Investment, Duration, and Exit Strategies for Corporate and Independent Venture Capital‐Backed Start‐Ups

• Date: 01 June 2015
• Published date: 01 June 2015
• Author: Yun Lou,Bing Guo,David Pérez‐Castrillo
• DOI: http://doi.org/10.1111/jems.12097

Investment, Duration, and Exit Strategies for

Corporate and Independent Venture Capital-Backed

Start-Ups

BING GUO

Universidad Carlos III de Madrid

Business and Administration Department

Calle Madrid 126, Getafe 28903, Spain

bing.guo@uc3m.es

YUN LOU

HEC Paris, Department of Accounting and Management Control

1 Rue de La Liberation, Jouy-en-Josas

Paris, France

lou@hec.fr

DAVID P´

EREZ-CASTRILLO

Universitat Aut`

onoma de Barcelona and Barcelona GSE

Department of Economics

Edifici B

Bellaterra 08193, Barcelona, Spain

david.perez@uab.es

We propose a model of investment, duration, and exit strategies for start-ups backed by venture

capital (VC) funds that accounts for the high level of uncertainty, the asymmetry of information

between insiders and outsiders, and the discount rate. Our analysis predicts that start-ups

backed by corporate VC funds remain for a longer period of time before exiting and receive larger

investment amounts than those financed by independent VC funds. Although a longer duration

leads to a higher likelihood of an exit through an acquisition, a larger investment increases the

probability of an IPO exit. These predictions find strong empirical support.

1. Introduction

Entrepreneurs and venture capitalists make investment decisions and choose the length

of their involvement in a start-up to maximize the chances of success and the value of

their ventures. Looking ahead, they also develop strategies to cash in on their companies.

We thank Albert Banal-Esta˜

nol, Marco Da Rin, Gary Dushnisky, Mar´

ıa Guti´

errez, Laurent Linnemer, In´

es

Macho-Stadler, Eduardo Melero, Philipp Meyer, Manuel N ´

u˜

nez-Nickel, Pau Olivella-Cunill, Neus Palom-

eras, Pedro Rey-Biel, Sara de la Rica, Pablo Ruiz-Verd´

u, Jo Seldeslachts, Anna Toldra-Simats, Arvis Ziedonis,

two referees, a co-editor of JEMS, and participants at the MOVE workshop on venture capital, the 2011 LSE

Alternative Investments Research Conference, the Symposium of Industrial Organization and Management

Strategy, EARIE 2012, the Sixth Annual Conference on Innovation and Entrepreneurship at Northwestern

University, and seminars at Universidad Carlos III de Madrid, CREST, GATE, Ben-Gurion University of the

Negev, and University College Dublin, for their helpful suggestions. We are grateful to AGAUR, research

projects ECO2009-07616, 2014SGR-142, ECO2012-31962, ECO2010-22105-C03-03, ECO2013-45864-P and IN-

FOINNOVA (03513A), the Government of Catalonia, ICREA Academia, and the Severo Ochoa Programme

for Centres of Excellence in R&D (SEV-2011-0075) for financial support. We also thank Gary Dushnisky for

sharing the VEIC-SIC Concordance with us. P´

erez-Castrillo is a MOVE fellow.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 2, Summer 2015, 415–455

416 Journal of Economics & Management Strategy

In particular, these strategies allow venturecapitalists to liquidate their shares. Planning

an exit strategy is as important as deciding how to start the enterprise.

There are two main exit routes for a successful start-up. The company can go

through an Initial Public Offering (IPO) or it can be sold to an existing firm via an

acquisition.1Under an IPO, the venture obtains a stock market listing, which enables

the company to receive additional financing for its projects and enables insiders to

eventually sell their shares to the public. If the start-up is acquired, the insiders obtain

immediate cash in return for their shares. Understanding the main trade-offs faced by

start-ups at the exit stage is crucial because this understanding not only allows one to

determine how venture capitalists and entrepreneurs divest their companies but also

how the decisions are taken at the onset of the venture.

The optimal exit route for a start-up depends on multiple factors, such as the

expected profitability of the venture, the level of uncertainty, the asymmetry of infor-

mation between the insiders and outsiders (e.g., potential buyers and new investors),2

the possible conflicts of interest among insiders,3the financial market conditions at the

time of the exit, and the characteristics of the venture capitalists. Whether the start-up

receives financing from Corporate Venture Capital (CVC) funds or only from Indepen-

dent Venture Capital (IVC) funds may be of particular importance. Some of these factors

are affected by the level of the partners’ investment as well as their decision concerning

the duration of the venture (i.e., the length of the relationship between the entrepreneur

and the VCs until the exit of the start-up). That is, there is a strong link between the

decisions concerning investment and duration and the exit route finally chosen by the

start-up.

We build a model that encompasses three crucial decisions in the lives of start-

ups (investment, duration, and exit) rather than focusing on other, albeit interesting,

aspects that appear at particular moments in time. This modeling strategy allows us to

obtain theoretical results concerning the aforementioned decisions, which we test using

data from U.S. start-ups. We propose a simple model that accounts for the high level

of uncertainty regarding the returns from an investment in a start-up, the existence of

private information in the hands of insiders, and the discount rates of the partners in

the start-ups. We choose to study a rather parsimonious model in which we abstract

from possible internal conflicts among insiders and the dynamic interaction between

investment and duration.

In our model, the amount of capital invested in a start-up influences the start-up’s

expected value. We assume that a higher investment leads to a higher expected value

of the start-up. Furthermore, the decision regarding the duration of the start-up affects

the market information about the probability of the venture’s success. We assume that

the potential value of the venture at the time of its exit will be known to every market

participant. Nevertheless, insiders have more precise information about the expected

profitability of a start-up because they know the probability of its success. Whether

outsiders are informed of this probability depends on how long the start-up remains in

the market before exiting.

1. Two other exit routes that are not as commonly used are Management Buy-out and Refinancing (or

secondary sales); see Schwienbacher (2010).

2. See Cumming and MacIntosh (2003) for a discussion about the information asymmetries between sellers

and the potential buyers of start-ups.

3. See, for instance, Gompers (1995); Kaplan and Str ¨

omberg(2003); De Bettignies (2008); and Macho-Stadler

and P´

erez-Castrillo (2010).

Investment, Duration, and Exit Strategies 417

We show that the ventureswith a higher expected value are more likely to attempt

an IPO, whereas those with a lower expected value prefer to seek an acquirer. Moreover,

the likelihood of exiting through an IPO increases with the potential value of the start-up

as long as that value is positive. In contrast, start-ups with a negative potential value are

liquidated. We link a start-up’s exit strategy with the investment decision and with the

market level of information. We show that a higher investment level induces a greater

likelihood of a successful exit. Of the successful exits, the higher the investment level is,

the higher the likelihood of an IPO exit. Moreover, the IPO exit rate is lower if outsiders

receive more precise information, that is, if the duration of the venture is longer. Finally,

we analyze the optimal investment and duration decisions of the start-up. In particular,

we show that both the level of investment and the duration of the venture decrease with

the discount rate of the venture capital.

In the empirical part of the paper, we test our theoretical results by analyzing the

differences in the investment, duration, and exit strategies of the start-ups depending

on the type of the venture capital fund. We focus on the fact that CVC funds are more

patient than IVC funds in realizing financial returns from their investments in start-

ups, and we analyze how this difference influences the strategies of the start-ups.4

Our empirical results confirm the theoretical predictions: CVC-backed start-ups receive

larger investment levels and have longer durations before their exit than start-ups that

only receive IVC financing. Moreover, these two consequences of the presence of CVC

funds in the start-ups have opposite impacts on the likelihood of an IPO exit: the larger

investment level increases the likelihood of an IPO exit whereas the longer duration

increases the probability of an exit though acquisition. Once these effects are considered,

the type of the VC fund has no significant influence on the exit decision.5

We acknowledge that, in the empirical tests, thereexists an identification problem,

because start-ups are not randomly matched with different types of VC investors (i.e.,

CVCs vs. IVCs). To mitigate the endogeneity problem, we use both a treatment-effects

model to test the effect of the VC fund type on the investment, duration, and exit

strategies and an instrumental variable approach to test the exit strategy. In the first

stage estimation of the treatment-effects model, we identify that the probability of a

start-up receiving CVC funds, compared with only receiving IVC financing, increases if

the start-up is in an industry with a higher average liquidity level, a higher average net

cash flow,or if it is in a geographical area with more CVC funds compared to IVC funds.

CVCs also invest more in start-ups with a higher number of patent applications. After

controlling for such effects on the matching between start-ups and CVC financing, we

find that our main predictions from the theoretical model are confirmed. Moreover, we

construct two instrumental variables for the endogenous variable (start-ups financed by

CVC funds): 5-year average working capital at industry level (to capture liquidity) and

the average CVC investment as a ratio of the total investment in a geographical area.

The instrumental variable estimation shows very similar results.

The main message of the paper is that the joint analyses of the major decisions

taken by the start-up at several moments of its life helps us better understand how the

nature of the VC fund influences these decisions. Abstracting from differences in the

4. In the next section, we discuss the nature of CVC and IVC funds and the implications of the differences

between the two types of fund on their patience in terms of investments.

5. We provide additional evidence of the effect of the discount rate by also analyzing the influence of the

VC fund size on the investment level, duration, and the likelihood of an IPO. The effects are similar to those

induced by the presence of CVC funds, which agrees with our theory because the discount rate of a fund is

likely to decrease with its size.