jointly (as in an acquisition), and to

ensure that the VC is truly committed to maximizing the value of the EF - and not merely the aggregate

value of the firms in its portfolio. By the same token, the VC will be anxious that the entrepreneur, in whom

much of the value of the firm resides, does not opportunistically exit.

One significant and ongoing source of tension between the VC and the entrepreneur (and a potential

source of exit opportunism) arises from the differing risk preferences of the VC and the entrepreneur. A

well-diversified VC will act as a risk neutral party (barring agency issues that arise between the fund’s

managers and its own investors154). The entrepreneur, on the other hand, will routinely be underdiversified,

because both her income and the bulk of her wealth will derive from the EF. She will thus behave in a risk

averse manner. On the principle that “a bird in the hand is worth two in the bush”, she might be tempted to

engineer a premature exit (e.g. by secondary sale or acquisition) at relatively inferior consideration, locking

in her gain, to accommodating the VC’s preference to wait until the time is ripe for an IPO (with all its

attendant systematic and unsystematic risks).

Various contractual means are used to address these issues, and many of these contractual provisions

are designed to ensure that a common form of exit occurs.155 For example, “go along” rights enable all

shareholders to participate in an exit negotiated by only some of the shareholders. This discourages both the

VC and the entrepreneur from attempting to negotiate a unilateral exit. Similarly, “drag along” rights allow a

super-majority of shareholders (typically 90%) to compel recalcitrants to participate in an exit.156

Even without such express stipulation, an experienced VC will often take the entrepreneur’s

preferences into account when choosing a form of exit, even if this results in a less profitable exit than might

153 ? Cumming & MacIntosh, supra note 11.154

? There is some potential for VC managers to act like corporate managers due to underdiversification, since the manager’s wealth will depend to a considerable degree of the performance of the fund. VC managers, by their nature, however, are likely to be less risk averse (and perhaps even risk preferring) when compared to corporate managers, attenuating this agency problem.

155 ? These issues are explicated at much greater length by Smith, supra note 6. See also Gompers & Lerner, supra note 4, ch. 3.

156 ? Id. Canadian corporate legislation typically supplies a de facto legislative drag along right even without contractual stipulation. See e.g. CBCA s. 206 (which only requires that the acquisition be formally structured as a takeover bid by the acquiror).

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otherwise have been the case. Cultivating the entrepreneur's interests protects and enhances the VC's

reputation in the entrepreneurial community, leading to a higher probability of investing in promising EFs in

the future.

IPOs

IPOs are a form of exit in which the entrepreneur and the VC exit together. Because of the high

returns that often flow from an IPO, an IPO is regarded as a desirable form of exit. Hence, an IPO exit will

be both a common form of exit and a common exit strategy (excepting opportunistic IPOs, such as those

resulting from grandstanding). While the entrepreneur and the VC may not sell at precisely the same time

(indeed, they may sell months or even years apart), they will both have the same opportunity to sell once any

pertinent hold and/or escrow requirements (contractual or regulatory) have expired.

Acquisitions

Acquisition exits, by definition, involve the sale of the entire firm, and so will necessarily entail a

common form of exit for the VC and the entrepreneur. Because acquisition exits, like IPOs, are usually

associated with high returns, an acquisition exit is also likely to form a common exit strategy.

At the time of the VC’s investment, both the VC and the entrepreneur will prefer either an IPO exit

or an acquisition exit. The IPO will often dominate as the preferred form of exit, because it tends to produce

the highest returns for both the VC and the entrepreneur.157 However, it will not be clear to the parties at the

time of investing whether an IPO will be feasible. The availability of an IPO will depend on a number of

variables that are difficult or impossible to forecast, such as the state of the public markets (and the economy)

at any given point in time, the fortunes of the firm, the array of products marketed by competitors, and so on.

As we argue elsewhere in this paper, for some firms an acquisition exit may dominate an IPO either at the

time of investment, or at the time when the exit possibility ripens. Thus, both IPOs and acquisition exits can

be regarded as common exit strategies.

Secondary Sales

157 ? See infra Part VI; Bygrave and Timmons, supra note 13; John Cochrane, The Risk and Return to Venture Capital, University of Chicago, mimeo; Gompers and Lerner, supra note 4.

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A secondary sale involves a sale of the VC’s shares alone. It is a non-cooperative form of exit, and

thus unlikely to represent a non-cooperative exit strategy. While a secondary sale (say, with the substitution

of a new VC) may represent an ad hoc cooperative strategy, given the way in which the investment has

developed, it is unlikely to form a cooperative strategy at the time of initial investment.

Buybacks

Buybacks are also a non-cooperative form of exit, involving the departure of the VC alone. Like

buybacks, they will not usually represent a preferred form of exit strategy at the inception of the parties’

relationship (although again, on an ad hoc basis, a buyback may become a cooperative exit strategy given the

company’s fortunes, an inability to utilize other sources of exit, and/or the state of the VC-entrepreneur

relationship, etc.).

Summary

IPOs and acquisition exits are common forms of exit, as well as common exit strategies. Secondary

sales and buybacks are neither a common form of exit, nor a common exit strategy.

M. The Cyclicality of Valuations in IPO Markets

There is evidence that IPO pricing is subject to psychological factors, and not merely investment

fundamentals.158 The operation of these psychological factors may result in periodic overvaluations of IPO

firms. IPOs will be particularly attractive means of exit during these periods of overvaluation.

The best evidence that psychological factors operate in IPO markets is that in the longer term

(typically defined as the five years following an IPO) IPOs are overpriced compared either to a relevant

158 ? Tim Loughran & Jay R. Ritter, Why Don’t Issuers Get Upset About Leaving Money on the Table in IPOs? REV. FIN. STUD. (2002, forthcoming); Tim Loughran & Jay R. Ritter, The New Issues Puzzle, 50 J. FIN. 23 (1995); Jay R. Ritter, The Long-Run Performance of Initial Public Offerings, 46 J. FIN. 3 (1991); Mario Levis, The Long-run Performance of Initial Public Offerings: The UK Experience 1980-1988 , 22 FIN. MGMT. 28 (1993); Tim Loughran, NYSE vs NASDAQ Returns, 33 J. FIN. ECON. 241 (1993); Jog, supra note 148; Gompers & Lerner, supra note 4.

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market benchmark or a matched sample of public firms.159 Ritter’s pioneering study, for example, found that

"a strategy of investing in IPOs at the end of the first day of public trading and holding them for 3 years

would have left the investor with only 83 cents relative to each dollar from investing in a group of matching

firms listed on the American and New York stock exchanges.160 Ritter also found that "younger companies

and companies going public in heavy volume years did even worse than average”.161 Ritter concluded that

purchasers of IPOs were overoptimistic about the prospects of IPO firms, stating that "[t]he evidence

presented here is broadly consistent with the notion that many firms go public near the peak of industry-

specific fads".162

Loughran, Ritter, and Rydqvist find further evidence supporting the view that investors cyclically

overprice IPOs and that firms time their offerings to coincide with 'hot issues' markets. 163 In 14 of 15

countries, they find a positive correlation between inflation-adjusted stock market prices and the annual

volume of IPO activity.

At first blush, this is not necessarily inconsistent with economic theory. In a strong economy, the

opportunity set of investment projects available to firms will widen, and the pool of positive net present

value opportunities will deepen. This will raise stock prices. It will also enhance both the demand for, and

supply of capital to fund new public companies. Thus, the correlation between rising stock prices and a

strong IPO market may be nothing more than a case of common causation. That is, each is a common

product of a strong economy.

As against this view, however, Loughran et al. find that the frequency of IPO offerings is much

more closely correlated with the stock market than with real economic factors.164 They conclude that "[t]he

evidence from around the world is consistent with the view that private companies have some success in

159 ? Id. See also Jay R. Ritter, The Long-Run Performance of Initial Public Offerings, 46 J. FIN. 3 (1991).

160 ? Ritter, Id., at 23.

161 ? See also Loughran et al., supra note 74.

162 ? Ritter, supra note 138, at 23.

163 ? Loughran et al., supra note 74.

164 ? Id.

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timing their IPOs to take advantage of misvaluations".

There is also evidence that venture capitalists can time market cycles and take their EFs public at

just the right time to capture peaks in the market. Gompers and Lerner find that VCs “successfully time

IPOs by being more likely to take companies public when their valuations are at their absolute and short-

term peaks,” and that experienced VCs are better able to time the market than their less experienced

counterparts.165

Interestingly, however, while psychological factors may account for the overvaluation of the

average IPO, long term overpricing appears to be concentrated among small, risky, young, and non-

venture-capital backed firms. As noted above, Ritter found that younger companies had the worst long-

term performance. In their multi-country review of IPO studies, Loughran et al. concluded that the worst

after-market performance was found in markets with an abundance of IPOs of risky firms. 166 Most

recently, Brav and Gompers find that "underperformance is almost entirely concentrated in the smallest

deciles of nonventure capital-backed issuers”.167

They note that purchasers of non-venture capital-backed IPOs tend to be retail, rather than institutional

investors, and speculate that such investors are more likely to be influenced by emotional, rather than purely

fundamental factors.

Although venture-backed IPOs may not therefore be prone to periodic overvaluations, there is

nonetheless good evidence that IPO valuations are cyclical in nature. Clearly, the attractiveness of an IPO

relative to other forms of exit will vary with the IPO pricing cycle.

N. The Life Cycle of a Venture Capital Fund: The Fire Sale Problem

In our general theory of exits, we assumed that venture capital funds are perpetual. In fact, most

165 ? Gompers & Lerner, supra note 4, at 213-14. See also Lerner, 1994b, supra note 7.

166 ? Loughran et al., supra note 80.

167 ? Alon Brav & Paul A. Gompers, Myth or Reality? The Long-Run Underperformance of Initial Public Offerings: Evidence from Venture and Nonventure Capital-backed Companies, 52 J. FIN. 1791 (1997). See also Gompers and Lerner, supra note 4, at 213-237. But see Lin and Smith, supra note 25, who find that venture-backed IPOs experience significantly negative post-IPO price performance.

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venture funds are organized as limited partnerships that terminate ten years from inception, subject to the

ability of the managers to extend the term with the permission of its unit holders.168 We posit that exit

behaviour will be affected by the time horizon to fund termination. As the fund approaches the termination

date, there will be pressure to exit the fund’s investments in order to return to the limited partners their

capital contributions and associated profits in liquid form. This may lead the VC to exit an investment even

though the prospective net value added by staying involved is in excess of the investment’s maintenance

costs, and even if the VC is the highest value-added investor. We call this the “fire sale” problem, which is

essentially a problem of foregone opportunity (i.e. opportunity cost).

The fire sale problem will often entail both inferior exit valuations and inferior forms of exit.

With respect to the former, a firm may be brought to the public market a year or two earlier than optimal

in order to create liquid consideration to return to investors. With respect to the latter, a firm that in a

year or two might be suitable for the public market might instead be sold in an inferior acquisition exit.

Or, investments that might have been exited via acquisitions will be exited via secondary sales or

buybacks.

The fire sale problem is often contractually mitigated by provisions in the agreement binding the

VC to its investors that prevent re-deployment of capital harvested from old investments into new

investments.169 These constraints often allow reinvestment only in the first few years of the fund, or with

the approval of the unit holders. They are testimony to the potentially serious nature of the fire sale

problem, given the opportunity cost associated with holding cash for a period that might easily run into

years.

In Table 1, we thus suggest that the fire sale problem will tend to favour inferior forms of exit

(save where the firm has already cleared the IPO size and growth hurdles), although what constitutes an

“inferior” form of exit will obviously be highly firm-specific.

O. Reputational Incentives

VCs, like other long-term players in capital markets, desire to maintain a favourable reputation in

168 ? Sahlman, supra note 4.

169 ? See supra, notes 91-93 and accompanying text.

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the market. A good reputation will assist in attracting investors, developing and maintaining useful

working relationships with entrepreneurs, and forging relationships with lawyers, investment bankers,

auditors and others who are capable of providing useful services to investee companies.

That VC reputation has value in the market has empirical support. Megginson and Weiss170

demonstrate that venture-backed (“VB”) IPOs have less short-term underpricing than non-venture-backed

(“NVB”) IPOs. The difference is both statistically and economically significant; on average VB IPOs

were underpriced by 7.1%, versus 11.9% for NVB offerings. Since the degree of underpricing is a proxy

for the market risk of the issue, the presence of a VC clearly reassures public investors as to the quality of

the offering. Megginson and Weiss also found that underwriter compensation was lower for VB

offerings, suggesting that the underwriters believe that their risk is lower in VB offerings.171

Lin and Smith also find evidence of the value of the VC’s reputation.172 A VC without an

established reputation is less likely to sell shares in a secondary offering at the time of the firm’s IPO.

VC’s with established reputations can afford to do so at lower cost; the VC’s reputation serves as a

“bond” that substitutes for ownership retention in reassuring investors that the VC is not selling merely

because it thinks that the stock is overvalued.

In this section, we suggest that reputational considerations are at work in the VC’s choice of exit.

IPOs

In general, the VC’s desire to build a good reputation will lead it to prefer the form of exit that is

associated with the greatest returns for both itself and its investors; i.e. an IPO or an acquisition exit. As

we have already indicated, however, there may be situations in which the VC’s and entrepreneur’s exit

preferences (whether as to timing or form of exit) will diverge.173 Gompers demonstrates that the desire

of younger VC firms to develop a good track record (in order to attract future funding) may lead them to

170 ? Megginson & Weiss, supra note 5.

171 ? See also Barry et al., supra note 5.

172 ? Lin & Smith, supra note 25.

173 ? Supra, Part III.K.

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“grandstand” and bring firms to the public market prematurely.174

Gompers does not discuss forms of exit other than IPOs, and therefore does not opine on whether

grandstanding might involve exits by means other than an IPO. There seems to be no reason why

grandstanding might not also lead the VC to make a premature acquisition exit as well, if an acquisition

exit will yield the highest consideration for a given EF. One additional factor might be important,

however. IPOs receive more widespread coverage in the press than acquisitions, and attract the interest

of a wide spectrum of investors who might also be future investors in the VC’s future funds offerings.

IPOs are thus associated with much greater publicity for the VC. This publicity extends well beyond the

exit, since publicly traded firms that do well continue to attract the interest of the financial press,

analysts, and investors long after the IPO is concluded (while EFs sold in acquisitions may be melded

into the acquiror’s assets and disappear from public view). This might lead the VC to prefer an IPO exit

even in cases in which an acquisition exit would result in a higher payoff. We thus posit that

grandstanding will bias exit decisions in favour of IPO exits, particularly in hot issues markets in which

IPO valuations are high.

Because secondary sales and buybacks are generally not associated with very high returns, it

seems unlikely that grandstanding would manifest itself by exits taken by either of these means.

P. Agency Costs of Debt

The firm’s maximum value is achieved when the sum of the agency costs of debt, the agency

costs of equity, and residual loss is minimized.175 Whether this optimum is achieved will affect the value

of the firm.

In this section, we focus exclusively on the agency costs of debt. While this abstracts away from

the agency costs of equity and residual loss, we suggest that when the agency costs of debt are extremely

high, the sum of the three constituent components of value is unlikely to be at a maximum. Thus, it is

important to determine the relative agency costs of debt associated with different forms of exit.

174 ? Gompers, 1996, supra note 7; Gompers & Lerner, supra note 4, at 239-261.

175 ? Jensen & Meckling, supra note 40.

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Different forms of exit will differentially affect the firm’s debt/equity ratio, and also the

concentration of equity holdings. In general, the lower the debt/equity ratio, the lesser the incentive of

equity holders to appropriate wealth from the debt holders, and the lower the agency costs of debt. 176 In

addition, the higher the concentration of equity ownership, the greater the incentive of the equity holders

to appropriate wealth from debt holders, and hence the greater the agency costs of debt.177

IPOs

IPOs add a new layer of public equity on top of the existing equity, while not immediately

affecting the firm’s debt load. Thus, the debt/equity ratio is lowered, resulting in a lower agency cost of

debt. In addition, ownership concentration is reduced, which might again be expected to reduce the

agency costs of debt. An IPO will thus be expected to lower the agency costs of debt.

There is empirical support for this proposition. Pagano, Panetta and Zingales produce evidence

that firms experiencing an IPO experience a reduction in the cost of bank credit – even after controlling

for the reduction in leverage that results from going public.178

Because IPOs will thus not generally lead to an inefficient level of agency costs of debt (it will

generally lower the agency costs of debt), in Table 1 we suggest that this factor favours an IPO exit.

Acquisitions

If an acquisition is effected by a purchase of shares, so that the target becomes a wholly owned

subsidiary (or nearly so) of the acquiror and retains a separate legal personality, equity ownership will be

highly concentrated. On its face, this will increase the agency costs of debt. However, if the acquiror is a

widely held public company, which will often be the case, then ownership of the target will in fact be

diffuse – and substantially more diffuse than prior to the VC’s exit. This points to lower agency costs of

debt.

176 ? Jensen and Meckling, Id. See also Barnea et al., supra note 38; Halpern et al., supra note 38. 177 ? Op. cit.

178 ? Pagano et al., supra note 61.

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However, the debt/equity ratio of the acquiror will also be important. An acquiror (particularly a

large one) with an extremely high debt/equity ratio may be unable to effect further borrowing against the

target’s assets, or will be able to effect borrowing only at a high cost. Thus, both the configuration of

equity holdings and the debt/equity ratio of the acquiror will play key roles in determining whether the

agency costs of debt increase or decrease post-acquisition. If the acquisition is effected by means of an

asset purchase, the analysis is much the same. Because of the factual dependence, in Table 1 we record

the effect of this factor on acquisitions as indeterminate.

Secondary Sales

Sale of the VC’s interest alone will simply substitute one equity holder for another, and thus will

not have any effect on the firm’s debt/equity ratio or on the concentration of equity holdings. It should

thus not affect the agency costs of debt.

Buybacks

The affect of a buyback on the agency costs of debt was discussed in the context of the effect of

information asymmetry on exit price.179 To briefly summarize, a buyback substantially increases the

debt/equity ratio and concentrates equity holdings in the hands of a few. Thus, we expect a buyback to

substantially increase the agency costs of debt.

Summary

Agency costs of debt are substantially increased by a buyback exit, and are lowered by an IPO

exit. They are not affected by a secondary sale, and are heavily fact-dependent in the case of an

acquisition. We thus suggest that this factor favours the IPO and disfavours the buyback.

Q. Public Profile

Going public can enhance a firm’s public profile in a manner that enhances the firm’s ability to

179 ? Supra section III.A.

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sell its products and to raise capital in the future.180 This is another advantage of the IPO over other

forms of exit, although once again if the acquiror in an acquisition exit is a public firm, similar benefits

may result. In a market characterized by rational expectations, these benefits will be reflected in the

VC’s exit price.

R. Governance Mechanisms

The exit price will be a function of the various contractual and extra-contractual mechanisms that

are put in to restrain agency costs post-exit.181 Since an exploration of the technology of contracting in

relation to various forms of exit is an undertaking in itself, we make no speculations on how the choice of

exit might be affected by such mechanisms.

S. A Rank Ordering of Exit Preference by Investee Firm Quality

The factors that we have suggested affect the VC’s exit decision are summarized in Table 1. The

best form of exit will thus be contingent on a variety of different factors to which it is difficult, a priori,

to ascribe particular weights. We nonetheless suggest that a general rank ordering of exit preference

(and/or availability) is possible.

The IPO appears to be the most desirable form of exit for high quality, rapid growth firms – the

“home runs” from which venture capitalists derive most of their returns. Public markets are unparalled in

their ability to supply capital on a large scale and to spread risk. They also give the firm an unparalleled

ability to adopt incentive compensation arrangements post-exit. By lowering the debt/equity ratio and

creating less concentration in shareholdings, IPO firms are unlikely to be characterized by inefficient

capital structures or to be constrained by high costs of debt. IPOs supply the VC with the most liquid

form of exit, save a subset of acquisition exits, and also furnish the new owners with unparalled liquidity.

It is true that IPOs take a back seat to acquisition exits with respect to the immediate realization of

transaction synergies. However, by exposing the firm to the possibility of a hostile takeover (and

elevating the probability of a friendly merger), the IPO facilitates the realization of future synergies, and

may facilitate the capture of a large share of those synergies by the new owners if a takeover auction

180 ? See e.g. Paul E.C. Benson, The Going Public Decision, Insight Press (Toronto), June 22, 1993, at 3-6. 181 ? Smith, supra note 6; Daines & Klausner, supra note 32; Hellmann, supra note 6.

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develops. IPOs maximally enhance the VC’s reputation, and also result in a public profile that will

facilitate sale of the company’s product and assist in future capital raising efforts. IPOs are not merely a

common form of exit for the VC and the entrepreneur, but are typically (with some exceptions, such as

grandstanding) also a common exit strategy from the inception of the investment. The IPO thus guards

against forms of opportunistic behaviour that result from either the pursuit or expectation of separate

exits.

IPOs do not, however, dominate all other forms of exit in all states of the world. As noted, they

are second to acquisitions in their ability to generate immediate synergies. Further, only firms that

surmount hurdle size and growth rates (and/or satisfy fad demands for particular types of firms) will be

saleable in the public market. VCs do, however, have an ability to time the IPO so as to maximize the

proceeds of sale in the public market, and this suggests that they may also have an ability to capture

windows of opportunity that allow otherwise unmarketable firms to be brought into the public market.

One of the more significant disadvantages of the IPO is the buyers’ collective inability to resolve

information asymmetries and value the firm at the time of sale. Underwriters and other intermediaries

(including the VC) will mitigate, but not fully resolve these difficulties. Other forms of exit are

characterized by lesser information asymmetries and greater buyer ability to value the firm.

Another significant disadvantage results from the comparative inability of public market buyers

to monitor and discipline the managers post-IPO. Well-known collective action and free rider problems

are not fully mitigated by the IPO “contract” crafted by the firm’s investment bankers and lawyers.

Again, other forms of exit appear to better address these problems.

Two other ways in which IPOs are inferior to other forms of exit arise from the comparatively

high costs of going public and of operating as a public company. In addition, IPO markets are highly

cyclical: valuations vary significantly depending on the general economic climate and the state of the

public market. In some periods of time, an acquisition exit may yield a higher multiple or may be

available when an IPO is not.

In general, we expect acquisition exits to be the second best form of exit. Strategic acquirors are

better placed than any other buyer to resolve information asymmetries and value the firm at the time of sale.

Moreover, because it will own the entire firm, a strategic acquiror will be uniquely well positioned (save

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perhaps in a buyback) to monitor and discipline the managers. Thus, acquisition exit will be comparatively

attractive for EFs characterized by a high level of information asymmetry between insiders and outsiders.

This might be the case, for example, for biotech firms with long product development times, or more

generally firms anticipating a long R&D process prior to bringing a product to market, making it difficult for

the owners, analysts and potential investors to evaluate managerial performance.

Perhaps the greatest advantage of the acquisition exit is the ability to generate transaction

synergies. An acquisition exit will be comparatively attractive when the firm’s technology is highly

complementary to technologies possessed by strategic acquirors.

An acquisition exit will also be attractive when the firm fails to meet the hurdle growth rate

demanded by the public market, too small to be of interest to institutional investors, or insufficiently

“sexy” to be sold in the public market.

An acquisition will result in transaction costs that are low compared to an IPO, and will avoid the

ongoing costs that attend the running of a public company. It may supply the VC with liquidity superior

to an IPO, although it will not usually result in high liquidity in the hands of the acquiror. It may result

in comparable efficiencies in risk bearing to an IPO, and is second to the IPO in attracting press coverage

(and hence contributing to the reputation of the VC). Like the IPO, it represents a common form of exit,

and will often also represent a common exit strategy, mitigating VC-entrepreneur agency problems.

Our review of the theory suggests that the buyback is an inferior form of exit. Perhaps the point

most in favour of the buyback is that at the time of sale information asymmetries will be low. In

addition, post-exit managerial incentives will be high, although we have suggested that post-buyback the

managers may indulge a preference for the pursuit of non-pecuniary ends (and in particular, indulging a

leisure preference). On the negative side of the ledger, buybacks result in no transaction synergies. More

importantly, buybacks are contraindicated for investments of home run quality. Home runs are

associated with a large scale of acquisition, and in the usual case the entrepreneur will not have the

resources to effect such an acquisition. Nor will she have the borrowing capacity; a buyback will drive

the agency costs of debt so high that borrowing will either be unavailable, or available only at great cost.

Only specialist MBO lenders, merchant bankers or mezzanine financiers will have the expertise to

resolve information asymmetries and monitor the managers (especially with technology firms), but such

lenders are typically interested only in large scale (and often pre-IPO) companies.

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Even if debt financing is arranged, high debt levels post-exit will make it difficult to effect

further expansion financings, or to expand through synergistic combination with other firms.

Buybacks are both a non-cooperative form of exit, and for this reason, will usually represent a

mutually non-preferred exit strategy. They result in inefficient risk bearing, and will fail to contribute to

the VC’s public profile (and hence reputation). Buybacks yield partial cash consideration for the selling

VC, but liquidity is typically constrained either because the buyback is partial or because the

consideration is paid over a period of time. For all of these reasons, we expect the buyback to be

associated with living dead investments rather than home runs or base hits.

We suggest that secondary sales are likely on average to be inferior to either IPO or acquisition

exits, but superior to buybacks. Because secondary buyers are usually strategic acquirors, they will be

able to overcome information asymmetries and value the firm - although not as effectively as in a 100%

acquisition. Nor will they have the same ability as in a 100% acquisition to monitor and discipline the

managers. Nor will they be able to freely mold the EF’s assets to their own uses, given the presence of

minority shareholder interests. Secondary sales will not immediately result in transaction synergies, but

may raise the probability that synergies will be realized in the future. The acquiror will receive an

investment with little liquidity. In addition, the buyback represents a non-cooperative form of exit and a

hence mutually non-preferred exit strategy. A buyback exit is unlikely to contribute to the public profile

or reputation of the VC.

Secondary sales have more capacity than buybacks to generate high returns, however. A

strategic acquiror will generally prefer to make a 100% acquisition, but may be unable to do so because

of an inability to convince all shareholders of the EF to sell. In such a situation, a high valuing acquiror

may be content to purchase the VC’s interest, and may be willing to pay a high multiple to effect the

purchase. Moreover, secondary sales will bring a new active monitor on board with specialized

knowledge, contacts, and/or monitoring capabilities, which will often enhance the value of the firm (and

hence increase the buyer’s willingness to pay to acquire the VC’s interest).

Acquisition, buyback and secondary sale exits are more likely to occur as a fund termination

deadline looms, at least if the firm cannot surmount the IPO hurdle rate and make an exit into the public

market.

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IV. TESTABLE HYPOTHESES

Given the limitations of our data, not all aspects of the above theory are testable. The following

describes the empirical tests that we were able to perform.

A. Firm Quality

Our first hypothesis is that firms of differing qualities will be exited via the rank ordering of exits

indicated in the last section; i.e. IPOs, acquisitions, secondary sales, buybacks, and write-offs. We use

the concept of “quality” as a proxy for the variety of factors digested in Table 1 (and discussed in the

previous rank-ordering) that have an influence on the VC’s exit price. We do not have the data to test all

of the factors in Table 1 that determine the firm’s quality (and because some of the hypotheses may not

in fact be testable). Thus, in our empirical analysis in section VI, we proxy firm quality by the

market/book ratio at the time of exit, where the “market” price is the exit or sale price, and the “book”

price is what was paid for the investment. This variable implicitly controls for scale effects. For

example, a large initial investment is likely to lead to a large exit price, even when the firm at exit is of

inferior quality and the VC’s rate of return is poor. By using the ratio of market to book, such as

investment will be ranked as inferior to a small investment that has a high exit price compared to the

VC’s initial investment.182 The market/book ratio is an indicator of how much the firm has increased in

value under the VC’s tutelage.

Hypothesis 1 Higher quality entrepreneurial firms will be exited, in decreasing order of likelihood) by

IPOs, acquisition exits, secondary sales, buybacks, and write-offs.183

This hypothesis gives rise to a potential for endogeneity. While we posit that firm quality affects

the choice of exit vehicle, it may be that causality runs in the opposite direction, and the choice of exit

182 ? This is not perfect either. It may be that the larger investment has a higher net present value than the smaller. However, there is no measure that is perfectly suited to proxy quality, given limitations that inhere in calculating evaluating risk ex post (or even ex ante) and calculating net present values.183

? In other words, (PIPO/PAcquisition)/(Quality) > 0 (i.e., the derivative of the probability of an IPO / the probability of an acquisition with respect to entrepreneurial firm quality is positive). Similarly, Hypothesis 1 states that (PAcquisition/PSecondarySale)/(Quality) > 0, and therefore (PIPO/PSecondarySale)/(Quality) > 0, etc.

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vehicle is a prime determinant of exit value. In general, we think this unlikely, since the implication

would be that IPO exits (perhaps coupled with acquisition exits for some EFs and some states of the

world) would strictly dominate other forms of exit. However, we clearly observe all forms of exit.

Because of cyclical pricing in the IPO market, however, an IPO exit becomes relatively more or

less attractive depending on the state of securities markets at the time of the contemplated exit. Thus, in

section VI and in the Appendix, we empirically test for the presence of endogeneity.

We acknowledge limitations in the private information furnished to us by our VC respondents.

We would have preferred, for example, to have data on corporate governance mechanisms put in place at

the time of exit to control agency costs post-exit. To the extent that governance mechanisms restrain

agency costs, they have the potential of affecting exit price. Nonetheless, we feel that our data is

sufficient to enable us to perform the first empirical tests of factors affecting the full range of VC exits.

B. Investment Duration and Exit Strategy

VCs are more than merely sophisticated investors with the ability to separate good investments

from bad. While they do not run the EF on a day-to-day basis, there are hands-on investors whose various

activities add value to their EFs. VCs monitor and sometimes replace management, participate in strategic

decisions, and offer informal advice on decisions of lesser importance. Experienced VCs have webs of

contacts that assist the firm in sourcing materials, finding customers, building distribution networks, and

locating strategic partners. They offer expert advice on (and participate in) finding other sources of

funding. VCs also use their experience to help the firm find skilled lawyers, accountants, investment

bankers, and other professional advisors.184

We posit that, just as the acceleration imparted to a physical mass depends on the duration of the

external force applied, the increase in value of an EF will depend on the duration of the VC’s involvement

with the firm. Put in more concrete terms, firms that have benefited from lengthy VC guidance will be

more likely to have a proven product, an established market, relatively experienced management, and more

elaborate internal information and control systems than at the time of initial investment. Contacts between

184 ? Supra, notes 11-14 and accompanying text.

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the firm and suppliers, marketing experts, lawyers and investment bankers will be in place.185 These factors

attenuate many of the risks that confront investors in the earlier stages of the firm's existence.186

Empirically, VC involvement with an EF has been demonstrated to be a signal of firm quality to

the public market in relation to IPOs. Venture-backed firms experiencing an IPO are subject to less

underpricing than their non-venture-backed counterparts.187 In addition, venture-backed firms perform

better post-IPO than other IPO firms.188 This suggests that the longer the involvement of the VC, the

more potent the signal of quality.189

This hypothesis is testable. If duration is a signal of quality, the signal will have the highest value

where information asymmetry is the greatest. We have suggested that information asymmetry is at its

greatest in IPOs, followed by secondary sales, acquisitions and buybacks.190 We thus conjecture the

following causal relationship:

Hypothesis 2 The longer the venture capitalist's investment duration, the more likely the following exit

vehicles will be used (in decreasing order of likelihood): IPOs, secondary sales,

acquisitions, buybacks, and write-offs.191

185 ? Megginson & Weiss, supra note 5; Gompers, 1996, supra note 7.186

? These risks are described in Sahlman, supra note 4, at 489; see also MacIntosh, supra note 14. Nonetheless, the degree of information asymmetry will be high compared with that of a typical public company. A public company will have a lengthier operating history. Moreover, much more information about a public firm will be on the public record, both as a consequence of the operation of private information gathering networks and mandatory disclosure requirements.

187 ? Barry et al., supra note 5.

188 ? Id.

189 ? See Cumming & MacIntosh, supra note 11. This is similar to the model developed by Chemmanur & Fulghieri, supra note 20, in which public offerings are better suited to older, more established companies in which moral hazard and adverse selection costs are less pronounced.190

? In addition, note that write-offs may be expected to be most frequent where investment duration is shortest. Mitigating informational asymmetry between the firm and its future owners obviously is irrelevant to an investment that will be written off. VCs will not actively contribute to an investee once they learn that its quality is so low that it must be written off. While "living-dead" investments may exist (whereby VCs hang onto the investment in hope of a turnaround) a strategy of supporting living-dead investments may diminish a VC firm's reputation and its ability to signal quality to future owners through their active participation in the development of the firm.191

? In other words, (PIPO/PSecondarySale)/(Duration) > 0 (i.e., the derivative of the probability of an IPO / the

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As with Hypothesis 1, Hypothesis 2 is tested in the Appendix for the possibility of endogeneity.

In addition, a variety of other factors appear to influence investment duration. Related research

indicates that investment duration is shorter when the exit is pre-planned or induced by an unsolicited

offer.192 Investment duration is also shorter for earlier stage (seed, start-up and expansion) investments. 193

In addition, VCs with large amounts of capital available for investment tend to exit their existing

investments sooner.194 In respect of IPOs, Gompers has shown that grandstanding affects investment

duration.195 Market liquidity may also affect investment duration. In order to take these factors into

account in our empirical analysis below we regressed various of these variables on duration and used the

residual explanatory variable [for what?]. Alternative specifications did not yield significant qualitative

differences in our results. Hence, in the analysis that follows, we use the total duration of the VC’s relation

with the entrepreneurial firm.

C. Exit Strategies and High-Technology Firms

High-technology firms (e.g., those in biotechnology, communications, computers, electronics,

energy, environmental technology, and medical related industries) are distinct from other entrepreneurial

firms in a number of important respects. First, information asymmetries are likely to be more pronounced

for technology firms. Such firms have assets that are intangible and transaction-specific.196 Further,

entrepreneurs' actions are difficult to monitor, and a greater proportion of the value of the investment is

concentrated in the hands of mobile human capital.197 Because of these factors, high technology firms are

probability of a secondary sale with respect to VC investment duration is positive). Similarly, Hypothesis 2 states that (PSecondarySale/PAcquisition)/(Duration) > 0, and therefore (PIPO/PAcquisition)/(Duration) > 0, etc.

192 ? Cumming & MacIntosh, supra note 11.

193 ? Id.

194 ? Id.

195 ? Gompers, 1996, supra note 7.

196 ? Thomas H. Noe & Michael J. Rebello, Asymmetric Information, Managerial Opportunism, Financing and Payout Policies, 51 J. FIN. 637 (1996).197

? Id. See also Oliver Hart & John Moore, A Theory of Debt Based on the Alienability of Human Capital, 109 QUART. J. ECON. 841 (1994); MacIntosh, supra note 14.

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more difficult to value.198 This raises the likelihood of an acquisition exit, since strategic acquirors are

better positioned than the public market to resolve information asymmetries and value the firm, and to

monitor and discipline managers post-exit.

Second, technology firms are probably better suited to the achievement of transaction synergies

than traditional firms. Since transaction synergies are better accommodated by an acquisition exit, this too

tends to push in the direction of an acquisition.

In short, as we noted earlier, for some firms and in some states of the world, acquisition exits may

dominate IPO exits – and this will be particularly true for technology firms. For this reason, in hypothesis

3 below, we hypothesize an equal probability of an IPO and an acquisition exit for technology firms.

The choice between secondary sales and buybacks is more difficult. Buybacks address problems of

information asymmetry better than secondary sales. However, secondary sales are more likely, in the long

run, to result in the realization of transaction synergies. We thus suggest that the presence of a technology

EF will raise the probability of a secondary sale compared to a buyback.

Hypothesis 3 High-technology entrepreneurial firms will be exited by (in decreasing order of likelihood)

by IPOs and acquisitions, then secondary sales, buybacks, and write-offs.199

Summary of Hypotheses

Three factors were conjectured to affect the choice of exit vehicle: entrepreneurial firm quality

(Hypothesis 1), venture capital investment duration (Hypothesis 2), and whether the investee is a high

technology firm (Hypothesis 3).

Before proceeding with the empirical analysis of these three hypotheses in section VI, in the

198 ? Op. cit.199

? In other words, (PIPO/Psecondary sale)/(Technology) > 0 (i.e., the derivative of the probability of an acquisition / the probability of an secondary sale with respect to binary indicator of whether it is a technology entrepreneurial firm is positive). Similarly, Hypothesis 3 states that (PSecondarySale/PBuyback)/(Technology) > 0, and therefore (PSecondarySale/PBuyback)/(Technology) > 0, etc. For reasons discussed in the text is difficult to predict, a priori, the likelihood of an IPO over an acquisition for technology firms.

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following section we first consider how the Canadian and U.S. data may reflect legal and institutional

differences.

V. LEGAL AND INSTITUTIONAL FACTORS AFFECTING CHOICE OF EXIT VEHICLE; U.S. AND

CANADIAN DIFFERENCES

This section briefly touches on a number of legal factors that affect exit strategy. 200 Subsection A

notes some differences between U.S. and Canadian VC funds, and the impact these differences might have

on exit data. Tax differences between Canada and the U.S. are noted in subsection B. Differences in

Canadian and U.S. securities regulation are discussed in subsection C, market liquidity in subsection D, and

underwriter support for IPOs in subsection E.

A. Type of Venture Capital Fund

The U.S. data examined in section VI is derived wholly from private venture capital funds. In

contrast, the Canadian data contains a mixture of types of VC funds. Macdonald & Associates classifies

the Canadian industry into 5 types of funds.201 The primary difference across funds arises in respect of the

source of contributed funds. "Private independent" funds are funded mainly by public and private pension

funds and wealthy individuals. "Corporate industrial" funds are wholly owned venture capital subsidiaries

of corporations, while "corporate financial" funds are wholly owned subsidiaries of financial institutions.

Together, these three types of funds, which correspond to those digested in the U.S. data, are referred to

below as "private" funds.

In addition, "government" or "public" funds are venture capital corporations owned and run by the

federal or provincial governments. Finally, hybrid funds are "funds which are formed in response to a

government incentive or an investment by government alongside private investors, or which have secured

200 ? For a more detailed analysis, see MICHAEL ANDREWS, INITIAL PUBLIC OFFERINGS BY CANADIAN GROWTH COMPANIES (1995); MacIntosh, supra note 14; Michael J. Robinson, Raising Equity Capital for Small and Medium Sized Enterprises Using Canada's Public Equity Markets , in PAUL J.N. HALPERN, ED., FINANCING GROWTH IN CANADA, 593-636 (1997).

201 ? MACDONALD & ASSOCIATES, VENTURE CAPITAL IN CANADA: A GUIDE AND SOURCES (1992).

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more than 50% of their capital from another hybrid fund".202

The two types of funds that dominate the Canadian VC landscape are private funds and hybrid

funds. In turn, the most important type of hybrid fund is the Labour Sponsored Venture Capital

Corporation (LSVCC). LSVCCs controlled roughly half the total amount of venture capital under

management in Canada between 1992 and 1995, the years spanned by our data, and significantly more than

any other type of fund.203

The LSVCC is a venture capital corporation created pursuant to special legislation of either the

federal government or one of the five provinces that have passed enabling legislation for such funds. 204 The

impulse that led to the establishment of the LSVCC was a desire to encourage blue-collar ownership of

small and medium-sized enterprises. The province in which the fund is created provides a generous tax

credit to fund investors, and this credit is matched by the federal government (regardless of the jurisdiction

of incorporation).205 Only individual investors may contribute to LSVCC funds. Because of the underlying

inspiration, a labour union must sponsor the fund, although anyone may invest in one.

In practice, LSVCCs investors are white-collar workers.206 Even though the union will nominally

control the fund (all jurisdictions require that it appoint a majority of the board), its only substantive

involvement is, in essence, to “rent” its name to the fund. The professional managers hired under contract

by the union run the fund’s operations more-or-less autonomously.

202 ? Id., at 4, note 3; MACDONALD & ASSOCIATES, THE VENTURE CAPITAL MARKET IN CANADA: AN ANALYSIS OF 1993 VENTURE CAPITAL ACTIVITY (1994).203

? See MACDONALD & ASSOCIATES, CANADIAN VENTURE CAPITAL ASSOCIATION ANNUAL REPORT (1992-1996).

204 ? See generally Douglas J. Cumming & Jeffrey G. MacIntosh, Law, Finance and The Canadian Venture Capital Cycle, University of Alberta and University of Toronto, mimeo (2001).

205 ? Prior to 1996, investors in LSVCCs received a 20% provincial tax credit plus a 20% federal tax credit on an investment of up to $5,000. The $5,000 contribution was also eligible to be deducted from taxable income if contributed through a Registered Retirement Savings Plan (“RRSP”) (similar to an American 401k plan). Under the March 1996 federal budget, the government's tax credit was reduced to 15% on a maximum investment of $3,500, and since that time the provinces have similarly reduced the provincial tax credit. The $3,500 contribution, however, is still eligible to be deducted from taxes if invested through an RRSP.

206 ? Francois Vaillancourt, Labour-Sponsored Venture Capital Funds in Canada: Institutional Aspects, Tax Expenditures and Employment Creation, in PAUL J.N. HALPERN, ED., FINANCING GROWTH IN CANADA (1997).

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LSVCCs operate under statutory constraints that do not apply to private funds. In particular,

LSVCCs are typically created with the dual mandate of creating jobs and investment in the sponsoring

jurisdiction. This difference between LSVCCs and private funds, however, is more apparent than real. In

the interests of attracting capital contributors, most funds207 operate in practice as profit maximizers, and a

number have publicly announced their intention to do so despite their statutory mandates.

Other statutory constraints may have a more real impact on exit strategy, via their impact on the

types of investments made by LSVCCs. First, federal and provincial LSVCC legislation typically penalizes

a fund for failing to invest a stated percentage of its committed capital within a certain period of time

(usually one or two years) following receipt of that capital. This creates an impetus to get the money out

the door quickly, which in turn may lead to poor investment choices. It may also prompt the fund to limit

its purview to larger (and therefore probably older and less risky) investments.

Second, we believe that the rapid influx of capital into LSVCCs has resulted in many of these

funds hiring inexperienced managers.208 If so, LSVCC managers are less likely act effectively at any of the

three stages at which VC expertise is applied: choosing investments, providing value-added services, and

providing sound exit advice. Inexperienced managers are more likely to shy away from younger, riskier

companies in making investment decisions. They are less likely to give effective advice to the entrepreneur

on exit strategy.

The hypothesis of lower skill levels is supported by anecdotal evidence suggesting that U.S. VCs

have specialized in particular types of EFs to a much greater degree than their Canadian counterparts.209

While most Canadian funds have historically been willing to entertain investments in virtually any industry

(especially the large LSVCC funds), many U.S. funds have limited themselves to investments in particular

areas of the high technology spectrum.210 Industry focus is likely to enhance VC profits.211

207 ? One notable exception is Quebec’s Solidarite Fund.

208 ? Cumming & MacIntosh, supra note 11.

209 ? MacIntosh, supra note 14; Macdonald & Associates, 1992, supra note 202, 1994, supra note 201; Sahlman, supra note 7, at 489.

210 ? E.g. biotechnology or computers; see Bygrave & Timmons, supra note 13.

211 ? Gompers & Lerner, supra note 4; Robert T. Klienman & Joel M. Shulman, The Risk-Return Attributes of

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Third, the LSVCCs are essentially open-ended mutual funds, from which investors may withdraw

at any time. During the period covered by our data, however, investors could typically withdraw after only

5 years without being subject to recapture of the investment tax credit (this has since been changed to 8

years, and investors in Solidarité, the largest Canadian VC fund, must normally wait until retirement to cash

out).212 By contrast, investors in private funds are usually locked in for 10 years.213 Thus, LSVCCs must

maintain a greater percentage of their investment portfolios in comparatively liquid form.

The conjecture that LSVCCs will make larger average investments in older (and probably therefore

less risky) firms is borne out by industry statistics.214 To the extent that the upside potential of LSVCC

investments is therefore lower, we would expect LSVCCs to exit their investments in a manner more suited

to lower growth firms; i.e. with fewer IPOs and acquisitions, and more secondary sales and buybacks.

It may be that the relative lack of expertise of the LSVCC funds will particularly elevate the

number of secondary sales. If LSVCCs are less capable of adding value than private funds, it makes sense

for the LSVCC to sell at least some of its investments to private funds.

The relative lack of expertise of LSVCC fund managers may introduce a more serious problem.

Unskilled managers are likely to make both investment and exit decisions that are not purely the product of

expertise. The resulting randomised component of exit strategy will show up in our data as “noise” that

attenuates the link between our 3 Hypotheses and actual exit behaviour. We thus expect the three

hypotheses to bear more fruit in respect of the U.S. data.

Although there are few government funds in Canada, the presence of government funds may

increase the number of buybacks. Governments are less concerned to make profits for the government than

to strengthen the entrepreneurial sector. Anecdotal evidence suggests that such funds will sometimes agree

to a buyback exit even when a more advantageous form of exit is available.215

Publicly Traded Venture Capital: Implications for Investors and Public Policy , 7 J. BUS. VENT. 195 (1992).212 ? Id.

213 ? Id.

214 ? Id.

215 ? Innovation Ontario, a now defunct Ontario government fund, was in fact required to give the entrepreneur

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The Canadian data, described in section VI below, does not distinguish between different types of

venture capital funds (our data is opaque as to fund identity). In view of the fact that the U.S. data are

entirely from private funds but the Canadian data mixes public, private, and hybrid funds, we expect

stronger support for Hypotheses 1, 2 and 3 in the U.S. than in the Canadian data.

B. Tax Factors

Tax factors are clearly important in directing investment dollars to VC funds as opposed to other

investment vehicles. It is clear that changes to the U.S. tax code, for example, were instrumental in the

rapid growth of the U.S. venture capital industry observed in the late 1970s and early 1980s.216 U.S. tax

law has also impacted upon the VC's choice of the limited partner form of organization that is used by

eighty percent of U.S. venture capital funds.217

For our purposes, the important question is whether different forms of exit are subject to

differential forms of taxation either within the U.S. and Canada, or between the U.S. and Canada. Such

differences may supply a reason for cross-sectional variations in patterns of exit. Taxation factors may also

account for changes in exit strategies over time. While no attempt was made to systematically determine

the tax consequences of all means of exit both in Canada and the U.S., discussions with VCs and tax

attorneys in both countries suggested that tax factors were relatively unimportant in the choice of exit

strategy, and that tax factors do not appear to have coloured the cross-sectional selection of exits as between

the two countries. Whether shares are sold by the VC in an IPO, a secondary market sale, an acquisition, or

a buyback, VCs in both countries will generally pay capital gains tax on an investment’s appreciation in

value. We thus do not expect taxation factors to have a material impact on observed exit strategies.

C. Securities Regulation

Related research suggests that securities regulatory requirements impact on the VC’s choice of exit

an option to repurchase the government’s interest. Because the identities of our survey funds are not known to us, we cannot tell if there are any Innovation Ontario funds in our data set.

216 ? Bygrave &. Timmons, supra note 13. 217 ? Gompers, Id.; Sahlman, supra note 7.

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vehicle.218 Both Canadian and U.S. securities legislation impose hold periods on any investor purchasing

securities in an exempt market transaction (i.e. one effected without the issuance of a registration statement)

prior to the date of the firm’s IPO. Such requirements, which will virtually always apply to VC holdings,

are designed to prevent a “back-door distribution” in which exempt investors (i.e. those who may purchase

the issuer’s securities without the issuer filing a registration statement) purchase securities not for

investment purposes, but solely for the purpose of funnelling them through to non-exempt investors (i.e.

those who are able to purchase only pursuant to a registration statement).

During the period covered by our study, regulatory hold periods in Ontario (which were

representative of other provincial enactments) ranged from 6 months to 18 months.219 However, virtually

all of the firms brought to market by VCs would have had hold periods of either 12 or 18 months.220 These

hold periods start to run from the later of the date on which the exempt purchase took place and the date of

the IPO.221 Thus, whenever the VC received its securities in the EF, it typically must hold those securities

for at least 12 months from the date of the IPO before selling, unless a sale is effected to another exempt

purchaser. By contrast, in the U.S., the typical hold period is two years, and this period begins to run from

the date of the exempt purchase and will typically have expired prior to the IPO.222 Thus, hold periods

constitute a constraint on the sale of VC shares in Canada but not in the U.S.

The escrow requirements in force in Canada during the period of our study were also in excess of

those in the U.S. During the period covered by our survey data, Canadian escrow requirements arose

218 ? MacIntosh, supra note 14.

219 ? Ontario Securities Act, R.S.O. 1990, c.S.5, ss. 72(4), (5); Ontario Regulation 1015, R.R.O. 1990, as am., s.25.

220 ? The 12 month period will apply if the firm is listed on the Toronto Stock Exchange, while the 18 month hold period will apply otherwise. Id.

221 ? Id.

222 ? SEC Rules 144 and 145. In April 1997, these hold-period requirements were lowered to one year after the purchase of restricted stock, with some restrictions between the first and second years; see SEC 17 CFR Part 230 [Release No. 33-7390; File No. S7-17-95].

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pursuant to both securities regulatory rules223 and stock exchange requirements,224 although for most of the

EFs in our sample, only the stock exchange requirements would apply.225 These rules are designed to

ensure that managers and key investors remain involved with an enterprise for a period of time after the

firm goes public (in order to ensure appropriate governance and continuity of management). Thus, under

the TSE requirements, shareholders holding 10% or more of the voting shares of the EF – including any

VC satisfying the ownership threshold - must place their shares with an escrow agent prior to the elapse

of the escrow period. While in the custody of the escrow agent, these shares cannot be sold without the

permission of the securities regulators. In the period covered by our sample years, the escrow

requirement could extend from 6 months to somewhat in excess of 5 years, although most escrow periods

would have been in the range of 1 to 3 years (Tucker, 1999)). Thus, Canadian VCs exiting via an IPO

experience less post-IPO liquidity than their American counterparts.

The view that these regulatory requirements make it more difficult to effect an IPO exit in Canada

as opposed to the U.S. must be qualified, however, to the extent that Canadian and U.S. markets are

integrated.226 If a Canadian VC can exit into the U.S. market without significant additional cost (as

compared to a Canadian IPO), these differences in regulatory burden would be essential moot. Since exit by

Canadian VCs into the U.S. market is much more likely than exit by U.S. VCs into the Canadian market,

we will deal with the former case only.

Canadian VCs (like other VCs) tend to prefer to invest close to home, and LSVCCs are in fact

constrained to invest only in firms for which the majority of employees, assets and/or payroll are located in

Canada.227 Thus, in most cases, Canadian VCs will be exiting investments in Canadian firms. Is the

Canadian/U.S. border fully transparent to such firms?

223 ? During the period of time covered by our study, OSC Policy 5.1, covering junior resource issuers, specified escrow periods. See (1991) OSCB 899.

224 ? See e.g. Toronto Stock Exchange Manual, Company Manual, [loose-leaf] (Toronto: Toronto Stock Exchange, 1984), Part III, C, s.327, and Appendix C (“Original Listing Requirements”).

225 ? Given that few VC-backed firms are resource issuers, OSC Policy would have applied at most to a trivial number of EFs in our Canadian sample.

226 ? See Edward B. Rock, Greenhorns, Yankees and Cosmopolitans: Venture Capital, IPOs, Foreign Firms & U.S. Markets, 2 Theoretical Inquiries in Law 711 (discussing IPOs by foreign firms in the U.S.).

227 ? Cumming & MacIntosh, supra note 203.

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We distinguish four cases. First, these markets will be fully integrated if a VC in either country

may choose an exit in either country at the same cost. They will be quasi-fully integrated if a VC in either

country may exit in the other country at the same cost as an identical exit taken by a VC in the other

country. In this case, there may be differences in exit costs in the two countries, but there must be national

treatment of all VCs for regulatory purposes (such that all VCs, wherever situate, may exit by compliance

with a common regulatory regime in any country in which the exit takes place). There will be imperfect

integration if there is non-national treatment in the two markets, such that the regulatory regime for

Canadian VCs when selling into the U.S. is more onerous than that confronted by U.S. VCs. Finally, the

two markets will be fully segregated if cost differences are so great (with or without national treatment) that

the Canadian/U.S. border is opaque to exit transactions.

In the case of VC exits, it is clear that markets are not fully segregated. Anecdotal evidence offers

examples of Canadian VCs exiting their investments through IPOs, acquisition exits, and secondary sales

effected to U.S. buyers. Buybacks are quit different, however. Because Canadian VCs prefer to invest

close to home, and LSVCCs are in fact constrained to invest in Canadian firms, a Canadian VC’s EFs will

usually be located in Canada. Buyback exits will therefore be effected from entrepreneurs located in

Canada.

In general, empirical evidence suggests that Canadian and U.S. markets are not fully integrated.228

A principal cause of the lack of integration is home bias, although due to our imperfect understanding of

what causes home bias, the phrase is perhaps more a description of the empirical result than an explanation

for it. In all likelihood, home bias results from information asymmetries arising between domestic and

foreign investors, with the result that local investors may be in a position to exploit less knowledgeable

outsiders.229

As a first approximation, Canadian issuers selling into the U.S. public market must comply with

the same rules to which U.S. issuers are subject. However, Canadian issuers are in addition subject to a

228 ? Usha Mittoo, Additional Evidence on Integration in the Canadian Stock Market , 47 J. FIN. 2035 (1992); Philippe Jorion & Eduardo Schwartz, Integration vs. Segmentation in the Canadian Stock Market, 41 J. FIN. 603 (1986).

229 ? Jeffrey G. MacIntosh, International Securities Regulation: Of Competition, Cooperation, Convergence and Cartelization, University of Toronto, mimeo (1995).

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requirement to reconcile their financial statements to U.S. accounting standards, a non-trivial expense that is

not experienced in a domestic IPO.

In addition, Canadian hold periods apply to securities purchased by a Canadian VC under Canadian

law even when the VC’s sale is effected in the U.S.230 Thus, Canadian VCs are subject to more onerous

hold periods than U.S. VCs even when selling into the U.S. public market.231

Finally, a number of Canadian VCs have suggested to us other factors that enter into the decision of

whether to sell into the U.S. or Canadian public markets. In favour of a Canadian IPO, it was suggested to

us that legal costs are substantially higher in the U.S. than in Canada. In addition, because the corporate

landscape is so much vaster in the U.S., it was suggested that it is easier to become an “orphan” firm. An

orphan firm is one that is not followed by analysts and that typically generates little interest from

institutional investors. Once a firm acquires orphan status, it can be extremely difficult to raise further

capital. Because there are Canada substantially fewer issuers in Canada than in the U.S., and because many

Canadian institutions are restricted in the extent to which they can purchase foreign securities,232 it was

suggested to us that it is more difficult to become an orphan firm in Canada.

In favour of a U.S. IPO, however, it was suggested that IPO stock valuations are generally higher in the

U.S. This may devolve from some of the other advantages that are said to inhere in a U.S. offering. In

particular, the pool of investors that an issuer may access in a U.S. offering is vastly greater than that in

Canada. Relatedly, the liquidity of the U.S. public markets is substantially greater than that in Canadian

public markets (see further infra). A few Canadian VCs suggested that they frequently face serious

230 ? The hold periods are set in motion when the “initial exempt trade” occurs under applicable securities law. See e.g. OSA, ss.72(4).

231 ? These hold periods will not typically affect the VC’s ability to effect a secondary sale or an acquisition into the U.S., given that in virtually every case a relevant exemption from Canadian secu rities laws will be available. See e.g. OSA ss.72(1)(d) (exemption purchases in excess of $150,000 from the prospectus requirement).

232 ? The restriction is question is typically known as the “foreign property rule”. Income Tax Act, S.C. 1970-71-72, c.63, s.206. The foreign property rules, which apply to all tax exempt investors (including holders of Registered Retirement Savings Plans, or "RRSPs", registered pension plans, and charities, limit the extent to which shares of non-domestic issuers may be purchased as portfolio investments. Failure to conform to the requirements of the Act results in tax penalties. The foreign property rules affect mutual funds that wish to sell interests to holders of RRSPs, since in order to qualify to do so they must become a "registered investment" and comply with the foreign property rules. See Income Tax Act, id., Part X.2.

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liquidity constraints following a Canadian IPO, making it difficult to effect an exit from a public company -

without substantially depressing the market price - for a period of many years after the expiry of pertinent

hold and escrow requirements. Also in favour of a U.S. IPO, it was suggested that once the firm has

acquired a public profile in the U.S., future financing efforts are greatly facilitated (again, because of the

deeper pool of potential investors). Each of these factors might yield higher valuations in the U.S. market.

Another factor that was said to motivate a U.S. offering was greater visibility and acceptability to

potential customers. When this is particularly important, the Canadian EF will not only make a public

offering in the U.S. (and list on a recognized U.S. exchange, such as NASDAQ) but will also reincorporate

in the U.S. (often in Delaware) and essentially pass itself off as a U.S. corporation.

We draw the following conclusions:

1. U.S. and Canadian markets are neither fully integrated nor fully segregated. In our lexicon, they

are somewhere in the region of quasi or imperfectly integrated.

2. Regulatory differences between Canada and the U.S. colour the cross-section of exits taken by

Canadian and U.S. VCs. In particular, Canadian VCs will effect IPO exits less frequently then

their U.S. counterparts.

3. Only a subset of IPO exits will be effected by Canadian VCs into the U.S. market.

D. Market Liquidity

Liquidity is of value investors and will affect the VC’s exit price. Canada’s economy is

approximately one-tenth the size of the U.S economy, and the depth of Canadian liquidity pools is

commensurately less than in the U.S.

Canadian illiquidity appears to be a function of more than just the number of potential traders on

each side of the market. Many VCs suggested to us that the greater liquidity in the U.S. market is also a

consequence of different appetites for risk in the two countries. U.S. institutions are said to be far more

willing than their Canadian counterparts to trade in comparatively risky technology stocks and more

generally in small firm stocks. While there is, so far as we know, no systematic evidence to back up this

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claim, it was almost universally adverted to in our discussions with Canadian VCs.233

The illiquidity of Canadian markets extends to secondary sales and acquisitions as well as IPOs,

insofar as there are far fewer domestic strategic acquirors than in the U.S. While the pool includes firms

such as Nortel, JDS Uniphase, and Newbridge Networks, it nonetheless lacks significant depth. This

suggests that the cross-section of Canadian exits, when compared to the U.S., will be tilted away from

IPOs, acquisition exits, and secondary sales, and toward buybacks, given that the liquidity of a buyback

will definitionally be the same in Canada and the U.S.

E. Underwriter Support for IPOs

Unfortunately, there is little systematic evidence on the comparative nature of Canadian and U.S.

underwriting industries. However, there is some evidence that there are proportionately more underwriters

willing to bring small and medium-sized firms to the public market in the U.S. than in Canada.234

The U.S. market is also characterized by the existence of niche underwriters that service the high

technology market. There are no such players in Canada, probably because of economies of scale that arise

in the larger U.S. market.235 In the face of imperfect integration, this suggests that the cross-section of U.S.

exits should exhibit more IPOs than in Canada.

Summary

We have noted a number of factors that we expect to affect the cross-section of exits taken in

Canada and the U.S. We have suggested that Canadian VCs are less skilled than their U.S. counterparts.

233 ? Institutional trading creates a public good, in the sense that an institutional decision to buy or sell creates an opportunity for a trader on the other side of the market. By creating liquidity, institutional activity in secondary markets also facilitates public offerings by small firms. This emphasizes the importance of regulating institutional purchases in a manner that does not restrict the purchase of small firms. Legal restraints on institutional investors have played an uncertain role in institutional purchases of small firm stocks by Canadian institutions. Even restrictive 'legal for life' statutes have 'basket clauses' allowing for purchases of risky small firm shares, although recent federal adoption of "prudent person" investing standards (also now adopted in many of the provinces) may encourage more small firm investment. See generally MacIntosh, supra note 14; BRIAN Z. GELFAND, REGULATION OF FINANCIAL INSTITUTIONS (1993).

234 ? “Top Brokers in Small-Cap IPO Market: First-Half 1994”, PROFIT 57 (Fall 1994); Economic Council of Canada, INTERVENTION AND EFFICIENCY (1982), at 29.

235 ? MacIntosh, supra note 14.

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This should lead to a greater proportion of inherently high-value IPO exits in the U.S. We also expect that,

in the face of imperfect integration between Canadian and U.S. capital markets (at least in relation to

smaller firms), the tendency toward fewer IPOs in Canada will be strengthened by more strenuous

regulation of IPOs in Canada, lower market liquidity, and less investment banker support for small firms.

The relative proportion of acquisition exits will also be affected by the comparative skill of U.S.

and Canadian VCs. In particular, we expect to observe more acquisition exits in the U.S. By the same

token, we expect to observe a higher level of secondary sales in Canada, since secondary sales are relatively

low-value exits. The tendency to effect more exits via secondary sales will be moderated to some extent,

however, by the comparative dearth of strategic acquirors in Canada (again, assuming the absence of perfect

integration).

The liquidity of buybacks is inherently the same in Canada and the U.S. Moreover, regulatory

factors are not likely to inhibit buybacks in Canada relative to the U.S. Coupled with the fact that buybacks

are typically low value exits, we thus expect to observe a higher proportion of buyback exits in Canada than

in the U.S.

VI. EMPIRICAL EVIDENCE

Our empirical analysis begins with the presentation of a number of summary statistics from the

Canadian and U.S. data in subsection A. A multinomial logit model is then employed in subsection B to

assess the impact of various factors that influence venture capitalists' choice of exit vehicle (Hypotheses 1, 2

and 3). Concluding remarks and policy implications follow.

A. Data

The survey data comprises exits from 112 portfolio companies from 13 venture capitalists in the

U.S. and 134 portfolio companies from 22 venture capitalists in Canada between 1992 and 1995. The IPO

exits are public data; the non-IPO exits (acquisitions, secondary sales, buybacks and write-offs) are private

data collected by means of a survey of Canadian and U.S. VCs.236

236

? Collection of the survey data was done in conjunction with Venture Economics in the U.S. and the Canadian Venture Capital Association Both companies produce annual yearly statistical summaries of the venture capital industry in their respective countries. The data comprises approximately 10% of all U.S. exits and 32% of

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The data are summarized in Tables II and III.237 Table II indicates that the most common exit

vehicles in the U.S. were write-offs (29.5% of the total), IPOs (26.8%), and acquisitions (26.8%); the least

common were secondary sales (8.0%), buybacks (5.4%) and other238 (3.6%). In Canada, the most common

exit methods were company buybacks (30.6%), IPOs (26.9%) and write-offs (20.1%); the least common

were acquisitions (11.9%), secondary sales (9.0%) and other (1.5%) (see Table III).

These cross-sectional results are only partly consistent with our earlier conjectures about the

relative frequency of different types of exits in Canada and the U.S. While we expected fewer IPOs in

Canada, the proportion of IPOs in the U.S. and Canada is virtually the same. The Canadian exits data,

however, shows a much greater proportion of buybacks and a much lower proportion of acquisition exits, as

expected. While we expected a higher proportion of secondary sales in Canada than in the U.S., the

proportion of such exits in the two countries is similar.

We also note, however, that the proportion of write-offs is lower in Canada than in the U.S. On its

face, this is inconsistent with the hypothesis of lower skill levels among Canadian VCs. However, this may

simply reflect the relative opportunity costs facing Canadian and U.S. VCs. If U.S. VCs are more skilled,

the opportunity cost of effecting a buyback (especially when managerial time spent negotiating and

documenting the deal is included) will be higher. Thus, some exits that would in Canada be taken as

buybacks may be taken in the U.S. as write-offs. This explanation is consistent with both the greater

proportion of buybacks and the lower proportion of write-offs in Canada. In support of this theory, we note

all Canadian exits from 1992 to 1995. Factors that may induce self-selection reporting bias of private data (acquisitions, secondary sales, buybacks and write-offs) across Canada and the U.S. are likely to be the same in the two countries; therefore self-selection bias, if it exists, should not affect the comparative cross-country results. The Canadian Venture Capital Association (1993-1996), supra note 9, reports the total dollar values of the exits in Canada for each exit vehicle; Venture Economics (1993-1996), supra note 9, only reports the total dollar values of IPO and acquisition exits. Additional industry data is not available in the Venture Economics (1993-1996) and Canadian Venture Capital Association (1993-1996) annual reports; nevertheless, the available industry data do not suggest significant discrepancies between the Canadian and U.S. samples and industry data.237

? All dollar amounts were converted into constant 1990 US dollars. US dollar values were converted into constant 1990 dollars using International Financial Statistics, label 11/64. Canadian dollar values were converted into constant dollars using the CPI from CANSIM, label P700000, and to US dollars using foreign exchange rates from CANSIM, label B3400.238

? "Other" exits involve mixed exit strategies (e.g., part buyback, part secondary sale). Other exits were included in the multinomial logit estimation below; however, their coefficients are not reported because their expected signs are ambiguous and the coefficients were generally insignificant.

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that the average annual real return for buybacks in Canada was about 4%, while the average in the U.S. was

about 25%. Given that only 6 exits taken were taken as buybacks in the U.S. this return figure should be

used cautiously. Nonetheless, the comparative rates of return are consistent with the view that the

opportunity cost of effecting buybacks is higher in the U.S. than in Canada.

[TABLES II AND III ABOUT HERE]

We also note, however, that U.S. investments are, on average, about twice the size of those in

Canada. Because repurchase of a larger stake will consume greater entrepreneurial resources (and/or

borrowing) to effect the buyback, also lowering the likelihood of a buyback in the U.S. relative to Canada.

Our data include both full and partial exits.239 A partial exit involves a disposition of only part of

the VC’s shares. In the case of an IPO, by convention, a full exit includes any case in which the VC

disposes of its entire investment within one year from the date of the IPO. In our data, a partial acquisition

is defined as an exit in which the VC received shares, rather than cash, in consideration for parting with its

interest. We also define a partial write-off as a write-down of the value of the investment on the books of

the VC.

That some exits were partial in nature creates a statistical problem in that, for partial exits, exit

value was reported, but the proportion of the VC’s interest that was liquidated was not. Thus, we were

compelled to estimate what proportion of its interest a VC would typically sell in a partial exit, and adjust

the exit value accordingly to obtain the value of the entire firm at the date of exit. From other published

data,240 a partial exit on average involves a disposition of 69% of the VC’s interest. As this adjustment to

the market values may create bias in the data, we present the summary statistics for the samples with and

without the sample of partial exits. The summary statistics for the full sample and the sample excluding

partial exits are similar. The empirics in the following subsection and the Appendix focus on the entire

sample including the partial exits, given that when we excluded the partial exits our data yielded

qualitatively similar econometric results, and the results in Tables 4 and 5 were robust to various

adjustments to the value of the partial VC dispositions.

239 ? For a theoretical discussion with empirical tests of when full and partial exits are likely to occur, see Cumming & MacIntosh supra note 100. 240 ? Gompers & Lerner, supra note 4; Cumming & MacIntosh, supra note 11.

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On average, there were higher initial investments in the U.S. than in Canada for IPOs, secondary

sales, and write-offs; initial investments were higher in Canada for acquisitions and buybacks (see Tables II

and III). Exit values were highest (lowest) for IPOs (write-offs) in both Canada and the U.S., which is

consistent with the Venture Economics and Canadian Venture Capital Association Annual Reports (1993-

1996). Both average investment and exit values were higher in the U.S. than in Canada.

For all exit vehicles taken together in the full sample, the average annual real return was positive in

the U.S. (5.61%), but negative in Canada (-2.25%). This is consistent with our working hypothesis.

Average annual real returns in the U.S. were highest for acquisitions (57.8%), IPOs (54.9%) and buybacks

(34.0%) (see Table II). Average annual real returns were negative for secondary sales and write-offs in the

U.S.

In Canada, average annual real returns were highest for secondary sales (54.9%), followed by IPOs

(27.8%) and acquisitions (13.3%). Average annual real returns were negative only for write-offs (see Table

III). The summary statistics for the data excluding partial exits are broadly similar; see Tables II and III.

The U.S. summary statistics on profitability are broadly in keeping with our hypothesized rank

ordering of exits by firm quality. While acquisition exits were the most profitable exits in the U.S.,

contrary to expectation, IPOs were a very close second. Given that the IPO market was not particularly hot

in the period covered by our data, this result is not seriously at odds with our hypothesized ranking or with

other published data. Further, our data indicates that those firms with the highest market/book ratio (our

proxy of firm quality) were exited via IPOs, rather than acquisitions.

The other anomaly in the U.S. data is the relatively high return associated with buyback exits

(34%). We note that there were very few buybacks in the U.S. sample (6 of 112) and the surprising

profitability of buybacks is thus not terribly robust. That secondary sales realized a negative annual real

return on average was another surprise: we expected secondary sales to do better than buybacks. Again,

this may be an artifact of the small number of buybacks.

The Canadian summary statistics on profitability are also broadly in keeping with our hypothesized

rank-ordering. The greatest surprise was that secondary sales led all exits in profitability. However, there

were relatively few secondary sales in the Canadian sample (12 of 134) and again this statistic may not be

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robust. Absent this anomaly, the rank ordering of exits by profitability is as predicted.

Given the context of the summary statistics, we now turn to a multinomial logit model to formally

test Hypotheses 1, 2 and 3. As discussed above, while there is some integration of U.S. and Canadian

capital markets for smaller firms, this integration is far from perfect. While this suggests that it is better to

segregate the U.S. and Canadian data, we also pool our samples of Canadian and U.S. data and conduct

separate empirical tests on this pooled sample.

B. Multinomial Logit Analysis

In order to investigate the factors that motivate a venture capitalist to choose one particular exit

strategy over another, we employ the multinomial logit techniques first developed by Theil.241 The log

likelihood function for the multinomial logit model was estimated by Newton's method.

The dependent variable used in our multinomial logit model is the choice of exit vehicle. The

explanatory variables include the market/book ratio, VC investment duration, and a dummy variable

indicating whether the portfolio company operated in a technology industry. The multinomial logit model

assumes the independence of irrelevant alternatives across the explanatory variables. The data did not reject

this assumption according to Hausman and McFadden's asymptotically distributed chi-squared test.242 Note

that other explanatory variables were explored but not included.243 For reasons outlined in sections III and

IV, we believe that these explanatory variables had the most direct effect on choice of exit vehicle. In

addition, inclusion of other variables yielded insignificant results and other variables were not supported on

the basis of Akaike and Schwartz information criteria.244

241

? Henri Theil, A Multinomial Logit Extension of the Linear Logit Model, 10 INTL. ECON. REV. 251 (1969). Our approach is analogous to that used by Peter Schmidt & Robert P. Strauss, The Prediction of Occupation using Multiple Logit Models, 16 INTL. ECON. REV. 471 (1975). Theil, Schmidt and Strauss have shown that this specification is not sensitive to ordering, and this specification is superior to a series of individual probits or logits.

242 ? Jerry Hausman & Daniel McFadden, A Specification Test for the Multinomial Logit Model, 52 ECONOMETRICA 1219 (1984).243

? For example, we tested the average annual real return (instead of the market/book value of the VC's shares upon exit) as a proxy for firm quality (see also Hypotheses 1, 2 and 3 and accompanying text). The results were not notably different. The market/book value of the VC's shares upon exit was believed to be a more suitable proxy of firm quality at time of exit. This specification maximized the information criteria. Other variables in the specification appeared to be inappropriate.244

? Standard tests did not indicate an omitted variable bias problem; see e.g., Lung-Fei Lee, Specification

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As discussed in sections III and IV, it is important to check for endogeneity of the market/book and

duration explanatory variables. The Durbin-Wu-Hausman test statistics presented in the Appendix do not

indicate significant endogeneity effects. As discussed in subsection A above, our sample contains both full

and partial exits. We present the empirical results using the full sample including partial exits. We also ran

the regressions for the sample excluding partial exits for comparison; some differences were observed, but

not enough to warrant presenting both sets of estimates. The Canadian and U.S. multinomial logit

estimates are presented in Table IV.

[TABLE IV ABOUT HERE]

Hypothesis 1: Quality and Exit Strategy

In Hypothesis 1 we conjectured that higher quality entrepreneurial firms (as proxied by higher

market/book values) would be exited by (in decreasing order of likelihood): IPOs, acquisitions, secondary

sales, buybacks, and write-offs.

In the U.S., we find mixed evidence in support of Hypothesis 1. As expected, the higher the

market to book ratio, the more likely an IPO exit is compared to acquisition, secondary sale, and write-off

exits. Similarly (and hardly surprisingly), increases in the market book ratio raise the likelihood of all exit

vehicles (considered jointly) compared to a write-off. Our data set, however, was unable to distinguish

between the comparative likelihood of acquisitions, secondary sales, and buybacks.

The picture is similar in Canada. As market/book rises, IPO exits are more likely than acquisition

exits, buybacks, and write-offs. Similarly, as market/book rises, all exit types become more likely than a

write-off. Again, however, as between acquisitions, secondary sales, and buybacks, most of the

hypothesized relationships were insignificant, except that secondary sale exits were more likely than

buybacks, as predicted.

The anomalous result that we earlier noted in relation to our raw data on secondary sale profitability

shows up in our multinomial analysis as well; high quality firms are as likely to be exited via a secondary

sale as by an IPO. There is also weak evidence (i.e. significant only at the 10% level) that secondary sale

Error in Multinomial Logit Models: Analysis of the Omitted Variable Bias, 20 J. ECONOMETRICS 197 (1982).

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exits are more likely than acquisition exits, which is contrary to Hypothesis 1. Once again, this may be a

product of the relatively small number of secondary sales in our data set.

The full sample estimates in Table IV indicate further mixed support for Hypothesis 1. As

market/book rises, the likelihood of an IPO increases relative to an acquisition exit, secondary sale, buyback

or write-offs (equations 1, 2, 3 and 4). Similarly, acquisitions, secondary sales and buybacks are all more

likely than write-offs (equations 7, 9 and 10). The full sample of U.S. and Canadian data, however, do not

suggest a rank ordering as between acquisitions, secondary sales and buybacks (equations 5, 6 and 8).

Hypothesis 2: Duration and Exit Strategy

In Hypothesis 2 we conjectured that the longer the VC's duration of investment, the more likely the

following exit vehicles (in decreasing order of likelihood): IPOs, secondary sales, acquisitions, buybacks,

and write-offs. The results in Table IV do not provide very strong support for Hypothesis 2. In the U.S.,

the longer the duration, the more likely the investment would be exited via a secondary sale rather than a

buyback, as predicted (equation 8), and the more likely a secondary sale would occur, rather than a write-

off, also as predicted (equation 9). However, longer investment duration had a negative effect on the

likelihood of IPOs relative to acquisitions and secondary sales (although only the latter was statistically

significant; see equations 1 and 2, respectively).

The Canadian evidence also provided mixed support. In contrast to the U.S. data, IPOs were more

likely than secondary sales the longer the investment duration (equation 2). IPOs were also more likely

than write-offs (equation 4). Acquisition exits and buybacks were also more likely than write-offs

(equations 7 and 10). These relationships were as predicted. However, longer duration enhances the

probability of a buyback compared to a secondary sale (equation 8), contrary to expectation, and an

acquisition exit was more likely than a secondary sale (equation 5), also contrary to expectation.

The combined sample offered only very weak support for Hypothesis 2. The evidence is generally

insignificant, with the exception of equations 7 and 10 in which acquisitions and buybacks are more likely

than write-offs the longer the investment duration, as predicted.

Overall, Hypothesis 2 is not supported. It would appear that there is a more complex relationship

between investment duration and the choice of exit vehicle than merely mitigation of information

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asymmetry between firm insiders and outsiders.

Hypothesis 3: Technology and Exit Strategy

We conjectured that high-technology entrepreneurial firms would be exited (in decreasing order of

likelihood) by IPOs and acquisitions, then secondary sales, buybacks, and write-offs. The U.S. evidence

provides weak support for Hypothesis 3. While acquisition exits were more likely than IPO exits (although

only at the 10% level of significance; equation 1), because of conflicting factors at work we had formed no

particular hypothesis about the rank ordering of IPOs and acquisitions. In support of Hypothesis 3,

technology firms were more likely to be exited via either an acquisition or a secondary sale than a buyback

(equations 6 and 8). However, technology firms are less likely to be exited via IPOs than acquisitions

(equation 1) and secondary sales (equation 2) in the U.S., but this evidence is only significant at the 10%

level. None of the other relationships was significant.

In Canada, contrary to the result in the U.S., technology investments were more likely to be exited

via an IPO than via an acquisition. The Canadian results were supportive of Hypothesis 3 insofar as IPOs

were also more likely than buybacks and write-offs. All other coefficients are insignificant.

The full sample estimates provide stronger support for Hypothesis 3. IPOs, acquisitions and

secondary sales are more likely than buybacks and write-offs for technology firms (equations 3, 4, 6, 7, 8

and 9). Contrary to expectation, however, equation 5 suggests that secondary sales are more likely than

acquisitions for high technology firms.

CONCLUSION

Our empirical results do not support Hypothesis 2. They provide some mixed support for

Hypothesis 3. They provide somewhat stronger support for Hypothesis 1. The data most clearly support

the hypothesis that IPOs are the preferred means of exit for highly valued firms, and (not surprisingly) that

write-offs are the preferred means of exit for the lowest value firms. The data provides mixed support for

the hypothesized rank ordering of acquisitions, secondary sales, and buybacks. In particular, in the U.S.

buybacks were ranked ahead of secondary sales, and showed surprisingly strong average returns. We

attributed this anomalous result to the small number of buybacks in the sample. In Canada, the rank

ordering was as predicted save for secondary sales, which were the most profitable means of exit on the

96

basis of annualised real return. We also attributed this to the small number of secondary sale exits in the

Canadian sample. The Canadian results, contrary to the U.S., affirmed the hypothesized low profitability of

buybacks exits.

We also observed significant differences between the U.S. and Canadian results, both in the

frequency with which types of exits are used, and in their profitability. Buybacks were used with much

greater frequency in Canada than in the U.S., although there were fewer Canadian write-offs. Given that

buybacks yield the lowest per annum return of any form of exit, other than write-offs, this is consistent with

our hypothesis that Canadian VCs have a lower average level of skill than their U.S. counterparts. While a

higher proportion of exits are taken as write-offs in the U.S., we suggested that this may be explained by the

U.S. VC’s higher opportunity cost. Exits that might be taken as write-offs in the U.S. are, with the lower

opportunity cost of Canadian VCs, negotiated into buyback exits. It may also be the case that the high

proportion of exits taken as buybacks in Canada reflects the comparative dearth of strategic acquirors in

Canada (when coupled with the lack of full integration between U.S. and Canadian small firm markets).

Supportive of the latter proposition, the data disclose that acquisition exits are used with much

lower frequency in Canada. From a public policy perspective, the comparative dearth of acquisition exits in

Canada is troubling, if acquisitions are (as we have hypothesized) a superior form of exit. It may be,

however, that there is little that government policy can do to correct the situation -- at least in the short

term. The lack of strategic partners in Canada is likely a product of the fact that Canadian markets are

smaller and less developed than those in the U.S. Nonetheless, policy makers should be aware that that

which tends to create a more vibrant, competitive large firm sector will also impact indirectly on the vitality

of the market for small, technology concerns by furnishing a greater variety of potential strategic partners

and hence enhancing exit opportunities. Further integration of U.S. and Canadian markets (e.g. by allowing

Canadian firms to reincorporate in the U.S. without triggering punitive tax consequences) would also lend

new vitality to the market for small EFs.

The evidence presented in this paper adds support to the view that IPOs are central to the venture

capital process. IPOs are the most frequently selected means of exit for high quality firms. This

emphasizes the importance of ensuring that regulatory hurdles to accessing public markets are cost-effective

and not unduly onerous. It also emphasizes the inextricable link between primary and secondary markets.

The price at which securities are sold in primary market transactions reflects the expected liquidity of those

securities in the secondary market.

97

We also provide the first comprehensive theoretical framework for understanding the comparative

advantages and disadvantages of all forms of VC exit, and not merely IPOs. While it is clear that this

framework needs elaboration (and testing on larger data samples) we hope that our work will lead other

researchers to probe more deeply in the important question if why VCs exit their investments as they do.

APPENDIX

As we used the venture capitalists' market/book value to proxy project quality, it is necessary to

check for the endogeneity of the market/book variable (see sections III and IV). We also noted the potential

for endogeneity with duration (section IV). Table V presents Durbin-Wu-Hausman statistics245 for the

effect of endogeneity in the duration and market/book coefficients in the multinomial logit regression

equations specified in section VI. We selected various states/provinces (including, for example, California

and Massachusetts in the U.S., and B.C., Ontario and Quebec in Canada) in which the entrepreneurial firms

were located as instrumental variables. These were particularly intuitive instrumental variables as an

entrepreneurial firm's quality may depend upon its location (e.g., its location may yield lower monitoring

costs, less informational asymmetry, and better growth prospects, and resources may be better and more

readily available in certain areas), but a firm's physical location in and of itself is at best a very weak and

indirect determinant of exit strategy. Standard diagnostic statistics confirmed the suitability of the location

instruments. The use of different instruments did not affect the interpretation of the results.

[TABLE V ABOUT HERE]

The Durbin-Wu-Hausman statistics provide strong evidence that endogeneity has not affected the

multinomial logit coefficient estimates presented in Table IV. Consistent with Cumming and MacIntosh,246

Table V indicates that significant endogeneity effects are only rarely observed for the market/book variable

and duration variable. There is some evidence of significant endogeneity effects (primarily with the write-

off exits) in Canada and the U.S. for the market/book and duration variables; but there is no systematic

245 ? See, e.g., RUSSELL DAVIDSON & JAMES G. MACKINNON, ESTIMATION AND INFERENCE IN ECONOMETRICS (1993).

246 ? Cumming & MacIntosh, supra note 11, supra note 100.

98

evidence across all exit vehicles, and therefore the use of instrumental variables would introduce more bias

than it would mitigate. As such, the standard multinomial logit estimates are presented in Table IV. (Use

of instrumental variables does not affect the qualitative results; e.g., lower market/book values leads to a

greater probability of a write-off.)

As discussed in section VI (see also Tables II and III), some of the VC exits were partial exits. The

DWH tests also consider this factor, and whether the decision to partially exit is a determinant of exit

strategy, or caused by the exit strategy. Consistent with Cumming and MacIntosh,247 the evidence in Table

V indicates that the extent of exit is determined by the choice of exit vehicle and is therefore not an

explanatory variable in Table IV.

247 ? Id.

99

F i g u r e I . E f f i c i e n t I n v e s t m e n t D u r a t i o n a n d C o m p a r a t i v e S t a t i c s

T i m e

0PMVA

V C E x i t 0

0PMC

$

1PMC

1PMVA

V C E x i t 1

C h a n g e i n m a r k e t c o n d i t i o n s , e t c .

C h a n g e i n c a p i t a la v a i l a b l e f o r i n v e s t m e n t , e t c .

IPO 4 4 - 5 1 4 5 1 1 1 2 Yes

5 for High-Tech

Acquisition 1 - 2 1 - 2 5 2 1 Indet Indet 4 - 5 1 No

1 for High-Tech 1 for High-Tech

Secondary Sale 2 4 Indet 2 1 5 Indet 3 2 - 4 No

Buyback 1 for equity 1 for equity 1 2 1 5 2 1, with 5 No

5 for debt 5 for debt variation

Table I. Summary of Factors Linking Project Quality to Exit Strategy

Table 1 continues on the next page…

* For IPOs, the ability to convert to cash within one year is considered a cash exit

Legend

1 = strongly favours; 2 = favours; 3 = Neutral; 4 = Disfavours; 5 = Strongly Disfavours; Indet = Indeterminate

Managerial Incentives Post-Exit

Transaction Synergies

Must New Capital Be Raised?

The Transaction

Costs of Effecting A

Sale

Ongoing Costs of Operating as a Public Versus a

Private Firm

The Liquidity of the Investment

to the Buyer

Liquidity of the Exit to Seller: Cash or Cash Equivalent*Exit Vehicle

Ability of New Owners to Resolve Information

Asymmetry and Value the Firm

Ability of New Owners to

Monitor and Discipline the

Managers

Black and Gilson's Implicit

Contracting Theory

102

The

Cyclicality Fund The Public

High Efficiency of Common Common of Valuations Termination VC's Agency Profile

Growth Risk Form of Exit in IPO Date Reputational Costs of

Exit Vehicle Firms Bearing Exit Strategy Markets Looms Incentives of Debt Firm

1, if IPO hurdle

IPO 1 1 Yes Usually time cleared: 1 1 1

dependent 5

otherwise

Acquisition 1-2 1 Yes Usually time 2 2 Indet indet

(with dependent

variation)

Secondary Sale 3 Indet No ad hoc 3 2 4 3 5

Buyback 5 5 No ad hoc 3 2 5 5 5

* For IPOs, the ability to convert to cash within one year is considered a cash exit.

Legend

1 = Strongly Favours; 2 = Favours; 3 = Neutral; 4 = Disfavours; 5 = Strongly Disfavours; Indet - Indeterminate

Table I (Continued). Summary of Factors Linking Project Quality to Exit Strategy

103

Table II. United States Venture Capital Full and Partial Exits Data Summarized by Exit Vehicle*

Number of Average Technology

Portfolio Duration Industry Average Average Average Gross Average Annual Variance in Average Annual Variance in Average Annual Variance in

Exit Vehicle Companies (Years) No Yes Partial Full Investment** Exit Value** Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%)

IPO 30 4.7000 12 18 8 22 2,035,036 12,565,880 464.6397 54.9152 51.1517 83.5759 154.3296 44.4932 14.9276

Acquisition 30 5.1667 9 21 6 24 1,720,349 3,859,077 143.0386 57.8286 754.7467 20.1013 18.0705 67.2604 943.0674

Secondary Sale 9 6.3333 2 7 3 6 519,931 1,005,871 54.8768 -7.5650 6.6850 -3.1798 15.3582 -9.7570 4.3797

Buyback 6 4.0000 5 1 5 1 784,397 2,687,449 145.0423 24.7910 3.2665 21.6493 3.3428 40.4996 0.0000

Write-off 33 4.3636 15 18 2 31 1,984,068 92,500 -97.8450 -90.0070 4.8772 -100.0000*** 0.0000 -89.3620*** 5.1315

Other 4 2.7500 2 2 1 3 1,112,445 1,539,990 35.2761 34.0191 83.9444 165.6761 0.0000 -9.8670 10.3594

Total 112 4.7500 45 67 25 87 1,714,030 4,706,597 147.3815 5.6146 256.6047 34.1439 83.5232 -2.5835 304.8443

Table III. Canadian Venture Capital Full and Partial Exits Data Summarized by Exit Vehicle*

Number of Average Technology

Portfolio Duration Industry Average Average Average Gross Average Annual Variance in Average Annual Variance in Average Annual Variance in

Exit Method Companies (Years) No Yes Partial Full Investment** Exit Value** Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%) Real Return(%)

IPO 36 5.8611 3 33 20 16 1,464,087 5,170,185 1385.8530 27.8282 9.8247 32.8825 10.6479 21.5102 8.6706

Acquisition 16 6.9375 9 7 1 15 1,945,386 3,271,514 84.5848 13.3089 2.9498 5.9532 0.0000 13.7993 3.1193

Secondary Sale 12 3.0833 0 12 5 7 402,144 968,181 165.6950 54.8972 90.2764 106.4305 179.2162 18.0877 8.0910

Buyback 41 6.3415 30 11 7 34 668,245 808,686 66.9712 3.8207 1.5041 9.9051 1.1401 2.5680 1.5212

Write-off 27 4.0741 18 9 1 26 332,038 3,821 -97.1010 -92.0440 4.3792 -100*** 0.0000 -91.7380*** 4.5280

Other 2 6.0000 2 0 1 1 2,412,731 3,687,627 60.1537 9.5346 0.1692 6.6257 0.0000 12.4435 0.0000

Total 134 5.5299 62 72 35 99 969,012 2,169,579 399.0807 -3.2530 33.8738 33.4777 41.8835 -16.2390 24.9186

Partial Exits Only

Partial Exits Only

Partial exit market values are adjusted to reflect full values. Real returns are calculated assuming investment at the beginning of the year, and exit at the end of the year, reflecting the lowest possible estimate.

Partial exit market values are adjusted to reflect full values. Real returns are calculated assuming investment at the beginning of the year, and exit at the end of the year, reflecting the lowest possible estimate.

CANSIM, label B3400. Values expressed in U.S. dollars for comparative purposes only. Returns were computed in Canadian dollars and do not reflect exchange rate changes.

Extent Full Sample Including Partial Exits Full Exits Only

*** Partial write-offs (write-downs) were recorded without indicating the full cost of the amount not written off. Full write-offs yielded a small return upon liquidation.

of Exit

* Source: Canadian Venture Capital Association.

** Real Canadian Dollars (base year=1990) converted to U.S. Dollars. CPI data source: CANSIM, Label P700000; available at www.chass.utoronto.ca. Foreign exchange rates from

Full Sample Including Partial Exits

*** Partial write-offs (write-downs) were recorded without indicating the full cost of the amount not written off. Full write-offs yielded a small return upon liquidation.

** Real U.S. Dollars (base year=1990). CPI data source: International Financial Statistics, Label 11/64; available at www.chass.utoronto.ca.

* Source: Venture Economics

Extent

of Exit

Full Exits Only

104

United States Canada2 Full Sample Estimates

Eqn Dependent Valiable Constant Market / Book Duration Technology Constant Market / Book Duration Technology Constant Market / Book Duration Technology*

1 Loge(PIPO/ PAcquisition) 0.473852 0.277205 -0.167006 -1.00568 -1.52238 0.389867 -0.118696 2.8197 -0.421111 0.238196 -0.0713458 0.586328

(0.5392) (2.47089)** (-1.26105) (-1.63826)* (-1.4582) (2.20297)** (-1.31563) (3.22714)*** (-0.7669) (2.85677)*** (-1.08785) (1.33447)

2 Loge(PIPO/ PSecondarySales) 3.35329 0.522465 -0.448334 -1.72381 28.0447 0.0203464 0.424986 -28.8889 1.01244 0.266633 0.0639193 -1.20425

(1.977)** (2.12665)** (-2.0953)** (-1.73018)* (0.00001) (0.147088) (2.13062)** (-0.00001) (1.09765) (2.19199)** (0.666359) (-1.48109)

3 Loge(PIPO/ PBuyback) -0.208652 0.153652 0.144977 1.76828 -2.98913 0.460851 -0.092537 3.44654 -1.15716 0.367704 -0.0970078 1.98332

(-0.18959) (0.74117) (0.693475) (1.45436) (-3.112)*** (2.88948)*** (-1.13291) (4.31548)*** (-2.092)*** (3.23658)*** (-1.40135) (4.2636)***

4 Loge(PIPO/ PWriteoff) -7.48779 16.8352 0.277339 0.26796 -7.32936 17.7706 0.214386 3.09104 -10.5105 17.6306 0.288145 3.47456

(-4.248)*** (3.33425)*** (0.975505) (0.202088) (-6.623)*** (3.64702)*** (2.2011)** (4.24466)*** (-6.236)*** (4.40986)*** (1.46972) (3.14651)***

5 Loge(PAcquisition / PSecondarySales) 2.87943 0.24526 -0.281327 -0.718134 29.5671 -0.36952 0.543682 -31.7086 1.43355 0.0284373 0.135265 -1.79058

(1.7438)* (1.02741) (-1.41433) (-0.761928) (0.00001) (-1.69706)* (2.57966)*** (-0.00002) (1.56315) (0.213054) (1.4196) (-2.22099)**

6 Loge(PAcquisition / PBuyback) -0.682504 -0.123553 0.311984 2.77396 -1.46675 0.0709841 0.0261589 0.626843 -0.736045 0.129508 -0.0256621 1.39699

(-0.5802) (-0.561258) (1.4588) (2.25385)** (-2.183)** (0.409778) (0.352646) (1.0150) (-1.4197) (1.08216) (-0.408597) (3.12813)***

7 Loge(PAcquisition / PWriteoff) -6.61956 16.0942 0.417211 1.56194 -4.94935 16.3436 0.292125 0.441833 -7.28116 16.2843 0.416716 2.32666

(-3.968)*** (3.18759)*** (1.59453) (1.28529) (-4.551)*** (3.35416)*** (2.7067)*** (0.681248) (-4.640)*** (4.0731)*** (2.34022)** (2.37087)**

8 Loge(PSecondarySales / PBuyback) -3.56194 -0.368813 0.593311 3.49209 -31.4274 0.440504 -0.517523 32.7289 -2.1696 0.101071 -0.160927 3.18757

(-1.8924)* (-1.19447) (2.16777)** (2.38165)** (-0.00001) (2.1618)** (-2.49996)** (0.00001) (-2.370)*** (0.655516) (-1.63109)* (3.90122)***

9 Loge(PSecondarySales / PWriteoff) -8.54875 15.3926 0.640184 2.14163 -5.45608 16.5026 -0.246808 32.3762 -8.58036 16.1894 0.258431 4.15646

(-4.205)*** (3.04892)*** (2.20639)** (1.56229) (-4.961)*** (3.3868)*** (-1.2787) (0.00002) (-5.000)*** (4.04937)*** (1.3524) (3.47707)***

10 Loge(PBuyback/ PWriteoff) -5.31655 15.8731 0.0963045 -1.25184 -3.91522 16.2766 0.251854 -0.189242 -6.62748 16.1319 0.451495 0.848536

(-3.022)*** (3.14345)*** (0.309387) (-0.742458) (-3.664)*** (3.34042)*** (2.62848)*** (-0.35481) (-4.251)*** (4.03499)*** (2.5535)** (0.862049)

Table IV. Multinomial Logit Estimates of U.S. and Canadian Exits1

2. Coefficients estimated separately in Canada for writeoff exits to avoid collinearity problems (but Canadian results are not materially affected by collinearity for other exit vehicles).

1. t-statistics in parentheses. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.

105

United States Canada Full Sample Estimates

Eqn Dependent Valiable Market / Book Duration Extent of Exit Market / Book2 Duration Extent of Exit Market / Book Duration Extent of Exit

1 Loge(PIPO/ PAcquisition) -0.359301 -1.02627 -0.678268 0.0674244 -1.25809 -2.37871 -0.132077 -0.468704 -0.846804

(-0.676147) (-1.29149) (-0.938224) (0.831664) (-1.21576) (-2.4603)** (-1.61616) (-0.649276) (-1.74079)*

2 Loge(PIPO/ PSecondarySales) -0.861271 -0.0194879 0.290059 0.082446 -1.26928 -0.253992 0.0563806 0.396351 0.147879

(-1.06888) (-0.0151998) (0.286349) (1.02729) (-0.492635) (-0.341154) (0.772614) (0.310766) (0.263324)

3 Loge(PIPO/ PBuyback) 1.18841 1.46051 3.77121 0.0876932 -1.3096 -1.46588 0.101197 -0.934904 -0.0702267

(1.38061) (0.920604) (2.43996)** (1.3101) (-1.38904) (-2.14952)** (1.45872) (-1.22546) (-0.137951)

4 Loge(PIPO/ PWriteoff) 3.35496 -4.83694 12.0014 0.236016 0.0797075 -2.64403 0.211202 -1.09827 -0.929086

(2.26571)** (-1.76092)* (5.62739)*** (3.0282)*** (0.0620274) (-2.63232)*** (0.996387) (-0.675417) (-0.713487)

5 Loge(PAcquisition / PSecondarySales) -0.50197 1.00678 0.968326 0.0150217 -0.0111951 2.12472 0.188457 0.865056 0.994683

(-0.713602) (0.859131) (0.998624) (0.150322) (-0.00424638) (1.88127)* (2.02478) (0.683859) (1.57606)

6 Loge(PAcquisition / PBuyback) 1.54771 2.48678 4.44947 0.0202688 -0.0515087 0.912834 0.233273 -0.4662 0.776578

(1.69843)* (1.51879) (2.79269)*** (0.267624) (-0.0751588) (1.00163) (2.72484)*** (-0.755409) (1.38469)

7 Loge(PAcquisition / PWriteoff) -0.500006 -6.88172 4.49973 0.168591 1.3378 -0.265315 0.365157 0.616319 -0.746592

(-0.403209) (-2.59751)*** (2.27461)** (1.98294)** (1.18618) (-0.220093) (1.73542)* (0.472905) (-0.603676)

8 Loge(PSecondarySales / PBuyback) 2.04968 1.48 3.48115 0.00524714 -0.0403135 -1.21189 0.0448163 -1.33126 -0.218106

(1.86696)* 0.780523 2.01009** (0.0594353) (-0.0154878) (-1.35628) (0.542565) (-1.02813) (-0.338869)

9 Loge(PSecondarySales / PWriteoff) 0.725084 -8.09311 -0.0583606 0.153569 1.34899 -2.39003 0.164238 -0.339667 -1.91667

(0.898567) (-3.23338)*** (-0.0312019) (1.6281) (0.494903) (-2.11288)** (0.777351) (-0.193436) (-1.52361)

10 Loge(PBuyback/ PWriteoff) -6.60438 -11.5102 -19.4639 0.148322 1.38931 -1.17815 0.112233 1.07079 -1.68199

(-4.04392)*** (-4.0752)*** (-5.49296)*** (2.16135)** (1.35176) (-1.16976) (0.570023) (0.840664) (-1.35154)

Table V. Durbin-Wu-Hausman Tests1

2. This DWH residual variable from first step regression in Canada was included in the second step without the original market/book variable to avoid singular Hessians.

1. t-statistics in parentheses. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.