Venturing beyond the IPO: Financing of Newly Public Firms by Venture Capitalists

• Author: MICHELLE LOWRY,PETER ILIEV
• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/jofi.12879
• Date: 01 June 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 3 •JUNE 2020

Venturing beyond the IPO: Financing of Newly

Public Firms by Venture Capitalists

PETER ILIEV and MICHELLE LOWRY∗

ABSTRACT

Contrary to conventional wisdom, we document that approximately 15% of venture

capitalist (VC)-backed firms raise additional capital from VCs in the five years af-

ter going public. We propose two explanations for why firms revert to VC financing

post-IPO (initial public offering). First, we hypothesize that VC participation in post-

IPO financing represents an efficient solution to informational problems that would

otherwise constrain firms’ abilities to exploit value-increasing investments. Analy-

ses of firm and VC characteristics, together with the finding that these investments

are value-increasing for both VCs and the underlying companies, support this hy-

pothesis. We find no support for the alternative that agency conflicts motivate these

investments.

ALARGE BODY OF LITERATURE documents that venture capitalists (VCs) focus

on young private companies, generally in high-tech industries. As Metrick and

Yasuda (2011) succinctly state, “A VC invests only in private companies. . . .

A VC’s primary goal is to maximize its financial return by exiting investments

through a sale or an initial public offering (IPO).” We show, however, that

these same investors fund companies after the IPO as well. In a sample of

private firms that go public for the first time, 15% of the firms backed by

VC financing prior to the IPO received additional funding from VCs within

the first five years after the IPO. Approximately half of these post-IPO VC

financings were from the same VC that funded the company prior to the

IPO. Press releases on these financings provide suggestive evidence of their

importance to the underlying companies. For example, when Fatbrain.com

received funding from their pre-IPO VC (Vulcan Ventures) one year after going

public, the company highlighted how the funding would help them bring their

∗Peter Iliev is with Pennsylvania State University. Michelle Lowry is with Drexel University.

We thank Dan Bradley; Casey Dougal; Matt Gustafson; Fabrice Herve; Jay Ritter; Anil Shivdasani

(a referee); Ralph Walkling;participants at the 2015 ENTFIN Conference at Lyon Business School,

2017 SFS Finance Cavalcade, 2017 Western Finance Association Meeting; and seminar partici-

pants at Aalto University, Drexel University, Pennsylvania State University, Rutgers University,

Purdue University,Temple University, the University of Arizona, and the University of Tennessee

Smokey Mountains Conference. Michelle Lowry thanks the Raj & Kamla Gupta Governance In-

stitute for financial support. We have read The Journal of Finance disclosure policy and have no

conflicts of interest to disclose.

Correspondence: Michelle Lowry, Drexel University, finance department, 3220 Market St,

Philadelphia, PA 19104; e-mail: michelle.lowry@drexel.edu.

DOI: 10.1111/jofi.12879

C2020 the American Finance Association

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1528 The Journal of Finance R

product to market, stating that, “We view the increased support of Vulcan as

a powerful endorsement of our success.”1

Viewing an IPO as the point at which public equity financing becomes

cheaper than VC financing, the patterns above raise the question of what leads

firms to revert to VC financing after going public. We focus on two factors that

potentially cause the relative cost of VC financing to decrease, and cause VC

financing to dominate other forms of capital for newly public firms. We refer to

these as the Information Asymmetry Hypothesis and the Agency Hypothesis.

The Information Asymmetry Hypothesis posits that VC participation in post-

IPO financing is an efficient solution to informational problems that would oth-

erwise constrain firms’ ability to exploit value-increasing investments. Many

newly public firms are undergoing rapid growth and change, making them sen-

sitive to unexpected shocks. Akerlof (1970) and Myers and Majluf (1984)show

that high information asymmetry in such firm-years can make it prohibitively

costly to raise public equity because investors rationally conclude that on aver-

age such firms are overvalued. Further,for many firms, a lack of collateralizable

assets prevents debt from being a viable alternative. Absent an intermediary

that has a comparative advantage in overcoming this information asymmetry,

firms are better off not raising financing, even if the lack of capital forces them

to forgo positive net present value (NPV) projects. The experience, skill set, and

information advantage of the VC give it a unique advantage in overcoming this

information asymmetry and identifying companies with positive NPV projects.

A VC’s comparative advantage, as posited by the Information Asymmetry

Hypothesis, stems from several sources. First, the VC’s prior interactions with

a given firm or with similar firms enable it to better assess “true” firm value.

Second, the VC’s in-depth industry knowledge makes it easier for management

to convey its business model and projected uses of capital. Finally, VCs have

relatively long investment time horizons, suggesting they may have less liquid-

ity pressures than other providers of capital. In sum, VCs are well positioned

to prevent a market breakdown of the type discussed by Akerlof (1970).

The Agency Hypothesis, in contrast, is based on the idea that VCs are moti-

vated by factors other than just the NPV of underlying investments. As shown

by Carpenter (2000) and discussed by Barrot (2017) and Nanda and Rhodes-

Kropf (2018), the convexity of VC compensation contracts incentivizes man-

agers to condition investment decisions on prior performance. VCs typically

earn a 2% management fee that is based on the total capital raised from lim-

ited partners (LPs), plus 20% of cumulative fund profits (commonly referred to

as carried interest). This convexity incentivizes managers of poorly performing

funds to invest in high-risk companies—they face little downside if these gam-

bles do not pay off, but substantial upside if they do. At the same time, managers

of funds with high past performance are incentivized to invest in lower risk com-

panies, to lock in the carried interest.2In sum, the structure of compensation

1See FatBrain.com’s November 1, 1999 8-K filing in the EDGAR system.

2The incentive to protect gains is potentially exacerbated by the concave relation between past

VC performance and fund size, which Kaplan and Schoar (2005) attribute to VCs’ voluntarily

Venturing beyond the IPO 1529

contracts can motivate VCs to prioritize risk over NPV. Although public firms

may be either high or low risk on average, the key potential advantage of public

firms is their higher liquidity, which enables VCs to lock in gains more quickly.

VC investments in public firms generally represent private investments in pub-

lic equity (PIPEs). In such investments, the investor can sell shares any time

after the shares are registered, typically three to four months after the offering.

Agency-related factors are likely to be particularly strong among young VC

firms. Gompers (1996) concludes that younger VC firms have greater needs

to establish a strong record quickly, so as to increase their ability to raise

follow-on funds. Lee and Wahal (2004), Tian and Wang (2014), and Barrot

(2017) provide additional support for such dynamics.

To test these two alternative hypotheses, we examine the post-IPO VC

financings from a variety of angles. Our first set of tests examines the charac-

teristics of firm-years with post-IPO VC financing, and the types of VCs that

provide this financing, using measures for the extent of a firm’s information

asymmetry, market conditions, the VC’s information advantage, and the VC’s

agency costs. We contrast the relevance of these factors across four forms of

financing: seasoned equity offerings (SEOs), syndicated loans, PIPEs in which

no VC belongs to the syndicate (which we heretofore refer simply to as PIPEs),

and post-IPO VC financings.3Among our sample of venture-backed IPO firms,

68% raise additional capital within five years of going public through one of

these means. The lowest percentage relies on PIPEs (10%) and the greatest

percentage relies on syndicated loans (41%). The percentage of firms raising

capital from a VC, 15%, lies between these two extremes.

Differences in firm characteristics across these various forms of financing are

striking. Most pertinent to our analysis, only post-IPO VC financings are char-

acterized by firms with particularly high information asymmetry and by the

pre-IPO VC investors (which are more likely than any other VC to invest after

the IPO) having a particularly high comparative advantage in overcoming this

asymmetry.None of the other three forms of post-IPO financing is characterized

by both these features. This difference is consistent with firms strategically

choosing the optimal form of financing, and with information asymmetry being

a driving factor behind a firm’s decision to turn to VCs for this financing.

Tests at the VC level, which enable us to measure the information advantage

of potential VC investors more precisely, provide further support for the

Information Asymmetry Hypothesis. Across all VCs in our sample, those with

the greatest information advantage, for example those that have previously

invested in the firm or that serve on the firm’s Board of Directors, are consis-

tently significantly more likely to provide such financing. Across a battery of

specifications, we find no evidence that VCs’ agency-related motivations, for

staying smaller (because VC success is not scalable). The implication is that the marginal benefits

of performance are more limited above certain thresholds.

3Most post-IPO VC financings are structured as PIPEs, but for clarity we refer to them as

post-IPO VC financings.