Capital structure in venture finance☆
Introduction
Theoretical research in venture finance consistently repeats the proposition that convertible preferred equity is optimal.1 Previous empirical research has considered up to 213 observations from US venture capital (VC) funds.2 Gilson and Schizer (2003), however, show US tax law biases venture capitalist's and entrepreneur's incentives to use convertible preferred equity, and this tax bias is the only plausible explanation for the US VC industry's remarkable convergence on only one security. This tax bias has been shown to be absent in Canada (Sandler, 2001; see also Mintz, 1997). It is therefore worthwhile to revisit the question as to whether convertible preferred equity really is the optimal form of venture finance by exploring non-US empirical evidence (see Denis, 2004, for this view and a survey of the literature). This paper offers new evidence from a sample of 3083 Canadian venture capital financings.
Why might convertible preferred equity be optimal in venture finance in a setting absent US tax biases? Convertible preferred equity provides the venture capitalist with a stronger claim on the liquidation value of the company in the event of bankruptcy, thereby shifting the risk from the venture capitalist(s) to the entrepreneur. Relative to straight common equity, convertible preferred equity reduces the entrepreneur's dilution of ownership. Convertible preferred shares also enable a greater amount of funds to be raised relative to straight debt as the venture capitalist has some equity participation. In the context of staged financing, convertible preferred equity mitigates window dressing problems and ensures that most positive expected NPV projects continue to receive financing. Convertible preferred shares also facilitate the conversion of illiquid holdings into cash, and mitigate problems associated with selling the firm, particularly when the incentive effects of trilateral bargaining are considered (see references listed in 1, 2).
Why might securities other than convertible preferred equity be optimal in a setting absent US tax biases? One natural explanation could be that different types of entrepreneurs are in fact different in ways that give rise to different sets of agency problems. Because different entrepreneurial firms are staged with different frequency based on expected agency problems (Gompers, 1995), syndicated with different frequency depending on expected agency problems (Lerner, 1994), and monitored with different intensity via seats on boards of directors depending on expected agency problems (Gompers and Lerner, 1999), it would be rather surprising to expect the same security choice for all entrepreneurial firms regardless of expected agency problems. Nevertheless, all prior academic work in venture finance consistently repeats the proposition that only one security is optimal: convertible preferred equity. The venture finance literature is in fact a complete outlier in the broader scope of literature on capital structure generally. Since the seminal work of Jensen and Meckling (1976), all work on capital structure (outside the realm of the narrowly focused venture finance literature) is consistent with the view that capital structure choices adjust to changes in expected agency problems. It is surprising that the application of this idea to the context of venture finance is as novel as it appears next to all prior work on topic, particularly in view of the fact that agency problems are both very heterogeneous and very pronounced in venture finance.
This paper makes use of a new data set of 3083 Canadian corporate and limited partnership venture capitalist investments spanning 1991–2000. A variety of forms of finance are observed. As well, different types of entrepreneurs receive VC finance. We provide empirical tests that relate firm-specific characteristics to the security selected. We show that the empirical tests are quite robust to numerous alternative specifications.
Some of the notable results from the data and empirical tests are as follows. Common equity was used in 36.33% of the 3083 investments; followed by straight (nonconvertible) debt: 14.99%; convertible debt (including mixes of straight debt and warrants): 12.36%; convertible preferred equity (including mixes of straight preferred equity and warrants): 10.87%; mixes of straight debt and common equity: 10.67%; straight preferred equity: 7.27%. In addition, a variety of less frequently employed combinations of other securities, such as mixes of straight preferred equity and straight debt and other combinations, were used in 7.53% of the investments. The use of different securities does not depend on the definition of venture capital. In the multivariate tests, the data indicate seed stage firms are more likely to be financed with either common equity or straight preferred equity, and less likely to be financed with straight debt, convertible debt, or mixes of debt and common equity. We also find some evidence that life science and other types of high-tech firms are more likely to be financed with convertible preferred equity. In the empirics, we explicitly show the statistical and economic significance of these results by reporting the probability of use of each form of finance depending on the context and characteristics of the entrepreneurial firm.
This paper is organized as follows. Section 2 briefly describes the data. Section 3 outlines the hypotheses. The empirical tests are carried out in Section 4. Concluding remarks follow in Section 5.
Section snippets
Data
The proposition that convertible preferred equity is optimal is tested in this paper using a sample of 3083 Canadian corporate and limited partnership venture financing transactions spanning the years 1991–2000. The data are from Macdonald and Associates, Ltd. (Toronto) http://www.canadavc.com). The data are described in Fig. 1a–d and Table 1A–D. Common equity was used in 36.33% of the 3083 investments; followed by straight (nonconvertible) debt: 14.99%; convertible debt (including mixes of
Testable hypotheses
In Subsection 3.1, we broadly frame four hypotheses that can be considered with the Canadian data described in Section 2, with deference to the predominant view in the prior literature that convertible preferred equity is optimal in venture finance (see 1, 2). Subsection 3.2 considers specific agency cost hypotheses. Subsection 3.3 addresses the issue as to whether tax and other institutional factors could be more pronounced for different types of firms in the Canada.
Empirical tests
The empirical tests are based on the data described in Section 2. Subsection 4.1 provides summary test statistics to further describe the data. Subsection 4.2 provides regression analyses.
Conclusion
This paper provided data on forms of venture finance in Canada based on 3083 transactions, together with empirical tests of the proposition that the selected securities depend on the context and firm characteristics. The data and empirical tests provide many insights into capital structure in venture finance. In these concluding remarks, we summarize two general and important findings. First, there is no single unique optimal form of venture finance, such as convertible preferred equity. A
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Cited by (0)
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Earlier drafts of this paper were distributed under different titles. I am indebted to an anonymous referee for very helpful comments and suggestions. I also owe special thanks to Ralph Winter and Tom Ross for helpful comments. I am also indebted to Varouj Aivazian, Paul Halpern, Aditya Kaul, NyoNyo Kyaw, Ted Liu, Mike Long, Mary Macdonald, Jeff MacIntosh, Frank Mathewson, Vikas Mehrotra, Randall Morck, Enrico Perotti, James Pesando, Corrine Sellars and the seminar participants at the University of Toronto (1998), Canadian Law and Economics Association (1998), Bank of Canada (1999), Lexecon (1999), Northern Finance Association (1999), Queen's University (1999), University of Alberta (1999), University of British Columbia (2000), Eastern Finance Association (2000), Schulich School of Business (2001), Rutgers University Conference on Capital Structure (2001), the European Financial Management Association (2001), the Financial Management Association (2001), the University of Amsterdam (2002), and Tilburg University (2002). Financial assistance from the University of Alberta SAS and Pearson Fellowships and the University of British Columbia Entrepreneurship Research Alliance is gratefully acknowledged. Macdonald and Associates (Toronto) generously provided the data.