Journal of Business Finance & Accounting, 18(2), January 1991, 0306 686X $2.

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VENTURE CAPITAL FINANCING: A CONCEPTUAL FRAMEWORK

SwEE-SuM LAM*

INTRODUCTION

Venture capital investments in the narrow sense are high returns investments in small and high risk firms that are founded on commercial applications of some technological innovations. In the broad sense these are investments in new businesses based on tested technology that is being transferred to new markets. For example these may be firms with patents or franchises. Venture capital investments are categorized by difiereni stages in the financing of the firm: seed capital, development, start-up, and expansion financing prior to going public. There is generally little information available tor the evaluation of venture capital investments. In fact an investment at each stage in the growth ofthe venture capital firm is an investment in information about the value ofthe firm. In another sense, each investment is in itself" also a purchase of an option to invest at the next stage. This paper explains how venture capitalists add value to the firm. They extend the firm's production possibility frontier through their direct and indirect participation in the strategic and tactical planning and operations ofthe firm. Venture capitalists maintain a long term perspective of capital gains. Much of these capital gains may be realized either through a negotiated private sale or a public offering. When the parameters of asset return distributions are unknown, investors estimate them using both time series of asset returns and other non-price information. In the absence of market prices this estimation problem is even more aggravated. The estimation risk of an asset is defined here to be the incremental variation of its predictive return distribution that is attributable to investors' ignorance of the parameters of its true return distribution. If investors' predictive returns on assets in an economy are correlated, estimation risk becomes partly non-diversifiable. It follows, as in Stulz's (1986) model, that investors require a higher risk premium as estimation risk increases. In this analysis it is suggested that estimation risk has two component risks: information risk and stochastic parameter risk. The information risk of an asset is that incremental variation ol its predictive return distribution relative to the
'The author is from the Departmcni of Finance and Banking, National University of Singapore. She wishes to thank Warren Bailey of Cornell University for his useful commenis on earlier drafts, and acknowledges the encouragement from various participants ai the Northern Finance Association mef tings in Ottawa, Canada, in October 1989. (Paper received January 1990, revised May 1990)

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limiting case when the asset has infmite sample information. The stochastic parameter risk of an asset, on the other hand, is that component ofthe variance of its predictive return distribution that is attributable to the intertemporal variation of parameters of its true return distribution. Barry and Brown (1985), Clarkson and Thompson (1989) and Lam (1988) discuss information risk with respect to assets being traded in the secondary equity market. This study extends discussion on estimation risk to assets that have no primary or secondary markets. Specifically discussed is the impact of estimation risk on the valuation of venture capital investments. It is suggested that there is an association between estimation risk of an asset and its information and predictability characteristics. The information characteristic of an asset refers (o the sample size of the time series of its returns. For a venture capital firm we consider the returns on its equity or the returns on its assets. A venture capital firm has higher information risk than one that has been established for many years. The predictability characteristic of an asset, on the other hand, refers to the intertemporal variation of parameters of its true return distribution. For example, a venture capital firm that has high product and market risks is likely to have low predictability and high stochastic parameter risk. This analy.sis implies that the estimation risk of venture capital investments tends to decline with each financing stage. Therefore, even when the firm's shares are nol traded, an increasing proportion of the value added by the venture capitalist can be realized as the estimation risk premium decreases with increasing information. This study is organized as follows. In the next section the multi-period fmancing decision process of venture capital investments is analyzed. A discussion of how the venture capitalist adds value to the firm is featured in the third section. The fourth section next analyzes estimation risk and its impact on value added. The fmal section concludes with a discussion about the implications ofthe estimation risk hypothesis for the valuation of venture capital investments.

THE MULTI-PERIOD FINANCING DECISION PROCESS OF VENTURE CAPITAL INVESTMENTS

Venture capital investments which are made at different stages in the growth of new businesses add value to the firm and offer different levels of risk. Early stage financing refers to the provision of seed capital, development and startup financing. Expansion financing refers to all subsequent fmancing to provide for the growth of the firm. In seed financing the venture capitalist invests a small sum in the entrepreneur who has an innovative idea or concept. This is followed by development financing for the construction of prototype and preparation for commercial production and marketing. The start-up stage is most crucial as market

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acceptance of the product or service is as yet untested. Expansion financing provides the new business with working capital for production, marketing as well as sales and plant expansion or product development. Sometimes bridge financing is required for working capital funding prior to going public. The entrepreneur is the key financier of the small business in early stage fmancing. If the venture capitalist does take an interest in the firm at this stage, it would usually be at a token level of, say, $50,000. This represents his investment in information about the value ofthe firm. For example, with the $50,000 investment in start-up financing, he would be informed ofthe outcome of commercial production and the degree of market acceptance of the new product or service. This information allows the venture capitalist to decide whether to commit further in expansion fmancing, and if so, how much and ibr what risk and expected return. Each investment is therefore in itself also a purchase of an option to invest at the next stage. Ry a self selection process the venture capitalist's capital budgeting decisions result in the prospective profitable businesses getting a larger and larger amount of venture capital financing at consecutive stages as increasing information reduces uncertainty of firm value. At the same time successive capital calls in the early stages of financing soon exhaust the entrepreneur's resources. The entrepreneur is therefore expected to rely increasingly on the venture capitalist for equity participation in the expansion financing stages.

VALUE ADDED BY VENTURE CAPITALISTS A venture capitalist usually specializes by industry or product market. A .successful venture capitalist is himself an entrepreneur. His appreciation of the industry or product market and the technology required to gain the competitive edge adds value to the firm by extending its production possibility frontier. The production possibility frontier maps the value of the entrepreneurship and technology ofthe firm that transforms current resources into future resources. Figure 1 shows the production possibility frontier of a Type A firm that has zero endowment. A venture capitalist can convert a Type A firm into a Type B firm by increasing the value of entrepreneurship and technology that is crystallized in say, an innovative idea or concept, or a patent or franchise. The slope ofthe production possibility frontier gives the marginal rate of transformation of current resources into future resources. For any given level of investment, a Type B firm has a higher marginal rate of transformation, and therefore a higher firm value than a Type A firm. In these new businesses there is information asymmetry between the entrepreneur and the venture capitalist over the value ofthe firm. Akerlof(I977) models this information asymmetry in the 'lemons' problem. His model predicts that in the extreme case oi information asymmetry there will be market failure. No venture capitalist will want to finance a new business. We do not observe

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Figure 1 The Production Possibility Frontier and Firm Value

Expected Period 1 Resources

Current Resources
O A venture capitalist can convert a Type A ilrni into a Type B firm, ln (his case, a Type A firm does not have profitable inve.stmenl opporlunities, but a Type B firm has profitable inveslment opportunilies. For a given opportunity cosi of funds, R. and investmeni /,], the value of firm A,

V^, is negative but the value of Firm B, V^, is positive. a market failure in the venture capital industry. We can therefore infer that this information asymmetry problem in venture capital investments has been resolved to some extent. We see how this 'lemons' problem is resolved. The successful venture capitalist has the expertise and research support to identify prospective profitable businesses. He sorts out the business with a production possibility frontier that, ex ante, returns at least the opportuntity cost of funds. This is the Type B firm in Figure 1. A typical venture capitalist in the USA receives, say, 50 business proposals monthly. In his evaluation process he briefly as.sesses and rejects as much as 40 per cent ofthe proposals without further investigation. He follows

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up with brief meetings with the other companies that have been short-listed. Subsequent analysis may result in counter proposals to about five per cent and investments in only one to two per cent of the proposals. This evaluation process may take up to six months. A venture capitalist effectively truncates the predictive returns distribution of new businesses by separating the gainers from the losers, or, what has been referred to as the 'lemons'. He invests only in businesses that are perceived to be at the upper end ofthe distribution. His investments are usually in the form of equity participation, though at times they can be loans or a mix of both. His investment decisions therefore signal for firm quality. In this respect, a venture capitalist also adds value to the firm by giving it access to the loanable funds market and then the capital markets. A firm in the .start-up and expansion fmancing stages often needs capital funds and working capital financing in increasing amounts which are beyond those that the venture capitalist will want to supply. It therefore approaches banks for financing. A bank would also face the same information asymmetry problem as the venture capitalist for such a first time applicant who has no track record. The firm suffers an opportunity loss in wealth if profitable investments are foregone for lack of funds. Leland and Pyle (1984) say that the size of wealth commitment by an entrepreneur can signal for the quality ofthe firm. However, the entrepreneur faces a wealth constraint in this model. It is suggested that the venture capitalist is the solution to the financing problem in both the short term as well as the long term. His start-up investment not only avoids the opportunity loss to the firm due to the wealth constraint ofthe entrepreneur, but it also lends credibility to the entrepreneur and the firm through the signalling effects of his investment decisions. If the wealth commitment ofthe venture capitalist results in the firm gaining access to the loanable funds market, then the value added would include the opportunity loss of foregone investments given that the firm is refused bank fmancing. Figure 2 illustrates this opportunity loss in wealth from foregone investments due to the firm's inability to access the loanable funds market. Traditionally the prime rate is the base rate on loans that are extended to the most creditworthy clients. Banks charge a risk premium that increases with the level of credit risk. For a first time applicant for bank financing and particularly for a firm in the start-up stage, the risk premium is likely to be high even if the bank agrees to oifer financing. A venture capitalist reduces the credit risk of a firm. His equity participation, though small at the start-up stage, often boosts the firm's equity base significantly and therefore raises the maximum permissible line of credit for a given leverage. His investment signals for the quality of the firm and lends credibility to the information and cash flow projections that are furnished to the bank. The bank can also moderate the credit risk through a security arrangement which often requires a joint and several guarantee or letter of commitment from both the entrepreneur and the venture capitalist.

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Figure 2 The Opportunity Loss in Wealth From Foregone Investments Due to the Firm's Inability to Access the Credit Market
Expected Period 1 Resources

X,

Credit Market Line Slope = -(1-+-^)

Current "v Resources

Foregone Investments

Opportunity Loss in Wealth

/(I is the optiinuni investment given the firm's production possibility frontier, OP, and the markel cost of hind.s, R. However, the entreprenuer underinvests at / to the extent nf/Q Z,, given his wealth constraint and his utiiity function V. TKe opponuniry loss in wealth from ihis underinvestment

Figure 3 illustrates the value added by the venture capitalist through a reduction in the firm's credit risk. This value added is translated into reduced interest costs and a larger line of credit. If the credit account is well-main tai ned the bank will usually finance the firm's growth. As the firm builds up its credit record it gains increasing acceptance in the loanable funds market and its borrowing costs will fall. A venture capitalist also adds value to a new business in his monitoring and

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Figure 3 The Value Added by a Venture Capitalist in Reducing the Firm's Borrowing Costs

Expected Period 1 Resources

Slope = - ( 1

-Slope = - ( 1 Current Resources

/,

!v

Vi,

r,

Xo

Consider Iwo scenarios. In the first scenario the firm is considered as a high credit risk because of a lack of track records, credibility and securiiy. Given limited bank financing at interi'st rate ff,,, the firm invests / and has a networth of V,,. The participation of ihe venture capitalist lowers the llrm's borrowing costs from R^ to Rj, and gives it access to a larj^er line of credit. It now becomes optimal for the firm to invest up to /,. Thi.s yields a higher networth of K,. The value .iddcd by the venture capitalist is then measured by K, FQ.

toniroliing activities. These include serving as director, consultant or strategic and tactical planner. He may assist in recruitment, management, and liaisons with authorities, as well as gaining credibility with suppliers and customer itiiroduction. These services are translated into incremental case Hows lor the lirm in terms of revenue or cost savings. Moreover, the venture capitalist's participation in management reduces the riskiness of the cash flows. The objective of a venture capitalist is to 'cash-out' on the value that he

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has added to the firm. This can be achieved in many ways: sale to another firm or investor, sale back to the firm or going public. This study highlights the point that there is further value being added to the firm if a venture capitalist takes it public. Fama and Jensen (1985) suggest that a firm gains economic value by going public. They say that when a firm goes public its production possibility frontier is extended and incremental cash flows accrue to the old shareholders. They explain: when a firm is organized as a proprietorship, partnership or a closed corporation, it tends to choose lower levels of investment in plant and equipment and different technology. Moreover, such a closely held firm tends to forego more profitable projects than a public corporation even when they have the same opportunities. This is because owners oi such a closely held firm have limited personal wealth and portfolio diversification in human capital and investment, and will find it optimal to undervalue future cash flows relative to the market value rule. A firm's current shareholders gain liquidity for their investments if thf firm goes public. This ability to adjust the risk-return characteristics of their asset portfolio through the capital markets allows shareholders to maximize their expected utility of consumption. Investors therefore require a smaller discount on the stock value of a public company than that of a private company. To the extent that a venture capitalist takes a firm public, he adds incremental value to the firm. Moreover, this decision allows him to realize his share ol the value that has been added to the firm because of his participation. In the next section we discuss why a venture capitalist may choose to realize his investments in graduated portions even after he takes a firm public.

ESTIMATION RISK AND ITS IMPACT ON VALUE ADDED BY VENTURE CAPITALISTS

There is a valuation problem when the entrepreneur or venture capitalist (to be referred to generally as 'investor' in this section) 'cashes-out' his investment either in a negotiated private placement or an initial public offering. In imperfect markets, signals like cash flows, dividends and prices do not fully reveal the true value of firms. In the case ofa public company, for example, the investor learns about the firm's future dividend growth from current dividends and prices. Even then the errors in estimating the dividend growth rate would cause prices to deviate from their fundamental or true values. This estimation problem is even more accentuated in the case of a private company or a closely held company as is often the case in venture capital investments. In the absence of market prices and a reasonable track record of dividend payments, the estimation errors in the valuation of venture capital investments can be expected to be significantly larger than those for public companies. In this section we consider the impact of estimation risk on the

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valuation of venture capital inve.stments. If estimation risk is partly nondi\ersinable, the expected value of venture capital investments given estimation risk will be a discounted value of that in the absence of estimation risk. Does it matter then when and how the venture capitalist or the entrepreneur 'cashesout' on his investment? This analysis offers an answer to this question which may help the investor to improve on the return on his investment. From the theoretical perspective, Zellner and Chetty (1965) in fact suggest that recognizing estimation risk is consistent with expected utility maximization. They argue that under Savage's (1954) extension of von NeumannMorgenstern's (1944) axioms, an investor who maximizes expected utility of terminal wealth will use the predictive return distribution to formulate expectations of asset returns. In the von Neumann-Morgenstern's (1944) framework, an investor chooses that decision C that will maximize his expected utility of terminal wealth:

E{Uy\e = lU\R(y,C)]f(y\d)dy

(1)

where^ is a vector of future stock returns, and C is a vector of portfolio weights or wealth invested in the stocks. The joint probability distribution function for^ is f(y\O) which is conditioned on 6, a parameter vector that characterizes the distribution. R(y, C) is then the random return resulting from the decision C. Finally, U{R) is the investor's utility function that is defined over the random return R. In the reference case of perfect markets and perfect knowledge, when the parameters, d, of the true return distribution are known, the investor conditions the return distribution on those parameters to formulate his expectations of asset returns. This discussion of estimation risk assumes imperiect markets and imperfect knowledge about asset returns. It is further assumed that asset return distributions have random parameters that vary both across assets and time. When the true parameters are unknown, investors use Bayesian inference to estimate parameters. That is, investors try to improve on sample information by incorporating their subjective beliefs or priors in formulating a posterior distribution of the mean parameter value. In other words, given imperfect knowledge when 6 is unknown, the investor summarizes his information about ^ in a posterior distribution ol' 6, q{6\l), where / represents the set of sample and the investor's prior information. He then formulates the predictive distribution function of stock returns, ^(^), which is unconditioned on $, and is defined as:

= ' mB)q{o\ndd.

(2)

In equation (2), the expectation is taken with respect to the posterior distribution of 0, q(O\I). In the Bayesian framework therefore, the investor

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chooses C to maximize his expected utility; E/U) = I U[R(y, C)]g(ji)6y. (3)

Hence, the investor accounts for estimation errors in d through the use of the posterior distribution of 6, q{\I). The implication of using posterior distributions of the mean parameter values when the true parameter values are unknown is an increase in the variance of the asset's predictive return distribution, g(j). This estimation process results in estimation risk. The estimation risk of an asset is therefore defined to be the incremental variation of its predictive return distribution which is attributable to investors' ignorance of the parameters of its true return distribution. Investors who maximize the expected utility of terminal wealth recognize that the posterior distributions of the mean parameter values have mean square errors. In the Bayesian framework, investors continuously update their estimates based on newly arrived information in an attempt to correct the errors made in the previous estimation. It is therefore hypothesized that investors' estimation errors have two components: a transitory and a permanent component. Part of the estimation errors is transitory because they can be eliminated by information Hows. There is a permanent component of the estimation errors, however, which is due to the random nature of asset return parameters. Specifically it is hypothesized that the information and predictability characteristics of an asset affect its estimation risk through the mean square errors of the posterior distributions. Consistent with Klein and Bawa (1977) and Barry and Brown (1985), a high information asset is defined as one that has a larger number of return observations than a low information asset. For low information assets like venture capital investments, investors rely primarily on their subjective beliefs about the mean parameter values to formulate their expectations of returns. However, as information increases, they rely progressively less on their subjective beliefs and more on the statistical estimators of the mean parameter values. The mean square error of the posterior distribution of a mean parameter value tends to decrease as information increases. Ceteris paribus, the variance of the predictive return distribution therefore decreases as the mean square errors of the posterior distributions of mean parameter values decrease. This explains the transitory nature of that component of estimation risk which is defined here as information risk. Specifically, the information risk of an asset is that incremental variation of iis predictive return distribution relative to the limiting case when the asset has infinite sample information. In contrast, there is a component of estimation risk that is permanent because we a.s.sume that asset return distributions have stochastic parameters or random parameters that vary over time. In this context, we can define a low predictability asset as one whose true return distribution has parameters with higher intertemporal variation than those ofa high predictability asset. In the extreme instance, venture capital investments in industries that thrive on

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innovative technology are very low predictability assets. These firms are probably the market leaders in their industry if not the industry in themselves. Some examples are firms in the biotechnology and tele-communications industries. Such firms face tremendous business risk which affects project viability. In these instances, investors' posterior distributions of the mean parameter values ol these assets' returns have mean square errors thai persist even as sample information increases. This stochastic parameter risk can therefore be defined as that component ofthe variance ofthe asset's predictive return distribution that is attributable to the intertemporal variation of parameters of its true return distribution. In this analysis, estimation risk comprises both information and stochastic parameter risks. Ilestimation risk is partly non-diversifiable, the expected value of a venture capital investment given estimation risk will be lower than that in the absence of estimation risk. Wang (1989) considers this discount in firm value as a risk premium. The analysis implies that this risk premium would decrease as estimation risk is dissipated with increasing infomiation or predictability of asset returns. In a similar development, Stulz (1986) models monetary policy uncertainty and how households learn about the distribution of money growth over time. Households use a predictive distribution of money growth to determine their holdings of risky assets. An increase in monetary policy uncertainty means an increase in the variance ofthe predictive distribution for money growth. He shows that when the risk premium for nominal assets is positive, the risk premium would increase with the variance ofthe predictive distribution for money growth. Lam (1988) finds empirical evidence that the average daily return on a sample of 100 initial public offerings declines exponentially with the number of trading days after listing while their cumulative average return remains significantly large and positive over the 25-day period after listing. Moreover, both Lam (1988) and Clarkson and Thompson (1990) find that the mean beta estimates of initial public offerings has a transitory component. This result suggests that information risk has an impact on both the returns and beta estimates of low information assets. It also implies that investors' predictive returns on such low information assets covary with those ofthe market. Both my analysis and this empirical evidence therefore suggest that an increasing proportion ofthe value added by the venture capitalist can be realized as the initial public offering seasons in the aftermarkct. This analysis implies that part ofthe estimation risk in the valuation of a venture capital investment is transitory. Wang (1989) also shows that imperfect information leads to temporary deviations in prices from their fundamental values. This analysis ofthe impact of estimation risk on the valuation of venture capital investments leads us to the question: How long will such deviations in price from the fundamental value persist? While this analytical framework docs not offer a closed-form solution to this question, it does offer implications

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for the 'cashing-out' policy of a venture capitalist or an entrepreneur. The objective of a venture capitalist is to 'cash-out' on his investment with maximum returns. Say, in a profitable venture, he can consider selling oui in a negotiated private placement prior to the firm going public, or divesting after a public offering. This analysis implies that part ofthe risk premium wili dissipate after a public offering as information about firm value increases. This is to say that for a given fundamental value of a firm, an investor can realize a higher return if he divests his investment after the firm has gone public.

CONCLUSION

Venture capital investments are high returnshigh risk investments. However, there is little discussion in the literature as to how value is added to a venture capital firm. This study identifies the sources of value added by the venture capitalist at various financing stages. It shows how the value ofthe firm increases with successive venture capital investments. A venture capitalist realizes his share ofthe value added only when he 'cashesout' his investment. The three commonest 'cash-out' alternatives for a venture capitalist including selling out to another buyer, buying out by the entrepreneur and taking the firm public. The venture capitalist usually provides tor a sellout or a buy-out by way of a put option. In any of these three cases, the firm has to be valued. This study specifically discusses the impact of estimation risk on firm value. The analysis on estimation risk implies that the expected firm value absent estimation risk will be discounted if estimation risk is non-diversifiable. This means that a venture capitalist cannot fully realize his share of the value added in a low information environment. F'urthermore, if part ofthe estimation risk is transitory and can be significantly dissipated in the aftermarket after the firm goes public, then it pays a venture capitalist to adopt a graduated 'cash-out' policy in taking a firm public. This paper has implications for the valuation of a venture capital investment in sequential investment and 'cash-out' decisions. Traditional valuation techniques in fundamental analysis like discounted cash flows cannot provide the answers for these decisions. However, Majd and Pindyck (1987), McDonald and Siegel (1985 and 1986) and Carr (1988) show that the option valuation approach may be well-suited for such sequential investment decisions. Though we cannot apply the Black-Scholes (1973) option pricing approach for nontraded assets, more generalized option pricing approaches have been suggested in the literature. For example, Constantinides (1978), Cox, Ingersoll and Ross (1985) and Bailey (1989) show that equilibrium asset values and returns can be completely specified as a function of the underlying state variables. Again, these underlying state variables need not be traded assets. Moreover, unobservable parameters (like estimation risk) can be incorporated in the valuation, as in Detemple (1986). This is the subject of further research.

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